CALCULATION THE REVENUE REQUIREMENTS prof. Vidmantas Jankauskas honorary ERRA member Budapest, March 6, 2013
Contents Pricing principles Revenue requirement (RR) formula and data sources Cost evaluation Valuation of the regulatory asset base (RAB) Ownership vs lease of assets Depreciation Cost of capital
Pricing principles
Different interests in pricing consumers want low prices and high quality energy companies want to maximize their profits politicians want low prices (especially for residential consumers voters) but also want to protect companies sponsors of election campaigns regulators want fairness balance interests of all
Pricing objectives least cost cost reflection cost recovery stability of revenues and tariffs simplicity and public acceptability fairness (no discrimination) no cross-subsidies
The main principle of the price regulation The regulator should set regulated tariffs for the regulated companies so that the regulated tariffs allow the companies to earn a revenue that covers the justified costs of their operation, that is the costs that are necessary and unavoidable to provide the regulated service at a predefined level of quality
More principles of tariff regulation Prices should not endanger financial viability of regulated companies. All justified costs must be covered, including opportunity cost of capital assets. Price regulation should stimulate more efficient functioning. Productive and allocative efficiency are also aimed incentive price regulation. Price regulation should be transparent and consistent. Simplicity of price structures can establish trust the regulation. Frequent and unexpected interventions should be avoided. Regulators are always in an imperfectly informed position. V.Jankauskas 7
Cost coverage The prices / tariffs set by the regulator should (just) allow for the recovery of the justified cost of the activities that fall under price regulation A pre-defined level of service quality should be guarantied Vertically integrated industry: end customer tariffs should cover the aggregate justified costs of the whole value chain (production + net imports + networks + storage V.Jankauskas + retail + taxes) 8
Pricing in a competitive market regulated Wholesale: Bilateral, PX System use charges: Network use System operation Crossborder capacity use Retail margin: Risk management services (wholesale, credit risk) + + = V.Jankauskas Final purchase price + taxes 9
Pricing is a two step procedure 1. Regulator determines the revenue requirements for the regulated company 2. Regulator chooses a tariff structure which allows the company to obtain enough revenues to cover its cost and earn a reasonable return alternatively Regulator revises a tariff structure proposed by the company
Sometime it is seen as a three step procedure 1.Regulator determines revenue requirements for the regulated company 2.Revenue requirement is spread among the various consumer classes and services that the company sells 3.Actual tariffs charged to consumers are developed
An average tariff Average tariff = Revenue requirement Consumption volume Both numerator and denominator are forecasted values V.Jankauskas 12
Calculation of the revenue requirement V.Jankauskas 13
Calculating the revenue requirement Revenue Requirement - total (annual) revenue which covers the operating expenses (including depreciation and taxes) of supplier(s) of a given service or product and ensures (them) a fair rate of return on assets utilized. Setting revenue requirement (RR) can substantially affect the profitability of the firm as well as the costs of ratepayers. Calculating RR is usually the first step of each well-known price regulation methodology (cost-plus regulation, incentive price regulation methods etc). V.Jankauskas 14
The main formula Typical formula of revenue requirement (RR) is the following: RR = O + D + T + r*b where RR = Revenue Requirement O = Operating Expenses D = Depreciation T = Taxes r = allowed rate of return B = rate base (or regulatory asset base RAB) V.Jankauskas 15
Data collection and analysis: 3 goals Collection of information (input data) for tariff-setting Control and feedback of existing tariffs (support of on the run price regulation: X- factor, profit cap, individual cost review) Possession of up-to-date data for ongoing issues (debates with firms, questions of politicians and/or consumers, publications) V.Jankauskas 16
Financial Statement (annual report) of a regulated company contains - Balance sheet - statement of the book value of the company at a particular date (end of the fiscal year) - Income statement (profit and loss account): records revenue and expenses over a specified period of time - Cash-flow (CF) statement: refers to the amounts of cash being received and spent during a defined period of time V.Jankauskas 17
Balance sheet The only statement which applies to a single point in time, instead of a period of time (also called snapshot of the company s financial condition). Classifies company s worth in two ways: according to time of use (current or fixed assets) and way of finance (shareholders equity and liabilities). Fixed assets + Current assets = Shareholders Equity + Liabilities V.Jankauskas 18
Balance sheet of the distribution company VST as of December 31, 2011 Assets MLTL Liabilities and equity MLTL Fixed assets 2164 Equity 1445 Current assets 188 inventories 10 Liabilities account receivables 102 long term 544 securities 62 short term 464 Prepaid expenses 13 TOTAL ASSETS 2454 TOTAL LIABILITIES and EQUITY 1 = 3.4528 LTL 2454 V.Jankauskas 19
Income statement Income statement records revenue and expenses over a specified period of time It indicates how revenue is transformed into net income (result after all revenues and expenses have been accounted for). Income statement is a non-cash approach of reporting company s result V.Jankauskas 20
Income statement of the distribution company VST as of December 31, 2011 Revenues and expenditures MLTL Total sales 1156 Other revenues 5 Cost of purchased electricity (831) Labour cost (79) Depreciation (231) Other expenses (26) Operating profit (65) Financial profit/loss (5) Profit before taxes (70) Taxes 13 Net profit V.Jankauskas (57) 21
Cash-flow statement CF refers to the amounts of cash being received and spent during a defined period of time. It is used to determine problems with liquidity. Shortage of cash can happen even while company is profitable (and vice versa)! Operational CF: result of the company s core business Investment CF: result of investments and acquisitions Financing CF: result of financial activities (receiving or paying loans, issuing stock, paying dividends etc.) V.Jankauskas 22
Why is Financial Statement (FS) useful for regulators? FS is prepared in accordance with general accounting rules, enacted by law. Thus reports of different companies are comparable FS is audited by accountants FS is not made directly for the regulator, annual report can be regarded as a real and reliable publication Publicly available for everybody who is interested in the financial performance of the company FS disclose overall picture on economic performance of the companies V.Jankauskas 23
What are the problems with Financial Statement? Within general accounting rules companies are free to evaluate their assets and liabilities (accounting policies). Thus comparability is limited. FS refers to the whole, usually vertically integrated company, regulated activities are not separated. FS is prepared and published once a year. Regulator s price regulation policies are not in line with companies internal accounting policies (problem of reasonable costs and assets). V.Jankauskas 24
Therefore Regulator asks for additional data supplies Financial Statement is appropriate for continuous economic monitoring, and as a starting point for price regulation as well Regulator usually asks for additional data supplies from the regulated companies Some balance between the necessity to understand of operation of the company and not missing in insurmountable volumes of data Regulator should not manage the regulated company! V.Jankauskas 25
Example: Lithuanian NCC requires Electricity distribution company (distribution licence holder) should submit the following reports: Quarterly reports general on quality of service (interruptions, disconnections, etc.) Annual reports on general activities connection of new customers connection of renewable generators consumer complaints V.Jankauskas 26
More problems with data Shared and centralized services within the vertically integrated holding (IT, legal services, accounting etc.) Regulatory tasks and competences concerning outsourcings Market-based pricing of outsourced services and acceptance by the Regulator Tariff-increase because of structural changes? V.Jankauskas 27
Asymmetry of information Regulator Regulated company Decisions to be made on the basis of best available information V.Jankauskas Distort information in order to serve the profitability objective (shareholders interest) 28
Cost (operating expenses) evaluation V.Jankauskas 29
Operating expenses Operating expenses (costs) (O) are related to operating and maintaining the utility plant and providing the utility services Main items are: - Fuel (generation) - Purchased power (wholesale and retail supply) - Maintenance (generation, transmissiondistribution) - Labour costs (staff expenses). - Services V.Jankauskas 30
Cost allocation Operating expenses(o) are related to operating and maintaining the utility plant and providing the utility services - O&M (Operations and Maintenance) costs can be directly assigned to particular operating functions - A&G(Administrative and General) costs have to be distributed among operating activities indirect costs V.Jankauskas 31
Cost of network losses Technical losses losses associated with the transmission and distribution of electricity Non-technical (commercial) losses losses due stealing energy and losses due to accidents Influencing factors: quantity (or percentage) average price of electricity V.Jankauskas 32
Example: electricity distribution losses in Hungary 14 12 10 8 6 4 set by HEO real 2 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 V.Jankauskas 33
Necessary costs Regulator will accept only reasonable and necessary costs in calculation of the Revenue Requirement How to know if certain costs are reasonable and necessary? Benchmarking if there are several similar companies (e.g. electricity distribution) International benchmarking may give some comparison, but due to different legal background it could also mislead V.Jankauskas 34
Historic data Historic data is very useful for understanding the costs levels as also their development But one should ask if company was managed and operated efficiently When setting tariffs regulator needs to evaluate the future costs, therefore some forecasts should be calculated The forecasts should evaluate the historic trends, current developments and make comparisons with such costs elements of similar companies V.Jankauskas 35
Normative values Some regulators are trying to give a scientific justification to almost all cost elements theoretical values are calculated based on complicated formulas and assumptions Though it is rather popular, especially in the CIS countries, one should understand that theory may significantly differ from reality Therefore, theoretical normative values may be used as benchmarks only Price regulation is more art than science V.Jankauskas 36
RAB calculation V.Jankauskas 37
Regulatory asset base (RAB) RAB usually refers to the measure of the net value of a company s regulated assets used in price regulation RAB drives two of the fundamental building blocks that make up the company s revenue requirements: the return on capital (i.e. the return on the RAB) and the depreciation allowance RAB is a key determinant of prices that may be charged for regulated services in the future V.Jankauskas 38
RAB initial value RAB is compilation and summation of the assets used in providing the regulated service generally only includes those assets funded with investor money regulators do not generally recognise intangible assets such as goodwill RAB should include the assets used for the provision of the regulated services only excludes customer contributed assets RAB is the investment base upon which the provider is permitted to earn a reasonable return V.Jankauskas 39
Fair value of RAB provision of certainty for investors provision of incentives for investors fairness - including: sharing benefits between investors and customers continuity of initial price level for social reasons provision of correct price signals for consumption, investment etc. interpretation of the regulatory contract - in what state are assets expected to be kept? V.Jankauskas 40
RAB calculation Opening value Prudent capital expenditures Asset disposals or retirements Regul. accumulated depreciation + - - = Net asset balance V.Jankauskas 41
RAB calculation: net approach The regulatory asset base for the year t is calculated according to the following formula: CB = OB + Inv - D - AD - DC + DWC where: OB - opening value of regulatory assets for year t of the regulatory period; Inv - investment (capital expenditures) for year t of the regulatory period; D - depreciation for year t of regulatory period; AD - assets disposal for year t of regulatory period; DC - annual change over year t in the value of assets funded by capital contributions; DWC - annual change over year t in working capital; CB - closing value of regulatory assets for year t of the regulatory period V.Jankauskas 42
RAB calculation: gross approach The closing value of the RAB for year t of regulatory period might be expressed by the following formula: where: CB = CFA - CCC CWC CFA = OFA + Inv - D - AD CB - closing value of regulatory assets for year t of regulatory period; CFA - closing value of fixed assets for year t of regulatory period; CCC - closing value of capital contribution; CWC - closing value of working capital V.Jankauskas 43
Capital contributions Capital contributions comprise of: grants obtained from international institutions and/or the government and direct payments by the user of a specific service for an asset, e.g. connection payments The assets financed by the capital contributions should be excluded from the RAB Therefore, it is necessary to disclose the values of capital contributions (for existing assets and for new investments) in order to ensure transparency of the process V.Jankauskas 44
Regulators should require that The net asset value of capital contributions and the relevant accumulated depreciation should be shown separately on the balance sheet for each energy activity; Capital contributions should be split into those associated with grants, connection contributions and other capital contributions; Where exact splits cannot be identified the regulated companies should provide estimates as well as an explanation of the methodology adopted and why it is considered appropriate V.Jankauskas 45
Working capital To the extent that the time at which a particular cost is incurred is not matched with its recovery (via tariff revenues), then capital is required to cover the time lag working capital An investment in working capital is a necessary part of conducting a regulated business In addition, there is also place for a return on the working capital similar to the requirement for a return on capital assets V.Jankauskas 46
Working capital regulatory treatment There are different approaches for working capital treatment in the regulatory price control In general, regulators want to give companies an incentive to manage working capital well The USA regulatory practices use cash cycle method called lead-lag approach. Some Eastern European (Bulgaria, Romania) regulators allow working capital allowance set equal to 1/8 of the revenue requirements V.Jankauskas 47
Construction work in progress (CWIP) Most of the regulators think that new capital expenditure should be introduced in the RAB on the basis of actual costs incurred up to the point at which the assets become operational Some regulators include construction work in progress in the RAB when construction is to be completed within a relatively short period of time, e.g. in one year There is also the question of prudent investment when considering whether the full cost of new investment should be added to the RAB V.Jankauskas 48
New investments Different type of investments extension investments: all investments needed for meeting the change of load and generation patterns in the future replacement investments: all investments related to replacement of aged (technically or economically) equipment exceptional investments: investment resulting from e.g. new legal obligations. Some investments could be both for network extension and for replacement reasons (e.g. replacement of an old transformer with a new one but more powerful) V.Jankauskas 49
Regulatory asymmetry Information asymmetry company always knows better than the Regulator The regulator will not accurately know the appropriate amount of capital expenditure required by the regulated service providers In this case there may be incentives for the regulated entity to inflate the reported capital expenditure relative to the true cost Investments may be examined from two perspectives: ex-ante and ex-post V.Jankauskas 50
Ex-post assessment of investments Ex-post assessment may be undertaken to supplement the ex-ante investment reviews Regulators aim to identify differences between the capital expenditures allowed in the ex-ante review and the actual investments undertaken by the regulated company Regulatory ex-post checks can also be undertaken without any previous ex-ante approval of the investments In this case, the companies are confronted with the uncertainty of whether the undertaken investments will be recognised by the regulator ex-post.
Used and useful concept Regulator needs to consider whether the company s assets are sufficient to carry the regulated activity On the other hand, if a regulated company has excessive number of assets the regulator may decide not to include these assets into the RAB Although the assets are being used the question is whether they are actually useful V.Jankauskas 52
Asset valuation V.Jankauskas 53
Asset valuation options Asset valuation Book valuation Market valuation Economic valuation Historic cost Current cost Current Revalued initial Net present value Indexed historic value Modern equivalent asset V.Jankauskas 54
Historic cost The historic cost methodology values assets at their original purchase price It has several advantages: it is administratively efficient and can be easily audited because the data should be available from financial statements; it is relatively inexpensive since it does not require experts to determine costs; and it is objective because it relies on actual data rather than judgements V.Jankauskas 55
Historic cost - disadvantages Historic costs may understate asset prices in times of high inflation and overstate asset prices in times of technological change this method may lead to unstable prices (e.g. prices may rise when new, more expensive assets replace existing assets) data may be inadequate (especially for assets that have been acquired a long time ago) and returns may also be inadequate to support the funding of new investments V.Jankauskas 56
Indexation This is the procedure for adjusting the value of the asset base for the effect of inflation Indexation should measure movements in the current replacement cost of the assets Consumer price index or industrial price index? A set of industry-based indices would be more accurate but too complex V.Jankauskas 57
Replacement cost Calculates the cost of replacing an asset with another asset (not necessarily the same) that will provide the same services and capacity as the existing asset The assets are valued based on what it would cost to replace them today Replacement costs reflect the price that a firm with a certain service requirement would pay for existing assets in preference to replicating the assets V.Jankauskas 58
Replacement cost advantages and disadvantages Advantages Disadvantages provide an incentive for efficient investment decisions as it allows the regulator to reduce the value of the assets once it becomes aware that a more efficient low cost alternative asset is available this reduces the risk of economically inefficient duplication of infrastructure replacement cost valuations entail a degree of estimation and judgment the information is more expensive to collect than historic cost data because it may require expert advice V.Jankauskas 59
Fair market value Sum of the prices that would be obtained from selling each of the assets in a competitive market What a third party would pay in an arm s length transaction Difficult if no active market, especially for large, specialised items Romanian example V.Jankauskas 60
Net present value Sum of the discounted cash flows associated with each asset Predict the cash flows expected to be generated, then discount it back to present values using appropriate risk-adjusted discount rate Discount rate is often a key determinant of the result V.Jankauskas 61
Valuation of assets in the CEE countries In many CEE countries assets of the energy companies were not properly valued, historic cost was very low Indexations were not sufficient and many countries introduced the replacement cost principle for re-evaluation E.g. in Romania asset value of the distribution companies after the re-evaluation increased from 3 to 7 times But it was impossible to put it into the revenue requirement V.Jankauskas 62
Bad example: Lithuania One of the two distribution companies (0.7 million customers) was privatised in 2003 by the local biggest retailer Competitive process, good price, but Law on Electricity was amended after the privatisation, in 2004 Assets were re-valued in 2004, increasing their value by factor 3 Consequently tariffs were raised Result: consumers complaining that the private investor caused such an increase of tariffs
Lessons from the CEE countries Privatisation of the distribution utilities in Bulgaria, Romania and Macedonia has shown that necessary to increase the asset value before the privatisation as it was usually kept too low could be too painful to switch to the replacement value of assets therefore it is important to agree on the revaluation of assets before the privatisation and on their further regulatory treatment Romania agreed on the market value V.Jankauskas 64
Example: RAB calculation in some CEE countries Country CWIP included CC included Assets value Revaluation Bulgaria no yes historic yes Croatia yes no historic no Estonia no no historic yes Hungary no no replacement yes Lithuania no no replacement yes Serbia yes no historic yes Slovakia yes no replacement yes 65
Ownership vs lease of the assets V.Jankauskas 66
Lease of the assets Companies often choose to lease longterm assets rather than buy them for a variety of reasons: the tax benefits are greater to the lessor than the lessees leases offer more flexibility in terms of adjusting to changes in technology and capacity needs and so on V.Jankauskas 67
Ownership of the assets Advantages Outright asset ownership Assets can be modified at any stage to suit changing business requirements Asset can be replaced or disposed of at any time Disadvantages Major capital outlay upfront Entity incurs maintenance and repairs costs which typically increase as assets age Entity incurs costs for the replacement or disposal of assets at the end of their useful lives V.Jankauskas 68
Lease of the assets Advantages Disadvantages Cash-flow effective method for gaining access to assets as no major capital outlay up-front Assets may be replaced more frequently, allowing the entity access to latest technology for no additional cost Possible access to knowledge, purchasing power and discounts offered by the lessor Assets may not be able to be modified and replaced to suit changing business requirements without lessor approval and attracting fees Potential capital outlay at the end of the lease term if purchasing the asset at the end of the lease V.Jankauskas 69
Financial implications The decision to either lease an asset or purchase it requires an analysis of the financial implications of the decision also Financial parameters, such as the interest rate as well as the implied opportunity cost of using the entity's own cash resources, may have a significant impact on the lease versus purchase decision V.Jankauskas 70
Depreciation V.Jankauskas 71
Depreciation The normal usage of assets involves a reduction in their ability to provide a service This consumption of the asset s value should be reflected in the operating costs and capital value of the company When determining a depreciation charge there are similar objectives to those for the RAB Is also a desire for equity - consumers should pay a fair cost for the assets that they are consuming However, since assets often have a longer life than the consumers there may be a strong intergenerational equity question V.Jankauskas 72
Approaches to depreciation Options to consider include: current cost depreciation; historic cost depreciation; depreciation of the initial RAB plus separate depreciation of new investment; and an infrastructure renewals charge Each option effectively impacts on the allocation of depreciation charges between existing and future assets since it alters the level of assets that are presumed to be kept in perpetuity V.Jankauskas 73
Depreciation value Yearly value of depreciation depends on company s depreciation policy Straight line (linear), non-linear, normal, extraordinary, time proportionate, performance related types of depreciation are available Accounting, taxation and regulatory depreciation requirements usually deviate from each other All assets should be depreciated with the exception of land and construction work in progress V.Jankauskas 74
Example: useful life times for calculation depreciation Asset group Life time of a new asset (years) High voltage lines 35 Medium voltage lines 30 Low voltage lines 25 Transformers 25-30 Buildings 50 Vehicles 8 V.Jankauskas 75
Rate of return V.Jankauskas 76
Required profit The forecast level of profit (rate of return) that a company should be able to earn depends on: the value of the company (the RAB) and the forecast rate of return (weighted average cost of capital) Is needed whether using incentive-based or rate of return type regulation V.Jankauskas 77
Rate of return (r) is the expected yield from the company (industry), taking into account the costs of financing the business (cost of capital) The cost of capital is usually measured as the Weighted Average Cost of Capital (WACC) The r sets the return that can be earned on: existing assets and net investment Rate of return This is a mixture of debt and equity V.Jankauskas 78
Rate of return Equity Debt Equity holders are residual claimants on the revenues the rest after all payment obligations are allocated to them Debt providers require a fixed interest rate on their investments Returns of other possible investments with similar risks (opportunity cost) Interest expenses V.Jankauskas 79
Capital gearing ratio It is a financial ratio that compares some form of owner's equity (or capital) to borrowed funds Gearing is a measure of financial leverage, demonstrating the degree to which a firm's activities are funded by owner's funds versus creditor's fund The share of borrowed funds my differ from 30% in the Czech Republic to 70% in Austria (by assumptions of national regulators) V.Jankauskas 80
Weighted average cost of capital WACC = r e E E + D + r d(1 + t) D E + D where r e = required rate of return on equity r d = rate of return on debt E = equity D = debt t = corporate tax rate V.Jankauskas 81
Different tax rates in the EU countries 40 35 30 25 20 15 10 5 0 % 2009 V.Jankauskas 82
Example: Hungarian WACC, distribution network tariffs, 2009 Before tax WACC = (8,92 % * 0,55) + (6,4 % * 0,45) = = 7,79 % C.Kovacs V.Jankauskas 83
Example: Armenian WACC, distribution network tariffs, 2011 Before tax WACC = (17 % * 0,50) + (7 % * 0,50) = 12 % A.Arshakyan V.Jankauskas 84
WACC of some European TSOs 10 9 8 7 6 5 4 3 2 1 0 % V.Jankauskas 85
The cost of debt This is the cost of borrowing funds for the company from the debt markets Could be estimated by considering the Eurobond markets May not be available to most of the companies, but is the key market for determining the cost of funds The cost of debt is defined as a risk-free rate plus a company premium Reality check is to consider the actual cost of borrowing and determine financial indicators V.Jankauskas 86
The cost of equity (r e ) is usually is determined with the Capital Asset Pricing Model (CAPM) r e = r f + β(r m -r f ) where The cost of equity r e = required rate of return on equity r f = risk free rate of return (e.g. treasury bills) β = Beta, the relative volatility of the specific stock to the market r m = market risk V.Jankauskas 87
Beta (β) Beta is a measure of the relative riskiness of the company, with respect to unavoidable risk So, beta is a scalar applied to the equity risk premium The value used in the calculation is the equity beta This measures: underlying business risk (referred to as the asset beta); and financial risk (arising from the debt-equity structure) So, although two companies have the same business risk, if they have different gearing levels then the equity beta will be different V.Jankauskas 88
The country risk calculation Political risk factors existence of special taxes, restriction on fund transfers, protection of local firms, etc. bureaucracy corruption Financial risk factors interest rate inflation exchange rate economy growth To every factor corresponding rating and weight are assumed V.Jankauskas 89
Example: Hungarian WACC, distribution network tariffs, 2009 After tax r e = 4,6 + 0,43 * 5,9 = 7,14 % Before tax r e = 7,14/(1-0,2) = 8,92 % C. Kovacs V.Jankauskas 90
Hungarian example V.Jankauskas 91
Development of price regulation in Hungary Market model Pricing model Components 1997-2000 Single buyer Cost plus and price cap 2001-2004 2005-2008 2009-2012 Single buyer/ hybrid Cost plus and price cap Cost plus and price cap Rate base Equity Book value Replacement value Hybrid/ Competitive Competitive Cost plus and price cap Replacement value Rate of return 8% 9,8% 7,1% 7,8% V.Jankauskas 92 P.Kaderjak
Development of price regulation in Hungary Calculation of r Internat. benchmark Depreciation Components 1997-2000 Law on Taxation 2001-2004 2005-2008 2009-2012 Risk free + premium WACC WACC Law on Taxation Useful life time Useful life time Inflation IPI*k CPI*k CPI-k CPI-k k 0,85-0.95 0,7-0,9 1,8-2,2 0,7-2,3 Network losses 12% 10,8% 8,7% 8,3% V.Jankauskas 93 P.Kaderjak
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