Valuation of the Regulatory Asset Base: Submission on the Commerce Commission s Decision Paper 10 November 2005 051104-powerco submission on valuation of rab.doc
Table of Contents 1 Introduction... 1 2 Re-cap on Powerco s earlier submissions... 2 2.1 Relative merits of alternative valuation methods... 2 2.2 Use of asset valuation information for post breach inquiry and control... 3 3 Appropriateness of ODV... 4 4 Incentives for efficient investment... 5 5 How do other regulators deal with asset valuation and investment incentives?... 6 Australian Competition and Consumer Commission... 6 The Victorian regulator... 8 Ofgem... 9 6 Conclusions... 10 7 Attachment: Specific comments on Draft Decisions... 11 Valuation frequency... 11 Indexing method... 11 Regulatory treatment of capital expenditure... 11 Scope of regulatory asset base... 11 Implications of M&A... 11 Reconciliation... 11 Accounting Standards and Systems, and Relationship with Statutory Accounts... 11 Audit and Independent Review... 12 Reporting... 12 Handbooks and other guideline documents... 12 051104-powerco submission on valuation of rab.doc
1 Introduction 1. On 13 October 2005, the Commerce Commission published a Decision Paper, titled Regulation of Electricity Lines Businesses Valuation of the Regulatory Asset Base. The Decision Paper serves two purposes: (a) It sets out the Commission s final decisions on the valuation of system fixed assets by ELBs for regulatory purposes under Part 4A of the Commerce Act 1986 (the Act). (b) The paper also describes further preliminary decisions on implementation aspects of valuation of the regulatory asset base that flow from the final decisions. 2. Notwithstanding the Commission s making of a final decision in relation to the valuation method to be applied by ELBs: (a) Powerco remains concerned that the Commission has not properly taken into account the matters raised by the company in relation to the risks and investment disincentives associated with ODV; (b) Powerco therefore lodges this submission to reiterate its key points regarding these matters. 3. In addition to re-stating Powerco s views on the disadvantages of the ODV method, the company s submission also provides comments on those elements of the Decision Paper which are draft or preliminary. 4. This submission is structured as follows: Section 2 re-caps on Powerco s earlier submissions on the relative merits of alternative valuation methods. Section 3 sets out Powerco s views on the appropriateness of using ODV to value the capital base in a targeted price control regime. Section 4 explains that within the threshold regime administered by the Commission ELBs which employ indexed historic cost would face incentives for efficient investment, even in the absence of detailed ex-ante reviews of investment decisions. Section 5 examines how other regulators in Australia and the United Kingdom deal with the issues of rolling-forward the regulatory asset base value, and providing incentives for efficient investment. Section 6 sets out concluding comments. The attachment provides Powerco s specific comments on the draft decisions contained in the Decision Paper. 1
2 Re-cap on Powerco s earlier submissions 2.1 Relative merits of alternative valuation methods 5. The Commission s Decision Paper provides a high level summary of Powerco s earlier submissions on the relative merits of alternative valuation methodologies. In particular, paragraphs 113 to 116 of the Decision Paper state: 6. Although the Commission appears to have acknowledged Powerco s submissions in response to the earlier Discussion Paper and Draft Decision, the Decision Paper provides no evidence of the Commission s proper consideration of the matters raised by Powerco. Indeed, the Commission s reasoning for its final decision is explained in the following statement, which appears in paragraph 135: In line with the majority of submissions, the Commission will also now lock in ODV as the mandatory regulatory valuation method. The Commission had already noted in the Discussion Paper that it considers that ODV is an acceptable method for it to use in meeting its statutory requirements, for the reasons that it described in its Discussion Paper. 2
7. This statement suggests that the Commission had formed its view regarding the application of ODV in advance of considering stakeholders input. 8. Powerco considers that the Commission has not properly assessed the company s submissions on the appropriateness of ODV, nor has the Commission given those submissions adequate weight in its final decision. 9. Powerco urges the Commission to re-consider its decision, in light of the submissions already made by the company, as well as the further information set out below. 2.2 Use of asset valuation information for post breach inquiry and control 10. The Commission has said that it intends to use ODV as the measure of the capital base value in monitoring ELB performance under the information disclosure (ID) regime, in setting thresholds, and in imposing control should a post-breach inquiry conclude that control is warranted. 11. Powerco s Submission (dated 23 February 2005) on the Commission s review of the information disclosure regime examined the statutory framework governing the use of disclosed information in post breach inquiry and control. Section 2.2 of Powerco s submission argued that: While the inclusion in Part 4A of both the thresholds and the disclosure regimes might suggest the two regimes are complementary, Powerco disagrees that the information required for the thresholds regime to operate is only a subset of that which may be required under the disclosure regime. In fact, it could be argued that the opposite is the case, i.e. that the information required under the disclosure regime is a subset of that which may be considered by the Commission under the thresholds regime. Section 57D is the interpretation section for Part 4A. When prioritising its duties under the thresholds regime, the Commission may have regard to the quality of information provided to it, and that information (applying the section 57D definition) is not limited to that provided under the information disclosure regime. It is difficult to see, therefore, how information provided under the thresholds regime could be considered a subset of that provided under the information disclosure regime, when the very language of Part 4A suggests otherwise. Care must be taken that the Commission, as the repository of information disclosed by the ELBs pursuant to section 57T, does not then use it for a purpose wider than that contemplated by the Act. The Commission itself has acknowledged that it is not necessarily appropriate to obtain all information required for post-breach inquiries and control through the general information disclosure regime. 12. In short, contrary to the assertions made by the Commission in its Decision Paper, the sections of the Commerce Act which relate to the asset valuation methodology and information disclosure do not necessarily mandate or require that those decisions be the same when it comes to determining the RAB for the purpose of estimating a building block revenue requirement. 3
3 Appropriateness of ODV 13. There are a number of reasons why ODV is likely to provide a negatively biased estimate of the capital base value of an efficiently managed ELB: (a) ODV is a theoretical concept which is intended to provide an indication of the minimum cost of an efficient new entrant to the (natural monopoly) market. In effect, it assumes that all past investment decisions have been made with perfect foresight of the technological, physical and market conditions that will exist when future ODV revaluations are performed. (b) The estimation of the notional cost of an efficient new entrant requires the application of greenfield development assumptions. These assumptions ignore the practical reality that the efficient development of a network takes place incrementally over a long period of time, and in response to the particular technological, physical and market conditions that exist when each individual investment decision is made. (c) ODV is a subjective and therefore inherently risky valuation technique. (d) The actual network is comprised of a mix of assets of differing vintages, scales and technologies, reflecting the different other conditions prevailing when individual investment decisions are made. (e) As a result, the total (efficient) accumulated written-down capital cost of an actual network is likely to be materially higher than the ODV. The following examples illustrate this point: i. Efficient incremental replacement / refurbishment expenditure (for instance, re-poling and re-conductoring of lines) is not explicitly captured in an ODV valuation. ii. iii. Incremental investment required to ensure compliance with increasing health, safety or environmental standards is not fully captured in an ODV valuation. Incremental investment undertaken to improve or maintain network reliability (for instance, installation of possum guards) is not recognised in an ODV valuation. 14. Unless these important considerations are explicitly taken into account in setting price thresholds and controls, the providers of capital will almost certainly fail to recover a normal rate of return on efficient investment. In this context it is noted that: (a) were such an outcome permitted to occur, then providers of capital would face strong disincentives for investment in essential infrastructure; and (b) such an outcome would not be in the long-term interests of consumers. 15. The Commission s asset valuation decision does not take into proper account the risk to investment incentives posed by the ODV valuation regime. In this 4
context, it is noteworthy that the Commission s own adviser (Associate Professor Lally) has stated: 1 ELBs face asymmetric risks, which comprise among other things the risks of assets being stranded or optimised out by the Commission under the ODV method. An ex-ante allowance for this risk could be provided, possibly via an addition to WACC. However, to ensure that investment is forthcoming, one must err on the generous side. Overseas experience suggests that it is very difficult to make ex-ante adjustments for asymmetric risks. An ex-post allowance for asymmetric risk could be provided, but there is always the possibility of ex-post compensation being denied. Since there will always be uncertainty on the part of the businesses as to the regulator s decisions in this area, then a regulator s promise to provide expost compensation must be worth less than face value, in which case businesses face a disincentive to invest. 16. Lally s advice to the Commission demonstrates clearly that providing compensation to investors for the asymmetric risk they bear under an ODV regime is a very significant and challenging issue. However, this problem can be resolved by removing this risk through the application of an indexed historic cost valuation approach. 17. A further source of risk under the ODV approach is the level of subjectivity and variability (from year to year) of standard replacement cost values. Allowances for labour and construction costs typically lag those that apply at the time of constructing new assets, resulting in under-valuation of new investment. As a result, the notional valuation of the regulatory asset base may be materially different from the accumulated actual value of capital committed by investors, compromising the achievement of financial capital maintenance, and leading to investment disincentives. 18. Once the initial capital base value is verified (through a once-off ODV), indexed historic cost would provide a less subjective, less information-intensive approach. Most importantly, it would give a much higher degree of certainty to the providers of capital. 4 Incentives for efficient investment 19. Powerco disagrees with the Commission s view that a detailed independent ex ante review of capital expenditure proposals must be undertaken if ODV is not applied. 20. Under the price threshold regime, the company s actual costs and its allowed revenue (as defined by the threshold) are de-coupled. Thus, the lower the company s costs, the higher the returns to shareholders. This feature of the regime provides a clear incentive to ELBs to optimise the level of investment 1 Martin Lally, The Weighted Average Cost of Capital for Electricity Lines Businesses, 4 August 2003, pages 67-68. 5
they undertake (noting that the quality threshold safeguards consumers from the risk of service standards deteriorating as a result of cost-cutting). The Commission s analysis ignores this important point. 21. The information disclosure regime requires the company to publish detailed information, such as asset management plans, relating to its investment criteria and capital plans. This information can be scrutinised independently, and provides stakeholders with an opportunity to test the robustness of the company s capital evaluation and investment processes. 22. The pressure on the company to minimise costs (whilst meeting the quality threshold) and to disclose information relating to its capital plans should provide all stakeholders with comfort that investment undertaken by the company is efficient. This obviates the need for detailed independent ex ante reviews of capital expenditure proposals. 23. The application of optimisation after the investment decision is made (and the asset constructed) exposes past investment decisions - which were efficient at the time - to on-going stranding risk, without providing any benefit in terms of improving the original investment decision. It does not serve any purpose to reappraise a past investment decision using new information, and to redistribute wealth between infrastructure users and owners on the basis of an ex post review of past investment decisions. 24. As already noted, in the context of a regulatory regime where there is a linkage between asset values and revenues, ex post optimisation unduly exposes investors to an unmanageable risk of capital loss; hence it provides a disincentive to investment. 5 How do other regulators deal with asset valuation and investment incentives? 25. Powerco considers that the Commission is wrong to argue that international precedents are not relevant to NZ regulation. It is not in customers long term interests for New Zealand to adopt regulatory arrangements that are inherently more risky than those employed overseas. Investors will simply demand a higher return to compensate them for increased risk, or they will invest in better designed and more stable regulatory regimes. 26. With these considerations in mind, this section examines the approaches to asset valuation and investment incentives adopted in Australia and the United Kingdom. Australian Competition and Consumer Commission 27. The ACCC was initially attracted to the idea that the risk of asset stranding and capital loss posed by regular ODV re-valuation would provide an effective incentive for efficient investment. 28. After commissioning a review by the Allen Consulting Group (ACG), the ACCC has changed its position. (In Australia, regulatory asset valuation approaches which involve optimisation of the entire asset base are almost universally regarded as inherently and unacceptably risky to investors.) 6
29. The ACG report sets out a comprehensive and robust analysis of the issues, with reference to the critical questions of: the incentive properties of the different options; the feasibility of, and costs involved in implementing effective asset revaluation arrangements that involve the application of optimisation and/or current cost principles; the risks (and therefore costs) involved in applying asset revaluation approaches that create higher uncertainty in relation to the recovery of investment; and the potential impacts on allocative efficiency (that is, the profile of transmission prices and revenues over time) of the different approaches. 30. Pages 5 and 6 of ACG s report to the ACCC state: The ODRC [optimised depreciated replacement cost an approach very similar to ODV] revaluation methodology represents the polar case along a spectrum of tradeoffs relating to the strength of incentives to reduce cost, and the degree of certainty over the recovery of costs. The rolling-forward methodology [which is comparable to the IHC approach proposed in the Draft Decision], in contrast, provides a degree of certainty over the recovery of costs incurred with the degree of certainty (and strength of the incentive to minimise cost) determined by the length of the regulatory period selected. We do not consider that the setting of prices completely independent of cost is feasible for regulated electricity transmission businesses in the short term. The application of the ODRC revaluation approach would require significant refinement to the methodology for estimating ODRC values to the methodology used to set regulated charges which would require a substantial investment by the Commission. Moreover, we do not consider that the application of such a methodology is desirable in the longer term. Whether a transmission business would expect to recover the cost of continuing to provide the service or expected to earn returns much larger than that required to justify its continued financing of the business would depend upon the accuracy of the estimated ODRC value, for which substantial statistical uncertainty will be inevitable. Given the risks associated with estimation errors, it is difficult to see how the Commission could commit credibly to adhere to such a regulatory regime over the long term. As a consequence, we do not consider the ODRC revaluation methodology to be appropriate Another point of distinction between the valuation methods is the level of prices expected at each point in time in the future. The ODRC level would maintain average prices at (approximately) the level consistent with those of the hypothetical (efficient) new entrant, whereas under the roll-forward approach, average prices could be higher or lower. It is noted that the structure rather than the average level of charges is more important for efficiency. It is also noted that the time profile of charges of an efficient new entrant may not be the most efficient charges and that the roll-forward methodology may permit the more efficient time profile of charges. 31. The ACG report concludes by stating on page 8: Having regard to the merits of the ODRC methodology relative to rolling forward the asset base, we do not consider revaluations based on ODRC to be feasible in the 7
short-term nor does it provide appropriate incentives for regulated transmission providers over the long term. A preferred approach is for the regulatory asset base to reflect the level of capital expenditure undertaken and return of funds received over the regulatory period that is, the rolling forward methodology. 32. The ACCC now favours the rolling forward of regulatory asset base values (an approach which is effectively the same as indexed historic cost.). The Victorian regulator 33. The Victorian regulator (the Victorian Essential Services Commission, formerly the Office of the Regulator-General), has recognised that: where total allowed revenue (as defined by a price control or price path threshold) is de-coupled from the regulatory value of assets, the company faces strong incentives to minimise its costs (by investing efficiently); and in these circumstances it might reasonably be argued that there is only a weak case for regulatory oversight of capital expenditure. 34. The Victorian regulator examined this issue in some detail in its most recent review of gas distribution prices. The Victorian regulator stated : [The] Gas Code requires capital expenditure to pass a number of tests for it to be included in the distributors regulatory asset bases and reflected in regulated charges. These include that the amount reflects an efficient (least-cost) means of providing the relevant service... The Office has noted that there are at least two approaches that it could adopt to form an opinion as to whether these requirements have been satisfied. One option would be for the Office to obtain information on the projects that have been undertaken, and to form its own view as to whether such projects are adequately justified and reflect efficient technologies and practices An alternative option would be to analyse the commercial incentives that may have influenced distributors expenditure decisions over the regulatory period, and to infer the efficiency of their investment decisions from the operation of these incentives These incentives and the inferences that they would permit to be drawn include the following: the incentive to minimise expenditure under a price cap regime, lower expenditure implies higher profits. In turn, this suggests that a distributor would be likely to adopt a least-cost approach Accordingly, the Office [considers] that it may not be unreasonable to infer that the distributors capital expenditure over the period has met the Gas Code s requirements 35. Similarly, in its most recent review of electricity distribution charges the Victorian regulator stated: [The Commission proposes ] to rely on the incentive properties of the regulatory regime to encourage efficient expenditure in the 2001-05 regulatory period to draw an inference that the actual expenditure undertaken was efficient rather than undertaking a prudency test of expenditure. 8
Ofgem 36. In its most recent electricity distribution price control decision, Ofgem commented 2 : The regulatory asset value (RAV) is a measure of the value of the capital employed in the regulated business, based on historical investment costs, on which the companies earn a return and receive depreciation. The RAV is widely used by the financial markets to assess value for both debt and equity investors and it is therefore important that it is calculated on a consistent basis between companies and over time. The RAV at 31 March 1998 was established as part of the last price control review. Rolling this forward to 2005 should simply be a matter of adding actual capital investment and adjusting for depreciation and inflation 37. The Ofgem decision noted some issues associated with differences between regulated companies in terms of their accounting for past capital expenditure (investment), and proposed that information be collected more regularly so that RAV calculations do not need to be revisited for reasons of cost definition. 38. Ofgem s latest decision explicitly recognised the need to encourage investment. Ofgem s fact sheet 3 stated: Ofgem's job has been to challenge companies'plans so that investment is made efficiently, and where it is needed. Where company forecasts have been fully justified they have largely been accepted. Where companies have not justified their forecasts adjustments have been made. Ofgem is consulting on a new 'sliding scale'approach to setting capital expenditure (capex) allowances and incentives. This is intended to: retain an incentive for efficiency throughout reduce the emphasis on Ofgem's or its consultant's view of the appropriate level of capex reduce the perceived risk that the price control causes under-investment allow but not encourage overspend, (expenditure in excess of the "allowance") reduce the possibility of "high" capex companies making very high returns from underspend reward the "low" capex companies if they deliver what they say, and avoid strong incentives to underspend by cutting corners and not delivering outputs or by storing up problems for subsequent periods. 39. It is particularly noteworthy that Ofgem, like the Victorian regulator, has explicitly recognised: the desirability of reducing the emphasis given to the regulator s or its consultants views of what constitutes an appropriate level of investment; the need to ensure that companies have an incentive to invest; and 2 Ofgem, Electricity Distribution Price Control Review: Final Proposals, November 2004, page 92. 3 http://www.ofgem.gov.uk/temp/ofgem/cache/cmsattach/7609_factsheet43_dpcr_28jun04.pdf?wtfrom=/ofgem/work/in dex.jsp§ion=/areasofwork/distpricecontrol 9
that the de-coupling of each company s own costs from its allowed revenue provides strong incentives to minimise costs, including capital expenditure. 40. Ofgem does not employ after-the-event asset base optimisation as a tool to encourage efficient investment. 6 CONCLUSIONS 41. Overseas experience demonstrates clearly that the risk to investment is unduly high, and investment incentives are compromised by regulatory regimes that involve: ex-post reviews of the efficiency of capex; and/or the threat of capital loss, through periodic optimisation of the regulatory asset base. 42. In light of this experience, Powerco urges the Commission to re-consider its decision, and to allow ELBs to elect to use IHC, to ensure that: undue risk to investment is minimised; and ELBs face appropriate incentives to invest efficiently in essential infrastructure, for the long term benefit of consumers. 43. If the Commission continues to require ODV to be employed in the targeted control regime, then it must carefully analyse the risks faced by investors under that regime, and ensure that investors are fully compensated for that risk, so that: long-term investment incentives are preserved; and all investors have a reasonable prospect of earning at least a normal market rate of return on the actual capital invested in ELBs. 10
7 ATTACHMENT: SPECIFIC COMMENTS ON DRAFT DECISIONS Valuation frequency 44. Re-optimisation of the asset base and re-determination of replacement costs would not be required under the IHC approach. This would lead to costsavings and reduced administrative effort associated with regulatory asset base valuation. Indexing method 45. Indexing the capital base with the CPI within an IHC framework will help ensure that providers of capital receive a normal real rate of return on investment, thereby ensuring that financial capital maintenance is achieved. Regulatory treatment of capital expenditure 46. The Commission should recognise the incentives for cost minimisation and efficient investment that are present in the targeted control regime (as described in section 4 of this submission), and should allow all actual capex to be rolled-in to the regulatory asset base. Scope of regulatory asset base 47. Powerco agrees that the regulatory asset base must include non-network fixed assets (such as IT hardware, motor vehicles, mobile plant, buildings, etc.) as well as network fixed assets. 48. Non-network fixed assets should be valued at their GAAP valuation. Implications of M&A 49. At paragraphs 221, and 226 to 229 there is a presumption that mergers and acquisitions will occur. This has resulted in the Commission focusing on the treatment of the RAB following an acquisition or merger. Powerco considers that the Commission s analysis of the issues relating to mergers and acquisitions over-emphasises post-merger regulatory accounting issues, whilst failing to recognise the fundamental need to ensure that the regime should provide incentives for efficient on-going investment, including by merger and acquisition. As they currently stand, the Commission s proposals are more likely to present a deterrent to efficient merger and acquisition activity. Reconciliation 50. Powerco is unable to provide further comment given that the detail of the proposed changes has yet to be published. Accounting Standards and Systems, and Relationship with Statutory Accounts 51. The assertion that the ELBs have over ten years of experience with ODV for regulatory purposes is a misleading statement given the proposal is to adopt an indexed ODV with interim HC updates for capital additions between 11
revaluations. Powerco has to date maintained these valuations in relatively simple spreadsheets and is only just moving to adopt a more sophisticated ledger for such purposes. Complex issues arise from the proposed mix of ODV and HC values for assets and depreciation of each. These complexities are in addition to the issues that arise from the requirement to index these values by CPI. These requirements would need to be defined with greater clarity and detail before further modifications could occur to implement the proposed ODV (or IHC) ledgers for regulatory purposes. 52. IHC, on the other hand could be implemented by Powerco given adequate notice, to enable systems to be modified. IHC is consistent with accounting standards. 53. It is unclear whether Powerco could or would adopt the RAB for statutory reporting purposes as seems to be implied. Powerco is planning to adopt International Financial Reporting Standards from 2006. Audit and Independent Review 54. Powerco has no comment on this particular aspect of the Commission s decision. Reporting 55. Powerco is unable to comment until the company has reviewed the guidelines. Handbooks and other guideline documents 56. The IHC handbook developed for Transpower could be adapted for application to the ELBs that are subject to IHC. 12