Asset Base Roll Forward or Re-Valuation - Dr Darryl Biggar

8/6/2019 Asset Base Roll Forward or Re-Valuation - Dr Darryl Biggar

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Updating the Regulatory Asset

Base:

Roll-Forward, Re-Valuationand Incentive Regulation

Darryl Biggar

Consulting Economist

Australian Competition and Consumer Commission

2 April 2004


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What is the issue? The 1999 statement of regulatory principles seems to

propose the revaluation approach

The Commission will conduct a DORC valuation toestablish the maximum value of the asset base (Statement

S4.2)

Depreciation will be linked to changes in RAB [taking

into account] likely changes in a DORC-based valuation ofthe RAB (Statement S5.5).

The discussion paper raises the issue of whether or not

to move to a roll forward approach.


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Updating the RAB How the regulatory asset base (RAB) is updated at

the end of the a regulatory period is one of the

fundamental questions in the design of a regulatoryregime

How the RAB is updated affects issues such as:

a) The principle of financial capital maintenance (FCM)

b) Incentives to select efficient capex projects

c) Incentives to carry out capex projects at least cost

d) How the sunk costs of investments are amortised or spread

over time


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FCM and incentive regulation Many submissions emphasised the importance of FCM

FCM ensures that a firm is able to recover in revenues

exactly what it spends on operating or capital expenses There is a tension between financial capital

maintenance and incentive regulation Incentive regulation requires that a firm is financially

rewarded for pursuing objectives which the regulator desires such as providing better quantity or quality of services at lower cost

incentive regulation requires windfall gains or losses

Regulator does not have to set the RAB and the depreciationin such a way as to precisely ensure FCM but must ensurethat any deviations from FCM induces desirable incentives


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The roll forward approach What is the roll forward approach?

Under the roll forward approach, at the end of the period the

regulator observes the out-turn capex and then updates theRAB using a formula similar to the formula above

closing RAB = opening RAB + capex allowance depreciation

allowance

Depending on how the regulator rolls forward actualversus forecast capex and actual versus forecast

depreciation determines the power of the incentive to

reduce capital expenditure


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The roll forward approach The roll forward regime could have:

Low-powered incentives to reduce capital expenditure

if the regulator rolls forward actual capex and forecast depreciation(i.e., closing RAB = opening RAB + actual capex forecast depn)

Medium-powered incentives to reduce capital expenditure

if the regulator rolls forward actual capex and actual depreciation

(i.e., closing RAB = opening RAB + actual capex actual depn)

This is the approach of the ESC in Victoria (and possibly other state

regulators)

High powered incentives to reduce capital expenditure

if the regulator rolls forward forecast capex and forecast depreciation

(i.e., closing RAB = opening RAB + forecast capex forecast depn)


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Is more power always better? High-powered incentives to reduce capital

expenditure may be undesirable Might induce the firm to reduce service standards

Might induce the firm to substitute opex for capex

Might induce the firm to act strategically to obtain atarget capex (or closing RAB) higher than was forecast.

When combined with weak incentives for service standardsstrong incentives to reduce expenditure could result in over-forecasting of capex requirements ex ante and under-spending ex post.

Power of the incentive to reduce capex should betailored to ensure a balance of incentives overall


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The revaluation approach What is the re-valuation approach

Under the re-valuation approach at the end of the period

the RAB is set equal to some methodology such as DORC

As before FCM requires that:

But now since the closing RAB is fixed, this equation shows that

depreciation must be set as follows:

Closing

RAB

Opening

RAB

Actual (out-

turn) capital

expenditure

Forecast

deprec-

iation+ -=

Forecast

closing RABOpening

RAB

Forecast

capital

expenditure

Forecast

deprec-

ia

tion

+ -=


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The revaluation approach In other words, FCM requires that the depreciation

must be set in a way which anticipates the expected

future changes in the end-of-period RAB. When the depreciation is set in this way:

(a) the revaluation approach is identical to a roll forward

approach based on forecast capex and forecast depn

this yields high-powered incentives for reducing capital expenditure(which may not be appropriate)

(b) however the regulated firm is also subject to risk that the

actual revaluation will differ from the forecast


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Interim summary Under the roll forward approach:

The depreciation is set first and then the closing RAB is set in

such a way as to preserve FCM

the incentive to reduce capital expenditure can be tailored to

ensure a balance of incentives overall

Under the revaluation approach The closing RAB is set using some methodology and the

depreciation is set in a way which preserves FCM The firm still faces some risk that actual closing RAB will not

equal forecast closing RAB

The incentive to reduce capex is high and cannot be varied

The firm has a strong incentive to act strategically to achieve a

higher closing RAB (and a higher capex target)


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Allocation of Sunk Costs Does one of these two approaches lead to a better

amortisation of sunk costs? i.e., a better path of

revenues / prices over time? It is important to recognise that the concept of

DORC valuation has no particular economic merit

The view [that DORC has some economic significance]

has been recited to the point that its validity is widelytaken for granted albeit without demonstration or

acknowledged authority (Johnstone, Abacus 2003)

There is no economic grounds for a link between

DORC and the price charged by an efficient new entrant


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Allocation of Sunk Costs Does the DORC approach lead to fewer or no price

shocks (i.e., a smooth path of revenue over time)?

the maintenance of revenue streams over time at a levelthat is consistent with a DORC asset valuation willminimise the likelihood of significant shocks to tariffs asthe replacement of assets becomes necessary (draft SRP,

page xi)

While the DORC approach may lead to less price shocksthan straight-line depreciation, it does not necessarilylead to less price shocks than an approach in which thedepreciation is set in a way which anticipates higherreplacement costs


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Allocation of Sunk Costs Some capital expenditure may not be fully reflected in

a change in the DORC valuation, and so must be

expensed (i.e., treated as opex) E.g., refurbishment expenditure (changing the engine in a

used car has no effect on the cost of buying a new car)

Or legacy upgrade effects (the cost of adding services to a

hypothetical optimal network may be less than the cost ofadding services to the actual network)

SPI PowerNet and ElectraNet recognised this and sought to

include refurbishment expenditure as opex in their revenue

cap applications


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Allocation of Sunk Costs

If the capex is $400, but the

DORC valuation only

increases by $50, all the

remainder of the capex must

be expensed (i.e., not

amortised). This could lead to

large fluctuations in the path

of revenue

Opening RAB 500

Capex 400

Closing RAB 550

Depreciation 350

E.g., A major capital expenditure which has little/no

effect on the ORC must be reflected in the depreciation,

leading to a jump in the allowed revenue


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Final summary Pros and cons of roll-forward

The long-term path of revenues/prices over time dependson how the level of depreciation is chosen over time over

which there is substantial flexibility. Path of depreciation can be chosen to so that path of revenues

reflects planned or unplanned stranding, changes in demand or intechnology

The incentives for minimising capital expenditure depends

on how the amount rolled into the RAB depends on thecapex out-turn

The regulator can tailor these incentives as necessary to ensurethey are balanced with the incentive to promote/maintain servicestandards and the incentive to minimise operating expenditure.


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But is it too late?

The Commission is considering adopting the policy

that at the end of the period the RAB will be updated

using the roll forward approach

But, in any case in revenue cap decisions to date thedepreciation has notbeen set in a way which anticipates

future end-of-period revaluations

Instead, depreciation has in practice been set on a straight

line basis. In these circumstances revaluing the asset base at the end

of the current period would violate the principle of

financial capital maintenance

Has the decision already been made, in effect?


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The Way Forward The way forward is clear:

There are strong economic arguments and strong support

in the submissions for the roll forward approach The details of the roll-forward approach need to be

specified

Issues that need to be addressed include:

The incentives to select (or the selection of) desirable projectsand the role of the regulatory test in this process

The power of incentives to carry out those projects at least cost

including the handling of capital over-spend or under-spend and

the handling of forecast versus actual depreciation

Documents

Asset Base Roll Forward or Re-Valuation - Dr Darryl Biggar