Helena S. Valderrama, Ph.D. Professor, Cesar E. A. Virata School of Business

University of the Philippines Diliman

BSP – UP Professorial Chair Lectures 24 May 2013

Study Objectives Provide an overview of the rate-setting methodologies

for the transmission and distribution businesses in the Philippines

Analyze the rationale in the use of the optimized depreciated replacement cost (ODRC) method in the valuation of transmission and distribution assets of Philippine utilities

Background • The Philippines embarked on a comprehensive

restructuring program for its power sector with the passage of the Electric Power Industry Reform Act (EPIRA) in 2001.

• Main Elements of Restructuring Unbundling Competition in generation and supply Privatization Open Access and Retail Competition

The Market After Restructuring Unbundled Generation and

Transmission Functions Unbundled Tariffs Generation Prices Market

Driven Open Access Presence of Competition Choice for large industrial

customers (1MW & above) Choice for small users in the

long run Transmission and distribution

continue to be regulated businesses

Customers

TRANSCo

DUs

Suppliers

GENCo / IPPs

Market Operator

Source: PSALM

-

2.00

4.00

6.00

8.00

10.00

12.00

14.00

Mar

ch-0

0Ju

ne-0

0Se

ptem

ber-

00D

ecem

ber-

00M

arch

-01

June

-01

Sept

embe

r-01

Dec

embe

r-01

Mar

ch-0

2Ju

ne-0

2Se

ptem

ber-

02D

ecem

ber-

02M

arch

-03

June

-03

Sept

embe

r-03

Dec

embe

r-03

Mar

ch-0

4Ju

ne-0

4Se

ptem

ber-

04D

ecem

ber-

04M

arch

-05

June

-05

Sept

embe

r-05

Dec

embe

r-05

Mar

ch-0

6Ju

ne-0

6Se

ptem

ber-

06D

ecem

ber-

06M

arch

-07

June

-07

Sept

embe

r-07

Dec

embe

r-07

Mar

ch-0

8Ju

ne-0

8Se

ptem

ber-

08D

ecem

ber-

08M

arch

-09

June

-09

Sept

embe

r-09

Dec

embe

r-09

Mar

ch-1

0Ju

ne-1

0Se

ptem

ber-

10

Residential Electricity Rates (MMla) 2000 to 2010

PhP/Kwh

June 2001 EPIRA passed

into law

Pre-EPIRA average: P5.35/kwh

Post-EPIRA average: P8.63/kwh Compound annual growth rate (2001-2010): 7.7%

Source: Valderrama (2011)

Note: Data for a residential consumer consuming >400 kWh/mo in Meralco franchise area

0

1

2

3

4

5

6

7

PhP

Movements of Major Components of Power Cost (2003-2010)

Generation Rate Transmission Rate Distribution

Transmission average: P0.88/kwh

Generation average: P4.67/kwh min: P3.19/kwh max: P6.77.kwh

Distribution average: P1.74/kwh

Source: Valderrama (2011)

Generation and Distribution Costs 2008 to 2012

0

1

2

3

4

5

6

7

0

200

400

600

800

1000

1200

1400

1600

Distribution Generation

CAGR = 9.98%

CAGR = 9.64%

Dis

trib

utio

n co

st fo

r 400

kWh

cons

umpt

ion

Generation cost per

kWh

Rate Setting for Transmission and Distribution EPIRA (RA 9136 Sec. 43 (f)) empowers ERC to prescribe the

rate-setting methodology for transmission and distribution. The methodology shall: “(Take) into account the efficiency or inefficiency of the

regulated entities “allow recovery of just and reasonable costs and a reasonable

return on rate base (RORB) to enable the entity to operate viably

“ensure a reasonable price of electricity “be non-discriminatory “promote efficiency”

As mandated, ERC promulgated rules for the setting of rates for T&D as follows: For Transmission

Transmission Wheeling Rate Guidelines in 2003 (amended in 2009; now called Rules for Setting Transmission Wheeling Rates or RTWR )

For Distribution Guidelines for the Setting of Distribution Wheeling Rates in 2004

(amended in 2006 and 2008; now called Rules for Setting Distribution Wheeling Rates or RDWR)

ERC prescribed the “performance-based rate methodology” for the T&D sectors, replacing the Return on Rate Base or cost of service approach used pre-EPIRA.

Rate Setting for Transmission and Distribution

RORB and PBR: How Similar? Both methods reimburse utilities for “prudent and

efficient costs of service” Operating expenses (operating and maintenance

costs; customer-related costs) Taxes Depreciation of the regulatory assets (a.k.a. “return of

capital” Return on capital

RORB and PBR: How Different? Note: Corporate income tax in revenue requirement is set to zero in ERC rate decisions, pursuant to a SC ruling

Source: ERC Case no. 2005-041 dated 12 July 2010

The Impact of Rate Base Valuation NGCP (2010-2015) Meralco (2012-2015)

ARR BUILDING BLOCK Amount

(Peso MM, real 2010)

% Amount

(Peso MM, real 2012)

%

return on capital 126,612.86 64% 79,853.30 42% opex 29,369.35 15% 61,214.90 32%

return of capital/regulatory depreciation

30,670.39 15% 23,348.70 12%

other taxes 3,935.27 2% 981.10 1% subtotal 190,587.87 96% 165,398.00 87%

net efficiency adjustment (5,666.73) -3% Under-recoveries , 2nd regulatory

period 10,836.67 5% 24,158.80 13%

others 2,869.85 1% total 198,627.66 100% 189,556.80 100%

The Optimized Depreciated Replacement Cost Approach

Source: ERC (2010), Valuation Handbook for Optimized Depreciated Replacement Cost Valuation of System Fixed Assets of Privately Owned Distribution Utilities Operating Under Performance-Based Regulation (Third Regulatory Period)

How Replacement Costs are Established Indexation method – historical costs are adjusted for

inflation using suitable indices (e.g., retail or consumer price index)

Replacement cost method – establishing the recent costs of similar assets

Modern equivalent asset (MEA) method – current market buying price, current reproduction or replacement cost of a “modern equivalent asset”, defined as “an asset that, in the normal course of a transmission entity’s business, would be used to replace an existing asset”

The Optimized Depreciated Replacement Cost Approach

ODRC Rationale “The ODRC method … determines a hypothetical value of

the assets which is a surrogate for market value in circumstances where it is not possible to determine values for specialized assets using a market comparison approach.

…the ODRC method assumes a hypothetical operating environment where the relevant market is contestable and there are no material barriers to entry into that market by an alternative service provider or an efficient new entrant.

… allows DUs to earn a reasonable (risk adjusted) return on their investment capital provided that the market continues to value the services produced from the capital invested. ”

Source: ERC (July 2010), Valuation Handbook for Optimized Depreciated Replacement Cost Valuation of System Fixed

Assets of Privately Owned Distribution Utilities Operating Under Performance-Based Regulation (Third Regulatory Period), Sec. 2.2 p. 11

Problems with ODRC Gale and McWha 2000

Price is not the only barrier to entry – incumbent’s response and access rights are other substantial barriers to entry

Can be a deterrent to new investment if cost of technology declines quickly

Johnstone 2003 No market to purchase assets at ODRC Significant uncertainty regarding response to new entrant by

incumbent Method not needed to ensure optimal asset use or promote

new investment Inability to measure ODRC in an objective and independent

manner ODRC provides a “free lunch” to existing asset owners

Insight from Financial Reporting FAIR VALUE “Fair value is the price that would be received to sell an

asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions (i.e. an exit price) regardless of whether that price is directly observable or estimated using another valuation technique.”

- IASB (2011), International Financial Reporting Standard 13 para. 24.

ODRC is NOT fair value.

Measured the returns of a hypothetical utility under 2 cases: case 1 – RAB valued at acquisition cost, and case 2 – RAB revalued (appraised upwards) at the beginning of the regulatory period

All variables constant (working capital, annual operating expense, annual capital expenditure, WACC, capital structure) except for RAB valuation

Cost of debt is 6%, cost of equity is 18%

ODRC Effect on Utility Returns

ODRC Effect on Utility Returns Historical cost-

based RAB Revalued RAB Difference

Equity beginning 33,000.00 33,000.00 - Appraisal increase

9,342.80 9,342.80

Income 82,045.92 88,194.73 6,148.81 Addl investments

for capex 100,000.00 100,000.00 -

Dividends 152,736.45 164,806.66 12,070.21 Equity end 62,309.47 65,730.87 3,421.40

IRR of equity holders

17.23% 20.19%

Conclusions 1. ODRC does not achieve the purpose of producing

electricity rates that would be obtained under competitive conditions. It does not represent the price at which bypass by a new entrant will be viable.

2. Fair value, as defined in International Financial Reporting Standards, reflects the utility’s capital on which an opportunity cost rationally applies. Depreciated replacement cost, computed using an index-inflated MEA value divided by a subjectively-determined economic life, is an invalid substitute for fair value.

Conclusions 3. Using the current MEA value for valuing the RAB

rather than the value of the prudent MEA at the time the investment was made can potentially and unfairly hurt an incumbent utility if technological progress rapidly lowers the replacement costs of the utility’s assets (Gale and McWha (2000)).

4. ODRC results in wealth transfers from electricity consumers to the utilities’ shareholders.

Epilogue

Thank you for your attention.

hsv@up.edu.ph