Regulated Asset Base

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E i t t

http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4

Training on Regulation

A webinar for the European Copper Institute

Webinar 4: Revenue Requirements and

Regulatory Asset Base (RAB)

Dr. Konstantin Petrov / Dr. Daniel Grote30.11.2009
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4


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30.11.2009 1

Agenda

2. Revenue Components

4. Asset Valuation

1. Introduction

3. Regulatory Asset Base (RAB)


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1. Introduction

Price Control Regulatory Tasks

Setting revenuerequirements /

cost determination

Decision onregulatory regime

Setting annualefficiency target

Tariff design

Webinar 4 - Revenue Requirements and RAB

Webinar 3 - Price Regulation

Webinar 8 - Pricing

Webinar 6 - Efficiency Assessment

Calculation ofregulatory asset base

Rate-of-Return, Cap Regulation,Sliding Scale,

Yardstick Competition

Data Envelopment Analysis,econometric approaches,reference network models

Tariff structures,cost allocation

Webinar 5 Cost of CapitalCalculation of

allowed rate of return


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1. Introduction

Price Control Models

Rate-of-Return regulation

Prices / revenues based on operating costs plus fair return

Price Cap and Revenue Cap regulation

Upper limit (cap) on prices or revenues

Efficiency targets

Regulatory period (3-5 years)

Price reviews


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1. Introduction

Price Control Revenue Requirements

Regulators have to recognize the importance to regulated service providers of recovering sufficient levels of

costs. Failure to include adequate costs as part of the revenue requirements may discourage investments

and deteriorate quality of supply. However, it is important that the regulated service provider does not incur

excessive or unnecessary costs in providing services.

Operating Expenditures (Opex) Capital cost

Opex are the costs incurred by a regulated company in

providing the regulated services and maintaining and

operating the relevant assets

The recovery of opex does not provide any return toshareholders and debt holders, as they are paid out in

the form of salaries, ongoing operating and

maintenance costs, etc

Capital costs provide an annual recovery of the capital

expenditures (capex) undertaken by a regulated service

provider in providing the regulated services

Capital costs include depreciation allowance and return



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1. Introduction

Price Control Revenue Requirements

Opex Capital costs

Revenue Requirements

Regulatory Asset Base

(RAB)Rate of Return

Revenue Requirements = Opex + Depreciation + (RAB Rate of Return)

Operation andMaintenance

Network LossesFuel (in case of

regulatedgeneration)

Return on AssetsDepreciation



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Operating Expenditures (OPEX)

OPEX usually split into: Controllable OPEX (costs the company can influence and decide upon) or Non-controllable OPEX (costs beyond the control of the company)Only controllable OPEX exposed to efficiency analysis

The split between controllable and not controllable costs depends on legal and regulatory

framework, technical standards and norms



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Depreciation

Systematic allocation of the investment cost to purchase an asset (capex) over the period

in which the asset provides benefits to the regulated company (asset life)

There might be differences between depreciation for regulatory, financial accounting and

tax purposes

Depreciation can be calculated by using various asset valuation methods (see next slides)

Typical depreciation methods are:

Straight-line method which allocates equal amounts of depreciation to each accounting

period of the asset life

Accelerated method (e.g. declining-balance) which allocates decreasing amounts of

depreciation to each accounting period of the asset life

Most regulatory authorities apply straight-line method



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Depreciation

time10 years 20 years

remaining asset value

Initial assetvalue

depreciation

straight-line method

declining-balance method

time10 years 20 years

remaining asset value

Initial assetvalue

depreciation


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Return on Assets Regulatory Asset Base (RAB)

The Regulatory Asset Base (RAB) comprises the assets used to provide the regulated

services

Typically regulators apply the following principles for RAB:

It includes only assets necessary to provide regulated services

It is based on the residual (depreciated) value of fixed assets

It may include allowance for net working capital

It excludes any capital contributions (external funding, subsidies) from customers,

government or third parties


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Return on Assets Rate of Return

The rate of return describes the return the regulated company is permitted to earn (alsoknown as the opportunity cost of investor capital)

It is based on a weighted average of the cost of debt and equity financing

There are several methods to calculate rate of return

The most prominent model to calculate the rate of return in practice is the Capital Asset

Pricing Model (CAPM)

The CAPM takes into account that investors need to be compensated for the time value of

money represented by the risk-free rate and risk premium (beta) measured by the

correlation between the returns of the regulated company and market returns

What is included in the costs of capital and how it can be calculated is addressed in detail

in webinar 5


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Components

RegulatoryAssetBase

Existing Assets

NewInvestments

RAB roll forward / revenue re-setting

Depreciation

CapitalContribution

WorkingCapital

ConstructionWorks inProgress

RAB Closing Value =

RAB Opening Value

+ Investments

Depreciation

Asset Disposal+/- Change of Working

Capital

+/-Change of Capital

Contribution


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Investments (1)

An investment is incurred when a business spends money either to buy fixed assets or toadd to the value of an existing fixed asset

Three types of investments may be considered:

Extension investments: investments needed for meeting the change of load and

generation patterns in the future

Replacements investments: investments related to replacement of aged (technically or

economically) equipment

Exceptional investments: investment resulting from new legal obligations for example

(e.g. if new labour safety rules require safety measures in substations or high voltage

pylons, this probably leads to investments)


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Investments (2)

Regulatory assessment of investments

ex-ante ex-post

Assessment of adequacy and efficiency of

companys proposed investment program for the

forthcoming regulatory period

Regulator asks regulated companies to submit their

capital expenditure projections

Companies get security that investment will be

approved by the regulator before investment is

carried out

Supplement to ex-ante investment reviews (identify

differences between allowed and actual investments)

Or undertaken without previous ex-ante approval

(e.g. hindsight efficiency assessment like in

Germany)

Companies face uncertainty of whether undertaken

investments will be recognised by regulator ex-post

Threat that investments may be rejected, or partially

disallowed - may provide an incentive to onlyundertake efficient investment, but may also

discourage investment


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Construction Work in Progress

Treatment of assets in construction Long debates between regulators and regulated companies on this issue

Some regulators include construction work in progress (CWIP) in the RAB only after

completion of construction

Other authorities base the inclusion of CWIP on other factors, such as

whether the construction projects are of short duration whether the investment in the project is so significant that its exclusion could impair

financing

whether the interest charged to construction represents a substantial portion of the

companys earnings

Some form of recognition of cost of capital committed during construction appears

appropriate


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Working Capital

If the time at which a particular cost is incurred is different from the time of its recovery (viatariff revenues), capital is required to cover the time lag which is associated with a cost

Working capital defined as current assets minus current liabilities

Regulatory treatment of working capital

Allowance for working capital to meet short-term obligations of regulated companies

Consideration should be given to the use of a good-practice target, to calculate a

working capital allowance designed to give companies an incentive to manage working

capital well


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4. Asset Valuation

Different Approaches

Asset ValuationMethods

Cost based Value based

Indexedhistoric cost

Replacementcost

Historiccost

Optimisedreplacement

cost

DCFvalue

Deprivalvalue

Marketvalue

Asset valuation must be considered with regard to functional adequacy and market value of

regulated assets

Different methods involve varying degrees of effort to calculate, give significantly different estimates

of the regulatory asset base (RAB), and also differ in their pricing and investment signals


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4. Asset Valuation

Historic Cost

Values assets at original purchase price (including any relevant set-up and financing costs) Advantages:

Administratively efficient, can be easily audited because the data should be available

from financial statements

Relatively inexpensive: does not require experts to determine costs

Objective because it relies on actual data rather than judgementsDisadvantages:

Understate asset prices in times of high inflation and overstate asset prices in times of

technological change

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)

Returns may be inadequate to support the funding of new investments


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4. Asset Valuation

Indexed Historic Cost

Historic asset values are adjusted upwards for the effect of inflationValue of the RAB is adjusted (increased or decreased) to reflect changes in the underlying

inflation index

Debate as to whether the index chosen should reflect price changes in the particular

industry under examination, or price changes in the economy as a whole

Advantages and disadvantages similar to historic costs


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4. Asset Valuation

Replacement Cost

Calculates the cost of replacing an asset with another asset (not necessarily the same) thatwill provide the same services and capacity as existing asset

Asset values are based on what it would cost to replace the asset today Advantages: Assets are valued in current prices, which may provide an incentive for efficient

investment decisions

Allows regulator to reduce value of assets once it becomes aware that a more efficientlow-cost alternative asset is availableDisadvantages:

Entails a degree of estimation and judgment Information is more expensive to collect than historic cost data because it may require

expert advice (e.g. from engineers and accountants) on a number of assets

May lead to higher prices and face political opposition


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4. Asset Valuation

Optimised Replacement Cost

Values RAB on the basis of replacement cost of optimised assets, which most efficientlyreproduce the capacity and service levels of existing assets

Removes inefficiencies in the RABs current asset configuration, such as duplication,

excess capacity and redundant assets

Advantages:

Eliminates inefficiencies in the existing assetsDisadvantages:

Relatively complex to implement, requires considerable input in terms of manpower and

financial costs

Requires a degree of subjective judgement about the optimum configuration of assets in

the RAB, and about the processes of optimisation


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4. Asset Valuation

Market Value

Values RAB on the basis of the price that would be obtained from selling the assets in acompetitive market

Advantages:

Uses the market to obtain the asset value

Avoids subjectivity in the asset valuation process

Disadvantages:

In many cases there is no indication of market value (share quotation) of regulated

companies / services

Even if there is a price indication based on a divesture / privatisation of a regulated

company, there may be no or insufficient competition


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4. Asset Valuation

DCF (Discounted Cash Flow) Value

Values RAB on the basis of the discounted cash flows of the regulated companyPredicts the cash flows that the company is expected to generate, and then discounts them

back to present values using the appropriate risk-adjusted discount rate

Disadvantages:

Requires assumptions and forecasting to estimate future cash flows

Circularity problem arises because the future cash flows will determine the value of theRAB, however the future cash flows depend on the value of the RAB

(RAB - > Return on assets -> Revenue -> Cash Flow)


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4. Asset Valuation

Deprival Value (1)

The deprival value of an asset can be defined as the lower level of its: Replacement cost (if it can be replaced) and

Recoverable value

The recoverable value of an asset can be defined as the higher level of:

The value that the company could receive for selling the assets (value in exchange)

The value that the company could create by using the asset within the business (valuein use determined by the future cash flows)

If the recoverable amount exceeds the replacement cost, and the company was then

deprived of the asset, it would buy another to replace it if possible.


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4. Asset Valuation

Deprival Value (2)

The replacement cost sets a maximum on the loss that the company would suffer throughthe deprival

Where the recoverable value is less than replacement cost, replacement of the asset would

not be justified

Advantages:

Discourages inefficient investment Provides information on the economic value of the RAB

Disadvantages:

Complexity

Requires assumptions and forecasting to estimate future cash flows

Circularity problem arises because the future cash flows will determine the value of theRAB, however the future cash flows depend on the value of the RAB

(RAB - > Return on assets -> Revenue -> Cash Flow)


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End of Webinar 4

KEMA Consulting GmbH

Kurt-Schumacher-Str. 8, 53113 Bonn

Tel. +49 (228) 44 690 00Fax +49 (228) 44 690 99

Dr. Konstantin Petrov

Managing Consultant

Mobil +49 173 515 1946E-mail: [email protected]

Documents

Regulated Asset Base