The valuation of assets and its impact on water utility ... · 1 . The Valuation of Assets and Its Impact on Water Utility Pricing in Australia . Angela Tan-Kantor . This thesis is

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The Valuation of Assets and Its

Impact on Water Utility Pricing in

Australia

Angela Tan-Kantor

This thesis is submitted in fulfilment of the requirements for the degree of Doctor of

Philosophy at Swinburne University of Technology

2014

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Declaration

This thesis contains no material which has been accepted for the award of any other

degree, except where due reference is made in the content of the thesis. To the best of my

knowledge, this thesis contains no material previously published or written by another

person except where due reference is made in the content of the thesis.

Signed: __________________________

Angela Tan-Kantor

Dated: 20 August 2014

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Glossary

Introduced terms: blocks buffer building block CPI-X deprival value economic worth free allowances gold-plating greenfield holding gains inclining block tariffs law of the lands line in the sand lumpy modern engineering equivalent assets money items

money worth moral hazard new- normal one size fits all operating capability optimised out rate base rebalancing regulatory period risk premium scrap value standards sunk use and useful value to the owner

Abbreviations: A Accounting information systems (AIS) Adelaide Desalination Plant (ADP) AGL Gas Networks Limited (AGLGN) Agricultural and Resource Management Council of Australia and New Zealand

(ARMCANZ) Aqwest-Bunbury Water Board (AQWEST) Australian Accounting Research Foundation (AARF) Australian Accounting Standards (AAS) Australian Accounting Standards Board (AASB) Australian Competition and Consumer Commission (ACCC) B Brisbane Water (BW) Busselton Water Board (BWB) C Capital Asset Pricing Model (CAPM) Constant Purchasing Power Accounting (CPPA) Consumer Price Index (CPI) Continuously Contemporary Accounting (CoCoA) Council of Australian Governments (COAG) Current cost accounting (CCA)

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D Depreciated actual cost (DAC) Depreciated inflation historical cost (DIHC) Depreciated optimised replacement cost (DORC) Depreciated replacement cost (DRC) Drought response strategy (DRS) E Economic Regulation Authority (ERA) Economic value (EV) ESC of South Australia (ESCOSA) Essential Services Commission (ESC) European Accounting Association (EEA) F Fair value accounting (FVA) Financial Accounting Standards Board (FASB) Fitzroy River Water (FRW) G Generally Accepted Accounting Practices (GAAP) gigalitre (GL) Gladstone Area Water Board (GAWB) Gold Coast Water (GCW) Government Prices Oversight Commission (GPOC) Gross domestic product (GDP) H Historical cost accounting (HCA) I Independent Competition and Regulatory Commission (ICRC) Independent Pricing and Regulatory Tribunal (IPART) Independent Procurement Entity (IPE) International Accounting Standards Board (IASB) International Financial Reporting Standards (IFRS) K kilolitre (kL) M Maximum allowable revenue (MAR) Megalitre (ML) Ministry of Economic Development (MED) Modern engineering equivalent assets (MEERA) Modern equivalent asset (MEA)

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N National Competition Council (NCC) National Competition Policy (NCP) National Water Initiative (NWI) Net present value (NPV) Net realisable value (NRV) NWI Commission (NWIC) O Operating and maintenance expenditure (OPEX) Optimised deprival value (ODV) Optimised replacement cost (ORC) Q Qualitative Characteristic (QC) Queensland Competition Authority (QCA)

R Redlands Water & Waste (RWW) regulatory asset base (RAB)

S South Australia Water Corporation (SA Water) South East Queensland Water Corporation Limited (SEQ Water) Standing Committee on Agriculture and Resource Management (SCARM) Steering Committee on National Performance Monitoring (SCNPM) Sydney Desalination Plant (SDP) U Upper revenue bound (URB) W Water Industry Regulatory Order 2003 (WIRO) Water Services Association of Australia (WSAA) Weighted average cost of capital (WACC)

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Table of Contents

Glossary ..................................................................................................................................... 3

Acknowledgements .................................................................................................................. 10

Abstract .................................................................................................................................... 11

Chapter One: Introduction ....................................................................................................... 12

1.1 Background and context ................................................................................................ 12

1.2 Infrastructure assets ....................................................................................................... 14

1.3 Issues .............................................................................................................................. 15

1.4 Research problem ........................................................................................................... 17

1.5 Research methodology ................................................................................................... 20

1.6 Contribution to knowledge ............................................................................................ 21

1.7 Structure of thesis .......................................................................................................... 22

Chapter Two: Characteristics of Urban Water and Current Water Pricing Approaches ..... 26

2.1 Introduction .................................................................................................................... 26

2.2 Main characteristics of water ......................................................................................... 27

2.3 The urban water industry ............................................................................................... 29

2.4 What is a regulation? ..................................................................................................... 31

2.5 Why is regulation important? ......................................................................................... 33

2.6 Rationale for regulation ................................................................................................. 35

2.7 How to regulate .............................................................................................................. 36

2.8 Economic efficiency and principles of efficient prices .................................................. 36

2.9 Approaches to urban water pricing ................................................................................ 39

2.10 The current urban water pricing approach ................................................................... 40

2.11 The current water pricing arrangements ...................................................................... 43

2.12 Background of regulatory models ................................................................................ 45

2.13 Price and revenue caps – individual price caps ........................................................... 46

Weighted average price cap (or tariff basket) .................................................................. 48

Weighted average revenue cap ........................................................................................ 48

Revenue cap ..................................................................................................................... 48

2.14 Summary ...................................................................................................................... 50

Chapter Three: Literature Review ....................................................................................... 54

3.1 Introduction .................................................................................................................... 54

3.2 The rationale for HCA ................................................................................................... 55

3.3 The rationale of CCA ..................................................................................................... 61

3.4 The rationale of value-based accounting method NRV ................................................. 68

3.5 The rationale of value-based accounting method NPV ................................................. 69

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3.6 The rationale of FVA ..................................................................................................... 71

3.7: The rationale of the use of ODV in utility businesses .................................................. 73

3.8 Summary of main types of asset valuation techniques used across various assets ........ 86

3.9 Survey and case study on asset valuation and pricing ................................................... 89

3.10 Definitions of natural monopoly .................................................................................. 93

3.11 Foundations of price regulation .................................................................................. 95

3.12 Effects of rate regulation and price on utility businesses ............................................ 99

3.13 Summary .................................................................................................................... 102

Chapter Four: The Urban Water Industry in Major Australian Cities ................................... 105

4.1 Introduction .................................................................................................................. 105

4.2 New South Wales ......................................................................................................... 106

The industry ....................................................................................................................... 106

Governance of urban pricing ......................................................................................... 106

Water supply .................................................................................................................. 107

Supply–demand balance ................................................................................................ 108

Water and sewerage reform ........................................................................................... 108

4.3 Victoria ........................................................................................................................ 109

The industry ....................................................................................................................... 109


Urban wholesale water providers ................................................................................... 111

Urban retail water providers .......................................................................................... 111

Water availability ........................................................................................................... 112



4.4 Queensland ................................................................................................................... 118

The industry ................................................................................................................... 118


Water supply–demand balance ...................................................................................... 121


4.5 South Australia............................................................................................................. 122

The industry ....................................................................................................................... 122

Governance of urban water pricing ................................................................................ 123

Water supply .................................................................................................................. 124


4.6 Western Australia ......................................................................................................... 126

The industry ....................................................................................................................... 126


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Water supply .................................................................................................................. 128



Western Australia water and sewerage reform .............................................................. 132

A separate procurement entity ....................................................................................... 132

4.7 Tasmania ...................................................................................................................... 133

The industry ....................................................................................................................... 133



Water supply .................................................................................................................. 135



4.8 Summary ...................................................................................................................... 138

Chapter Five: Urban Water Regulation and Pricing .......................................................... 140

5.1 Introduction .................................................................................................................. 140

5.2 Water pricing and institutional reform ......................................................................... 141

5.3 New South Wales ......................................................................................................... 142

Building block approach to determining revenue requirement ...................................... 142

Return of capital ............................................................................................................. 143

Return on capital ............................................................................................................ 144

5.4 Victoria ........................................................................................................................ 144

Overview on ESC‟s approach to assessing water plans ..................................................... 144

Overview of revenue requirement ................................................................................. 147

The ESC‟s assumptions ................................................................................................. 148

Operating expenditure .................................................................................................... 150

Capital expenditure ........................................................................................................ 151

Financing capital investments ........................................................................................ 152

Regulatory asset base ..................................................................................................... 153

Rate of return ................................................................................................................. 154

Regulatory depreciation ................................................................................................. 155

Final decision ................................................................................................................. 155

5.5 Queensland ................................................................................................................... 155

Pricing principles and methods ...................................................................................... 156

Methodology: maximum revenue requirement .............................................................. 156


Return on capital ............................................................................................................ 157

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Weighted average cost of capital ................................................................................... 158

Return of capital ............................................................................................................. 158

Operating costs ............................................................................................................... 158

Two-part tariffs .............................................................................................................. 159

Pricing water .................................................................................................................. 159

New developments ......................................................................................................... 159

5.6 South Australia............................................................................................................. 160

Overview ............................................................................................................................ 160

Cost recovery of capital expenditure ............................................................................. 161

Urban water tariffs ......................................................................................................... 161

Ongoing business viability ............................................................................................. 162

Overview of revenue requirement ................................................................................. 162



Rolling forward asset values .......................................................................................... 164

Return of assets – depreciation ...................................................................................... 164

Operating, maintenance and administrative costs .......................................................... 165

5.7 Western Australia ......................................................................................................... 165

Key findings on Western Australia Water Corporation‟s revenue requirement operating expenditure ..................................................................................................................... 167


Depreciation ................................................................................................................... 168

Rate of return ................................................................................................................. 169

Initial RAB ..................................................................................................................... 169

5.8 Tasmania ...................................................................................................................... 170

The building block approach ......................................................................................... 171

Operational, maintenance and administrative costs ....................................................... 172

Asset consumption costs ................................................................................................ 172

Highlighted reforms of Tasmania‟s water and sewerage sector .................................... 173

5.9 Summary of water pricing and economic regulation ................................................... 175

5.10 Summary .................................................................................................................... 178

Chapter Six: Asset Valuation Techniques Used in Water Utility Businesses ....................... 180

6.1 Introduction .................................................................................................................. 180

6.2 Recognition and measurement of assets ..................................................................... 181

6.3 Asset valuation ............................................................................................................. 184

6.4 Role of asset valuation and regulatory control issues .................................................. 189

6.5 What is deprival value? ................................................................................................ 193

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6.6 Background information of the ODV .......................................................................... 196

6.7 Overview of asset valuation techniques ....................................................................... 196

6.8 Summary ...................................................................................................................... 206

Chapter Seven: Asset Valuation Method Using the ODV ..................................................... 209

7.1 Introduction .................................................................................................................. 209

7.2 Brief overview of the CCA .......................................................................................... 210

7.3 Developments of the deprival value in Australasia ..................................................... 212

7.4 The „O‟ in the ODV ..................................................................................................... 217

7.5 Steps involved in ODV ................................................................................................ 221

7.6 System optimisation ..................................................................................................... 225

7.7 Valuation of the ODV at EV ........................................................................................ 229

7.8 Summary ...................................................................................................................... 234

Chapter Eight: Research Methodology .................................................................................. 237

8.1 Introduction .................................................................................................................. 237

8.2 Research methodology ................................................................................................. 238

8.3 Overview of accounting research ................................................................................. 242

8.4 Accounting research methodologies ............................................................................ 244

8.5 The case study methodology to this thesis ............................................................... 249

8.6 The exploratory case study methodology to this thesis ............................................... 253

Step 1: Determine and define the hypothesis of the thesis ............................................ 255

Step 3: Determine data gathering and analysis techniques ............................................ 258

Step 4: Collect data in field ............................................................................................ 258

Step 5: Evaluate and analyse data .................................................................................. 259

Step 6: Prepare the report ............................................................................................... 260

8.7 Summary ...................................................................................................................... 261

Chapter Nine: Results and Discussions ................................................................................. 264

9.1 Introduction .................................................................................................................. 264

9.2 Comparison of pricing-based asset valuation techniques ............................................ 265

9.3 Justifications for the findings ....................................................................................... 270

9. 4 Case studies in water industry..................................................................................... 270

9.4.1 New South Wales ...................................................................................................... 271

9.4.2 Victoria ..................................................................................................................... 275

9.4.3 Queensland ................................................................................................................ 280

9.4.4 South Australia.......................................................................................................... 283

9.4.5 Western Australia ...................................................................................................... 288

9.4.6 Tasmania ................................................................................................................... 294

9.4.7 Key findings .............................................................................................................. 297

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9.5 Regression analysis ...................................................................................................... 299

9.5 Summary of current institutional structure arrangements ............................................ 303

9.6 Water Pricing Principles as outlined by the NWI ........................................................ 305

9.7 Summary of asset valuation techniques used by water utilities in major Australian jurisdictions ........................................................................................................................ 311

9.8 Is the price of water high or low? ................................................................................ 315

9.9 Summary ...................................................................................................................... 319

Chapter Ten: Summary and Conclusions ............................................................................. 323

10.1 Introduction ............................................................................................................... 324 10.2 Outline of the thesis ................................................................................................... 324

10.4 Limitations of the research ......................................................................................... 335

10.5 Suggestions for future research .................................................................................. 335

10.6 Summary .................................................................................................................... 337

References .......................................................................................................................... 340

Appendix 1: ........................................................................................................................ 366

Examples of Optimisation .................................................................................................. 366

Appendix 2: ............................................................................................................................ 373

Water Price Structures ....................................................................................................... 373

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Acknowledgements

I would like to express my gratitude to all those who made it possible for me to complete

this thesis. Without the supportive academic and research environment at Swinburne

University of Technology, Faculty of Business and Enterprise, Hawthorn, (formerly

Faulty of Higher Education, Lilydale) the completion of my thesis would not have been

achievable.

I owe a debt of gratitude to Associate Professor Malcolm Abbott for his encouragement,

guidance and support throughout this research project. Thank you for your patience in

reading all my draft chapters. Without your expertise and suggestions, I would not have

completed this thesis.

I would also like to express my gratitude to staff from the Faculty of Business and

Enterprise, Hawthorn, in particular to Head of Academic Group, Dr Mary Dunkley, for

her continuous support, especially at the time of the writing of the thesis. Thank you to

Professor Christine Jubb, Associate Professor Jean Raar, Senior Lecturer Judy Oliver and

Senior Lecturer Dr John Lourens for the feedback and assistance they provided for this

thesis.

Thank you and appreciation is also extended to my colleagues, in particular Dr Sarod

Khandaker, Dr Omar Bashar, Dr Craig Macintosh and Dr Jason Skues who willingly

availed me of their expertise.

Finally, I am thankful and forever indebted to my family for their understanding and

patience throughout this thesis project.

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Abstract

In Australia, asset valuation is used to determine a „rate base‟ that helps regulate water

prices using the „building block‟ approach. Different asset valuation techniques result in

significantly different figures for the same assets, and will lead to different levels of water

prices affecting consumers‟ and investors‟ behaviour in the industry.

Using the exploratory case study research methodology and regression analysis, the thesis

is the first study undertaken that explores the use of deprival value, an accounting

measurement concept developed for the purpose of determining the initial value of

regulatory asset base (RAB). The RAB is an accounting figure and asset valuation used

for price-setting purposes. Under the deprival value method, two main asset valuation

techniques are used for price-setting purposes; that is, the depreciated optimised

replacement cost (DORC) and economic value (EV) valuation models, in context of water

utility pricing in major Australian jurisdictions. A common understanding is established

to justify as to why the two main techniques stand as the recommended asset valuation

techniques for the pricing of water in Australia.

In undertaking this research, academics and practitioners will be able to better judge

whether DORC or EV principles are well suited for tariff regulation and whether the

financial models can be transported usefully to other price-setting and financial modelling

applications, whether in the public or private sector or both.

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Chapter One: Introduction

1.1 Background and context

Utilities (including electricity, gas, water and wastewater) provide essential services.

According to the Australian Bureau of Statistics, the industry employed 1.2 per cent of

the total Australian workforce and contributed 2.3 per cent or $25.3 billion to the nation‟s

gross domestic product (GDP) in 2009–10 (Australian Workforce and Productivity

Agency 2013, p. 1).

A key feature that distinguishes the Australian environment from that of other countries is

that water is a scarce resource relative to its many uses. Australia is the driest inhabited

continent on Earth, and yet it is among the world‟s highest consumers of water as

reported by the Australian Natural Resources Atlas (2000, p. 8). On a per capita basis,

each Australian uses an average 1.31 million litres of water each year; leading to an

average total of 24 000 gigalitre (GL) of water used in 1996–97 – enough water to fill

Sydney Harbour 48 times (one GL is 1 000 000 000 litres).

A more recent record reveals that each Australian household uses an average of 350 litres

of water per day, of which gardening is responsible for up to half, while flushing toilets

accounts for approximately one-quarter. In comparison, consumers from Asia, Africa and

Latin America use 50–100 litres per day, while in the United States they use

approximately 400–500 litres. Out of the 24 000 GL water, 19 000 GL (80 per cent)

comes from rivers and dams, and 5 000 GL (20 per cent) is groundwater. In Australia, 75

per cent of water is used for irrigated agricultural, 20 per cent for urban and industrial

purposes, and 5 per cent for domestic purposes (Agriculture, Fishery and Forestry

Australia 2000, p. 2).

Rainfall is the best available source for water, but according to the Australian Bureau of

Statistics (2012, p. 83), the years 2001 to 2009 were the driest ever over parts of eastern

Australia. Droughts in south east Australia (southern Queensland, New South Wales,

Victoria, Tasmania and parts of South Australia) and south west Western Australia were

most economically damaging, since 75 per cent of Australia‟s population and its

agriculture are located in these areas. As a consequence of below-average rainfall,

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restrictions have been implemented in many cities and most irrigation areas on usage of

water by households and industries (including agriculture).

Droughts can have a severe economic impact. For example, it was estimated to have had

a downward impact on GDP of almost 1 percentage point between 2001–02 and 2002–03,

while the 2006–07 drought had a downward impact of 0.6 per cent (Australian Bureau of

Statistics 2012, p. 83).

At present, the price of water is a focus of intense interest to Australian states and

territories, national governments and the general public. Water is an essential basic

component of all life; no life (human, animal or plant) can live without it. The setting of

water prices (rates) affects not only the cost of living for many other goods and services,

but also the general cost of living for ordinary citizens.

Water is a critical and necessary resource for Australia. On its own, it is a major enabler

of economic activity. Most importantly, water is a predominant economic sector in its

own right and is essential to maintaining a high living standard for all Australians. The

availability of reliable and affordable water must therefore be provided to all citizens. It

underpins the success of future Australian cities.

In a broader context, the supply of water (and infrastructure) is one of the cores of social

and economic development in Australia. Therefore, as water scarcity grows, it is more

important than ever to fully account for water stored, traded and consumed, to ensure

sufficient investment is made in water infrastructure to secure supplies.

National investment in water supply and wastewater disposal related infrastructure is an

important part of government policy, given that the industry is heavily regulated and the

bulk of physical assets are government-owned. Investment in water is important, not only

for ensuring the viability of bulk water supplies from dams and other sources (e.g.

recycling and desalination plants), but also for reducing losses from leakages and

overflows.

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1.2 Infrastructure assets

From storage, water is typically distributed across a wide network of pipes. In Victoria,

for instance, most of Melbourne‟s water catchments are in forested areas high in the

eastern and north eastern ranges. Here the rainwater is caught, held and filtered as it flows

into streams and reservoirs, where it is stored for long periods. Then with the help of large

pipes (distribution mains), water flows to service reservoirs, from where it is distributed

to the metropolitan retail water businesses via small pipelines, reaching the ultimate

consumer.

For the company South East Water in Melbourne, 8 585 km of largely underground pipes

carry the water through a complex network. Water infrastructure assets include dams,

weirs, barrages, pump stations, channels, pipelines, reservoirs, balancing storages, fish

ways and water meters that measure the water going in out and out of the system. Other

assets include electrical and mechanical equipment to make it fully functional.

An example of recent important investment in water infrastructure is the enlarged Cotter

Dam, one of the biggest construction projects undertaken in the Australian Capital

Territory, which aims to extend the current Cotter Dam downstream, increasing its

current capacity from 4 GL to about 78 GL – almost 20 times its current size. The

enlarged Cotter Dam project will be a part of the Australian government‟s continued

response to ensure a secure water supply for the Australia Capital Territory, and to deal

with drought, climate change and its variability. Construction was completed in 2013, at a

total cost of $363 million (ACTEW 2011).

Another recent water project was the Murrumbidgee to Googong pipeline in the

Australian Capital Territory. The one-metre diameter pipeline of this project transfers up

to 100 megalitres per day (ML/d) of raw water from Murrumbidgee River near Angle

Crossing to a pipeline running via the Burra district to Googong Reservoir. The project

was valued at almost $155 million and was completed in August 2012. It was quoted in

the Canberra Times that the engineering projects in the Australian Capital Territory in

2010–11 were worth $760 million at 2008–09 prices (Downie 2011, p. 2).

http://www.melbournewater.com.au/content/water_storages/water_supply/water_catchments.asp

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The South East Queensland Water Grid is another project that was one of the largest of its

time and was built in response to the drought that affected water supplies in Brisbane and

surrounding areas between 2004 and 2007. Its bulk water assets include twelve connected

dams, ten connected drinking water treatment plants, three advanced water treatment

plants producing purified recycled water, one desalination plant, twenty-eight water

reservoirs, twenty-two bulk water pump stations, and 535 km of potable bulk water mains

that connect areas with water to areas lacking water. The South East Queensland Water

Grid project cost $6.9 billion (Queensland Government 2010).

Another project, the Western Corridor Recycled Water Scheme which is located in South

East Queensland, was constructed in 2006 and completed in 2008. Three advanced water

treatment plants were constructed at Bundamba, Luggage Point and Gibson Island, where

water is drawn from six existing wastewater treatment plants to produce up to 232 million

litres of purified recycled water daily. A network of pipelines over 200 km long

distributes water to consumers. The Australian Government funded $408 million through

its Water Smart Australia Program. The Western Corridor Recycled Water Scheme was

Australia‟s largest recycled water project, which cost $2.5 billion (Queensland

Government 2010).

Finally, Australia‟s largest, indeed the Southern Hemisphere‟s largest desalination plant,

is located in Victoria at Wonthaggi, and the cost of this project was $3.5 billion. The

Wonthaggi Desalination Plant supplies 30 per cent of Melbourne‟s water needs (State of

Victoria Government 2009, p. 2).

1.3 Issues

Australia has a public policy of open access and regulation of infrastructure assets that are

regarded as possessing natural monopoly characteristics. The principal features of natural

monopoly industries include large fixed and sunk costs, and economies of scale over the

relevant range of demand for the service. With an expansion in demand, it might be

possible to achieve efficient production through an increase in the number of firms

(providers) (Fearon 2006, p. 2). Lee and Fisher (2004, pp. 349–350) stated from a

financial accounting perspective that infrastructure assets are defined as “all non-current

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assets including the public facilities which provide essential services and enhance the

productive capacity of the economy. This is the case whether the assets are government or

privately-owned and include roads, bridges, railroads, power generations and distribution

networks and in particular water supply and sewerage systems.”

Water supply is generally regarded as having natural monopoly characteristics, which

means that it can also be subjected to economic regulation of prices and revenue, in turn

influencing levels of investment. In Australia, the water supply and wastewater

businesses are regulated by state government-based bodies, such as the Essential Services

Commission (ESC) in Victoria, and the Independent Pricing and Regulatory Tribunal

(IPART) in New South Wales. This is in place of national bodies such as those that exist

for other utilities like telecommunications, electricity and natural gas. In undertaking this

regulation, state-based bodies depend upon using a range of accounting methodologies to

determine what is regarded as being „fair‟ prices to both consumers and investors/owners.

These prices are determined with the aim of ensuring a fair rate of return to investors, at

levels that do not exploit consumers. Formal regulation of this type also exists in other

countries including the United Kingdom and United States.

Abbott and Cohen (2010, p. 48) noted that in Australian capital cities, public ownership

and operation of water supply assets is still the norm; although a noteworthy exception to

this is Adelaide where the system is state-owned but operated by a private company.

Public ownership has endured for a number of reasons, including high interest in

environmental and quality standards, as well as water supply security issues. One

additional reason, perhaps, is that there have not been any large-scale success stories of

water privatisation overseas, unlike other industries such as telecommunications.

Current regulatory measures that rely upon the application of accounting methodologies

were not entirely intended for the purpose of determining asset valuation and depreciation

schedules. To add to this, there is no complete consensus on which techniques can be

used across Australian states and territories, or even internationally. Instead, for the

purpose of charging (pricing), the deprival value is used along with historical costs and

replacement costs in some overseas jurisdictions.

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1.4 Research problem

In competitive markets, the buyers and sellers do not need to go through the process of

establishing a price for a particular good or service. Market forces determine demand and

supply, and price, and hence also the asset values. Unlike in the competitive markets, the

provision of services by the water industry has natural monopoly characteristics (free

from direct competition), which means consumers cannot change water providers. It is

more efficient in terms of cost-technology for production to be served by a single and

large supplier of the entire market.

Water businesses charge their customers with regulated rates (prices) within a defined

geographic service area. They must provide water services within their defined

jurisdiction and expand their capacity, finding alternative ways to source water as demand

for water services increase, or where rainfall decreases due to prolonged drought and low

dam inflows.

The operating and regulatory environment in relation to issues such as pricing, licensing,

health and environmental standards for drinking water supply, wastewater treatment and

disposal from where a water utility business operates is different to other non-regulated,

„mainstream‟ businesses in Australia. Water infrastructure assets such as dams, pipelines

and sewerage treatment plants are rarely, if ever, sold in Australia. Given that they do not

have any alternative use and many are government-owned, they are unlikely to attract

potential buyers under the present regulatory conditions.

Both water retailers and customers pay for the transmission and distribution of water

services and prices within the tariff setting activity in regulated water utilities. The final

decision on water prices lies in the hands of the regulators, and over many decades

regulatory bodies in Australia have faced this fundamental issue in many different

contexts. Government regulation and the pricing of utilities in the free market continues

to be a questionable issue that is strongly debated by all parties, including academics,

researchers, regulators, utility businesses and customers.

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The most significant impact on the average price of water is the regulatory asset base

(RAB), an accounting figure that determines the value of all new and old physical assets

funded directly by the business, to which customers are required to pay for water and

services. The RAB value is an asset valuation, and it is set in „periodic review‟ and fixed

during the regulatory period of three to five years. The RAB drives three-quarters of the

revenue requirement of a water business and is considered the key determinant of

performance; it has the ability to turn revenue into profit, which in turn determines prices.

In recent years, desalination plants were built in major capital cities including Sydney,

Melbourne, Adelaide and Perth, to reduce the reliance of urban water supplies on rainfall.

This thesis examines the impact of capital expenditure (investment of new assets) on

RAB, revenue requirement and the price of water derived based on these figures.

If prices, revenue and profits are dependent on the value of a RAB, and investment is

determined by levels of productivity, then the asset valuation techniques have a vital role,

not only in relation to consumer pricing, but also the return to owners and the long-term

investment of the industry.

A water business such as South East Water in Melbourne is considered a capital-intensive

industry, with a minimum decline in book value of its asset. A large portion of capital is

used to buy expensive new assets (e.g. pipelines, pumping stations and storage tanks), to

replace existing ageing assets, and to expand the stock of assets so as to meet increasing

demands, standards and regulatory obligations. The issue of asset valuation for water

businesses is of critical importance, as it is the principal component in the building block

approach to pricing. Zauner (2000, p. 1) claimed that asset valuation determines up to 80

per cent of the maximum allowable revenue (MAR) when applied.

The valuation of assets has major consequences for defining the total costs of providing

relevant services, and the determination of water prices that will be passed on to

customers. In other words, asset valuation has a significant potential impact on the pricing

of water.

In accounting there is minimal consensus on the preferred asset valuation approach that

should be adopted, as reflected in Australian and international accounting standards,

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where a variety of measurement techniques are permitted as long as they are within the

guidelines. There have been many debates on asset valuation techniques in terms of

regulation and financial accounting. The controversy surrounding asset valuations is often

not only inconclusive but also confusing; one of the reasons is that there are different

implicit understandings of the underlying conceptual framework, if there is any such

framework.

The deprival value method, also known as „value to the owner‟ was originally

recommended in Australia by some government authorities for the purposes of

determining water utility businesses‟ revenue requirements. This method is described in

the National Water Initiative (NWI) Pricing Principles, an agreement made in 2004 by the

Council of Australian Governments (COAG) and the Standing Committee on Agriculture

and Resource Management (SCARM) (National Competition Council 1998, p. 112). Both

the COAG (National Competition Council 1998, p. 112; Australian Government 2009,

pp. 4–5 & 7) and the SCARM (National Competition Council 1998, p. 112) have

recommended this method for valuation of water business assets.

The deprival value is described as the value of any asset to the business; that is, how

much the company would be worse off if it were deprived of the asset‟s sale, or it being

worn out after years of use as a non-current asset. The use of deprival value has been

promoted in many Australian Government policy documents as the appropriate current

value basis for valuation of its publicly held assets (Lee & Fisher 2004, pp. 253–356). It

is essential that a common understanding be established to justify why the deprival value

stands as the recommended method.

Similar but limited work has previously been done on energy (electricity and gas)

businesses in Australia (Johnstone 2003, pp. 1–41). Yet even though comparisons have

been made on the use of deprival value and depreciated optimised replacement cost

(DORC) approaches in Australia‟s energy infrastructure, this has not been done for water

infrastructure assets. This is regrettable, because water does not face the same conditions

as electricity and natural gas, as it instead depends upon climatic conditions, and fixed

infrastructure makes up a much more significant proportion of assets (Abbott & Cohen

2009, p. 48).

20

1.5 Research methodology

The exploratory case study research methodology was applied in this thesis, which

produces an invaluable deep understanding and insightful appreciation of the cases. The

end result provides issues and challenges about the behavior of the RAB, its meaning and

the effect it has on water pricing. In this thesis, the case study research methodology is

used to explore and test the existing theories, such as the building block approach from

which water prices are determined, and the upper- and lower-bound pricing principles

described in economics and by the NWI Pricing Principles. The data collection

methodology used consists of archival (secondary data) and quantitative (numerical). The

three case studies described in this thesis are in Chapters Four, Five and Nine.

The methodology in this thesis follows the approach used by the energy (electricity and

gas) industry, in that it uses case studies to analyse the impact of using different asset

valuation techniques in water regulatory pricing decision-making. The case studies

include examples from all jurisdictions of Australia. Simulations of different asset

valuation techniques are taken from electricity and gas companies because of the lack of

experience and comparison of asset valuation techniques in the water industry. In doing

so, these asset valuation techniques closely match those of the real-world results.

In Chapter Nine, regression analysis is used to test the relationships between the

dependent variable, capital expenditure and independent variables, asset valuation, length

of pipes connecting residential properties‟ water supply, and the amount of the population

connected to urban water services. Data are collected from the Water Services Australia

Association (WSAA) website, and water businesses industry reports over eight years

from 2004 to 2012 are used to predict the behaviour and value of the dependent variable,

capital expenditure.

The hypothesis of this thesis is to test to see if there is a direct relationship between:

(i) investment in water assets;

(ii) does (i) impacts on the price of water and the RAB

21

The thesis will test to see if a relationship exists between asset valuation techniques

(independent variable), prices, profitability and investment levels (dependent variable) in

the industry, as well as the industry‟s long-term viability.

1.6 Contribution to knowledge

In recent times, the price of utilities (water) has been one of the most critical and widely

discussed issues. In particular, the increasing cost of water services has caused the price

of water to increase, resulting in the existing rate-making process being questioned, re-

examined and criticised. In addition, one of the most controversial and problematic issues

in public utility economics-accounting is the fair return to owners. It represents a growing

and major concern, not only to regulators but also to utility businesses and customers.

Of primary importance in the regulation of network utilities is that they are natural

monopolies, and yet they must be able to generate efficient pricing. Water prices are

proposed by a water business, and then assessed and approved by its regulator. The price

of water that consumers pay provides the total revenue of the water businesses, and

reflects a fair and reasonable cost incurred by them, including a rate of return on the

RAB. The price of water must be high enough to provide businesses (and their owners)

with a fair and reasonable opportunity to recover the total costs of providing water

services, and for the businesses to survive in the long term. At the same time, water

businesses must be able to recover costs, so as to ensure that clean and reliable water

services are provided in the long term.

The water industry can enhance trust and reduce the adverse perceptions of rising prices

by communicating transparent information to their stakeholders. This thesis assists in our

understanding of the industry, possibly leading to increased market efficiency and the

lowering of the cost of capital. On the one hand, the price of water must be high enough

to provide the business (and its owners) with a fair and reasonable opportunity to recover

the total costs of providing water services and for the business to survive in the long term.

On the other hand, the price of water must remain at minimum levels to provide the

business recovery of ongoing costs while consumers enjoy a dependable and reliable

water service.

22

Research into economics-accounting issues affecting utility businesses is treated as

unique due to the relevant operating and regulatory environments. Hughes et al. (2012, p.

49) argued that they are excluded from samples consisting of non-regulated, mainstream

businesses that may possibly impose opportunity cost from excluding this sector of the

economy. As such, this thesis is the first study undertaken in the area of asset valuation

and the pricing of water utilities in Australia. The main objective of this research thesis is

to investigate whether the price of water charged by water regulators in all Australian

jurisdictions is indeed the correct price. It discusses how the price of water is calculated,

and establishes a common understanding as to why the two main asset valuation

techniques remain the recommended techniques in Australia.

In the absence of a definitive economics-accounting framework and guidance, the aims of

this thesis are to ensure that the accounting profession, academics and the regulators have

a detailed theoretical understanding of the deprival value method. In particular, under the

deprival value method, two main asset valuation techniques are used for price-setting

purposes; that is, the depreciated optimised replacement cost (DORC) and economic

value (EV) valuation models, in context of water utility pricing in major Australian

jurisdictions. In doing so, some practical issues that arise in the implementation of asset

valuation techniques can be resolved on a basis consistent with its underlying objectives.

In making these objectives apparent, academics and practitioners will be able to judge

whether deprival value principles are well suited to tariff regulation, and whether the

financial models can be usefully transferred to other price-setting and financial modelling

applications, in the public and private sectors.

1.7 Structure of thesis

The structure of the thesis, including a diagram illustrating it (see Figure 1.1 below), is as

follows.

Chapter One – Background information on Valuation of Assets and its Impact on Water

Utility Pricing in Australia: The history, definitions and development of the valuation of

water infrastructure assets is discussed, as well as some issues in relation to regulation of

water utility assets pricing. The chapter includes a brief review of asset valuation

23

techniques used in other utilities, and a discussion of the methodology adopted for this

research.

Chapter Two – Characteristics of Urban Water and Current Water Pricing Approaches:

This chapter discusses the main characteristics of the industry, along with the regulatory

approaches used by the states/territories and the NWI which binds them. The regulation

of water prices exists to ensure safe and adequate provision of essential water services.

Three aspects of economic efficiency – allocative efficiency, dynamic efficiency and

productive efficiency – are therefore described. The method used to regulate water prices,

the building block approach, is also described in this chapter.

Chapter Three – Literature Review: A general overview of the valuation of assets from an

academic point of view is provided in this chapter. The chapter reiterates the fact that at

present, academic research in relation to asset valuation and pricing of utilities,

particularly water, is very limited.

Chapter Four – The Urban Water Industry in Major Australian Cities: This chapter

provides an overview of water industry governance, structure and the broad area of

ownership of urban water services in major Australian cities.

Chapter Five – Urban Water Regulation and Pricing: This chapter focuses on the history

of water pricing and institutional reform. The differences in the coverage of economic

regulation between Australian jurisdictions is examined in this chapter, followed by a

discussion of existing pricing structures in the water and wastewater sectors in Australia‟s

major capital cities.

Chapter Six – Asset Valuation Techniques Used in Water Utility Businesses: This chapter

discusses a range of issues in relation to the valuation of water businesses‟ assets. To

begin with, some general issues are discussed, followed by a debate on the role of asset

valuation in relation to regulatory control, and then a discussion of the deprival value and

background information of the optimised deprival value. An overview of asset valuation

techniques is also provided in this chapter.

24

Chapter Seven – Asset Valuation Method Using the ODV: This chapter continues with

the discussion on asset valuations. The deprival value is part of current cost accounting

(CCA) standards in Australia, and an overview of the history and development of CCA is

provided in this chapter. It also includes an examination of the steps involved in asset

valuation method using the ODV.

Chapter Eight – Research Methodology: One of the most important decisions to be made

in any research project is selecting the research methodology. A general overview of

research methodology is discussed in this chapter, followed by an overview of the types

of research methodology used in accounting research. The exploratory case study

research methodology was used in this thesis, which draws on archival (secondary) data

collection and quantitative (numerical) methodology. Figures of different asset valuation

techniques are taken from electricity and gas companies‟ random events. This approach is

called „simulation‟, a process that approximates those of the real-world results. The

process of preparing and collecting data is presented, so that analysis of important issues

can be finalised in the next chapter.

Chapter Nine – Results and Discussions: A summary of comparisons and findings of

different asset valuations used by utility businesses is provided in this chapter. It

discusses in detail why the deprival value stands as the recommended asset valuation

method for charging purposes, and concludes by reviewing whether the current price of

water is reasonable.

Chapter Ten – Summary and Conclusions: Summary, conclusions and lessons to be learnt

are discussed here, and future research directions are also drawn out. The scope,

assumptions and limitations of this research are also outlined in this final chapter.

25

Figure 1.1: Summary of thesis structure

Chapter Ten

Summary and Conclusions

Chapter Nine

Results and Discussions

Chapter Eight

Research Methodology

Chapter Seven

Asset Valuation Method Using the ODV

Chapter Six

Asset Valuation Techniques Used in Water Utility Businesses

Chapter Five

Urban Water Regulation and Pricing

Chapter Four

The Urban Water Industry in Major Australian Cities

Chapter Three

Literature Review

Chapter Two

Characteristics of Urban Water and Current Water Pricing Approaches

Chapter One Background information on the Valuation of Assets and its Impact on Water Utility Pricing

in Australia

26

Chapter Two: Characteristics of Urban Water and Current

Water Pricing Approaches

2.1 Introduction

In general terms, water satisfies people‟s thirst and is considered a public necessity. As an

essential component of life, the urban water industry comprises of approximately 300

utilities in Australia, and most states are responsible for their own water policy decisions.

These decisions are bound by their signatory obligations to the NWI, an agreement that

was signed by all Australian states and territories at the 2004 meeting of the COAG. Its

aims are to provide a long-term, national plan for water reform (Langford & Piccinin

2004, pp. 70–71; Engineers Australia 2010, p. 63).

As most parts of Australia receive highly erratic rainfall, water supply requires

considerable planning, which can be very challenging for the Australian Water

Management. There are also infrastructure costs associated with the delivery or use of

water, which has led to excessive use, over-investment in infrastructure, and

environmental degradation in some areas. Furthermore, as discussed in Chapter One,

there are no market-determined prices available to signal relative scarcity value of water.

Since the water industry is a natural monopoly, competition is often not possible; hence it

is important that the price of water is regulated to reflect its scarcity value.

In line with this, this chapter discusses the meaning of such regulations, including their

importance and the rationale behind them. It also reviews some common policy

objectives for regulation of water prices, along with discussion on economic efficiency

which is promoted not only when water prices reflect the opportunity cost of supplying

water, but also when regulation is in place. Efficient prices need to be set so that efficient

water usage and supply outcomes can encouraged.

The price for water is not determined in a market that reflects demand and supply for

water service, but is instead governed by a regulator based on a number of factors and

stipulations. While it takes into consideration the burden for consumers, it must also

provide appropriate signals to users with respect to the resources used and costs incurred

27

in the context of current and future availability of water, as well as environmental

considerations, consumer needs and social policy objectives.

Following this general discussion, the chapter will further refer to the actual specific

approaches used in urban water pricing. Even though most regulators in Australia use the

building block approach to regulate their urban water prices, there are other approaches

such as price caps, weighted average or tariff baskets, and revenue caps which directly or

indirectly control water providers‟ charges. The approaches used vary depending on the

incentives presented to the water industry, the allocation of risks associated with

unexpected changes in water demand, the level of pricing flexibility, and the different

pricing mechanisms dependent on water providers‟ administrative complexity.

Pricing principles for water are contained in the strategic framework for water, as

explained in the Compendium of National Competition Policy Agreements, and the urban

water services industry adopted the water resource policy by no later than 1998.

Paragraph 6 of the COAG Water Resources Pricing Principles (NWI 2010, p. 18) states

that economic regulators (or equivalent) determine the level of revenue for the water

industry based on efficient resource pricing and business costs. Furthermore, paragraph 7

of the COAG Water Resources Pricing Principles (NWI 2010, p. 18) states that in

determining the prices, transparency is required in regards to community service

obligations, contributed assets, their opening value, externalities such as resource

management costs, and tax equivalent regimes.

With the combination of specific prices and revenue controls, this approach forms the

basis of water prices in Australia.

2.2 Main characteristics of water

As an essential component of all life, water has some characteristics distinct from any

other goods. Some of its main characteristics are summarised in Diagram 2.1 below.

28

Diagram 2.1: Main characteristics of water

Water is the basic necessity that no life, human, animal or plant, can live without. Water

is a special commodity which has an EV, as people are willing to pay for water rather

than go without it. Water is a raw material that is used in the production of food and that

satisfies people‟s thirst, and therefore qualifies as an economic good; that is, something

intended to satisfy wants and needs of a consumer. Water is also a public good; no one

can be denied access to water with the exception of the driest parts of the world, and there

are no close substitutes or alternatives to it. It is plentiful in some places, such as the

uninhabited mountain ash forests high up in the Yarra Ranges, east of Melbourne, but it is

scarce in other areas such as the densely populated parts of south east Australia.

Water, relative to its value, is difficult and expensive to transport against gravity. It is not

only heavy, but unlike gas cannot be compressed. Water in lakes and rivers, for example,

is not freely tradeable or dividable as a resource, and is therefore subject to government

regulation and price control. A key implication of this is that water markets serving

Australia‟s major cities are not and are unlikely ever to be as closely integrated as the

electricity markets have become. This means that a „one size fits all‟ approach to urban

Characteristics of water

Basic essential

A special commodity

Economic good

Public good

Non-substitute

(no alternative)

Scarce in some

places, plentiful in others

Difficult & expensive

to transport

Not freely tradeable

Subject to regulation & price control

29

water markets is unlikely to succeed. Each market needs to be considered separately,

particularly in regard to the supply of water (The Allen Consulting Group 2009, p. 7).

2.3 The urban water industry

The year 2009–2010 represented a positive change for the Australian urban water

industry, as increased rainfall across eastern Australia (including South East Queensland

and areas of New South Wales) led to a rapid rise in storage levels in many of Australia‟s

catchments. Yet even though most water utilities were able to ease water restrictions or

move to permanent water conservation measures, Perth continued to record low rainfall.

The unexpected floods in early 2010 in Queensland highlight Australia‟s extreme climate

variability and the ongoing water challenges (Australian Government 2011, p. 1).

In relation to the approximately 300 water utilities, an estimated 70 per cent of

Australia‟s population is serviced by 26 of them, while the 200 smaller utilities

collectively serve only three million customers (Water Services Association of Australia

2004, p. 46; National Water Commission 2005, p. 31). In total, Australia‟s urban water

industry services 20 million customers and the urban-based industries, manage 17 per

cent of Australia‟s water use (Water Services Association of Australia 2004, p. 46). The

Queensland Competition Authority (QCA) (2000, p. 11) suggested that before water can

be provided to communities, there are costs (infrastructure designed to harvest, store,

treat and deliver water) involved in its provision. Water as a resource has costs

associated with diverting it from other users to meet the requirements of domestic,

commercial and industrial users, or particular groups within these categories.

While demand for water is determined by needs, preferences and practices of consumers

and industries within a particular region, and the need to maintain sustainable

environmental systems, its supply is governed by the hydrological cycle, the availability

of groundwater, and the infrastructure to harvest and distribute it to consumers and users.

The Allen Consulting Group (2009, p. 5) explained that the urban water supply and

wastewater management consists broadly of functions ranging from water harvesting and

storage, through to provision of drainage and the management of sewerage (refer to

Figure 2.1 and Table 2.1).

30

Figure 2.1: Urban water supplies

Environmental use → Stormwater → Drainage → Ocean

Potential convert wastewater back to water supply

(The Allen Consulting Group 2009, p. 5)

Table 2.1: Key water functions

Functions Components

Supply,

harvesting

and storage

Water storage and harvesting, including catchments, dams,

aquifers, desalination, recycling and stormwater collection

Treatment Treatment of water to meet appropriate standards

Distribution Water transport, system operation and management of temporary

storage (reservoirs)

Retail Billing services, marketing, customer management

Wastewater Sewerage transportation, wastewater treatment and disposal

Drainage Collection and transportation of stormwater

(The Allen Consulting Group 2009, p. 5)

Urban

water supplies

Supply sources, e.g. desalination and

recycling

Treatment, e.g. treatment plants

Distribution, e.g. reservoirs

Retail, e.g. grey water and sewerage

Waste, e.g. treatment and distribution

31

The two main services provided by the urban water industry are the supply of reticulated,

potable water, and the collection, treatment and disposal of wastewater (Australia

Government 2011, p. 3).

The physical and economic characteristics of urban water are common to those of other

reformed utility industries, such as gas and electricity. For instance, the two key features

of water particularly relevant to the Australian urban management are that the rain-fed

supply of water is uncertain, and that while water is in dams and reservoirs, it is relatively

cheap to store (The Allen Consulting Group 2009, pp. 6–7).

The essential nature of water services raises important questions: How much of a supply

„buffer‟ should be maintained as insurance against extensive drought? How much future

growth is required so that supply can cater for demand?

Maintaining surplus capacity is not only expensive, but also limits the ability to adapt to

changing seasonal and demand conditions. The size of a supply buffer involves a trade-

off between a consumer‟s willingness to pay for reliability and the cost of constructing

and maintaining surplus capacity.

The issue of planning for uncertain water supply is particularly challenging for Australian

Water Management, as most parts of Australia‟s urban water supplies are dependent on

highly erratic rainfall. As recent history demonstrates, much of the Australian continent is

subject to periodic droughts that can be severe and extended, and this creates a problem in

determining the reserve supply that needs to be stored for future consumption. A solution

to this problem is to produce water via alternative processes such as desalination,

recycling sewage, and collecting and treating stormwater for reuse. However, the cost of

desalination and recycling can be prohibitively high compared with existing sources (The

Allen Consulting Group 2009, pp. 6–7).

2.4 What is a regulation?

A regulation is defined in the Oxford Dictionary as a „prescribed rule‟ or „authoritative

direction‟. The Macquarie Dictionary defines it as „a rule of order, as for conduct,

32

prescribed by authority; a governing direction or law‟. The Department of Treasury and

Finance (2007, p. 3) described it as „rules‟ (e.g. primary and subordinate legislation and

codes of practice) set by government, either through legislation or similar instruments in

order to set standards for appropriate behaviour in the public‟s interest. Traditionally,

regulations exist to ensure safe and adequate provision of essential public services, such

as energy, water and transport. Fundamentally, they exist to protect customers, the

community and the natural environment.

Water being a natural monopoly calls for regulation. In the water industry, economies of

scale are large in relation to the size of the water market, where capital costs are typically

70–80 per cent of the total cost and it is probably expensive to build or duplicate water

pipelines. The monopolist‟s market is therefore unlikely to be entered by a potential

competitor, as this would involve a considerable amount of capital investment. Rather, it

is cheaper if one infrastructure is used with its price-setting controlled.

It is wasteful to duplicate the entire infrastructure and would also cost the community a

considerable amount of money. Thus in the water industry, regulation can be viewed as a

substitute for competition where competition is either lacking or not possible (SAHA

International Limited 2007, p. 8; Pardina, Rapti & Groom 2008, p. 1; Abbott & Cohen

2009, p. 233).

In this market environment, water regulation intervenes for consumer welfare at a number

of levels; one of the most important is that without it, the power of the providers would be

such that they could set prices at a level that delivers more than a normal commercial

return. Further, the lack of choice for consumers to change providers leads to the

providers being able to offer a potentially substandard level of service without the risk of

losing a consumer.

Regulation also intervenes in respect to the environment, as there are potential unwanted

side effects from water service provision, such as damage to the environment or risking

public health. Some form of government intervention is also appropriate for maintaining

minimum health standards for particular customer groups, such as low-income families,

to ensure that they are treated equitably.

33

In South Australia, Queensland, Tasmania and Western Australia, regulatory agencies

conduct reviews on matters referred to them by the government, including water pricing.

These regulatory agencies advise government on pricing as opposed to regulating prices

(reviewing pricing policies), as they do in other states and territories including Victoria,

New South Wales and the Australian Capital Territory (Economic Regulation Authority

2007, p. 4).

Research in accounting regulation draws on a variety of explanatory theories, such as

public interest theory (Posner 1974, pp. 335–358), private or economic interest theory

(Deegan, Morris & Stokes 1990, pp. 261–280), institutional theory (Powell & Steinberg

2006), political economic theory (Puxty et al. 1987, pp. 273–292) and capture theory

(Walker 1987, pp. 269–286). In particular, capture theory regulation is a theory associated

with both Richard Posner, an American economist and lawyer and George Stigler, an

American economist. Capture theory regulation is applicable to regulated industries such

as water utilities. The industry may benefit from the process via direct subsidies of

money, entry control, price fixing, or control over substitutes or complements. Regulatory

industries such as water, railway and electricity utilities submit to certain rules,

regulations, „standards‟ of conduct, or other interferences. Stigler (1971, pp. 3-21) argued

that in doing so, there are costs involved and the net return to the regulated industry is

higher (on average) than non-regulated industries. As long as the net benefit is positive

and lobbying costs are not prohibitive, those who stand to gain from the regulatory

process will demand it.

2.5 Why is regulation important?

In Australia, the current regulatory frameworks for the water industry are based on a

combination of legislative, regulatory instruments and decision-making bodies. The first

system for regulation of the water industry was developed under the umbrella of the

Trade Practices Act 1974, since replaced by the Competition and Consumer Act 2010.

While the Act deals with all aspects of water in the marketplace, including relationships

among suppliers, wholesalers, retailers and customers, it also covers regulation of water

industry. Following this, in 1994, through the COAG, the NWI was built. However, in

many aspects, regulation of the water industry is still new and developing.

34

The regulation of utilities including water has been implemented in most countries by

constraining the rate of return on capital. It seems that this is a necessity to attract capital

to utilities while avoiding excessive exercise of monopoly power. Some main

characteristics of this type of regulation, as asserted by Laffont (1994, pp. 507–508), are:

A fair rate of return on investment above the market rate is guaranteed as long as

investments are prudent.

Prices are determined to equal average costs with imputed charge for capital.

Prices remain fixed during the regulatory period, until a new regulatory review

leading to new prices comes about.

The regulatory review is a process of checks and balances in which the conflicts

between the firm which demands high prices and the consumers who demand low

prices are arbitrated by the regulatory commission.

If left unregulated, water providers cannot be relied upon to deliver services where it

should be valued by the community. That is, a business operating with purely commercial

objectives will not operate to provide services unless it can make a profit. The business is

likely to establish infrastructure where it can maximise profits, and may neglect other

areas where smaller or no profits are available (Department of Treasury and Finance

2007, p. 5; SAHA International Limited 2007, p. 8).

Regulation sets directions and ensures that service providers deliver services to all their

customers. The regulatory regime provides certainty and protection to all stakeholders by

implementing adequate penalties and incentives to promote desirable behaviours. It also

ensures a better understanding of the expectations of the government and customers to

support long-term business planning and decision-making. Long-term investments of

service providers are also protected, and prices can be recovered from efficient

operational and infrastructure costs (SAHA International Limited 2007, p. 8).

The National Competition Policy (NCP) requires of all Australian states and territories

that where legislation exists that restricts competition through licensing operators, they

must be able to justify it as being in the public‟s interest (Department of Treasury and

Finance 2007, p. 3).

35

2.6 Rationale for regulation

In order to supply water services, significant infrastructure is required to store, treat and

deliver water; however, it is not easy for a non-competitive market to establish these

facilities. The Economic Regulation Authority (ERA) (2005, pp. 16–17) has explained

that regulation of water prices commonly seeks to achieve multiple policy objectives,

including the following:

To signal the scarcity value of water that may arise because of infrastructure

constraints or limited hydrological capacity.

To control the revenue requirements of water businesses, so as to avoid passing on

monopoly pricing of services to customers.

To enhance the efficiency of service delivery without the absence of a competitive

market. The rationale of water regulation should allow water providers to recover

their cost of service delivery and earn a commercial rate of return on capital, at the

same time promoting efficient service delivery.

To manage demand through tariff structure adjustments. Price is one tool for

managing the supply-demand balance.

To reflect the net cost of environmental externalities. Its aim is either to recover

costs associated with meeting environmental standards, or to send a price signal to

water users to allow them to modify their consumption habits in order to avoid

future environmental costs.

To set tariff structures in order to meet social objectives in relation to the equitable

distribution of costs to different customer groups.

To encourage efficient outcomes that involve lowest possible costs to society.

To encourage outcomes that are judged as fair.

To use pricing rules that are simple, transparent and avoid excessive regulatory

burdens.

These objectives often involve trade-offs; for example, it is not possible to implement

prices that optimise economic efficiency while also meeting equity and fair pricing

criteria. Pricing structures must be developed to take into consideration administrative

36

practicalities and cost, revenue stability for water providers, price stability for the

customer, customer acceptability, and transparency.

Under „normal‟ market conditions, resources that are capable of being traded attract a

scarcity that reflects users‟ willingness to pay. However, this is not the case with water

and regulatory prices, which must be used to reflect those scarcity values. The rationale is

that if scarcity prices are revealed and resources efficiently allocated, this will maximise

the sum of benefits from water by all users. However, there are efficiency problems

related to water provision, because the characteristic of water is distinct from the resource

itself (Johnstone 2003, p. 1; Vinnari 2006, p. 159; Department of Treasury and Finance

2007, p. 5; Fearon 2006, pp. 4–5; Sibly & Tooth 2008, p. 220; Economic Regulation

Authority 2008, p. 10).

2.7 How to regulate

A trend in regulation is to delegate the decision about structure of prices to the regulated

entity, and to provide incentives for the entity to set efficient prices. In the water industry,

within a regulatory period, the specific form of control over prices affects the pay-offs

that may be associated with tariff rebalancing. It is a mechanism where the incentive to

set efficient prices can be provided (The Allen Consulting Group 2003, p. 18).

There are many forms of economic regulation. Fearon (2006, p. 5) suggested that it can

be either characterised as „light‟ or „heavy‟ handed, and is generally applicable to sectors

or businesses that exist along a continuum from pure natural monopoly to competitive

markets. For example, in Victoria the ESC approach to regulation included regulation of

natural monopoly networks under various forms of price-cap regulation, and regulating

those industries experiencing some emerging competition, such as rail access, ports and

grain handling, with some retaining power.

2.8 Economic efficiency and principles of efficient prices

Regulation attempts to create prices that promote economic efficiency. Economic

efficiency is:

37

A state of affairs in which, given the values of resources utilised, one has

taken advantage of every available opportunity to increase the economic

welfare of consumers through the provision of larger quantities of outputs,

better products, or a mixture of outputs better adapted to consumer

preferences (Kahn 1992, cited in Farrier Swier Consulting 2002, p. 20).

Economic efficiency should provide incentive for consumers to use water efficiently,

which can be enhanced through regulatory mechanisms. Water prices can be kept at a

minimum level compatible with long-run sustainability of the service when economic

efficiency is achieved, which can be categorised into three aspects: allocative efficiency,

dynamic efficiency and productive efficiency. In any economy, prices reflect the

opportunity cost of the available resources, and allocative efficiency ensures that

resources are allocated to their most productive use through production and consumption

decisions. Allocative efficiency is maximised where resources are allocated such that the

value in use of the product is equal to the increment in the cost of supplying the product,

at the very least.

Dynamic efficiency ensures efficient investment decisions in the long term through the

correct combination of options and right timing. In the water industry, dynamic efficiency

refers to the ability of water businesses to improve the quality and cost of water and

services, and to respond to emerging market developments. It relates to processes of both

technological and managerial innovations, such as capital investments, research and

product innovation. Productive efficiency focuses on producing at the minimum possible

cost, given the available technology and input prices.

Both allocative and dynamic efficiencies are also relevant issues given that the existing

assets of the businesses are sunk costs. Productive efficiency is maximised where the

regulated business treats prices as it would in a fully competitive market, and where

existence of a number of distinct water service businesses makes it possible to compare

the efficiency among them. In doing so, it induces competitive behaviour. Efficient

investment in water network assets is a significant part of productive efficiency. It is

critically important that correct decisions are made for investments, as this involves long-

term decisions that may extend over regulatory periods for setting price caps.

38

Economic efficiency is reflected in NWI Pricing Principles, and promoted through

efficient and sustainable use of water resources, water infrastructure assets and

government resources devoted to management of water. The NWI is a shared

commitment by governments to increase the efficiency of Australia‟s water use (NWI

2010, p. 2). By doing so, it leads to greater certainty for investment and productivity, not

only for rural and urban communities, but also for the environment.

The neo-classical approach to economics claims that equilibrium prices will just equal

costs, including an allowance for return on capital. Even though natural monopoly

represents a type of market failure, regulation can potentially solve these market failure

problems. Regulation attempts to set prices just equal to cost and to replicate the

outcomes of perfect competition. It is when the returns on capital are just sufficient to

attract capital investment that allocative efficiency is achieved.

Economic theory of market failure suggests that a private monopoly will abuse its market

power in order to achieve profits in excess of those which would be available in a

competitive environment. However, in contrast with this theory, Baumol and Willig

(1986, pp. 27–32) set out the principles for efficient prices. These principles suggested

that as long as the market is contestable, monopoly power will not be abused.

Baumol and Willig explained what was required to ensure efficiency in presence of

economies of scale or scope. The two principles they proposed have been widely adopted

in Australia for instituting monopoly infrastructure services, particularly for intellectual

justification of the DORC approach to asset valuation. They are designed to mimic the

constraints placed on firms by contestable markets, and state that:

No price, or set of prices, should exceed the stand-alone costs of providing service

or services, where stand-alone costs are determined as the costs that an efficient

competitor would incur in providing just that service or group of services.

No price, or set of prices, should be less than the incremental (or avoidable) costs

of providing the service or services, where incremental costs are additional costs

incurred by the monopolist in providing just that service or group of services.

39

The two principles accord with upper-bound and lower-bound pricing principles

developed by the NWI and its pricing working group (ACIL Tasman Economic Policy

Strategy 2006, p. 2; ACIL Tasman 2008, p. 3). These two pricing principles will be

discussed in detail in Chapter Nine.

2.9 Approaches to urban water pricing

Efficiency is promoted when prices reflect the opportunity cost of supplying a particular

good or product. For instance, the opportunity cost of consuming a unit of water is the

value of supplying that water to another customer, or storing that water for future

consumption to reduce the likelihood of future water shortages, given the inherent

uncertainty with climate-dependent water supply sources. Opportunity cost is often the

marginal cost of the resources required to provide another unit, such as a kilolitre (kL) or

a GL of water to consumers. The National Water Commission (2008, pp. 6–7) broadly

proposed economic efficiency as achievable where scarce resources, in this case water

and assets involved in production, distribution and use of water, are allocated to uses that

consume most at the highest value.

In economic theory, consumption and production decisions in a particular market will be

consistent with efficiency where the price of a good or service equals its marginal cost.

That is, the price falls below marginal cost, demand from users will be far greater on the

system, and this will result in resources being diverted to provide these services rather

than providing a more valuable service elsewhere in the economy. If prices are more than

marginal costs, consumers will not use enough water and the associated infrastructure

services, which will result in a social welfare loss. Efficient prices therefore need to be

set, as it is crucial to encourage efficient water use and water supply outcomes.

For this purpose, the National Water Commission (2008, pp. 6–7) recommended that for

efficient decision-making, it is crucial that the marginal cost or price reflects the full cost

to society from providing a good or service, including any externalities. Externalities are

costs or benefits which arise from an individual‟s economic activity that affect others,

such as environmental impacts. To date, externalities are not yet reflected in water

delivery prices, even though a key goal of the NWI is to ensure that prices reflect

externalities.

40

Other than to ensure an efficient allocation of resources, prices play an important role in

signalling the requirement for, and the value of, new investment. When supply–demand

balance tightens, the marginal cost of meeting demand also increases. This increase in

marginal cost of supply provides important information about the type and timing of any

new investment that is required. One of the ways typically used to address the issue of

revenue adequacy while maintaining the efficient signals associated with marginal-cost

pricing is the use of a two-part tariff, which consists of a variable charge and a fixed

charge. The variable charge facilitates cost-reflective pricing and enables the costs

associated with water usage to be signalled to customers, who can then adjust their

consumption accordingly. In contrast, fixed charge ensures revenue adequacy, and

reduces variability of revenue to the water business.

The structure of the variable component of water charges for residential customers in

Australia is known as „inclining block tariffs‟, whereby the price of water increases as its

consumption increases. It is comprised of one or more blocks or tiers (up to 11). The

National Water Commission (2010, p. 17) noted that one block tariff is used by Sydney

Water, while 11 blocks tariffs is practised by Albany and Kalgoorie-Boulder Water

Corporation in Western Australia. The only jurisdiction which allows more than three

inclining blocks is Western Australia. All major Australian cities with the exception of

Newcastle, Gold Coast and Darwin have incorporated inclining block tariffs into variable

components of tariffs.

Some would argue that inclining block tariffs can send a strong signal about the need to

conserve water to high-volume users. However, a large family may engage in water

conservation to achieve reduction in demand but not be rewarded for their effort.

2.10 The current urban water pricing approach

The price for water cannot be determined in a market that reflects demand and supply for

water service, where the regulator assesses the price for water proposed by water utility

business, taking into consideration two aspects. Firstly, the water price paid in total by

customers, and the total revenue the water businesses derive from the price of water must

reflect the reasonable costs incurred by the water utility businesses, including a rate of

return on the RAB. Secondly, the structure of the water price must provide appropriate

41

signals to users of water in respect to the resources used and costs incurred in provision of

services, in the context of current and future availability of water, environmental

considerations, customer needs, and social policy objectives (Economic Regulation


The National Water Commission (2008, p. 8) acknowledged that in general, the current

approach to urban water pricing varies across Australian jurisdictions. The Steering

Group was established in 1990 to develop a consistent approach to pricing and has

identified four areas of inconsistency of approach between jurisdictions. These

inconsistencies are:

recovery of capital expenditure

setting of urban water tariffs

recovery of costs of water planning and management

recycled water and stormwater use.

The IPART in New South Wales and the Australian Capital Territory, and the ESC in

Victoria govern pricing regulation. It is also the ESC in South Australia, while the QCA

performs that role in Queensland. Tasmania relies on the Pricing and Oversight

Commission, while Western Australia‟s pricing regulator is the ERA.

While it was noted that not all jurisdictions adopt all of the same elements, there are some

similarities between them. For instance, water regulators use the building blocks

methodology, where an annual operational expenditure and a rate of return on and of an

RAB are used to determine a revenue requirement to be recovered from customers. The

building blocks equation is described in various literature, such as the NWI Steering

Group on Water Charges (2007, p. 14), cited in the NWI Pricing Principles (2009, pp. 5

& 164), ERA (2004, p. 3), Balance and Taylor (2005, p. 37) and Nera Economic

Consulting (2014, pp. 5-6) as follows:

Revenue requirement =

Benchmark operating expenditure (including operations, maintenance,

administration costs)

+

42

Return on capital (RAB)

+

Return of capital (D) or depreciation.

Expressed in the simplest form, the building block equation is as follows.

Figure 2.2: The building block equation

MAR = maximum allowable revenue

WACC = weighted average cost of capital (post-tax nominal)

RAB = regulatory asset base

D = depreciation

OPEX = operating and maintenance expenditure

In Australia, most regulators use the building block approach to regulate urban water

prices. An annual forecast revenue requirement is calculated, based on estimates of funds

the business requires to efficiently deliver its services and to meet its regulatory and other

obligations.

Klein (1996, p. 16), Johnstone (2003, p. 2) and Balance (2006, pp. 234–235) all identified

the building block approach as including such things as the operating cost, such as what

the pipelines company pays for managing the water system. This example may include

workers‟ wages, the cost of constructing new pipelines, water plants suitably depreciated,

Return on capital

(WACC * RAB)

Return of capital (D)

OPEX MAR

43

depreciation or maintenance of existing investments, and cost of capital. Some common

characteristics of the building block approach are as follows:

The use of periodically reviewed price caps, where a fixed duration of the

determination is used (usually between three and five years) to recover the

revenue requirement.

The use of a two-part tariff (comprising a fixed, service availability charge and a

variable volumetric charge).

The use of inclining block tariffs in the variable component of charge, where this

charge is set to two or more usage blocks, with increasing prices as consumption

increases. Inclining block tariffs are used in all major Australian cities, with the

exception of Newcastle, Gold Coast and Darwin.

The use of postage stamp pricing, where uniform prices are charged to customers

in different geographical regions or across different customer types.

The use of developer charges, where developers pay up-front charges to utility

companies for the infrastructure costs incurred in servicing new developments.

2.11 The current water pricing arrangements

The National Water Commission (2008, p. vii; 2011, pp. 7–8) acknowledged that the

pricing arrangements vary between jurisdictions, but are typified by a regulated approach

based on the building blocks methodology with periodic price reviews. The most

commonly used is the two-part inclining tariff, which consists of a volumetric (variable)

and a fixed component. The volumetric (variable) component is set with regard to the

long-run marginal cost of additional supply capacity, while the fixed component is set to

ensure revenue adequacy.

The volumetric (variable) charge is used where this charge increases in „blocks‟ with the

quantity consumed. The more a customer uses water, the higher the volumetric charge is.

The volumetric (variable) component has a stronger impact on water use decisions and is

particularly important when water is scarce. In times of water shortages, restrictions are

enforced to manage demand, and the current approach to urban water pricing encourages

44

technical efficiency and protects against the practice of market power (Sibly & Tooth

2007, p. 5).

Every state and territory in Australia, with the exception of Western Australia and South

Australia, has converted from property-based charges to volume-based. Sydney Water,

ACTEW Corporation, NT Power, Water Authority and Brisbane Water have adopted a

standard flat charge. The four Melbourne retail water companies and Hunter Water in

Western Australia have adopted a two-part tariff comprising a service charge and a usage

charge, based on estimated discharge. Sydney Water, ACTEW Corporation and Brisbane

Water have all adopted a fixed service charge.

With the exception from Hobart, all Australian capital cities and many regional urban

areas adopted two-part tariffs for potable water supply. This is largely to allow

jurisdictions to meet NWI commitments. Water meters with a variable and fixed service

component are used. This replaced property values and „free allowances‟ as the basis of

water charges. The National Water Initiative (2011, p. 80) reported that since 2009,

Tasmania has been rolling out water meters to all remaining unmetered urban areas,

particularly in southern Tasmania. From July 2012, two-part pricing based on

consumption was adopted across Tasmania.

In 2002, the IPART found that a two-part tariff was not warranted for cost-reflective

reasons, due to the high proportion of fixed costs and inelastic internal demands. The

South Australia Water Corporation has adopted a minimum charge, together with a rate

based on property value, where the unimproved value exceeds a certain minimum limit

(Government of Western Australia, Department of Treasury and Finance 2005, pp. 25–

26).

In most water jurisdictions in Australia, it is the independent pricing regulators who are

left with the task of actually determining the price, and/or at least setting the principles

that might be applied in making a decision on what the price should be for water. Those

prices that the regulator naturally considers in some detail are costs that are incurred in

this process (including the capital investment costs). This will form a view as to whether

the expenditure involved is efficient and prudent, and will then establish an appropriate

45

form of regulation that will allow the recovery of these costs in revenues collected by the

utility over the regulatory period.

Some of the issues that are considered by the regulators include the following:

need for capital investment being proposed

extent of any efficiency savings that have been made

how these savings should appropriately be shared between water utility and

customers

the likely level of demand over the relevant regulatory period.

Taking into consideration some of these issues, assumptions can be made regarding

recovery of costs through prices that are set, and appropriate amortisation and handling of

costs whether they are capital equipment costs or investments in skills and expertise that

will have benefits that extent beyond the regulatory period.

As Australia recently experienced a period of unprecedented drought, it is obvious that

water utilities do not have the ability to determine whether it will rain, or to predict a

possible significant shift in Australia‟s rainfall patterns going forward (Independent

Competition and Regulatory Commission 2008, p. 13; Rowe 2008, p. 3). Regulators of

water utilities must therefore take every reasonable step to ensure that reliable water

supplies are available for urban areas, and that there is a financial incentive to deliver on

these water requirements. Enforceable service standards must apply for such things as the

repair of broken water mains, the quality of the water delivered and the reliability of

supplies.

2.12 Background of regulatory models

Some form of regulatory price control is required to promote efficiency in the urban water

industry and to achieve social and environmental goals. For some water services, it may

be sufficient for the regulator to allow the service provider to propose prices that comply

with a number of regulatory principles, rather than prescribe specific tariffs or weighted

caps (price and revenue caps). For instance, in Victoria the ESC has considered such an

approach for services that are required by a small number of specific classes of

46

customers, such as developers, commercial firms discharging trade waste, and users of

recycled water (Economic Regulation Authority 2005, p. 150).

There are a number of options available to control the prices, directly or indirectly, that

water providers charge for their services. These approaches vary depending on the

incentives presented to water providers, allocation of risks associated with unexpected

changes in water demand, level of pricing flexibility they can afford, and different pricing

mechanisms used depending on water providers‟ administrative complexity (Economic

Regulation Authority 2005, p. 150).

2.13 Price and revenue caps – individual price caps

Water businesses are permitted to set a rate of return on their capital. As can be observed

in Figure 2.2, this rate of return is the RAB used in the calculation of MAR. Price-cap

regulation is a form of regulation in which utilities companies are permitted to place a

price cap on the price of services they charge based on a return on capital. In price-cap

regulation, the price of water is the regulated variable.

Price-cap regulation when implemented can hold down prices for services that are not

subjected to competition (Organisation for Economic Cooperation and Development

1995, p. 5). In 1984, British Telecom in the United Kingdom implemented prices for

these services that were typically close to their maximum price cap permitted levels,

when regulation based on incentives such as price and revenue caps were first introduced.

In price-cap regulation, the „CPI-X‟ system sets revenue caps. The Consumer Price Index

(CPI) is the rate of inflation measured by CPI, and subtracts the expected efficiency

savings; X. The price caps regulation first began in the United States telecommunications

industry in the mid-1980s, and by 2000 thirty-nine states in the United States had

employed pure price caps regulation.

Sappington et al (2001, pp. 71–79) reported that the first price-cap regulation was

introduced in 1992 for the United States telecommunications markets, when the

telecommunications markets became increasingly competitive because of technological

changes.

47

In Australia, the price-cap regulation was first used by Telecom in 1989, with a CPI -4

per cent formula. The scheme was applied to regulatory periods of three years between

July 1989 and June 1992. However, it was not until recently, within the last 10 to 15 years

or so, that price caps have been applied more widely to other sectors, such as those of

long-term natural monopolies including the electricity and gas distribution, and water

utility networks.

The price cap is the most common method used in regulated utility businesses. It is made

up of the sum of operations, maintenance, administration, and depreciation costs. For this

reason, the price cap is known as the building block price-setting (Queensland

Competition Authority 1999, p. 8). The price cap is typically applied in the context of

access pricing when setting arbitrated prices for access to individual pieces of

infrastructure in a network. Prices are either approved by the regulator or government at

the start of a defined „regulatory period‟, or escalated annually in line with inflation. The

water provider must adhere to the approved prices, and no adjustments are allowed within

the regulatory period. The volume of water sold becomes a key driver of total business

revenues (Economic Regulation Authority 2005, pp. 150–151).

The price cap approach is prescriptive in those specific services that are set for the term of

the regulatory period, with explicit efficiency factors built into the price path. The

advantage of using this approach is that it provides price-certainty for the water business,

and a strong incentive to improve efficiency. However, the provider is unlikely to make

price adjustments in response to changes in its operating costs, or changes in demand for

its services over the regulatory period. Price caps are similar to a revenue cap in that the

price cap may be applied to particular customers or services, but is established on a unit

basis, such as per KL or ML, rather than as a total revenue amount.

The two state regulators currently using the price cap approach to regulate water

providers are the IPART of New South Wales and the Victorian ESC, both of which have

capped their prices for 2004–05, with a view of using a tariff basket in future years. Price-

cap regulation has been adopted extensively in Water Services Regulation Authority

(OFWAT), in England and Wales (Queensland Competition Authority 1999, p. 9).

48

Weighted average price cap (or tariff basket)

The approach to price control limits price increases on the basis of a weighted average of

the prices of a basket of services. The weights are usually based on the actual quantity of

service sold, and is fixed with reference to a base year. On the condition that the weighted

average increase in prices is within the overall cap, the provider is able to adjust prices

(known as „rebalancing‟) within the basket, and the cap is escalated in line with inflation

and an efficiency factor (e.g. CPI-X). To date, tariff baskets are used to regulate

electricity and gas businesses, and have not been applied to water businesses (Economic

Regulation Authority 2005, pp. 150–151).

Weighted average revenue cap

Instead of prices being regulated, the weighted average revenue cap approach of control

limits the water provider‟s average revenue per ML of water sold. Prices can be

rebalanced, as long as the adjustment does not exceed the average revenue cap. The cap is

set on the basis of a benchmark revenue requirement set by the regulator, together with a

demand forecast. Weighted average revenue cap indirectly controls the price by placing a

cap on average revenue per ML of water sold. This allows the water provider some

flexibility to adjust the prices and quantities of different services supplied.

A disadvantage of greater pricing flexibility is higher price volatility for customers.

However, this approach to price control does not restrict the water provider from

expanding its customer base. One state which has recently opted for a weighted average

revenue cap to regulate water prices is the Independent Competition and Regulatory

Commission (ICRC) in the Australian Capital Territory (Economic Regulation Authority

2005, p. 152).

Revenue cap

The revenue cap is another indirect method to control the prices. With this form of

control, the maximum revenue that can be earned by the water provider is set at the

49

commencement of a regulatory period, and it is up to the water provider to adjust prices,

quantity or costs, as long as revenue does not exceed the stipulated cap. This approach

provides water businesses with an incentive to improve efficiency; however, it is a

disincentive to sell more water (Economic Regulation Authority 2005, p. 152). The

revenue cap is also a potential useful tool for achieving conservation targets. However,

this form of control has been known to be problematic, because the water provider is

exposed to the risk of unexpected increases in demand, and in such cases must be able to

meet new demands by either lowering the cost or the price below its revenue

requirements to remain within the cap (Economic Regulation Authority 2005, p. 152).

On the other hand, when demand is lower than expected, such as due to enforced water

restrictions, the water provider has an incentive to increase prices, which could impose

additional costs on consumers. Higher prices imply a less reliable service. IPART of New

South Wales, for example, generally constructs a maximum revenue target for the

business, comprising a return on capital, return of capital and operating costs, and then

sets specific price paths for water services consistent with this constraint.

This became the base for price caps for Western Australia‟s Hunter Water and the Sydney

Water Corporation. The IPART has also used a form of revenue cap for regulation of

water services provided by Gosford and Wyong City Councils. However, these entities

are concerned that revenue cap regulation provides less flexibility to manage climate-

induced demand variability (Queensland Competition Authority 2000, p. 27).

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2.14 Summary

As established earlier, water is the most precious natural resource, and it is difficult for

any living being to survive without it; thereby categorising it as an economic good. In

Australia, it is plentiful in some places such as the uninhabited mountain ash forests high

up in the Yarra Ranges, East of Melbourne, but scarce in other areas such as the densely

populated areas in south east Australia.

Australia is, on a per capita basis, one of the highest consumers of water in the world,

with each Australian using 1.31 million litres of water per year. On an average, this was a

total of 24 000 GL as at 1996–97 – enough water to fill the Sydney Harbour 48 times (one

GL is 1 000 000 000 litres).

The year 2009–2010 represented a positive change for the Australian urban water

industry, with an increased rainfall across eastern Australia (including South East

Queensland and areas of New South Wales), which led to a rapid rise in storage levels in

many of Australia‟s catchments. Most water utilities were able to ease water restrictions

or move to permanent water conservation measures, except in Perth which continued to

record low rainfall. The recent unexpected floods in early 2010 in Queensland highlight

Australia‟s extreme climate variability and the ongoing water challenges.

The urban water industry consists of the provision of two main services: the supply of

reticulated potable water, and the collection, treatment and disposal of wastewater. Even

though most states and territories are responsible for their own decisions about water

policy, these decisions are bound by the fact that they are signatory to the NWI, an

agreement signed by all Australian states and territories at the 2004 meeting of the

COAG.

Traditionally, regulations exist to ensure safe and adequate provision of essential public

services, including water. Fundamentally, they exist to protect customers, the community

and the natural environment.

51

The natural characteristic of water as a natural monopoly calls for regulation. Without

regulation and a lack of competition in the water industry, it means that the providers

yield a level of power where they could price at a level that delivers more than a normal

commercial return. Also, the lack of choice for customers to change providers leads to the

providers being able to offer a potentially substandard level of service without the risk of

customer loss.

Regulation is particularly important in South Australia, Queensland, Tasmania and

Western Australia, because regulatory agencies carry out reviews on matters referred to

them by the government, which includes water pricing. These regulatory agencies advise

the government on pricing, as opposed to regulating prices as in other states and

territories such as Victoria, New South Wales and the Australian Capital Territory.

In Australia, the current regulatory frameworks for the water industry are based on a

combination of legislation, regulatory instruments and decision-making bodies. The first

system for regulation of the water industry was developed under the umbrella of Trade

Practices Act 1974, now known as the Competition and Consumer Act 2010. In 1994

through the COAG, the NWI was established, which means that in many aspects

regulation of the water industry is still new and developing.

Regulation is the public economics face of industrial organisation. Regulations allow

governments to not only explore in various ways, but also interfere with industrial

activities. Under complete information, technological efficiency requires a single

operating firm; most importantly, the framework of the new economics of regulation can

be viewed as an application of principal-agent methodology. This is based on contractual

relationship set-up, in which the principal is the state or the regulatory institution, and the

agent is the regulated firm (i.e. water business).

The regulation of utilities has been implemented in most countries by constraining the

rate of return on capital, which is a necessity to attract capital to utilities while avoiding

excessive exercise of monopoly power. Some main characteristics of this type of

regulation are that a fair rate of return on investment above the market rate is guaranteed,

as long as investments are prudent, prices are determined to equal average costs with the

imputed charge for capital, prices remain fixed during the regulatory period until a new

52

regulatory review leading to new prices is released, and the regulatory review is a process

of checks and balances where the conflicts between the firm demands high prices and the

consumers who demand low prices are arbitrated by the regulatory commission.

Without regulation and lack of competition, service utility providers cannot be relied

upon to deliver services where they are most needed and valued by the community. A

business operating based on its commercial objectives will not function to provide

services unless it can make a profit. Such a business is likely to establish infrastructure

where it can maximise profits, and may neglect other areas where smaller or no profits are

available. Regulation can therefore set direction and ensure that service providers deliver

services to all their customers.

Regulation attempts to create prices that promote economic efficiency. The three aspects

of economic efficiency – allocative efficiency, dynamic efficiency and productive

efficiency – have previously been discussed.

A regulated approach based on the building blocks methodology with periodic price

reviews typifies the current pricing arrangements, although they vary between

jurisdictions. The most commonly used approach is the two-part, inclining block tariff,

which consists of a fixed and volumetric (variable) component. In Australia, almost all

properties are connected to reticulated systems, which allow water to be metered. A water

bill incorporates a separate fixed charge and usage (variable) charge. The fixed

component is set to ensure revenue adequacy, and the volumetric (variable) component is

set with regard to the long-run marginal cost of additional supply capacity.

Every state and territory in Australia, with the exception of Western Australia and South

Australia, has shifted from property-based charges to volume-based ones. Sydney Water,

ACTEW Corporation, NT Power, Water Authority and Brisbane Water have all adopted a

standard flat charge. The four Melbourne retail water companies and Hunter Water in

Western Australia have adopted a two-part tariff comprising of a service charge and a

usage charge, based on estimated discharge.

In the water industry, the regulation of prices relies on the building block approach,

whereby the components of total costs of providing the services are assessed to determine

53

the revenue requirement of the service provider for a predetermined period. Based on the

forecasts, prices are then derived so that they will deliver this revenue. Water businesses

use a number of options such as price caps, weighted averages, or tariff baskets and

revenue caps to control the price of water. The price cap is the most common method

used, also known as the building block price-setting, and is a result of the sum of

operations, maintenance, administration and depreciation costs. The price of water is the

regulated variable in price-cap regulation.

The next chapter is the literature review, providing a general overview of valuation of

assets from an academic point of view.

54

Chapter Three: Literature Review

3.1 Introduction

Chapter Two outlined the main characteristics of water and the methods used to regulate

water prices; that is, the building block approach. It also discussed the characteristics of

the urban water industry and the current water pricing approach in major Australian cities.

The current approach to urban water pricing varies across Australian jurisdictions. Water

regulators use the building block approach, where periodic price reviews are conducted

and an annual operational expenditure and a rate of return on and of an RAB are used to

determine revenue requirements to be recovered from customers.

Chapter Three provides a general overview of asset valuation from an academic point of

view. Very little academic research has been published on this topic, particularly in

relation to the deprival value methodology, which is used to determine water pricing.

Later chapters will provide an extensive literature of asset valuation based on research

published in industry reports.

Past research in relation to asset valuation techniques has concluded that the sensitivity of

asset valuation is not only on the RAB, but also potentially on price levels. The building

block approach is used to calculate the MAR for the regulated water business, where the

regulatory period is typically between three and five years. Total revenue is forecast for

this predetermined period, and the price of water is derived on the basis of demand

forecasts, which are expected to deliver from forecasted revenue. The asset valuation

method has made a significant impact on profit; the excess of income over expenses can

be compared over time and between various water utility businesses.

A central role of accounting theory is to provide prescription and to inform others about

the optimal accounting approach to be adopted and why particular approaches to

accounting are considered optimal. Based on this perspective of the role of accounting,

normative accounting theory prescribes that assets should be valued using specific asset

valuation techniques. This chapter therefore considers normative theories in discussing

and describing asset valuation techniques used in utility businesses.

55

The first discussion in this chapter is based on the rationale of historical cost accounting

(HCA) – the original cost or purchase price of an asset. This is followed by a discussion

on other main accounting measurements for valuation of assets, CCA, net realisable value

(NRV) and net present value (NPV). Unlike HCA, CCA introduces CCA into accounts. It

recognises the effects of changes in the specific price level on the basis of replacement

cost (entry prices), NRV of assets (exit prices) or its EV (NPV).

The next discussion is about the asset valuation method from a utility context – the

deprival value. The assets of water businesses are considered „sunk‟, as the characteristics

of these assets are such that they have no alternative use; they are non-marketable and are

considered as public goods by nature. For this reason, unlike the assets of a competitive

market business, asset valuation in a utility business gives rise to complex valuation

issues.

To support these discussions, Chapter Three outlines the results of three surveys

conducted in New Zealand to determine the appropriateness and consistency of asset

valuation techniques used by local governments to financially report on infrastructure

assets. A case study with specific reference to Sydney Water Corporation is also

examined, as well as an academic research study on the effect of rate regulation on prices

of other utility businesses.

3.2 The rationale for HCA

The definition of HCA can be found in most accounting textbooks. In particular,

Framework for the Preparation and Presentation of Financial Statements (September

2009) paragraph 100(a), defines HCA as:

“the amount of cash or cash-equivalents paid to acquire assets or the fair value of the

consideration given to acquire them at the time of their acquisition. Liabilities are

recorded at the amount of proceeds received in exchange for the obligation, or in

some circumstances (for example, income taxes), at the amounts of cash or cash

equivalents expected to be paid to satisfy the liability in the normal course of

business.”

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HCA assumes that money holds a constant purchasing power, as under the Generally

Accepted Accounting Practices (GAAP). It is a collection of rules and procedures

followed by accountants worldwide, and on the basis of financial accounting is the

original cost or purchase price of an asset. All transactions are supported by availability

of documentary evidence; that is, the source or original document. It is a measurement

which does not change as the value changes. In accounting, it has become common

practice to record historical cost of an asset as its cost on a balance sheet.

The use of HCA was well-documented as early as 1494 by Luca Pacioli, often known as

„the Father of Accounting‟ in his famous Summa de Arithmetica, Geometrica,

Proportioni et Proportionalita – in English, Everything about Arithmetic, Geometry, and

Proportions. Some sections of this book served as the only accounting textbook until well

into the 16th century. The sections which are still used in accounting today and are based

on HCA include the accounting cycle; the use of journals, ledgers (including the five

types of accounts: assets, liabilities, capital, income and expense), year-end closing

entries, and trial balances; and topics such as ethics and cost accounting.

Middleditch (1918, pp. 114–115) explained that “today‟s dollar is a totally different unit

from dollar of 1897. As the general price level fluctuates, the dollar is bound to become a

unit of a different magnitude.” A similar observation can be found in Paton (1920, pp. 2–

3). The significance of the dollar, the accountant‟s yardstick, is constantly changing. One

of the fundamental limitations of accounting arises where the unit of measurement is

always the same to allow comparisons of situations and phenomena arising at different

times to be made in this field.

Similarly, based on the accounting–Darwinism perspective, which notes that most

efficient and effective processes will survive over time, the accounting profession,

academics and reporting entities have maintained partial support for use of HCA. During

the first 35 years of the 20th century, history witnessed many companies arbitrarily

revalue their fixed assets to suit their immediate purposes (Sweeney 1964, pp. 45–47).

By the 1930s the accounting profession adopted HCA methodology for valuing assets.

Kohler (1963, p. 38) explained that despite over a decade of rejection, HCA persisted as

the basis of valuation method for all assets. The executive committee of the American

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Accounting Association in the 1936 Statement of Accounting Principles Governing

Corporate Reports said:

Accounting is not essentially a process of valuation, but the allocation of historical

costs and revenues to current and succeeding fiscal periods. There seems to be no

sound reason for repeated adjustments of asset values for ordinary changes in price

levels commonly experienced from one generation to another. A history of cost and

cost amortisation is a consistent record of actual occurrences. It constitutes an

essential starting to financial interpretation.

The Australian Accounting Research Foundation (AARF) maintained that:

It is difficult to construct a theory which will provide a rationale for selective

departure from the historical cost basis (Australian Accounting Research Foundation

1994, p. 16).

Paragraph 101 of Framework for the Preparation and Presentation of Financial

Statements (September 2009) states that HCA is the preferred method predominantly used

today, but that some entities are allowed to use the current cost basis as the HCA model

fails to deal with the effects of changing prices of non-monetary assets. Only recently, the

conceptual framework and Australian and International Accounting Standards, IAS 16/

AASB 116 Property, Plant and Equipment (June 2009) introduced elements of current

value or fair value measurement for asset valuations.

Lee (1985, pp. 52–53) reported that accounting income calculated according to historical

cost has the benefit of a sound, factual and objective transactions base. This is because the

recording of historical costs may be factual, but the accompanying conventions of the

realisation principle, the notion of conservatism and the matching principle introduce

judgement into recognition of revenue and allocation of costs. The reported income figure

is a heterogeneous mix of gains of the current and prior periods and not just the

straightforward, factual number which it is sometimes claimed to be.

McCarthy (2004, pp. 18–19), on the other hand, believed that “the reliability offered by

historical financial reporting is infinitely more valuable”. Flegm (2005, pp. 12–14),

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meanwhile, argued in favour of HCA-based valuations because of the inherent objectivity

associated with such measurements. The world‟s largest frauds in management history

were initiated by the move towards fair (market) value accounting.

Another similar concern of using fair value estimates is that overstatements of their

valuations can lead to the collapse/bankruptcy of companies. This concern was raised by

Benston (2006, pp. 456–484), who used the example of Enron and Harris and Kutasovic

(2010, pp. 119–125), suggesting that Lehman Brothers, the largest bankruptcy (2008)

ever filed in the United States, was a result of fair value accounting (FVA).

Mautz (1973, pp. 23–27 & 93–98) identified that the nature of accounting as a service

activity has been widely influenced in more recent times not so much by the accountants,

but by business people. That is, those who make management and investment decisions

had not found financial reports based on historical cost useful over the years, changes in

accounting would have long since been made.

However, this still does not mean there are no other asset valuation techniques that are

better than HCA. The common error made by proponents of decision-usefulness studies is

that they either attempt to provide support for or rejection of particular respondents or

users based on those respondents‟ or users‟ indications on whether HCA would or would

not be useful for their particular purposes.

Gray, Owen and Adams (1996, p. 75) asserted that: „Decision usefulness purports to

describe the central characteristics of accounting in general and in financial statements in

particular. Often there might be things that can be more „useful‟ but failed to be looked

into by respondents.” Henderson, Peirson and Herbon (2008, pp. 115–116), in contrast,

stated that HCA maintains financial or money capital intact, and that it ensures that the

value of an investor‟s initial capital investment can be preserved. Pursuant to paragraph 9,

IAS 2/ AASB 102, it is a requirement for entities to measure their inventory at the

historical cost or net realisable value, the amount of cash that could currently be obtained

by selling the asset in an orderly disposal; whichever one is the lower.

Out of the 10 characteristics of Qualitative Characteristics of Accounting Information,

HCA outperforms the FVA in only two. Chapter 3 Qualitative Characteristics of useful

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financial information, specifically QC (Qualitative Characteristic) QC30-32 of CF 2013-1

Amendments to the Australian Conceptual Framework (January 2014) recommend that

accounting information must be understandable to users who are generally assumed to

have a reasonable knowledge of business and economic activities. This advantage is

obtained simply by the usage and longstanding common practice of HCA (Hanselman

2010, p. 10).

Moreover, verifiability, which is a function of reliability, is defined in Chapter 3

Qualitative Characteristics of useful financial information, specifically QC26 of CF

2013-1 Amendments to the Australian Conceptual Framework (January 2014) or the

United States Statement of Financial Accounting Concept, SFAC 2 (SFAC 2, cited in

Deegan 2006, p. 193) as „the ability through consensus among measurers to ensure that

information represents what it purports to represent‟.

Daines (1929, p. 98) argued that that HCA has its greatest advantage because this original

cost method is most easily subject to objective verification and is the easiest to use in

practice. Accounting information can be verified by reference to an original or source

document. HCA, the costs incurred upon acquisition, is assumed to be unquestionably

highly verifiable. HCA will have gained the verifiability advantage, as the information is

certain to be confirmed by several independent evaluators. The original purchase price is

fixed and can be easily verifiable or determined by third parties, such as auditors.

A number of scholars such as Edwards and Bell (1961), Chambers (1966), MacNeal

(1970), and Lee (1996) have all criticised, raised concerns and questioned the relevance

of the application of HCA to current economic decisions in their published books. Such

criticism occurred during high-inflation periods of the 1950s to early 1970s and 1980s.

The criticism caused the accounting standard setters in a number of countries, including

Australia, to consider some modifications to HCA in order to provide more relevant

accounting information to users.

Most notable among the criticisers is Chambers (1966, pp. 86–114), who argued that

HCA information suffers from problems of irrelevance in times of rising prices.

Chambers raised the question of whether it is useful to be informed of the cost of a

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particular asset purchased many years ago when the asset‟s current value reflected by its

replacement cost or current market value is considerably different.

Graham and Xavier (1987, p. 19) revealed that it has long been recognised that accounts

drawn up on HCA are misleading, especially where assets are long-life and inflation is

significant. Balance sheet figures of original cost do not represent the value of assets to

the business, while profits and financial trends are also misrepresented. Accounts which

show resource use and economic performance must allow for general inflation,

fluctuations in specific prices and costs, and for technological progress as a result of

changes in the value of capital equipment.

There is, however, a real problem of additivity. Government trading enterprises such as

water businesses have a high proportion of long-lasting assets (10–150 years) that are

purchased and invested at various points of time, and these assets are subject to different

price levels. The issue here is whether it is logical to add together assets acquired during

different time periods when those assets were acquired with a different purchasing power.

Historical cost figures may have limited application under such conditions (Lee & Fisher

2004, p. 351).

Graham and Xavier (1987, p. 19) argued about a similar concern, where they claimed that

balance sheet figures of HCA conventions are misleading, especially for long-life assets.

Since HCA does not take into account the effects of factors such as inflation on the value

of capital assets, it often leads to both capital value and capital costs being

underestimated, which therefore results in overstated rate of return on the entity‟s assets.

Other shortcomings are summarised by the International Accounting Standards

Committee, which was later replaced by IAS 29/ AASB 129 Financial Reporting in

Hyperinflationary Economies (June 2009). Paragraph 2, IAS 29/ AASB 129 reads:

In a hyperinflation economy, reporting of operating results and financial position in

the local currency without restatement is not useful. Money loses purchasing power at

such a rate that comparison of amounts from transactions and other events that have

occurred at different times, even within same accounting period, is misleading.

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Elliot (1986, p. 33) asserted that the HCA is an implicit and troublesome assumption

model where the monetary unit is fixed and constant over time. Elliot also identified three

components of modern economy that make this assumption less valid than it was at the

time the model was developed. Firstly, the specific price-level changes occasioned by

technological advances and shifts in consumers‟ preferences; secondly, the general price

level changes (inflation); and thirdly, the fluctuation in exchange rates for currencies.

According to Elliot, the book value of a company, as reported in its financial statements,

only coincidentally reflects the current value of assets. Reflecting on the lack of

agreement on this issue and relying on metaphors associated with evolution, Elliot (1986,

p. 35) claimed:

There is growing evidence in the market place that the historical cost basis

information is of ever declining usefulness to the modern business world. The issue

for the financial accounting profession is to move the accounting model toward

greater relevance or face the fact of the dinosaur and the messenger pigeon.

3.3 The rationale of CCA

Apart from the HCA, the other main accounting measurement for valuation of assets is

the CCA. CCA, unlike the HCA, introduces current costs into accounts and recognises the

effects of changes in a specific price level on the basis of replacement cost (entry prices),

NRV of assets (exit prices) or its EV (NPV). The current cost of stocks including its

depreciation is added to arrive at CCA operating profit. The replacement cost is the

cheapest possible replacement, by the use of modern equivalent assets (MEA); while the

recoverable amount is the higher of net disposal price (net realisable value) or present

value of the additional cash flows, as a result of the retention of the assets (NPV).

A pure CCA system does not include appreciation of stocks and fixed assets, known as

„holding gains‟. This accounting approach to capital maintenance is based on maintaining

the „operating capability‟ of a business. CCA uses an operating capability concept of

capital maintenance. Profit is recognised only after charging for maintenance of real

operating (physical) capability of the business, as assets are valued at their value to the

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business. In other words, the business would suffer a loss if it were to be deprived of the

use of the asset.

Most economists and some accountants, such as Sweeney (1936, pp. 44–53), Edwards

and Bell (1961), Chambers (1965, p. 736), and Sterling (1970), have advocated the use of

CCA to valuing assets. However, many of these scholars have raised a similar concern

about the basic problem with the use of CCA. That is, it is difficult to determine exactly

what the „correct‟ concept is for CCA.

Table 3.1: Comparison of traditional HCA and CCA

Traditional HCA CCA

Sales $ 150 Sales $ 150

Less cost of goods sold 100 Less current cost of goods sold 125

Profit 50 Profit 25

We can observe from Table 3.1 above, under the traditional HCA, that profit is $50.

Under the CCA, cost of goods sold, after the charge of current replacement cost of the

commodity (bananas), is $125; profit after deduction of current replacement cost is $25.

Assume that inflation exists at a rate different from that of the change in the price of a

specific commodity; in this example, bananas. If this is the case, realistically the owner

should aim at maintaining their „real‟ wealth that is their command over goods and

services in general before recognising profit. Assuming that inflation exists at a rate of 10

per cent and affects the change in the price of bananas, we would regard the owner‟s

closing capital requirement as $110 ($100 X 1.1) and profit as $40. When the calculation

is rearranged, profit is arrived at as the table on the left:

Table 3.2: Comparison of Constant Purchasing Power Accounting (CPPA) and

combination of CCA and CPPA

CPPA Combination of CCA and CPPA

Sales $ 150 Sales $ 150

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CPPA Combination of CCA and CPPA

Less cost of goods sold 110 Less current cost of goods sold 125

Profit 40 Operating profit 25

Add real holding gain on stock 15

Profit 40

In this example (refer to Table 3.2 above), we see the application of CPPA, which was

advocated by the accounting profession in 1973 (Singer 1991, pp. 164–169). Its definition

can be found in International Accounting Standard IAS 29/ AASB 129 Financial

Reporting in Hyperinflationary Economies (June 2009). Under CPPA, only constant real

value, non-monetary items, such as shareholders‟ equity (not variable real value, non-

monetary items), are measured in units of constant purchasing power during low inflation

and deflation respectively. Accountants can choose CPPA to implement a financial

capital concept of invested purchasing power; that is, the financial capital maintenance in

units of constant purchasing power during low inflation and deflation, instead of the

traditional HCA concept of invested money.

Profit can also be presented in an alternative way as shown in the right column in Table

3.2 above. This yields the same profit figure as the CPPA example. However, it also

shows how the profit was alternatively made, which provides more information and might

assist the owner towards a better understanding of how the gains were derived.

Firstly, we can tell the owner of the current cost operating profit is $25. $25 ($150–$125)

is the cash profit (also known as „holding gain‟ in money terms), which would have been

made if the stock was bought at current prices. However, as this was not the case here,

they saved money by doing so. We would then subtract this $25 from $10, which is the

allowance for inflation, the general devaluation of money, which has taken place since the

purchase.

Important information which combines the useful features of both CCA and CPPA

enables the ability to distinguish profit statements between the nominal holding gain and

the adjustment for inflation. Logically, business profit will show how the entity has

gained in financial terms from the increase in cost of its resources, which is a limitation of

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the HCA. These useful features have been advocated by many other great pioneers of

inflation accounting, such as those of Middleditch (1918).

On one hand, Middleditch (1918, p. 119) explained that if a business has assets consisting

mainly of „money items‟, it naturally will suffer from rising prices. Alternatively, if it

mainly had „goods‟, then it will be benefit from rising prices. It has since been built on in

the past six decades, and became the seed for an idea that gradually formalised in most of

the prescriptions for general price-level adjustments. Historically, this was Middleditch‟s

only contribution, but his views were kept alive through references to his 1918 article by

well-known scholars such as Paton and then Sweeney.

Paton referred to Middleditch‟s work and explained that it was „not unreasonable‟ for

accountants to prepare “supplementary statements, to show by making proper allowances

for the change in the value of money, which is the true comparative economic status of

the business” (Paton 1922, p. 429; Mills 1926, pp. 3–4).

Similarly, Sweeney‟s work in 1927 and 1931 made considerable advances over other

earlier attempts (e.g. Paton (1922) in his accounting theory book) by refining the process

of price-level adjustments. Both Sweeney (1927, p. 185) and Hayek (1941, pp. 276–280)

favoured the general price-level adjustments and related maintenance of real financial

capital intact concept. They argued that the maintenance of nominal capital, which is

overlooked when money is depreciating in value, may be kept intact by maintenance of

same money, which may be maintained by constant ownership of the same amount of

material quantities. In line with this, maintenance of value, not only physical equivalence

ensures preservation of the same economic power over goods and services, and such

preservation, which is maintenance of real capital, is much more worthwhile.

Paton and Paton (1952, p. 325) emphasised the replacement of productive capacity of

assets; the replacement cost-new is equal to the amount of cash or other consideration

needed to replace or reproduce the productive capacity of an asset with a new asset

reflecting changes in technology. They considered the alternative of replacement of an

existing asset with an asset of equivalent capacity:

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It should be understood that the significant replacement cost is the cost of providing

the existing capacity to produce in terms of the most up-to-date techniques. It is a

waste of time to estimate the cost of replacing an obsolete or semi-obsolete plant unit

literally in kind. Such an estimate will never afford a basis for a sound appraisal of the

property nor furnish a useful measure of current operating cost. What is of interest is

what it would cost to replace the capacity represented in the existing asset with a

machine modern design. Put differently, the cost of replacing in kind is a significant

basis on which to measure the economic importance of property in use only in the

case of standard, up-to-date facilities.

In contrast, two other important theoretical writers, Edwards and Bell (1961, p. 286)

attached a „current‟ value to income by including changes to buying prices and general

purchasing power. Their model was consistent with the CCA model example described

above, and paragraph 104(a) of AASB Framework for the Preparation and Presentation

of Financial Statements, (December 2009), which notes that all non-monetary assets have

to be adjusted to their respective replacement costs. An important feature of their model

was that they were able to develop a „pragmatic‟ solution to the problem of inflation that

was not only palatable to practitioners, but also useful for managerial decision-making

and evaluations of managerial performance by external users.

Their model focused on replacement of an existing asset with an identical asset. It not

only provided support for replacement costs, but it was specifically explicit in acceptance

of traditional GAAP‟s going concern convention:

It must be remembered that it is not the current cost of equivalent services provided

by fixed assets over some time period which we wish to measure but the current cost

of using the particular fixed asset which the entity chose to adopt and is still using.

This is the particular decision that the entity wishes to evaluate on the basis of

accounting data. It is possible that he then might wish to compare these data with

opportunity cost data which relates to selling and/or replacing the fixed asset. So that

he can make decision about the future, he must have information about the actual

present and past.

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Later in 1975, the Consultative Committee of Accountancy Bodies advocated in practice

by in their response to the Sandilands Report that some features of the current cost are

incorporated in the current United States standard on accounting for changing prices,

Financial Accounting Standard, FAS 33 in 1979 (Whittington & Zeff 2007, p. 201).

Beildelman (1973, pp. 653–667) noted that the application of CCA can be seen across

many accounting literatures in Australia. The 1970s in particular was an active period in

the development of a comprehensive system of CCA in Australia. The driving force in the

practice of CCA was high inflation rates in Australia, particularly in the mid-1970s when

it was around 12 per cent. There was also a growing body of Australian and international

literature recommending abandonment of HCA and movement towards CCA by

international standard-setting bodies.

Additional influence of CCA can be found in the Mathews Committee on Inflation and

Taxation, which was appointed by the Australian Government in December 1974;

subsequently, the Mathews Report was issued in May 1975. This report contained

submissions, public hearings and final recommendations that undoubtedly indicated some

significant public support for practice of CCA in Australia (Barnea, Ronen & Sadan

1976, p. 111).

The support for CCA‟s underlying principles has also been strongly endorsed by the

AARF, as evidenced by some of its activities. By far, Australian history has witnessed the

release of three exposure drafts on CCA from 1974 to 1978. These three exposure drafts

were: ED 7 – Accounting for Changes in the Purchasing Power of Money, issued in

December 1974; ED 9 – A Method of CCA, issued in June 1975; and ED 10 – The

Recognition of Gains and Losses on Holding Monetary Resources in the Context of

Current Value Accounting, released in July 1978. Next was ED 15 „current cost

accounting‟, which was a collection of exposure drafts issued and suggested for

expansion of the Provisional Accounting Standard.

CCA has also been subjected to public lobbying by some influential organisations, such

as the Institute of Directors. In late 1978, the Institute of Directors issued a critical review

of CCA exposure drafts by making specified references to the lack of support for CCA

regulations, the level of subjectivity of information produced, and the lack of guidance of

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CCA disclosures to company shareholders (American Institute of Certified Public

Accountants 1974, p. 26).

However, CCA was issued as the Statement of Accounting Principles, SAP 1 in

November 1983, which was amended in 1989. Even though it is obvious that it was

subject to criticism by certain bodies and institutions, the AARF appeared to have found

enough support to justify the issuance of SAP 1. The requirements of SAP 1 are relevant

in the public sector, particularly because they recommend the use of written-down current

cost of an asset, where market buying prices are not available, which is relevant to long-

life infrastructure assets.

Previous Australian accounting standards, which have permitted or recommended the use

of replacement cost accounting and make reference to SAP 1 include AAS 27 – Financial

Reporting by Local Departments, AAS 29 – Financial Reporting by Government

Departments, and AAS 31 – Financial Reporting by Governments. Until recently,

following the move to International Financial Reporting Standards (IFRS), the Australian

Accounting Standards Board (AASB) moved steadily away from a replacement cost

approach towards fair (market) value accounting.

Jones and Riahi-Belkaoui (2010, pp. 189–190) suggested that the CCA provides better

comparability of various entities‟ performances, as one entity‟s profits are more realistic

not simply because it bought assets years earlier and would have generated lower

depreciation under HCA. However, under CCA it is difficult to determine replacement

costs, which makes it just as arbitrary as it is with HCA.

In relation to infrastructure assets such as water, past costs are sunk costs. Water

businesses might decide to replace a given asset, as it might be more efficient and less

costly to acquire these different types of assets. If this is the case and the businesses were

required to acquire this new asset, replacement cost is irrelevant, as it does not reflect

what it would be worth if the business decided to sell it.

Likewise, Chambers, an advocate of CCA and founder of Continuously Contemporary

Accounting (CoCoA), was particularly critical of the Edwards and Bell model of

accounting. Both Chambers (1995, p. 82) and Clarke (2000, p. 276) have stated:

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In the context of judgement of the past and decision making for the future, the

products of CCA of the Edwards and Bell variety are irrelevant and misleading.

3.4 The rationale of value-based accounting method NRV

The two common value-based accounting models for asset valuations are NRV

accounting and NPV accounting. Edwards and Bell (1961, p. 75) defined NRV

accounting of an asset as its „current exit value‟; that is, “the maximum price a currently

held asset could be sold for in the market, less the transactions costs of the sale.” Lee

(1985, p. 14) described it as representing the “opportunity cost” of assets, or the “value of

a resource in its next available form”.

The Framework for the Preparation and Presentation of Financial Statements, paragraph

100(c) (December 2007), defines realisable (settlement) value as “assets carried at the

amount of cash or cash equivalents that could currently be obtained by selling the asset in

an orderly disposal. Liabilities are carried at their settlements values; that is, the

undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the

liabilities in the normal course of business.” Paragraph 101 specifies that inventories are

usually carried at the lower of cost and net realisable value.

The concept behind NRV accounting lies within the periodic change in the realisable

value of capital, which is directed towards maintenance of financial capital. Those who

support NRV accounting include Chambers (1966), MacNeal (1970) and Sterling (1970).

The most notable form of this capital maintenance was developed by Chambers, now

known as the CoCoA model. Chambers suggested that assets should be reported at their

exit prices or realisable market value; that is, either cash or cash equivalents that would

currently be obtained from sale or when sold in the normal course of business. The

CoCoA model highlighted that “liabilities should be reported at the undiscounted

amounts of cash or cash equivalents that the entity expects to pay, in order to satisfy the

liabilities in the normal course of business.”

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In fact, Lee (1985, p. 92) found NRV accounting to be advocated as the most reasonable

opportunity cost to use, (as) it is an expression of economic sacrifice being made by an

entity when it invests in resources it has rather than in its alternatives. Such a sacrifice is

therefore expressed in terms of the entity‟s ability to command alternative goods and

services.

In practice, NRV accounting, unlike the HCA, lacks objectivity. Sterling (1970, p. 328)

defined NRV accounting as „forced liquidation value‟, rather than a „going concern‟

notion. That is the price that could be obtained by selling to the first man on the street that

happened to meet or like two accountants attempting to construct net realisable values for

a firm‟s assets. They would not generally come up with the same values – the market

values are not easy to obtain and it would be absurd to report such values. Sterling

therefore called for a less radical notion of exit price or NRV accounting.

On the contrary, NRV accounting has some advantages. The idea of „money worth‟ in

regard to assets is undeniably understandable. It highlights the fact that businesses do

have a choice in relation to the assets they hold. The NRV accounting also provides a

measure of such alternative choices, together with the current sacrifices implied in

holding the chosen resources. The concept of NRV accounting is consistent with the

maintenance of financial and physical capital. It has been presented in the CCA debate as

a measurement concept which provides an indication of both adaptability and liquidity

(Gibson & Goyen 1996, p. 61).

3.5 The rationale of value-based accounting method NPV

The view where the appropriate value for an asset is the discounted stream of future net

revenues or NPV accounting can be attributed to the work of Fisher and Canning. Fisher

(1897, p. 527) maintained the flow of services from an article of capital of any duration or

distribution of rate as the discounted value of its anticipated services, while Canning

(1929, p. 207) stated that:

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“If one could approximate the future of series of money outgoes and of money

receipts of a business, one could find, given a rate of discount, a direct capital of that

business.”

To add to this, Des Jardins (2001, p. 78) pointed out that the practice of discounting

future interests finds a contemporary expression in the economic concept of discounting

the present value of future payments. One dollar held now is worth more than one dollar

held at some time in future, because we could invest that dollar today, earn interest on it,

and therefore have more than one dollar at a future date. Future dollars must be

discounted to be equivalent to present value.

The Framework for the Preparation and Presentation of Financial Statements, paragraph

100(d) (December 2007), defines NPV accounting as “assets carried at the present

discounted value of future net cash inflows that an item is expected to generate in the

normal course of business. That is, liabilities are carried at present discounted value of

future net cash outflows that are expected to be required to settle the liabilities in the

normal course of business.”

Accountants have traditionally been concerned with income calculations based on market

transactions and prices. The NPV accounting is an economic concept based on prediction

of future cash flows. According to Lee (1985, cited in Gibson & Goyen 1996, p. 62)

valuation of capital on the basis of discounted future net cash flows is believed to be the

measurement model that is closest to the economists‟ idea of „true‟ or „ideal‟ income.

In theory, the NPV accounting model is considered the best model. This approach

includes within the income calculation all cash flows, while the traditional HCA measures

include only those gains which have been realised. In the event that the forecasted flows

are accurate, the main difference between the economists‟ and accountants‟ income

measurement techniques is simply the periodic differences. Gibson and Goyen (1996, p.

62) asserted that these timing differences will self-cancel by the end of the asset‟s or the

entity‟s life.

However, NPV accounting is recognised for its practical deficiencies. For instance, it

requires not only an estimate of future net cash receipts and the timing of those receipts,

71

but also the selection of appropriate discount rates. Although they are conceptually

preferable, the subjectivity and the uncertainty surrounding their use make their

implementation impractical (Raar 2008, p. 798; Jones & Riahi-Belkaoui 2010, pp. 455 &

471).

3.6 The rationale of FVA

The FVA first arose in the 1890s utility rate base setting context; namely from the 1898

United States‟ Smyth v Ames utility pricing judgement. Consumer bodies were in favour

of a rate base that reflected lower prices, the current costs, but the monopoly utility

companies were in favour of the historical or higher costs. The fair value rate base was

therefore the monetary amount considered „fair and reasonable‟ to both operators and

consumers according to the circumstances of that time.

Most recently, the ideas and practices underpinning initial understandings of FVA have

changed from the initial concept of the utility rate-setting context to that of corporate

financial reporting. The definition of FVA can be found in paragraph 6 of IAS 16/ AASB

116 Property, Plant and Equipment (June 2009), and the equivalent paragraph 9 of the

IFRS 13/ AASB 13 Fair Value (September 2011), as „the amount for which an asset

could be exchanged between knowledgeable, willing parties in an arm‟s length

transaction‟. This definition of FVA is consistent with the term adopted in other

accounting standards.

Paragraphs 42–45 of IAS 40/ AASB 140 Investment Property (October 2010), further

defines „knowledgeable‟ as both the willing buyer and the willing seller who are

reasonably informed about the nature and characteristics of the particular asset (or group

of assets), its actual and potential uses, and market conditions at the reporting date. A

willing buyer is motivated but not compelled to buy. This buyer is neither over-eager nor

determined to buy at any price, and hence would not pay a higher price than a market

comprising of knowledgeable, willing buyers and sellers. A willing seller is neither an

over-eager nor a forced seller, prepared to sell at any price, nor one prepared to hold out

for a price not considered reasonable in current market conditions. The willing seller is

motivated to sell the asset at market terms for the best price obtainable. An „arm‟s length

72

transaction‟ is the one between parties that do not have a particular or special relationship

that makes prices of transactions uncharacteristic of market conditions. The transaction is

presumed to be between unrelated parties, each acting independently.

Supporters of FVA such as Barth, Landsman and Wahlen (1995, pp. 77–104) have

asserted that fair value is relevant, because it reflects present economic conditions related

to economic resources and obligations; that is, the condition under which financial

statement users will make their decisions.

In recent years, a major new influence on the process of setting accounting standards has

emerged. The global financial crisis of 2007–2008 placed the accounting standards setters

such as the United States Financial Accounting Standards Board (FASB) and the IASB

under pressure to change those standards related to fair value measurement for financial

instruments.

The use of FVA has been blamed for the collapse of major financial institutions such as

Lehman Brothers, the largest mortgage bond underwriter in the United States. On 15

September 2008, Lehman Brothers was declared bankrupt with a debt of over $US613

billion (Dow Jones Newswires 2008; MarketWatch 2008). Its collapse provoked

turbulence not only in the financial markets, but more importantly to the world of IFRS.

Around the same time, Merrill Lynch, headquartered in New York City and occupying

the entire 34 floors of the Four World Financial Center in Manhattan, agreed to sell itself

to Bank of America for $US50 billion; a price representing a discount of 61 per cent from

its September 2007 price (Poirier & Comlay 2008; France Agency Press 2008). These

events raise important questions on the impact of FVA during current financial crisis.

The global financial crisis has significantly raised the level and stakes of discussion on

the contrasting views for and against the use of FVA, which is increasingly under attack

and subject to intense discussion and debate. Magnan (2009, pp. 1–16) argued that FVA

is difficult to verify and might be based on unreliable assumptions or hypotheses. FVA

provides management with too much discretion in the preparation of financial statements,

and is not only easy to manipulate but is also unstable; hence making it unsuitable to be

used as an estimate for value of an asset. It is difficult to make an estimate based on flows

http://en.wikipedia.org/wiki/New_York_City

http://en.wikipedia.org/wiki/Four_World_Financial_Center

http://en.wikipedia.org/wiki/Manhattan

73

expected in future from use of a specific asset. FVA is associated with more volatile and

less conservative financial statements.

Although its use is based on present value or exit price estimates, and it has been adopted

universally by accounting standard setters, it previously led and contributed to Enron‟s

failure (Benston 2006, pp. 465–484). Likewise, troubled firms in the United States such

as Lehman Brothers and Merrill Lynch were forced to sell their assets, creating an

artificially low industry standard for the value of their assets (Gwilliam & Jackson 2008,

pp. 240–259).

In relation to determination of FVA for property, plant and equipment, which includes

water infrastructure assets, paragraphs 33 and 34 of IAS 16/ AASB 116 Property, Plant

and Equipment (June 2009) and the equivalent paragraph 62 of the IFRS 13/ AASB 13

Fair Value Measurement (September 2011) provide the following guidance:

“Fair value of items of property, plant and equipment is usually their market value

determined by appraisal.”

“If there is no market-based evidence of fair value because of the specialised

nature of property, plant and equipment and the item is rarely sold (this is

applicable to water infrastructure assets), except as part of a continuing business,

an entity may need to estimate fair value using an income or a depreciated

replacement cost approach.”

If this is the case, international and Australian accounting standards allow fair value to be

estimated using an income approach or a depreciated replacement cost (DRC) approach.

No further guidance in the Accounting Standard is provided or can be found as to whether

both techniques are equally acceptable to all entities in all circumstances, or whether each

of the available techniques should only be applied in certain circumstances, as

appropriate.

3.7: The rationale of the use of ODV in utility businesses

The ODV, a variant of the deprival value, is the lesser of the DORC and the EV of the

asset. Bloom and Debessay (1987, p. 159) established that very few firms have applied

74

the deprival value in their asset valuation, with the exception of utilities, and that

presumably the deprival value approach estimations are extremely difficult. In particular,

the estimation of present value is subjective to varying degrees.

Supporters of the deprival value were generally accounting theorists such as Baxter

(1971, p. 36; 1975, pp. 125–126; 2003, pp. 1–23), Edey (1974, p. 75) and Solomon (1966,

p. 127, cited in Johnstone & Gaffikin, p. 51). In Australia, the institutional history of the

deprival value has been documented by Clarke (1998, pp. 8–16), and Walker, Clarke and

Dean (2000, pp. 1–32). Walker, Clarke and Dean (2000, p. 2) asserted that adoption of

deprival value accounting by government trading enterprises has occurred only after

limited debate within the public sector.

Walker, Clarke and Dean (2000, p. 132) reported that deprival value accounting, a variant

of replacement cost, has become the dominant public sector accounting method. In fact,

since a COAG agreement in August 1994, it is now recognised as the preferred valuation

method for network assets (Independent Pricing and Regulatory Tribunal 1998, p. 35;

Australian Competition and Consumer Commission 1998, p. 8, cited in Johnstone 2003,

p. 3).

Outside of Australia, similar developments in the United Kingdom have been discussed

by Whittington (1994, pp. 88–101; 1998, pp. 28–31), while Baxter (2003, pp. 1–21)

outlined conventional thinking in the use of deprival value accounting.

Prior to that, there were virtually no debates at all within the technical journals of the

accounting profession. Dean 1998 (pp. 1–2) argued that there appear to be no published

research into the appropriateness or serviceability of this form of reporting to guide

decision-making, or for any other purpose in the private or public sector. Interestingly, it

has been noted that the limited local debate pays no attention to post-1980s United

Kingdom literature on alternative forms of CCA and especially more complex for

government trading enterprises. The initial formulation of replacement cost accounting

was the idea of an Austrian economic in the later part of the 19th century. It resurged in

Europe in the 1920s, before dying down in the 1970s because there was little or no

attention given to concerns about ensuring the maintenance of physical operating

75

capability (Deans & Wells 1979 and Tweedie & Whittington 1984, cited in Walker,

Clarke & Dean 2000, p. 2).

In the 1990s, Australia applied CCA for all government trading enterprises. It appears to

have been initially motivated by a desire to use replacement cost as a surrogate for EV,

also referred to as the „recoverable amount‟. The Canadian Accounting Standard

pronouncements asserted in paragraph A.27 that deprival value measurements are

surrogates for present value of cash flows from use of the assets in question (Bloom &

Debessay 1987, p. 159). This resulted in denominator and numerator rates of return of

asset calculations, and established demanding rate-of-return targets for government

trading enterprises, and such data could be used to legitimise rate increases (Victorian

Government 1986 and Swan 1989, cited in Walker, Clarke & Dean 2000, p. 2).

The first deprival value approach, with application of „optimisation‟ (ODV), was

undertaken by Transpower, an electricity transmission company established on 1 July

1994 after the separation of the Electricity Corporation of New Zealand into transmission

and generation companies. In 1992, both the accounting firm Ernst & Young and Oxford

Research Associates were engaged in undertaking a study regarding asset valuation of the

transmission company. The ODV was chosen as the asset valuation method for

Transpower for two major reasons.

Firstly, it allowed Transpower to attract private capital for all necessary replacements, as

the price of assets is set at levels below the ODV, where it is sufficient to finance bypass

(duplication of network). A large number of producers compete with each other in a

competitive market to meet the wants and needs of a large number of consumers. The

ODV is considered the best method because it mimicked a long-run competitive

equilibrium where no business in the industry will want to leave and there is no reason for

entry. The implications of a long-run competitive equilibrium are that no existing

business will incur a loss, but any potential business that entered the market would

(Salisbury 1998, p. 1; New Zealand Institute of Economic Research (INC.) 2000, p. 4).

Competitors would build a second network if Transpower‟s prices were above the ODV

levels.

76

Secondly, the ODV minimises the required regulatory oversight of the business. A price

cap is imposed to provide incentives for efficient investment, which would allow

investors to be able to see cash flows in place, making it sufficient for any replacements

(New Zealand Institute of Economic Research (INC.) 2000, p. 4).

It was necessary to separate both the transmission and energy pricing, and the value for

Transpower‟s asset needs to be derived for separation to take place. The ODV was

recommended as the best valuation methodology, even though the most common practice

for electricity utilities in other countries at that time was to value their transmission

system based on HCA. Most importantly, the New Zealand Government required the

electricity line companies to provide ODV valuation figures for the purpose of

performance comparison and not for pricing. Following the adoption of ODV valuation

figures into their accounts, it was observed that these companies priced their services on

the basis of these much higher valuations.

As discussed earlier, the concept of deprival value has been around since the 1920s. It

was first developed for use in insurance and damage estimation. The deprival value is the

original work of Bonbright (1937, p. 71) who stated:

The value of property to its owner is identical in amount with the adverse value of the

entire loss, direct or indirect, that owner might be expecting to suffer if he were

deprived of the property.

Bonbright‟s concept of the deprival value was extended by Baxter (1971, p. 36), as the

lower of replacement cost or the „expected direct benefits‟. Bonbright‟s concept was later

broken into two parts by MacDonald (1974, p. 269, cited in Fraser 1988, p. 86), and the

first part is the „deprival value‟. This part is applicable to an owner who has lost an asset

and measures the quantum of the loss. The second part is „value to the owner‟, which

applies to an owner in possession of an asset. In simple terms, deprival value is based on

the legal notion of compensation for loss, including value to the owner, or entity, for

accounting purposes. It represents the future economic benefits that would be foregone by

the entity if it were deprived of the service potential or future economic benefits

embodied in the asset.

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As seen in the diagram below (Baxter 2003, p. 7; Macve 2010, p. 113), the deprival value

relates to current cost or current replacement cost, the present value and the net realisable

value.

DV = min [RC, RA]; that is, the lower of replacement cost and „recoverable amount‟ and

the higher of NRV and present value (PV), or equivalently, put together, DV = min [RC,

max (PV, NRV)].

Diagram 1: Deprival value

Several researchers have suggested the six valuation cases implicit in the deprival value

(DV) concept, and the implications of each are presented in Table 3.3 below (Norstrom

1985, p. 265; Bloom & Debessay 1987, p. 168; Johnstone & Gaffikin 1996, p. 52; Stark

1997, p. 44; Zijl & Whittington 2006, p. 125; Weetman 2007; p. 240; Rushdi 2008, p. 7).

Table 3.3: Six valuation cases, including the option to wait

Valuation cases Presumed course of action and implication

1. PV > NRV > CC DV = CC; replace the asset. It may well be unlikely for NRV to

exceed CC

2. CC > PV > NRV DV = PV; do not replace the asset. The owner uses the asset until

it is worn out – it will generate cash flows with that given PV

3. CC > NRV > PV DV = NRV; do not replace the asset. The owner sells the asset,

as it seems ready for liquidation

4. PV > CC > NPV DV = CC; replace the asset

5. NRV > CC > PV DV = CC; replace the asset, which seems unrealistic

6. NRV > PV > CC DV = CC; replace the asset, which seems unrealistic

PV = present value; value in use

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CC = current cost

NRV = net realisable value

If the entity replaces the asset it has lost, the appropriate valuation base is replacement

cost. Edwards, Kay and Mayer (1987, cited in Stark 1997, p. 42) suggested the

replacement cost in this case refers to the cost of replacing the „services‟ yielded by an

asset, and not the cost of „physical‟ replacement.

If the entity does not replace the asset it has lost, the deprival value (DV) would be

represented by the greater of its NRV and NPV. Stark (1997, p. 42) explained this as the

option to wait. The value of the option to wait associated with an asset is the „economic

worth‟; that is, the present value of the entity‟s future cash flows, which can be attributed

to the opportunity to acquire the asset in future.

Stark (1997, p. 42) emphasised this value as all possible opportunities to optimally invest

in the asset at all feasible points in the future. Any surplus assets are measured at their net

realisable value; whereas the NRV represents the deprival value of assets. He argued that

it is assumed that asset markets are active to allow immediate disposal at a certain price,

and that the NRV represents the proceeds from selling the assets for their „scrap value‟.

The same version can be succinctly expressed as (Weetman 2007, p. 239):

DV = min [RC, RA].

Where the deprival value is represented as (DV), the replacement cost (RC) is an asset‟s

replacement cost, and the recoverable amount (RA) is that made possible by current

ownership of the asset:

RA = max [PV, NRV]

DV = min [RC, max (PV, NRV)]

PV represents the present „value in use‟ and NRV is the NRV.

Lennard (2010, p. 98) claimed that support for widespread use of deprival value

(replacement cost) in many circumstances is because it represents the extent to which the

79

entity is better off as a result of its ownership of an asset, as long as it exceeds the price

paid for the asset. A business takes into account the returns it will enjoy through the

ownership of an asset and perhaps will earn by using it jointly with other assets. This

would suggest that the returns from the asset should be the basis on which the asset

should be measured; however, it could overstate its value to the entity.

The ownership of the asset can therefore justified, as it permits the earning of future

returns. Those returns lie in the future and should not be reflected in the value of an asset

that is currently owned. With reference to Bonbright‟s definition of deprival value, it can

be concluded that if the entity was deprived of the asset, it would not lose its future

returns. The entity‟s loss would simply be the cost of replacement, which captures the

extent to which the asset makes the entity better off financially.

The deprival value (entry value) has some advantages over some exit value approaches,

such as fair value (market value) accounting. Under fair value (market value) accounting,

the asset would have been written down or sold at the price that a buyer would be

prepared to pay for it. In doing so, a great deal of subjectivity is involved; in particular for

specialised (infrastructure) assets such as those of utility businesses. However, fair value

(market value) could result in not only scrap valuation but a significant loss for the

business.

The original concept of the deprival value or value to the owner as noted by Bonbright

appears to be misinterpreted. As the replacement cost is not a measure of value to the

owner, in a similar way the linking of Bonbright‟s name with deprival value derivation in

many textbooks is inappropriate (Fraser 1998, p. 89).

Careful re-examination of Bonbright‟s definition was found to have a discrepancy. The

calculation of deprival value according to Bonbright ignores the indirect loss, in the case

where deprival value is the replacement cost; that is, when the owner of the asset decides

to replace that particular asset. Bonbright did, however, explain that based on grounds of

expediency, indirect loss might be ignored.

Bonbright (1937, p. 77) stated “there are situations under which a court is quite justified

in valuing property, „for the purposes of the case‟ at an amount which concededly does

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not measure „value‟ in any sense of the term”. He therefore managed to distinguish

between his concept of value to the owner and what might be objectively awarded by way

of compensation for loss in a court of law.

Bonbright (1937, p. 93) also established that the owner may suffer important incidental

losses, which cannot be avoided by replacing the property. Even though the losses are not

always taken into account in an appraisal, he emphasised that it should be taken into

account if the objective is to find the full value of the property to its owner.

Chambers (1971, p. 66), on the other hand, found that Bonbright indicated only vaguely

at value to the owner, which might take the form of a variety of measures, including the

replacement cost or NRV, or some amount between those two figures, or the lower of

capitalised income and a derivative of replacement cost.

Careful study of Bonbright‟s text clearly brings out his view of value to the owner, as he

concluded (1971, pp. 66–67) that the very characteristic of market value means that the

concept has but a limited usefulness in the valuation of property. The essential distinction

between value to the owner and market value is that the former represents a state of mind,

a favourable attitude of a particular person or group of persons towards the item valued.

Market value may therefore be a fairer basis than value to the owner, even if the latter

could be estimated with equal accuracy and convenience.

All of this means that in principle, according to Bonbright, the deprival value or value to

the owner is not measurable by market values, regardless of whether these take the form

of either buying or selling prices. The extracts from Bonbright‟s work indicate that he did

not, in principle, equate deprival value or value to the owner with market values. This is

because certain circumstances market value is necessary, or even a more desirable

alternative.

In contrast with Bonbright-derived deprival value, where value to the owner is defined as

replacement cost or net realisable value, market value has been found to be adopted as a

surrogate, to be accurate, in five cases out of six on the usual inequality basis (Solomon

1966; Whittington 1983, p. 132; Johnstone & Gaffikin 1996, p. 52; Stark 1997, p. 44;

Rushdi 2008, p. 7).

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Talking about exit value approaches, Lennard (2010, p. 98) described it as

„hypothesising‟ a purchaser that is in exactly the same economic position as the entity.

That ism if this exit value is recognised on acquisition, the returns that subsequently

materialise will seem to be ample. However, the losses arising on acquisition can be

easily an accounting fiction, as it is unlikely that the same assiduity would be employed in

explaining and assessing the subsequent return. In comparison, a replacement cost

approach such as the deprival value shows the asset initially at the price at which it was

acquired, and compares its returns against that price; hence it will inevitably seem more

modest. This is the reason why many would suggest a more realistic indication of the

returns earned on the investment.

Expanding on this, Baxter (1971, pp. 34–36, cited in Macve 2010, p. 114) claimed that

replacement cost needs interpreting, not only as the second-hand purchase price, but more

generally as „the adverse consequences of deprival on the present value of all future cash

flows, given that asset now has to be replaced earlier than planned‟. It requires

management estimates of optimal actions, the same as the present value concept, and

hence deprival value is criticised to be „too subjective‟. When markets get deeper, the

replacement cost and the NRV become ever more readily observable.

Baxter also demonstrated that deprival value must always be bound by market prices, so

that the subjectivity lies in fixing where on the spectrum in-between them and including

them is where deprival value lies. In doing so, deprival value and equivalently the

replacement cost tend towards fair value in „perfect markets‟, but they cope inadequately

and simply compares to fair value in real-world market imperfections.

Baxter‟s work (cited in Weetman, 2007, p. 239) on deprival value is particularly

impressive, as he argued based on the first principle below. For him, deprival value was a

process of computing budgets or values with and without the asset:

DV - PV (with asset) minus PV (without asset) (1).

In order to observe the connection between the two specifications, a familiar model was

rewritten: DV = min [RC, RA], add and subtract RA = max [PV, NRV] from the right-

hand side, and rearranged as follows:

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DV = RA + min [RC - RA, 0] (2)

= RA - max [RA - RC, 0] (3).

According to Baxter, deprival value is the amount in which the entity is better off from

owning the asset. As observed in the above equation, deprival value is the higher (not

lower) of two values. What this means is that in determining the replacement cost of a

long-life asset, such as those of utility businesses, in principle it entails forecasting far

into the future. Baxter highlighted the inherent subjectivity with the application of the

deprival value.

In October 1994, the Steering Committee on National Performance Monitoring (SCNPM)

of government trading enterprises produced a monograph where it detailed the findings

and recommendations of asset valuations. According to these guidelines, the deprival

value concept should be adopted as the preferred asset valuation method (Steering

Committee on National Performance Monitoring 1994, pp. 31 & 35; Walker, Clarke &

Dean 2000, p. 3).

The SCNPM (1994, p. 8) defined „deprival value‟ as value to the entity of future

economic benefits that the entity would have to forgo if deprived of the asset. The value

to the entity in most cases should be measured by replacement cost of the services or

benefits currently embodied in the assets, given that deprival value will normally

represent the cost avoided as a result of controlling the assets. The replacement cost

represents the amount of cash necessary to obtain an equivalent or identical asset. This

definition is similar to those provided by Bonbright (1937, p. 71) and Baxter (1971, p.

36). From a different perspective, the deprival value of assets is the lesser of the NPV of

the income to be generated by the assets and their replacement cost.

In adopting deprival value as the preferred asset valuation method, the SCNPM was

averting the financial reporting practices of private sector entities. There is no standard

that requires a consistent valuation methodology for assets, as most utility businesses

would generally adopt a partial and selective revaluation of asset approach. There is

inconsistency in the approach used in the valuation of assets, and hence one needs to take

care in an attempt to compare the performance result of government trading enterprises,

83

including rate of return on assets, with bodies reporting in line with private sector

practices.

The SCNPM‟s advocacy of the deprival value is consistent only with respect to non-

current physical assets; other asset classes, such as intangibles, marketable and non-

marketable securities, inventories, monetary assets, and research and development

expenditures, are all valued according to various relevant professional pronouncements

and guidance statements. In doing so, it invokes those same private sector practices that

are disparaged in relation to non-current physical assets (Steering Committee on National

Performance Monitoring 1994, pp. 17–18 & 35).

The deprival value method used in government trading enterprises has been criticised by

a number of scholars such as King (1966, pp. 1–28), Lawrey (1994, pp. 21–34), and

Johnstone and Gaffikin (1996, pp. 50–65). A common criticism is that it involves a

circularity problem, especially when an entity is not likely to replace an asset if deprived

of it. In such cases, deprival value would be the EV; that is:

Max [NRV, NPV].

If the entity would not replace an asset if deprived of it, an assessment is made of the

maximum tariff that could be charged without the consumers disconnecting or some other

barrier being encountered. The EV, the „recoverable amount‟, is the maximum of the

present value of the maximum revenue the assets can earn, minus capital and operating

expenditure. This is the value to the user of an asset, or the value of the asset measured at

its current net market selling value. In cases where the asset has been removed from the

service, it is the present value of the NRV of the assets at the time of retirement, or its

disposal value.

The equation above would be unable to value assets in a competitive price for output or

influence by monopoly price. If any costs increase, these should be reflected in the asset

valuation and vice versa. Potential entrants should set price equal to long-run marginal

costs; and where price is equal to these costs, the threat of entry provides a sufficient

incentive for the incumbent firm to price close to the economically efficient price level

(Troughton, Swier & Associates 1996, pp. 14–15, cited in Rushdi 2008, pp. 10–11).

84

The RAB on which prices are based is kept equal to long-run marginal costs; and

therefore prices will also equate to long-run marginal costs. Since valuation of assets

under this equation is affected by monopoly rents, in terms of infrastructure regulation,

monopoly rents arise where prices charged to consumers produce a return in excess of a

reasonable return on capital invested. If this is the case, it would lead to an increase in

production costs, which will push up the price. In such instances, the sum of deprival

values for individual assets will not match the collective deprival value (Troughton, Swier

& Associates 1996, pp. 14–15, cited in Rushdi 2008, pp. 10–11).

Likewise, where an entity does not replace an asset, this is interpreted as having surplus

assets. The deprival value would cause the price to increase due to depreciation charges

on assets that are not required for the current level of output. These surplus and stranded

assets do not form any part of inputs used in the provision of services, and should be

assigned a zero value for pricing purposes (Troughton, Swier & Associates 1996, pp. 14–

15, cited in Rushdi 2008, p 11).

A further issue is that the existing network owner should be able to secure a return on

what the network would cost to replace, not what it has actually cost. For instance, when

the network owner‟s capital is invested in pipes, the opportunity cost is the scrap value.

This is the real choice faced by a network infrastructure owner, as the network owner has

used up the liquid capital and has physical capital assets, which when valued would have

minimal or zero opportunity cost. In economics, these assets are sunk assets with no

alternative use except as scrap, and hence the initial capital base should be close to zero.

When capital has been sunk, there should be no opportunity cost, and no regulated

revenue stream should be awarded to induce investment to create what already exists, or

to keep in place assets which have no alternative use (Dwyer 2001, p. 45).

In particular, the IPART rejected the deprival value as a valuation method, as it believed

that this approach was unsuitable for price regulation of monopolies where assets would

not be replaced if deprived of, or where the assets do not have a market (Australian

Competition and Consumer Commission 1996, p. 12, cited in Rushdi 2008, p. 8). Under

the deprival value approach, as seen its formula, the assumption is that the network owner

will only replace an asset if the present value of future free cash flow generated from its

85

use exceeds the existing replacement cost. IPART (1996, p. 13) asserted that this

assumption will not apply when a government directs the continuation of the service.

Contradictory to IPART, Bertram and Terry (2000, p. 21) advocated that the use of ODV

for pricing would lead to prices that are a good proxy for those that would eventuate in a

competitive market where supply and demand are balanced. In a perfectly competitive

market, such prices that arise reflect the real short-run marginal cost. In such instances,

businesses would continue to produce additional output as long as the cost of producing

an extra unit of output was less than the price they would receive.

The ODV is based on prices set in a hypothetical long-term competitive market with

balanced supply and demand, and short-life, non-lumpy assets. This picture simply does

not translate sensibly to infrastructure assets, such as water utility businesses. On the one

hand, the ODV cuts out „gold-plating‟ or past over-investment, so that investors remain

responsible for some errors of judgement. Yet arguably, there is no evidence that the

ODV is this efficient. It is not generally sustainable, as the correct comparison for a past

investment is not the MEA now, but rather the MEA at the time when the investment was

made (Bertram & Terry 2000, p. 21; Gale & McWha 2000, p. 10).

On the other hand, deprival value is known as the appropriate asset valuation for

government trading enterprises‟ statutory reporting and performance monitoring

purposes. It is a conservative method of asset valuation intended to prevent overstatement

of asset values. If the underlying circumstances of the deprival value approach are

adopted by an entity, it will provide a logical, selective means of choosing the most

significant value of either an asset or group of assets according to the underlying

circumstances facing the entity. Any asset valuation method involves some degree of

subjectivity that is an element of estimation and uncertainty. The DORC therefore takes

into account depreciation that places the risk of technological changes on the investor. It

ensures consumers do not pay more than what they would be paying in a competitive

market (Bloom & Debessay 1987, p. 172; Rushdi 2008, pp. 15–16).

ODV is used to determine surplus capacity in an entity and to determine access prices on

the basis of how much the network owner will be deprived of by not using the surplus

86

capacity. Deprival value may well have some theoretical weaknesses, but it is better than

other known alternatives (Rushdi 2008, pp. 15–16).

3.8 Summary of main types of asset valuation techniques used

across various assets

Figure 3.1 summarises the main types of asset valuation techniques currently used across

Australia and recommended by both international and Australian accounting standard

setters. The AARF (1994, p. 13) suggested that measurement is one of the most

significant contemporary issues in financial reporting. Paragraph 100 of AASB

Framework for the Preparation and Presentation of Financial Statement (September

2009) proposes that “a number of different measurement techniques and guidelines be

employed to different degrees and in varying combinations in financial statements, for the

valuation of assets.”

Figure 3.1: Main types of asset valuations and their associated measurement rules

Ass

et

1. Cash

2. Account receivable

3. Inventory

4. Property, plant and equipment

5. Marketable securities

6. Assets leased by way of a finance lease

7. Goodwill

8. Biological assets

Mea

sure

men

t ru

le

1. Face value

2. Net realisable value (NRV)

3. Lower of cost and net realisable value

4. Lower of 'cost' and 'recoverable amount'

5. At cost or fair value

6. At the present value of the minimum lease payments

7. At cost of acquisition (fair value), internally generated goodwill is not to be recognised

8. At fair value, less estimated point-of-sale costs (NRV)

87

In practice and as acknowledged in paragraph 101 of the Framework, HCA represents the

dominant framework for recognition and measurement; however, this is being replaced by

FVA. HCA is usually combined with other measurement bases; for example, property,

plant and equipment are measured at either the lower of cost or the recoverable amount,

and marketable securities may be carried at cost or fair (market) value.

Figure 3.1 confirms that the international and Australian accounting standard setters

appear to be moving steadily towards a fair (market) value asset valuation approach as the

preferred current value model for different types of accounting transactions. There are

numerous international and Australian accounting standards that require or permit the use

of FVA for reporting purposes, but there is no uniform current value model for such use

of FVA by all companies.

Paragraph 110 of the AASB Framework for the Preparation and Presentation of

Financial Statement (September 2009) suggests that the most relevant and reliable

measurement to be adopted in the preparation of financial statements. Asset valuation is

essential to ensure that only the most appropriate asset values are adopted to satisfy

accounting statutory reporting requirements. Further information on the recognition and

measurement of assets is discussed in Chapter Six of this thesis.

The other applicable International and Australian Accounting Framework is SAC 2

Objective of General Purpose Financial Reporting. As of January 2014, SAC 2 was

withdrawn. The relevant framework is Chapter 1 The objective of general purpose

financial reporting of the AASB CF 2013-1 Amendments to the Australian Conceptual

Framework (January 2014). Chapter 1 seeks to establish the objectives of general purpose

financial reporting for reporting entities. The primary purpose of this chapter is to provide

information on an entity‟s economic or financial performance, rather than on the

reporting of social or environmental performance. Public disclosures in relation to social

and environmental performance, such as information on a business corporate social

responsibility and its community involvement, are not mandatory by law in Australia.

Most importantly, the main qualitative characteristic of financial information is that the

information should be useful for economic decision-making. In accounting, without the

presence of useful financial information for economic decision-making, the central

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objective of the general purpose of financial statements would be meaningless. In relation

to water utility industry, users of the financial statements would be interested in the

capability of the business‟ to provide goods and services in the future (paragraph

AusOB3.1). The preparation of general purpose financial reporting allows management of

the business to discharge their responsibilities to make efficient and effective use of the

business‟s resources (paragraph OB16). Accounting information is useful both for

assessing the business‟s past and future ability to generate net cash inflows through its

operations as well as useful for assessing whether income was sufficient to meet the cost

and quality of goods and services (water and sewerage services) the business provides

(paragraph AusOB18.1).

Chapter 1 suggests that one objective of general purpose financial reporting is to

communicate relevant and reliable information to enable report users to make and

evaluate decisions about the allocation of scarce resources. Users of general purpose

financial reports are the resource providers (water utility businesses), recipients of goods

and services (consumers), and parties performing a review or oversight function

(regulator) (paragraph OB 2.1). By doing so, the water business is able to discharge

public accountability via maintenance of relevant and reliable information as required in

its audited financial statements (paragraphs OB4 and OB16). As well, level of water rates

and charges are set to take into account the cost of capital (assets) and operating

expenditures, including asset deprecation (National Asset Management Steering Group

2001, p. 1.2).

The main GAAP applicable to asset valuation and specifically the ODV concept are the

going concern assumption and the prudence or conservatism assumption. The going

concern specifics that existing business will continue to operate in the future. In contrast,

the prudence convention emphasises that accountants should recognise losses in asset

values as early as possible, while gains should only be recognised when it is certain and

the amount is realised. In line with this, assets are to be valued so as to provide a relevant

and faithful representative for economic decision-making.

Accounting standards relevant to ODV are the IAS 16/ AASB 116 Property, Plant and

Equipment (June 2009); particularly specific standards in paragraphs 7, 29–31 and 33.

Paragraph 7 proposes that “the cost of property, plant and equipment shall be recognised

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as an asset if it is probable that future economic benefits associated with it will flow to the

entity and the cost of the asset must be measured reliably.” Paragraphs 29–31 recommend

that property, plant and equipment (water utility‟s assets) should be valued at either the

lower of „cost‟ or „recoverable amount‟ that is the amount expected to be recovered in

future cash flows through use and/or sale of the asset.

Paragraph 33 of IAS 16/ AASB 116 (June 2009) or states that “where there is no market-

based evidence of fair value because of specialised nature of the item of property, plant

and equipment and the item is rarely sold, except as part of a continuing business, an

entity may need to estimate fair value using an income (net realisable value) or a DORC

approach.”

These standards are the same ideas specified in the COAG published „guidelines‟ in 1994,

as mentioned in Chapter 6 (Steering Committee on National Performance Monitoring

1994, pp. 3 & 42). They were also reflected in the United Kingdom Sandilands Report in

1975, where scholars such as Solomon (1966), European business economists such as

Theodor Limperg and Fritz Schmidt in the 1920s, and 19th century economist Bohm

Bawerk had all introduced these same rules (Edwards, Kay & Mayer 1987, pp. 38–49;

Walker, Clarke & Dean 2000, pp. 132–133).

That is:

The ODV = lower of DORC (replacement cost) / „recoverable amount‟ (i.e. the higher of

NPV/NRV), or equivalently.

3.9 Survey and case study on asset valuation and pricing

In Australia, academic research in relation to asset valuation and pricing specifically

related to utility businesses is very limited. Most of the published work in this area can be

accredited to three accounting academics: Clarke (1998, pp. 8–16), and Walker, Clarke

and Dean (2000, pp. 1–32 & 2000, pp. 123–159).

The main issue identified in most of this asset valuation and pricing research is the need

to reduce the degree of subjectivity behind the deprival value method. It is also

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recognised that because most valuation techniques have an element of estimation and

uncertainty, consideration should be given to the development of industry-specific

guidelines, including the practical approach to optimisation. For instance, the treatment of

surplus capacity, planning horizon and technological change are examples of this

practical approach. Further clarification is also required on requirement for discount in

the application of economic valuation/ recoverable amount tests.

A great deal of concern has been raised regarding conceptual and implementation issues

of asset valuation; in particular, many respondents have expressed their concerns about

the application of deprival value in relation to long-life assets. The omission of the notion

„optimisation‟ can change the asset value, which is subject to optimisation and is based on

a „greenfield‟ approach that may result in substantially different asset values compared

with like-for-like replacement costs.

Such concerns are similar to those raised by Johnstone and Gaffkin (1996, pp. 50–65),

including the internal inconsistencies approach to valuation of assets, conceptual

limitations regarding net revenue allocation, non-additivity of deprival values, and the

„undefined‟ concept of capital. In relation to the conceptual limitations, the ODV, as

previously discussed in this study, is a function of three „arguments‟: the replacement

cost, the NRV and the NPV.

NPV is known to be the most problematic, as an asset‟s NPV is difficult to assess because

it needs to be allocated from projected net income stream, flowing to the surrounding

profit centre or entire entity and the revenues (and costs) attributable to that particular

asset. If such allocations can ever be made, they should be based on a true „cause and

effect‟ foundation.

In real-world circumstances, where individual assets interact, the deprival values are

generally nowhere near additive. For instance, if a business has 20 machines and one

machine is destroyed by fire, then the business will probably cope and be reasonably

content if the deprival value, which would be the replacement cost of that machine, is

paid by the insurance company. If 10 or 20 machines were lost, this might cause

production to drop, customers to disappear and the business as a whole to be ruined. In

such cases, the owner would clearly need more than 10 or 20 times the deprival value of

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that one machine if they were to be indemnified. Expressed another way, deprival value

of the business is much greater than the sum of deprival values of its part.

The SCNPM (1994, p. 33) provided a response to such concerns in noting that deprival

value is the sum of the individual deprival value and the best available „surrogate‟ for the

value of the entity as a whole. Many scholars have claimed that there is also the

unanswered question of concept of capital. Johnstone and Gaffkin (1996, p. 60) asserted

that the most important error of omission in the SCNPM guidelines is that no particular

capital maintenance objective is explained. Similarly, the Sandilands Report in 1975 was

also found to be lacking of this concept.

To take this discussion further, three surveys were carried out in New Zealand in relation

to asset valuation and pricing. The first was a survey of New Zealand local authorities to

study the procedures and techniques for recording and valuing infrastructure assets. The

second was carried out to determine which asset valuation approach is more adopted, how

is it applied, and what, if any, innovative approaches are being adopted that are more

appropriate and would lead to more consistent infrastructure valuation practices.

The findings of the first survey indicated that progress had been made towards greater

consistency in accounting for and valuation of local authority infrastructure assets. That

is, more local authorities now keep a record of assets owned, from 90 per cent in 1996 to

100 per cent in 2003. Infrastructural asset valuations are also performed more regularly

compared to the 1996 study, which is 90 per cent versus 68 per cent previously (Bond &

Sakornvanasak 2006, pp. 44–46).

The first survey revealed that nearly three-quarters, which is 73 per cent of the

respondents, revalue their asset only every three years. The replacement cost approach is

the valuation methodology employed for infrastructural valuation, and 94 per cent of the

respondents indicated that DORC is used, while the remaining 6 per cent use DRC.

The second was a comprehensive survey on current practices in the valuation of a

wastewater treatment plant of a local authority infrastructural asset. This survey was

designed according to the results obtained from the first survey, particularly to identify

any problems encountered in performing the DORC calculation. The first section of the

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survey consisted of general questions related to utilisation of the DORC approach. The

second section comprised of more specific questions on the DORC approach and how it

relates to the valuation of the wastewater treatment plant.

The results of the second survey revealed that valuation approaches underlying the DORC

method are not consistent in deriving an appropriate valuation figure for financial

reporting purposes.

Some of the inconsistencies include the componentisation level used in DORC valuation

and the application of appropriate approaches required to derive the replacement cost,

optimised figures, remaining useful lives and depreciation rates. These inconsistencies

highlight the need for further research, initiatives and guidelines so that infrastructural

asset valuation can be performed accordingly (Bond & Sakornvanasak 2006, pp. 45 &

47).

The third survey was conducted to assess the extent and quality of disclosure in the 1998–

99 annual reports of the New Zealand electricity retail and distribution (or lines or

network) company. Following electricity (Information Disclosure) Regulations 1999,

electricity line companies are required to report the ODV of their network assets to their

regulator, the Ministry of Economic Development (MED). It was revealed that

disclosures on the ODV method of network assets fall a long way short, as the details

provided in those annual reports were sparse. In most cases, current ODV is given, but all

the previous value figures were omitted, making it impossible to study changes in

valuations (Hooks, Coy & Davey 2002, p. 509).

Another case study was conducted on Sydney Water Corporation, one of the largest water

entities in water utilities businesses in Australia, which is engaged in water harvesting,

distribution and the provision of wastewater facilities. It operates under the State Owned

Corporations Act, which provides water, sewerage and drainage services to over 1.3

million properties in metropolitan Sydney, and the surrounding Illawarra and Blue

Mountain areas, with an annual turnover of more than $1.2 billion. Under its earlier name,

Sydney Water Board revalued some of its pipes and tunnels in its 1989–90 financial year.

This was the first time that it deviated from recording its long-life assets at historical cost.

By doing so, Sydney Water Board recorded its largest balance sheet revision ever

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undertaken in a single year in Australia. Water mains, tunnels and canals were revalued

and said to represent only 18.5 per cent of the its infrastructure, presumably, calculated

with reference to prior book values. Interestingly, the revaluation lifted the book value of

these assets from $674.6 million to $3.24 billion – an increase of nearly 400 per cent

(Walker, Clarke & Dean 2000, p. 13).

The following year in 1990–91 witnessed an even larger revaluation, which covered all of

the remaining infrastructure assets, except land. This case study found that the impact of

these asset revaluations has increased reported depreciation substantially, and reduced

reported profit. It inflated total asset value and equity, which is the denominator in the

rate of return on assets calculations (Walker, Clarke & Dean 2000, p. 13).

In 1994–95, Sydney Water Corporation reported that it had used the modern engineering

equivalent assets (MEERA), which is the DORC valuation basis, to value system assets

and produce a downward revaluation of more than $2 billion for those items, and after the

upward revaluation of other assets it led to the net downward revaluation of $1.677

billion. The experience with Sydney Water‟s asset revaluations suggested that its reported

data would be contestable. It is unlikely that its financial performance could be correctly

evaluated (Walker, Clarke & Dean 2000, p. 17).

3.10 Definitions of natural monopoly

The Oxford Dictionary defines a monopoly as either the exclusive possession or control

of the supply of or trade in a commodity or service. The word „monopoly‟ originated via

Latin from the Greek word „monopolion‟ – „monos‟ means „single‟ and „polein‟ means

„sell‟. For example, Australia Post is in charge of all postal services in Australia. By

contrast, a natural monopoly such as a water utility business is a condition which involves

the lowest long-run average cost, whereby it is most efficient on cost-technology for

production to be served by a single, largest supplier of the entire market for a particular

industry.

Many academics and economists have attributed the original concept of natural monopoly

to the work of John Stuart Mill in his book Principles of Political Economy in 1848. He

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used the term „concerned natural abilities‟ to refer solely to market failure in utility

businesses such as rail, post and electricity. He developed the idea that what is true of

labour is also true of capital, and made specific reference to network industries (e.g.

electricity, post and rails) as „practical monopolies‟. Mill‟s description of natural

monopolies fits into the modern description, as he claimed that government is partly in

control of the business or retains power over it. In doing so, the profits of the business

may be obtained from the public, and there is often a legal prohibition against

competition in rates of any business regulated by the government.

Posner (1969, p. 548) suggested that natural monopoly is a relationship between demand

and the technology of supply. Another scholar, Kahn (1971, pp. 119–123), described

natural monopolies as the inherent tendency to decrease unit cases over an entire range of

market. Factors of a natural monopoly consist of large fixed investments, fixed and

essentially immovable connections between suppliers and customers, obligation of

instantaneous supply, and wide fluctuations in demands for service. Posner also stated

that the (telephone) network effects could lead to subadditive costs, and when more

customers are connected to the network, cost per customer will increase because there are

more subscribers. The average cost per subscriber will increase, but it is still more

efficient for a single firm to supply the network service.

Similarly, Kahn (1970, pp. 119, 173) noted that both economies of scale and the presence

of fixed or sunk costs contribute to destruction of competition within the natural

monopoly business, resulting in a single-firm production rather than a small number of

firms in the long run. Kahn stressed that economies of scale can be achieved; however,

there are related cost-side economic attributes that are potential social costs of „duplicated

facilities‟ to a single-firm production being less costly, compared with multiple firm

production. That is, a combination of economies of scale and sunk costs will allow natural

monopoly to emerge in the market. Carlton and Perloff (2004, p. 104) maintained that

natural monopoly is a single firm in a market, whereby total production costs would rise

when two or more firms have produced instead of one.

All four scholars have pointed out that in terms of a firm‟s cost function, it would be most

efficient for a single firm to produce, assuming that costs are lowest based on the same

technology and input prices. By adding only one more customer, the company‟s revenue

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will increase, and the average cost of providing the company‟s customer base will

decrease. As long as the natural monopolist‟s average cost of serving customers is

decreasing, a single, largest firm can efficiently serve the entire customer base.

Baumol, together with Bailey, Panzar and Willig (1977, pp. 809–810), not only

formalised but also extended the current definition of a natural monopoly. They

established that a natural monopoly is an industry where multiform production is costlier

than production by a monopoly. That is, a single industry can produce output to supply

the entire market at a lower per-unit cost compared with two or more firms (subadditivity

of the cost function).

Baumol also linked the definition of a natural monopoly to the mathematical concept of

subadditivity of the cost function. He claimed that the scale economics (are) neither

necessary nor sufficient for monopoly to be the least costly of productive organisation.

Economies of scale are not a necessary but a sufficient condition for subadditivity. His

theory demonstrated that economies of scale on its own do not constitute a barrier to

entry. In order for them to work and to deter entry, they must be associated with sunk

costs, investments made in long-life physical assets such as those of water utility

businesses. Otherwise the values of these assets are considered almost worthless and have

no alternative use.

3.11 Foundations of price regulation

Regulation is the public economics face of industrial organisations, as it enables

governments to explore various ways and interfere with industrial activities. Under

complete information, technological efficiency requires a single operating firm. Watts and

Zimmerman (1978, pp. 112–134; 1990, pp. 131–156) developed an accounting theory,

which is part of positive accounting theory, called „agency‟ or „contracting theory‟. This

is where the authority, acting as a consumer agent, commits to setting prices on the basis

that it can recoup the long-run costs of efficient supply. In the same way, as described in

Diagram 3.1 below, Laffont (1994, pp. 507–508), and Loeb and Magat (cited in Pardina,

Rapti & Groom, E 2008, p. 2) identified the framework of new economics of regulation

as an application of principal-agent methodology, based on contractual relationship set-up

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in which the principal is the state or the regulatory institution, and the agent is the

regulated firm (water business).

Diagram 3.1: Agency theory

Efficient supply is the level where the market can prevail, assuming that it is a contestable

market. The regulated supplier derives a stream of residual income that depends on the

costs it incurs relative to the prices that it would set under a contestable market. The

regulator has to balance the legitimate business interests of the owner, the water utility

business, to provide service against the rights of access seekers and users for an

efficiently priced water service. These competing interests can impact the price of water

and the incentive for investment in this essential infrastructure. Price of water must be set

correctly, or else it will send incorrect signals to both consumers and investors, resulting

in a less than efficient allocation of resources.

Several authors including Lapsley (1993, pp. 69–73), Vass (1992, pp. 1–8), Whittington

(1994, p. 90), Puxty (1997, pp. 713–735) and McInnes (2002, pp. 387–418) have all

maintained that accounting is a central part of the regulatory system, with the creation of

a monopoly that gave rise to the challenge of devising a regulatory system to protect

consumers. The same concept can be found in economics theory, where Golberg (1976,

Principal (regulator/ state)

Agent (water

utility business)

Customers

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pp. 426–448), Williamson (1976, pp. 73–104) and Schmalensee (1979, pp. 151–170) also

maintained that regulation is either an implicit or an explicit contract between the

regulatory authority, consumers and supplier(s).

Where natural monopoly exists, such as in water businesses, the regulatory goal is to

improve the incentives for owners (water utility businesses), so that their behaviour is

more closely aligned with that of a competitive market. The key task of the regulator is to

balance these interests.

Historically, it was not until the 1930s that the notion of what constituted a „public utility‟

could be legitimately regulated by state, federal or municipal authorities, via the power

delegated to them by their state government. Prior to the 1930s, government price

regulation was constitutionally quite narrow; the landmark case was Munn v. Illinois 94

U.S. 113 (1877), where the Court upheld legislation proposed by the National Grange to

regulate the rates of railroads owned by grain elevators.

The grain elevators and warehouses in Chicago were required to obtain licences and to

charge prices which did not exceed levels specified. The important factor in the Court‟s

decision was that the ownership of these facilities constituted a virtual monopoly. The

Court declared that the business interest (private property) used for public good needed to

be regulated by the government. It was after the Munn case that states were allowed to

regulate utility businesses such as railroads; this case was also regarded to be a milestone

in the growth of federal government regulation. Bonbright (1961, p. 8) found that the

product had to be „important‟ or „necessary‟, and the production technology had to have

natural monopoly characteristics.

Another leading case was Smyth v. Ames 171 U.S. 361 (1898), which was a Supreme

Court case in the United States. The case was argued on 5–7 April 1897, and decided on 7

March 1898 by a unanimous vote of nine to zero for the Court. In Smyth v. Ames, the

Supreme Court made void a schedule of railroad tariffs, and defined the constitutional

limits of governmental power to set railroad and utility rates. The Court held that

regulated industries were constitutionally entitled to earn a fair return on the „fair value‟

of the business. Under the fair value rule, a governmental authority was not only required

http://en.wikipedia.org/wiki/Case_citation

http://www.answers.com/topic/fair-value-rule

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to determine a rate base, which was the present value of the business's assets, but was also

allowed to charge rates sufficient to earn a normal return on that value.

Three approaches for asset base determination were also identified from the decisions of

this Court, which are the historical cost, market (fair) value and replacement cost.

The Smyth v. Ames case was decided as the Court's protection of the free market economy

in the late 19th century. It was subjected to criticism that the fair value rule was

impractical because of complex administrative proceedings required to determine current

value of utility assets as the rate base. The problem of „circularity‟ was thus created. That

is, it was illogical for a utility's value to be determined by its rates, as it is impossible to

set rates according to a business‟s value, since that value cannot be known until the rates

are determined.

The decision in Smyth v. Ames was adhered, and set the constitutional limits of rate

regulation for over 46 years. This notion of fair value remained the „law of the land‟ until

it was overruled in Federal Power Commission v. Hope Natural Gas Co. 320 U.S. 591

(1944).

By 1944, the United States Supreme Court had realised that the problem of circularity,

(i.e. fair value) is the end product of the process of rate-making, and not the starting point.

At the heart of this problem is that rates cannot be made to depend upon fair value when

the value of the going business depends on earnings under whatever rates may be

anticipated. As the deprival value depends on revenue expectations; it cannot at the same

time be the basis for setting revenues. Put differently, the original intention was that the

rate base should be used to determine asset value, and not the other way around.

Hope‟s case was described by Bonbright (1948, p. 465) as:

One of the most important economics pronouncements in the history of American

Law. Unless the Court reverses itself, no longer will it impose upon legislatures or

commissions, state or federal, the severe restrictions upon their powers to fix rates

that it previously imposed under its doctrines in Smyth vs. Ames. The rule of

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„reasonable return on fair value‟ may still be retained by states that choose to retain it.

But it has ceased to be „law of the land.

Following the Hope decision, there was no specific asset valuation methodology for

utility businesses‟ regulatory assets. It not only signalled the end of the Court‟s role in

settling disputes between the regulated entities and the regulators, but also put an end to

the use of fair value as the appropriate asset valuation methodology. The important

ongoing implication from this case is that the court should not be involved as long as

utility businesses are able to operate successfully and attract capital. In practice, the

decision as to which asset valuation methodology needs to be used is now left to the

regulatory commissions.

Even today, the United States Supreme Court‟s old judicial precedent decision set the

basis for subsequent utility regulation in the United States, and has been adopted by

regulators in the United Kingdom and Australia. Similar principles were also confirmed

in the Supreme Court of Canada in British Columbia Electric Railway Co. v. Public

Utilities Commission, [1960] S.C.R. 837.

3.12 Effects of rate regulation and price on utility businesses

The benefits of a regulatory framework include lower network service costs,

improvements in service quality, investment to expand the network to support changes in

supply and demand for network services, and development of efficient network platforms

to support robust competitive wholesale and retail markets (Joskow 2008, p. 548).

Traditionally, rate-of-return regulation has been used to set prices for utility businesses, as

it incorporates pricing flexibility elements, wherein it allows utility businesses to charge

preferred prices that it sees fit within the total MAR cap. The business is given a review

period of three to five years to recover relevant costs, and is also allowed to recover its

asset value through depreciation charges (return of capital), and earn a return on the

outstanding balance.

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In theory, pricing principles set prices to recover fully the most efficient costs of service

provision, including the significant impact of consumption behaviour and investment

activity. This is the reason why capital charges are said to allow „a return of and on‟ the

asset base. That is, the regulator would be expected to increase prices whenever the

company‟s revenue requirements rise under rate-of-return regulation.

Price control is intended to last for a defined regulatory period, between three and five

years, regardless of what happens to the water utility business‟s costs. However, it is

possible for water utility businesses, being natural monopolies, to meet targets simply by

increasing prices and revenues, or by reducing quality of service, rather than by seeking

the most efficient methods of production (Temple-Heald 1991, p. 12).

Most academic research on regulation and effects on pricing have focused on the

telecommunications industry. Ter-Martirosyan (2003, p. 2), and Currier and Jackson

(2008, p. 261) claimed that within the last 20 years, rate-of-return regulation has

predominantly been replaced with price-cap regulation, as the latter generates more

efficient pricing structures and strong incentive for cost reduction. In fact, the principal

innovation in regulatory policy in the last 20 years has been the application of price-cap

regulation. All 50 states in the United States, as well as many other countries around the

world, have implemented price-cap regulations.

Research into the effect of rate regulation on utility businesses and prices not only varies

widely, but is also limited. While there is extensive literature on incentive regulation

(price-cap), there is very limited guidance for its practical application in real-world

circumstances.

Averch and Johnson (1962, pp. 1052–1068) developed a theory of monopoly business,

seeking to maximise profit and subject to a constraint on its rate of return. They

concluded that the regulated business operates inefficiently because social cost is not

minimised by the output the business selects. They disclosed the behaviour of the

business where misallocation of economic resources exists from the regulator‟s use of the

rate-of-return constraint for price control. They claimed that it is difficult to determine the

correct rate of return, as there is a poor incentive for cost reduction, and the regulatory

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practices provide an incentive for businesses to operate even at a loss, as certain activities

of a business are considered to be public knowledge and can be subsidised.

Tardiff and Taylor (1993, cited in Kridel, Sappington & Weisman, p. 301), in contrast,

found virtually no statistical evidence that regulation can enhance infrastructural

investment. In contrast again, Greenstein, McMaster and Spiller (1995, cited in Kridel,

Sappington & Weisman, p. 301) found that price-cap regulation leads to significant

investment in telecommunications infrastructure. Crandall and Waverman (1995), in their

book Talk is cheap, revealed that under price-cap regulation, residential and business

telephone prices were the lowest compared with other forms of incentive regulations.

During the 1990s in Latin America, Rudnick and Zolezzi (2001, pp. 180–184) examined

changes in several dimensions of productivity in electricity sectors. Their studies found

significant improvements in productivity indicators.

In the United States, Ai and Sappington (2002, pp. 133–160) provided the most

comprehensive study on the impact of state incentive regulation mechanism on network

modernisation, aggregate demand, revenue, cost, profit and local service rates applied to

local telephone companies from 1986 to 1999. Evidence of lower operating costs, lower

rates for business customers, and increased network modernisation were identified by

them under various forms of incentive regulation. Most importantly, they examined and

discovered that incentive regulation contributes to cost reductions and network

modernisation.

Currier and Jackson (2008, p. 262) confirmed that the application of price-cap regulation

will increase productivity and consumer welfare. In general, price caps have proven far

more superior incentives, because they combine both incentives for cost reduction and

efficient pricing, which lead to Pareto improvements compared with rate-of-return

regulation (Vogelsang 2002, p. 5).

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3.13 Summary

Normative theories of accounting that prescribe that assets should be valued using

specific asset valuation techniques have been considered in this chapter. Broadly, the

variety of asset valuation techniques have been discussed, which is the HCA, the CCA,

the NRV accounting, the NPV accounting and the FVA. Other varieties which are

applicable to utility businesses, such as the ODV and the DORC techniques, were also

discussed. In practice and as stated in paragraph 100 of the International and Australian

Accounting Conceptual Framework – Framework of the Preparation and Presentation of

Financial Statements, HCA is the dominant framework for recognition and measurement.

However, this foundation is slowly being replaced by FVA.

Clearly no asset valuation method is perfect, and neither is entirely satisfactory. Within

competitive markets, the business‟s asset valuations are not as important or complex as

they are for government trading enterprises, such as water utility businesses, which have

the potential to exert monopoly power; therefore, their efficiency and profits are of

interest. Profit should be reasonable to the amount of assets employed. All of the asset

valuation techniques have serious accounting implications, as many of these assets have

little, if any, resale value or alternative use (sunk cost).

In principle, HCA provides a fair and reasonable return to service providers. On one

hand, it can guarantee capital maintenance in that there is certainty about recovery of

investment costs. It is potentially the most objective and lowest cost asset valuation

method. On the other hand, it constrains price increases to consumers, and therefore

cannot be considered economically efficient. Its foundation as the dominant framework

for recognition and measurement of assets has therefore been replaced by FVA.

The discussion in this chapter has revealed that the deprival value method is forward-

looking; it eliminates the problems associated with inflation, and includes technological

advancements unlike the traditional HCA. The deprival value method reflects the EV of

capital equipment used, as its underlying assumption is that the assets should be valued in

terms of the economic loss suffered if deprived of the use of the asset. The loss can either

be measured on the basis of the cost of replacing the asset with a modern equivalent or, if

this is not economical, on the basis of future income stream foregone. However, this

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method can unnecessarily inflate the rate base for depreciation charges, leading to higher

prices for consumers and windfall profits for the owners. Nevertheless, this method is

more consistent with modern economics/accounting theory, even though it is not perfect.

Unfortunately, there is no rigorous basis to determine the „correct‟ valuation that is in-

between.

The first asset valuation survey result concluded that progress has been made for better

appropriateness and consistency in accounting for local authority asset valuations. The

second survey revealed that asset valuation using the DORC method is not consistent in

deriving an appropriate RAB figure for financial reporting purposes. These

inconsistencies existed due to the main elements of the DRC method, ranging from the

component level used in the valuation, the application of approaches used to derive the

replacement cost, the optimised asset figures, the assets remaining useful lives and the

depreciation rates used.

The third survey concluded that the disclosures on the ODV fall a long way short because

under the ODV, details provided in the annual reports are sparse. In many cases the

current optimised value is given; however, any previous figures are omitted, making it

impossible to compare changes in asset valuations from one financial year to another. The

case study found that when assets are optimised, asset revaluations result in substantial

increments in reported deprecation, inflated total asset values and reduced reported profit.

The original concept of natural monopoly was the work of an economist, John Stuart

Mill, in his book Principles of Political Economy in 1848. The formalised and current

definitions of natural monopoly are the work of Baumol, together with Bailey, Panzar and

Willig in 1977. Their theory demonstrates that economies of scale on its own do not

constitute a barrier to entry. For economies of scale to work and to deter entry, it must be

associated with sunk costs.

Several scholars have identified the framework of the new economies of regulation as an

application of principal-agent methodology, based on the contractual relationship set-up

in which the principal is the state or the regulatory institution, and the agent is the water

business. The regulator needs to balance the legitimate business interests of the owner,

the water business, to provide service against the rights of the consumers to an efficiently

104

priced water service. The price of water must be correctly priced for the economy as a

whole. Regulation is an implicit or explicit contract between the regulatory authority,

consumers and the regulated supplier(s). The key task of the regulator is to balance the

interest of the owners (water businesses) so that their behaviour is more closely aligned

with those that would occur in a competitive market.

Research into the effects of rate regulation and prices in utility businesses not only varies

widely, but is also limited. There is very limited guidance for its practical application in

real-world scenario.

The following chapter provides an overview of the industry governance, structure and the

broad area of ownership for urban water services in major Australian cities.

105

Chapter Four: The Urban Water Industry in Major Australian

Cities

4.1 Introduction

Chapter Two presented the main characteristic of water as a natural monopoly where a

single, largest supplier in the industry rules the market. In water business, the supplier has

an overwhelming cost advantage over other actual and potential competitors. Therefore, it

is far more economical for one business with similar technology and consumer demand to

serve the relevant market than for several businesses to do so. Water businesses are

considered long-term, capital-intensive type with minimum decline in their book value.

However, since economies of scale in relation to the size of water market are often

created, there are high barriers to entry and competition is often not possible.

Chapter Three then discussed a general overview of asset valuation from an academic

point of view. The purpose of this chapter was to provide an overview of the industry

governance and structure, and the broad area of ownership for urban water services in all

Australian states – New South Wales, Victoria, Queensland, South Australia, Western

Australia and Tasmania. Urban water means both water and wastewater services, such as

water provision and wastewater disposal for private individuals and businesses, as well as

water services for environmental uses and stormwater management for public services.

The urban water industry is mainly involved in two main sectors, which is the supply of

reticulated potable water, and collection, treatment and disposal of wastewater.

Governments are particularly interested in water more than other natural resources,

because they need to ensure that water resources are used and provided to maximise

society wellbeing. In the absence of a competitive market, where demand and supply

determine price, governments need to be actively involved to ensure that water is both

allocated and priced efficiently, and that water services are provided at maximum value

and minimum cost. There are many similarities as well as significant differences between

the organisation and the operation of urban water and wastewater sectors in Australia‟s

major cities, and these will be discussed in detail in this chapter.

106

4.2 New South Wales

The industry

In New South Wales, the IPART looks after regulation of the electricity, gas, water and

transport industries. There are two major bulk water storage operators in New South

Wales, that is, the Sydney Catchment Authority (provides bulk water storage for Sydney)

and the State Water Corporation (operates bulk storages in regional and rural areas). The

water utilities and local councils are responsible for treating the water and distributing it

beyond river systems.

Over half a million people in six local government areas, including Newcastle, Lake

Macquarie, Maitland, Cessnock, Port Stephens, Dungog and small parts of Singleton

receive water from Hunter Water. A number of other bulk storages throughout the state

are also owned and operated by Hunter Water and local councils. Hunter Water in

Newcastle, and the local councils distributes and provides water retail services for the

remaining urban areas. The National Water Services Association (2008, p. 17) recorded

that there are 106 non-metropolitan local water utilities, 27 of which serve over 10 000

connected properties, serving a total population of 6.6 million, including 1.8 million in

non-metropolitan NSW.

Governance of urban pricing

Diagram 4.1 below shows that in New South Wales, water management responsibilities

rest with various states, regional and local organisations (National Water Commission

2009).

107

Diagram 4.1: Management of water in New South Wales

Source: http://www.nwc.gov.au/www/html/1204-new-south-wales.asp

(National Water Commission 2009).

(National Water Commission 2009)

Water supply

Currently, Sydney‟s potable water supply is sourced from 11 major dams. Warragamba

Dam is the largest dam. There are several dams in the catchments of the Upper Nepean,

Woronora, Blue Mountains and Shoalhaven. Marsden Jacob Associates (2006, pp. 8–9)

stated that during dry periods, Sydney‟s dams can store around 2 400 GL of water at full

capacity; able to provide for four years under zero inflow conditions.

Local Regional State

Ministers departments Economic regulator Major water utilities

Water planning and management

Water quality management

Water markets

Water supply and services

Water pricing and economic regulation



Local water utilities Irrigation companies

NRM bodies

108

Supply–demand balance

In Sydney around 420 litres per person per day was used before implementation of water

restrictions in 2003. Of that 256 litres was used for residential purposes. WSAA (2005)

indicated that in 2002–03, after the introduction of Level 2 Water Restrictions, residential

water use per capita fell by 17 per cent, and commercial and industrial water use fell by 9

per cent (Marsden Jacob Associates 2006, p. 11).

Planned demand management strategies need to be put in place to cater for the growth in

population as Sydney‟s population is expected to grow to around 5.3 million by 2031.

Marsden Jacob Associates (2006, p. 11) predicted that water use would be expected to

grow over 800 GL per annum over the same period. By 2015, water supply availability

could reduce by approximately 80 GL per annum when the New South Wales

Government have the information needed to decide on the environment flows to be

provided to the Hawkesbury River from the Warragamba Dam.

Water and sewerage reform

Since 2006 there have been major changes at the national level, including the transfer of

some state water management powers from the Murray-Darling Basin to the

Commonwealth. The Murray-Darling Basin extends across four states: Queensland, New

South Wales, Victoria and South Australia. A large proportion of it passes through about

57 per cent of New South Wales‟s land area, and some 51 per cent of its surface water

extractions. All of inland New South Wales, with the exception of the far north-west

corner of the state, lies within the Murray-Darling Basin. The majority of New South

Wales‟ water use and licence holders are within this Basin, and any changes to Murray-

Darling Basin water management will significantly impact this state‟s water management

activities (New South Wales Office of Water 2009, p. 8).

The signing of an inter-governmental agreement on the Murray-Darling Basin reforms in

July 2008 resulted in significant changes, such as:

109

The establishment of the Murray-Darling Basin Authority to develop a Strategic

Basin Plan by 2011, which sets new (and probably lower) water extraction limits

for each catchment in the Basin.

The involvement of the Australian Competition and Consumer Commission

(ACCC) in developing water market trading and water charging rules.

The expansion of water information functions of the Bureau of Meteorology.

The entry of the Commonwealth into the Murray-Darling Basin as a major

purchaser and holder of water licences (New South Wales Office of Water 2009,

p. 8).

4.3 Victoria

The industry

Victoria‟s water businesses provide water and wastewater services to customers of 19

regions. In metropolitan Melbourne these services are provided by four providers:

Melbourne Water Corporation (one bulk water company), and the four water retailers –

City West Water (includes the central business district and western Melbourne); South

East Water (includes south eastern Melbourne, parts of the Dandenong Ranges and

Mornington Peninsula); Yarra Valley Water (includes eastern and north eastern

Melbourne, and the Yarra Valley); and Western Water (includes Sunbury, Melton,

Macedon Ranges, Gisborne, Woodend, Romsey, Lancefield and Bacchus Marsh). These

five state-owned corporations were established when Melbourne Water was split up in

1995 (Engineers Australia 2005, p. 37).

The list of the 19 Victorian state-owned water businesses is set out in Diagram 4.2 below.

110

Diagram 4.2: 19 state-owned water businesses in Victoria

These 19 water businesses report to the Victorian Government, and each supplies water

and/or sewerage services to customers within its specified geographic region within the

metropolitan or urban service area, as set out in Figure 4.1 above. Grampians Wimmera

Mallee Water and Lower Murray Water are the result of amalgamations of both urban and

rural businesses from 1 July 2004.

The Melbourne Water Corporation manages supply catchments, reservoirs and major

distribution systems for metropolitan Melbourne, and is responsible for the harvesting,

treatment and transfer of water to the four Melbourne retail water providers (Engineers

Australia 2010, p. 66). The structure of the Melbourne Water Corporation is similar to

that of Sydney, as both provide wholesale water to the retailers and are responsible for

catchment management. By contrast, the Melbourne Water Corporation is also

responsible for both the operation of major sewerage treatment and the drainage systems.

In Sydney, these fall under the Sydney Catchment Authority.


Diagram 4.3 below shows that in Victoria, water management responsibilities rest with

various state and regional organisations (National Water Commission 2009).

Melbourne

•Melbourne Water

•South East Water

•Yarra Valley Water

•City West Water

•Western Water

East

•Gippsland Water

•East Gippsland Water

•South Gippsland Water

•Westernport Water

North

•Lower Murray Water

•North-East Water

•Goulburn-Murray Water

•Coliban Water

•Goulburn Valley Water

West

•Grampians Wimmera Mallee Water

•Wannon Water

•Barwon Water

•Central Highlands Water

•Southern Rural Water

111

Diagram 4.3: Management of water in Victoria


Urban wholesale water providers

Melbourne Water, Goulburn-Murray Water, Grampians Wimmera Mallee Water and

Southern Rural Water pass on bulk water charges to urban retail water providers. These

charges are in line with those determined by the regulator, the ESC.

Urban retail water providers

In Melbourne, urban water providers are there are four metropolitan water businesses,

that is, City West, South East, Yarra Valley and Western Water. Retail water and

wastewater charges are pass on to urban water customers by the 12 regional urban retail

water providers, that is Barwon, Central Highlands, Coliban, East Gippsland, Gippsland,

Goulburn Valley, Grampians Wimmera Mallee, Lower Murray, North-East, South


Ministers departments Economic regulator Urban and rural water authorities



Water markets



NRM bodies

112

Gippsland, Wannon, and Westernport. These charges are in line with those determined by

the ESC.

Water availability

In Victoria, the ESC regulates the prices and service standards of water providers

throughout the state, and significant restructuring has resulted in the separation of

Melbourne Water as the bulk supplier (wholesaler) and four retail companies, which

supply different regions in greater Melbourne.

As a result of a series of amalgamations of smaller local government and independent

water bodies, the remainder of the state of Victoria is served by a number of regional

water service providers. These amalgamations have given these regional utilities a clear

focus on water services, and substantially greater scale of service provision with

commensurate gains in operations capability, efficiency and skill base (Langford &

Piccinin 2004, p. 72; ACIL Tasman 2005, p. 31).

This is in contrast with New South Wales, where the state government owns water service

providers for the cities of Sydney and Newcastle, while local governments are the owners

elsewhere in NSW. The New South Wales structure is all vertically integrated with the

exception of Sydney, where Sydney Water is responsible for water treatment, retailing

and wastewater services, and Sydney Catchment Authority is responsible for bulk water

provision (Langford & Piccinin 2004, p. 72; ACIL Tasman 2005, p. 31).

On the other hand, in Victoria the four retail water and sewerage companies operate

according to their allocated geographic areas as follows:

City West Water, serving approximately 700 000 people, including the central

business district and western Melbourne

South East Water, serving approximately 1.4 million people, including south

eastern Melbourne, parts of the Dandenong Ranges, and the Mornington Peninsula

Yarra Valley Water, serving approximately 1.5 million people, including eastern

and north eastern Melbourne, and the Yarra Valley.

113

Western Water, serving approximately 158,300 people, including North West of

Melbourne (Melton, Bacchus Marsh, Lancefield and Sunbury).

These four companies are state-owned and operate under the Corporations Act 2001,

following commercial principles. They are responsible for retail water supply to

customers and sewerage collection and limited sewerage treatment, and each company

has its own customer base. Even though they do not compete directly for each other‟s

customers, they compete under the ESC‟s monitoring regime by comparison of services

(Engineers Australia 2005, p. 38).


At present, Melbourne‟s water storages are 34 per cent full. Most of Melbourne‟s water

comes from its uninhabited catchments high up in the Yarra Ranges (Melbourne Water,

2009).

The majority of water used in Melbourne today is sourced from rivers and reservoirs.

Table 4.1: Melbourne’s water sources

Water source Volume used

Rivers and reservoirs 435 GL in 2004–2005

474 GL (average from 1990–2005)

Recycled water 46 GL (most recycled at sewerage treatment plants)

Groundwater Up to 33 GL

Rainwater and

stormwater

Less than 1 GL

(Marsden Jacob Associates 2006, p. 44)

As shown in Map 4.1 below, Melbourne has nine major reservoirs that currently supply

its water, excluding Tarago. The reservoirs have a total storage capacity of 1 773 GL, the

largest being the Thomson Reservoir which holds almost 60 per cent (1 068 GL) of the

114

total system storage capacity. Water can be moved between reservoirs, mostly from east

to west through use of gravity. Approximately 75 per cent of Melbourne water passes

through either the Silvan Reservoir which is 40 km east of Victoria, or the Cardinia

Reservoir located in Emerald-Clematis-Dewhurst in the south eastern suburbs of

Melbourne (Engineers Australia 2010, p. 66).

Map 4.1: Melbourne’s major reservoirs

(Engineers Australia 2010, p. 66)

According to Marsden Jacob Associates (2006, p. 45), water is stored and then delivered

to metropolitan retail water companies, Western Water and regional water business

Gippsland Water. Water is also released from the Thomson Dam for Southern Rural

Water‟s irrigators.

In reference to the supply of water, in a typical year Victoria receives about 150 000 GL

as rainfall. This can either be consumed by plants or evaporation – only 16 per cent (23

000 GL) flows into streams, and 1 per cent filters through to recharge groundwater

aquifers.

115

Of the water which enters the rivers, 27 per cent is extracted for consumptive use, with

some 77 per cent of this extracted water used for irrigation, 4 per cent for domestic and

livestock purposes on rural properties, 10 per cent for Melbourne residents and providers,

and 9 per cent for regional towns and providers. About 3 per cent of the water is used by

brown coal power generators in the Latrobe Valley, as identified in Figure 4.1 below.

Figure 4.2: Total surface water – Victoria per cent of use and Melbourne per cent of

use

Total surface water 2004/05

Water for rivers

Water used

Victoria % of use

Irrigation

Rural, domestic& stock

Melbourne % of use

Residential

Non-revenue

Industry

116

(Engineers Australia 2010, p. 64)


In the last decade, Victoria has experienced drought created along with the water crisis in

the last five years. A 30 per cent reduction in average rainfall, persistent declines in water

storages, ongoing drought and population growth have forced the Victorian Government

to implement water restrictions, conservation measures and supply augmentation projects.

The water crisis has accelerated the need to manage all water resources (water supply

such as rainfall, inflows, groundwater, wastewater, recycled water and stormwater) in an

integrated manner (Engineers Australia 2010, p. 61).

This means that to deliver water for economic, social and environmental benefits, savings

in water and wastewater treatment and ecological restoration should occur. This can be

achieved by using different water types such as recycled water for their highest value use,

without becoming reliant on one source (Engineers Australia 2010, p. 61).

Victoria‟s water strategy can be found in its 2004 Victorian Government White Paper

Securing Our Water Future Together. This document outlines the state‟s action plan to

secure water for all interests over the next 50 years. It describes actions to address the

following priority areas:

To improve the framework for allocating water resources by recognising the needs

of all water users and the environment, and setting up a process for regional water

planning and review.

To restore stressed rivers and aquifers by creating a legal water entitlement for the

environment, and improving planning and management of river health.

To promote smarter use of irrigated water by separating water entitlements and

land ownership rights, and promoting investments in new, more efficient irrigation

practices.

To encourage the smarter use of urban water via a range of investment and pricing

measures, to increase water conservation and recycling.

117

To make the water sector more efficient, accountable and innovative by improving

the institutional governance arrangements (Engineers Australia 2010, p. 61;

Victorian Government 2010).

Following the reform in 2007, an update was produced and this plan is now called Our

Water Our Future – The Next Stage of the Government‟s Water Plan, or the Victorian

Water Plan. It was produced in response to unprecedented low inflows into water storages

in 2006, increased demand due to higher than expected growth in the population and

economy, and projected climate change impacts (Engineers Australia 2010, p. 62;

Victorian Government 2010).

This plan cost $4.9 billion and it has identified the need for urgent, large-scale supply-

side augmentations for the Melbourne water supply system. The key initiatives are to:

build a desalination plant in Wonthaggi region (estimated to supply up to 150

billion litres of water a year)

save water by upgrading irrigation channels in the Food Bowl region of northern

Victoria

expand the Water Grid to pipe water around the state, including the new Sugarloaf

Pipeline connecting Melbourne to the Goulburn River

extend water conservation and recycling programs, including upgrading the

Eastern Treatment Plant.

The most significant of all the measures to address Victoria‟s water crisis is construction

of the desalination plant. The plant enables water reservoirs to refill and will possibly

allow for water restrictions to be removed over the next few years. As of 1 December

2012, Stage 1 Water Restrictions were lifted, and if no further major policy changes

occur, the growing population and economy will eventually result in demand exceeding

supply. Following the current suite of augmentation, water storage levels are again

forecast to drop to a level requiring Stage 1 Water Restrictions to be introduced by 2036

(Engineers Australia 2010, p. 62; Victorian Government 2010).

118

4.4 Queensland

The industry

In Brisbane, the Brisbane City Council is responsible for its major water services. Bulk

water supply is provided in a number of regions by corporate entities of the Queensland

Government, including the South East Queensland Water Corporation Limited (SEQ

Water), SunWater, Gold Coast Water (GCW), Redlands Water & Waste (RWW),

Gladstone Area Water Board (GAWB), and Fitzroy River Water (FRW).

SEQ Water is a major supplier of untreated water in bulk to local governments and

industries in the South East Queensland region. SEQ owns Wivenhoe, Somerset and

North Pine dams. SEQ Water is a public company. 20 per cent ownership is owned by the

Queensland Government, 45 per cent by Brisbane City Council, and eleven other local

governments in South East Queensland own 35 per cent of SEQ Water. According to

Marsden Jacob Associates 2006, (p. 58), SEQ Water provides services to 18 local

government areas, including Beaudesert, Boonah, Brisbane, Caboolture, Caloundra, Esk,

Gatton, Gold Coast, Ipswich, Kilcoy, Laidley, Logan, Maroochy, Noosa, Pine Rivers,

Redcliffe, Redland and Toowoomba.

SunWater is another Queensland Government-owned water corporation, and it operates a

regional network of water supply infrastructure throughout regional Queensland.

SunWater supports irrigated agriculture, mining, power generation, and industrial and

urban development. SunWater's water storage and distribution infrastructure includes 26

major dams, 81 weirs and barrages, 72 major pumping stations, and more than 2 500

kilometres of pipelines and open channels. SunWater supplies approximately 40 per cent

of the water used commercially in Queensland (Marsden Jacob Associates 2006, p. 58).

The GAWB operates as a commercialised statutory authority, with responsibility for

water management and bulk supplies. It owns and operates Awoonga Dam on the Boyne

River in Calliope Shire, along with a network of delivery pipelines, water treatment plants

and other bulk water distribution infrastructure in Gladstone City and Calliope Shire in

Central Queensland (Marsden Jacob Associates 2006, p. 58).

119

FRW supplies bulk water to Livingstone and Fitzroy Shires, and water and wastewater

services to 60 000 Rockhampton residents. It is a commercialised business unit of the

Rockhampton City Council (Marsden Jacob Associates 2006, p. 58).

Water is supplied to households and businesses in towns and cities of Queensland by 125

local governments. According to Marsden Jacob Associates (2006, p. 59), many of the

councils operate standalone water supply systems, while others purchase water from one

of the bulk water service providers. Councils typically operate the delivery network and,

in many cases, water treatment infrastructure. Some of the larger council operations

include:

Brisbane Water (BW), a commercialised business unit of the Brisbane City Council,

providing infrastructure to treat and deliver water purchased from SEQ Water

GCW, a directorate of the Gold Coast City Council – the northern part of the Gold

Coast is supplied by SEQ Water, while the remainder of the region mainly relies on

supplies from Hinze Dam and Little Nerang Dam, which are owned by Gold Coast

City Council

RWW, a commercial business unit of Redland Shire Council, where water is sourced

from Leslie Harrison Dam on Tingalpa Creek and North Stradbroke Island.

In South East Queensland, as part of the Queensland Government‟s reform of water

supply arrangements, the water businesses of Gold Coast City Council, Logan City

Council and Redland City Council transferred to and now known as Allconnex Water

(Essential Services Commission of South Australia 2012, p. 4).

A planning system is designed by the Queensland Government to oversee and facilitate

sufficient supply through catchment planning, providing allocations of water for

consumptive use and environmental requirements. The Queensland Government is

responsible for much of the infrastructure planning that lies with the actual service

providers (e.g. SunWater, SEQ Water and BW). Storage and major water distribution

infrastructure is owned by a mix of SEQ Water and local government service providers,

while reticulation infrastructure is generally owned by the local government infrastructure

providers (Marsden Jacob Associates 2006, p. 59).

120

The QCA oversees water pricing and practices of declared government monopolies, or

simply monitors the prices charged by them when directed by ministers. So far there are

only three investigations which have been referred to the QCA: the Burdekin Haughton

Water Supply Scheme, and two on the GAWB (Marsden Jacob Associates 2006, p. 59).


In Queensland, water management responsibilities rest with various state organisations

(National Water Commission 2009).

Figure 4.3: Management of water in Queensland



Ministers departments


Water markets Water markets




Local councils Water supply schemes

Water authorities

121

Water supply–demand balance

In South East Queensland, SEQ Water is a major supplier of untreated water.

Traditionally, a degree of separation exists between the responsibilities for water supply

planning, managing bulk water infrastructure and managing the reticulation of services to

customers.

Marsden Jacob Associates (2006, p. 60) reported that South East Queensland experienced

its worst drought in over 100 years from April 2001 to April 2006. The exacerbated

drought conditions highlighted the apparent failure in coordination of resource and

infrastructure in South East Queensland in the previous 12–18 months. The Queensland

Government in conjunction with local governments is developing a strategy to improve

the coordination of water management across the region. Examples are the establishment

of the South East Queensland Regional Water Supply Strategy and the Queensland Water

Commission.

The combined capacity of dams in the region has fallen below 30 per cent, and without

significant rainfall it is expected to fall even further. Most of South East Queensland‟s

local governments are now on Level 3 Water Restrictions, which includes a ban of garden

watering with hose pipes or sprinkler systems. Marsden Jacob Associates (2006, p. 60)

recommended that more stringent restrictions are likely to be imposed in the coming

months.


To amplify drought conditions, South East Queensland, which includes Brisbane and

Gold Coast areas in particular, is also Australia‟s fastest growing metropolitan region, and

this area is predicted to continue to grow strongly from its 2006 population of 2.8 million

to a 2026 population of 3.7 million. This growth will place additional strain on existing

water supplies, and an extensive drought response strategy (DRS) will need to be adopted

in the region (Marsden Jacob Associates 2006, p. 61).

122

The DRS is a three-tier approach to reduce water usage, including the implementation of

water restrictions from May 2005, a widespread marketing campaign targeting water

savings, and fast tracking or bringing forward the implementation of a number of long-

term demand management and water saving programs (e.g. subsidy schemes for retro-fit

of water-efficient appliances, rainwater tanks, home water efficiency audits and leakage

reduction programs). A strategy has also been implemented to develop additional

supplies, such as the Western Corridor Recycling Scheme, Tugun Desalination Plant and

bore water scheme (Marsden Jacob Associates 2006, p. 61).

The major water company in Queensland, SEQ Water, is not only responsible for

constructing, managing and operating water-related infrastructure within its region, but

also plays a key role in infrastructure planning. The water companies are the key

contributors to the relevant state- or region-based planning documents. South East Water,

SunWater and the local government water entities contribute to the regional water supply

strategies in their parts of Queensland.

Within the broader planning frameworks overseen by the Queensland Government, these

water companies have developed their own strategic documents to plan for meeting future

demand, such as the South Australia Water Strategic Plan 2005–2009 (National Water

Commission 2005, p. 23).

4.5 South Australia

The industry

In Adelaide, the South Australia Water Corporation (SA Water) is responsible for

providing water, wastewater and related services to 1.4 million customers in both

metropolitan and country areas in South Australia. It is the main bulk water supplier for

the entire state, and is a wholly owned business enterprise of the South Australian

Government.

South Australia is an example of a vertically-integrated supplier (undertaking both bulk

and distribution/retail functions) to most parts of their respective states (National Water


123

Marsden Jacob Associates (2006, p. 73) maintained that in 1995, SA Water had allowed

the operation and maintenance of water and wastewater services in Adelaide metropolitan

area (including the delivery of capital works for rehabilitation and augmentation) to be

outsourced to a privately-owned company, United Water International Pty Ltd (United

Water). It was a 15-year, long-term contract and was a consortium between three private

sector companies: Veolia Water, Thames Water and Haliburton KRB.

This was the largest water outsourcing contract in Australia, and it remains unique in its

current form as the concept of private sector involvement in provision of water and

wastewater services, which was relatively new to Australia in 1996. The main focus was

on provision of services rather than development of infrastructure. Significant efficiency

gains, performance improvements and risk transfer are the key aims to achieve while

retaining ownership and investment control (Marsden Jacob Associates 2006, p. 73).

Marsden Jacob Associates (2006, p. 73) claimed that an estimated 20 per cent saving of

cost reduction objective had been achieved, as compared to SA Water‟s historical costs. It

is a saving in excess of $160 million over the life of the contract. SA Water remains the

asset owner and maintains control of all asset investment decisions for rehabilitation,

renewal and infrastructure augmentation, and it continues to provide services in rural

areas and have responsibility for bulk supply. SA Water remains an informed purchaser

and is able to benchmark its country operations – it retains all customer billing services

and customer service standards decisions.

Governance of urban water pricing

In South Australia, the water management responsibilities relate to various states,

regional and local organisations (National Water Commission 2009).

124

Figure 4.4: Management of water in South Australia


Water supply

South Australia has a reliable urban water supply. Adelaide has access to a diversified

water supply, with Adelaide Hills' reservoirs being supplemented by pumping from the

Murray River. South Australia‟s extraction from the Murray River for urban water supply

is considered small, and in a normal year total South Australian urban extractions are

about 1.5 per cent of total extractions from the Murray-Darling Basin, while those for

Adelaide are about 1 per cent (South Australian Government 2009, p. 7).


Ministers departments Major water utility



Water markets

Water supply And services




Private irrigation trusts

NRM bodies

125

In the years of normal rainfall, Mt Lofty Ranges‟ reservoirs are the source of about 60 per

cent of Adelaide‟s water supply, with the remainder being sourced from the Murray

River. However, during drought years, the Murray River is the primary water source of

up to 90 per cent of Adelaide‟s water supply (South Australian Government 2009, p. 7).

Marsden Jacob Associates (2006, p. 73) found that compared with the approach of other

major Australian cities that have built water storages capable of meeting three to four

years‟ demand, SA Water does not have large storage reservoirs. For instance, the total

capacity of the storages in the Mt Lofty Ranges is equal to less than a year‟s demand.

The current level of storage is estimated to be equivalent to that required to reliably

service a population of around 30 per cent the size of Adelaide. Extensive pipelines from

the Murray River provide a second water source and promote water security in South

Australia.

South Australia‟s current water consumption is approximately 140 000 ML. The physical

infrastructure includes six major water treatment plants, 9 000 kilometres of water mains,

and 52 pumping stations (Abbott & Cohen 2009, p. 10).


The South Australian Government took steps to improve water security beyond those

taken in response to drought conditions, resulting in substantial investment in critical new

water supply infrastructure planned over the next few years from 2009. For example, the

Adelaide Desalination Plant (ADP) was commissioned one year earlier than first

anticipated; water was anticipated to be used from it in 2010. A further 30 GL of

temporary water allocations from other Murray River users were purchased by the South

Australian Government to ensure that South Australia‟s water needs are able to be

supplied in the short term, regardless of the drought (Government of South Australia

2009, pp. i, 15 & 35).

These major investments needed to be funded through water charges, and were a major

influence on the South Australia Government‟s 2009–10 water pricing decision,

126

culminating in a 17.9 per cent rise in average water pricing that year. Metropolitan

wastewater charges remained constant in real terms, while regional wastewater charges

increased by 0.5 per cent in real terms, to redress the lower average wastewater bills in

regional areas as compared with the metropolitan area (Government of South Australia

2009, pp. i, 15 & 35).

The most substantial in Australia is the Adelaide‟s water recycling program, representing

almost 21 per cent of total wastewater collected in 2004–05. Recycled water is mainly

used for irrigation rather than as a substitution of potable water. However, it does not

typically improve the supply of water to the city itself. The Water Proofing Adelaide

Strategy outlines plans to increase water recycling by 16 GL per annum, which is 16 per

cent of current wastewater collected. There is also a plan to develop large-scale

stormwater reuse for a further 11 GL per annum by 2025 (Marsden Jacob Associates

2006, p. 84).

4.6 Western Australia

The industry

Western Australian water services are provided for 1.8 million customers across the state.

These customers are provided with a mixture of potable and non-potable water, and

sewerage and drainage services by a number of organisations. Western Australia‟s major

urban water utilities service providers are Western Australia Water Corporation, Aqwest-

Bunbury Water Board (AQWEST), and Busselton Water Board (BWB). Water

Corporation supplies water and wastewater services on a state-wide basis, while

AQWEST and BWB supply potable water to their respective regional centres

(Government of Western Australia 2007, p. 9).

In 1996, the Western Australia Water Authority was reconstituted as a government/ state-

owned statutory corporation. The corporation was established to provide water,

wastewater and stormwater services to a population of around 1.5 million people across

the state (urban and regional areas) (Marsden Jacob Associates 1999, p. 86).

127

95 per cent of both wholesale and retail water services are provided by the Water

Corporation to all Western Australian cities and towns, with the exception of Bunbury

(provided by AQWEST) and Busselton (provided by BWB). The corporation also

provides wastewater collection and disposal and stormwater services across the entire

state. Local government provided wastewater services in a number of rural and regional

towns (Marsden Jacob Associates 1999, p. 85).

In Western Australia, the Department of Water is responsible for gathering water resource

information, issuing licences, regulating water use, protecting water quality, and

preparing water resource policies and plans. The ERA oversees regulation and licensing,

and investigates matters referred to it by the Western Australian Government. No private

sector providers exist in Western Australia. However, public–private partnerships have

been developed for a number of major infrastructure projects, such as the Perth Seawater

Desalination Plant and the Woodman Point Wastewater Treatment Plant. The Water

Corporation utilises the private sector via alliance contracts for operations and

maintenance in Perth (Marsden Jacob Associates 1999, p. 85).


National Water Commission 2009 stated that in Western Australia, water management

responsibilities rest with various state and local organisations (National Water

Commission 2009).

128

Figure 4.5: Management of water in Western Australia


Water availability

Water supply

In Perth, potable water is supplied from the Water Corporation‟s Integrated Water Supply

Scheme, which also supplies water to goldfields and agricultural regions, including

Kalgoorlie and Boulder to the east, and to many towns in the South West and Great

Southern regions in the south (Marsden Jacob Associates 1999, p. 86).

The Integrated Water Supply Scheme is a fully integrated water services system, regarded

as one of the most complete water cycle management systems in Australia (Government

of Western Australia 2007, p. 10).


Ministers departments Urban water utilities Economic Regulator


Water markets




Private irrigation companies


129

Water within the Integrated Water Supply Scheme is supplied from a range of sources

and at a variety of costs, as shown in Table 4.5 below (Marsden Jacob Associates 1999, p.

15).

Table 4.5: Water Corporation’s Integrated Water Supply Scheme supply sources

2006–07

Integrated Water Supply Scheme supply sources 2006–07

GL Operating costs ($/kL)

Surface water 111 0.14

Groundwater 168 0.19 Desalination 18 0.51 Water reclamation 4 0.42 Total 301 0.19 (weighed average of

operating costs)


Perth relies on a greater degree of groundwater, that is around 60 per cent compared to

any other Australian capital city. Water is drawn from a series of interconnected surface

water sources, including Canning Dam, Mundaring Weir, Serpentine Dam, North and

South Dandalup Dam, and Striling Dam. Around 60 per cent of the Integrated Water

Supply Scheme water is drawn from groundwater sources, including the Gnangara and

Jandakot mounds. Currently, both the Water Corporation and the Western Australia

Government are examining the viability and sustainability of drawing water from the vast

groundwater resources held in the South West Yarragadee Groundwater Aquifer

(Marsden Jacob Associates 1999, p. 86).


As discussed, 95 per cent of the supply of water and wastewater in Western Australia is

undertaken predominantly by the Water Corporation, which makes it a monopoly service

provider (see Figure below) (ERA 2008, p. 14).

130

A report from Marsden Jacob Associates (1999, pp. 87–88) showed that Perth

experiences long periods with little or no rainfall over the summer months. But yet water

is typically used in gardens at a higher rate than in eastern Australian states. An estimated

50 per cent of total residential water use in Perth is for outside of the house.

Since 2001, the Western Australian Government has imposed water restrictions on the

metropolitan Perth area. However, the restrictions of two days per week have been

relatively mild compared with the total sprinkler bans imposed by many other cities. In

2001, Perth residents used around 519 litres per person per day (around 30 per cent higher

than the Australian average), of which 352 litres were used for residential purposes prior

to the introduction of water restrictions.

In 2004–05, information from WSAA facts 2005 confirmed that the fourth year after the

introduction of two days per week restrictions, residential water use per capita had fallen

by 16 per cent to 294 litres per person per day. Other uses for water, including

commercial, industrial, municipal and fire fighting, fell by 27 per cent per capita over the

same period.

In 2031, Perth‟s population is expected to grow from 1.8 million people to over 2 million.

To be able to cope with this growth, the Water Corporation plans to develop a suite of

sources over the next five years through the following:

The establishment of a seawater desalination plant, known as Perth Seawater.

The desalination plant (or Desalination No. 1) located at Kwinana, 40 kilometres

south of Perth, which started supplying water to the Water Corporation‟s

Integrated Water Supply Scheme in November 2006. It became the first plant in

Australia to provide desalinated water for large-scale public consumption. It is

also the Water Corporation‟s biggest single water source feeding into the

Integrated Water Supply Scheme, providing some 17 per cent of Perth‟s water

needs. On average, the plant produces up to 130 million litres of drinking water

per day, or 45 GL per year (Water Corporation 2010).

The Harvey Pipe Project, which is a three-year, $72 million project to pipe the

Harvey irrigation district. The goal of this project is to pipe the balance of unpiped

area in Harvey district by the end of 2009, which will result in the delivery of 17.1

131

GL of water savings that will be transferred to the Water Corporation on a

permanent basis (Harvey Water 2010).

The development of the South West Yarragadee Groundwater Aquifer is to

provide 45 GL of water use in the Integrated Water Supply Scheme (Marsden

Jacob Associates 1999, p. 88).


It is more important than ever in this uncertain Australian climate to ensure that the water

business is structured in a way that is as innovative as possible. The effect of climate

change is projected to be more pronounced in south west Western Australia than

elsewhere in the country. The characteristics of the water and wastewater sectors are such

that the structure of the water market will, at least in the short term, be different to other

utility industries such as gas and electricity (ERA 2007, p. v).

The key difference arises from uncertainty regarding water supplies; specifically the

amount of inflows into dams and groundwater aquifers. Electricity and gas supplies can

be forecast with relative certainty; however, there is great uncertainty over predictions of

future water supplies. The current difficulty is difficult to establish how much climate

change is affecting inflows, and whether a drought is compounding the problem. Any

market price would therefore be likely to include a significant „risk premium‟ considering

the investment needed in the face of uncertain future sales (Economic Regulation

Authority 2007, p. v).

One implication of uncertain future inflows in the water business is that storages have a

value; that is, an opportunity cost of usage that can exceed the immediate cost of

delivering water into the system.

„Opportunity cost‟ is defined in standard economics textbooks as “the amount lost by not

using the resource (labour or capital) in its best alternative use” (Begg, Fisher &

Dornbusch 1987, p. 118).

132

A factor which can complicate the design of a bulk water market is when water in storage

is used today and not replenished. The costs of meeting demand in the future may

therefore be increased as additional and more expensive sources are required. A well-

functioning competitive market may be able to effectively manage uncertainties by

factoring in such opportunity costs. This type of market would take time to develop, and

would require the introduction of an access regime and retail contestability (Economic

Regulation Authority 2007, p. v).

Western Australia water and sewerage reform

A separate procurement entity

An inquiry into the competition in the water and wastewater services sector in the Perth

metropolitan region was reviewed by the ERA in 2007–08. The current arrangements for

maintaining supply security have not convinced that the enhancements proposed by the

Water Corporation will be effective. Some of the shortcomings include a lack of

centralised coordination, without sufficient checks and balances, unclear delineation of

roles and responsibilities, and a lack of opportunity and incentive for the private sector to

develop alternative innovative supply and demand management options. The Independent

Procurement Entity (IPE) would be established as a statutory authority with responsibility

for ensuring least expected cost balancing of supply and demand within the Integrated

Water Supply System, subject to the constraint of maintaining security of supply at a

level set by the Western Australia Government (ERA 2008, pp. 18–19).

The IPE would receive from the government a supply security requirement. The Water

Corporation and various private sector proponents would then compete to provide the

optimum supply–demand balance which can be maintained at least possible cost. Subject

to this security requirement, the IPE would identify future supply shortfalls, and seek

ways to meet these shortfalls via supply augmentations and demand management options

developed by the private sector and the Water Corporation. The water customers would

fund the IPE through water tariffs. In return, the IPE would manage existing and newly

acquired options to ensure security of supply was maintained at least possible cost

(Economic Regulation Authority 2008, pp. 18–19).

133

4.7 Tasmania

The industry

Tasmania has only 1 per cent of the nation‟s land, yet it has around 14 per cent of

Australia‟s water resources. This is a potentially significant comparative advantage for

Tasmania. Urban water services are provided by 28 of Tasmania‟s 29 councils (excluding

Tasman). The 29 local councils are Launceston, Break O'Day, Dorset, Flinders, George

Town, Meander Valley, Northern Midlands, West Tamar, Burnie, Devonport, Central

Coast, Circular Head, Kentish, King Island, Latrobe, Waratah-Wynyard, West Coast,

Hobart, Clarence, Glenorchy, Brighton, Central Highlands, Glamorgan-Spring Bay, Huon

Valley, Kingborough, Derwent Valley, Sorell, Southern Midlands, and Tasman

(Department of Treasury and Finance 2007, pp. 3–4).

There are three bulk water authorities in Tasmania:

Hobart Regional Water Authority, which is the supplier of bulk water to councils

in the southern region

Cradle Coast Water Authority, which is the supplier of bulk water to councils in

the north western region

Esk Water Authority, which is the supplier of bulk water to councils in the

northern region.

These bulk water authorities are jointly owned by 18 of the councils. They supply bulk

water to their owner councils and other councils, as well as other water users such as off-

peak water for irrigation and to businesses directly.

Sewerage services are provided by 27 of the 29 councils (excluding Flinders and

Tasman). One of the three bulk water authorities supplies bulk water to 17 councils.

These councils are generally responsible for collecting, treating and transferring bulk

water. The remaining councils, with the exception of Tasman, are responsible for capture

and treatment of their bulk water supplies.

134

Sewerage treatment services vary considerably in form and sophistication, as sewerage

treatment infrastructure ranges from simple ponds or treatment tanks to complex arrays of

tanks and mechanical equipment with electronic controls.

In total, across Tasmania these providers service approximately 192 000 water

connections and 175 000 sewerage connections.


The National Water Commission (2009) maintained that in Tasmania, water management

responsibilities rest with various states, regional and local organisations, as shown in

Figure 4.8 below.

Figure 4.8: Management of water in Tasmania


Ministers departments Economic regulator



Water markets


Water markets



Rural water suppliers

Regional water corporations

135


Water availability

Water supply

Marsden Jacob Associates (2006, p. 99) claimed that Hobart Water‟s water supply system

comprises of water treatment, eight storage dams, pumping stations and pipelines, holding

a capacity of 11 GL. The ratio of mountain to river sourced water is 40:60. In order to

promote security to Hobart Water supply approximately 60 per cent of Tasmania‟s annual

supply of water is sourced from Derwent River, 20 per cent from Mount Wellington

catchment, and 20 per cent from Mount Field National Park.

Table 4.3 shows sources of water supply for Hobart, in 2003–04 to 2004–05 (ML).

Table 4.3: Sources of water supply for Hobart

2003–04 2004–05

Derwent water supply 22 836 21 378

Mount Wellington (Hobart) 7 342 8 593

Mount Wellington (Glenorchy) 484 448

Lake Fenton 7 416 6 147

Southern regional supply 3 313 4 086

Total 41 394 40 679

(Hobart Water 2005 Annual Report 2004–05, p. 8)

The Water Development Plan for Tasmania (Department of Primary Industry, Water and

Environment 2001; cited in Marsden Jacob Associates 2006, p. 99) stated that Hobart

Water‟s total water allocation from all sources was 78 GL. Hobart Water does not have

large storage reservoirs compared with the approach of most other Australian capital

cities; its total storage capacity is less than one-third of its annual demand (Marsden Jacob

Associates 2006, p. 99).

136


Marsden Jacob Associates (2006, pp. 99–100) reported that Hobart primarily supplies

bulk water to its owner councils. Hobart developed an off-peak market for irrigation and

commercial users, and its off-peak users typically receive water during winter only.

Hobart has not been subjected to severe water restrictions unlike Australia‟s mainland

cities. Prior to 2003, Infrastructure and Resource Information Service noted that the

regional water supplier had excess capacity but individual councils still imposed

restrictions; these were not extended in later years.

The only councils in Australia that charge residential water use on the basis of property

value with an excess usage charge are the Hobart councils. There is no metering for water

use, which means that many demand management options will be unavailable to Hobart

councils, including signalling the cost of water usage through volumetric charges, or

providing residents with information about their water use relative to other households.


As of 1 July 2009, new structural and regulatory arrangements commenced in the water

and sewerage sector in Tasmania, wherein four new water corporations became the

common service providers: Ben Lomond Water in the north, Cradle Mountain Water in

the north west, Southern Water in the south, and Onstream. They replaced the three bulk

water authorities and 29 local councils (Marchment Hill Consulting 2009, p. 3).

The new structural arrangements were supported by enhanced regulatory oversight of the

sector:

The Water and Sewerage Corporations Act 2008 created powers to establish a

new industry framework and new corporations.

The Water and Sewerage Industry Act 2008 created the role of an independent

economic regulator to oversight prices and service standards in the sector. It

links the technical regulation of the sector with the economic regulatory

137

framework. This Act contains a series of pricing principles to which new

corporations had to adhere from the commencement of the first regulatory period

for the sector on 1 July 2012. By this date, the variable component of two-part

water pricing was based, for each consumer on actual (metered) use.

The Interim Price Order for the sector commenced on 1 July 2009. It provides

for year-on-year price increases of a maximum of 10 per cent.

138

4.8 Summary

After observing regulations across the states and territories, a number of broad similarities

and differences can be detected. Australia‟s major cities are faced with serious long-term

water challenges due to factors that include prolonged drought, water supply shortages as

a consequence of prolonged drought, a drier climate, floods, wasteful water use and

strong population growth. In response to these challenges, various measures have been

put in place, such as alternative sources of water supply including the development of

desalination plants, as well as pricing reforms and regulatory changes. In particular, the

COAG water reform has resulted in separation of policy, and the regulatory and

commercial function of most water utility businesses in major Australian cities.

Water is managed on a state-by-state basis in Australia. There is a national approach to

some issues; however, each state or territory retains ownership of its own water business.

Up until recently, these water businesses underwent structural reforms as a result of the

water reform process. Each state or territory has a government statutory that acts as the

regulator of water businesses. This applies in all jurisdictions, regardless of whether the

utilities are government or privately-owned (South Australia).

The water utility provider is vertically integrated in all states and territories in Australia;

an example of this is the combination of wholesale water capture and treatment, and final

reticulation to the customer. In South Australia, SA Water undertakes bulk and

distribution/retail functions to most parts of its respective state. However, it is difficult to

achieve a „one size fits all‟ structure model for all of Australia‟s urban water businesses.

Diversity is evident in water business structures throughout Australia‟s urban water

industry. In terms of institutional arrangements, the water utility providers in South

Australia and Western Australia have opted for state-wide water service providers. For

instance, water utility businesses own and operate their assets in both of these states.

Water service providers in South Australia own the assets, but maintenance of their

infrastructure assets has been outsourced through a long-term contract to United Water, a

consortium of private firms.

139

New South Wales, Victoria, Queensland and Tasmania have opted for local water service

providers. In New South Wales, the state government owns the water service businesses

for the cities of Sydney and Newcastle, while the local government is the owner of the

water service businesses elsewhere. In Victoria, the water service provider for the city of

Melbourne is disaggregated into a wholesaler; that is, Melbourne Water and the three

retailers City West Water, South East Water and Yarra Valley Water. The non-

metropolitan regions of Victoria are served by a number of regional water service

providers. All states have corporatised water entities at least in the major cities.

The following chapter will provide a discussion of the current approach to urban water

pricing and regulation in Australian jurisdictions.

140

Chapter Five: Urban Water Regulation and Pricing

5.1 Introduction

Chapter Four provided an overview of the industry governance, structure and the broad

area of ownership for urban water services in major Australian cities. The COAG water

reform has resulted in separation of policy, regulatory and commercial function of most

water utility businesses in major Australian cities. Similarities as well as significant

differences between the organisation and the operation of the urban water and wastewater

sectors in Australia‟s major cities were discussed.

This chapter looks at the history of water pricing and institutional reform. After several

reforms from the early 1990s, in 2004 the NWI became the blueprint of water reform in

Australia, and most jurisdictions comply with the NWI‟s commitments. The key

difference among the jurisdictions is in pricing functions among regulators, and reviewing

bodies will also therefore be discussed in this chapter. This chapter then reviews the key

differences in coverage of economic regulations between jurisdictions.

The remainder of the chapter provides a background discussion of existing regulation and

pricing structures in urban water and wastewater sectors in Australia‟s major state capital

cities. Water businesses are subjected to licensing and other forms of regulations in all

states and territories. An economic regulator is in place in every state or territory in

Australia, which provides advice, arbitration and/or direction on water pricing and other

financial issues in relation to water. Urban water businesses are either government- or

state-owned corporations that operate under the corporation law. In most Australian

cities, water businesses are owned by the state or territory government, except for

Queensland, Tasmania and some regional centres in New South Wales. The local

governments are owners of these water businesses.

In Victoria, water businesses are owned by local governments, while there are some

government-owned water businesses in regional urban centres around the state. The legal

form of water businesses in Victoria is typically a commercialised division (arms of

government departments) or the councils. Regardless of who owns the water businesses,

there is generally little to no competition for customers.

141

5.2 Water pricing and institutional reform

In 1994, water pricing and its institutional reform that began under the COAG‟s Strategic

Water Reform Framework continued to evolve under the 2004 NWI best practice pricing

and institutional arrangements. In 2004, the NWI became the blueprint for water reform

through the agreement between the Commonwealth and state and territory jurisdictions at

the COAG meeting. Recently, the 2010 NWI Pricing Principles were endorsed by the

Natural Resource Management Ministerial Council. The COAG recommends the deprival

value methodology for asset valuation for charging purposes.

The 2010 NWI Pricing Principles are aimed at not only ensuring that pricing is primarily

used to achieve economically efficient water use and service provision, but also to ensure

financial viability of water service businesses. Three main agreed pricing reforms were

implemented as follows:

Full cost recovery – to ensure that full efficient cost of providing water services

to customers can be recoverable through prices charged.

Structure of tariffs – consumption-based component (variable) is to provide

correct signal for efficient water usage. Fixed component reflects the fixed costs

of service provision and is not based on property values.

Efficient costs that are recovered through prices – these costs must be sufficient

to provide the levels of service that customers are willing to pay for, while the

economic viability of water businesses is maintained in the long run.

Independent regulators set water prices in major water businesses and bulk water utilities

in the Australian Capital Territory and Victoria and for metropolitan water utilities in

New South Wales.

In contrast, prices are still controlled by state governments in other jurisdictions where

independent bodies with limited pricing functions largely provide advice to these

governments. Ultimately, water prices are either set or approved by governments, or

reviewed by governments‟ price-setting processes.

142

Another key difference addressed by the NWI (2011, p. 79) was the coverage of

economic regulation between jurisdictions. In New South Wales, the IPART determines

prices for metropolitan businesses, water planning and management charges. Bulk water

services are provided by State Water, and the IPART does not determine water prices

charged by local water utilities in regional areas.

In Victoria, however, the ESC determines prices for all metropolitan, regional and rural

water services.

Regulators have limited coverage of water prices in some rural water services, such as in

rural New South Wales, South Australia and Western Australia, where private irrigation

providers determine infrastructure charges paid by customers.

New transitional arrangements are in place so that prices of water in most jurisdictions

can be set by the regulators. Progress has been made to strengthen economic regulations

in the water sector in Tasmania, South Australia and Queensland jurisdictions.

5.3 New South Wales

The IPART is the independent economic regulator for New South Wales, and it oversees

regulation in not only the water but also the electricity, gas and transport industries. It

undertakes other tasks referred to it by the New South Wales Government. In terms of the

water industry, the IPART was established by the New South Wales Government in 1992

to regulate maximum prices charged for monopoly services by government water utility

and its other monopoly businesses.

Building block approach to determining revenue requirement

For water utilities regulated by IPART, the revenue requirement must usually be

sufficient to cover the efficiently incurred operating, maintenance and administration

expenses of the utility, plus any return of and on the capital. This is represented in Figure

5.1‟s formula, commonly defined as the building block approach:

143

Figure 5.1: The building block approach defined by the IPART

R = revenue requirement

Non-capital costs O = operating expenses

M = maintenance expenses

A = administration expenses

Capital costs C = return on capital

D = return of capital (depreciation)

As shown in Figure 5.1 above, the revenue requirement does not explicitly include capital

expenditure, as it might be funded from return of capital, injections of equity or other

borrowings (or other financing approaches) (Independent Pricing and Regulatory

Tribunal 2009, p. 19).

Return of capital

Return of capital, commonly known as „depreciation‟ or „maintenance of capital‟,

recognises that through provision of services to customers, a utility‟s capital infrastructure

will wear out and the cost of maintaining the capital base is therefore a legitimate

business expense. It represents the opportunity cost of capital invested in a utility by its

owner, and ensures that efficient investment in capital will continue for future

maintenance and growth of the infrastructure system. A straight-line depreciation method

is used to calculate return of capital for water businesses, which means that the total value

of an asset is recovered evenly over its assumed life (Independent Pricing and Regulatory

Tribunal 2009, p. 26).

D C + A + M + O + R =

144

Return on capital

An allowance for return on capital is usually included in price-setting by the IPART,

representing its assessment of opportunity cost of funds invested in these utilities. The

IPART‟s approach to calculating return on capital is to use real pre-tax weighted average

cost of capital (WACC) to determine an appropriate range for rate of return. It uses the

Capital Asset Pricing Model (CAPM) to derive the cost of equity, and calculates the cost

of debt as margin over the risk-free rate. Allowance for return on capital can be calculated

by multiplying the utility‟s RAB by the WACC for each year of the determination period

(Independent Pricing and Regulatory Tribunal 2009, p. 27).

5.4 Victoria

Overview on ESC’s approach to assessing water plans

In Victoria, the ESC became the independent economic regulatory reviewer of the water

business in 2004. The ESC determines water charges for all Victorian businesses,

including electricity, gas, ports and rail freight industries. The ESC previously undertook

a review of prices to be levied by 19 state-owned water businesses for a regulatory period

of three years commencing 1 July 2005.

As part of that process, the Water Industry Regulatory Order 2003 (WIRO) requires the

ESC to ensure that the prices proposed by each of the water businesses allow them to

recover return on assets in place as of 1 July 2004. The RAB is valued in a manner

determined by, or an amount otherwise specified by, the Minister for Water at any time

before 1 July 2004 (Essential Services Commission 2004, p. 4).

Under the new economic regulatory framework established under WIRO, and as also

noted in the ESC consultation papers, sewerage services and water prices will possess a

formal relationship to cost and changes to cost. Prices will allow the water business to

recover any costs incurred in operating and maintaining its assets, along with a

commercial return on new capital expenditure, including return of funds invested over

145

time through a regulatory depreciation allowance (Essential Services Commission 2004,

p. 7).

In deciding whether to approve a business‟s proposed prices, firstly the ESC is required to

assess the water plans against the regulatory principles as outlined in the WIRO. It must

also be satisfied that they provide the water business with only enough revenue over the

regulatory period to meet its obligations and deliver the level of service required by

customers. The ESC must not allow monopoly profits, but instead ensure among other

things that:

revenue is sufficient to allow the business to recover operating and capital

expenditure

the water business receives a reasonable return on assets

the expenditure forecasts reflect efficient delivery of the proposed outcomes

outlined in the water plan, and take into account a long-term planning horizon

the business has incentives to improve efficiency in delivering services to

customers and to promote sustainable water use

prices indicate towards the costs of use of water, and give customers various

incentives towards sustainable water use

customers‟ interest is taken into account

customers or potential customers are able to understand the prices charged

including how they can be calculated.

In assessing the proposed prices, the ESC‟s approach is often described as a building

block approach, characterised by three steps (refer to Figure 5.2). The first step is to

confirm the outputs or outcomes; for this, the ESC needs to identify the service standards,

regulatory obligations (e.g. water quality, dam safety) and other outcomes that the

business proposes to deliver over the regulatory period.

All the standards and outcomes reflect obligations imposed by the Minister for Water

through the Department of Human Services, the Department of Sustainability and

Environment, and customer preferences for service improvements. It is crucial that

customer service standards proposed by each business be clear, appropriate, and reflects

the needs and interests of customers (Essential Services Commission 2009, p. 11).

146

Figure 5.2: Steps in assessing and approving prices

(Essential Services Commission 2009, p. 11)

The second step is for the ESC to determine the revenue the business requires to meet its

service obligations and expected outcomes identified in step one. Here, the ESC is

required to assess whether the business‟s expenditure forecasts reflect efficient costs of

supply, its capital works program is deliverable over the period, and its business strategy

reflects a long-term planning horizon. It is the ESC‟s role to ensure that businesses

receive return on their capital investments that reflect an efficient cost of capital. The

ESC assumes efficient expenditure to assess whether prices will result in the business

earning sufficient revenue to deliver services, but these assumed expenditure levels do not

represent amounts that businesses are required to spend or direct to particular activities or

projects. Businesses are free to determine their own expenditure priorities in light of

changing circumstances, but customers have to be consulted prior to this. Businesses can

also implement innovations and efficiencies that enable them to outperform the cost

assumptions (Essential Services Commission 2009, p. 12).

However, circumstances might change, which may result in a business not proceeding

with a project or activity that it has proposed in its water plan and that was included in the

ESC‟s calculation of assumed expenditure. This can occur when the business, in

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Outputs/

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-Augmentation/ extension

- Renewal

- Cost of capital

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Prices

- Structure of prices

- Annual price control approvals

- Adjustments during period

147

consultation with its customers, identifies a higher priority project or activity that should

instead be undertaken. However, costs may have increased by far more than forecasted at

the time of the price review, leading to the business not being able to defer or cancel a

lower priority project or activity. The projects and activities that are more highly valued

by customers can still go ahead without causing revenue shortfall that has to be recovered

from customers at a later date (Essential Services Commission 2009, p. 12).

The third step in the process is to determine the prices that will apply during the

regulatory period, and care must be taken by the ESC to ensure that for each business,

prices generate its revenue requirement, taking into account forecasts of demand (which

determine quantities expected to be used). In this final step, the ESC assesses whether the

business‟s demand forecasts are reasonable and reflect the best information. Other

considerations include whether prices and proposed tariff structures provide appropriate

signals about the costs of providing services, provide incentives for sustainable water use,

and take into account the interests of customers (Essential Services Commission 2009, pp.

12–13).

Overview of revenue requirement

Under the building block approach, prices set by the ESC reflect the revenue required to

recover efficient cost of delivering services over a regulatory period, along with

considering forecast levels of demand. The ESC has to be satisfied that the prices it

approves will provide each business with sufficient revenue over the regulatory period to

meet its obligations and deliver the level of service required by customers. It has to ensure

that prices do not reflect monopoly rents or inefficient expenditure, and revenue required

to deliver proposed service standards and outcomes must also be estimated. The revenue

requirement reflects operating expenditure and a return on regulatory asset value, updated

every year to reflect any additional capital expenditures, net of asset disposals and

regulatory depreciation (Essential Services Commission 2009, p. 27).

This building block methodology is used solely to assess whether prices will result in

each business earning sufficient revenue to deliver services, and it does not represent the

costs businesses are required to incur or direct to particular activities or projects.

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Businesses are free to determine their own expenditure priorities after consultation with

customers and taking into account the changing circumstances. It is their aim to pursue

innovation and efficiencies that enable them to outperform the revenue benchmarks

(Essential Services Commission 2009, p. 27).

As part of the price review, the ESC has so far only assessed revenue requirements in

relation to the metropolitan businesses‟ water and sewerage services. Melbourne Water‟s

revenue requirement for its drainage and waterways services is not subjected to the

current price review, because the ESC approved prices for Melbourne Water‟s drainage

and waterways services in the 2008 water price review final decision (Essential Services


The ESC’s assumptions

Research by Marsden Jacob Associates (2004, p. 2) and clause 14(a) of the WIRO

provision claims that assumptions made by the ESC are based almost entirely on use of a

standard regulatory building block approach which takes account of:

return on capital, through application of rate of return on the RAB

return on capital, through depreciation allowance on the RAB

operations, maintenance and administration expenses

tax expenses

adjustments for assets disposals, and possibly service standard incentives and/or

efficiency incentives.

These assumptions are closely linked to revenue estimations mechanisms outlined in the

COAG Pricing Principle 4, which states:

“To avoid monopoly rents, a water business should not recover more than the

operational, maintenance and administrative costs, externalities, taxes or TERs [tax

equivalent regime], provision for the cost of asset consumption and cost of capital, the

latter being calculated using a WACC [weighted average cost of capital].”

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The ESC prefers this pricing principle as described in the regulatory building block

approach. Experience demonstrates that this mechanism generally produces a revenue

estimate that more than adequately ensures commercial viability. That is, there is less

need to consider in detail the impact of cash outflows in the form of dividends to

shareholders, actual debt costs or actual tax payments (Marsden Jacob Associates 2004, p.

3).

The COAG Pricing Principle 5, however, provides a fundamentally different mechanism

for estimating minimum or lower-bound commercial viability revenue. The mechanism

associated with this principle does not require consideration of value of sunk assets or a

rate of return. The COAG Pricing Principle 5 states:

“To be viable, a water business should recover, at least, the operational, maintenance

and administrative costs, externalities, taxes or TERs (not including income tax), the

interest cost on debt, dividends (if any) and make provision for future asset

refurbishment/replacement (as noted in (3) above). Dividends should be set at a level

that reflects commercial realities and stimulates a competitive market outcome.”

The COAG Pricing Principles use a number of terms that require further comment in the

context of these guidelines, including the following terms used in Pricing Principle 5.

The phrase „not including income tax‟ in Pricing Principle 5 only applies to those

organisations that do not pay income tax:

“Externalities in Pricing Principles 5 and 7 mean environmental and natural

resource management costs attributable to and incurred by the water business.”

That is, COAG Pricing Principle 5 requires explicit consideration of impact of cash

outflows required for the ongoing, long-term maintenance of asset capability, actual cost

of debt (if any), actual cost of tax equivalent payments and the possibility of dividend

payments to shareholders.

By comparison with the outcome associated with the COAG Pricing Principle 4 upper-

bound revenue estimate, particular care is generally required to test the adequacy of the

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lower-bound revenue estimate (in much the same way that the ESC proposes) through

comparison with financial ratios. This is because, by definition, the lower-bound revenue

estimate only ensures commercial viability of the relevant entity. If cash outflows in the

future require significant borrowings (which may occur from time to time during periods

when the cost of capital asset maintenance exceeds the revenue allowance associated with

future asset refurbishment/replacement), then it is essential to ensure that revenue is

sufficient to assure „bankability‟ (Marsden Jacob Associates 2004, p. 5).

Operating expenditure

The businesses‟ revenue requirements comprise of their forecast operating expenditure, a

return on assets (existing and new assets) and regulatory depreciation (return of assets).

The businesses set out assumptions underpinning their forecast levels of operating

expenditure over the regulatory period in their water plans. The ESC identifies a

reasonable trend in operating expenditure consistent with an efficient business in the draft

decision. If it considers that the proposed operating expenditure does not represent a

reasonable trend, adjustments are made to the operating expenditure benchmark

(Essential Services Commission 2009, pp. 3 & 31).

The operating benchmarks adopted by the ESC for each of the businesses represent

assumptions about the overall level of expenditure to be recovered through prices that the

ESC considers to be sufficient to operate the business and to maintain assets over the

regulatory period. They do not represent amounts that the business must spend or allocate

to particular operational, maintenance or administrative activities.

It is important to note that if a business‟s actual operating expenditure during the

regulatory period exceeds the benchmarks used to set prices because of inefficiency or

additional expenditure on other activities, it is required to manage this rather than increase

prices for customers. In contrast, if a business identifies additional ways to improve the

efficiency of its operations during the regulatory period, which reduces its operating

expenditure, it would allow the business scope to either improve services to its customers

or to reduce the process below the maximum prices approved by the ESC.

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The ESC will consider the businesses‟ responses to the draft decision, and may adjust the

relevant benchmarks for each business. Before the final decision, the ESC adjusts

controllable operating expenditure benchmarks for all businesses. This final decision

completes the ESC‟s review of metropolitan Melbourne water prices and service

standards for the four-year regulatory period commencing on 1 July 2009. Melbourne

Water reported that an operating expenditure benchmark over the regulatory period was

increased by $10.1 million from the draft decision, compared with its proposal (draft) to

increase it by $16.1 million (Essential Services Commission 2009, pp. III & 43).

Capital expenditure

Capital expenditure is a key component of revenue requirements under the ESC‟s

building block approach, as The ESC is required to maintain the existing functions of

water infrastructure. It is usually heavily benchmarked against past performance and/or

other suppliers, to ensure that the proposal expenditures are efficient. Expenditures which

are intended to improve levels of service, also termed as „discretionary expenditures‟,

need to be supported by evidence of willingness to pay on the part of customers. All the

capital expenditures are subjected to scrutiny (often imposed by the ESC) regarding the

efficiency of delivery and productivity savings (ICIL Tasman 2006, p. 5).

Net capital expenditure is recovered by adding it to the RAB, and this is reflected in

prices through a return on RAB; that is, the WACC multiplied by RAB and a return of

RAB, through regulatory depreciation (Essential Services Commission 2009, p. 47).

The WIRO stipulates that the ESC ensures that the prices levied by the businesses provide

the business with a sustainable revenue stream that does not reflect monopoly profits or

inefficient expenditure, and allows the business to recover expenditure on reviewing and

rehabilitating existing assets. The businesses must also meet the ESC‟s requirements that

the proposed expenditure forecasts are efficient and accounted for in a planning horizon

that extends beyond the regulatory period of four years (Essential Services Commission

2009, p. 47).

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The ESC will consider the capital expenditure benchmarks adopted in the final decision,

which will allow each business to deliver its proposed services and meet known

regulatory obligations. If proposed adjustments put forward by the businesses are not

accepted, the ESC does not consider that it will restrict businesses‟ abilities to recover

sufficient revenue or meet their required levels of service delivery (Essential Services


The ESC‟s final decision in its 2009 Water Price Review provided for a total capital

expenditure of $4.1 billion over the regulatory period for the metropolitan water

businesses. The total capital expenditure comprised of the following:

$0.5 billion for City West Water – a 15.6 per cent increase over the draft decision.

$0.6 billion for South East Water – a 12.1 per cent increase over the draft

decision.

$1.1 billion for Yarra Valley Water – a 7.0 per cent increase over the draft

decision.

$1.9 billion for Melbourne Water – an 8.3 per cent increase over the draft decision


Financing capital investments

The WIRO requires that prices allow each water business to recover its expenditure on

renewing and rehabilitating existing assets. That is, a rate of return on assets on 1 July

2004 that are valued in a manner determined by, or at an amount otherwise specified by,

the Minister for Water on any date before 1 July 2004, and a rate of return on investments

made after 1 July 2004 to augment existing assets or construct new assets (Essential

Services Commission 2009, p. 57).

These WIRO principles allow each water business to recover the cost of capital

investments that are initially funded by the water business over time, through regulatory

depreciation and to recover financing costs through a return on assets. The next sub-

chapter sets out the ESC‟s final decision based on the assumptions used by water

businesses for financing capital investments; namely the initial regulatory asset values,

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the rate of return on investments, and the techniques for calculating depreciation


Regulatory asset base

The RAB of each business represents the net value of its past investments for pricing

purposes. The business recovers a return on assets calculated by multiplying the RAB by

a regulatory rate of return. It is determined by the Minister for Water, and it reflects the

initial regulatory asset value on 1 July 2004 and the net value of each of the new assets

constructed by the businesses since then. It is adjusted each year to include new capital

expenditure to deduct contributions, proceeds from asset disposals, and regulatory

depreciation (Essential Services Commission 2009, p. 57).

The ESC adopts a standard method for calculating an opening RAB for the regulatory

period for each water business. The formula for calculating the opening RAB is:

Opening RAB 2009

equals Opening regulatory asset value 2004

plus Gross capital expenditure 2004–2009

less Contribution (by government and customers) 2004–2009

less Proceeds from disposal of assets 2004–2009

less Regulatory depreciation 2004–2009

To update the RAB, the ESC adopted actual figures of capital expenditure, contributions

and proceeds from disposals for the period 1 July 2004 to 30 June 2008, and forecasts for

2008–9 and the regulatory depreciation assumptions adopted for the 2005–2008 regulatory

period have also been updated. Once the opening RAB has been established, the same

approach can be used to roll forward the RAB for each subsequent year of the regulatory

period. Figures of capital expenditure, contributions, proceeds from asset disposals and

regulatory depreciation are used for this calculation (Essential Services Commission

2009, p. 57).

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Rate of return

In order to estimate an efficient rate of return, the ESC uses a WACC, which reflects the

cost of two alternatives sources of finance; that is, debt and equity. As the WACC is

expressed in real post-tax items, benchmark assumptions about businesses‟ tax liabilities

will need to be incorporated with their revenue requirements. The return on assets

component of a water business‟s revenue for any particular year is calculated as the

product of average RAB for that year and the approved WACC (Essential Services


In the draft decision, the ESC calculates a feasible range for WACC between 4.3 and 4.9

per cent. This range was calculated by accounting for probable ranges for a real risk-free

rate and debt margin, the market-based WACC parameters, and point estimates for the

non-market parameters. The ESC decision was to adopt a WACC towards the upper end

of the feasible range based on a number of factors, and was mindful that in the months

leading up to the draft decision, there had been significant cuts in the official target cash

rate by the Reserve Bank of Australia that led to large decreases in the real risk-free rate

(Essential Services Commission 2009, pp. 59–60).

This was offset by severe tightening of credit markets, followed by increases in the cost

of debt, and the final decision by the ESC was to adopt a real post-tax WACC of 5.1 per

cent, which was towards the conservative (higher) end of the feasible range. It is

considered that a rate of return towards the upper end of the feasible range is appropriate

in recognition of volatility and the fact that it is difficult to forecast how financial

conditions may change during the forthcoming regulatory period (Essential Services

Commission 2009, pp. 59–60).

The ESC also took into consideration the fact that the businesses often obtained credit at

fixed rates and had to borrow at rates higher than the present levels. By adopting WACC

towards the upper end of the feasible range, it was ensured that the businesses would be

able to cover their actual costs of existing debt and the likely cost of future borrowings


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Regulatory depreciation

In the past, the ESC has approved straight-line depreciation profiles used by water

businesses, and the reason for allowing a return of capital expenditure through regulatory

depreciation when setting regulated charges is to return to investors the value of capital

that has been invested over the life of the assets (Essential Services Commission 2009, p.

68).

Final decision

The ESC‟s final decision report completed its review of metropolitan Melbourne water

prices and service standards for the four-year regulatory period that commenced on 1 July

2009. Its final decision resulted in a net $218 million reduction in revenue requirement

proposed by the retail businesses. Price increases were significantly lower than initially

proposed in the water plans, saving households up to $70 on their average annual water

bills. Approved prices in the final decision were 2.7 to 3.8 per cent higher in 2012–13,

which was the final year of the regulatory period. It was higher than those proposed in the

ESC‟s draft decision in April 2009 largely due to additional and revised capital and

operating expenditures (Essential Services Commission 2009, p. III).

The assumed financing costs, having risen from 4.8 to 5.1 per cent since April 2009,

reflect recent market conditions and updated advice from the Treasury Corporation of

Victoria on appropriate debt margins (Essential Services Commission 2009, p. III).

5.5 Queensland

In Queensland, most water businesses set their own charges with the economic regulator,

QCA, providing oversight only where matters are referred to it by the Queensland

Government.

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Pricing principles and methods

The QCA objectives follow on from the requirements of the Queensland Competition

Authority Act, which are firstly to guide the nature of the pricing principles, particularly in

regard to protection of consumers from abuses of monopoly power, promotion of

competition, efficient use of resources and other relevant public interest concerns (e.g.

social and welfare, the impact on the environment). Secondly, third-party access seeks to

promote greater utilisation of essential infrastructure facilities to increase competition in

upstream or downstream markets, and to promote more efficient outcomes. Thirdly,

competitive neutrality reforms seek to ensure that public sector businesses do not enjoy

certain competitive advantages or disadvantages over actual or potential competitors.

Certain requirements relevant to each element of monopoly prices oversight and third-

party access (e.g. relevant to asset valuation) are generally consistent with requirements

of competitive neutrality (Queensland Competition Authority 2000, p. 2).

Methodology: maximum revenue requirement

In approaching individual situations, the QCA sets a maximum revenue requirement that

consists of the following three building blocks:

An appropriate return on capital necessarily invested in the business. This requires

determination of appropriate RAB and appropriate rate of return on that

investment.

Return of capital.

The cost of operating a business in an efficient manner, including tax equivalents

(where applicable) (Queensland Competition Authority 2000, p. 3).


The value of the RAB needs to be established first, as it will provide an initial step in

estimating building blocks underpinning maximum revenue requirements. The RAB is

then applied to establish return on capital, and is determined by four components,

including the following:

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Estimate the deprival value of the relevant assets. In terms of monopoly prices

oversight, it is likely in most cases to result in RAB being valued according to the

DORC method.

Optimisation of the asset network as part of the valuation process. At a minimum,

entities should specifically account for unplanned excess capacity, to ensure that

fully redundant assets are removed from the RAB.

Adjust the RAB to account for reasonable capital expenditure, with such

adjustments generally affected in the new period in which new investment is

brought into use.

Recognise capital contributions by including user funded or contributed assets in

the RAB, and establish an offsetting arrangement with contributors or users. If

there is no agreement, treatment of capital subsidies and grants from Queensland

Government should be at the asset owner‟s discretion (Queensland Competition


Return on capital

After the RAB has been established, an appropriate return on capital needs to be

estimated; one that should reflect the level of risk in relevant business activities. Rate of

return is the return expected by investors in capital markets for investments of a given

level of risk. It represents the opportunity cost to investors of expected returns on

foregone investment opportunities; that is, the expected return from the next best

alternative investment.

The rate of return plays a central role in rewarding or compensating the asset owner for

their past investment, and also in providing guidance as to the return on future investment

in the network. For example, where rate of return is set above the business‟s actual cost of

capital, there is an incentive for the regulated business to over-invest and to substitute

capital for other factors of production (Queensland Competition Authority 2000, p. 41).

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Weighted average cost of capital

The WACC approach is generally considered the most appropriate method of estimating

cost of capital for contemporary monopoly regulation. However, the QCA would need to

establish a capital structure suitable to the individual characteristics of regulated business

for the purposes of estimating the WACC (Queensland Competition Authority 2000, p.

42).

Return of capital

The QCA considers that the return of capital should be set to provide a cash flow

sufficient to maintain the service potential of the relevant water asset/network. An asset

consumption charge seeks to measure the decline in service potential from use of an asset.

This charge is referred to as a „depreciation charge‟ or „return of capital‟. Where demand

warrants regular service provision, consumption charges should aim to provide cash flow

sufficient to maintain the service potential of the relevant water asset/network

(Queensland Competition Authority 2000, p. 43).

For many water facilities, asset consumption and return on assets can represent up to 85–

90 per cent of the total economic cost of providing water services, suggesting that

derivation of estimates for these cost components is a critical regulatory issue. A range of

methods are used, including forms of cost-based depreciation or renewals annuity

approaches, as long as it can be demonstrated that it meets the abovementioned objective.

If renewals annuities are adopted, an asset management plan should be established by the

relevant business activity to promote transparency, and the planning period adopted must

be consistent with commercial principles, usually between 20 and 30 years (Queensland

Competition Authority 2000, p. 43).

Operating costs

An appropriate estimate of operating costs of any regulated water business must represent

efficient service delivery, based on the scale of operation and nature of activity being

undertaken. It must be evaluated on an individual basis, and this usually includes

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benchmarking against other relevant organisations (Queensland Competition Authority

2000, p. 46).

Two-part tariffs

Where prices need to be set, it should reflect long-run marginal costs. If such prices do

not achieve revenue adequacy, two-part tariffs (fixed and variable charges) will best meet

the objectives of efficient pricing, cost recovery and equity for most urban water

businesses (Queensland Competition Authority 2000, p. 53).

Pricing water

In Queensland, delivery of water prices effectively represents (at least) two separate

components: a price (cost) for infrastructure services associated with its treatment,

transmission and distribution, and the price of water itself (Queensland Competition


New developments

The QCA ordered a third price review in 2010, which was conducted on the GAWB‟s

pricing practices. The pricing model, although not publicly released, provided customers

with indicative prices based on GAWB‟s proposed minor changes in the regulatory

arrangements, consistent with the commercial framework (Queensland Competition


Among other things, the most significant proposed changes to regulatory arrangements

for five years of this regulatory control period (2010–2015) has been changing the form of

regulation from price-cap to revenue-cap. There is no change as to how the maximum

revenue requirement is determined, and GAWB is not seeking to revalue assets, but is

proposing a roll-forward of the 2005 DORC valuation. That is, the straight-line method of

determining return of capital components of prices is to be retained. A review of WACC

parameters was carried out partly due to the impact that the global financial crisis has had

on the financial markets (Queensland Competition Authority 2009, p. 4).

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Before the final decision is made, GAWB requested that the QCA makes

recommendations as to whether it approves, rejects or requires alterations to the proposals

contained in this submission (Queensland Competition Authority 2009, p. 4).

5.6 South Australia

Overview

As discussed in Chapter Four, South Australia has gone over and above plans for its

current drought conditions to ensure water security in the state. Its most significant

progress is the Adelaide Desalination Plant, which began catering to water needs in 2010.

The ESC of South Australia (ESCOSA) is the state‟s economic regulator and reviews

price-setting processes, underpinning water and wastewater pricing decisions made by the

South Australian Government. The ESCOSA also considers whether the government's

process for setting charges has adequately applied the COAG‟s principles. The South

Australia Treasurer is responsible for budget deliberations and for monitoring SA Water‟s

financial performance. It presents matters such as budget and relevant inter-governmental

agreements to the Cabinet (South Australian Government 2009, p. 10).

In June 2004, the South Australia Government signed the NWI, a 10-year reform agenda

to improve the management of Australia‟s water resources. The NWI builds on the

COAG Strategic Framework. The COAG‟s draft on national pricing principles, which

built on 1994‟s COAG Strategic Framework and the NWI, include the following:

recovery of capital expenditure

urban water tariffs

recovering the costs of water planning and management activities

recycled water and stormwater reuse.

The ESCOSA, at the direction of the South Australia Treasurer and pursuant to part 7 of

the Essential Services Commission Act, has undertaken inquiries since 2004 regarding

161

government processes for setting SA Water's water and wastewater (sewerage) charges.

Its inquiries focused on application by the South Australia Government of certain pricing

principles enunciated by the COAG in 1994, as well as the NWI in 2004. The underlying

intent of these pricing principles is to improve the efficiency of provision and use of

water services, for the benefit of the wider community. It can be concluded that the South

Australia Government remains committed to COAG Pricing Principles and NWI‟s

obligations (Essential Services Commission 2009, p. 1).

Cost recovery of capital expenditure

The South Australian Government (2009, p. 11) mentioned that charges for new assets, or

those replaced after the legacy date of 1 July 2006, were set to achieve full cost recovery

of capital expenditures through return of capital (depreciation) and return on capital

calculated as the WACC on the depreciated RAB. New and replacement assets should

initially be valued at efficient actual cost, and any assets existing as of 1 July 2006

(legacy assets) should be valued at DRC.

The RAB, comprising of new and legacy assets, is rolled forward by adding prudent

capital expenditure, and deducting depreciation and asset disposals. It is escalated at the

expected inflation rate, consistent with WACC. Contributed assets should be excluded

from the RAB. The upper revenue bound (URB) is the revenue that would result if all

assets earned return on capital as per the WACC (South Australian Government, p. 11).

Urban water tariffs

The following approaches are used by the South Australian Government (2009, p. 12) for

its urban water tariffs:

Tariffs should be set to achieve forecast target revenue, which should move to

URB.

Two-part tariffs should be used, comprising of service availability charge and

water usage charge.

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Water usage charge(s) should be based on consideration of long-run marginal

cost.

Service availability charge for water should be based on the difference between

target revenue and revenue recovered through water usage charges.

The process of setting water and wastewater charges should be transparent and

subject to public scrutiny.

Ongoing business viability

SA Water‟s financial viability is closely monitored by its management, the Board and the

South Australia Government (as owner). Its key financial performance and viability

indicators include areas like profitability and returns on investment; financial capacity to

finance investment including new assets and replacement of existing assets; gearing;

capacity to service and repay debt levels (interest cover); liquidity; and long-term cash

flows (South Australian Government 2009, p. 11).

Overview of revenue requirement

SA Water‟s revenue should be high enough to ensure business viability, and it must be

able to cover the full cost of service delivery and ensure that it does not earn monopoly

rents (revenue is below the upper bound) (South Australian Government 2009, p. 15).

In terms of efficiency, the COAG‟s Pricing Principles require that the URB includes

efficient business costs (both operating and capital expenditure). This means that the

outcomes that the South Australian Government seeks from SA Water should be

delivered at lowest cost possible, taking into account the full range of costs such as

externalities, equity and risk. In doing so, it requires that the combination of sources used

to supply water to South Australia be in efficient balance with the available options. In

other words, the capital expenditure on infrastructure is prudent (South Australian

Government 2009, p. 15).

The URB should also include new capital expenditure valued at an efficient actual cost.

Efficiency, in a sense, should be delivered in a more technical way by taking into

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consideration past capital decisions as given, and the organisation‟s existing operations

should be conducted at lowest sustainable cost (South Australian Government 2009, p.

15).


The NWI Commission‟s (NWIC) draft principles for recovering capital expenditure can

be found in paragraph 22, which provides that the RAB should only reflect „prudent‟

capital expenditure:

The RAB comprising prudent new investments and legacy investments should be rolled

forward each year in accordance with the following formula that can be expressed in

nominal or real terms:

RABt = [RABt-1 + Prudent Capital Expendituret – Depreciationt – Disposalt (discarded

assets)]. (Where t = the year under consideration).

As in the above formula, SA Water‟s real RAB in any given year is its rolled-forward

RAB from the previous year, plus capital expenditure less depreciation and disposal of

assets. Assets that are contributed to SA Water, such as by grant of gift from a

government or by customers, are excluded from the RAB where sufficient information is

available to identify and value them (South Australian Government 2009, p. 15).

Capital expenditure

Capital expenditure was a significant factor in the 2008–09 and 2009–10 decisions, as

substantial capital expenditure was planned by the South Australian Government to

provide improved water security. The continuing drought has placed unprecedented

pressure on South Australia‟s integral water supply, the Murray River, and in response

the SA government has decided to take various steps to improve the state‟s future water

security. Most notable is the decision to build a desalination plant at Port Stanvac.

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When making its 2009–10 pricing decision, the government factored the cost of the

desalination plant in, and it expected that water revenue be increased by a similar amount

as the 2008–09 pricing decision (12.7 per cent (real) per annum) until 2012–13, largely to

meet the cost of these decisions (South Australian Government 2009, p. 15).

Rolling forward asset values

SA Water‟s RAB in respect of the 2009–10 decision was derived by the rolling forward

of asset values as of 30 June 2006. The RAB is rolled forward in nominal terms including

new capital expenditure and depreciation, and asset disposal is deducted. Existing asset

values are escalated at 3.5 per cent per annum, consistent with the inflation forecast

assumption in the real WACC calculation. It can be concluded that the South Australian

Government‟s 2009–10 pricing decision is consistent with the COAG Pricing Principles,

as SA Water‟s RAB has been rolled forward appropriately (South Australian Government

2009, p. 17).

Return of assets – depreciation

In its 2008–09 pricing decision, the South Australian Government used the straight-line

method over the estimated average useful lives of assets as the depreciation method.

Further work has since been done to improve the estimate of useful lives of assets, and

based on a preliminary analysis of SA Water‟s asset database as of 30 June 2006 and new

assets commissioned in 2006–07 and 2007–08, the regulatory depreciation is calculated

using weighted average useful life. This is due to the different treatment of contributed

assets and revaluation/escalation of assets (South Australian Government 2009, p. 17).

The useful life estimates of assets adopted for the 2009–10 pricing decision are based on

knowledge of performance of those assets, having regard to specific materials and

operating conditions. Legacy assets, or those in existence as of 1 July 2006, are estimated

to have an average useful life of 50 years. All other new or replacement assets have an

estimated average useful life of 60 years. For new assets, this revised depreciation rate

replaces the useful life assumed in the 2008–09 regulatory model, which was 100 years.

The depreciation rate used for calculation of RAB was at 3.5 per cent per annum, and the

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South Australia Government concluded that its 2009–10 pricing decision was consistent

with the COAG Pricing Principles (South Australian Government 2009, p. 17).

Operating, maintenance and administrative costs

The main intention of the NWI is to ensure that water charges are efficient; the South

Australian Government interprets South Australian obligations in this respect as ensuring

that revenues, and therefore water charges, reflect reasonable forecasts of efficient

operating, maintenance and administrative costs.

There are two key factors in place to ensure that operating, maintenance and

administrative costs are efficient: significant outsourcing and transparent public

disclosure of costs and the basis for decisions, such as to build the desalination plant.

Given these factors, the government considered SA Water‟s operating, maintenance and

administrative costs to be reasonably efficient, and it acknowledges ESCOSA‟s

comments in its 2008–09 final report that improvements could be made to increase SA

Water‟s incentive to further improve efficiencies. While this is currently beyond the

scope of this transparency statement, the government will continue to work with

ESCOSA on this issue (South Australian Government 2009, p. 18).

5.7 Western Australia

In Western Australia, the Water Corporation‟s revenue is set to recover total costs. It has

been noted, however, that customer revenue from some of the Water Corporation‟s

regional systems is less than what it would have received from application of lower-

bound pricing. The West Australian Government practices a uniform pricing policy; that

is, it charges the Water Corporation‟s customers the same amount for water, up to a

certain level, wherever they live in the state.

However, there is an economic principle that may be compromised by this policy – the

avoided cost pricing principle, which is consistent with the view that society is better off

by providing services to only those customers who were willing to pay at least the costs

that could be avoided if the service were no longer provided. The ERA is therefore

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establishing whether alternative providers could provide the service more economically,

such as an inquiry into the cost of supplying bulk potable water to Kalgoorlie. In the

eastern states, the regional water system in Western Australia has been managed by one

organisation. The Community Service Obligation policy is reflected in the difference

between costs and revenues (Economic Regulation Authority 2006, p. 7).

The ERA (2005, p. 54) assessed Western Australia Water Corporation‟s revenue

requirements by using the building block approach to forecast the total revenue required

for a predetermined period. The level of demand for services is assumed, and prices and

tariff structures are then formulated to recover this revenue.

The building block approach involved a „bottom-up‟ determination of total revenue from

components, as shown in Figure 5.3.

Figure 5.3: Western Australia’s building block approach

Identifying an appropriate level of revenue requires consideration of the level of return on

assets, the allowance for depreciation that is necessary to reflect the ageing of assets, and

the efficient level of operating and maintenance expenditure (OPEX). The asset value

referred to in the formula above is often referred to as the „RAB‟, and it is the value

which has the most significant impact on average price for services. The RAB tends to

= Total Revenue

Forecast Operating

& Maintenence

Costs +

Assets Depreciation

+

Rate of return X

Asset Value

(RAB) +

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drive three-quarters of water businesses‟ revenue requirements, and is increased each year

by the net value of capital expenditure and reduced by depreciation.

One way to determine an initial RAB is to consider the level of revenue that would be

appropriate for the business, and then back-calculate the asset value given its forecasts of

operating and maintenance costs, depreciation, and a rate of return on capital (Economic


Key findings on Western Australia Water Corporation’s

revenue requirement operating expenditure

The Water Corporation‟s operating costs per property are among the lowest of all water

providers in Australia, but its staff levels are relatively high. Reference to the Water

Corporation‟s operating expenditure is shown in Table 5.1 below, confirming that labour

and hired/contracted services are the largest cost items other than depreciation.

Even though the Water Corporation outsourced around half of its IT services and its

technical engineering consultancy services, there may still be scope for up to 15 per cent

reduction in total staff numbers, which would result in a saving of $20 million in

operational costs in 2004–05, increasing to $34 million in 2008–09 (Economic Regulation


Table 5.1 Breakdown of Water Corporation operating expenditure, 2003–04

Item Value ($m) Share of

total (%)

Regulatory business 130 21

Chemicals 13 2

Energy 35 6

Materials 15 2

Hired and contracted services 76 12

IT and telecommunications 25 4

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Item Value ($m) Share of

total (%)

Cost of assets retired 25 4

Costs of assets sold and disposed 7 7

Corporate charges 23 4

Plant and equipment 14 2

Other expenses 20 3

Depreciation 243 40

Contestable business 12 2

Total 626 100

(Economic Regulation Authority 2005, p. 57)

Capital expenditure

The Water Corporation‟s five-year capital investment program totals to $3 048 million,

averaging to $610 million per year, and the projected level of capital expenditure from

2005 to 2009 was significantly higher than historical capital expenditure. This is mainly

because of planned supply augmentation works and upgrades of the wastewater treatment

system (Economic Regulation Authority 2005, p. 73).

Depreciation

The asset lives assumed by the Water Corporation are consistent with industry standards,

although they appear to be at the lower end of the range identified. The Water

Corporation has proposed use of a straight-line deprecation schedule based on the indexed

regulatory asset value and standard asset lives. It has indicated that for future pricing

inquiries, it will be worthwhile to consider renewals annuity methodology, as adopted in

the United Kingdom.

The Water Corporation is also proposing to write assets down, to reflect revenue forecasts

for the next five years, as the choice of methodology will not affect the revenue level for

this period. It is therefore proposed to continue with the current depreciation plus return

on assets methodology (Economic Regulation Authority 2005, p. 65).

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Rate of return

An appropriate rate of return (cost of capital) for the Water Corporation was 6.5 per cent

(pre-tax real). A key element of the required revenue for a regulated entity is the rate of

return that investors, including both the providers of debt and equity, require in order to

compensate for the non-diversifiable risks associated with the assets in which they invest.

The ERA has used capital average cost of capital (CAPM) to estimate an appropriate

WACC for the Water Corporation‟s regulatory assets. The WACC is the average cost of

debt and equity capital, weighted by proportion of debt and equity to reflect the financing

of the assets (Economic Regulation Authority 2005, p. 66).

Initial RAB

The RAB proposed by the Water Corporation of $9 100 million in 2006–07 was

consistent with a value that preserves the revenue and average prices forecasted for the

period 2004–05 to 2008–09. This method is consistent, in a general sense, with the line in

the sand approach to asset valuation (Economic Regulation Authority 2005, p. 68).

The line in sand approach recognises that past expenditures are sunk and are largely

irrelevant for efficient decisions regarding usage and future investment. In essence, the

value attributed to the existing business is a cost allocation process driven by questions of

equity and acceptability to the stakeholders involved rather than efficiency per se. Value

is measured in terms of income-generating ability; that is, „customer benefit,‟ being the

sunk cost of the assets on which customers are not expected to provide a return (ACIL

Tasman 2006, p. 4).

In Western Australia, the initial RAB implemented in a framework of cost-based

regulation of prices would return a set of regulated prices, and a value of expected

revenue equal to current prices and expected revenue. The Water Corporation

acknowledged that there is a degree of circularity in setting the initial regulatory asset

value, and the value is based on expected revenue, while revenue for the determination

period is based on the asset value (Economic Regulation Authority 2005, p. 68).

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5.8 Tasmania

In Tasmania, the Water and Sewerage Economic Regulator is responsible for

implementing and administering the water and sewerage regulatory framework, in

accordance with the Water and Sewerage Industry Act 2008 and its subordinate legislation

(Government of Tasmania 2003, p. 3; Office of Tasmanian Economic Regulator 2008, p.

1).

The Tasmanian Government is committed to implementing water business reforms as

embodied within the Strategic Framework for Efficient and Sustainable Reform of the

Australian Water Industry. This was part of the NCP agreements made at the February

1994 meeting of the COAG (Government of Tasmania 2003, p. 3).

In relation to urban water pricing and within the Framework, councils are required to

address reforms, particularly:

implementation of two-part tariffs for water pricing, where it is cost-effective to do

so

adoption of water pricing regimes which achieve full-cost recovery, including

requirement to meet long-term asset maintenance and renewal costs.

The Urban Water and Wastewater Pricing Guidelines for the local governments, which are

based on Agricultural and Resource Management Council of Australia and New Zealand

(ARMCANZ) Full Cost Recovery Guidelines, have been prepared with the assistance of

the Government Prices Oversight Commission (GPOC) to support councils in

implementing the water reforms (Government of Tasmania 2003, p. 3).

The ARMCANZ Guidelines for Water Pricing specifies that “a likely future price

regulation approach that embraces full cost recovery and use of building block approach to

determine maximum revenue requirements” (Office of the Tasmanian Economic

Regulator 2008, p. 71).

http://www.thelaw.tas.gov.au/tocview/index.w3p;cond=all;doc_id=13%2B%2B2008%2BAT%40EN%2B20090618000000;histon=;prompt=;rec=;term=water%20and%20sewerage

171

The building block approach

Using the building block approach, the Tasmanian regulator analyses each council‟s

reported costs to supply, to ascertain an efficient cost to supply. The cost to supply must

be ascertained to conclude the annual revenue requirement for each municipal area to meet

operating and maintenance costs and depreciation (return of capital), and provide a

commercial risk-adjusted return on its capital investment (return on capital) (Government

Prices Oversight Commission 2007, pp. 11–13; Office of the Tasmanian Economic

Regulator 2008, pp. 16 & 73–74).

The building block approach discussed in the context of ARMCANZ Guidelines for Water

Pricing was used to calculate the efficient cost of water and sewerage assets, as shown in

Figure 5.3 below.

Figure 5.3: The building block approach described by the ARMCANZ Guidelines for

Water Pricing

Where:

AARR = aggregate annual revenue requirement

TC = total costs

AV = asset value

WACC = weighted average cost of capital

D = depreciation

OM = operating and maintenance expenditure

AARR = TC = AV*WACC+D+OM

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Operational, maintenance and administrative costs

An allowance is made for efficient cost of operating and maintaining the systems, and

administration costs under the building block approach. The revenue needs of each

municipal area and each regional corporation have been established according to the upper

limit of the ARMCANZ Guidelines (Government Prices Oversight Commission 2007, p.

14; Office of the Tasmanian Economic Regulator 2008, p. 74).

The operational, maintenance and administrative costs are defined as follows:

Operations – operational costs are those costs incurred in operating the water

system, including the cost of collecting, treating, testing and pumping the water,

and will include royalties, chemicals, power and labour.

Maintenance – maintenance costs are the direct costs of maintaining the system,

and include materials, internal labour costs and contractor costs. The total cost of

maintenance will vary based on type, age and general condition of the assets.

Administration – administration costs include all overhead costs, salaried staff

costs (including costs of planning and engineering staff) and other items such as

Board costs, but exclude depreciation and interest costs (Government Prices

Oversight Commission 2007, pp. 39–54; Office of the Tasmanian Economic


Asset consumption costs

Depreciation is included in the building block approach to enable each of the providers to

recoup the investment in water assets over the life of those assets, and to ensure future

sustainability of the water business as it provides for return of capital. Depreciation on

established assets is calculated on a straight-line basis by use of the regulator‟s estimate of

average forecast economic lives of assets and the roll-forward asset values (Office of the

Tasmanian Economic Regulator 2008, p. 78).

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The methodology adopted to calculate depreciation is based on weighted average

depreciation rate of all councils as the ratio of sum of total depreciation for 2006–07 and

the sum of total asset values as of 1 July 2006. That is:

Weighted average depreciation rate = Σ Depreciation (all councils) 2006–07

Σ Opening asset values (all councils) 1 July 2006

The weighted average depreciation rate for the water and sewerage sector was calculated

at 3 per cent per annum. In relation to new assets, an average asset life of 70 years was

assumed, which implied a depreciation rate for new assets of 1.3 per cent per annum

(Office of the Tasmanian Economic Regulator 2008, p. 78).

Highlighted reforms of Tasmania’s water and sewerage sector

Tasmania needs to have access to sustainable water and sewerage services to ensure that it

is able to build sustainable communities and to maximise its economic opportunities.

Water and sewerage in Tasmania is a very large business activity for its local

governments. As shown in Table 5.2 below, the total value of the state combined water

and wastewater infrastructure assets is approximately $1.7 billion (Government of

Tasmania 2006, p. 6).

Table 5.2: Asset values, 2004–05

Bulk supply Total assets ($ million)

Hobart Regional Water Authority 189

Cradle Coast Water 70

Esk Water Authority 127

Council water assets 571

Council wastewater assets 725

Total $ 1 682 million

(Government of Tasmania 2006, p. 6)

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There is growing evidence that Tasmania‟s water and sewerage infrastructure has not kept

pace with the state‟s strong economic progress in more recent years. In 2005, Tasmania

was ranked as having the worst water and wastewater infrastructure in Australia by

Engineers Australia (Government of Tasmania 2006, p. 3).

However, it has been noted that the cost of recovery benchmarks may not accurately

reflect the true cost of maintaining the infrastructure on a sustainable basis, as it was noted

by the GPOC that many of the councils have not undertaken comprehensive asset audits.

Furthermore, during 2004–05, 23 council water supply systems placed on permanent

boiled water notices, some of which are key tourist towns in the state. It is obvious that in

some council areas, sewerage and wastewater infrastructure is not delivering services at a

level expected by residents (Government of Tasmania 2006, p. 9).

This has directly affected 5 000 Tasmanians and many other national and international

tourists. Approximately 50 per cent of eighty-one plants in Tasmania are not compliant

with their licence conditions. There was evidence of low levels of compliance with

standards for Level 2 wastewater treatment plants (Department of Treasury and Finance

2007, p. 15).

There is no consistency in the way water prices are determined by councils, as some have

established charges based on how much water volume residents consume, while others

charge for water based on alternatives methods, such as annually assessed value of the

property. Tasmania‟s pricing methodology may not convey the true cost of providing the

service. The lack of consistency and absence of proper pricing signals towards inequity

across the state, and customers not being encouraged to use water wisely (Government of

Tasmania 2006, p. 12).

It was found in an analysis of the 2004–05 GPOC review of councils‟ compliance with

NCP Guidelines for urban water and wastewater pricing that the average returns in the

sector were in the order of 2–3 per cent. This indicated that most of the councils were not

generating a commercial rate of return from the infrastructure, which is incompatible with

appropriate use of debt to fund investment. As indicated in Table 5.3 below, most of the

councils produce a range of results for their returns, with the returns on wastewater

greater than on water (Government of Tasmania 2006, pp. 15–16).

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Table 5.3: Real rates of return

Real rates of return Water Wastewater

Negative 5 3

Less than 4 per cent 15 13

4 per cent or more 8 11

(Government of Tasmania 2006, p. 16)

5.9 Summary of water pricing and economic regulation

Table 5.4 below provides a summary of water pricing and economic regulations in

Australian jurisdictions.

Table 5.4: Water pricing and economic regulations in Australian jurisdictions

Economic

regulator

Key responsibilities Regulated services Who sets water

prices?

New South

Wales

IPART

- Price determination

functions for the

urban water industry

- Recommends

licensing guidelines

to the Minister of

Water

- Metropolitan bulk

water, retail water,

wastewater,

stormwater services

and recycled water

- Rural bulk water

IPART – Metropolitan

bulk and retail water,

and rural bulk water

- 106 water utilities,

non-metropolitan retail

- 5 private irrigation

companies, rural retail

Victoria

ESC

- Price determination

and service

standards monitoring

- Urban bulk water

and retail water,

sewerage services,

metropolitan

drainage services,

recycled water

services

- Rural bulk water,

- ESC

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Economic

regulator


prices?

retail water and

irrigation drainage

services

Queensland

QCA

- Price

recommendation,

review of pricing

policies, third-party

access and price

monitoring

- - 110 local government

councils, urban bulk

and retail

- SunWater, rural bulk

and retail for SunWater

water supply schemes

- SEQ water, rural bulk

and retail for SEQ

Water Supply Schemes

- 12 water boards, rural

retail

South

Australia

ESCOSA

- Review

government price-

setting

- - South Australia

Cabinet, urban retail

- 27 private irrigations,

rural retail

Western

Australia

ERA

- Price

recommendation

- Oversight for urban

and rural water

pricing practices

- - Western Australian

Cabinet, urban bulk and

retail

- 3 cooperative

irrigations, rural retail

Tasmania

Economic

Regulator of

Water and

Sewerage

(Commissioner

Price

Oversight

- Regulate water and

sewerage prices

- Monitor annual

performance

- Urban bulk water

and retail water,

sewerage services

- 3 urban retail water

corporations

- 5 rural retail irrigation

entities

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Economic

regulator


prices?

Commission)

Australian

Capital

Territory

ICRC

- Price

determination and

licensing

- Urban retail water,

sewerage, waste

water and bulk

water, trade waste

and water reuse

- ICRC

(National Water Commission, 2011)

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5.10 Summary

Water regulators use the building block approach, where periodic price reviews are

conducted. The building block approach adopted by Australian water regulators is a

similar terminology, although differences are substantial in the approaches adopted by

other utilities such as airports, electricity, gas and telecommunications. Annual

operational expenditure and a rate of return on and of a RAB are used to determine a

revenue requirement to be recovered from customers. The upper-bound pricing described

by the COAG Pricing Principles, as well as principle 4 of the National Competition

Council (NCC) 1998 (pp. 112–113), is that efficient cost is achieved as the aggregate of

return on and of capital, the efficient capital base plus operating expenses. Regulated

monopoly utilities services such as water have applied this efficient cost principle to set

the maximum price.

Efficient tariff structures are required for efficient water pricing. Water businesses in

Australia and elsewhere in the world have therefore adopted two-part tariffs, where the

variable volumetric charges reflect the long-run marginal cost of water supply. When the

marginal cost of supply is equal to the price, it is then that economic efficiency is

achieved. The long-run marginal cost of providing new water sources is reflected in the

variable volumetric charge, known as „inclining block tariffs‟, which can comprise of one

or more blocks or tiers (up to 11). For example, a one block tariff is used by Sydney

Water, while an 11 blocks tariff is practised by Albany and Kalgoorie-Boulder Water

Corporation in Western Australia. A fixed service charge allows water businesses to

recover all remaining administrative and other asset costs. Water prices should reflect the

marginal cost; that is, the full cost to society from providing a good or service, including

any externalities such as environmental impacts. To date, externalities are not reflected in

water delivery prices.

Water pricing and its institutional reform began in 1994 when the COAG set up its

Strategic Water Reform Framework. This was followed by the 2004 NWI best practice

pricing and institutional arrangements which became the blueprint for water reforms.

Most recently the 2010 NWI Pricing Principles were endorsed by the Natural Resource

Management Ministerial Council. These pricing principles are aimed at ensuring that

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water pricing is used predominantly to achieve economically efficient water use and

water service provision, and that water businesses are financially viable. Most Australian

jurisdictions comply with these NWI commitments.

In general, the current approach to urban water pricing varies across Australian

jurisdictions, with the key difference being pricing functions among regulators and

reviewing bodies. The independent regulators set water prices for major water businesses

and bulk water utilities in the Australian Capital Territory and Victoria, and for

metropolitan water utilities in New South Wales, whereas in other jurisdictions prices are

still controlled by state or territory governments. The other significant difference is

coverage of economic regulation between jurisdictions. For instance, prices for

metropolitan businesses and water planning and management charges is determined by

the IPART in New South Wales, but the IPART does not determine water prices charged

by local utilities in regional areas. In contrast, water prices for all metropolitan, regional

and rural water services is determined by the ESC in Victoria, while private irrigation

providers determine infrastructure charges paid by customers in rural New South Wales,

South Australia and Western Australia.

The next chapter will focus on asset valuation techniques used in water businesses.

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Chapter Six: Asset Valuation Techniques Used in Water Utility

Businesses

6.1 Introduction

This chapter focuses on a range of issues associated with the valuation of water utility

assets. It begins by discussing some general issues related to the definition and

recognition of an asset. The asset recognition criteria are conventional. Firstly, an asset is

expected to provide future economic benefits; and secondly, an asset must be controlled

by the entity. Thirdly, the basis for measurement of the value of an asset is its cost, and it

must be able to be measured reliably in monetary value. Accurate asset valuation is

important, because the rate base used in the calculation of MAR for the pricing of water is

a key determinant of a water business‟s performance.

That is, the asset base which drives revenue requirements, price and asset valuation has

major consequences for defining total costs of providing the relevant service and pricing

decisions passed on to water customers.

In earlier chapters, we discussed the methodology used to regulate urban water prices,

which is the building block approach – a standard approach also used to regulate other

utility sectors (e.g. airports, electricity and gas, and telecommunication) in network

infrastructure. The building block approach consists of three building blocks: return on

capital, return of capital, and appropriate estimate of efficient operating costs. It is used to

determine the amount of revenue in which the water business can efficiently operate to

remain commercially viable.

The key ingredient of the building block approach is RAB, which comprises of physical

assets. On the other hand, capital costs comprise of return on capital (allowed rate of

return) and return of capital (depreciation). Based on the MAR equation, the RAB (asset

value) is a significant determinant of the asset base. As the asset value (RAB) and the

WACC dominate the revenue calculation over other terms, at least in the asset‟s early life,

valuation of asset base is of fundamental importance for this component of cost. One

expert claimed that asset valuation determines 80 per cent of the MAR when applied.

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Accurate asset valuation and capital cost allowances are important for generating

appropriate prices. The higher the asset valuation, the higher the revenue needed to

generate the required return on assets, and hence the higher the prices charged to

consumers and vice versa. Accurate asset valuation will encourage efficient network

usage and efficient investment in the medium and long term.

Along with the issue of price regulation, the problem of circularity also arises in a natural

monopoly, as its assets are considered specialised with no alternative use. The regulator‟s

original intention is for the RAB to be used to determine asset value, which depends on

revenue expectation; however, it cannot at the same time be the basis for setting revenue.

This chapter provides a brief comparison between various asset valuation approaches for

water utility businesses, followed by an overview of the deprival value.

There are two main techniques used in asset valuation: value- or market-based, and cost-

based. Valuation of an asset is determined largely from its cash-generating capacity under

the value- or market-based approaches; while cost-based approaches either relate the

value of an asset to the cost of purchasing the asset, or are dependent on the service

potential embodied in the asset at the original cost or the original cost adjusted to reflect

its current cost. The costs would include any cost incurred in set-up or acquisition of the

asset, along with any associated financing costs.

The third approach, deprival value, is a hybrid approach that considers both value-based

and cost-based approaches to arrive at an asset value. If the entity was deprived of an

asset, deprival value is the value of future economic benefits that would be foregone. That

is, if the asset is lost or replaced, it can be valued at its market price, replacement cost or

reproduction cost, depending on the circumstances.

6.2 Recognition and measurement of assets

Asset values are used in the determination of MAR required by water regulators, and

hence they act as an important basis for determining both appropriate return of capital

(depreciation charge) and return on capital. When cost of capital is applied to the asset

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value, it determines the amount of revenue required to earn an appropriate return on

capital. Water businesses‟ capital costs generally consist of both the return on and of

capital, both of which represent the amount with which the business can recover, along

with its operating costs, through its charges. However, it is important that the assets are

valued appropriately. When the business‟s revenue exceeds its capital and operating

costs, it will earn a return in excess of its cost of capital. In such instances, it would be

exploiting a position of market power.

In accounting, for a transaction or event to be recognised as an asset, it must meet three

fundamental definitions of an asset, and then satisfy the recognition criteria. Finally, it

must have a cost or other value that can be measured „reliably‟. Asset recognition criteria

are mostly conventional. Specifically, it must be „probable‟; that is, more likely rather

than less likely that service potential or future economic benefits presented by the asset

will in some sense be realised. The asset must have a cost or other value that can be

measured reliably, as per the SAC 3, Qualitative Characteristics of Financial Information

(Steering Committee on National Performance Monitoring 1994, p. 23; the Institute of

Charted Accountants in Australia 2010, p. 36). Asset valuation information should also

satisfy the other concepts sets out in SAC 3: reliability, comparability (Chapter 3:

Qualitative Characteristics of Useful Financial Information, QC20–QC25) and

understandably comparability (Chapter 3: Qualitative Characteristics of Useful Financial

Information, QC30 – QC32).

SAC 3 was withdrawn and superseded by Chapter 3 Qualitative characteristics of useful

financial information of the AASB CF 2013-1 Amendments to the Australian Conceptual

Framework (December 2013).

In 1990, the COAG set up the SCNPM of Government Trading Enterprises with the

purpose of monitoring the performance of Australia‟s major government trading

enterprises in the electricity, gas, transportation, communications and water industries.

The SCNPM of Government Trading Enterprises‟ guidelines (1994, pp. 2–6 & 23–30)

defined and measured an asset the same way as the Statement of Accounting Concept 4

(SAC 4), Definition and Recognition of Financial Statements, paragraph 14 (SAC 4),

which has been replaced and is now known as the AASB Framework for the Preparation

and Presentation of Financial Statements.

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Australian accounting standards provide guidance in relation to recognition and reporting

of assets. In particular, relevant definitions and commentary on assets are specified in the

Framework for the Preparation and Presentation of Financial Statements, published by

the AASB in 2004. This framework superseded Statements of Accounting Concepts 3

(SAC 3) and Statements of Accounting Concepts (SAC 4) on 1 January 2005.

Definition of an asset can be found in paragraph 49(a) of AASB Framework for the

Preparation and Presentation of Financial Statements (December 2009) and SCNPM of

Government Trading Enterprises (1994, p. 23). The main points are:

future economic benefit

control

past transaction.

Paragraph 89 of AASB Framework for the Preparation and Presentation of Financial

Statements (December 2009) states:

“An asset is recognised in the balance sheet when it is probable that the future

economic benefits will flow to the entity and the asset has a cost or value that can be

measured reliably.”

The two essential components of recognition are:

Firstly, it must have probable future economic benefits – probable means that it is

more than less likely that the benefits will be realised.

Secondly, it must be able to be reliably measured; it should have reliability,

which means faithful representation of underlying transactions or events, without

any bias or error. Essentially, a third party would come to a similar value if

presented with information relating to transactions or events.

Next, the basis for measurement of value of an asset is its cost. Paragraph 15 of the IAS

16/ AASB 116 Property, Plant and Equipment (June 2009) outlined this in:

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“For an item of property, plant and equipment to qualify for recognition as an asset, it

shall be measured at its cost. With reference to not-for-profit entities such as water

utility businesses, if an asset is acquired at no cost, or for a nominal cost, the cost of

this asset is its fair or market value as at the date of acquisition.”

Assets are defined as resources controlled by an entity, and they must be a result of past

events from which future economic benefits are expected to flow to the entity. Once a

transaction or event fulfills these three fundamental characteristics, recognition criteria

are necessary. The AASB Framework states that for an asset to be recognised, future

economic benefits must be probable and capable of reliable measurement. An asset also

requires a cost or other value which can be measured reliably.

The IASB is presently reviewing the Conceptual Framework for Financial Reporting,

and issued an Invitation to Comment (ITC 29) in July 2013 as a proposed way forward.

The IASB proposes the new definition of an asset in paragraphs 2.6–2.16 of ITC 29: that

proposed definition of an asset is „a present economic resource controlled by an entity as

a result of past events‟.

Arguably, the proposed new definition of an asset is more relevant than the existing one

to the public sector, such as the water industry, because it makes no mention of future

economic benefits flowing to the entity. In the case of the public sector, future economic

benefits of the asset do not flow to the government as owner, but to the public who use

the asset (goods or service). In the public and government sectors, the right to dispose of

the asset is very restricted, especially within the present regulatory environment.

6.3 Asset valuation

Following the discussion of recognition and measurements of assets, the issue of physical

asset valuation for water businesses is of critical importance. Both the COAG and the

NWI Pricing Principles (2010, pp. 4 & 6) state that a water business is regarded as part of

a capital-intensive industry with minimum decline in book value. The business uses a

large portion of capital to buy expensive assets (i.e. pipelines, pumping stations and

storage tanks) and for replacement of its existing assets, to expand the stock of assets so

185

as to meet increases in demand, and to meet standards and any increases in regulatory

obligations. However, with these additional expenses there is greater financial risk. Asset

valuation has major consequences for defining total costs of providing the relevant

service and pricing decisions passed on to water customers.

The IPART (1996, p. 42) claimed that over $90 billion is invested in assets in

replacement cost terms, which makes water businesses one of Australia‟s largest and

most capital-intensive industries. The National Productivity Report (NWI 2011, p. 16)

claimed that in 2009–2010, capital and operating expenditure by urban water utilities

from providing water and wastewater was more than $13 billion, of which $7.7 billion

was for capital expenditure. This included capital expenditure on new works, renewals or

replacements, and water recycling assets.

In relation to asset valuation, a key ingredient of the building block approach is the RAB,

comprising of physical assets. It represents the value of investment upon which the

owners earn a return, and the return over the economic life of the assets (regulatory

depreciation). The IPART reported in its 2004 Electricity Price Determination that

capital-related costs represent a significant component; in fact, up to 70 per cent of the

total cost of providing regulated distribution services is capital (Country energy 2003, p.

1). In line with this, Davies and Zauner (cited in Johnstone 2003, p. 3) maintained that

when assessed on a replacement cost basis, capital costs are typically 70–80 per cent of

total costs.

Johnstone (2003, p. 2) noted that the building block model can be categorised as period

costs of owning (financing) and operating the necessary transmission infrastructure assets

and totals these to give a maximum or upper limit (a price cap) on allowable period of

tariff revenue.

Expressed as a formula, the MAR in period t is:

Operating expense + depreciation + opportunity cost.

Return on capital is the opportunity cost; that is, the dollar return on capital that could

have been earned had a cash amount equal to the period of opening asset value that was

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invested elsewhere for that period. Capital costs comprise of return on capital (allowed

rate of return) and return of capital (depreciation). From the above equations, RAB (i.e.

the asset value) is a significant determinant of asset base. The RAB is multiplied by the

WACC to determine the return on capital. WACC is the return on capital employed, and

includes appropriate risk allowances and profit.

Zauner (2000, p. 1) pointed out that asset lives are often long, such as 50 years, and

depreciation per annum is 2 per cent, and the WACC is in the order of 7.5 per cent.

Therefore, the asset value (RAB) and the WACC dominate the revenue calculation over

the other terms, at least early on in the asset‟s life. Valuation of asset base is of

fundamental importance for this component of costs. In fact, Zauner claimed that asset

valuation determines 80 per cent of the MAR when applied. Operations and maintenance

costs, tax and adjustment for new capital expenditure (capex) are generally small relative

to the first two terms (operations and maintenance costs and tax and adjustment), and are

not further considered in this thesis.

Return of capital (depreciation) measures decline in service potential to ensure that it is

matched against revenue earned by the asset, so as to give a fair estimate of the asset

owner‟s return on investment. Depreciation is of significant importance, as it is a part of

the assessment process of asset valuation. The AASB 116/ IAS 116, Property Plant and

Equipment (June 2009) definition of depreciation is as follows:

“Depreciation is the systematic allocation of the depreciable amount of an asset over

its useful life. Depreciable amount is the cost of an asset, or other amount substituted

for cost, less its residual value.”

Depreciation provides two key information sets for public sector entities, such as those of

water businesses. Based on the building block formula, depreciation is the rate at which

the entity‟s asset base is used up, and it is the information crucial for pricing of services.

In the context of asset capitalisation, depreciation is an important determinant of current

fair value of an asset. Paragraphs 43–47 of the IAS 16/ AASB 116, Property Plant and

Equipment (June 2009) provide guidance to applying the concept of depreciation to parts

of assets.

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Figure 6.1: Recognition of an asset

(Australian Infrastructure Financial Management Guidelines 2006, p. 2)

Figure 6.1 above illustrates how an asset is recognised at its cost of acquisition, with an

estimated residual value and an estimated useful life. The asset is depreciated over its

useful life down to its residual value at the time when it is planned to be replaced or

disposed of, in case the service provided by the asset is not required.

Inappropriate calculation depreciation of a water asset utility will produce inappropriate

asset valuations; likewise, inappropriate depreciation methods may distort decisions

related to maintenance and replacement of water assets infrastructure (Queensland

Competition Authority 1999, p. 2).

Indeed, both the return on and of (depreciation) capital depend on the RAB, and for the

purpose of this thesis, depreciation is the dependent variable. The building block formula

illustrates that the RAB affects the calculation of MAR. Asset valuation is a key

determinant of water businesses‟ performances which drives revenue requirements and

prices.

Accurate asset valuation and capital cost allowances are important in order to generate

appropriate prices. If the return on capital (asset valuation) is set too high, the water

business would be encouraged to invest in network to an excessive extent. Customers

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would be required to pay too much for using the network, and hence it would result in

monopoly rents being extracted from customers (Queensland Competition Authority

2001, p. 10).

Similarly, if return on capital is set too low, the water business would not be compensated

adequately for its investment. Consumers would pay a lower price for their water usage in

the short term; however, it would then be unlikely to undertake further investment in the

network, which would potentially lead to inefficient allocation of resources across the

economy (Queensland Competition Authority 2001, p. 10).

Asset valuation by government trading enterprises such as those of water businesses has

important implications for financial reporting and performance, and significant direct and

flow-on effects on pricing of goods and services provided by government trading

enterprises. Government trading enterprises have to price their goods and services in

order to achieve a target rate of return on their investments and assets. The issue of

application of an appropriate assets base to be used is crucial for price-setting purposes


Accurate asset valuation will encourage efficient network usage and efficient investment

in the medium and long term. However, it may not be desirable for water utility

businesses to delay investment until demand exceeds capacity. Any new investment

should be based on reasonably anticipated future demands, as excess capacity may be

dynamically and allocatively inefficient (Queensland Competition Authority 1999, p. 1;

2001, p. 9; Ministry of Economic Development 2002, p. 21).

Equally important, it is undesirable from an efficiency perspective for the business to

over-invest in facilities. Investment planning should therefore aim at ensuring that there is

an appropriate level of investment to support production, with no excess, or under,

capacity. Inaccurate asset valuations tend to distort prices of water to end users of this

commodity delivered via the network. That is, if the price of water is set too high, it will

undermine the competitiveness of water businesses in both domestic and international

markets (Temple-Heald 1991, p. 1; Queensland Competition Authority 1999, p. 1;

Ministry of Economic Development 2002, p. 21).

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6.4 Role of asset valuation and regulatory control issues

Deloitte Energy & Resources (2010, p. 2) mentioned that water utility assets are valued

for the purpose of asset replacement and management programs, transfer of assets from

one water business to another, impairment testing, and determination of the assets‟

carrying values for annual financial reporting. The IPART (2000, p. 79) acknowledged

that valuation of assets and accounting for major infrastructure projects (e.g. water utility)

is one of the most difficult and challenging tasks. The valuation of assets is important in

the determination of revenue (i.e. the regulated water prices) by the regulated water utility

business for two main reasons.

Firstly, asset valuation is the basis for the determination of appropriate return of capital,

the depreciation charge. Secondly, cost of capital is applied to the asset value to

determine the amount of revenue required to earn an appropriate return on capital. Both

return of and on capital form the business‟s capital costs that would be recouped, along

with its OPEX through its charges. When the business‟s revenues exceed its capital and

operating costs, it will earn a return in excess of its cost of capital, although a business

that persistently earns excess returns is likely to be doing so by exploiting a position of

market power.

Prices are set independently of asset values in competitive markets. In theory, in any

market the EV of an asset is ultimately determined by the NPV of the cash flows it can

generate. That is, the value of the business‟s assets is determined by its revenue, prices

and volumes. In a competitive market, market forces determine prices, and prices in turn

determine the asset value. This assists in providing an equitable basis on which to charge

prices. The efficient price outcome would provide appropriate opportunity cost signals,

irrespective of whether investments should be undertaken and maintained. On the

contrary, in a natural monopoly market, such as those of water businesses and where

assets are specialised, a circularity problem arises as shown in Figure 6.2 below.

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Figure 6.2: Circularity of prices, revenue and asset value

(Independent Pricing and Regulatory Tribunal 1996, p. 12; Queensland Competition

Authority 1999, pp. 2–3)

Figure 6.2 above illustrates the circularity problem associated with the methodology used

to value sunk assets. The government sets the revenue through price regulation, taking a

„fair‟ rate of return into consideration, and the revenue earned by the government trading

enterprises depends on the RAB. That is, as water prices increase, the asset value will

increase and vice versa. It highlights the interdependency between product (water) price,

asset value and revenue (Independent Pricing and Regulatory Tribunal 1996, p. 12;

Queensland Competition Authority 1999, p. 2).

Such issues of circularity have received heavy criticism from academics and lawyers such

as Bauer (1924, pp. 658–672), Bonbright (1926, pp. 465–482) and Southworth (1922, pp.

606–613), and via a series of sessions in the papers and proceedings of the American

Economic Review in 1924, 1927 and 1928. By 1928 the debate was at its height. Kahn in

his classical text on regulation (1988, cited in Grout & Zalewska 2001, p. 4) asserted that

inability to value assets in the face of circularity had become an industry standard. This

was evidenced by Bauer in 1918, when he noted that “the circle of value and rates has

been pointed out perhaps a thousand times” (Bauer 1918, pp. 113–133; Grout &

Zalewska 2001, p. 4).

Price of water

Regulatory asset base (RAB)

Maximum allowable revenue

(MAR)

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In the absence of a competitive environment where market forces will determine demand,

prices and hence asset values, the provision of services by the business, in a regulated

environment, is often not contestable. It is therefore necessary for the regulator to play a

role in the valuation of assets. That is, the higher the prices charged by a natural

monopoly, the greater the discounted cash flows received by the business, and as a result

the higher the value of the business‟s assets. A natural monopoly might be able to charge

almost any level of prices as being no more than a „normal‟ or competitive rate of return

on the assets committed to the business. It is important that assets are valued

appropriately, as only when assets are valued independent of prices, can efficiency of the

business‟s pricing and returns on the value of its assets be adequately assessed.

The main concern with regard to asset valuation in a business operating in a market where

competition is limited (i.e. natural monopoly) is that it may operate less efficiently. This

could potentially be due to the use of a greater amount of assets or assets of a higher

quality than required or necessary, or that it would employ if it were to operate in a

competitive market. The regulator must therefore ensure above normal returns on capital

are not permitted (Ministry of Economic Development 2002, p. 105).

Another issue is that only those assets that are currently „used and useful‟ would be

included in the asset base on which a rate of return is calculated. Optimisation is a cost

analysis approach used in asset valuation; it is a condition in which efficient pricing can

be achieved. The business rebuilds its existing system using modern techniques,

technology (where technology had changed) and assets for replacement of the system.

Costs that should be recovered through pricing are those that reflect the least cost of

production. However, when combined with minimised operating costs, optimisation will

result in the optimal (minimum) cost of providing services.

The optimised system will represent least cost, modern equivalent replacement assets that

would provide service the potential of existing assets (Queensland Competition Authority

1999, p. 9; PricewaterhouseCoopers 1999, p. 3; Ministry of Economic Development

2002, p. 105).

All other assets should be „optimised out‟, so that the business is only permitted to earn a

return of and on only at an efficient level of assets, as well as to ensure that current and

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future customers are not asked to cover the cost of this investment through access prices.

The QCA (1999, p. 7) specified that the optimisation process should provide for

elimination of redundant assets and excess capacity. Excess capacity is the difference

between actual and theoretical/engineering capacity; the excess capital assets should be

optimised out of the business‟s asset base.

Investment in water infrastructure is by its nature „lumpy‟, and there is likely to be a

degree of excess capacity that needs to be taken into account in the asset base. The excess

capacity should therefore be incorporated in the asset valuation to determine the purpose

of setting a ceiling price. Unless an allowance is made for this characteristic of water

infrastructure, there will be an adverse impact on the infrastructure owner‟s incentive to

invest.

More importantly, use of optimisation should be beneficial in providing incentives for the

business to ensure that it invests in appropriate technology, prevents gold-plating of its

assets (i.e. goods or services supplied of a higher quality than what would be demanded

by consumers, such as through over-designing of the assets), assets being constructed

inefficiently (i.e. doubling up), and reducing the risk of inefficient bypass of the existing

assets, if there is any. Due to a lack of alternatives, consumers are forced to pay higher

than efficient prices. Bypass occurs when it is cheaper for current purchasers of network

services to construct and operate an alternative service themselves rather than use the

existing network. Consumers should not have to pay for all these (over-investment, gold-

plating and any inefficient past investment).

Optimisation for valuation purpose is not concerned with improving the system from its

current state. In fact, the system should never be valued as better than it is, regardless of

terms of capacity or other standards. Optimisation leads only to reductions in replacement

costs of network system assets (Australian Rail Track Corporation Ltd 2001, p. 30). It

should instead assist in providing an equitable basis on which to charge prices, and hence

it is important that efficient pricing signals the economic cost of the consumption of

services (Queensland Competition Authority 1999, pp. 3–4; Ministry of Economic

Development 2002, p. 90). An investigation by PricewaterhouseCoopers (1999, pp. 3–4)

found that an important concept associated with asset valuation is based on replacement

cost subject to optimisation. Optimisation of assets recognises that system assets will

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practically never be rebuilt in exactly the same configuration, over the same location,

using exactly the same materials as originally utilised; thus making its system assets

theoretically more efficient.

However, inclusion of optimisation in the asset valuation process often involves a social

cost – the trade-off of the creation of investment risk. There is therefore the need to

compensate investors for such risk against reduction in investor „moral hazard‟ a situation

refers to a person‟s weakened incentives to act prudently when they do not bear all the

costs of their actions and/or inefficient bypass (Ministry of Economic Development 2002,

p. 111; Commerce Commission 2002, pp. 5-6).

6.5 What is deprival value?

Originally, the deprival value was a concept used in insurance. It referred to whether the

owner was deprived of an asset; that is, the asset was lost. The replacement cost meant the

amount of compensation that the owner would have to receive to leave them indifferent to

the loss of the asset. The replacement cost, as its name suggests, is the cost of replacing

an asset with another asset on a „new-for-old‟ basis. The replacement asset does not

necessarily have to be the same asset, but will provide the same services and capacity as

the existing one. Asset valuation are carried out based upon how much it would cost to

replace the asset today.

For the water business, if it is deprived of the value of the asset, under the replacement

cost rules this should leave it indifferent, with an assurance that it can continue to provide

the existing market with an equivalent flow of services. The settlement amount, if the

water utility business is deprived of its assets, is an „exit value‟ notion. That is, there is an

incentive for efficient investment decisions, as assets are valued in current prices.

The concept of the deprival value originates from Bonbright, a scholar and Professor

Emeritus of Finance at Columbia University in 1920–60. Bonbright‟s views on deprival

value were set out in two of his books, The Valuation of Property (1937) and Principles

of Public Utility Rates (1961).

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The deprival value, as on page 72 of the book, is:

When I say, „My house is worth $10,000 to me‟, I mean (if I am precise in my use of

language) that retention of the house is worth to me as much as the acquisition of $10,000

in cash would be worth to me. However, this is the same thing as saying that the

anticipated loss of my ownership interest in the house has an adverse value to me of

$10,000. Such negative terms including „anticipated loss‟, „damage‟, and „injury‟ are

simply the converse of such positive words as „value‟, „worth‟ and „importance‟.

It can be said that an asset‟s „value to the owner‟ is the loss they would suffer if deprived

of the asset. The deprival value is the amount of money that would make up the loss and

would „make them whole‟. In other words, deprival value looks at liability following the

loss of an existing asset. It also attempts to answer all the important questions, such as

what difference would it make if the owner is deprived of the asset? If x is the unit of

asset, deprival value, as a set of valuation rules, looks at exactly how much an owner

would be worse off with (x-1) asset units. Various working definitions of the deprival

value can be found, such as the working definition adopted by the SCNPM (1994, pp. 43–

45):

… in most cases [deprival value] will be measured by the replacement cost of the

services or benefits currently embodied in the assets.

The replacement cost is the cost which is the cheapest and the most efficient way, using a

MEA. It is based on the technology of the day and current market values (Commerce

Commission 2002, p. 7; Utilities Commission 2005, p. 12).

The SCNPM (1994, pp. 43–45) added an extra element to the determination of deprival

values, which is the consideration of whether or not the assets would be replaced if they

were no longer available. Under these guidelines, where an asset would be replaced, the

deprival value is taken to be the current replacement cost of the asset or of an alternative

asset with the same service potential. Such a definition is consistent with the deprival

value of assets being the lesser of the NPV of the income able to be generated by the asset

and the DRC of the asset, or the DORC value of the asset.

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Depreciation of a replacement value reflects the age of the existing asset and is not

explicitly contemplated. That is, an accountant may interpret the terms „similar asset‟ and

„the same service potential‟ as taking into account the age of the existing asset and hence

valuation at DRC or DORC. The most important issue with interpretation in reference to

the deprival value is to understand the circumstances under which the asset owner would

be deemed to replace an asset if the business was deprived of that asset (and hence the

circumstances when the deprival value methodology would result in an asset being valued

at the DORC value).

Under the guidelines developed by the SCNPM, there is an expectation that a business

generally would replace assets that were being used, regardless of whether the

replacement of the asset would be economic; that is, the provision of the service generates

a return at least equal to the cost of capital.

In New Zealand, assets are only valued at replacement cost if NPV of revenues from the

asset exceed the cost of the asset. Assets are only deemed notionally to be replaced when

the utility would be under implicit or explicit service obligations to continue to provide

the service (ACCC 1999, pp. 39–40).

A regulator can reduce the value of assets when it is aware that a more efficient lower-

cost alternative asset is available. The replacement cost, if it can in fact be replaced, is its

value in exchange in the market where the business can purchase the asset. The

replacement cost seeks out to answer the question: What will it cost the business to get rid

of (replace) a present-day asset with an MEA that could provide a similar level of service

to the asset in question?

In the case of a water utility business, in order to replace assets, it would use the most

economically efficient technology and a corresponding inventory of capital assets with

the same remaining life as the actual assets. Deprival value answers the question: What

would it cost today to provide an asset to deliver the same service potential as the asset

being value? (Bertram 2000, p. 3)

A rationale for this valuation rule is that the business would acquire the asset because the

return it will secure on its investment would exceed its cost. When deprived of the assets,

the business would not lose those returns, but would replace the assets of equivalent

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value. The extent to which the business is better off as a result of its ownership of the

assets is represented by the replacement cost.

6.6 Background information of the ODV

The ODV is a variant of deprival value, and it relies on the deprival concept. The

opportunity cost, amount lost by not using the resources, such as labour or capital in its

best alternative uses, of infrastructure asset is low, and the outlay from investment in

these assets cannot be recouped by reselling the assets for some other use. In many cases

these assets will never be replaced. Existing water pipelines may be renewed or upgraded,

but it is unlikely that they will ever be scrapped and rebuilt (Independent Pricing and

Regulatory Tribunal 1996, p. 85; Ministry of Economic Development 2002, p. 108;

Deloitte Energy & Resources 2010, p. 2).

The portion of the asset‟s value that cannot be recouped is called „sunk cost‟. For such

sunk assets, replacement cost cannot be a measure of opportunity cost, as opportunity cost

in relation to alternative uses of such assets is very low or even zero. The owner forgoes

very little in its present use, as their assets are being used optimally, and there is no

alternative use once built. An oft-quoted saying in economics is that „bygones are forever

bygones‟ (Jevons 1888, p. 164; Peart 1996, p. 105; Bond & Sakornvanasak 1996, p. 40;

New Zealand Institute of Economic Research 2000, p. 5).

Given the large, sunk, long-life investments associated with water businesses‟ activities,

and the fact that such assets invested are used optimally, their investment behaviour is of

critical importance. Over- or under-investment will have direct implications on prices

charged to consumers (Ministry of Economic Development 2002, pp. 102–103).

6.7 Overview of asset valuation techniques

In order to understand the concept of ODV methodology, the concept of the deprival

value needs reviewing. The deprival value is the amount of loss to a business if it were

obliged to forfeit the asset in question.

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Assets are valued at an amount that represents the loss of service potential flowing from

the asset. Asset valuations are one of the most difficult, controversial and challenging

issues associated with determining the revenue requirement of a service provider. The

main reason is that because valuation of water utility assets is not related to a competitive

market, there is no specific procedure for asset valuation which is necessarily correct or

suits all accounting, performance monitoring and price regulation.

The IASB/ FASB has previously discussed the „measurement objective‟, but this concept

has remained rather confusing and controversial. This is because issues related to

measurement (valuation) cannot be considered independently from the context of some

underlying objective for financial accounting and reporting. The FASB/ IASB is currently

grappling, as part of its conceptual framework revision and major concerns include

whether there is any likelihood of international agreement on a single measurement

objective, given that there is a lack of homogenous users and uses (SCNPM 1994, pp. 31

& 34; Solomon 1995, pp. 46–47; Johnstone & Gaffikin 1996, p. 53; National Asset

Management Steering Group 2001, p. 1.2; Walker & Jones 2003, pp. 356–357; Cooper

2007, pp. 17–18; & Macve 2010, p. 111).

There is little consensus on a measurement approach, although the issue of measurement

in financial reporting has been widely discussed by both professional and academic

accounting forums for decades.

The AARF (1994, p. 13) suggested that measurement is one of the most significant

contemporary issues in financial reporting. This is reflected in the Australian accounting

standards Framework for the Preparation and Presentation of Financial Statements,

paragraph 100, where a variety of measurement techniques and guidelines for

measurement bases are employed to different degrees and in varying combinations in

financial statements.

This thesis discussed earlier that one of the most important aspects of determining the

RAB is the choice of asset valuation methodology. That is, the asset valuation

methodology used could have significant consequences for the RAB, the MAR and

consequences, and the prices charged to consumers. If the price of water is under-priced,

it will erode the capital base and the capacity of the water utility business to remain

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financially viable. Similarly, over-pricing will result in consumers being extracted of

monopoly rents.

Ideally, the choice of asset valuation methodology should be established in a regulatory

framework. However, in practice, the asset valuation methodology is not defined in the

regulatory framework. There are a variety of techniques of asset valuation available,

depending on the choices of valuation available to entities. There are two main techniques

used in asset valuation: value- or market-based, and cost-based.

Figure 6.3 depicts each approach and the various accompanying asset valuation

techniques.

Figure 6.3: Overview of valuation techniques

(Queensland Competition Authority 1999, p. 5; PricewaterhouseCoopers 1999, p. 2)

With the former value- or market-based approaches, valuation of asset is determined

largely from its cash-generating capacity. This can be measured either by the NPV of

future cash flows (i.e. the value to the user of the asset), or the NRV, which is the cash

generated by selling the asset. In general, value-based approaches require significant

amounts of information and assumption. It is therefore potentially affected by the

problem of circularity, where the asset value is determined by (regulated) prices and

Net present value (NPV)

Net realisable

value (NRV)

Fair (market) value

Value-based

Historical cost (HC)

Replacement cost (RC)

Depreciated optimised

replacement cost (DORC)

Cost-based

Deprival value (DV)

Optimised deprival

value (ODV)

Line in the sand

Hybrid

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revenues which, in turn, are based on the asset value (Queensland Competition Authority

2000, p. 32; KPMG 2005, pp. 4–8).

The latter cost-based approaches relate to the value of an asset to the cost of purchasing

the asset. It also depends on the service potential embodied in the asset, either at the

original cost or the original cost adjusted to reflect its current cost. Cost-based

approaches, such as historical costs, are more easily established. This includes any cost

incurred in the set-up or acquisition of the asset, along with any associated financing

costs.

As the original purchase price of the assets is supported by documented evidence, such as

receipts or invoices, it is not only less costly to establish, but also administratively

efficient. All data required is available from the financial statements. Also the business

invests in capital; any cost savings will subsequently be passed on to consumers in the

form of lower prices.

These cost-based approaches do not require experts to determine cost, as they rely on

actual data rather than professional judgements. They also reduces the risk to asset

owners of the impact of technological change. However, cost-based approaches are less

relevant to current and future economic decision-making, particularly for long-life assets

during persistent periods of inflation. That is, the asset prices will be understated in times

of high inflation, while during times of technological change the asset prices will be

overstated.

For water businesses, it is difficult to determine accurately the lives of some water assets,

as it may well be more than 100 years. This may lead to unstable prices, which may rise

when the asset is new, and drop when more expensive assets are used to replace existing

assets. Arguably there are limited incentives for the business to increase its capacity or

make services available to more users, because it does not get compensated for doing so.

Other cost-based approaches include replacement cost and DORC (Queensland

Competition Authority 2000, p. 32; Australian Competition and Consumer Commission

2009, p. 97).

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There is a clear and constant asset valuation allowance until the expiration of the assets.

For these reasons, the depreciated actual cost (DAC) is widely accepted as the basis for

recording asset values by the commercial sector and for financial accounting purposes.

Figure 6.4: DAC valuation method

The existing assets may become obsolete due to technological change. The DAC would

overstate efficiently incurred cost, causing productive inefficiency and distorting

consumption decisions, causing allocative inefficiency. For this reason, the DAC does not

take into consideration the impact of inflation and technological changes.

The main disadvantage with this method in the valuation of water businesses‟ assets is the

problem associated with the long-life assets and lumpy (sunk) investments. As such, the

DAC may not accurately reflect the adequate rate of returns to owners that is required to

maintain the financial and operating capability of the water business. The owners may

therefore not be able to fully fund new investments. It has little resemblance to the EV of

the assets, and has no direct relationship with future cash flows generated by an asset in

its normal use.

The DAC method takes into account depreciation, but it does not consider periodic

inflation. The depreciated inflation historical cost (DIHC) is a variant of historical cost. In

Depreciated actual cost (DAC)

= Opening values

+ Prudent capital

expenditures

- Asset disposals or retirements

= Ending asset balance

- Regulatory accumulated depreciation

= Net asset balance

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Figure 6.5, the asset historical value is adjusted for inflation by applying either inflation

or appropriate indices to the actual capital costs. The asset value under the DIHC is

consistent with a regulatory regime, as it allows a real rate of return after inflation is

adjusted on the calculated RAB. Thus, the DIHC is a form of CCA.

Figure 6.5: DIHC valuation method

The decisions incorporated into the DAC and DIHC techniques are all appropriate for

taxation and accounting purposes. That is, customers pay for the actual network provided

and not the market value of the network assets or technology changes that occurred, since

the assets were constructed because of changes in asset designs or regulators‟ decisions.

As in Figure 6.3, the third approach, the deprival value, is a hybrid approach that

considers both value- and cost-based approaches to arrive at an asset valuation. The NWI

2010 (p. 7) stated that the deprival value “is the value of future economic benefits that

would be foregone if the entity was deprived of an asset.” If the asset to be lost was to be

replaced, it can be valued at its market value, replacement cost or reproduction cost,

depending on the circumstances. Otherwise, the asset should be valued at its EV, which is

Depreciated inflation

historical cost (DIHC)

= Opening values

+ Prudent capital

expenditures

- Asset disposals or retirements

+ Index allowance

= Ending asset balance

- Regulatory accumulated depreciation

= Net asset balance

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the greater of either the NPV of the income expected to be earned from the asset, or the

fair market value if it is not to be replaced (National Water Initiative 2010, p. 7).

Deprival value has been endorsed by the COAG as the preferred approach to valuing

network assets for public reporting processes (performing monitoring) and the

ARMCANZ (Australian and New Zealand Environment and Conservation Council, and

Agriculture and Resource Management Council of Australia and New Zealand) as a basis

for water pricing. It is considered to be the best estimate of what a private sector provider

would pay for a similar asset, provided that the expected market and other conditions

prevailed (Queensland Competition Authority 2000, pp. 33–34).

When the businesses are deprived of the asset and the recoverable amount exceeds the

replacement cost, then the businesses would probably go and buy another asset as a

replacement. It is therefore logical for a business to follow the deprival value when it

makes a rational value-maximising decision. The replacement cost will set a maximum

amount on the loss that the business can suffer through deprival. However, if the

economic benefit that arises from the ownership of the asset (i.e. the recoverable value) is

less than the cost of replacing it, then the business would logically choose to keep the

asset rather than replace it. The recoverable value will depend on what the business is

planning to do with the asset, whether it considers making the most money or derives

other benefits from it.

There are two basic choices: either to sell it (value in exchange), or to use it within the

business (value in use). It is logical for a business to choose whichever offers the highest

return. The NPV of the future cash flows described previously is the value in use and the

present value of future cash flows obtainable as a result of the continued use of an asset,

including those resulting from the asset final disposal. It involves use of techniques like

the discounting future cash flows.

An example in which value in use or NPV of future cash flows is an appropriate

determinant of its value to the business is where an old specialised machine which would

not be replaced as it is still producing cash flows with a NPV exceeds the asset‟s net

realisable value. Under these circumstances, the business will retain and use the asset

rather than sell it. On the other hand, the asset‟s NRV is the value in exchange of a sale,

or in other words the sale proceeds less the future costs of sale.

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The New Zealand Institute of Economic Research (2000, p. 8) maintained that the

historical costs approach was rejected on the basis that the prices it gave rise to were

unsustainable. When new assets were added, a shock in the price occurs. Historical costs

valuation was therefore considered inequitable over time, as the service did not change

with the price change. Therefore, even though historical cost is considered potentially the

most objective and lowest cost method, records are somewhat inconsistent.

Government trading enterprises (i.e. government authorities which provide goods and

services directly to the community and are responsible for the provision of electricity,

gas, telecommunications, rail transport services and water) have a high proportion of

long-life assets (10–150 years) which have been purchased and invested at various points

of time. In Victoria, the ESC reported that some of its large infrastructure projects are

recovered over 70–100 years, while its other expenditures may have a shorter

depreciation life. These assets are therefore subjected to different price levels.

Historical cost figures may have limited application under these conditions, and may fail

to provide a meaningful base for performance measurement. Other limitations of HCA

include overstatement of profit unless there is no inflation, as well as leaving a business

unable to replace its assets (Independent Pricing and Regulatory Tribunal 1996, pp. 15 &

84; Lee & Fisher 2004, p. 351). As an example, research by Logan City Council in

Queensland identified one of its reinforced concrete pipes as having a useful life for 100

years; however, in reality it could last for more than 200 years (Kennedy 2006, pp. 1–12).

An extreme example of water assets that are long-term and capital-intensive assets with

low rates of technological obsolescence (i.e. subject to optimisation of excess capacity)

can be witnessed in Rome and Italy. In these countries, the modern sewerage system still

uses some assets installed by the ancient Roman Empire, dating back to 600 BC – about 2

610 years ago (Hopkins 2007, pp. 1–15; Deloitte Energy & Resources 2010, p. 7)!

The deprival value is classified in the third hybrid approach as shown in Figure 6.3. It

considers both value- and cost-based approaches to arrive at an asset value (Queensland

Competition Authority 2005, p. 5; Australian Government 2010, p. 15). In theory, the

deprival value is drawn on principles set by Bonbright in 1937, which is conceded, in

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particular, by Solomons (1960, pp. 374–383; 1995, pp. 47–51) and Baxter (2003, pp. 1–

23).

As discussed, specialised assets are those that are employed in non-contestable or

monopoly markets. In particular, water utilities are specifically recognised as natural

monopolies, where they are characterised as being the largest supplier that has an

overwhelming cost advantage over actual and potential competitors. Therefore, it is not

possible for competitors (suppliers) to enter the existing market.

In addition, water pipelines are very expensive to build and have no alternative use. Facts

from Australian Water Association (2007, p. 47) have specified that water is too heavy to

be transported. That is, 1 KL (1 000 litres) of water weighs approximately one tonne.

Additional energy is therefore required to move water, to overcome frictional resistance.

It takes pump power to drive the water through, and extra pump energy is required to lift

the water if the pipelines have to climb up a mountain range.

Thus competition in the water business is impossible. Other characteristics of water

business are such that there are large sunk investments, a large share of fixed costs, and

economies of scale and scope. It is therefore unlikely that a potential competitor would be

willing to make the capital investment needed to enter the natural monopolist‟s market.

The fair (market) value accounting is most commonly used by investors in commercial

entities. It is known to be an appropriate concept to capture business risk, capital structure

and economic valuation based on expected future stream of income. However, the assets

of government trading enterprises, such as those of water utilities businesses, have no

market values, and in the absence of a competitive market, the deprival value approach is

considered an appropriate starting point from the regulatory perspective.

The line in the sand valuation is an asset valuation technique presently not discussed in

any published academic journals. NERA Economic Consulting and

PricewaterhouseCoopers (2009, p. 16) noted that the line in the sand valuation has been

proposed by utilities asset owners and accepted by regulators in Australia. It can be

expressed as the EV limb of the deprival value technique. The line in the sand valuation is

adopted by Australian regulators to establish the initial RAB for the purpose of

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determining the price of utilities, including water. Future capital expenditure undertaken

after the initial line in the sand valuation is „rolled into‟ the RAB „at cost‟. In adopting

this technique, regulators consider a wide range of factors to ensure that the initial RAB is

„locked in‟ and set to deliver a specified outcome such as a targeted level of price for

customers, a targeted level of revenue or a targeted level of profitability for the business.

NERA Economic Consulting and PricewaterhouseCoopers (2009, p. 2) emphasised that

this technique requires a choice on the exact measure of current outcomes, whether it

involves setting the initial RAB consistently with maintaining prevailing prices, revenues

or profit into the future.

When the initial RAB is „locked in‟ and set, the valuation had no particular regard or

relation to asset valuation undertaken for financial reporting purposes. Using this asset

valuation technique may result in inefficient prices being set from the initial RAB.

Existing or current prices may have „locked in‟ inappropriate asset valuation which

includes some form of monopoly profit and is carried forward into future prices.

Similarly, if low current prices are „locked in‟ with low level of capital investment, an

asset valuation based on current prices will result in losses carried forward into the future.

For example, the ESC in Victoria first approved the price of water (and the provision of

sewerage services) that each water entity may charge its customers from 1 July 2005 for

regional urban businesses and from 1 July 2006 for rural businesses. The RAB is used for

the purpose of determining the price of water under the regulatory regime. The initial

RABs of the metropolitan water businesses were set higher than their financial reporting

asset values. On the other hand, the initial RABs of the regional and rural entities were set

lower than their financial reporting asset values and carried into the future. The initial

RABs of the rural water businesses were set to zero. This resulted in a large depreciation

expense not recovered through the price water charged to customers by the regional and

rural water businesses. Over a period of time, the difference between the RABs and

financial reporting asset values grew, magnifying the shortfall between the prices of water

charged to customers and the revenue required to recover efficient operating costs. The

Victorian Auditor General pointed out that this is the key factor contributing to the

operating losses in a number of regional urban and rural water businesses in Victoria

(Auditor-General 2013, pp. 32-33).

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6.8 Summary

An item or event should meet three fundamental characteristics to qualify as an asset of

an entity. The asset is expected to provide future economic benefits and it must be

controlled by the entity, and occurrence of transaction or event must be of the past. The

asset must satisfy the recognition criteria. That is, the asset must have a cost or other

value that can be measured reliably.

Physical asset valuation is important for water businesses. In 1996 it was reported that

over $90 billion was invested in assets in replacement cost terms. The National

Productivity Report claimed that capital expenditure for all urban water utilities in

Australia for 2009–2010 was estimated at $7.7 billion. Water businesses use a large

portion of capital, to buy expensive assets such as pipelines, pumping stations and storage

tanks. It is also expensive to replace the existing assets, to expand the stock of assets to

meet increases in demand, and to meet standards or any increases in regulatory

obligations.

Water businesses spend a substantial amount of expenditure on investment, as well as

maintenance of assets to supply, treat and deliver water, and then collect, treat and

dispose of wastewater. A high proportion of long-life assets, from 10–150 years, are

owned by water businesses, and these assets were purchased and invested in at various

points of time. For example, the ESC in Victoria reported that some of its large

infrastructure projects are recovered over 70–100 years, but its expenditure may have a

shorter depreciation life. Logan City Council in Queensland identified that one of its

reinforced concrete pipes had a useful life of 100 years, but in reality these concrete pipes

can last for more than 200 years. In Rome, Italy, the modern sewerage system still uses

some assets installed by the ancient Roman Empire, dating back to 600 BC. These are all

examples of water assets being long-term, capital-intensive assets with low rates of

technological obsolescence subjected to optimisation of excess capacity.

Water businesses‟ assets do not have alternative uses and they are effectively considered

sunk. No accounting or economic theory therefore provides determination of an initial

RAB value for the assets of an established water business. Economic theory, however,

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has suggested that the setting of a regulatory value for monopoly network assets at a

particular time is typically interpreted as within a feasible range; that is, at the upper

bound or lower bound. When the RAB on which price of water is based is equal to long-

run marginal costs, the price of water will also equal this.

Paragraphs 4 and 5 of the COAG provide a description of upper bound and lower bound.

That is, economic efficiency criteria is satisfied when the assets are valued between lower

bound and upper bound of costs incurred by an efficient new entrant (bypass cost). The

upper bound is the estimate of the DORC, while the lower bound is the value that assets

would have in their next best use. Upper bound is the value in which the asset should be

scrapped and a new asset installed. It would be better off for consumers at any price

above the upper bound to have a new entrant to enter the market in competition with the

existing network. In contrast, at any price below the lower bound, the water business

would not be able to cover its cost and it would suffer financially if it kept on serving its

consumers.

Once investment in water assets has been made, its outlay is considered sunk. This outlay

cannot be recouped by re-selling the assets for some other use. This is because water

assets are considered specialised and they have few, if any, alternative uses once built.

Water businesses‟ investment decisions are irreversible. It is important that their past

expenditures that are sunk be considered irrelevant for efficient decisions regarding usage

and future business investment.

One advantage of DORC and ODV asset valuation methodology is that the „O‟ in both is

optimisation of asset base, which stipulates that only assets relevant to future demand are

included in asset valuation. These assets are both optimally configured and constructed to

be included in asset valuation. In particular, the DORC is the benchmark for efficient

pricing and service delivery. The value of its assets is consistent with the maximum price

achievable in a competitive market.

Asset valuation determines water businesses‟ performances which drives revenue

requirements and prices. The asset base is usually the key determinant for water

businesses, and asset valuation has major consequences for defining total costs of

providing the relevant service and pricing decisions passed on to water consumers. The

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key ingredient of the building block approach is RAB, which comprises of physical

assets. The RAB and WACC dominate revenue calculation at least early in an asset‟s life.

The two characteristics of asset valuation techniques are value- or market-based, and

cost-based. Valuation of asset is determined largely from its cash-generating capacity

under value- or market-based approaches. In contrast, the cost-based approaches relate to

the value of an asset, to the cost of purchasing the asset. It also depends on the service

potential embodied in the asset, either at the original cost or the original cost adjusted to

reflect its current cost. This would include any cost incurred in the set-up or acquisition of

the asset, along with any associated financing costs. Examples are the historical cost, the

replacement cost and the DORC.

The third approach, the deprival value, is a hybrid approach that considers both the value-

and cost-based approaches to arrive at an asset value. The deprival value is the value of

future economic benefits that would be foregone if the entity is deprived of an asset. That

is, if the asset to be lost is to be replaced, it can be valued at its market value, replacement

cost or reproduction cost, depending on the circumstances. An asset valuation not

presently discussed in any published academic journals is the line in the sand valuation.

The line in the sand valuation is the EV limb of the deprival value technique.

Chapter Seven next provides an overview of the CCA and its development in Australia,

followed by discussion of steps involved in asset valuation method using the ODV.

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Chapter Seven: Asset Valuation Method Using the ODV

7.1 Introduction

While Chapter Six covered a range of issues associated with valuation of water utility

assets, this chapter continues with the discussion of asset valuations. In particular, it

provides an overview of CCA and its development in Australasia. The CCA is

particularly important since deprival value was a part of CCA standards in Australia,

Canada, New Zealand, the United Kingdom and the United States. It uses current costs

rather than historical or original costs for asset valuation, and it is currently a requirement

but not mandatory for utilities businesses to account for their regulatory assets and

liabilities.

There are some important dates that need to be highlighted in relation to deprival value,

development of the NWI and Water Pricing Principles. It was in the Statement of

Accounting Practice No. 1 (SAP 1) that deprival value was initially found in 1976. In

1990 the COAG set up the SCNPM of Government Trading Enterprises, followed by

Guidelines on Accounting Policy for Valuation of Assets of Government Trading

Enterprises Using Current Valuation Techniques, which was proposed and issued in

1994. These guidelines suggest that non-current physical assets should be measured on

deprival value or on a value to the business basis. The guidelines are developed to

encourage comparability as part of its performance monitoring exercise.

In 2004 an agreement by the Commonwealth and state and territory jurisdictions at the

COAG meeting made NWI the blueprint for water reforms. In 2009, a draft copy of NWI

Pricing Principles was released, which was endorsed by the Natural Resource

Management Ministerial Council in 2010. The deprival value methodology is

recommended for asset valuation for the purpose of water pricing. All three organisations

– the COAG, the SCNPM of Government Trading Enterprises, and the NWI –

recommended that assets be valued on a deprival value basis for price-setting.

This chapter examines the steps involved in asset valuation method using ODV, along

with discussing systems and examples of optimisation. The ODV methodology for asset

valuation is based on the assessment of DORC and EV of system fixed assets. If the

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DORC value of an asset is lower than its EV, DORC will be the appropriate value for the

asset. However, in cases where the system was deprived of the asset, it would be replaced

with the technically optimum equivalent.

The basis for ODV of asset valuation is to value assets at the level at which the business

can sustain, and not to reflect the cost of providing the service in an economically

efficient way. System fixed assets that are uneconomic would not be replaced, but would

be valued at their EV, indicating the amount a business would be willing to spend on

replacement assets to provide the same level of service provided by the existing assets.

7.2 Brief overview of the CCA

The concept of deprival value is well-known to both accounting theorists and accounting

policymakers, and it was previously part of CCA standards in Australia, Canada, New

Zealand, the United Kingdom and the United States.

CCA is one of the various inflation accounting techniques that have been used as an

alternative to counter problems associated with HCA. CCA is a form of accounting,

stated in the current 2012 Framework for Preparation and Presentation of Financial

Statements, paragraphs 102–110, in which capital maintenance is used to maintain the

operating capability of a business.

Capital maintenance is a concept used in accounting where capital value is determined

before profit can be computed. It is based on the assumption that profit can be realised

only after capital of the entity has either been restored to its original level or maintained at

a predetermined level (the Institute of Chartered Accountants 2010, pp. 39–40). CCA

operating profit is then calculated after charging depreciation and current cost that has

been consumed.

Capital maintenance is a question of high concern for water utility businesses. Under-

pricing water will result in erosion of the water business capital base, and the business‟s

capacity to remain financially viable will also reduce. In contrast, over-pricing water will

result in monopoly rents being extracted from consumers. Under- or over-pricing water

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costs will contradict with the policy set by the NWI, paragraph 65 (2010, p. 2), which

states that:

“In accordance with the National Competition Policy commitments, the States and

Territories agree to bring into effect pricing policies for water storage and delivery in

rural and urban systems that facilitate efficient water use and trade in water

entitlements, including through the use of full cost recovery for water services to

ensure business viability and avoid monopoly rents.”

Recommendations about current cost disclosures, in which current cost definition was

found to be equivalent to the deprival value, are contained in the International Accounting

Standards (IAS) 15 Information, reflecting the effects of changing prices (IASC, 1995,

page 250, paragraph 12). In December 2003, the IASB withdrew IAS 15 as part of its

Improvements Project, effective as of 1 January 2005; however, it was unable to reach an

international consensus on disclosure of information reflecting to the effects of changing

prices.

Some of the reasons behind the failure were due to declines in the rate of inflation. That

is, as inflation declines, the effects of changing prices become less important. To add to

this, changes in government policy meant that tax reliefs were not given on the basis of

CCA, as it was no longer required as a means of justifying price increases (Tweedie &

Whittington 1997, p. 149). A similar pattern was seen in the United States where

Financial Accounting Standards 33 (FAS 33), Financial Reporting and Changing Prices,

was introduced in 1979, while around the same time the United Kingdom Financial

Reporting Standard 7 (FAS 7) was also introduced (Whittington 1994, p. 88).

In the United Kingdom, deprival value was mentioned in Financial Reporting Standard 7

(FRS 7), Statement of Standard Accounting Practice 16 (SSAP 16), and the Sandilands

Report in 1975. More recently, such recognition is suggested for extension to

(re)valuation of tangible fixed assets in general (ASB, 1996a/b).

Based on the above discussion, it is reasonable to conclude that deprival value is accepted

as a practically applicable valuation basis, which has featured in both past and current

accounting standards concerned with effects of changing prices in numerous jurisdictions.

http://www.iasplus.com/agenda/improve.htm

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It is currently a requirement, but it is not mandatory for utility companies such as water

businesses to account for their regulatory assets and liabilities.

In terms of valuation of water infrastructure assets, no guidance has been provided in

Australian accounting standards in regards to whether any one method is acceptable to all

entities in all circumstances, or whether each of the available techniques should only be

applied in certain circumstances whenever appropriate.

The IASB issued its Exposure Draft, Rate-regulatory Activities, on 23 July 2009, which is

applicable to valuation of water infrastructure assets, as it limits prices charged to

consumers for services or products, such as water through regulations. In general, the

standard is imposed by the regulator or government when the entity enjoys a monopoly or

a dominant market position that gives it significant market power. The proposal, if

adopted, will allow for assets and liabilities that arise from rate-regulated activities within

the scope of Exposure Draft to be recognised under the IFRS. To date, the IASB (the

Board) is undecided as to whether Rate-regulatory Activities should be recognised in

accordance with the current Framework, or whether they should be consistent with other

IFRS (IASB 2009, pp. 4–27). As of 30 January 2014, the Board issued IFRS 14

Regulatory Deferral Accounts (effective for financial reporting periods beginning on or 1

January 2016) to provide interim guidance on accounting for first-time adopters of IFRS

while the Board considers comprehensive guidance on the effects of rate regulation.

In practice, the appropriateness of each asset valuation method should be assessed to

ensure that when applied, it will result in information relevant to the economic decision-

making needs of the users of financial statements.

7.3 Developments of the deprival value in Australasia

Statement of Accounting Practice No. 1 (SAP 1) was first issued in 1976, when deprival

value concepts were first found. Later in 1983, the Australian professional bodies issued a

non-mandatory recommendation, (SAP 1) Current Cost Accounting. Statement of

Accounting Practice No. 1 (SAP 1) recommended that a supplementary profit and loss

account and balance sheet be set up on a current cost basis, with use of deprival value or

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value to business as the valuation method, and with operating capability as the capital

maintenance concept.

Under the concept adopted in SAP 1 Current Cost Accounting, price-setting and

depreciation ensures that an organisation generates cash flows sufficient to replace its

assets and maintain its physical operating capacity. At the time when Statement of

Accounting Practice No. 1 (SAP 1) was first recommended but was non-mandatory, it

received widespread opposition to price change in Australia, particularly among the

business community, especially following the government‟s failure to base corporate

taxation on the CCA method. Consequently, there were no favours to its adoption, and

even though it continued to be a lively debate in the 1970s, it never took hold in

Australian private sector financial reporting practice.

Similarly, in the United Kingdom, CCA attracted subsequent interest with government-

owned enterprises. All these occurred at the same time as the Byatt Report was under

discussion.

It was not until July 1986 that the State of Victoria issued Accounting Policy Statement 1

(APS 1), Rate of Reporting, when Australia began to see development of CCA within the

public sector. APS 1 was different from previous accounting standard Statement of

Accounting Practice No. 1 (SAP 1), in that the latter is concerned with measuring a real

rate of return on assets from the perspective of the finance provider, the government,

rather than the business itself. A financial measure of capital maintenance was preferred

to operating capability measure, which was similar to the United Kingdom‟s Byatt

Committee approach adopted in 1986. Following the statement released in July 1986, a

paper was issued by the South Australian Treasury in 1989.

Existence of the concept of ODV and its association with current replacement cost

concepts first began in the late 1980s and early 1990s, as a result of the Australian

Government‟s desire to improve the measure of financial performance of government-

business enterprises. Later in 1990, the COAG set up SCNPM of Government Trading

Enterprises, and in 1994 Guidelines on Accounting Policy for Valuation of Assets of

Government Trading Enterprises Using Current Valuation Techniques was proposed and

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issued, which measured non-current physical assets on deprival value or value to business

basis.

The guidelines were developed for the purpose of encouraging comparability as part of

the COAG performance monitoring exercise. However, the asset valuation sub-committee

focused specifically on valuation of non-current physical assets (including water and

sewerage). These have the greatest impact on performance indicators, but at present it is

difficult to determine the most relevant asset valuation method (Steering Committee on

National Performance Monitoring 1994, p. 16; Lee & Fisher 2004, pp. 353–354).

These guidelines, together with the companion overview which is a synopsis of the

guidelines, is to this date a primary source for accounting in government trading

enterprises, for determining asset valuation principles and procedures. It is to some extent

consistent with the accounting standards and other pronouncements of accounting

professional bodies. More importantly, this report has the backing of state premiers and

treasuries. The Australian Accounting Review (1996, p. 51) also mentioned that this

report may well represent the highest reference point for financial reporting in

government trading enterprises.

Other organisations that support the deprival value method of asset valuation are NWI

Pricing Principles, agreed in 2004 by the COAG and the SCARM (National Competition

Council 1998, p. 112). Both the COAG (National Competition Council 1998, p. 112;

Australian Government 2009, pp. 4–5 & 7) and the SCARM (NCC 1998, p. 112) have

recommended the deprival value method for the valuation of water business assets, and

conceded that deprival value should be set as the minimum of the DORC and/or the EV,

which represents the present value of the revenue stream those assets will generate.

Similarly, clause 6.2.3(d)(4)(iv) of the National Electricity Code (2005, p. 13) states that

the Commission must have regard to the agreement made by the COAG on 19 August

1994, which stated that deprival value should be the preferred approach to valuing

network assets. Deprival value, based on capital maintenance concept, is derived from a

desire to improve the measure of financial performance of government-business

enterprises. Even though these guidelines are not binding on state governments, they have

215

in practice been influential in determining accounting requirements placed by

governments on statutory and government departments.

In 2009, a draft copy of NWI was released, followed by endorsement of the deprival

value concept by the COAG and the Ministers of the ARMCANZ in 2010. The deprival

value method is recommended for asset valuations underlying the determination of water

utility business revenue requirements and definitions of asset-related cost in the provision

of water services. The water industry‟s current regulatory frameworks are based on a

combination of legislation, regulatory instruments and decision-making bodies. The

timeline of the development of NWI and Water Pricing Principles and its relation to the

deprival value concepts are summarised in Figure 7.1 (below).

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Figure 7.1: Timeline of the development of the NWI and Water Pricing Principles

and its relation to the deprival value

2010: The NWI Pricing Principles was endorsed by the Natural Resource Management Ministerial Council. Among other things, the deprival value methodology is recommended for asset valuation for charging purposes. It was established in the COAG Pricing Principles that water businesses would not engage in monopoly pricing. Asset valuation should be

determined by the deprival value methodology.

2009: Draft copy of NWI Pricing Principles released.

2004: The NWI became the blueprint for water reform. It was agreed by the Commonwealth and state and territory jurisdictions at the COAG meeting. The National

Water Commission has to date accredited nine states' NWI plans.

2000: Explicit guidance on the principles for water pricing were found from the Water Act 2000. Section 346 (3d)(ii) states that pricing should be consistent with government

commitments under inter-governmental agreements, including the NWI.

1998: ARMCANZ refined the COAG Water Resource Policy. The upper bound pricing is the MAR for water businesses. Price of water is set to recover all costs, including a return on

capital equivalent to the WACC.

1994: The NWI was built based on the 1994 COAG's Strategic Water Reform Framework. The deprival value was endorsed by the COAG as the preferred approach to valuing network assets for public reporting processes (performance monitoring) and ARMCANZ as a basis for

water pricing; unless specific circumstances justifies another valuation method.

1994: The COAG developed Guidelines on Accounting Policy for Valuation of Assets of Government Trading Enterprises using Current Valuation Methods.

1990: The COAG set up the SCNPM of Government Trading Enterprises.

1976: The deprival value concepts were found in Statement of Accounting Practice No. 1 (SAP 1).

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In addition, Walker et al. (2000, p. 132) asserted that in Australia “the deprival value

accounting, a variant of the replacement cost has become the dominant public sector

accounting method”. In theory, IPART (1998, p. 35) and the ACCC (1998a, p. 8)

conceded that deprival value was the preferred valuation method for network assets in the

COAG agreement in August 1994 (p. 35; Australian Competition and Consumer

Commission 1998a, p. 8).

To date, only a small part of CCA practice has been adopted by the private sector, to

revalue non-current assets and the requirement for downward revaluation to recoverable

amount, as regulated by Australian Accounting Standard AASB 1010, Accounting for

Revaluation of Non-current Assets. There is evidence that a system that best reflects the

CCA has been modified from historical cost, which resembles current practice in the

United Kingdom.

7.4 The ‘O’ in the ODV

So far in this chapter, we have discussed the general issues relating to assets and how

asset valuation for water utility businesses plays a central role in the final price-setting of

water. We identified that the deprival value method is the preferred method of water

utility businesses‟ asset valuation; in particular, both the COAG and the SCARM support

its use. The SCARM (National Competition Council Compendium 1998, p. 112) requires

that assets be valued on deprival basis for price-setting, which is the lesser of the DORC

or the EV.

The „O‟ in ODV and DORC, (an extension of the ODV) is a process that involves

adjustment of asset valuation to reflect changes in the required deployment, modernity

and the scale of assets to achieve the same level of services as supplied by the existing

assets. It can range from only elimination of surplus assets to complete redesign of

operations at the other (greenfield).

Optimisation is consistent with deprival value philosophy, and it has been suggested that

if a network owner is deprived of the assets, those assets should be optimised out. In

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general, there are two types of optimisation (Ministry of Economic Development 2002, p.

112).

Firstly, greenfields optimisation is the hypothetical designing and building of an entirely

new, optimal collection of assets for the entity. This approach assumes that the network

would be completely redesigned in such a way that it will have optimal planning horizon

capacity and minimal operating cost. For example, in an airport context it involves a

complete redesigned or re-engineered airport, possibly at a different location. In a water

utility business, this could be the use of a completely new alignment, reduction in number

of assets, or an increase in the load carrying capacity, leading to lower operating costs

using the most modern technology and available equipment (PricewaterhouseCoopers

1999, p. 5; Ministry of Economic Development 2002, p. 112).

The National Asset Management Steering Group (2006, p. 4.10) has previously noted

some examples of greenfields optimisation. For instance, in case of water supply

businesses, it can be found in the mains and service connections, which are the most

significant asset groups in a water distribution network. However, the nature of the

mains‟ staged construction and possible changes in its design or other policies over the

years can present greatest optimisation opportunities.

PB Associates (2002, p. 11) also established that a greenfields approach to optimisation is

applied, where a completely new network is configured, is the most efficient way, having

no regard to the existing network design. However, the downside to this approach is that

it ignores the fact that networks evolve over an extended period and may have to be

adapted in response to changing patterns of supply and demand. Most regulators have

therefore generally accepted an incremental (brownfields) approach to optimisation.

The second type of optimisation is the lower level known as „brownfields‟ – the

„incremental‟ or „in the ordinary course of business‟ approach. The brownfields approach

involves replacement of under-utilised and removal of redundant assets, and it retains the

historical configuration of key assets. The existing assets will be replaced using

fundamentally the same techniques and configurations, as it does not involve a total

redesign of the way services are delivered or of processes or networks.

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However, brownfields optimisation is limited to individual assets or perhaps a „regional‟

reconfiguration, which does not involve optimisation of the entire system. In the case of

the airport example, this would be completed in the context of the current site only

(PricewaterhouseCoopers 1999, p. 5; Ministry of Economic Development 2002, p. 112).

The result of optimisation may be a reduction in size of mains due to changing acceptable

pressure ranges, based on current demand plus growth allowance being less than the

projected demand at the time when mains were constructed, or overall reduction in total

lengths through elimination of redundant or duplicate mains along the same streets and

unnecessary interconnections (National Asset Management Steering Group 2006, p.

4.13).

Some examples of optimisation of water infrastructure assets are downsizing of pipe

networks. Pump stations such as buildings housing electrical equipment being replaced by

modern control cabinets and valued at modern cost is another example of the optimisation

of pump stations. Water pumps can be made redundant because of system reconfiguration

and additional storage.

Table 7.1: Optimisation of water networks

Activities Issues/constraints

Remove

unnecessary lengths

- Identify abandoned mains, duplicate mains, dead ends, etc.

- Ensure current consumers still served.

- Ensure security of supply satisfied.

- Ensure existing supply points (e.g. service reservoirs) are

maintained

Reduce size of over

capacity assets

- Any reduction should exclude nominal or planned growth, which

is necessary for safety or standby purposes.

Apply optimum

sizes to remaining

assets

- Consider standards applicable, levels of service to be delivered,

and minimum sizes for efficiency.

Apply MEA

materials to

- Consider applicable standards.

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remaining assets

Establish optimum

set of assets

(National Asset Management Steering Group 2006, p. 4.13)

Even though Table 7.1 (above) sets out the brownfields (incremental) optimisation of

water networks, it can be applicable for other network types, such as roads.

In particular, support for the concept of incremental optimisation can be found in

paragraph 52 of SAP 1, which states that:

In determining current cost with reference to the most appropriate modern facility, the

modern facility should be of economically available technology and should not

require a redesign or re-engineering of an existing of an existing entity‟s plant.

In a related report, the Energy Regulatory Commission (2009, p. 17) claimed that the

brownfields approach is widely used for DORC valuations, including electricity, gas and

water infrastructure assets in most countries that have adopted the DORC or the ODV

techniques. It is considered an appropriate approach because it is consistent with the

deprival value concept of establishing the potential business‟s lowest alternative cost to

replicate the network. A duplicate network would need to be built in the existing

environment in the ordinary course of business, instead of a complete system redesign.

However, there are cases where practitioners have supported more of a greenfields

approach to optimisation, such as the Victorian Government offering substantial direct

funding under a tender process outside of the provisions of the National Gas Code

(because its competitive tender provisions failed to result in any successful projects

completions) and pressing for reform of the National Gas Code‟s greenfields provisions

as a longer-term solution (TXU Australia 2003, p. 9).

Some of the optimisation possibilities and adjustments required are set out in Figure 7.2

below.

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Figure 7.2: Degrees of optimisation

(Commerce Commission 2002, p. 36; Ministry of Economic Development 2002, p. 112; New Zealand

Infrastructure National Asset Management Steering Group 2006, p. 3.2)

7.5 Steps involved in ODV

Examples of steps involved in ODV have been adopted from other utility sectors.

Practically, the ODV asset valuation method, which is applicable to valuing a system of

fixed assets, consists of the following steps.

Figure 7.3: Steps involved in the ODV

Low •Reproduction of existing assets – surplus assets eliminated

↓

•Surplus assets eliminated – technological obsolescence eliminated

↓ •Over-design eliminated

↓ •Site re-configuration; highest brownfields

↓ •Changed location

High •Complete or greenfields approach

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In Figure 7.3, the first step is to prepare a detailed asset register. It involves collection of a

comprehensive asset register of system fixed assets and their configuration. All utility

businesses should keep a comprehensive database for their assets, which can be used for

optimisation calculation and application of EVs. Ideally, the database should be

computerised to facilitate sorting and reporting in accordance with various numbers and

levels of sort keys (e.g. age, asset type, physical capacity, location, quantity). The

network register has to be built up from and be divided into relatively small segments to

allow for adequate optimisation and application of the EVs (Ministry of Economic

Development 2000, pp. 13 & 17; PB Associates 2002, p. 6).

Asset registers should be checked for consistency, and therefore sample checks should be

carried out to verify that quantities and ages recorded are accurate within reasonable

limits. The system fixed asset register should be in a form that facilities scrutiny and can

give an understanding of how it was composed (Ministry of Commerce 1999, p. 16;

Ministry of Economic Development 2000, pp. 17–18). The QCA (2006) reported that its

asset register containing a list of likely system fixed assets of a water utility business

needs to be valued; for example, reservoir, pump station, valve and hydrant.

The second step is to prepare existing system fixed assets to be economically valued at

their estimated replacement cost of their MEA. That is, if a business was deprived of the

use of an asset, it would not replace it with the same or equivalent asset; instead it would

1. Prepare a detailed asset register

2. Prepare existing system fixed assets to be valued at modern

equivalent asset (MEA)

3. Existing system's fixed assets are subjected to

depreciation

4. System optimisation

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replace it with a MEA that is able to provide a similar level of service (Ministry of

Economic Development 2000, p. 18; PB Associates 2002, p. 6).

System fixed assets are to be valued using the replacement cost of MEA that would be

installed today, such that it would provide the same level of service as the assets already

in place. The assets must be able to be constructed or purchased at the time of the

valuation with current technology, and should have lowest lifetime cost. The MEA

(including costs for all materials, labour, plant and overheads) should not reflect

improvements required by legislative changes made since the assets were first built or

installed, regardless of whether the existing assets have to comply with additional

requirements. Such improvements would result in higher replacement costs (Ministry of

Economic Development 2000, p. 18; Energy Regulatory Commission 2010, p. 20).

Lower values can be applied; however, maximum values for MEAs are not to be

exceeded. Specifically, the maximum replacement costs and the maximum asset lives are

not to be exceeded for the purpose of assessing the DRCs of system fixed assets (Ministry

of Economic Development 2000, pp. 18 & 41).

Some indicators that can be used to determine what assets to select for costing when

determining MEA include the asset‟s proven reliability of the technology, its functional

compliance with modern operating requirements, and its least lifetime costs (taking

account of all aspects of performance, including losses) (Ministry of Economic

Development 2000, p. 18). Where there is no guidance on how to value particular major

assets, the valuers should obtain cost estimates from manufacturers or suppliers of those

major assets. The replacement cost and total asset life assumptions used should be

explicitly identified in the valuation report (Ministry of Economic Development 2000, p.

18).

After the quantities and the replacement costs of assets have been determined, costs need

to be depreciated. This is the third step where the replacement cost of a system fixed asset

is subject to depreciation, to reflect its remaining economic life, because an older asset,

which has not been refurbished, does not have the same service potential as a new one.

The existing asset‟s remaining life is less than the life expected from a new asset, and

depreciation will effectively recognise the limited remaining life of the asset.

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The straight-line method of depreciation should be used such that the depreciated value

(DV) is determined as:

DV = UDV x RL/TL

Where, UDV = undepreciated value [i.e. replacement cost]

RL = remaining life

TL = total life.

It can be observed from the above that both total life and remaining life need to be

established for all assets (Ministry of Economic Development 2000, p. 19). The

maximum total life of an MEA is not to be exceeded. However, total life lower than

specified may be used and may be appropriate in some circumstances (Ministry of

Economic Development 2000, p. 19).

The life of each asset commences when the equipment is commissioned. The age of the

asset is subtracted from its total life to determine its remaining life. The age of assets for

initial ODV valuations is determined from records establishing the age, or where

necessary from engineering assessments of the age. If engineering assessments have been

carried out for one valuation, the age in successive valuations should be based on the

same assessment. It is not allowable to reassess the time of installation of the asset unless

clearly documented (Ministry of Economic Development 2000, p. 20).

Grouping of assets and assessment of weighted average remaining life is acceptable in

circumstances where materiality of the value of assets is not an issue, and where data of

the assets were available but complex calculation could not warrant determination of age

(Ministry of Economic Development 2000, p. 20).

When an asset becomes redundant as part of the development of a system, it will be

considered as retired early from service. However, in such instances, it should not be

taken into account when assessing the remaining life of that asset. Instead, when a class

of assets is routinely replaced as part of the evolution of the system before its technical

life expires, it should be taken into account when assessing the total life for that class of

assets (Ministry of Economic Development 2000, p. 20).

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The fourth and final step is system optimisation. It is undertaken only after replacement

cost and DRC of the existing network asset base have been calculated, as already done in

the second and the third step (Energy Regulatory Commission 2010, p. 22).

7.6 System optimisation

The MED of New Zealand (2000, pp. 14 & 21) established that system fixed assets are

subject to optimisation if it is no longer in use and have excess capacity or over-design,

on the basis that if the business was deprived of such assets it would just install

appropriate assets necessary to provide the required type and level of service. Excess

capacity assets have been defined as assets with a greater service capacity than necessary

to meet the service delivery outputs within the entity‟s business and total asset

management planning horizon, while overdesigned assets have features unnecessary for

goods or services that the asset provides (National Asset Management 2007, p. 16;

Energy Regulatory Commission 2009, p. 22).

Optimisation should be based on the reasonable expected level of use of the asset,

determined with reference to the required level of service potential or output, consistent

with reasonably foreseeable future demand and the objective of minimising the whole-life

costs of assets. However, both projecting growth and the issue of what represents a

reasonable timeframe are problematic, as they each have a degree of subjectivity in their

determination. Many infrastructure assets are long-life and have a high capital cost, and if

an artificially short timeframe is adopted, it can have a distorting effect on this type of

asset valuation (Energy Regulatory Commission 2009, p. 21).

Optimisation will either remove any surplus assets or excess capacity from network

elements, given the required level of service and network capacity, or it will make an

adjustment to the valuation. Permanent excess capacity and any redundant assets or

components that are not used should not be assigned a value.

Overdesigned, gold-plated assets should also not be included in the replacement cost of a

MEA. If an adjustment is required, the assets should be adjusted to reflect the cost of

replacing the existing service potential during valuation, based on an efficient set of

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MEAs to achieve the required level of service output within the entity‟s planning horizon

(National Asset Management 2007, p. 16; Energy Regulatory Commission 2009, p. 22).

It should be stressed that optimisation is not concerned with improving the system from

its current state. The system does not need notional redesigning to be better than it already

is, regardless of its capacity or other standards, as this would cost more. Optimisation will

only result in cost reduction for valuation purposes where alternative lower cost

replacement options are available. Optimisation cannot increase the value of the asset,

and in no circumstances should the optimised capacity exceed the current system capacity

(Ministry of Economic Development 2000, pp. 14 & 21; National Asset Management

Steering Group 2006, p. 4.10; National Asset Management 2007, p. 16).

The process of optimisation consists of three stages: identification of stranded assets,

optimising system configuration, and optimising elements in the system (Ministry of

Economic Development 2000, p. 21; Energy Regulatory Commission 2010, p. 22). Any

system fixed assets that are not required to supply distribution services to existing

consumers should be identified and excluded from the optimised network; such assets are

known as „stranded assets‟. These assets are value at NRV and assign a value to „other

businesses‟.

System fixed assets less stranded assets will determine the DRC. Stranded assets may be

valued as network spares. If this is the case, it shall be assigned a zero value for the

purposes of calculating the ODV (Ministry of Economic Development 2000, p. 24;

Energy Regulatory Commission 2010, pp. 26–27).

When the asset is optimised to zero value, it means that it is no longer required. This asset

can then only be reinstated if, for example, there is an increase in demand. The utility

business‟s revenue must increase because it is now effectively providing additional

services, as it has satisfied new demand, and the value of the investment in used and

useful assets has increased (Transpower New Zealand Limited 2006, p. 32).

The utility business‟s engineer or other suitably qualified person carries out optimisation

of system configuration. This requires good current knowledge of system planning, as

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optimisation is concerned with redesigning of the system configuration (Ministry of

Economic Development 2000, p. 24; Energy Regulatory Commission 2010, p. 27).

Next, optimisation of system configuration must be carried out by considering alternative

configurations and identifying the one which satisfies relevant optimisation criteria at

minimum overall replacement cost (Ministry of Economic Development 2000, p. 24;

Energy Regulatory Commission 2010, p. 27).

However, the process of optimisation does not include determination of MEA that would

replace existing individual network components. This must be done prior to calculation of

replacement cost, and for most networks‟ components should have already been taken

into account (Ministry of Economic Development 2000, p. 21; Energy Regulatory


Once configuration of the system has been optimised, the elements within that system

should be optimised by considering whether lower capacity, more cost-efficient elements

with a lower replacement cost would be adequate. The excess capacity would be valued at

nil. The engineering of the network has to be examined at this stage to confirm that the

optimised asset base is not over-engineered, which may occur if parts of the existing asset

base are engineered to a standard that exceeds the current practice, or if a more cost-

efficient arrangement or configuration should be used if the existing assets were replaced

(Ministry of Economic Development 2000, p. 24; Energy Regulatory Commission 2010,

p. 27).

The Energy Regulatory Commission 2009 (p. 22) identified over-engineering assets

(based on today‟s standards) as either having a longer life or lower life cycle costs than

the MEA. Any level of over-engineering consideration can be determined by going back

to the basic principles of this valuation, which is the minimum cost of replicating the

service potential embodied in the network with a MEA. To a certain extent, whether an

asset is considered to be over-engineered is subjective and will change over time.

If it is found that a more cost-efficient arrangement would result from applying existing

engineering standards, the relevant assets will change and be replaced by a notional asset

arrangement that reflects current best practice. Minimum tests are carried out in

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optimising the network capacity (Ministry of Economic Development 2000, p. 24; Energy

Regulatory Commission 2010, p. 27).

Lastly, network equipment spares may be included in ODV as long as the spares are the

same as the assets previously installed in the network. That is, the quantity of the spares

to be valued in the ODV must not exceed a reasonable quantity required (Ministry of

Economic Development 2000, p. 24; Energy Regulatory Commission 2010, p. 27). Figure

7.4 below summarises the steps that should be taken in carrying out optimisation and

shows how they fit together.

Figure 7.4: System optimisation

(Ministry of Economic Development 2000, p. 26; Commerce Commission 2006, p. 16)

After the optimised system has been determined, the parts in which the optimised network

are different from the existing network have to be revalued by applying the cost of MEA

and ensuring that these assets are depreciated to reflect the service potential of the

existing assets. Assets that are notionally brought into the network from the result of

optimisation should be valued at their replacement cost to determine the total replacement

cost of the system fixed assets. The aggregate of individual replacement costs of the

Define demand load requirements

Remove stranded assets, valued at NRV,

and assign value to 'other businesses'

System less stranded assets. Determine

DRC

Optimise configuration. Excess

assets are value at NIL

Useful existing and new notional assets

Optimise elements. Excess capacity are

valued at NIL

Optimised systems are value at DRC to give the 'O' of the

DORC

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system fixed assets in the optimised system will produce the total ORC for the network

(Ministry of Economic Development 2000, p. 25; Energy Regulatory Commission 2010,

p. 28).

Some constraints in the process of optimisation are that the potential level of service of

the optimised network should not exceed that of the existing network, and no part of the

network should exceed its disclosed quality of supply criteria unless non-standard

contracts with consumers exist that enhance quality of supply. The locations of points of

connection to other networks should be assumed to be fixed, which can be readily

bypassed and will allow a reduction in the replacement value of the utility business‟s

assets. If this is the situation, then that fixed point of connection shall be deleted for

valuation purposes, and a more cost-efficient network shall be included. The location,

number of existing consumers and existing boundaries of the utility business should be

assumed fixed, and the optimised network should use standard equipment, ratings and

sizes to optimise construction and maintenance practices (Ministry of Economic

Development 2000, p. 21; Energy Regulatory Commission 2010, p. 22).

Two examples of optimisation of water assets are discussed further in Appendix 1.

7.7 Valuation of the ODV at EV

The ODV methodology involves the following steps, as summarised in Figure 7.5 below:

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Figure 7.5: Steps in the ODV

Steps (a) (i) to (v) have been discussed earlier. With regard to step (b), determination of

the EV, in practice the ODV is the DORC plus an EV assessment. An EV assessment is

applicable to both the replacement cost and the historical cost valuations. If the DORC is

less than the EV, then DORC is the appropriate ODV. That is, if the system of assets was

deprived of the asset, the owner would replace it with a technically optimal equivalent.

In contrast, if the EV is less than the DORC, then the EV is the appropriate measure of

the ODV, since it would be replaced with an economically preferable alternative. In

essence, the EV of an asset to the user is the minimum cost of replacing the asset with a

more economical alternative. The asset must be capable of providing the same level of

service as before.

System fixed assets are valued at their EV when it would not be possible for them to earn

sufficient long-run profits to provide an appropriate return on the DORC of the assets.

These assets are unlikely to continue past their useful life that it will be servicing;

therefore making it commercially unsustainable in the long run. This is because profit

maximising revenue that they could generate is insufficient to cover all costs and allow an

appropriate return to be made on DORC of the assets. Put differently, parts of the system

(a) Calculation of the DORC

(i) Prepare a detailed asset

register

(ii) Calculate the RC using modern equivalent asset

(MEA) values

(iii) Assessment of depreciation

(DRC)

(iv) System Optimisation

(v) Determination of the DORC

(b) Determination of the EV

Determination of the ODV; ODV =

minimum (DORC/ EV)

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are incapable of generating a commercial rate of return on their DORC valuation. In this

case, a detailed DORC valuation need not be undertaken, and the EV of the asset must

instead be derived.

Where this is relevant, the owner would not replace the asset, as to do so would be

irrational. The present value of future earnings would be less than the cost of replacing

the asset. The EV is the loss to the owner in this deprival situation. Therefore, when the

EV of an asset is less than its DORC, the ODV is its EV (which is the maximum of the

NPV of earnings or the NRV) (South Australian Centre for Economic Studies 1998, p. 8;

Queensland Competitive Authority 1999, p. 9; Ministry of Economic Development 2000,

pp. 15 & 27; New Zealand Institute of Economic Research 2000; p. 7; Commerce

Commission 2002, p. 50; Sinclair Knight Merz 2005, p. 1; Energy Regulatory


The NPV of the earnings or the NRV is the net increase or decrease in welfare, which

arises from the owner being deprived of the use of assets. This NPV of earnings or the

NRV can be estimated over a period of time.

The ODV method and the EV option measure the extent of welfare loss on deprival. The

assumption used in the EV option is that there is rational behaviour in the market, and

participants are driven by profit-maximising motives. Regardless of the price of water, the

water utility businesses will utilise the lowest cost production units, taking into account

cost and capacity, and availability of resources and demands. Consistent with the delivery

of economic efficiency, where production of the required output should be at the lowest

cost possible, this market mechanism developed in place will ensure that the lowest costs

of production are utilised (Transpower New Zealand Limited 2002, p. 80).

The MED (2000, pp. 27–32) accurately identified the approach used to calculate EV (the

maximum of present value and NRV). This involves, firstly, the selection of network

segments (with reference to feeders and spurs for local distribution businesses and to

point of supply), which are based on those parts of the network that apply certain general

and specific criteria which are least likely to be economical.

Next, having identified the segments for which the EV must be calculated, the (long-run)

profit-maximising line tariffs that could be charged for consumers on the segments to be

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tested would have to be determined. Using these (long-run) profit-maximising line tariffs

(i.e. the maximum revenue that could be earned from each segment), the EV can be

calculated either as the maximum of the present value or the NRV of each segment.

The present value of an asset is the EV (i.e. at the time t = 0) of the system fixed assets in

the segment. The NRV of an asset is its value at its best alternative use. It is most

commonly viewed as the scrap value of the asset, and is the proceeds, less the costs of

realisation. That is, if the NRV of an asset exceeds the present value of cash flows that

can be obtained from the asset, the EV of the asset is its NRV.

Finally, the valuation of the asset in a segment at the EV should be determined where it is

less than the DORC. Figure 7.6 below illustrates the prescribed ODV method.

Figure 7.6: Prescribed ODV method

(New Zealand Institute of Economic Research 2000; p. 17; Commerce Commission 2002, p. 56)

As described in the illustration above, the first step is to prepare a detailed asset register

of the existing system fixed assets and their configuration. This is the starting point for

DORC

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assets valuation. Next, system fixed assets are valued at their replacement cost. This is

determined by the use of MEAs that are capable of providing the same level of service as

existing assets. The maximum standard replacement costs for MEAs are prescribed for

majority of assets. These replacement costs are not to be exceeded, to ensure objectivity

and consistency. Following the calculation of replacement costs, the existing asset ages

(or its remaining asset lives) are recognised by providing for its depreciation or its DRC.

To ensure objectivity and consistency, the maximum standard asset lives are prescribed

and are not to be exceeded.

Having calculated the asset‟s DRC, the next step is to optimise the distribution network.

With the objective of mimicking the outcomes in a competitive market, system fixed

assets are optimised – some may be notionally removed from the distribution network to

recognise any surplus assets or excess capacity. The required levels of service, quality of

supply and network capacity are only some of the aspects that should be taken into

consideration when conducting optimisation.

System optimisation involves redesigning the network using MEAs, changing the

configuration and size of components to meet forecast demand and growth at the end of

the relevant planning period, as prescribed, varying between three and five years, and to

meet existing or published minimum quality standards, at least cost. The number and

location of network connections are assumed to be fixed, and optimisation can only result

in reduction of the value of system fixed assets. It cannot be used to notionally improve

the system network, as this would cost more. The optimisation process involves

considerable engineering expertise, and typically makes reference to traditional or

conventional engineering practice. Therefore, to determine the DORC, an existing asset is

optimised out (excluded from valuation) and replaced by a notional asset. The notional

asset is depreciated on the basis that its remaining life is equivalent to the life of the

existing asset.

In conclusion, to determine the EV as either the maximum of the present value or the

NRV involves the selection of network segments, the determination of profit-maximising

line tariffs is important, and then using the same assets to calculate the EV.

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7.8 Summary

The deprival value methodology is recommended for asset valuation for the purpose of

water pricing. All three important water industry organisations – the COAG, the SCNPM

of Government Trading Enterprises and the NWI – have recognised the deprival value

basis for price-setting.

This chapter provided an overview of CCA and its development in Australasia. CCA is

deemed important, because the deprival value is a part of CCA standards in Australia,

Canada, New Zealand, the United Kingdom and the United States. It is not mandatory,

but it is currently a requirement for utility companies such as water businesses to account

for their regulatory assets and liabilities.

CCA has been used as an alternative to counter problems associated with HCA. It is one

of a number of inflation accounting methods, also defined in the current 2012 Framework

for the Presentation of Financial Statements, paragraphs 102 to 110, as capital

maintenance used to maintain the operating capability of a business. In accounting, the

capital maintenance concept is the value of capital, which is determined before the

amount of profit can be computed. It is based on the assumption that capital of the entity

has to be either restored to its original level or maintained at a predetermined level before

profit can be realised. Calculation of CCA can be done after charging the current cost

consumed and its deprecation.

The issue of capital maintenance is important in relation to water businesses. If water is

under-priced it will result in erosion of its capital base, which will undermine the capacity

of the business to remain financially viable. On the contrary, over-pricing will result in

water businesses extracting monopoly rents from consumers.

More importantly, under- or over-pricing water contradicts the policy set by the NWI,

paragraph 65, which notes that “all states and territories agree to bring into effect pricing

policies for water storage and delivery in rural and urban systems that facilitate efficient

water use and trade in water entitlements, including the use of full recovery for water

services to ensure business viability and avoid monopoly rents.” It is reasonable to

conclude that deprival value is acceptable as a practically applicable valuation method, as

235

it has been featured in both the past and current accounting standard with regards to

accounting for the effects of changing prices in numerous jurisdictions.

In terms of valuation for water infrastructure assets, there is no guidance in the Australian

accounting standards as to which valuation techniques are acceptable to all entities in all

circumstances, or which of the available techniques should only be applied in certain

circumstances whenever appropriate.

However, the IASB issued its Exposure Draft, Rate-regulatory Activities, on 23 July

2009, which is applicable to water businesses because it restricts the setting of prices that

are charged to consumers for utility services or products, such as water. The standard is

imposed by the regulator or government when the entity enjoys monopoly or a dominant

market position. The proposal, if adopted, will allow for assets and liabilities that arise

from rate-regulated activities within the scope of the Exposure Draft to be recognised

under the IFRS. To date, the IASB is undecided as to whether Rate-regulatory Activities

should be recognised in accordance with the current Framework, and whether they are

consistent with other IFRS.

At present, IFRS 14 Regulatory Deferral account balances was issued by the IASB on 30

January 2014 to provide interim guidance on accounting for regulatory deferral account

balances by first-time adopters of IFRS to allow the Board to consider comprehensive

guidance on accounting for the effects of rate regulation.

This chapter followed on to examine the steps involved in the asset valuation method

using ODV, as recommended for charging purposes. That is, it is based on assessment of

the DORC and the EV of the system fixed assets. That is, if the DORC value of an asset

is lower than the EV of the asset, then the DORC is the appropriate value for the asset,

because if the system was deprived of the asset, it would be replaced with a technically

optimum equivalent.

The basis for ODV of asset valuation is to value assets at the level at which the water

business can be sustained and no more, to reflect the cost of providing the service in an

economically efficient manner. System fixed assets that are uneconomical would not be

replaced. Such assets are valued at their EV, which is the amount a business deprived of

236

the assets would be willing to spend on replacement assets to provide the same level of

service.

In practice, the ODV applicable to valuing a system of fixed assets consists of, firstly,

detailed preparations of the asset register. It involves the collection of a comprehensive

asset register of the system fixed assets and their configuration. This is the same database

used for the purpose of calculation of optimisation and the application of the EVs.

Secondly, existing system fixed assets are valued at their MEA. That is, when a business

is deprived of the use of an asset, it would replace the asset with an MEA that is able to

provide a similar level of service. Thirdly, the replacement cost of a system fixed asset is

subject to depreciation to reflect its remaining economic life, since an older asset that has

not been refurbished does not have the same service potential as a new asset. The final

step is system optimisation. This step can be undertaken only after the replacement cost

and the DRC of the existing network asset base have been calculated, as discussed in the

second and third step.

The following chapter discusses the research methodology used for this thesis.

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Chapter Eight: Research Methodology

8.1 Introduction

This chapter contains the methodological framework for this research project. Research

methodology entails the procedures for describing, explaining and predicting the work

plan phenomena of a research project. A research methodology decision is one of the

most important, as it must not only be capable of supporting the research, but should also

facilitate accomplishment of the main aim of the research from beginning through to

completion. This chapter is structured as follows.

Section 8.1 provides an introduction to the chapter, followed by a general overview of

research methodologies in section 8.2. Section 8.3 provides an overview of accounting

research and how accounting research affects the world. Accounting as a social science

discipline should not be studied in its own, but must take into consideration broader social

and political objectives. Modern accounting research must seek to enhance the

understanding of the relationship between accounting and these wider objectives.

Section 8.4 explains the types of research methodologies used in accounting, including a

discussion of the main research methodologies used. The first accounting research and

methodologies was undertaken by Oler, Oler and Shousen. To date, with the increasing

availability of externally reported financial statements and stock price information,

research into financial accounting and archival research has become more common.

Section 8.5 discusses the case study methodology approach that is used in this thesis. Five

different types of case studies – descriptive, illustrative, experimental, exploratory and

explanatory – are discussed.

Section 8.6 looks at the specific case study methodology used in this thesis – the

exploratory case study approach. Simulations of different asset valuation techniques and

steps involved in exploratory case study are also discussed in this section. This section

provides information on the process of preparing and collecting data for this thesis. The

archival data collection and quantitative (numerical) research method was used in this

thesis. Information from data collections are kept on record before analysis of important

issues are finalised in Chapter Nine.

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8.2 Research methodology

The Shorter Oxford English Dictionary defines a methodology as the „science of

method‟, or more historically as a „treatise on method‟. It is the activity or business of

choosing, reflecting upon, evaluating and justifying the techniques used in research.

Without knowing the research methodology, no-one can access or judge the value of that

research. Put simply, the purpose of research methodology is to describe and analyse

methods, throwing light on their limitations and resources, clarifying their suppositions

and consequences, and relating their potentialities to the „twilight zone‟ at the frontiers of

knowledge (Kaplan 2004, p. 23).

Historians and sociologists of science, such as Bocchi and Ceruti (1981), Latour (1991),

and Oldroyd (1986) (cited in Quattrone 2000, pp. 132–133), have characterised the

contemporary organisation of human knowledge via a twofold process of

institutionalisation, known as the hierarchical „Encyclopaedia‟ as shown in Figure 8.1

below. The work in this thesis is predominately accounting-focused, although some

aspects of economics are also discussed. In general, accounting researchers established a

political, social and economic order for it to reach a level of importance to be recognised

as a discipline. This is evident based on both the quality and quantity of accounting

research output.

Figure 8.1: The hierarchical organisation of the Encyclopaedia

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(Quattrone 2000, pp. 132–133)

Figure 8.2 (below) provides the main research methodologies used in social sciences, all

of which have been used by researchers in important, creative and engaging research

projects. These research methodologies not only give some indication of the depth and

complexity in social sciences research, but also provide a succinct introduction to the

more frequently used research methodologies.

Figure 8.2: List of research methodologies in social sciences

The Universe of Knowledge

Natural sciences

Physics

Chemistry

Social sciences

Economics

Accounting

Financial accounting

Management accounting

Sociology

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(Quinlan 2011, pp. 104, 179 & 182)

Ethnography research represents ways of studying cultures through methods that involve

becoming highly active within that culture. That is, when a researcher wants to carry out

an in-depth examination of a culture, ethnography research calls for observation in the

field of the phenomenon under investigation. For example, an ethnographer can simply

become part of the environment by allowing children to do what they do naturally and

recording their behaviour (Zikmund, Babin, Carr & Griffin 2010, p. 139).

Alternatively, action research was developed by Professor Kurt Lewin from

Massachusetts Institute of Technology in 1944. He described action research as a form of

research that involves collaboration between social scientists and practitioners in their

attempt to understand a social problem. For example, Lewin‟s own action research related

to the problem of minorities in the United States.

Action research is used to bring about change, improvement and development in the

quality of any organisation, and/or in the practice or performance of any team, group or

organisation. This research is a particularly effective approach to problem-solving in

organisations. One form of action research widely used in development research is the

Survey Case study

Experimental design Ethnography research

Action research Grounded theory Content analysis

Discourse analysis Documentary analysis

Historical analysis Life history

Phenomenology research Narrative analysis

Semiotics Attitude research

Image-based research Archival research Textual research

Meta-analysis Feminist research

http://en.wikipedia.org/wiki/Action_research

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participatory action research. In accounting, Liu and Pan (2007, pp. 249–264) used

participatory action research to successfully develop an Activity-based Costing system for

a large Chinese manufacturing company with no previous theory tested or generated.

Grounded theory methodology is an inductive investigation where specific focus is on

building theory from data. The researcher poses information provided by respondents or

taken from historical records. The researcher questions one's self, and the responses are

repeatedly questioned to derive deeper explanations. Questions can also be applied to

visuals in an effort to develop the theory (Zikmund, Babin, Carr and Griffin 2010, p.

140).

Phenomenology research methodology, in contrast, is a philosophical approach used in

the social sciences to experience live situations (e.g. a worker in a factory, the CEO of a

company, or an undergraduate business student) from a first-person point of view.

Narrative research or analysis is a methodology used to gather and analyse narratives.

Often narratives data or personal experience stories narrated to the researcher are gathered

and analysed. For example, narrative was developed around Lara Croft, a fictional

character from Square Enix video game series Tomb Raider, and her image was used to

promote diverse products from video games, magazines, credit cards to soft drinks.

Historical research or analysis is a method that explores and analyses the history of

certain phenomenon. For instance, useful lessons can be learned from studying the history

of companies such as Apple Computer Inc. or the Microsoft Corporation.

To add to this, life history methodology is used to compile life histories of different

people in order to understand the changes that have occurred in their lives. It can also be

used to compile the life history of changes that have occurred in the life of a company.

Other than observing people and physical objects, researchers may use content analysis to

obtain data by observing and analysing the contents or messages of advertisements,

newspaper articles, television programs, letters and so on. For example, content analysis

can be used to explore the information content of television commercials directed at

children, the company images portrayed in adverts or other aspects of advertising.

242

Documentary analysis or research is a methodology that involves the systematic analysis

of data in the form of documents or data drawn from written documents such as books,

papers, magazines, notices, letters and records.

Meta-analysis is a quantitative research analysis of the amalgamation of previously

existing research data sets. This methodology involves analysis of quantitative data sets

from previously conducted research projects, in combination. However, meta-analysis is

dependent upon the validity of existing data sets, so the possibility of error is large when

using this methodology.

8.3 Overview of accounting research

Accounting is known as the language of business. Oler, Oler and Shousen (2009, p. 3)

claimed that accounting research is a literature that not only draws from but also adds to a

larger body of work dealing primarily with businesses, as well as their interactions with

society at large through capital markets. One of the most important arguments regarding

accounting research was put forward by Hopper and Powell (1985, p. 450), that

accounting as a social science should no longer be studied in a mode that is divorced from

its social context and that ignores the influence of wider social and political objectives.

They recommended a research program that seeks to enhance understanding of the

relationship between accounting and these wider objectives.

Their point of view is especially relevant in this thesis, given the key role accounting

valuation of assets has on the determination of regulated prices, which in turn has a

number of economic and social implications.

Hopwood (1983, p. 303) noted that many researchers from other disciplines had begun

identifying a variety of interesting research avenues in the accounting domain. For

instance, sociologists have started recognising the research potential offered by the

accounting craft. Questions have been asked about how accounting might be related to the

more general elaboration of calculative practices in modern society. There are many ways

in which accounting has provided a powerful calculus for forging a new visibility which

243

can facilitate specific modes of control within the business enterprise in particular, and

more legitimised functions of the accounting craft.

As with any other research, accounting research in general plays an essential part in the

creation of new knowledge. It can make a difference in the world as it affects the

accounting standard setters, which in turn affect the business practice, usually at the level

of decision-makers. Mentor researchers‟ thinking can then change the world through

consulting, professional service, teaching and so on. In terms of this research project, as

accounting is now known as the language of business, accounting information is of

paramount importance, both to accountants and academics. For example, research into

asset valuations used by water utility regulators.

The two broad areas in accounting are financial accounting and management accounting.

Coyne, Summers, Williams and Wood (2010, p. 7) identified the six broad areas of

research in financial and management accounting, as shown in Figure 8.3 below. They are

accounting information systems (AIS), auditing, financial accounting, managerial

accounting, tax, and other.

Figure 8.3: Six broad areas of research in accounting

(Coyne, Summers, Williams & Wood 2010, p. 7)

Six

bro

ad a

reas

of

rese

arch

in

acco

un

tin

g

Accounting information systems

Auditing

Financial accounting

Managerial

Tax

Other

244

The current state of accounting research is characterised as research into the effect of

economics events on the process of summarising, analysing, verifying and reporting

financial information, and the effect this reported information has on economic events.

Accounting research has shifted over time. In the pre-1960s, accounting research was

mostly normative; that is, the correct accounting application was argued, or put

differently, accounting research was based on what it should be. Normative research

seeks to derive and prescribe accounting standards. Over time, it has increasingly taken

citations, particularly from economics and finance disciplines, suggesting that it is

drawing closer to these disciplines. Post-1960s, accounting research moved into positive

research; that is, examining what is rather than what should be, and seeking to explain

and predict actual accounting practices. Positive research became more dominant because

it can embrace the consequences of accounting in wider institutional settings. Accounting

research became more focused on the effects of accounting information on economics

events (Granof & Zeff 2008, p. A34; Oler, Oler & Skousen 2009, pp. 7 & 10–11).

A landmark paper was written and published by Watts and Zimmerman (1978, pp. 112–

134), who articulated how positive research can play a role in setting accounting

standards, an area where one would expect normative research to naturally dominate. It

was this paper which helped justify the growing output of positive research from

academics. Researchers such as Plumlee et al. (2005, pp. 1–63), and Tuttle and Dillard

(2007, pp. 387–409) have consistently argued that financial accounting is increasingly

dominant in accounting research. The research scope in accounting is broad, the evidence

of which can be found from the literature, ranging from countless papers and books to

journals and so on.

8.4 Accounting research methodologies

A methodology needs to be selected by the researcher in order to determine how the

research is to be conducted. The three main research methodologies in accounting are

archival, analytical and experimental design. The other accounting methodologies include

case study, field study, grounded theory, review, survey, theoretical and normative. Most

surveys are quantitative research projects with some qualitative elements. The type of

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data collection methods used in surveys are questionnaires or scales, which are an

effective method to use in engaging with large research populations. If the population is

geographically scattered, a questionnaire can be posted or mailed, or made available

online. It is quite common that the internet is used in survey research.

As its name suggests, experimental is the methodology used when conducting

experiments. Experimental design research is best implemented when the designed

experiments are properly set up in laboratories or laboratory conditions. In general, due to

the difficulty in controlling all the different variables in social science situations, and the

phenomena and the difficulty of replicating the social world or in the study of social

phenomena, true experiments are rarely conducted in business research or in social

science research.

The defining feature of the experimental methodology in accounting is that data from

human subjects are assigned to multiple treatment groups, unlike survey methodology

which has no treatment group. It can include analysing both economic and behavioural

factors. The researcher manipulates one or more variables with subjects that are assigned

randomly to various groups. It is possible for the researcher to select different populations

to „manipulate‟ a variable. If this is the case, these would be included as experimental in

nature. For example, participants of different experience levels were selected for this

research thesis.

Archival research is research carried out on the content of archives. Archives are stored

records and/or documents of a company or a business, the size of which may be very

small to very extensive. The website of The National Archive of the United Kingdom

defines archives as “documents in any medium that have been created by an individual,

family, business or organisation during its existence and have been chosen to be kept

permanently because they are considered to be of continuing value”. In contrast with

experimental methodology, archival research requires that in a natural setting, data are

produced as a result of the researcher‟s conducts of the contents of that archival research

(Quinlan 2011, p. 187).

Archival research includes studies in which the researchers collect data that has objective

amounts such as net income, sales and fees. For example, fundamental analysis of

246

accounting numbers to the content analysis of texts and narratives such as accounting

standards and other regulation, as long as the research is restricted to analysis only. An

example of archival research methodology in finance is the use of data from historical

market information such as stock prices, bonds or commodity prices. Archival research

methodology is also known as „capital markets research‟.

Field or case study research methodology is preoccupied with the study of the role and

function of accounting in its natural context. The term „case study‟ usually implies

research which is confined to a single unit of analysis. On the other hand, „fieldwork‟

encompasses more general studies of social activity.

Non-empirical or analytical research methodology, unlike other methodologies discussed,

is not guided by research experience or experiment. It comprises theory construction and

evaluation using formalised, mathematical models to predict, explain or give substance to

theory. Examples include financial modelling, formal game theory and agency models in

accounting areas such as auditing, financial reporting and disclosure.

Fulbier and Sellhorn (2008, pp. 1–37, cited in Gruszczynski 2009, pp. 6–7) compiled a

list of research methodology in accounting based on accounting papers presented to the

annual congresses of European Accounting Association (EEA) in 2000 and 2005.

Notably, as presented in Figure 8.4 below, 70 per cent of papers presented to the EAA

Congress in 2005 were classified into archival (empirical) research methodology, which

made it the most popular research methodology in accounting. The „other‟ category

captures researchers who adopted multiple methodologies, which includes methodologies

not easily assigned to previous categories. The „ambiguous‟ category includes those

research methodologies that are not made clear in the abstract.

Oler, Oler and Shousen‟s study (2009, pp. 1–72) is considered the first research paper

about accounting research and methodologies, and their findings have arrived at very

similar conclusions. For instance, the relative proportion of citations drawn from prior

accounting papers appears to be borrowed from economics and finance, and research in

financial accounting and archival methodology is becoming increasingly dominant. In

noting this, the trend towards more financial accounting and archival research is

247

consistent with a significant number of events beginning with the Journal of Accounting

Research in 1963 and the publication of Ball and Brown (1968, pp. 159–178) in 1968.

This is aided by an increasing availability of externally reported financial statement and

stock price information. However, there was no corresponding increase in the availability

of other information; for example, internal accounting information to support managerial

research. These trends of increasing availability of externally reported financial statement

and stock price information are linked to the conscious decision of many researchers to

pursue a positive research paradigm following social sciences.

248

Figure 8.4 Research methodologies in accounting – papers presented to EAA Annual

Congress, 2000 and 2005

2000 2005

Archival % 51 70

Experimental % 2 0

Field/ case study % 3 1

Survey % 7 6

Analytical % 0 1

Theory % 7 6

Other % 21 10

Ambiguous % 7 6

0

10

20

30

40

50

60

70

80

Archival %

Experimental %

Field/ case study %

Survey %

Analytical %

Theory %

Other %

Ambiguous %

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8.5 The case study methodology to this thesis

The case study is one of the many methodologies used in social sciences research. Yin

(2003, p. 1) asserted that case study is the preferred methodology when the research focus

is about a contemporary phenomenon, within some real-life context such as a project or

program in an evaluation study. It is used in many situations to contribute to knowledge

of individual, organisational, social, political or other related phenomena. It can be used

when „how‟ or „why‟ (illustrating why something was done or came to be, or when and

why something works) questions are posted, and when the researcher has little control

over the events. One of the strengths of case study methodology is that it is not linked to a

particular type of evidence or method of data collection (Olalere 2011, p. 24).

Cooper and Morgan (2008, pp. 159–178) explained that case study research in accounting

can be a valuable tool to understand complex phenomena. It has multiple benefits such as

providing valuable insights that open up new and promising areas. As such, it can be used

to test existing theory and generate a new one. Cooper and Morgan demonstrated that

case study research in accounting can be useful to accounting practitioners by helping

them understand the applicability of specific accounting innovations in complex contexts,

re-assessing their conceptualisations of problems, and learning how to be more skilled in

using rules. Yin (1989, pp. 147–148) suggested that for a case study to be complete, “the

boundaries of the case, that is the distinction between phenomenon and context, are given

explicit attention”. The documentation demonstrates not only that the researcher

“expended exhaustive effort in collecting the relevant evidence, but also artifactual

conditions are absent (not because they researcher ran out of time)”.

The case study methodology has been applied to this thesis. Rather than using samples

and following a rigid protocol to examine a limited number of variables, the case study

methodology involves an in-depth study of a single or multiple instance/s or event/s that

is a „case‟. The case study methodology provides a systematic way of not only looking at

events, but also collecting data, analysing information, and reporting the results. The

researcher gains a sharpened understanding of why the event happened as it did, and

discovers what might become important to study more extensively in future research.

Case study methodology leads itself to both generating and testing hypotheses (Flyvbjerg

http://en.wikipedia.org/wiki/Data

http://en.wikipedia.org/wiki/Information

http://en.wikipedia.org/wiki/Hypotheses

250

2006, pp. 219–245). It is a systematic and organised way to produce information about a

topic, as well as the product of this approach. It is an in-depth, contextually informed

examination of specific organisations or events that explicitly address theory (Cooper &

Morgan 2008, p. 160).

All case study methodologies exhibit the same compelling feature; that is, the desire to

derive a(n) up-close or otherwise in-depth understanding of a single or small number of

„cases‟ set in their real-world contexts (Bromley 1986, p. 1, cited in Yin 2012, p. 4). The

main aim of the case study methodology is to produce both an invaluable and deep

understanding of the insightful appreciation of the „case(s)‟, with the end result of

achieving new learning about the real-world behaviour and its meaning.

The history of case study methodology can be traced to Europe, predominantly France.

Well documented in the United States from the early 1900s until 1935, the case study

research methodology was mostly associated with the University of Chicago Department

of Sociology, where the school was pre-eminent in the field and the source of a great deal

of literature (Tellis 1997, p. 2). Yin noted that case studies should not be confused with

qualitative research, and pointed out that the case study methodology can be based on any

mix of quantitative and qualitative evidence (Yin 2014, p. 19). Accounting practitioners

find the „how‟ questions to be particularly important; for example, it is valuable in

describing the details of how new accounting and auditing innovations were created.

Table 8.1: Relevant situations for different research methodologies (Source:

COSMOS Corporation)

Research

methodology

Form of research

question

Requires control

of behavioural

events?

Focuses on

contemporary

events?

Case Study Who, what, where, how

many, how much?

No Yes

Experimental How, why? Yes Yes

Archival Who, what, where, how

many, how much?

No Yes/No

http://www.bookrags.com/Qualitative_research

251

Research

methodology

Form of research

question

Requires control

of behavioural

events?

Focuses on

contemporary

events?

Case study How, why? No Yes

(Yin 2003, p. 5)

Table 8.1 above shows the main research methodologies used in accounting. It displays

the three conditions of when to use each methodology, which are: (a) the type of research

question posed; (b) the extent of control a researcher has over the actual behavioural

events; and (c) the degree of focus on contemporary as compared to historical events. For

instance, the case study research methodology is used when a „how‟ or a „why‟ question

is being asked about a contemporary set of events over which the investigator has little or

no control.

The case study research methodology can be used in a variety of ways by accounting

researchers. Researchers such as Stake (1995) and Yin (2003) identified at least six

sources of evidence (documents, archival records, interviews, direct observation,

participant observation and physical artefacts) used in case study methodology.

The five different types of accounting case studies are shown in Figure 8.6 below.

Figure 8.6: Types of accounting case studies

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The first type of case study is descriptive, which is one of the most common. It presents a

complete description of a phenomenon within its context (Yin 2003, p. 5). It begins with a

descriptive theory that covers the depth and scope of the case under study or whether the

researcher could face the possibility that problems will occur during the project. The

descriptive case studies imply that this is a formation of hypotheses of cause-effect

relationships. The selection of cases and the units of analysis are developed in the same

manner as other cases. Descriptive case studies describe accounting systems, including

the techniques and procedures used in real-world practice. Such a study can be beneficial

to explore the use of traditional or modern accounting techniques and practices.

Professional accounting bodies have often supported this methodology, as it offers the

possibility of determining „best practice‟, sometimes conceived as the most common

practice, and other times as the practice adopted by „successful‟ companies.

The second type of case study is illustrative, which attempts to illustrate new and possibly

innovative practices developed by particular companies. This type of case study provides

an illustration of what has been achieved in practice. The illustrative case study can

provide examples for researchers to learn from these innovative companies (Ryan,

Scapens & Thoebald 2002, p. 143).

The third type of case study is the experimental case study, which consists of procedures

and techniques developed from existing theoretical perspectives, using normative

3. Experimental

case study

253

reasoning, and is intended to indicate what should be done in practice. This type of case

study includes new accounting procedures and techniques intended to be helpful to

accounting practitioners.

The fourth type of case study is the exploratory case study, one which uses fieldwork and

the data collected, aimed at defining the questions and hypotheses of a subsequent study,

or at determining the feasibility of the desired research procedures. Unlike other case

study, the exploratory case study has been considered a prelude (“exploratory”) to some

social research. However, the framework of the study must be created first. Fieldwork

and data collection must be undertaken before the research question and hypotheses are

defined, and it is useful to use pilot projects to determine the final protocols. Based on the

outcome of the pilot study survey, questions may be added (Yin 2003, pp. 5–6). However,

the exploratory case study is often perceived as sloppy, since the researchers may follow

intuitive paths. The best part of this methodology is that the research goal may justifiably

be to discover theory, by others directly observing a social phenomenon in its raw form

(Glaser & Strauss 1967, cited in Yin 2003, p. 6).

On the other hand, the exploratory case study may be used to explore reasons for

particular accounting practices. It enables the researcher to generate hypotheses about the

reasons for particular practices that can be subsequently tested in large-scale studies. This

case study methodology represents a preliminary investigation, and is intended to

generate ideas and hypotheses for rigorous empirical testing at a later stage.

The fifth type of case study is the explanatory case study that focuses on a specific case. It

attempts to explain the reasons for observed accounting practices, and it uses theory to

understand and explain the specific, rather than to produce generalisations. This theory is

used to enable researchers to provide convincing explanations of the observed practices.

However, it may be necessary to modify or develop new theory, which can be used in

other case studies. The explanatory case study type of research is used to generate

theories that can provide good explanation of the case being studied.

8.6 The exploratory case study methodology to this thesis

Figure 8.7: The environment and relationship between research thesis elements

254

Figure 8.7 shows the environment and relationship between elements of this research

thesis. In any research thesis there are six methods of collecting data (i.e. survey

questionnaire, interview survey, test and measurement, direct observation/participation,

focus group/seminars, and archival). The exploratory case study research methodology

was applied to this thesis, which was used to test the existing theories, such as the

building block approach from which water prices are determined, the upper- and lower-

bound pricing principles described in economics, and the NWI Pricing Principles.

The specific data collection used in this thesis is archival (secondary data) and

quantitative (numerical) methodology. Initially, certain major aspects of the case study

(e.g. research questions, hypothesis of the study, data collection methods and accessibility

to the data) appeared uncertain, and these issues needed to be investigated. The

hypothesis of this thesis is to test if there is a direct relationship between investment in

water assets, pricing and the RAB.

After the investigation, the pilot and exploratory phase was considered and completed.

The researcher started the case study from scratch, developed a research methodology,

found a set of information from various sources, and collected a fresh set of data. This

pilot study pointed to the need for some experimental research methodology or some

methodology different from a case study. It showed that sufficient evidence and

alternative perspectives needed to be considered for the research to be complete.

Idea: The Valuation of

Assets and its Impact on

Water Utility Pricing in Australia

Researcher

Methodology: Exploratory Case Study

Method: Quatitative

and Archival Data

Collection

255

The case study methodology followed the design suggested by researcher Yin (2003), and

was applied as shown in Figure 8.8 below.

Figure 8.8: Case study methodology design, as identified by Yin (2003)

Step 1: Determine and define the hypothesis of the thesis

This is the first step where the researcher establishes a firm focus to which they can refer

to over the course of the project of a complex phenomenon. The focus of the study was

established by forming questions about the situation or problem to be studied, and hence

the purpose of this study was determined. In any case study, the research object is often a

program, an entity, a person or a group of people, and as each object is likely to be

connected to political, social, historical and personal issues, these provide a wide range of

possibilities for questions (Soy 1997). The object of the case study is investigated in

depth using a variety of data gathering methods to produce evidence, leading to an

understanding of the case and in answer to the research questions.

In general, any case study research should be able to answer either one or more questions

that begin with „how‟ or „why‟. These questions are limited to a number of events or

conditions and their inter-relationships (Soy 1997). In Chapter Three of this thesis, the

1. Determine and define

the research question

2. Select the cases

3. Determine data gathering

and analysis techniques

4. Collect data in field

5. Evaluate and analyse

data

6. Prepare report

256

researcher conducted a literature review to assist in targeting and formulating the

questions. This review established and discussed academic researches previously

conducted, leading to refined and insightful questions about the problem. The review

pinpointed the evidence that helped determine the methods of analysis to be used in this

study (Soy 1997).

The researcher used both the literature review and industry reports to define the following

listed research questions listed on the impact of rival techniques of asset valuation in

water utility pricing in Australia. In general, utility providers and businesses use a variety

of asset valuation techniques that result in different valuation figures in the construction

of the company‟s balance sheet. From the context of water utility pricing, this thesis

explores the use of two main rival asset valuation techniques, the DORC and the EV.

The researcher was primarily interested in determining whether the „rate base‟ asset

valuations used in Australia, based on water prices and determined using the building

block approach, led to different levels of water prices and the degree to which different

asset valuation techniques affected the pricing. Since water businesses are subjected to

price regulations, a notional cost in relation to the business‟s existing assets is reflected in

the price that it is allowed to charge. The process of asset valuations and accounting for

water providers and businesses in order to determine the correct price of water is known

to be particularly challenging. The researcher set out to explore three basic areas in this

thesis, which are as follows:

if different asset valuation techniques affect the behaviour of consumers and

investors

if these asset valuation techniques provide efficiency for water businesses to

finance their activities

if different asset valuation techniques prevent monopoly rents.

The purpose of this thesis is to reveal to academics and practitioners whether the DORC

or EV principles are well suited for tariff regulation, and whether the financial models can

be transported successfully to other price-setting and financial modelling applications,

either in the public or private sector, or both.

257

Step 2: Select the cases

In this design phase, either a single or multiple real-life case study research needs to be

examined in depth. If multiple cases are used, each case can be treated as a single case.

Each case remains as a single case, but these individual conclusions can be used as

information that contributes to the study as a whole. For a case study to be exemplary,

cases must be carefully selected, and the choices available must be examined from among

the many research tools available (Soy 1997).

The researcher must determine either to study cases that are considered typical, or cases

that are unique in some way. Cases may be selected to represent a variety of geographical

regions, size parameters or other parameters. It may be useful in this step to repeatedly

refer back to the purpose of the study as part of the selection process. In doing so,

attention can be focused on where to look for cases and evidence that will satisfy the

purpose and provide answers to the research questions posted.

The key element in this step is the selection of either a single or multiple cases. A case

study research methodology may involve more than one unit of embedded analysis. It

may involve study of a single industry and a firm participating in that industry. If

relevant, this case study involves two levels of analysis and increases the complexity and

amount of data to be gathered and analysed (Soy 1997).

In this thesis, multiple (three) cases were used. The first one was discussed in Chapter

Four, where case studies were used to provide an overview of the industry governance,

structure and the broad area of ownership for urban water services in major Australian

cities. The second one was in Chapter Five, where case studies were used to discuss

existing regulations and pricing structures in water and wastewater sectors in Australia‟s

major capital cities. The third one is in Chapter Nine, where case studies of major

Australian cities will be used to link the RAB and the regulator‟s pricing decision.

258

Step 3: Determine data gathering and analysis techniques

The case study research methodology has the advantage that it involves use of multiple

sources, tools and techniques (e.g. documents, archival records, surveys, interviews,

direct observation, participant observation and physical artefacts) in the data gathering

process.

In this step, evidence needs to be gathered and the techniques used with the data for

analysis need to be determined in advance. The data gathered is generally largely

qualitative, but can also be quantitative. The researcher must ensure that the designated

data gathering tools are chosen and be used systematically and consistently in collecting

the evidence (Soy 1997). In this design step, the researcher must ensure that the study is

well constructed and has high validity and reliability, so that its measurement provides

consistent results.

The researcher gathered data from regulators and water utility businesses‟ reports, and the

variables that make up the calculations for the rate base formula were collected so that an

in-depth simulation could be conducted. This procedure is well documented, multiplied

repeated with the same results, and cross-checked with the literature review to ensure that

the methodology and design are exemplary.

The data gathered has been used for the regression analysis, specifically the Least Squares

Regression Method in Chapter Nine, to test the relationships between the dependent

variable, capital expenditure and independent variables, asset valuation techniques, length

of pipes connecting residential properties water supply, and the amount of population

connected to urban water services. Regression analysis was used to test if a relationship

exists between asset valuation techniques, prices, profitability and investment levels

(dependent variable) in the industry, as well as the long-term viability of the industry.

Step 4: Collect data in field

This researcher comprehensively and systematically collected and stored various report

sources to be used as evidence. The formats were referenced and sorted so that lines of

259

inquiry and patterns could be uncovered. The object of the case study was carefully

observed, and causal factors associated with the observed phenomenon are identified (Soy

1997). As the study progresses, the object of the study is renegotiated and data collection

is updated whenever necessary. This case study research is flexible, as it is not only

documented systematically, but changes are made whenever required (Soy 1997).

Archival (secondary) and quantitative (numerical) methodology is the specific data

collection used in this research thesis. In accounting research, Oler, Oler and Shousen

(2009, p. 6) pointed out that the archival data collection method is the most common

technique. The researcher has no contact with the research participants and the data used

are collected by previous researchers, water regulators, providers and businesses.

Significant time and cost is saved, because the focus is on data analysis as in Chapter

Nine.

In step 4, the researcher enters data such as RAB, return on capital, return of capital,

investment, length of pipes and number of residents connected to water pipes data into a

database, and other data are physically stored. The researcher documents, classifies and

cross-references all the evidence to be efficiently recalled for sorting and examination

over the course of the thesis (Soy 1997). However, due to lack of experience and

comparison of asset valuation techniques in water businesses, simulation of different asset

valuation techniques were taken from electricity and gas companies. In doing so, these

asset valuation techniques closely match the real-world results. The relationship between

the issue of whether the price of water will be impacted by the use of two rival asset

valuation techniques, the DORC and EV valuation, and the evidence used to prove this

was maintained.

Step 5: Evaluate and analyse data

The raw data were examined by the researcher using many interpretations, so that links

between the research object and the outcomes with reference to the original research

questions could be found. Throughout this evaluation and analysis step, new opportunities

and insights are explored (Soy 1997). One of the advantages of case study research is that

multiple data collection methods and analysing techniques were used. This allows the

260

researcher not only the opportunity to triangulate data to strengthen the research findings

and to reach the conclusions, but the researcher is also able to move beyond initial

impressions to improve the likelihood of accurate and reliable findings.

In this step, the researcher categorises, tabulates and recombines the data to address the

initial proposition or purpose of the study. Facts are cross-checked and any discrepancies

in accounts were noted. Throughout this step, additional data are gathered to verify key

observations and to double-check a fact. The researcher uses quantitative data that has

been collected to corroborate and support the qualitative data. These data will be useful

for understanding the rationale and theory underlying relationships. Specific techniques

used include placing information into arrays, creating matrices of categories, and creating

flow charts and diagrams (Soy 1997).

Step 6: Prepare the report

The final step is to prepare the report; that is, to analyse and interpret the data by

attempting to explain the meaning of what it is that the researcher sees in the data, as

explained in Chapter Nine. The case study report should transform complex issues into

ones that can be understood, allowing the reader to question and examine the report and

reach an understanding, independent of the researcher. It is important that particular

attention is given to displaying sufficient evidence in order to gain the reader‟s

confidence, and that all avenues have been explored. The boundaries of the case study are

discussed and attention is also given to conflicting propositions.

In the following Chapter Nine, the researcher further interpreted the data, stating what the

data shows and the researcher‟s interpretation of it, and reaching conclusions based on

this. These are considered in detail in the final chapter, Chapter Ten. The conclusions that

the researcher draws, based on the analysis and findings from the data in Chapter Nine,

add up substantially to contribute to the overall conclusions in Chapter Ten.

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8.7 Summary

One of the most important decisions to be made in any research project is the

methodology framework. The research methodology used must be able to not only

support the research, but also facilitate the accomplishment of the main aim of the

research from the beginning through to its completion. The methodology is the activity or

business of choosing, reflecting upon, evaluating and justifying the methods used in

research. No-one is able to assess or judge the value of that piece of research without

knowing the research methodology used. The contemporary organisation of human

knowledge can be explained via a twofold process of institutionalisation known as the

„hierarchical Encyclopaedia‟. Accounting is an academic subject placed below

economics. This thesis is predominately accounting focused; however, some aspects of

economics also remain important.

In social sciences, researchers use many different research methodologies to conduct

important, creative and engaging research projects. The types of research methodologies

in social sciences include survey, case study, experimental design, ethnography, action

research, grounded theory, content analysis and discourse analysis. They provide an

introduction to the frequently used social sciences research methodologies, and provide

some indication of the depth and complexity in social sciences research.

In general, accounting research plays an essential part in the creation of new knowledge,

as it can influence the accounting standard setters, which will in turn affect the business

practice and the decision-makers. Financial and management accounting are the two

broad areas in accounting, and the other six broad areas of accounting research are AIS,

auditing, financial accounting, managerial accounting, tax, and other. AIS relate to the

systems and the users of systems that collect, store and generate accounting information.

Financial accounting relates to financial markets and decision-making based on financial

accounting information, while managerial accounting examines decision-making within

an enterprise, incentives, and allocation of resources within an enterprise, as well as

budgeting and compensation. Tax relates to all issues regarding tax; that is, taxpayer

decision-making, tax allocations, tax computations and so on.

262

Accounting research was mostly normative in the pre-1960s. Normative accounting is

based on what it should be; under which, accounting seeks to derive and prescribe

accounting standards. Over time, accounting research has shifted and it has increasingly

taken citations from economics and finance disciplines, suggesting that it is drawing

closer to them. Accounting research moved into positive research post-1960s, examining

what is rather than what should be. In positive research, accounting seeks to explain and

predict the actual accounting practices. A landmark paper was written and published by

Watts and Zimmerman, where they not only articulated how positive research can play a

role in setting accounting standards, an area where normative research naturally

dominates, but that is also helped justify the growing output of positive research from

academics.

The three main accounting research methodologies are archival, analytical and

experimental design. In archival research, the researcher gathers data by asking subjects

to perform tasks in a controlled setting. In a natural setting, archival research requires that

data are produced as a result of the researcher‟s initial action. Analytical or non-empirical

research methodology comprises of theory construction and evaluations using formalised,

mathematical models to predict, explain or give substance to theory; it is not guided by

research experience or experiment. Experimental design methodology is used when

conducting research experiments.

The research methodology used in this thesis is the case study methodology, which

provides a systematic way of looking at events. In case study methodology, data are

collected, information is analysed and results are reported. The compelling feature of all

case study research is the desire to derive a(n) up-close or otherwise in-depth

understanding of a single or small number of „cases‟ set in their real-world contexts. The

case study methodology produces not only an invaluable but also deep understanding of

the insightful appreciation of the case(s), with the end result of achieving new learning

about the real-world behaviour and its meaning.

The exploratory case study research methodology was applied in this thesis. It tests

existing theories, such as the building block approach, based on which water prices are

determined – the upper- and lower-bound pricing principles. The data collection method

used in this thesis is the archival (secondary data) and quantitative (numerical)

263

methodology. The hypothesis of the thesis is that there is a direct relationship between

investment in water assets, pricing and the RAB.

The case study methodology used in this thesis followed the design (six steps) described

by researcher Yin. In the first step, the researcher establishes a firm focus to which they

can refer to over the course of the project on a complex phenomenon. This researcher set

out to find three basics findings from this thesis: (i) whether different asset valuations

affect the behaviour of consumers and investors; (ii) whether the asset valuation

techniques provide efficiency for water businesses to finance their activities; and (iii)

whether different asset valuation techniques can prevent monopoly rents.

In the second step, the researcher selects either a single or multiple cases. In this thesis,

multiple (three) cases were used. The first case study was in Chapter Four, the second in

Chapter Five, and the third is in Chapter Nine. In the third step, this researcher gathered

data from regulators and water utility businesses‟ reports, and variables that make up the

calculations for the rate base formula. This procedure was repeated with the same results

over and over again, and cross-checked with the literature review to ensure that the

methodology and design are exemplary.

In the fourth step, the researcher collects and enters data into a database, and other data

are physically stored. Next is the fifth step where the researcher categorises, tabulates and

recombines the data to address the initial propositions or purpose of the study. Facts are

cross-checked and any discrepancies in the accounts noted. Quantitative data are collected

to collaborate and support the qualitative data.

The final step is step six, where the report on findings is presented. The report transforms

complex issues into those that can be understood, allowing the reader to question and

examine the report and reach an understanding, independent of the researcher. In this

thesis, this is done in Chapter Nine, where the researcher analysed and interpreted the

data to explain the meaning of what it is they observed in the data, and what they believed

this means to draw conclusions from.

The next chapter shows results and discussions of different asset valuation techniques

used by water utility businesses and the impact on pricing of water.

264

Chapter Nine: Results and Discussions

9.1 Introduction Chapter Eight provided a general overview of the research methodology, followed by an

overview of the research methodology used in accounting. The exploratory case study

methodology used in this thesis was also discussed in the previous chapter, along with

information from data collections that is kept on record. In this chapter, detailed

information of the process of preparing and collecting data for this thesis is provided,

before important issues are analysed and finalised.

Chapter Nine is structured as follows. Section 9.2 presents a comparison of seven asset

valuation techniques. These comparisons are based on information from data collections

kept on record as per Chapter Eight. Data was taken from both the electricity and gas

industries, while various asset valuation techniques are based on random events called

„simulation‟ from electricity and gas companies. These techniques closely match the real-

world results. However, a comparison of different asset valuation techniques for water

businesses is limited due to fact that the deprival value has been recommended as the

preferred valuation method for the purpose of charging water prices. Also, there is a lack

of competition in the water industry; customers do not have the option of changing and

accessing other water providers. In addition, the experience with the use of the deprival

value, including the DORC, is less compared with other utilities such as electricity, gas

and rail; hence the comparison is limited.

This is followed by justifications for the findings of these techniques in section 9.3. The

ODV asset valuation method is the preferred approach of valuing network assets, as

endorsed by the COAG. It is important to note that deprival value is not the DORC. The

DORC is the replacement cost and the absolute upper limit of the deprival value concept

(Bonbright 1937, p. 1139; Solomon 1971, p. 111; Bertram 2000, pp. 30–31; King 2000, p.

2; 2001, pp. 14–15). DORC is also the upper-bound pricing recommended in the COAG

Water Resource Pricing Principles. The lower side of the deprival value is the EV,

specifically the NRV, which is the lower-bound pricing in the COAG Water Resource

Pricing Principles. An asset cannot be of less worth to its owner than its resale value. That

265

is, the loss that the owner would sustain if they were deprived of the asset cannot be

greater than the cost of replacing the asset.

Section 9.4 presents case studies of the RAB and its relation to the pricing of water in

major Australian cities, while section 9.5 summarises the current institutional structure of

water and wastewater provision in major Australian cities. Section 9.6 reviews water

pricing principles as outlined by the NWI, the national blueprint for water reform.

Section 9.7 presents a summary of asset valuation techniques used by water utilities in

major Australian jurisdictions, and based on these discussions, section 9.8 concludes by

looking at whether the price of water is too high or low.

9.2 Comparison of pricing-based asset valuation techniques

Four asset valuation techniques used by two gas companies, that is AGL Gas Networks

Limited (AGLGN) in NSW and ActewAGL in Canberra, are shown in Tables 9.1 and 9.2

below.

Table 9.1: Asset values at 1 July 1996 using four different asset valuation techniques

(DAC, DIHC, DORC and ODV asset valuation techniques) in ($ million)

Capital assets

(system and

non-system

assets)

AGLGN (original

proposal)

Final decision

(June 2000)

DAC 1 059 961

DIHC 1 721 1 400 – 1 600

DORC 2 101 2 060

ODV 1 956 1 500 – 1 700

(Independent Pricing and Regulatory Tribunal 2000, p. 8 & 79)

266

Table 9.2: Asset values using four different asset valuation techniques (DAC, DIHC,

DORC and ODV) in ($ million)

Capital assets

(system and

non-system

assets)

ActewAGL

(original

proposal)

Final decision (October

2000)

DAC 90 90 (agreed)

DIHC 148.5 130–148

DORC 255 255

ODV 245 Correct to submission;

essentially equal to DORC

(Independent Competition and Regulatory Commission 2000, p. 21)

Tables 9.3 to 9.5 show asset valuation techniques used by two electricity companies, that

is Transpower Limited NZ and PowerCo.

Table 9.3: Asset values using five different asset valuation techniques (replacement

cost, DRC, ORC, DORC and ODV) in ($ million)

Capital assets

(system and non-

system assets)

Final decision (30 June

2002)

RC 5 652

DRC 2 584

ORC 4 726

DORC 2 153

ODV 2 151

(Transpower Limited NZ 2002, p. 98)

267

Table 9.4: Asset values using five different asset valuation techniques (the

replacement cost, DRC, ORC and DORC) in ($ million)

Capital assets

(system and non-

system assets)

Final decision (30 June 2006)

RC 5 545

DRC 2 277

ORC 4 832

DORC 2 032

ODV 2032

(Transpower Limited NZ 2006, p. 75)

Table 9.5: Asset values using five different asset valuation techniques (replacement

cost, DRC, ORC and DORC) in ($ million)

Capital assets

(system and non-

system assets) (*1 000)

Final decision (2004)

RC 1 672 876

DRC 2 277

ORC 4 832

DORC 2 032

ODV 2 032

(PowerCo 2004, p. 4)

The preference adopted in regulated water businesses and their jurisdictions is to „lock in‟

or „roll forward‟ the value of RAB, calculated at the start of each regulatory period. It is

calculated as the opening RAB of the previous regulatory period, plus the actual capital

expenditure over the period, less regulatory depreciation and any disposals. The RAB is

adjusted to reflect both the actual capital expenditure and actual funds returned to the

268

investors. Future water prices are based on the actual cost in providing water services.

Any asset valuation method used is an estimate valid at a particular point in time.

Over a regulatory period, regulated water businesses will engage in capital expenditure

programs that will be added to the RAB. The existing components of the RAB will be

subjected to depreciation. The RAB excludes any asset disposals and any capital

contributions (external funding, subsidies) from government or third parties. This method

is known as the „rolled-forward RAB‟ under the price-cap regulatory regime. It is used to

set water prices at the start of a new regulatory period under price-cap regulation. The

water price is set to recover revenue and will not change until it is reset at the next

periodic price review.

Figure 9.1 below shows the plotting of figures collected from Tables 9.1 and 9.2. Four

different asset valuation techniques – DAC, DIHC, ODV and DORC – are compared.

Figure 9.1: Comparison of Pricing-based asset valuation techniques

IPART (2000, p. 8 & 79) and the ICRC (2000, p. 21)

The graphical results reveal that when these four asset valuation techniques are plotted

against capital assets (system and non-system assets), consistently under the DAC, asset

DAC ($) DIHC ($) DORC ($) ODV ($)

Independent Competitionand Regulatory

Commission: AGLGN (Final:Nov 2000)

90 139 304 254

IPART: AGLGN (Final: June2000)

961 1,500 2,060 1600

0

500

1000

1500

2000

2500

Cap

ital

ass

ets

($M

)

Comparison: Pricing-based asset valuation techniques

269

value is the lowest, followed by the DIHC; the ODV is the second highest, and the DORC

produces the highest asset valuation.

Figure 9.2 below plots the figures from Tables 9.3 to 9.5. Five different asset valuation

techniques – replacement cost, DRC, ORC, DORC and ODV – are compared.

Figure 9.2: Comparison of Pricing-based asset valuation techniques

Transpower Limited NZ (2002, p. 98); PowerCo (2004, p. 4); Transpower Limited NZ (2006, p. 75)

The graphical results conclude that when these five asset valuation techniques are plotted

against capital assets (system and non-system assets), consistently under DORC asset

values are lower than those of the replacement cost, DRC and ORC, but higher than

ODV. ODV produces the lowest asset valuation of all the five asset valuation techniques

used.

RC ($) DRC ($)ORC($)

DORC($)

ODV($)

PowerCo (2004) (*1000) 1,672,876 910,058 1,659,297 905,538 905,538

Transpower Ltd NZ(2006)

5,545,000 2,577,000 4,832,000 2,032,000 2,032,000

Transpower Ltd NZ(2002)

5,652,000 2,584,000 4,726,000 2,153,000 2,151,000

0

2,000,000

4,000,000

6,000,000

8,000,000

10,000,000

12,000,000

14,000,000

Cap

ital

ass

ets

($M

)

Comparison: Pricing-based asset valuation techniques

270

9.3 Justifications for the findings

The choice of different asset valuation techniques involve varying degrees of effort and

time to calculate. It can be observed that these different valuation choices result in

significantly different valuation figures for the same assets. Consequently, not only will

significantly different asset valuation techniques produce different estimates of the RAB,

they will also produce different water pricing and investment signals.

When the result of seven different asset valuation techniques is put together, it can be

concluded that (in descending order), over the life of the assets, the replacement cost asset

valuation method will yield the highest asset value, followed by DRC, ORC, DORC and

ODV. A depreciated inflation historical cost (DIHC) asset value will be greater than the

DAC asset value.

Accounting estimates of asset value begin with HCA or the book value. HCA is one of

the GAAP, and it is widely accepted by businesses and is often viewed as the best

estimate of the value of an asset. In terms of economic efficiency, the DAC and the

depreciated inflation adjusted historical cost (DIHC) perform poorly. The RAB under the

DAC and depreciated inflation historical cost (DIHC) valuations will be underestimated.

That is, water businesses will yield insufficient revenues to finance capital investments, as

well poor pricing signals reflected.

9. 4 Case studies in water industry

RAB and regulator’s pricing decision

As a natural monopoly, water providers or businesses set water pricing directly based on

their assets (RAB). The price of water should only be raised in line with the increased

asset value, and if and when it can effectively earn a return on and of capital invested in

the business. Long-life assets are built with enough spare capacity to meet current and

future water and sewerage services demand, and hence when it is not economical to

increase the network capacity each year.

271

In each year of the regulatory period, the price of water does not need to be set to recover

the annual revenue. Water prices are smoothed over the regulatory period to limit any

impact of sharp price increases to customers. If a water business effectively earns a return

on and of capital above what is invested, consumers should not be made to pay for the

increase in water price; that is, increased earnings by water businesses and at the same

time increased earnings for consumers as well as receive no improvement or upgrade in

the level of service.

This section provides case studies of the water industry in major Australian cities. Each

jurisdiction has different planning and reporting cycles (regulatory periods), and it is

therefore not possible to present information and analysis as a common year.

9.4.1 New South Wales

The delivery of New South Wales‟ urban water arrangements is summarised in Table 9.6

below.

Table 9.6: Bulk water and water service providers in New South Wales

Area Name Services Institutional structure

Sydney Sydney Water

Corporation

Treatment, distribution

and retail

Statutory state-owned

corporation

Sydney Catchment

Authority

Bulk water, catchment

management

Statutory authority

Newcastle

and

Hunter

Valley

region

Hunter Water Bulk water, treatment,

distribution and retail


corporation

Other

urban

centres

Local governments

(e.g. Wyong City

Council, Gosford

City Council,

Bulk water, treatment,


Local government

272

Goulburn Wulwaree

City Council)

State Water

Corporation

Regional and rural bulk

water delivery


corporation


In New South Wales, the Sydney Catchment Authority is one of the two major bulk water

storage, which was created in 1999, after a major cryptosporidium and giardia incident

affected Sydney‟s water supply. It is a state-owned statutory authority, responsible for

managing and protecting Sydney's catchments and supplying bulk water to its customers,

including Sydney Water and a number of local councils.

The Sydney Water Corporation is the other major bulk water storage in New South

Wales, which is a statutory state-owned corporation; that is, it is wholly owned by the

New South Wales Government. The Sydney Water Corporation provides drinking water,

recycled water, wastewater services and a few stormwater services to more than four

million people in Sydney, Illawarra and the Blue Mountains.

Data from 2006 recorded that each day, the Sydney Water Corporation supplies over 1.4

billion litres of water to over 1.6 million homes and businesses each day. It has a network

of 255 service reservoirs, 151 pumping stations and 20 960 km of water mains (Total

Environment Centre Inc. 2007, p. 3). Both the Sydney Catchment Authority and Sydney

Water Corporation are obliged to charge water at the price determined by the IPART,

unless the New South Wales Treasurer‟s approval is obtained to set a lower price.

Hunter Water is a statutory state-owned corporation that provides water and wastewater

services to Newcastle, Lake Macquarie, Maitland, Cessnock and Port Stephens, while the

Gosford City Council and Wyong Shire City Council are water supply authorities under

the Water Management Act 2000. The Gosford City Council provides water and sewerage

services within the Gosford City Council area, while Wyong Shire Council provides

water and sewerage services within its area.

http://www.sca.nsw.gov.au/

http://www.sydneywater.com.au/

http://www.hunterwater.com.au/

http://www.gosford.nsw.gov.au/

http://www.wyong.nsw.gov.au/

http://www.wyong.nsw.gov.au/

273

When undertaking pricing determinations, the IPART seeks submissions from interested

parties during each pricing review, and holds public hearings.

Table 9.7: Sydney Water total revenue requirement ($ million, 2011–12)

IPART’s draft

decision

2012–13 2013–14 2014–15 2015–16

Regulated asset values 761.7 791.8 822.4 844.9

Operating expenditure 1 283.5 1 276.2 1 270.6 1 263.4

Depreciation 207.1 219.8 232.0 242.6

Total revenue 2 197.5 2 237.1 2 273.2 2 299.0

Water rates 132.99 120.15 107.49 94.88

Sewerage rates 377.8 389.3 330.8 258.2

Total notional revenue

requirement

2 197.5 2 237.1 2 273.2 2 299.0

Return on assets 721.9 751.5 781.6 804.0

IPART’s final decision

Return on assets 761.7 791.8 822.4 844.9

Return of assets

(depreciation)

213.1 226.6 239.4 250.3


Total notional revenue

requirement

2 258.3 2 294.6 2 332.4 2 358.5

(Independent Pricing Tribunal 2012, pp. 15, 46, 82, 107 & 111)

Table 9.8: Sydney’s Water proposed notional revenue requirement ($ million, 2011–

12) – including costs of Sydney Desalination Plant (SDP) operating 100 per cent

2012–13 2013–14 2014–15 2015–16


Allowance for return on

assets

955.5 995.5 1 034.9 1 069.4

274

2012–13 2013–14 2014–15 2015–16

Allowance for

regulatory depreciation

211.1 226.4 241.4 255.1

Total notional

requirement (NRR)

2 528.3 2 594.0 2 650.7 2 698.8

Estimate of NRR

excluding SDP

production costs

2 473.9 2 534.8 2 588.4 2 636.3

(Independent Pricing and Regulatory Tribunal 2012, p. 45)

Table 9.7 compares IPART‟s final decision on the notional revenue requirement with its

draft decision and Sydney Water‟s proposal. Sydney Water‟s revenue requirement

increased during the determination period, due to forecast increases in the costs of

maintaining and renewing its assets, servicing urban growth, implementing the Priority

Sewerage Program, and other factors such as the carbon price. Its revenue requirement

remained fairly stable, within 1–2 per cent over the determination period, suggesting

efficiency and prudence of its past, forecast expenditures and the market cost of capital


On the other hand, Table 9.8 shows the size of the costs and their impact on customers

and the SDP‟s actual operating schedule. Sydney Water set its prices on the basis that its

desalination plant would operate at 100 per cent capacity for the entire period, and that

customers would be given a refund if there were any savings or variations arising from

this operating schedule. The cost of SDP accounts for the difference in the proposed

revenue requirement per year, which was between $54 million and $63 million, or

approximately $238 million in total over the whole period (Independent Pricing and

Regulatory Tribunal 2012, p. 44).

If the SDP operates at 100 per cent capacity for any full year, it will cost Sydney Water

approximately an additional cost of $50 million (2011–12) to $65 million (2015–16).

Customers with a 20 millimetre individual meter will have to pay an additional fee of $25

to $31 (2011–12) in the following year, while customers with a 25 millimetre individual

275

meter will have to pay an additional fee of $44 to $61 (2011–12) in the following year for

the next four years.

9.4.2 Victoria

In Melbourne, the 2013 Water Price Review is a five-year regulatory period from 1 July

2013 to 30 June 2018. Melbourne‟s bulk water supplier, Melbourne Water, and its three

retail water businesses submitted their Water Plans (including forecast costs, delivery

volumes, prices, service levels, and capital works program) to the ESC for review. Prices

in the Water Plans, as shown in Table 9.9 below, were based on the building block

methodology and were set to meet and recover the total revenue requirement made up of

forecast costs for the period. The final decision was released by the ESC following further

consideration of the businesses‟ revised pricing proposals, submitted in response to the

draft decision and comments in public submissions.

Table 9.8: Melbourne Water’s proposed revenue requirement compared to draft

decision 2013–14 to 2017–18 ($ million 2012–13)

Proposed

by business

($)

Draft

decision

($)

Difference

($)

Difference

(per cent)

Revenue requirement

excluding desalination

costs

5 569.1 5 154.7 -414 -7.4

Desalination costs 3 042.8 2 968.3 -74 -2.4

Total revenue

requirement

8 611.9 8 123.0 -489 -5.7


Table 9.9: Melbourne Water’s revenue requirement – final decision 2013–14 to

2015–16 ($ million 2012–13)

276

2013–14 2014–

15

2015–

16

Total 2016–17

(estimate)

2017–18

(estimate)

Final

decision

1 563.3 1 599.1 1 623.6 4 786.0 1 618.9 1 643.0


Table 9.10: Melbourne Water’s breakdown of revenue requirement based on

building block methodology – final decision 2013–14 to 2015–16 ($ million 2012–13)

2013–

14

2014–

15

2015–

16

2016–17

(estimate)

2017–18

(estimate)

Operating expenditure 1 001.1 994.8 983.2 948.0 950.8

Return on capital (existing

assets)

395.3 388.7 382.3 375.9 396.6

Return on capital (new

investments)

10.6 31.7 51.2 68.3 81.9

Return of capital

(depreciation)

152.0 173.7 193.0 208.3 218.3

Tax liability 4.2 10.1 13.9 18.3 22.4

Total 1 563.3 1 599.1 1 623.6 1 618.9 1 643.0

4 786.0


Table 9.11: Melbourne water businesses’ (retailers) revenue requirement – final

decision (includes gross of Melbourne Water’s bulk charges) 2013–14 to 2017–18

($ million 2012–13)

Proposed by

business

Final decision

City West Water 3 157.2 2 917.5

277

Proposed by

business

Final decision

South East Water 4 560.5 4 210.1

Yarra Valley Water 4 936.6 4 569.7

Western Water 405.1 368.4

Retailers’ total

revenue requirement

13 059.3

12 067.7


As shown in Table 9.8 above, Melbourne Water sought (proposed) $8 611.9 million in

revenue for a five-year regulatory period. Tables 9.9 and 9.10 show that $4 786 million

was approved by the ESC for a shorter period of three years (instead of five years), which

commenced on 1 July 2013 for 2013–14 and 2015–16. The need to capitalise a portion of

the desalination costs has been confirmed by the ESC. The ESC has accepted Melbourne

Water‟s assessment that the capacity to do so would be in the later years (2015–2018) of

the five-year regulatory period. The regulatory period for Melbourne Water was cut down

to three years to allow for matters to be re-examined, and for the amount to be capitalised

to be decided.

In Table 9.11, $13 059.3 million of combined revenue was sought over the next five

years. The businesses charged end-use customers for service, so that they can recover

their revenue requirements, including charges paid to Melbourne Water for bulk water

and sewerage services. In the final decision, the Commission approved a lower revenue of

$12 065.7 million or $12.1 billion (approximately $3 billion is for desalination costs) for

their five-year regulatory period. In the current regulatory period, more than 80 per cent

of the increase in total revenue requirement contributed to the increase in the price of

water and was due to the commencement of payments for the desalination plant.

Operating expenditure

Table 9.12: Melbourne Water operating expenditure, 2013–14 to 2017–18 – final

decision ($ million 2012–13)

278

Operating

expenditure

Total

proposed

Final

decision

Difference

($ m)

Difference

(per cent)

Desalination

payments

3 058.9 2 978.0

(61%)

-80.8 -2.6

Controllable costs 1 983.3 1 889.0 -94.3 -4.8

Regulatory

charges

10.2 10.8 0.7 6.5

Total 4 877.8


Table 9.10 shows Melbourne‟s Water total expenditure is $4 877.8 million for the five-

year regulatory period. However, the desalination cost is a major cost that fundamentally

changed Melbourne Water‟s cost profile. The desalination plant represents 61 per cent of

Melbourne Water‟s total annual operating expenditure for the regulatory period (Table

9.12).

Return on capital

Capital expenditure

The ESC approved $1 549.6 million of capital expenditure for the next three years.

Included in this amount are the changes to the timing of delivery of certain projects, such

as the Western Treatment Plant Capacity Augmentation Stage 2 Upgrade, and the

scrapping of projects such as City West Water‟s Altona Stage 2.


Table 9.13: Updated RAB ($ million 2012–13)

2007–

08

2008–

09

2009–

10

2010–

11

2011–

12

279

2007–

08

2008–

09

2009–

10

2010–

11

2011–

12

Opening RAB 5 597.1 5 942.6 6 995.3 7 872.2 8 444.3

Plus gross capital expenditure 495.3 1 212.9 1 058.0 791.6 555.8

Less government contributions 0.0 0.0 0.0 0.0 0.0

Less customer contributions 44.4 45.8 47.9 55.5 66.9

Less proceeds from disposals 1.2 4.8 13.0 30.7 5.4

Less regulatory depreciation 104.3 109.5 120.3 133.2 143.9

Closing RAB 5 942.6 6 995.3 7 872.2 8 444.3 8 783.9


Table 9.13 shows the updated RAB. As at 1 July 2012, the ESC approved the initial RAB

($8 783.9 million) to reflect the verified net capital expenditure. Subsequent years‟

opening RAB are based on forecasts by the Commission. Any difference between

assumed and actual net capital expenditure for 2012–13 will be adjusted when the

opening RAB is calculated for the next fourth regulatory period. In Table 9.14 below, the

closing RAB for 2012–13 was $8 861.1 million, which became the opening RAB (capital

expenditure) for 2013–14. The lesser of either, the actual net capital expenditure or the

2008 determination forecast of 2012–13 net capital expenditure, was proposed by the

Commission for 2012–13. This approach mainly reflects the 2012–13 capital expenditure;

it allows the business an incentive to deliver projects on schedule.

For the final year of the previous regulatory period, the Commission adopted updated

forecasts of the previous regulatory period to recognise a sharp increase in water security

projects at the time. A number of specific projects initiated in response to government

policy were rolled into Melbourne Water‟s 2012–13 RAB and considered capital

expenditure. These were the Eastern Treatment Plant Tertiary Upgrade (cost $36.4

million), the Eastern Drop Structure Air Treatment and Civil Works (cost $6.9 million),

the Silvan Fluoride Plant Upgrade (cost $5.8 million) and the IT System Renewals –

Asset Management System (cost $4 million).

Table 9.14: Melbourne Water rolled-forward RAB ($ million 2012–13)

280

2012–13 2013–

14

2014–

15

2015–16 2016–17

(estimate)

2017–18

(estimate)

Opening RAB 8 783.9 8 861.1 9 180.7 9 507.3 9 763.1 9 981.7

Plus gross capital

expenditure

292.7 521.7 541.0 495.9 480.0 379.6

Less government

contributions

0.0 0.0 0.0 0.0 0.0 0.0

Less customer

contributions

60.4 29.7 38.6 44.6 51.2 56.6

Less proceeds

from disposals

0.0 11.4 2.0 2.5 1.9 2.0

Less regulatory

depreciation

155.1 152.0 173.7 193.0 208.3 218.3

Closing RAB 8 861.1 9 180.7 9 507.3 9 763.1 9 981.7 10 084.4

(Essential Services Commission 2013, pp. 36 & 101)

Table 9.13 and table 9.14 above shows that the opening asset base for each year is

calculated by the use of annual forecasts for net capital expenditure, regulatory

depreciation and disposals for subsequent years in the regulatory period.

9.4.3 Queensland

An overview of the water operation and ownership in Brisbane and the Gold Coast is

provided in Table 9.15 below.

Table 9.15: Overview of operation and ownership in Brisbane and the Gold Coast

Brisbane Gold Coast

Infrastructure Operators Owners Operators Owners

Storage (dams) SEQ Water Queensland

Government

and local

SEQ Water and

GCW

Queensland

Government

and local

281

Brisbane Gold Coast

Infrastructure Operators Owners Operators Owners

governments

(incl. Brisbane

and Gold Coast

City Councils)

governments

(incl. Brisbane

and Gold Coast

City Councils)

Treatment/

transport

BW Brisbane City

Council

GCW Gold Coast

City Council

Reticulation BW Brisbane City

Council

GCW Gold Coast

City Council


Table 9.16: Allconnex (Gold Coast City Council, Logan City Council and Redland

City Council) RAB roll-forward

2008–09 2009–10 2010–11

Opening RAB ($m) 3 557.28 3 796.19 4 107.72

plus net capital expenditure

(includes capital expenditure as

commissioned, less disposals,

donated assets and cash

contributed)

267.3 299.22 135.88

plus indexation 74.46 125.64 135.88

less depreciation 93.34 102.79 129.57

less disposals 9.51 10.54

Equals RAB 3 796.19 4 107.72 4 255.91

(Queensland Competitive Authority 2012, p. 58)

Table 9.17: Capital program, by product and expenditure driver ($000s)

Product 2010–11 2011–12 2012–13 2013–14

282

(actual)

Drinking water 64 302 76 591 66 750 60 773

Other core water 2 858 8 603 13 868 14 112

Wastewater 138 391 187 817 259 520 230 804

Trade waste 11 953 16 473 22 914 20 478

Total capital expenditure 217 504 289 484 363 052 326 167

(Queensland Competitive Authority 2012, p. 7)

In Table 9.16, Allconnex Water‟s interim opening RAB was $4 255.91 million as at 1

July 2011. As per Table 9.17, in 2011–12, Allconnex Water‟s capital expenditure was

expected to increase to $289.5 million compared with $217.5 million in 2010–11, but it is

expected to be relatively stable from 2012–13 to 2013–14. Approximately 70 per cent of

the forecast expenditure for the year is accounted by wastewater, especially in relation to

major wastewater expenditures associated with growth in Coombabah, Loganholme and

Stapylton wastewater catchments. These forecast that the capital expenditure programs

will start at a lower but more achievable level of capital expenditure, and will

progressively increase to achieve optimum resource efficiency and increased capacity and

capability (Queensland Competitive Authority 2012, pp. 6–7).

The two largest capital expenditure projects for Allconnex Water are the Stapylton

Wastewater Treatment Plant and the Merrimac West Wastewater Upgrade. Construction

of the Stapylton Wastewater Treatment Plant was deferred in favour of an upgrade to the

adjacent Beenleigh Wastewater Plant, and reconfiguration of the Beenleigh and

Loganholme Wastewater catchments. The reconfiguration allowed transfer of loads from

the Beenleigh and Loganholme Wastewater Treatment Plant, and use of free capacity

within Loganholme Wastewater Treatment Plant, with an improved capacity of 66 ML/d

compared with the loading of 45 ML/d.

This strategy reduced anticipated capital costs by approximately $60 million over the next

five years, and provided much lower ongoing operational costs compared with

establishment of the new Stapylton Wastewater Plant. Similarly, the Merrimac West

Wastewater Upgrade was reviewed following the development of a Target Outturn Cost.

The cost was approximately $126 million more than the alternative pump station, which

283

meant that implementation of the project based on the tunnel option was suspended in

favour of development of an alternative arrangement which is currently underway

(Queensland Competitive Authority 2012, p. 60).

Allconnex Water calculates its maximum revenue requirement using the building block

methodology, represented by the sum of capital expenditure, deprecation, operating

expenditure and taxation, and less indexation. In 2011–12, Allconnex Water‟s total MAR

for all regulated services was $807 million, an increase of $104 million (14.9 per cent)

from 2010–11 because of higher bulk water costs and capital investment across its

operating area. Due to forecast revenue increases, Allconnex Water was operating below

lower-bound pricing, and its MAR for three years from 2011–12 to 2013–14 is forecasted

to increase by 15.5 per cent, to a total of $932 million, in 2013–14.

The main reasons for this increase are the continued upward trend in the bulk water price

path that contributes to higher annual operating expenditure, the business‟s continued

significant investment in prudent and efficient capital projects to provide for new growth,

and improvements/refurbishments of existing assets to maintain high service quality

(Queensland Competitive Authority 2012, pp. 8–9 & 85).

Recovery of total MAR is forecast to be 77.9 per cent in 2011–12, and will increase

marginally to 78.3 per cent in 2013–14. The history of under-recovery of MAR is mostly

due to external cost pressures, such as increasing bulk water charges and Queensland

Government legislation to cap distributor-retail price increases at CPI for both 2011–12

and 2012–13. Due to this two-year price cap, Allconnex Water was under a revenue glide

path to minimise price increases to customers. Over the longer term, the shortfall in cost

recovery will be recouped in later years with single revenue that exceeds MAR. In doing

so, it ensures that price increases are smoothed and price shocks to customers are

minimised (Queensland Competitive Authority 2012, pp. 8–9 & 86–-87).

9.4.4 South Australia

Table 9.18: South Australia water estimates total revenue requirement

SA Water (2007–08 prices $ million)

284

Regulated asset

values

2008–09 2009–10 2010–11 2011–12 2012–13 2013–

14

Legacy assets 6 868 6 787 6 704 6 619 6 532 6 442

New assets 955 2 046 2 752 3 043 3 200 3 406

Asset values 7 862 8 833 9 457 9 662 9 732 9 848

Upper revenue

pricing

Operating

expenditure

376 388 427 403 446 446

Depreciation 150 160 200 208 215 223

Return on assets

(6 per cent)

472 530 567 580 584 591

Total revenue 998 1 077 1 194 1 191 1 245 1 260

Water rates 125 109 111 136 166 204

Water sales 214 336 412 486 575 695

Sewerage rates 275 279 284 293 296 295

Community

service

obligations

179 189 166 115 76 48

Other 50 56 55 56 57 59

Total revenue 843 969 1 027 1 086 1 171 1 301

(South Australian Government 2010, p. 61)

Table 9.19: Rolled-forward RAB for South Australia water and wastewater assets

Nominal $ million 2007–

08

2008–

09

2009–

10

2010–

11

2011–

12

2012–

13

Opening balance 7 000 7 325 8 051 9 054 9 790 10 231

Capital expenditure 227 629 892 636 328 534

Inflation adjusted 240 251 276 310 335 350

Depreciation (135) (154) (165) (209) (222) (234)

Closing balance 7 325 8 051 9 054 9 790 10 231 10 882

285

Water assets (nominal $ million)

Nominal $

million

2007–08 2008–09 2009–10 2010–11 2011–12 2012–13

Opening

balance

4 596 4 848 5 429 6 215 6 743 7 025

Capital

expenditure

188 517 710 464 207 479

Inflation

adjusted

158 166 186 212 231 240

Depreciation (93) (103) (110) (148) (156) (163)

Closing

balance

4 596 4 848 5 429 6 215 6 743 7 581

Wastewater assets (nominal $ million)

Nominal $

million

2007–08 2008–09 2009–10 2010–11 2011–12 2012–13

Opening

balance

2 404 2 476 2 622 2 839 3 047 3 206

Capital

expenditure

39 112 182 172 121 56

Inflation

adjusted

82 85 90 97 104 110

Depreciation (47) (49) (51) (55) (61) (71)

Closing

balance

2 404 2 476 2 622 2 839 3 047 3 301

(South Australian Government 2009, p. 44)

Table 9.20: South Australia water forecast capital expenditure ($ million nominal)

Nominal $ million 2008–09 2009–

10

2010–

11

2011–

12

2012–

13

Total

286

Nominal $ million 2008–09 2009–

10

2010–

11

2011–

12

2012–

13

Total

2009–10 Transparency

Statement

Water 530 728 476 212 491 2 436

Wastewater 115 187 176 124 57 659

Total 645 914 652 336 548 3 096

2010–11 Transparency

Statement

Water 537

(actual)

932 564 187 163 2 383

Wastewater 113

(actual)

181 238 176 61 769

Total 650

(actual)

1 113 802 363 224 3 152

Difference 5 119 150 27 (324) 56

(Essential Services Commission of South Australia 2010, pp. 13 & 34)

Table 9.18 provides the estimates of South Australia Water‟s total revenue requirement

from 2008 to 2014, while Table 9.18 sets out the proposed (estimate) rolled-forward RAB

for South Australia Water, including capital expenditure from 2007 to 2013.

The ESCOSA (2010, pp. 13 & 34–35) noted that a key driver for the 60 per cent real

increase in water prices between 2008 and 2009 ($84 per year or $1.62 per week) was

because of the significant increase in capital expenditure in relation to the government‟s

water security investments. This particularly referred to the ADP, the implementation of

the Network Water Security Program designed to better connect the northern and

southern water supply systems, and the purchase of Murray River water to ensure that

sufficient quantity of water was available for critical human needs.

Water prices increased by an average of 17.9 per cent in real terms in 2009–10, followed

by an average increase of 21.7 per cent in 2010–11 and the capital costs forecasts

287

provided for 2010–11, and future years have changed since the 2009–10 forecasts due to

the following reasons:

The ADP at Pt. Stanvac was known to be the highest water capital expenditure in

Australia during 2009–10, costing approximately $1.82 billion. It not only

represents over half of the total forecast capital expenditure, but also dominated

most of the capital expenditure program from 2008–09 to 2013–14. It has

delivered approximately 15 million litres per day since April 2011, progressing to

50 GL capacities by end of August 2011, and to 100 GL full capacities at the end

of December 2012. The decision by the South Australian Government to expand

ADP is reflected in the significant increase in capital expenditure in 2009–10 and

2010–11, as shown in Tables 9.18 and 9.19, as compared with the estimates

provided in 2009–10 in Table 9.17. For this reason, the increase in capital

expenditure has impacted on nearly 60 per cent real increase in water prices since

2008–09.

Metropolitan sewerage capital expenditure increased significantly above 2008–09

levels in 2009–10 and 2010–11, to meet the demand growth. The two key upgrade

projects were the capacity upgrades of Christies Beach and Aldinga Wastewater

Treatment Plants.

Upgrades to treatment plants driven by growth in regional water capital

expenditure declined from 2010–11 to 2012–13, before increasing again in 2013–

14 due to upgrades to treatment plants driven by growth.

Upgrades to treatment plants driven by growth in regional sewerage capital

expenditure declined from 2011–12 to 2012–13, before increasing again in 2013–

14.

Table 9.21: South Australia water key capital expenditure projects ($ million

nominal)

Project Expected

completion

2009–10

expenditure

Estimated

total cost

ADP December 2012 832.8 1,824.0

Christies Beach Wastewater Early 2012 80.0 272.0

288

Project Expected

completion

2009–10

expenditure

Estimated

total cost

Treatment Plant Upgrade

Glenelg to Adelaide

Parklands Park Lands

Recycled Water

December 2009 17.2 74.9

Southern Urban Reuse December 2010 35.5 62.6

Bird in Hand Wastewater

Treatment Plant Nutrient

Reduction

December 2012 10.3 38.5

(Essential Services Commission of South Australia 2010, p. 35)

Table 9.21 lays out a summary of the top five capital expenditure projects by estimated

total cost in South Australia. Water prices are expected to almost double over the next

four years, so that the government can fully recover the costs associated with major water

security projects and other costs such as externalities (Coastal Water Study,

Environmental Impact Assessment– Essential Services Commission of South Australia

2010, p. 18).

9.4.5 Western Australia

The institutional and governance arrangements of the urban water supply arrangements in

Western Australia are summarised in Table 9.22 below.

Table 9.22: Water service providers in Western Australia

Area Name Services Institutional

structure

Western

Australia (other

than Bunbury

and Busselton)

Western Australia

Water

Corporation

Bulk water, catchment

management, treatment,


Statutory state-

owned corporation

289

Area Name Services Institutional

structure

Bunbury AQWEST Bulk water, treatment,


Statutory authority

Busselton BWB Bulk water, treatment,


Statutory authority


Table 9.23: Water Corporation revenue requirement, 2005–06 to 2014–15

Value ($ million, real dollars as of June 2005)

Asset account 2005–

06

2006–

07

2007–

08

2008–

09

2009–10

Opening asset value 10 599 11 076 11 270 11 561 11 898

Capital expenditure 735 465 570 626 498

Depreciation 259 271 280 290 301

Closing asset value 11 076 11 270 11 561 11 898 12 095

Cost of service 2005–

06

2006–

07

2007–

08

2008–

09

2009–10

Operating expenditure 396 401 405 409 413

Depreciation 259 271 280 290 301

Return on assets 597 624 635 651 670

Gross cost of service 1 252 1 296 1 319 1 350 1 384

Net revenue requirement 729 761 782 811 841


11

2011–

12

2012–

13

2013–

14

2014–15

Opening asset value 12 095 12 246 12 452 12 618 12 756

Capital expenditure 460 524 493 473 487

Depreciation 309 317 327 335 344

Closing asset value 12 246 12 452 12 618 12 756 12 899

Cost of service 2005–

06

2006–

07

2007–

08

2008–

09

2009–10

290


06

2006–

07

2007–

08

2008–

09

2009–10

Operating expenditure 417 421 425 429 433

Depreciation 309 317 327 335 344

Return on assets 682 690 702 711 719

Gross cost of service 1 407 1 428 1 453 1 475 1 495

Net revenue requirement 863 881 904 924 941


Table 9.24: AQWEST revenue requirement, 2005–06 to 2014–15

Value ($ million, real dollars as of June 2005)


06

2006–

07

2007–

08

2008–

09

2009–10

Opening asset value 25.1 29.7 34.6 36.0 38.1

Capital expenditure 5.3 5.6 2.1 2.9 5.2

Depreciation -0.6 -0.7 -0.8 -0.9 -1.0

Closing asset value 29.7 34.6 36.0 38.1 42.4

Cost of service

Operating expenditure 3.9 3.9 4.0 3.9 3.9

Depreciation -0.6 -0.7 -0.8 -0.8 -0.9

Return on assets 1.5 1.7 2.0 2.1 2.2

Gross cost of service 6.0 6.4 6.8 6.8 7.0

Net revenue requirement 4.3 4.9 5.2 5.2 5.4


11

2011–

12

2012–

13

2013–

14

2014–15



Depreciation -1.0 -1.0 -1.0 -1.1 -1.1


Cost of service 2005– 2006– 2007– 2008– 2009–10

291

06 07 08 09


Depreciation -1.0 -1.0 -1.0 -1.1 -1.1

Return on assets 2.5 2.6 2.7 2.8 2.9




Table 9.25: Busselton revenue requirement, ($ million, real dollars as of June 2009)

Asset account 2005–06 2006–

07

2007–

08

2008–

09

2009–10



Depreciation -0.4 -0.4 -0.4 -0.5 -0.5


Cost of service 2005–06 2006–

07

2007–

08

2008–

09

2009–10


Return on assets 0.4 0.4 0.4 0.5 0.5

Depreciation 0.9 1.0 1.1 1.2 1.3


Net revenue requirement 1.7 3.2 3.5 3.6

Asset account 2010–11 2011–

12

2012–

13

2013–

14

2014–15



Depreciation -0.5 -0.6 -0.6 -0.6 -0.7


Cost of service


292

Return on assets 0.5 0.6 0.6 0.6 0.7

Depreciation 1.4 1.5 1.6 1.7 1.7




As summarised in Table 9.23, Western Australia Water Corporation‟s revenue

requirement over the period from 2005–06 to 2014–15 at a present value with a discount

rate of 5.63 per cent (real pre-tax) is $6 240 million. The Water Corporation‟s proposed

asset value of $10 599 million as at 30 June 2005 was determined and verified by its

regulator, the ERA, by constructing a set of regulatory accounts based on the Water

Corporation‟s forecast of operating and capital costs.

The asset value is the value determined through the building block methodology, where

prices are set based on operating and maintenance costs, depreciation, and a return on the

regulatory asset value. The Water Corporation‟s capital expenditure program is projected

to a total of $6 196 million or an average of $620 million per year over the 10-year period

from 2005–06 to 2014–15 (Economic Regulation Authority 2005, p. 74).

The basis for water tariffs set by the government followed the 2005 inquiry, and formed

the Water Corporation‟s capital expenditure program for the regulatory period (three

years) from 2005–06 to 2007–08. The proposed capital expenditure amount was $1 720

million (in nominal dollars), but the actual expenditure for that period was $2 011

million; an increase of $291 million, mainly due to cost escalation (+$149 million),

additional projects (+$168 million, including $69 million on various wastewater treatment

plant projects, $30 million on infill sewerage, $20 million on the Southern Seawater

Desalination Plant, and $14 million on the Gnagara Mound Replenishment Trial),

deletion of the South West Yarragadee project (-$103 million), and expenditure carried

over from projects that were not completed in earlier years ($99 million) (Economic

Regulation Authority 2009, pp. 124–125).

In 2007–08, the government approved the Water Corporation‟s capital expenditure for the

period 2008–09 to 2012–2013 of $4 027 million (in nominal dollars). This projected

capital expenditure was expected to average $805 million per year, in comparison with

293

$670 million per year over the previous regulatory period 2005–06 to 2007–08

(Economic Regulation Authority 2009, pp. 124–125). Major projects for this regulatory

period from 2008–09 to 2012–13 included $935 million on the Southern Seawater

Desalination Plant, $2 674 million on regional projects in Western Australia, $230 million

on the Alkimos Wastewater Treatment Plant, $205 million on the Mundaring Water

Treatment Plant, $145 million on the Beenyup Wastewater Treatment Plant, and $37

million on the Woodman Point Odour Control (Economic Regulation Authority 2009, pp.

125–126).

Table 9.24 demonstrates the basis for water tariffs set by the government following the

2005 inquiry, and formed the Water Corporation‟s capital expenditure program for the

regulatory period (three years) from 2005–06 to 2007–08 for AQWEST. The proposed

capital expenditure amount was $11.9 million (in nominal dollars), but the actual

expenditure for that period was $19.7 million – an increase of $7.8 million. The increases

in capital expenditure were mainly based on two reasons: first, capital construction was

for an 8.4 km pipeline at a cost of $4.6 million (the City Link Project), with the purpose

of reducing the need to produce water from AQWEST‟s coastal bores; second, capital

expenditure was to make provision for future high-volume demand from development in

Bunbury.

For the following regulatory period from 2008–09 to 2012–13, AQWEST‟s proposed

capital expenditure program came to $34.4 million (in nominal dollars), with an average

of $3.7 million per year, compared with $6.5 million per year over the previous

regulatory period from 2005–06 to 2007–08. The capital expenditure was $6.3 million on

water treatment plants, and $5.0 million on mains (Economic Regulation Authority 2009,

p. 127).

Table 9.25 demonstrated the basis for water tariffs set by the government, following the

2005 inquiry, and forms the Water Corporation‟s capital expenditure program for the

regulatory period (three years) from 2005–06 to 2007–08 for Busselton Water. The

proposed capital expenditure amount was $6.4 million (in nominal dollars), but the actual

expenditure for that period was $5.8 million. For the following regulatory period from

2008–09 to 2012–13, Busselton Water‟s proposed capital expenditure program amounted

to $19.5 million (in nominal dollars), with an average of $3.9 million per year, compared

294

with $1.9 million per year over the previous regulatory period. The main capital

expenditure was the $2 million purchase of a new administration building (Economic


9.4.6 Tasmania

Table 9.26 shows the upper revenue limit ($‟000) used in calculation of RAB for existing

and new assets for the three main water businesses in Tasmania: Ben Lomond Water

(operates in the northern region), Cradle Mountain Water (operates in the north western

region) and Southern Water (operates in the southern region). These new assets are rolled

forward as the existing assets, and their value will increase over time as water businesses

invest in new assets. The regulated entities propose that capital expenditure for each year

of the regulatory period should be split between water and sewerage assets.

Table 9.26: Upper revenue limit ($’000)

2012–13 2013–14 2014–15

Ben Lomond Water

Water

Capital expenditure (existing) 17 615.05 17 072.23 16 529.79

Capital expenditure (new) 2 894.43 3 711.52 3 984.02

Depreciation (existing) 10 088.57 10 084.99 10 081.50

Depreciation (new) 904.97 1 176.42 1 280.36

Operating expenditure 20 611.36 21 093.26 21 786.78

Total water 52 114.38 53 138.42 53 662.45

Wastewater




Depreciation (new) 480.78 695.39 1 031.93


Total wastewater 50 795.22 51,575.93 53 060.05

Total 102 909.60 104 714.35 106 722.50

Cradle Mountain Water

295

2012–13 2013–14 2014–15

Water




Depreciation (new) 1 486.78 1 985.23 2 165.53


Total water 47 168.16 47 695.12 48 265.65

Wastewater


Capital expenditure (new) 944.60 1 372.52 1 733.87




Total wastewater 45 654.55 46 252.26 47 049.22

Total water 92 822.71 93 947.39 95 314.87

Southern Water



Depreciation (existing) 20 370 20 367.71 20 365.08



Total water 102 384.40 102 188.69 102 526.89

Wastewater




Depreciation (new) 540.64 1 163.36 1 718.34


Total wastewater 88 956.31 90 364.17 91 677.18

Total 191 340.72 192 552.86 194 204.07

(Office of Tasmanian Economic Regulator 2012, pp. 47–57)

296

In Tasmania, the current regulatory period covers a period of three financial years,

starting from 1 July 2012 to 30 June 2015. A state government review in 2006 revealed

that the prices charged for water did not cover the cost of providing water services (and

sewerage) for all Tasmanians. It was found that water prices were too low to fund both

new plant and equipment, and to replace worn-out assets it needed to meet acceptable

standards of safe drinking water, and public and employee safety, and to control pollution

to Tasmania‟s environment. Water services in Tasmania were not only below the

standard, but it was likely to fall further as Tasmania‟s water and sewerage sector was not

financially sustainable.

The Tasmanian Government made a series of reforms to the water (and sewerage)

industry to ensure that sufficient funds will be available to meet the cost of providing

water services, maintain the existing water infrastructure, and invest in the new and

upgraded infrastructure to ensure that Tasmania‟s water is safe to drink and that sewerage

does not continue to pollute its environment (Office of the Tasmanian Economic


For Ben Lomond Water, in real terms, revenue was projected to grow by 9 per cent over

the first regulatory period, and even though revenue is now trending towards the lower-

bound pricing, it is still below a sustainable level. The Office of the Tasmanian Economic

Regulator (2012, p. 70) predicted that the MAR will not reach the expected levels by 30

June 2015, as the revenue of $67 925 million is just over two-thirds of the upper-bound

pricing limit of $106 723 million. Over the first regulatory period, Ben Lomond Water

will experience increased revenue from customers, which will be utilised to pay off debt

and returns to owners, and to fund capital expenditure at levels which are expected to

decline after the first year of the initial regulatory period.

For Cradle Mountain Water, in real terms, revenue is projected to grow by 13 per cent

over the first regulatory period, and revenue is trending towards the lower-bound pricing,

and is transitioning from an unsustainable level over the previous period. In 2013–14,

revenue is expected to be above the lower-bound pricing. The Office of the Tasmanian

Economic Regulator (2012, p. 72) predicted that the MAR will not be reached by 30 June

2015, as the revenue of $62 484 million is well short of the upper-bound pricing limit of

$95 315 million. Over the first regulatory period, Cradle Mountain Water will experience

297

increased revenue from customers, which will be utilised to pay off debt, to meet the

increase in operating expenditure and returns to owners, and to fund capital expenditure at

levels that are expected to decline over the period.

For Southern Water, in real terms, revenue is projected to grow by the slowest rate of 3

per cent over the first regulatory period. Revenue remains under the sustainable level

under the lower-bound pricing. With debt costs projected to increase by 34 per cent, the

Office of the Tasmanian Economic Regulator (2012, p. 73) predicted that the MAR will

not be reached by 30 June 2015; revenue of $120 543 million is less than two-thirds of

the upper-bound pricing limit of $194 204 million. As a result of price reforms over the

first regulatory period, Southern Water will experience a small annual increase in revenue

from customers. However, due to lack of revenue growth, Southern Water remains in a

financially unsustainable position and is only close to achieving the lower-bound pricing.

9.4.7 Key findings

The core in any regulation of utilities is the RAB, an accounting figure that contains the

physical bundle of new and existing assets. This value is the opportunity cost of

investment, and represents the investors‟ claims in the business, where return on capital is

required and depreciation represents the return of capital.

The economic problem in relation to utility businesses being a natural monopoly

is that they are part of a capital-intensive (in the tens to hundreds of billions of

dollars) industry, which means that their assets are long-life (10 to over 100 years)

and immobile, and they are sunk costs once invested with no alternative use.

The calculation of the building block equation and the RAB means asset valuation

requires not only a significant amount of planning (each regulatory period lasts

from three to five years), but also structuring from a regulatory perspective. The

right operating and regulatory environment needs to be created, and it demands a

high degree of understanding between all parties involved (the business, investors

and regulator). The RAB (asset valuation) may not be suitable for all markets due

to its complexities. It is best suited to utility businesses that are natural

monopolies, subjected to regulation and facing limited market risk. It works

exceptionally well where large capital investments are required.

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The RAB used in the building block equation brings in significant amounts of

capital into infrastructure on a long-term basis. It attracts large amounts of capital

into infrastructure (utilities), and at the same time provides transparent and

consistent mechanisms that reduce investor risk by providing stable, deep capital

resources in the long term, and better defined cash flow. On one hand, investors

can recover the exact capital they invest into the assets, as RAB is based on

financial (operating) maintenance as discussed in Chapter Three. That is, a price

cap is placed on consumer prices. On the other hand, the RAB is based on a

regulatory contract and there is no „guarantee‟ of the exact capital invested into

the assets.

Return on RAB is the price of water that customers pay for the past investments,

but is reflected in the current and future price of water. Past expenditures are not

only sunk, but also largely irrelevant for efficient decisions in relation to future

usage and investment. The building block equation, specifically the return on

capital, suggests that there will not be any profit forecasted from the calculation of

MAR. It is therefore inappropriate for the business to earn profits such as those

realised or anticipated in perfectly competitive (non-regulated) markets.

RAB calculations are inconsistent across jurisdictions due to the size of businesses

and the regulatory period in which they are done and compared.

Utility businesses are not restricted to past investments only, as they also engage

in carrying out new investments and running day-to-day business, as reflected in

OPEX.

The inherent flaw in the calculation of MAR is the failure to consider any

increment in cost of capital during the regulatory period, if there is any.

The price of water is not set to recover the annual revenue requirement in each

year of the regulatory period, as it is smoothed over the regulatory period to limit

any impact of sharp price increases on consumers.

The value of water service or the true costs of providing service is not reflected in

water rates (price).

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9.5 Regression analysis

The Least Squares Regression Method is used to predict whether there is a link between

investment; that is, net capital expenditure and asset valuation techniques used in water

utility businesses in Australia. The least squares regression method has been chosen for

this thesis because it can estimate the true value of any quantities based on a

consideration of errors in observations or measurements. The analysis found mixed

relationships between the residuals, which cancel each other out and explains how well

the line fits by adding up all the residuals. The sum of all the squared residuals shows

how well the line fits the data set. A standard deviation is calculated to measure the

spread between the residuals.

Data are collected from the WSAA website and water businesses industry reports over

eight years from 2004 to 2012. The primary purpose of the analysis is to model the linear

relationship, particularly between asset valuation techniques (independent variable) and

net capital expenditure (dependent variable). Values of the independent variables (i.e.

asset valuation techniques, length of pipes connecting residential properties water supply

and the number of population connected to urban water services) are collected to predict

the behaviour and value of the dependent variable, net capital expenditure.

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Table 9.27: Least Squares Regression Method (DORC = 1 and Line in the sand, EV = 0) Dependent Variable: CAPX_TA (net capital expenditure) Method: Least Squares Sample (adjusted): 137 Included observations: 28 after adjustments Variable Coefficient Std. Error t-Statistic Prob. C 0.160703 0.133347 1.205149 0.2399 ASSET_VALUATION 0.364510 0.095450 3.818873 0.0008 LENGTH_OF_PIPES 4.60E-06 2.78E-06 1.654737 0.1110 POPULATION -1.60E-07 1.48E-07 -1.085628 0.2884 R-squared 0.769352 Mean dependent var 0.095530 Adjusted R-squared 0.740521 S.D. dependent var 0.098940 S.E. of regression 0.050399 Akaike info criterion -3.006113 Sum squared resid 0.060962 Schwarz criterion -2.815798 Log likelihood 46.08559 Hannan-Quinn criter. -2.947932 F-statistic 26.68484 Durbin-Watson stat 1.149275 Prob(F-statistic) 0.000000

CAPX_TA = net capital expenditure

ASSET_VALUATION = asset valuation technique

Depreciated optimised replacement cost (DORC) = 1; Line in the sand, EV = 0;

LENGTH_OF_PIPES = length of pipes connecting residential properties water supply

POPULATION = the number of population connected to urban water services

Based on Table 9.27, the straight line can be written as:

CAPX_TA = 0.16 + 0.36 ASSET_VALUATION + 0.0000046 LENGTH_OF_PIPES –

0.00000016 POPULATION

In this regression analysis, dummy variables for asset valuation techniques are used. Net

capital expenditure (dependent variable) is influenced by both the quantitative variables

(length of pipes connecting residential properties water supply and the number of

population connected to urban water services) and the qualitative variable (asset valuation

techniques). In the first regression analysis, dummy variables (independent variable) or

dummy explanatory variables take the values of 1 for DORC and 2 for line in the sand,

EV (table 9.27). The dummy variables eliminated some categorical effect that may shift

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the outcome of the regression and sorted data into mutually exclusive categories, that is

DORC = 1 and EV = 0 (table 9.27).

The R-squared number for both regressions (Table 9.27 and Table 9.28) is known as the

coefficient of determination when expressed as a percentage. For this thesis, the value of

the R-squared number is 0.769; meaning 76.9 per cent of the total sum of squares can be

explained by the estimated regression equation above when used to predict or forecast

future net capital expenditure. This suggested that 76.9 per cent of the total variation in

net capital expenditure (dependent variable) can be explained by its relationship with

asset valuation techniques, length of pipes connecting residential properties water supply,

and the number of population connected to urban water services (independent variables).

From Table 9.27, the slope 0.36 means that on average, every $1 increase in DORC asset

valuation technique resulted in a 36 cent increase in net capital expenditure. Likewise, on

average, every 1 km increase in length of pipes will result in 0.0000046 cent increase in

net capital expenditure. The number of population connected to urban water services has

a negative impact on net capital expenditure. On average, every one increase in the

number of population connected to urban water supply will result in a negative

0.00000016 cent in net capital expenditure.

The t-statistic of the Least Squares Regression Method is the regression coefficient of a

given independent variable, divided by its standard error. The coefficient of asset

valuation technique was significant with a positive sign t-statistics of 3.8 (Table 9.27),

implying that DORC asset valuation technique positively impacted on net capital

expenditure. It can be therefore concluded that DORC asset valuation technique

(independent variable) has a significant positive impact on net capital expenditure

(dependent variable). In theory, DORC asset valuation technique is the upper-bound

pricing. Higher asset valuation resulted in higher price of water and higher level of capital

expenditure by the business.

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Table 9.28: Least Squares Regression Method

(DORC = 0 and Line in the sand, EV = 1)

Dependent Variable: CAPX_TA (net capital expenditure) Method: Least Squares Sample (adjusted): 137 Included observations: 28 after adjustments

Variable Coefficient Std. Error t-Statistic Prob. C 0.525212 0.133347 1.205149 0.0280

ASSET_VALUATION -0.364510 0.095450 -3.818873 0.0008 LENGTH_OF_PIPES 4.60E-06 2.78E-06 1.654737 0.1110

POPULATION -1.60E-07 1.48E-07 -1.085628 0.2884 R-squared 0.769352 Mean dependent var 0.095530

Adjusted R-squared 0.740521 S.D. dependent var 0.098940 S.E. of regression 0.050399 Akaike info criterion -3.006113 Sum squared resid 0.060962 Schwarz criterion -2.815798 Log likelihood 46.08559 Hannan-Quinn criter. -2.947932 F-statistic 26.68484 Durbin-Watson stat 1.149275 Prob(F-statistic) 0.000000

CAPX_TA = net capital expenditure

ASSET_VALUATION = asset valuation method

Depreciated optimised replacement cost (DORC) = 0; Line in the sand economic value

(EV) = 1;

LENGTH_OF_PIPES = length of pipes connecting residential properties water supply

POPULATION = the number of population connected to urban water services

In the second regression analysis as in Table 9.28, the dummy variable for asset valuation

techniques is DORC = 0 and line in the sand, EV = 1. The slope of negative 0.36 means

that on average, every $1 increase in line in the sand, EV asset valuation technique

resulted in a 36 cent decrease in net capital expenditure. The length of pipes and the

number of population connected to urban water supply remained the same. The

coefficient of asset valuation is significant, with a negative sign (t-statistics of -3.8)

implying that line in the sand, EV asset valuation technique impacted negatively on net

capital expenditure.

303

It can therefore be concluded that the line in the sand, EV asset valuation technique

(independent variable) has a significant negative impact on net capital expenditure

(dependent variable). In theory, EV asset valuation technique is the lower-bound pricing.

That is, lower asset valuation technique resulted in lower price of water and lower level of

capital expenditure by the business. High investment is associated with DORC asset

valuation technique rather than with the EV asset valuation technique.

A water business invests in capital expenditure regardless of the asset valuation

techniques used. The findings of both regression analysis, particularly whereby the length

of pipes and the number of population connected to urban water supply remained the

same regardless of the asset valuation techniques used is consistent with the argument

made by Topp and Kulys (2012, p. 98). That is, it takes many more years for the

aggregate supply capacity and existing supply capacity, including new capacity, to be

fully utilised after investment is made and new water supply assets are operational. Dam

levels cannot be raised every year, and pipes and wastewater treatment plants cannot be

widened each year to meet the growing demand for water and wastewater treatment.

Water assets are constructed with a long-term aim of meeting both current and future

demand. Output will increase in line with population growth and the available capital

capacity. The trend is that once these lumpy new assets are constructed, capital

expenditures will slow down.

This regression analysis confirmed the hypothesis of this thesis, that is, there is a direct

relationship between investment in water assets which impact on the RAB and ultimately

the price of water.

9.5 Summary of current institutional structure arrangements

The majority of Australian households (i.e. 93 per cent) are connected to reticulated

network of water and wastewater services. These water services are predominantly

provided by vertically integrated and government-owned water providers that are

regulated monopoly businesses. There is some vertical disaggregation in Australian major

metropolitan areas. For example, vertical disaggregation can be observed between bulk

supply and retail services, while horizontal disaggregation can be observed between

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geographical regions. Water businesses do not compete with each other in the provision

of water services.

In general, urban water and its related systems are not physically connected. The key

difference is a large variety of institutional arrangements and structures that have emerged

across different Australian jurisdictions and their regions. Table 9.29 below summarises

the institutional structure arrangements in major Australian cities.

Table 9.29: Institutional structure of water and wastewater provision in major

Australian cities

Region Metro Regional

New South Wales Sydney is vertically separated

between Sydney Water

Corporation and Sydney

Catchment Authority

Local government authorities

predominantly provide these

services outside of Sydney and

Newcastle

Victoria Melbourne Water is vertically

separated; the three water

retailers are horizontally

disaggregated

Reform in 1994 has resulted in

140 non-metropolitan water

providers, consolidated into 13

and later 15 state-owned regional

urban water authorities providing

integrated water services

Queensland There are separate vertically

disaggregated authorities for

manufactured water, bulk

water, and bulk transport and

grid management; there are

10 local government

authority-owned retailers

which provide retail services

Local government authorities

predominantly provide these

services, with the exception of

South East Queensland

South Australia South Australia Water

provides water and

wastewater services; it is a

Water services are provided by

South Australia Water; local

government authorities provide

305

Region Metro Regional

vertically integrated water

utility

sewerage services in non-

metropolitan areas

Western Australia Western Australia Water

Corporation provides water

services to Perth; it is a


utility

Water services are provided by

Western Australia Water

Corporation or other water

boards; local government

authorities provide sewerage

services in non-metropolitan areas

Tasmania Southern Water provides

Hobart water services; it is a


utility

Local governments previously

provided these services; however,

in 2009 three regional utilities

supported by a common shared

services utility amalgamated

Australian Capital

Territory

ACTEW AGL is the provider

of water services. It is a


utility.

-

(National Water Initiative 2011, p. 7)

9.6 Water Pricing Principles as outlined by the NWI

The NWI is the national blueprint for water reform, and it was agreed upon by the

Commonwealth and state and territory jurisdictions at the COAG meeting in June 2004.

These NWI Pricing Principles drew from not only those in the 1994 COAG Water

Reform Framework, but also the 1999 Tripartite Agreement, the NWI, as well as the

report of the Expert Group on Asset Valuation Techniques and Cost Recovery Definitions

for the Australian Water Industry (the Expert Group) (NWI 2010, p. 3).

The NWI Pricing Principles are based on the COAG Water Resource Pricing Principles.

It was developed by the Expert Group who made a number of recommendations

regarding asset valuation and cost recovery. The group suggested that the price of water

be set by the jurisdictional regulators, who in examining full-cost recovery as an input to

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price determinations, should have regard to these pricing principles. The deprival value

methodology should be used for asset valuation. These pricing principles are the basis for

setting water pricing in all jurisdictions, and have been agreed by all state and territorial

governments. If a decision was made not to apply these principles in a particular case,

Australian governments agree that the reasons need to be tabled in the parliament.

Tasmania joined in later in June 2005, followed by Western Australia in June 2006 (NWI

2010, p. 3).

The NWIC established the Steering Group on Water Charges, not only to provide

technical advice on water pricing, but also to support the implementation of NWI pricing

reforms. Later, on 23 June 2010, the NWI Pricing Principles were also endorsed by the

Natural Resource Management Ministerial Council.

The pricing principles set by the NWI represent a shared commitment by governments to

increase the efficiency of Australia‟s water use, which leads to greater certainty for

investment and productivity, both for the rural and the urban communities, and for the

environment (NWI 2010, p.2).

The Australian governments have made commitments to best-practice water pricing under

the NWI, including promoting economically efficient and sustainable use of water

resources, water infrastructure assets and government resources devoted to the

management of water; ensuring sufficient revenue streams to allow efficient delivery of

the required services; facilitating efficient functioning of water markets, giving effect to

the principle of user-pays and achieving pricing transparency in respect of water storage

and delivery in irrigation systems and cost recovery for water planning and management;

and avoiding perverse or unintended pricing outcomes.

Paragraphs 65 (iii) and 67 of the NWI state the main objective of the pricing principles is

to assist jurisdictions (the Commonwealth and state and territory governments) to achieve

consistency in water pricing. The set principles for recycled water and stormwater reuse

have been developed consistent with NWI paragraph 66(ii), to assist states and territories

to meet their commitment in developing pricing policies for recycled water and

stormwater use, congruent with pricing policies for portable water.

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The four sets of pricing principles are principles for recovering capital expenditure,

principles for setting urban water tariffs, principles for recovering the cost of water

planning and management, and principles for recycled water and stormwater reuse.

The principle for recovery of capital expenditure suggests that capital expenditure

(including expenditure for replacement of existing assets, to expand the stock of assets, to

meet increases in demand, and to meet required service standards and any increases in

regulatory obligations) in water businesses constitutes the major proportion of costs

recovered through water charges.

Figure 9.3 (below) summarises the COAG Water Resource Pricing Principles. The upper-

bound pricing provides guidelines to avoid monopoly rents. In practice, a water business

should not recover more than the operational, maintenance and administrative costs,

externalities, taxes or tax equivalent regimes, provision for the cost of asset consumption,

and cost of capital. This is the value consistent with the price that would be charged if a

hypothetical (efficient) new entrant enters the market. DORC valuation would be able to

achieve this when implemented correctly. Rationalisation for the upper-bound pricing is

that in a perfectly contestable market, prices would reflect the cost structure of the

efficient new entrant, and prices set higher than those earned in a contestable market

would contain monopoly rent.

The lower-bound pricing provides guidelines for a water business to remain viable. In

practice, a water business should recover, at least, the operational, maintenance and

administrative costs, externalities, taxes or tax equivalent regime, interest cost of debt,

and dividends (if any), and make provision for future assets refurbishment/replacement.

Dividends should be set at a level that reflects commercial realities and stimulates a

competitive market outcome (NWI 2010, p.10).

Figure 9.3: COAG Water Resource Pricing Principles

308

A review of the financial performance of 24 water utility government trading enterprises

for the period between 2004–05 and 2006–07 was released by the Australian Government

Productivity Commission in July 2008. The water businesses examined in the report

varied substantially in size, with the smallest provider controlling $105 million in assets,

and the largest controlling $12.3 billion. The review found that the 24 water utility

government trading enterprises recovered their costs; in fact, they reported positive

returns on capital assets in 2006–07, which was consistent with achieving lower-bound

pricing.

Ten of the 24 water utility businesses were providers of urban water services, and half of

these (5) were providers of urban water services. They reported returns on assets

exceeding the „risk-free rate of return‟; that is, 5.8 per cent of the return on 10-year

Commonwealth Government bonds. This was the definition of upper-bound pricing

adopted by the Productivity Commission. These five water businesses are considered to

be operating commercially.

Principle 6 of the COAG Pricing Principles notes that economic regulators should

determine the level of revenue for a water business based on efficient resource pricing,

which includes the need to use pricing to send the correct signals to consumers on the

high cost of augmenting their water supply (NWI 2010, p. 18). That is, water is priced

through a two-part tariff arrangement, where there are separate components for access to

the infrastructure (this is the fixed service availability charge) and for usage (this is the

variable, volumetric or usage charge).

The variable component of water charges is the inclining block tariff. In most

jurisdictions, two or more blocks or tiers (up to 11) are incorporated into variable charges

Upper-bound pricing: provides guidelines to avoid monopoly rents

Lower-bound pricing: provides guidelines for

water businesses to remain viable

309

levied on residential users. The variable component of the charge increases when water

consumption exceeds pre-determined blocks or thresholds. The inclining block tariffs are

set with reference to an estimate of the long-run marginal cost of supply, so that the

correct pricing signals are sent (NWI 2010, p. 18).

The Steering Group on Water Charges identified that there were different areas in pricing

approaches across jurisdictions. The most obvious three were the approaches to recover

capital expenditure, the approaches to setting urban water tariffs, and the approaches to

recovering the costs of water planning and management (NWI 2010, p. 2).

Principles for urban water tariffs are developed where there are large monopoly water

providers. That is, there is an absence of water trading competitive pressures to bring

about efficient levels of cost recovery and associated tariff structures. There are many

reasons why operation of water trading in an urban context is limited, and due to physical

limitations it is likely to remain so. Water service availability and usage charges

determine the cost of water to users, and the term „service availability charge‟ describes

the access/connection/fixed charge, and the term „water usage charge‟ describes the

variable charge.

Paragraphs 6–8 of the NWI Pricing Principles note the approaches to setting urban water

tariffs, in a way which comprises a service availability charge and a water usage charge.

The service availability charge can be determined as the residual component to be

recovered to meet the revenue requirement after the revenue from water usage charges

has been estimated. The revenue to be recovered through the service availability charge

should be calculated as the difference between the total revenue requirement, and the

revenue recovered through water usage charges and developer charges (costs of new or

upgraded infrastructure required to service a given region or development) (NWI 2010, p.

9).

The usage component of the charge, known as the „inclining block tariff‟ or „two-part

tariff‟, has been adopted by many Australian jurisdictions. It is generally set with

reference to long-run marginal cost of supply (NWI 2010, p. 9).

310

The key difference and the degree to which urban and regional water businesses achieve

full cost recovery vary widely across Australia. These are identified by the NWI (2011) as

follows:

The ESC in Victoria regulates the prices in all metropolitan, regional and rural

water services. It is progressing towards upper-bound cost recover.

In Queensland and New South Wales, local councils provide regional urban

services. Surprisingly, local councils are not subject to economic regulation,

which means local councils‟ water prices are not closely scrutinised. Instead, local

governments have their compliance with cost recovery assessed via reporting

against guidelines and benchmark returns issued by governments such as the New

South Wales Best Practice Management of Water Supply and Sewerage

Guidelines 2007.

Many non-metropolitans in South Australia, Western Australia and the Northern

Territory do not achieve full cost recovery. In fact, these governments fund

revenue shortfalls and adopt uniform state pricing policies. Currently, Western

Australia is phasing in more cost-reflective charges for both country commercial

and high-use residential consumers.

Three regional water businesses in Tasmania – Ben Lomond Water, Southern

Water and Cradle Mountain Water – generate rates of return below full-cost

recovery levels. As of July 2009, a major restructure of the water business was

undertaken, with a recent rise of water and sewerage charge price cap to 10 per

cent to allow full-cost recovery for the businesses.

All Australian jurisdictions, except for the Northern Territory and Queensland,

demonstrate that they have achieved lower-bound pricing. Their price-setting processes

are either consistent with or moving towards being consistent with upper-pricing for

metropolitan water storage and delivery (Australian Government 2009, p. 159). The NWI

(2011, p. 79) confirmed most metropolitan areas in Australia have arrangements in place

to achieve upper-bound cost recovery. However, significant differences can be identified

in levels of cost recovery, depending on accuracy of a number of underlying assumptions

such as demand forecasts, projected costs and government policies such as specifying the

WACC.

311

9.7 Summary of asset valuation techniques used by water

utilities in major Australian jurisdictions

A summary of recent findings from asset valuations considered in various utility

businesses has drawn a conclusion that replacement cost accounting (i.e. DORC method)

is not universally applied in Australia. The DORC has been accepted by both the

Australian governments and regulators as one of a number of legitimate techniques for

valuing utility assets.

However, the fact that replacement cost accounting (DORC) has been adopted without

any adjustment in a broad number of cases in Australia has confirmed that it is widely

accepted as the principal asset valuation method, and that it is consistent with those

observed in effectively competitive markets. The outcomes of a competitive market in

turn provide a useful guidepost for regulation. In relation to water utility businesses, the

COAG commissioned a report in 1994 on asset valuation techniques and cost recovery

definitions to assist in the development of an appropriate water pricing regime. Its main

principle objective was to set up an efficient and sustainable water business (NERA

Economic Consulting & PricewaterhouseCoopers 2009, pp. 2 & 20).

Of the six states and two territories in Australia, finding concluded that two states and one

territory, the Australian Capital Territory, Queensland and South Australia, have

employed COAG Pricing Principles when valuing assets.

Table 9.30 (below) provides a summary of the regulatory arrangements that were in place

in each jurisdiction when values of assets were established (NERA Economic Consulting

& PricewaterhouseCoopers 2009, p. 21).

Furthermore, Table 9.31 provides a summary of the method used to determine initial asset

valuation methodologies employed by each jurisdiction. It can be observed that consistent

with COAG‟s Pricing Principles and its reform, Queensland, Australian Capital Territory,

South Australia and Western Australia have explicitly employed the deprival value

concept, which has resulted in a DORC valuation being adopted in both Queensland and

South Australia, while the ODV, specifically the line in the sand or the EV option based

312

on existing prices, was adopted in the Australian Capital Territory, New South Wales and

Victoria (KPMG 2007, pp. 29–30; NERA Economic Consulting &

PricewaterhouseCoopers 2009, p. 21).

In practice, it can be concluded that in many cases it is the line in the sand or the EV

option based on existing prices, and not the DORC, that has been adopted in many of

Australia‟s water utility jurisdictions. The line in the sand or the EV option based on

existing prices is the lower-bound pricing and consistent with the ODV principle. For

example, in Western Australia the ERA accepted the Water Corporation‟s proposed

regulatory asset value of $10 599 million as at 30 June 2005 as within the upper-bound

pricing range. The DORC determination of this initial asset value would result in a

substantial increase in the Water Corporation‟s revenue requirement, and could

potentially result in a regulatory price shock if this cost-based regulation was introduced.

Regulatory asset value of $9 100 million, based on the EV option on existing prices, were

instead accepted (Department of Treasury and Finance Draft Report Submission, p. 17,

cited in ERA 2005, pp. 74–75).

It makes sense that when a business acquires assets the business takes the view that the

returns it will enjoy through ownership of the asset. That is, the returns that it will enjoy

through the ownership of the asset (and jointly with other assets) will exceed the price

paid to acquire the asset. The DORC replacement cost provides a ceiling (upper-bound

pricing) on the value of the asset. That is, if the entity was deprived of the asset, it would

not lose its future returns; its loss would simply be the cost of replacing the asset. That

cost captures the extent to which the asset makes the entity better off. It ensures that

future (unearned) returns are not anticipated, but are reflected only when they arise via

use or disposal of the asset (Lennard 2002, pp. 6–7; Lennard 2010, pp. 97–98).

The deprival value from an accounting perspective is the value of an asset to the current

owner if the owner is deprived of the asset. That is, if the owner was required to continue

to deliver the same level of service, the assets have to be valued at an amount that

represents the entire loss that might be expected to be incurred if the entity were deprived

of the service potential of future economic benefits embodied in that particular asset at the

reporting date (Framework for the Preparation and Presentation of Financial Statements,

paragraph 49(a) AASB 2013, p. 30). That cost is the EV of the asset and the lower-bound

313

pricing. The deprival value is a valuation rule which reflects a non-market concept of the

value in the use of assets as part of a going concern; a GAAP convention applied by

accountants.

Table 9.30: Jurisdictions which have employed the COAG Pricing Principles when

valuing assets

Jurisdiction Regulatory instrument/

terms of reference

Asset valuation

principles

Australian

Capital

Territory

Government initiated inquiry into

water and wastewater prices

No specific asset valuation principles set

down in terms of inquiry; reference made by

Independent Pricing and Regulatory

Commission (IPRC) has complied with

COAG Pricing Principles

New South

Wales

The review of maximum prices

charged by Sydney Catchment

Authority is initiated by the

government

IPART relied upon external assessment of

different valuation methodologies; no specific

asset valuation principles were set in its price

determination

Queensland Inquiry into pricing principles is

initiated by the government for

GAWB

Pricing framework developed by GAWB was

based on COAG Pricing Principles; no

specific asset valuation principles were set

down in terms of inquiry

South

Australia

Inquiry into process of developing

urban water and wastewater prices

is initiated by the South Australia

Government

ESCOSA directed to have regard to the

COAG Pricing Principles

Victoria As required by Water Industry

Regulatory Order 2003, ESC must

undertake a review of prices

proposed by urban and rural water

businesses

No specific asset valuation principles

specified in the legislation or terms of inquiry;

Minister for Water indicated that an EV

approach would be employed. As at 1 July

2004, the Minister for Water was accorded

responsibility to determine the value of assets

under this order; it then directed the ESC to

314

Jurisdiction Regulatory instrument/

terms of reference

Asset valuation

principles

advise on the value attributed to each business

(NERA Economic Consulting & PricewaterhouseCoopers 2009, p. 21)

Table 9.31: Water industries regulatory instrument and asset valuation principles

Jurisdiction

and

regulator

Network Asset

valuation

is

determined

by

Asset valuation method

used to determine RAB

Role of prices in

determination of

RAB

ESC –

Victoria

18 rural and

regional

water

businesses

Vic Govt Line in the sand. In

2004–05, asset values

assumed for most

businesses were based on

its expected returns (EV).

If the ESC concluded that

there was a risk to the

business‟s financial

viability, a higher asset

value would be adopted

by the Minister

Asset base for most

assets was set by

reference to 2004–

05 prices, unless

business‟s financial

viability was at risk

ESCOSA –

South

Australia

SA Water SA Govt Deprival value approach,

DORC

N/A

IPART –

New South

Wales

Sydney

Catchment

Area

Regulator Line in the sand, that is

economic valuation based

on prices in 1996

determination

Asset base was set

by reference to

1996 tariffs

IPRC –

Australian

ACTEW

Water and

Regulator Line in the sand, that is

economic valuation based

Asset base was set

by reference to

315

Jurisdiction

and

regulator

Network Asset

valuation

is

determined

by

Asset valuation method

used to determine RAB

Role of prices in

determination of

RAB

Capital

Territory

Sewerage on existing prices; EV

$130m was lower than

DORC value

existing tariffs

QCA –

Queensland

GAWB Regulator Deprival value approach,

DORC

(NERA Economic Consulting & PricewaterhouseCoopers 2009, p. 22)

9.8 Is the price of water high or low?

Many scholars such as Bonbright (1937, p. 1139), Solomon (1971, p. 111), Bertram

(2000, pp. 30–31) and King (2000, p. 2; 2001, pp. 14–15) have noted that DORC

valuation of assets is the maximum valuation which would prevent system bypass of the

assets. Figure 9.4 (below) shows that the gap between ORC and DORC asset value is

monopoly rent. The DORC asset value sets the upper limit to asset valuation, and this is

what it attempts to measure. This is why the water regulator designed a reference tariff or

revenue tariff policy to provide water businesses with the opportunity to earn a

commercial stream of revenue known as the upper-bound pricing (Independent Pricing

and Regulatory Tribunal 2000, p. 180).

Figure 9.4: The gap between the ORC and DORC asset value

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Evidence suggests that the price of water captured through the RAB calculation under the

ODV does not capture any degree of monopoly profit. This valuation approach is

sensible, given that water prices are influenced by non-economic considerations. In recent

years, water prices have been rising at a rate greater than inflation across Australia

because of the need to increase investment to replace ageing infrastructure, and to expand

existing infrastructure such as recent capital works programs (desalination and recycled

plants) and rising operating costs.

One main reason for the increase in capital expenditure is because of the construction of

desalination plants in Sydney, Melbourne and Adelaide. These plants are built to reduce

the reliance of urban water suppliers on rainfall, but the increase in capital expenditure

will result in a higher RAB (through the return on and of capital), which will contribute to

higher annual and future year revenue requirements. Both governments and regulators

have found it necessary to balance the need to recover revenue with the consumer‟s

ability to absorb the price increase.

Figures from the Australian Bureau of Statistics (ABS 2013) revealed that water prices

had increased by 18 per cent in the past year. Water pricing is kept low for social policy

reasons; at an average of $1.77/ kL in 2008–09, increasing to $2.10/ kL in 2009–10,

$2.44/ kL in 2010–11 and $2.72 in 2011–12. Detailed information on the current water

price structure is provided in Appendix 2.

Some people believe that because water is a basic human need it should be free; for the

same water quality, some Australians are willing to pay more than a thousand times the

price for bottled water over tap water. In some public places, water is available for all,

ORC (optimised replacement cost)

DORC (depreciated optimised

replacement cost) is the upper-bound

pricing

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which means the government virtually gives away water for free because water price is

politically sensitive.

Most recently, Melbourne Water which services the city‟s three water retailers (Yarra

Valley Water, City West Water and South East Water) and is owned by the Victorian

Government, is believed to have collected an extra $306 million (equivalent to an average

of $177 per household) from consumers. The fees were to help cover capital expenditure

for the Wonthaggi Desalination Plant.

The Baillieu Government ordered Melbourne Water to refund the money it has had

overcharged consumers, which was expected to begin during Water Plan Three, starting

on 1 July 2013. From July to September 2012, water businesses estimated that $26.4

million was returned to customers, most of which was returned through the 2012–13 price

freeze and top-up payments in customers‟ bills for 2013–14. Additional amounts may be

returned in the form of further rebates (Wells 2012; Wells & Levy 2012 & McArthur

2012).

The key difference in the RAB applied in water businesses compared with those of other

utilities is observe by Marsden Jacob Associates (2006, pp. 45–47) and NWI (2008, p. 9).

That is, the RAB and the MAR used in water businesses are well below the replacement

cost of infrastructure and the benchmark for setting asset values in other utilities. In

particular, Marsden Jacob indicated that if the same approach was applied for water as

with other utilities, based on figures obtained from WSAA facts (2005; cited in Marsden

Jacob Associates 2006, p. 47), revenue levels across Australian capital cities could

potentially increase on average by as much as 33 per cent.

The combined annual revenue for Australia‟s eight capital cities‟ water businesses could

be up to $600 million higher per year and still remain within the upper-bound of efficient

pricing levels. By comparing current revenue levels with the indicative full-cost estimates

and assuming that full cost were to be defined in the same manner as in other utility

businesses, the level of cost recovery for water businesses is only 75 per cent, with

Melbourne estimated from a low cost recovery of 68 per cent to a high of almost 87 per

cent for Hobart.

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This means that the level of water prices and revenue set by economic regulators is below

the maximum level consistent with a competitive market. The price of water set by

Australian economic regulators is sufficient only to recover future expenditure to

encourage investment in the business. Water businesses received low returns on

investment; they are compensated for new investments only, not for past investments.

In other words, all of Australia‟s major urban water businesses are charging just enough

to cover their minimum cash flow requirements, including debt and interest repayments.

None of the businesses are charging high prices to earn a commercial return on existing

(sunk) assets.

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9.9 Summary

The seven different asset valuation techniques used in this thesis have resulted in

significantly different valuation figures for the same assets. These differing asset

valuation figures not only produce different estimates of the RAB, but also produce

different water pricing and investment signals. The correct asset valuation method used

should provide incentives for economic efficiency; most importantly to ensure both

minimum cost to society, as well as continual investment in utility businesses in the most

efficient way.

Evidence compiled from Chapter Eight suggested that replacement cost will yield highest

asset value, followed by DRC, ORC, DORC and ODV. The asset valuation under DAC

and DIHC techniques will result in underestimation of RAB. This will result in water

businesses not having sufficient revenues to finance capital investments and poor pricing

signals will be reflected.

Overall, comparisons of different asset valuation techniques revealed that there is no

single asset valuation method that will provide a „perfect‟ asset valuation figure. That is,

no specific asset valuation method is superior to the others. Without the existence of a

competitive market for water businesses, asset valuation techniques are preferable to

replicate as close as reasonably possible to those in a competitive market. This is what

ODV and DORC attempts to measure.

The main reason why asset valuation is needed in utility businesses was because it served

as a basis for economic regulation to measure RAB and to revalue the businesses‟ assets

over time. In doing so, efficient pricing can be achieved. However, water utility

businesses are unique given that there is no market value for their infrastructural assets.

Experience with the use of DORC in water businesses is low compared with other utility

businesses such as gas, electricity and rail. It has been suggested that this is perhaps

reflecting the reduced level of competition in the water business.

The specific asset valuation method used by water utility businesses to calculate the cost

that they would incur and the revenue they would forgo when they are deprived of their

asset is the ODV. The ODV as a variant of the deprival value relies on the deprival value

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concept and, in theory; an optimised network would be used. The main principle

underlying ODV is that it provides the basis for an adequate but not excessive return on

capital, and promotes prudent investments. ODV of an asset is the lower of either the

DORC if the assets can be replaced, or the EV which is the recoverable amount as

appropriate.

In simple terms, the ODV is a valuation rule that prescribes the value of the upper and

lower boundaries for specialised assets, such as water assets. The ODV of an asset is the

lower of either the DORC or the EV. In theory, the DORC is the replacement cost as well

as the absolute upper limit of the deprival value concept. It is also the upper-bound

pricing described in the COAG Water Resource Pricing Principles. The result of the first

regression analysis confirmed that DORC asset valuation technique is the upper-bound

pricing and is associated with higher asset valuation. DORC asset valuation technique

resulted in higher price of water and higher level of capital expenditure by the business.

On the other hand, the lower side of the ODV is bounded by the EV, specifically the

NRV, which is also the lower-bound pricing described in the COAG Water Resource

Pricing Principles. The result of the second regression analysis confirmed that line in the

sand; EV asset valuation technique is the lower-bound pricing and is associated with

lower asset valuation. The EV asset valuation technique resulted in lower price of water

and lower level of capital expenditure by the business.

The ODV is not essentially or necessarily the DORC. If the system was deprived of the

asset, it would be replaced with the technically optimum equivalent. However, the EV

may be less than its DORC when the business is deprived of an asset. If this is the case,

the deprival value of the asset (i.e. its EV) is the greater of the NPV of expected cash

flows from its continued use (that is the present value of expected cash flows).

The RAB is the value as the sum of the discounted cash flows associated with each asset.

It is the value to the user of the asset, or the NRV of disposing of the asset (i.e. the

amount that could be realised by the sale of the asset); that is, its disposal or recoverable

value. It is it not easy and often questionable to estimate the cash flows that are expected

to be generated by each asset or by discounting the value back to present values using

risk-adjusted discount rates.

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The national blueprint for water reforms is the NWI. The upper-bound pricing of Water

Resources Pricing Principles provides guidelines to avoid monopoly rents. Paragraph 5 of

the NWI Pricing principles states that a water business should recover no more than the

operational, maintenance and administrative costs, externalities, taxes, provision for the

cost of asset consumption, and cost of capital. This is the DORC valuation when

implemented correctly. It is the asset value consistent with the price that would be

charged if a hypothetical (efficient) new entrant enters the market. Any prices set higher

than those earned in a contestable market would contain monopoly rent.

Local councils provide regional urban services in Queensland and New South Wales.

They comply with cost recovery assessed through reporting against guidelines and

benchmark returns issued by local governments. State governments in many non-

metropolitans areas in South Australia, Western Australia and the Northern Territory fund

revenue shortfalls and adopt uniform state pricing policies because these areas do not

achieve full cost recovery.

The price of water captured through the RAB under the ODV does not consider any

degree of monopoly profit. Water prices have been rising at a rate greater than the

inflation across Australia due to the need to increase investment to replace ageing

infrastructure, to expand existing infrastructure and to meet rising operating costs.

Construction of desalination plants in Sydney, Melbourne and Adelaide is one of the main

reasons for the increase in capital expenditure, which has resulted in higher annual and

future year revenue requirements.

A water business as a natural monopoly that sets the price of water directly from the value

of its assets (RAB). An increase in asset value will have a direct impact on the price of

water. Regression analysis confirmed the hypothesis of this thesis, that there is a direct

relationship between investment in water assets which impacts on the RAB and ultimately

the price of water. However, customers should not be made to pay for the increase in the

price of water if the water business effectively earns a return on and of capital above what

is invested. A conclusion can be drawn from the most recent findings that DORC

methodology has not been applied universally throughout Australia. The deprival value

methodology is recommended for the purpose of asset valuation and the determination of

water utility businesses‟ revenue requirements.

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This thesis findings concluded that out of five states in Australia, three states/territories

(Australian Capital Territory, Queensland and South Australia) have employed COAG

Pricing Principles when valuing assets. In addition, consistent with the COAG‟s Pricing

Principles and its reform, four states/territories (Australian Capital Territory, Queensland,

South Australia and Western Australia) have explicitly employed the deprival value

concept. A DORC valuation has been adopted in Queensland and South Australia, while

the ODV, specifically the line in the sand or the EV option based on existing prices, was

adopted in the Australian Capital Territory, New South Wales and Victoria. It can be

concluded that it is the line in the sand or the EV option based on existing prices and not

the DORC valuation that has been adopted by most water businesses in Australian

jurisdictions.

The next chapter is the final chapter, which will summarise and conclude the entire

research thesis.

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Chapter Ten: Summary and Conclusions

10.1 Introduction

This chapter provides a summary of the entire thesis, the hypothesis of the thesis and its

key findings. Aligned with the general structure of this thesis, this chapter begins with a

discussion on some of the basic characteristics of urban water.

A recent rise in rainfall across eastern Australia in areas including South East Queensland

and New South Wales has caused a rapid rise in storage levels in many of Australia‟s

catchments. As a result, most water utilities have been able to ease water restrictions

and/or move to permanent water conservation measures. The recent rise in rainfall and the

Queensland floods (early 2010) highlight Australia‟s extreme climate variability and the

ongoing water challenges.

As a natural monopoly, it is more economical for one water business with technology and

consumer demand to serve the one relevant market than for several businesses to do so.

Competition is often not possible and there are high barriers to entry. In addition, water

consumers cannot change providers. In line with this, regulation ensures that water supply

businesses earn enough to cover operating costs, depreciation and a modest return on

capital. At the same time, water prices are kept as low as possible by the regulatory

authorities.

Next, this chapter discusses the current urban water pricing approaches, which vary

across Australian jurisdictions. The main difference is in pricing functions among

regulators and reviewing bodies. As most Australian jurisdictions comply with the NWI

Pricing Principles and commitments, water businesses have adopted two-part tariffs for

efficient water pricing in Australia and elsewhere in the world.

In 1994, as part of the water pricing reforms and its institutionalisation, the COAG set up

its Strategic Water Reform Framework. The NWI became the blueprint for water reforms

in 2004, and its pricing principles were endorsed by the Natural Resource Management

Ministerial Council in 2010.

324

Having established the water pricing reforms, what follows on is a discussion on the

research hypotheses used and the thesis‟s key findings. The standard approach used by

most regulators to regulate utility sectors (including water) in network infrastructure is the

building block approach. The valuation of RAB is important in this component of cost.

Limitations as well as suggestions for future research are also discussed in this chapter.

10.2 Outline of the thesis

Water is known to be the most precious of all natural resources, as it is not possible for

any life – human, animal or plant – to survive without water. The Australian urban water

industry experienced a positive change in 2009–10 due to increased rainfall across eastern

Australia (including South East Queensland and areas of New South Wales), leading to

rapid rises in storage levels in many of Australia‟s catchments. Most water utilities were

therefore able to either ease water restrictions or move to permanent water conservation

measures. Australia‟s extreme climate variability and ongoing water challenges were

evidenced through Queensland‟s flood in early 2010.

Water businesses are natural monopolies where the largest supplier has an overwhelming

cost advantage over actual and potential competitors. It is more economical for one

business with technology and consumer demand to serve the relevant market than for

several businesses to do so. Water assets such as pipelines are very expensive to build or

duplicate, which means that there are high barriers to entry and competition is often not

possible. Other characteristics of the water industry are such that there are large sunk

investments, and a large share of fixed costs and economies of scale and scope, which

means that a potential competitor is unlikely to be willing to make the capital investments

needed to enter the natural monopolist‟s market. It is cheaper for a single entity to provide

the service.

Unlike other utilities, water consumers cannot change providers, as water businesses

provide services within a defined geographical area. It is therefore necessary for water

prices to be regulated as an integral part of the transformation. In Australia, water supply

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businesses are highly regulated. Water prices are determined by regulatory authorities and

kept as low as possible. Many water supply businesses are government-owned entities.

The current water pricing arrangements vary between jurisdictions, and the main

difference is in pricing functions among regulators and reviewing bodies. In the

Australian Capital Territory, Victoria and metropolitan water utilities in New South

Wales, independent regulators set water prices for major water businesses and bulk water

utilities. Prices are still controlled by state governments in other jurisdictions.

Another significant difference is the coverage of economic regulations between

jurisdictions. For instance, the IPART in New South Wales determines prices for

metropolitan businesses and water planning and management charges. The State Water

Corporation provides water services charged by local utilities in regional areas. In

contrast, the ESC in Victoria determines water prices for all metropolitan, regional and

rural water services, while in rural New South Wales and South Australia and Western

Australia, private irrigation providers determine infrastructure charges paid by customers.

Water prices are typified by a regulated approach based on the building blocks

methodology with periodic price reviews (between three and five years); that is, the two-

part inclining tariff, which consists of fixed and volumetric (variable) components. Every

water bill incorporates a separate fixed charge and usage (variable) charge. The fixed

component is set to ensure revenue adequacy – the residual of the revenue requirement

less total water usage charges. On the other hand, the volumetric (variable) component,

also known as the „inclining block tariff‟, is set with regard to the long- run marginal cost

of additional supply capacity.

The tariffs can comprise of one block (used by Sydney Water for economic efficiency

reasons) or more blocks or tiers of up to 11 (used by Albany and Kalgoorie-Boulder

Water Corporation in Western Australia). In practice, water businesses set a low water

usage charge for the amount of water required to meet basic needs. Any amount of water

usage charged in excess of this amount is billed at a higher rate.

Water pricing reform and its institutionalisation began in 1994 when the COAG set up its

Strategic Water Reform Framework. In 2004, the NWI became the blueprint for water

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reforms, where nine jurisdictions were accredited with NWI plans. In 2010, the NWI

Pricing Principles were endorsed by the Natural Resource Management Ministerial

Council. The aim of these pricing principles is to ensure that water pricing is

predominantly used to achieve economically efficient water use and water service

provision, and that water businesses are financially viable.

10.3 Summary of the hypothesis of the thesis and key findings

The hypothesis of this thesis is to test to see if there is a direct relationship between:

(i) investment in water assets;

(ii) does (i) impacts on the price of water and the RAB

In chapter nine, the Least Squares Regression Method is used to test the relationship

between asset valuation techniques (independent variable), prices, profitability and

investment levels (dependent variable) in the industry, as well as the long-term viability

of the industry. The Least Squares Regression Method was chosen for this thesis because

the method estimated the true value of any quantities based on a consideration of errors in

the observation. The method is used to predict the relationship between investment, that is

net capital investment and asset valuation techniques used in water utility businesses in

Australia.

Secondary and archival data were collected from the WSAA website and water

businesses reports over eight years from 2004 to 2012. Values of the independent variable

(asset valuation techniques, length of pipes connecting residential properties water supply

and the number of population connected to urban water services) were collected to predict

the behaviour and value of the dependent variable (net capital expenditure).

Dummy variables for asset valuation techniques are used because net capital expenditure

(dependent variable) is influenced by not only the quantitative variables (length of pipes

connecting residential properties water supply and the number of population connected to

urban water services) but also the qualitative variables (asset valuation techniques, that is

DORC and line in the sand, EV). For this thesis, the R-squared (known as the coefficient

327

of determination) for both regressions is 0.769 or 76.9 per cent, suggesting that 76.9 per

cent of the total variation in net capital expenditure (dependent variable) can be explained

by its relationship to asset valuation techniques, length of pipes connecting residential

properties water supply, and the number of population connected to urban water supply.

As well, this means that 76.9 per cent of the total sum of squares can be explained by the

estimated regression equation when used to predict or forecast future net capital

expenditure.

In the first regression analysis, dummy variables (independent variable) take the values of

1 for DORC and 0 for EV. The regression slope is 0.36 meaning that on average, every $1

increase in DORC asset valuation technique resulted in a 36 cent increase in net capital

expenditure. Every 1 km increases in length of pipes resulted in 0.0000046 cent increase

in net capital expenditure. Every one increase in the number of population connected to

urban water supply resulted in a negative 0.00000016 cent in net capital expenditure. The

coefficient of asset valuation is significant with a positive sign t-statistics of 3.8. DORC

asset valuation technique (independent variable) has a significant positive impact on net

capital expenditure (dependent variable). DORC asset valuation technique impacts

positively on net capital expenditure. This finding supported the view that in theory,

DORC asset valuation technique is the upper-bound pricing. Higher asset valuation

resulted in higher price of water as well as higher level of capital expenditure by the water

business.

Likewise, in the second regression analysis when dummy variables (independent

variable) take the values of 0 for DORC and 1 for line in the sand or EV, the regression

slope was a negative 0.36. This means that on average, every $1 increase in line in the

sand, EV asset valuation technique will result in a 36 cent decrease in net capital

expenditure.

The hypothesis of this thesis has been supported by the findings of the two regression

analysis. There is a direct relationship between investment in water assets which impact

on the RAB and the price of water.

Regardless of the asset valuation techniques used, there were no changes in the length of

pipes and the number of population connected to urban water supply. A water business

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invests in capital expenditure regardless of the asset valuation techniques used. The

findings of the two regression analysis, particularly in relation to no changes observed in

the length of pipes and the number of population connected to urban water supply is

consistent with the argument made by Topp and Kulys (2012, p. 98). Water assets are

constructed with a long term view to meeting not only current but also future demand.

Capital expenditure invested in water assets increases in line with population growth and

the available capital capacity. Topp and Kulys (2012, p. 98) argued that it takes many

more years for the aggregate supply capacity to be fully utilised after investment is made

and new water supply assets are operational. For example, it is not possible to raise dam

levels every year. Pipes and wastewater treatment plants cannot be widened year to cope

with the growing demand for water and wastewater treatment. There is a trend whereby

once these lumpy new assets are constructed; capital expenditures will eventually slows

down.

This thesis answers the following key questions: explanation of asset valuation techniques

used to estimate the MAR and the RAB for charging (pricing) purposes. The two asset

valuation techniques used are the DORC and the EV asset valuation. This thesis also

revealed how asset valuation techniques are applied, published statements in relation to

these two techniques, arguments of regulators, completing missing details and essential

mathematical connections.

The building block approach is the standard approach used by most regulators to regulate

utility sectors (including water) in network infrastructure. It consists of three main

„building block‟ components – a return on capital (allowed rate of return), a return of

capital (depreciation), and an appropriate estimate of efficient operating costs. As a

natural monopolist, a water business is considered a long-term, capital-intensive (in

hundreds of billions of dollars) industry. Its assets are not only long-life and immobile,

but once they are invested, they are considered sunk with no alternative use.

Normative theories of accounting prescribe that assets should be valued using specific

asset valuation techniques. While there is no one asset valuation method that is deemed

perfect or entirely satisfactory, different techniques result in significantly different

valuation figures for the same assets. For instance, estimates of RAB are different under

significant asset valuation figures.

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Paragraph 100 of AASB Framework of the Preparation of the Preparation and

Presentation of Financial Statements suggests that the rules of asset valuation techniques

vary across different types of assets, and a number of different measurement techniques

and guidelines are employed to different degrees and in varying combinations in financial

statements. In accounting there are two main measurable attributes in the measurement of

assets (non-current), one of the main elements of financial statements; these are cost-

based techniques, based on the cost of purchasing the assets (historical cost and

replacement cost), and value-based techniques, which is the NPV of cash generated from

the business or the NRV from selling the asset.

In theory, numerous accounting and financial literature have identified the present value

model as the best accounting model for asset valuation. Under the present value

accounting, assets are valued at their present discounted value of the future net cash

inflows that they are expected to generate in the normal course of business. However, the

practical deficiency of this model is that it lacks objectivity and is highly subjective, since

it requires not only the estimation of future net cash receipts and the timings of those

receipts, but also the selection of appropriate discount (risk) rates. Given the uncertainty

surrounding their use, this model can be impractical when implemented.

The HCA is the dominant framework for recognition and measurement of assets;

however, this foundation is being replaced by FVA. Both the HCA and the CCA are

based on the concept of capital maintenance. However, the main disadvantage of both of

these techniques is that they do not recognise changes in the purchasing power of the

dollar. That is, water business assets are long-life (10–150 years) and these assets are

purchased and invested at various points of time and subject to different price levels.

Historical cost figures have limited application under these conditions.

It is essential that a common understanding be established to justify why deprival value

stands as the recommended method in Australia. There is very limited academic research

published in relation to this methodology, particularly in relation to asset valuation and

the determination of water pricing. In addition, research into the effects of rate regulation

and prices in utility businesses not only vary widely but are also limited.

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This research revealed that deprival value is the preferred asset valuation method for

water businesses, as it is recognised by four important organisations: the COAG, the

Steering Committee for National Performance Monitoring of Government Trading

Enterprises, the NWI, and the Natural Resource Management Ministerial Council.

Water businesses‟ assets do not have alternative uses, and effectively they are considered

sunk costs. There is no accounting or economics theory which provides the determination

of an initial RAB value for the assets of an established water business. Economic theory

suggests that the setting of a regulatory value for monopoly network assets at a particular

time are typically interpreted as within a feasible range; that is, at upper- or lower-bound.

The ODV, a variant of the deprival value, relies on the deprival value concept. It is only

the valuation rule that prescribes the value of upper and lower boundaries for specialised

assets (water assets). The ODV is the lower of the DORC if the assets can be replaced or

the EV, the recoverable amount, as appropriate. The DORC is not only the replacement

cost, but also the absolute upper limit of the deprival value concept, also described as

lower-bound pricing in the COAG Water Resource Pricing Principles. The lower side of

the ODV on the opposite side is bounded by the EV, specifically the NRV, which is also

the lower-bound pricing described by the COAG Water Resource Pricing Principles.

It is important to note that the ODV is not essentially or necessarily the DORC. It is only

the appropriate value for the asset if the DORC of an asset is lower than its EV. The asset

would be replaced with a technically optimum equivalent asset if the system was deprived

of the asset. Alternatively, the EV forgone may be less than its DORC when the business

is deprived of an asset. The deprival value of the asset is its EV; that is, the greater of the

NPV of expected cash flows from its continued use. The sum of the discounted cash

flows associated with each asset is the RAB. This is the asset disposal or recoverable

value, which is the value to the user of the asset or the NRV of disposing of the asset.

That is, this is the amount that could have been realised by the sale of the asset. However,

the estimated cash flows that are expected to be generated by each asset or discounting

the value back to present values using risk adjusted discount rate is not only difficult but

also questionable.

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The ODV concept is used for statutory reporting and performance monitoring purposes to

determine the price of water. Paragraphs OB 4 and OB 16 of Chapter 1, Objective of

General Purpose Financial Reporting of the AASB CF 2013-1 Amendments to the

Australian Conceptual Framework (December 2013) proposes that a water business is

able to discharge public accountability via maintenance of relevant and reliable

information required in its audited financial statements. Asset valuation and specifically

the ODV concept is consistent with the going concern and prudence or conservatism of

GAAP and paragraphs 7, 29–31 and 33 of IAS 16/ AASB 116 Property, Plant and

Equipment (June 2009).

The going concern notes that the business will continue in the future, while the prudence

convention states that accountants should recognise losses in the value of assets as early

as possible. Gains should only be recognised when they are certain and the amount is

realised. Assets are to be valued so as to provide a relevant and faithful representative for

economic decision-making. Paragraph 7 of IAS 16/ AASB 116 (June 2009) states that the

cost of property, plant and equipment shall be recognised as an asset if it is probable that

future economic benefits associated with it will flow to the entity, and the cost of asset

must be measured reliably. Paragraphs 29–31 state that property, plant and equipment

(the water utility‟s assets) should be valued at either the lower of „cost‟ or „recoverable

amount‟; that is, the amount expected to be recovered in future cash flows through use

and/or sale of the asset. That is:

The ODV = lower of DORC (replacement cost) / recoverable amount (i.e. the higher of

NPV/NRV), or equivalently.

In addition, paragraph 33 of both the International and Australian Accounting Standards

states that where there is no market-based evidence of fair value because of the

specialised nature of the item of property, plant and equipment and the item is rarely sold,

except as part of a continuing business, an entity may need to estimate fair value using an

income (NRV) or a cost (DORC) approach.

From the most recent findings in Chapter Nine, one can conclude that the DORC method

is not applied universally throughout Australia. Even though the deprival value

methodology is recommended for the purpose of asset valuation and determination of

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water utility businesses‟ revenue requirements, only three out of the five Australian states

and territories (Australian Capital Territory, Queensland and South Australia) have

employed COAG‟s Pricing Principles when valuing assets. Four states/territories

(Australian Capital Territory, Queensland, South Australia and Western Australia) have

explicitly employed the deprival value concept, consistent with the COAG‟s Pricing

Principles. Queensland and South Australia have adopted a DORC valuation, while the

ODV method, specifically the line in the sand or the EV option based on existing prices,

was adopted in the Australian Capital Territory, New South Wales and Victoria. In many

cases it can be concluded that it is the line in the sand or the EV option based on existing

prices and not the DORC valuation that has been adopted in many water businesses in

Australian jurisdictions.

Key findings from Chapter Nine also revealed that the RAB applied and the MAR used

are well below the replacement cost of infrastructure and the benchmark for setting asset

values in other utilities. If the same approaches were applied for water as with other

utilities, revenue levels across Australian capital cities could potentially increase by an

average of as much as 33 per cent. In total, the annual revenue levels for Australia‟s eight

capital cities‟ water businesses could be up to $600 million higher per year and still

remain within the upper bound of efficient pricing levels. The level of cost recovery for

water businesses is only an average of 75 per cent; from a low cost recovery of 68 per

cent in Melbourne to a high cost recovery of 87 per cent in Hobart.

The DORC valuation of assets is the maximum valuation that would prevent system

bypass of the assets. It sets the upper limit (upper-bound pricing) to asset valuation; what

it attempts to measure. However, regardless of the depreciation method used, the DORC

valuation is the cost to construct or replace the exact same asset today. For this reason, it

delivers a high asset value compared with valuation techniques discussed. The gap

between ORC and DORC asset value is called the „monopoly rent‟. The price of water

capture through RAB calculation under the ODV does not capture any degree of

monopoly profit. As an essential component of all life, governments take a special

interest in the security, sustainability and pricing of water. Australian economic regulators

set water prices just sufficient to recover future expenditure, to encourage investment in

the business. Since water businesses receive low returns on investment, they are only

compensated for new investments and not for past investments.

333

One of the most difficult, controversial and challenging issues associated with

determining the revenue requirement of a water service provider is the asset valuation

technique used in the determination of the RAB. As valuation of water utility assets is not

related to a competitive market, there is no specific procedure for asset valuation which is

necessarily correct or suits all accounting, performance monitoring and price regulation.

Asset valuation is needs in utility businesses to serve as a basis for economic regulation to

measure the RAB and to revalue the businesses‟ assets over time for the purpose of

determining the price of water. The ODV (i.e. the DORC and the EV option based on

existing prices) is superior, because it provides complex but sophisticated measures of the

RAB by eliminating inefficiencies in the business‟s current asset configuration. The two

asset valuation techniques attempt to measure and very closely replicate those techniques

in the competitive market. At the same time, the two techniques address the economic

efficiency criteria far better than any other asset valuation techniques.

The relationships between the two asset valuation techniques and the pricing of water

must be clearly understood. In doing so, regulators are able to create transparency in their

pricing decisions.

This thesis concludes that the current urban water pricing policy in Australia allows for

urban water businesses to recover only a modest return on and of capital, and barely

recover the sum of operating expenses and tax obligations. Regression analysis confirmed

the hypothesis of this thesis, that there is a direct relationship between investment in

water assets which impacts on the price of water and the RAB. Over several decades, the

water industry and its businesses have generated minimal to no-profit (negative or low

return on assets) pricing, which has implications on their long-term viability. In addition,

these raised two important questions: first, whether the water resources are efficiently

used by consumers; and second, whether water prices provide correct signals for efficient

investment.

Since water is an essential component of life, the average price of water at $2.72 per kL

in 2011–12 is considers very low. It does not signal to consumers the scarce value of

water. As the most basic essential resource, humanity places very little value on water.

334

Yet there is no question that water is essential for the development and sustainability of

any country.

The affordability and availability of water is fundamental to maintaining a high living

standard for all Australians, and the true economic benefits of water utility assets are

enjoyed by many Australian businesses and households that receive a clean and reliable

water supply at a price kept low by the regulatory regime and the government.

The question of whether deprival value is the appropriate asset valuation method to be

used by the water industry for charging (pricing) purposes is difficult to answer, and is

often debated by academics and practitioners. The fact is that the DORC and the line in

the sand or the EV options communicate the cost of replacing the potential service

capacity or future economic benefits of the assets when the assets are destroyed or lost.

This asset valuation reflects the worth of assets to consumers, and it is the value reflected

to the public and water consumers.

On the contrary, the underlying value of assets is determined from their ability to generate

future cash flows, in order to provide monetary returns to water businesses. In this

circumstance, the NPV of the cash flows generated from the use of assets (EV) is less

than the DORC. Without any further economics and/or accounting theories, as well as the

absence of authoritative accounting guidance from Australian and international

accounting standards, the DORC and the EV option based on existing prices would

appear to be a valid asset valuation technique.

To date, the NWI Pricing Principles and the COAG do not have any specific asset

valuation guidelines or publication in relation to water industry and deprival value

method. The appropriateness of adopting these two asset valuation techniques is a matter

of judgement. It is subjective and difficult to implement because of the measurement

challenges it presents, and should be considered by the water industry on a case-by-case

basis, within their specific circumstances.

335

10.4 Limitations of the research

This study investigated only a sample of water utility infrastructure assets and their

relation to water pricing, for which the necessary data was readily available. The

conclusions drawn are based on the data collected, and as a case study and exploratory

study, the regulatory period differs according to jurisdictions. The samples collected for

this project were collected from industry reports (simulation process), and due to limited

data availability in the water industry, asset valuation figures were based on other utility

businesses such as gas and electricity.

Conceptually, the ODV method was based on prices set in a hypothetical long-term

competitive market where supply and demand will balance, and where the assets are

short-lived and non-lumpy. The fact is that there is no market for water infrastructure

assets, as effectively these assets are considered sunk. That is, as specialised

(infrastructure) assets, they have few, if any, alternative uses once built. Past investment

is used (in the calculation of revenue) at the time when the investment is made, and is

reflected in current and future water prices.

The assets classes as well as sub-major assets have not been investigated in any detail

due to the lack of asset data available from industry reports. Academic research into asset

valuation and pricing of water utilities is by far very limited. Also, due to the lack of

competition in the water business, a comparison of asset valuation techniques is also

limited. The regulation and reform of the water industry is very new and is still

developing in many ways. Accounting for asset valuations and water utility pricing is

therefore a relatively new research area.

10.5 Suggestions for future research

A limitation of this study is its sample size, which is based on information collected from

various industry reports and the best information available at that time. This research is

based on case study (exploratory) methodology, and it might be useful if future research

is conducted via surveys of water utility businesses, specifically in the area of recording

how they value their assets. Other areas of potential interest include step-by-step

336

instructions on how water businesses conduct their asset valuations using deprival value

and/or the DORC method.

Future research could concentrate on providing detailed information on how water

businesses conduct the process of „optimisation‟. In this thesis, return of capital (i.e.

depreciation) is the dependent variable. Further potential research could look into the

impact that depreciation has on utility prices. At present, there is very limited accounting

or economics literature on such issues.

337

10.6 Summary

Water is known as the most precious natural resources for any life; human, animal or

plant. In 2009–10, the Australian urban water industry experienced a positive change, as

water storage levels in many of Australia‟s catchments rose because of the increased

rainfall across eastern Australia (including South East Queensland and areas in New

South Wales). Most water utilities therefore eased water restrictions or moved to

permanent water conservation measures.

Water businesses are natural monopolists, where the largest supplier has an

overwhelming cost advantage over actual and potential competitors. It is also necessary

for water prices to be regulated as an integral part of the transformation, since water

consumers cannot change providers. Regulation allows service providers to hold a level

of power that enables them to price at a level that delivers greater than normal

commercial return and/ or provides substandard levels of service.

The findings of the regression analysis confirmed the hypothesis of this thesis. There is a

direct relationship between investment in water assets which impacted on the RAB and

ultimately the price of water. DORC asset valuation technique is the upper-bound pricing

and associated with higher asset valuation. Higher asset valuation will result in higher

level of capital expenditure by the business and consequently higher price of water.

Similarly, EV asset valuation technique is the lower-bound pricing. EV asset valuation is

associated with lower level of capital expenditure and consequently lower price of water.

The main difference in current water pricing is in pricing functions among regulators and

reviewing bodies. Water prices are regulated based on the building blocks methodology,

with periodic price reviews between three and five years. Every water bill incorporates a

separate fixed charge and usage (variable) charge. The fixed component is set to ensure

revenue adequacy. The volumetric (variable) component is also known as the „inclining

block tariff‟, and is set with regard to the long-run marginal cost of additional supply

capacity.

338

The building block approach consists of three main „building blocks‟; that is, return on

capital (allowed rate of return), return of capital (depreciation), and an appropriate

estimate of efficient operating costs. The building block approach is used by water

businesses to determine the amount of revenue to allow them to operate and remain

viable. The key ingredient of the building block approach is the RAB comprising of the

physical assets.

No one asset valuation is perfect or entirely satisfactory. In accounting, the two main

measurable attributes related to alternative asset valuation techniques are the cost-based

techniques based on cost of purchasing the assets (historical cost and replacement cost),

and the value-based techniques which represent the NPV of cash generated from the

business or the NRV of selling the asset. The present value model is known to be the best

accounting model for asset valuation. The NPV lacks objectivity and is highly subjective,

since it requires estimation of future net cash receipts and the timings of those receipts, as

well as the selection of appropriate discount (risk) rates. This model can be impractical

when implemented, given the uncertainty surrounding its use.

There has been very limited academic research published in relation to deprival value

methodology; specifically its relation to asset valuation and determination of water

pricing. Research regarding the effect of rate regulation and prices in utility businesses

not only varies widely but is also limited. Its practical application in the real world is very

limited.

The setting of a regulatory value for monopoly network assets at a particular time has

been suggested and interpreted in economic theory as within a feasible range, between

upper- and lower-bound prices. The deprival value is the preferred asset valuation method

for water businesses, and ODV is its variant, relying on the deprival value concept. It is

consistent with prudence or conservatism GAAP and the IAS 16/ AASB 116 Property,

Plant and Equipment (June 2009).

Whether deprival value is the appropriate asset valuation method to be used by water

businesses is questionable and often debated by academics and practitioners. There is no

further guidance in economics and/or accounting theory, or Australian and international

accounting standards, further explaining the appropriateness of the two options available

339

for the ODV (the DORC and the line in the sand or the EV option based on existing

prices) for asset valuation. Whether these two asset valuation techniques are appropriate

is a matter of professional judgement, as it is subjective and should be considered by

water industry on a case-by-case basis, within their specific circumstances.

340

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366

Appendix 1:

Examples of Optimisation

The first example is of Filter Optimisation at Victoria‟s largest water treatment plant. The

report provided by Jarvis (2005, pp. 116–124) sets out the steps in filter optimisation.

Melbourne Water‟s Treatment Plant Winneke Water Treatment Plant, located north east

of Melbourne, adjacent to Sugarloaf Reservoir, is an off line storage. Water is mostly

pumped from Yarra River and Maroondah Aqueduct and depending on demand, Winneke

Water Treatment Plant supplies up to 30 per cent of Melbourne‟s drinking water. Water is

drawn from Sugarloaf Reservoir and the pumping station at the reservoir delivers it to the

plant. Water is treated at Winneke Treatment Plant, at Sugarloaf Reservoir in Christmas

Hills.

Purification of the water occurs naturally due to long detention time in the major storage

reservoirs and only minimal disinfection (by chlorination) is required to ensure that water

is safe and healthy to drink. Filter optimisation is required as the Winneke Water

Treatment has operated at flows greater than original intended capacity. Filters were

operating significantly below optimal performance leading to a need for efficient

filtration and backwashing an essential. Successful commissioning of water relies on

having established filters and effective backwash sequence. There is a further driver for

efficient filter operation. The current project is to increase Winneke‟s capacity to 620

ML/d. The new filter design and operation is based on existing filters.

An audit was carried out and the consultant had identified a number of possible process

improvements. First, the inefficient backwash sequence needs improvement; second, the

media height differences on either side of the fillet gullet can be addressed; third, media

losses can be reduced and finally, a number of other process improvements have been

identified and rectified (e.g. flow hunting) as filtration involves a myriad of operating

variables. Optimisation is considered a compromise between conflicting target

parameters.

Table 1: Original design manual backwash sequence

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Step Blower Pump Duration 1 Blower (37.4 m/hr) OFF 2 Minutes 2 Blower (37.4 m/hr) 1 Pump (5.7 m/hr) 3 Minutes 3 OFF 2 Pumps (21 m/hr) 5 Minutes

(Jarvis, 2005, p. 118)

Note: These air and water flow rates are at near maximum available capacity.

Table 2: Previous backwash sequence

Step Blower Pump Duration 1 Blower (27.4 m/hr) 1 Pump (5.7 m/hr) 5 Minutes 2 Blower (27.4 m/hr) OFF 2 Minutes 3 Blower (27.4 m/hr) 1 Pump (5.7 m/hr) 1 Minute 4 OFF 2 Pumps (17.5 m/hr) 3 Minutes 5 OFF 1 Pump (12.4 m/hr) 5 Minutes

(Jarvis, 2005, p. 118) Note: The sequence detailed above is similar to most of the 12 Winneke filters.

Table 1 (above) shows the original design of backwash sequence while in Table 2 (above)

the sequence used is shown. The backwash sequence included a number of steps provided

minimal additional value and backwash water flow rates are not sufficient for adequate

media expansion. The air scour rates are below the limits recommended for adequate

flocculent break up. Moreover, each filter backwash sequence is different, which resulted

in unequal performance. This inefficient backwash sequence was first observed during a

1997 upgrade and we can conclude that the Winneke filter backwash sequence strayed

from the original design.

A controlled upgrade should be followed, which means that the original design should be

reviewed to ensure a reliable transition between systems. Treatment plant operating

parameters should be regularly changed to accommodate for current climate, raw water

quality and plant upgrades. In February 2005, in an attempt to increase backwash

efficiency, the sequence was changed to closely follow the original design manual and

reverting to the original design has resulted in significant reductions in backwashing time,

volumes, energy consumption, operating costs and head loss.

In regards to the filtered water flow control, for many years, only the clarifier outlet level

was programmed to control. In contrast, the original plant design was intended to filter

368

water flow and be controlled from the level in both the clarifier inlet and outlet. A rapid

control loop caused filtrate flow hunting of 80 - 100 ML/d every hour which caused a

number of process difficulties, most noticeable, chemical dosing control.

In order to reduce flow variability, a trial began on July 2005 with filtrate flow to control

flow, in accordance to the original design. It was found, as can be observed in the graph

below, that the control changed on 4 July 2005, which includes clarifier inlet level, has

resulted in reduction with hourly flow variability. Flow spikes in Figure 1 below indicate

backwashing. The backwash water is supplied from the filtered water channel. Flow

variation during backwashing is unavoidable without significant capital upgrade.

Figure 1: Filtrate flow before and after control change

(Jarvis, 2005, p. 119)

Table 3 (below) outlines the flow and pH variability prior to and following control

change. It is compiled by using all available July 2005 data (Jarvis, 2005, p. 119).

Table 3: Flow and pH variability

Flow Variance

Flow Std Dev

pH Variance pH Std Dev

Prior to control 1 222 35 0.28 0.53

369

change Following control change

999 32 0.14 0.38

Percentage reduction 18 10 49 29

(Jarvis, 2005, p. 119)

Optimisation process to reduce flow variability can be further achieved through control

tuning. The process to reduce backwash water volumes also facilitated reduced flow

variation and by reverting to the original plant; it not only reduced flow variance by 18

per cent but more importantly, it reduced pH variance by 49 per cent.

As mentioned, treatment plant operating parameters regularly change to accommodate for

current climate, raw water quality and plant upgrades. These parameters can deviate

significantly from the original design and as such should be periodically scrutinised

against the plants‟ original design. Admittedly, operating a plant based on the original

design is unlikely to achieve optimisation and it is the job of the plant engineer or

operator to consider other steps to attain optimisation.

Optimisation of the backwash sequence is conducted by reverting it to its original design.

The combined air and water step is removed and the backwash sequence includes air

scouring followed by high rate water washing. Optimisation of backwash sequence is

detailed in table below (Jarvis, 2005, p. 120).

Table 4: Optimisation of backwash sequence

Step Blower Pump Duration 1 Blower (37.4 m/hr) Nil 4 minutes 2 Nil 2 pumps (21 m/hr) 5 minutes 20 secs

(Jarvis, 2005, p. 120)

It showed that the sequence varies greatly from previous sequence in Table 1, the original

design and Table 2. It has been suggested that this technique is an extremely powerful

filter optimisation tool and in saying this, it should be repeated regularly to maintain

optimisation.

The new backwash has resulted in following optimisation:

370

The 38 per cent reduction in backwash water volumes, or over 700 ML per

annum.

Operating cost reduction of ~$30 000 per annum due to reduced water treatment

and energy costs.

Backwash pump and blower extended life due to reduced operation time.

Increased filtration capacity of 3.5 ML/d due to both backwash water volume

savings (2 ML/d) and backwash time savings provided increased production time

(1.5 ML/d).

The measurement of backwash water turbidity will optimise backwash water flows and

times and in turn can provide significant operational savings. Other optimisation includes

the optimisation of filters, as shown in Table 5 (below), which reduced head loss. In

returns, it facilitates filter run times of over one hour longer (Jarvis, 2005, p. 124).

Table 5: Optimisation of filters

Clean bed head loss (m)

Terminal head loss (m)

Non-trialled filters 0.64 1.51 Optimised filters 0.50 1.29 Improvement 0.14 (22%

reduction) 0.22 (15% reduction)

(Jarvis, 2005, p. 124)

Note: May 2005 data was used.

It is followed therefore that significant operational gains can be made from vigorous

water treatment plant optimisation, which is recommended to occur periodically and

involve trialling original design specification operating conditions, reviewing and

adopting current industry literature, engagement of a water treatment process auditor and

possibly communication with the original design engineer.

The optimisation process resulted in filtrate turbidity reduction by 13 per cent, increased

filtration capacity of over 4 ML/d, reduced media losses, reduced head loss by 15 per

cent, reduced flow variance by 18 per cent, reduction of pH variance by 49 per cent and

reduced annual backwash water requirements by over 700 ML. More importantly,

371

Winneke Water Treatment filter optimisation has resulted in a total reduction of $30 000

in annual operating costs.

The second example is optimisation of filtration process using Porous Ceramic Dual

Media technology at Hamilton Water Treatment Station, New Zealand. The report

provided by Hansen (2006, pp. 147–153) sets out the steps in optimisation of filtration

process.

Hamilton is a major service centre and the seventh largest city, to be exact; it is the fourth

largest urban area. Its water supply comes from Waikato River, located within the

Waikato region in the upper central North Island of New Zealand. An average of 2200

glasses of high quality water is produced in every second of every day at Hamilton Water

Treatment Station. It is situated on the southern bank of the Waikato River within the city

boundary. The treatment plant was constructed in 1971 based on standard Patterson

Candy (PCI) design with COAG regulation, rapid sand gravity filtration and chlorine gas

disinfection. The plant capacity was 64 ML/day at the time of construction. However, this

was increased to approximately 85ML/day with addition of polymer dosing in the 1980‟s.

It has been confirmed from previous studies that the total Water Treatment Station was

limited by filtration process. According to water demand forecasts and population

projections, Hamilton water consumption will increase substantially over the next 10

years, exceeding the current Water Treatment Station capacity. The ability of the

conventional filters to achieve benchmark consistently over a variety of source water

conditions was questionable. In saying this, there is definitely a need for an ongoing

solution for the filtration issues to ensure adequate and safe water supply for the future.

In respect to optimisation and the Porous Ceramic Dual Media technology, the Porous

Ceramic Dual Media nozzles are fabricated from New Zealand patented, number 212330

ceramic. It is made from water crushed glass and titanomegnetic sand. The irregular

nature of the ceramic pores that result from the irregular shapes of the constituent crushed

glass particles is the fundamental feature to the design of nozzles systems. It is important

to optimise not only the water collection but also the air and water distribution during

backwashing. The average pore sizes that can be controlled by mesh size of the crushed

glass and the combination of high porosity, inertness and mechanical strength make these

improved nozzles ideal for sand filtration.

372

Hamilton City Council‟s Water Treatment Station nozzles are hollow ceramic disks. Two

disks are cemented face to face to form a hollow core and it is attached using a modified

plastic stem.

With intensive monitoring of water quality and filter performance of the initial

refurbishment filter, the installation of the PCDM technology had optimised the filtration

process. It increased filter capacity and run times between backwashing with no

degradation to filter water quality resulting in lower operating costs. Future demands for

water can be met without the need for further capital expenditure investment or for the

construction of extra filters.

Consistent water quality (turbidity) meets compliance with Drinking Water Standards of

New Zealand, which means retention of the Ministry of Health „A‟ grade can be

achievable. The continued implementation and use of Porous Ceramic Dual Media

technology at Hamilton City Council Water Treatment Station has resulted in an

optimised filtration and total plant capacity, with consistent filtered water quality.

373

Appendix 2:

Water Price Structures

Under the 2010 NWI Pricing Principles, reforms of pricing include addressing the

structure of tariffs. Consumption-based charges were introduced to provide a signal for

efficient water prices. The fixed charges are to reflect fixed costs of service provision and

can no longer be based on property values. Fixed charges are costs that do not change

regardless of the amount of water used or sewage removed. They are designed to recover

the cost to the water businesses from providing services to a property such as the cost of

maintaining dams, pipes, reservoirs and other essential infrastructure. On the other hand,

variable charges (for example, the cost of water treatment and pumping) are designed to

recover the variable costs of delivering water to, or removing sewage from a property.

It is observed that water prices vary substantially across Australian jurisdictions for

reasons including system and location specific costs in relation to assets and infrastructure

age.

In Table 1 (below), in Sydney, since October 2006 water prices were restructured with

introduction of inclining tariff block. The variable components consist of a two-tiered

usage charges. Water usage up to 400 kL per year (100 per kL per quarter) is priced at

$1.20 per kL in 2005/06 (increasing to $1.31 per kL in 2008/09). Any usage beyond this

is priced at $1.48 per kL (increasing to $1.85 per kL in 2008/09). Water prices increased

to $2.10 per kL (one block) from period 1 July 2011 to 30 June 2012. The annual fixed

charge is $144.82.

In Melbourne, since October 2004, the variable components consist of a three tiered block

tariff system for residential consumers. From 1 July 2006, water prices are charges as

follows (per kL):

Block 1 (0-440 litres/day) $0.8205

Block 2 (441-880 litres/day) $0.9628

Block 3 (881 + litres/day) $1.4223.

374

Between 1 July 2011 to 30 June 2012, water prices in Melbourne increased to as below

(per kL):

Block 1 (0-440 litres per day) $1.75-$1.78

Block 2 (441-880 litres per day) $2.08-$2.13

Block 3 (881 + litres per day) $3.08-$3.44.

The annual fixed charge is between $82.44 and $170.40.

In Perth, the ERA recommended a two tier inclining block tariff structure for residential

water services. Water usage up to 550 per kL per year (with an average unrestricted usage

of a six member household) is charged at $0.82. Usage over 550 per kL per year is

charged at $1.20 per kL.

From 1 July 2011 to 30 June 2012, Perth‟s water usage represents the first and second

meter reads. Water prices increased to as follows (per kL):

0-150 kL per year $0.98-$1.19 per kL

Next 200 kL per year $1.24-$1.54 per kL




Over 950 kL per year $1.96-$2.17 per kL.

The annual fixed charge is $186.60.

In Brisbane, residential water charges are based on three price tiers. From 1 July 2006,

water prices are charges as follows (per kL per year):

The first 200 kL is charged at $0.91 per kL

Between 201 kL and 300 kL /yr is charged at $0.94 per kL

In excess of 300 kL is charged at $1.20 per kL.

375

Between 1 July 2011 and 30 June 2012, water prices in Brisbane were as follows (per kL

per year):

The first 255 kL is charged at $0.67 per kL

Between 256 kL to 310 kL is charged at $0.71 per kL

In excess of 310 kL is charged at $1.26 per kL.

The annual fixed charge is $167.16.

In Adelaide, the South Australian Cabinet approved the 2007-08 metropolitan and

regional water and wastewater prices and revenue direction to 2011-12. Water usage is

charged at $0.50/kL for the first 125kL and $1.16/kL for each additional kL. Between 1

July 2011 and 30 June 2012, water prices in Adelaide were charged at $1.93 per kL for

the first 30 kL per quarter, $2.75 per kL between 30-130 kL and $2.98 per kL in excess of

130 kL per quarter. The annual fixed charge is $234.60.

From 1 July 2011 to 30 June 2012, water prices in Canberra were based on two price

tiers. The first 255 kL per day is charged at $2.33 per kL. Any usage more than 0.548 kL

per day is charged at $4.66 per kL. Water prices in Hobart are based on property value for

majority of properties whilst in Darwin a flat rate of $1.29 per kL is charged. The annual

fixed charge in Darwin is $197.35.

Table 1: Comparison of capital cities’ water prices between two regulatory periods,

from 1 July 2006 and from 1 July 2011

City Annual fixed

charge (from

1 July 2006)

Annual

fixed

charge

(from 1

July 2011)

Usage charge

(from 1 July

2006)

Usage charge (from 1

July 2011)

Sydney Based on

property

values

$144.82 0 to 400 kL per

quarter $1.20/

kL

$2.10/ kL

376

Melbourne Based on

property

values

$82.44 to

$170.40

- Block 1 (0-440

litres/ day)

$0.8205

- Block 2 (441-

880 litres/ day)

$0.9628

- Block 3 (881 +

litres/ day)

$1.4223

- Block 1 (0-440 litres/

day) $1.75-$1.78

- Block 2 (441-880

litres/ day) $2.08-$2.13

- Block 3 (881 + litres/

day) $3.08-$3.44

Perth Based on

property

values

$186.60 - 0-550 kL/ year

$0.82

- Over 550 kL/

year $1.20/ kL

- 0-150 kL $0.98-$1.19

- Next 200 kL/ year

$1.24-$1.54 per kL

- Next 150 kL/ year

$1.33-$1.58/ kL

- Next 50 kL per year

$1.44-$1.90/ kL

- Next 400 kL/ year

$1.80-$2.08/ kL

- Over 950 kL/ year

$1.96-$2.17/ kL

Brisbane Based on

property

values

$167.16 0- 200 kL $0.91/

kL

201 - 300 kL/

year $0.94/ kL

> 300 kL $1.20/

kL

0-255 kL $0.67 per kL

256 - 310 kL $0.71/ kL

> 310 kL $1.26/ kL

Adelaide Based on

property

values

$234.60 0-125 kL $0.50/

kL

> 125 kL $1.16/

kL

0-30 kL/ quarter $1.93/

kL

30-130 kL/ quarter

$2.75/ kL

> 130 kL/ quarter $2.98

377

/ kL

Canberra Based on

property

values

$95.63 NA 0-0.548 kL/ day $2.33/

kL

> 0.548 kL/ day $4.66/

kL

Hobart Based on

property

values

Based on

property

values

Darwin Based on

property

values

$197.35 NA $1.39/ kL

(WSSA 2011, p. 9)

Table 2: Summarised residential urban water tariffs in major capital cities

City Water

Sydney 2-part tariff with a single usage

Melbourne 2-part tariffs. The majority of water businesses use 3 tiered inclining

tariffs.

Perth 2-part tariff structure with 6 tiered inclining block used by the Water

Corporation. In 2012-13, the tariff structure was simplified with the

number of pricing tiers reduced from 6 to 3 for residential customers and

from 3 to 1 for commercial customers.

Brisbane 2-part tariff with 3-tiered inclining block tariff

Adelaide 2-part tariff with 3-tiered inclining block tariff

Canberra 2-part tariff with 2-tiered (previously 3 tiers) inclining block tariff

Darwin 2-part tariff, usage charge was determined with reference to the variable

components of total supply costs

(National Water Commission 2011, p. 29)