asset base roll forward or re-valuation - dr darryl biggar
TRANSCRIPT
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Updating the Regulatory Asset
Base:
Roll-Forward, Re-Valuationand Incentive Regulation
Darryl Biggar
Consulting Economist
Australian Competition and Consumer Commission
2 April 2004
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What is the issue? The 1999 statement of regulatory principles seems to
propose the revaluation approach
The Commission will conduct a DORC valuation toestablish the maximum value of the asset base (Statement
S4.2)
Depreciation will be linked to changes in RAB [taking
into account] likely changes in a DORC-based valuation ofthe RAB (Statement S5.5).
The discussion paper raises the issue of whether or not
to move to a roll forward approach.
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Updating the RAB How the regulatory asset base (RAB) is updated at
the end of the a regulatory period is one of the
fundamental questions in the design of a regulatoryregime
How the RAB is updated affects issues such as:
a) The principle of financial capital maintenance (FCM)
b) Incentives to select efficient capex projects
c) Incentives to carry out capex projects at least cost
d) How the sunk costs of investments are amortised or spread
over time
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FCM and incentive regulation Many submissions emphasised the importance of FCM
FCM ensures that a firm is able to recover in revenues
exactly what it spends on operating or capital expenses There is a tension between financial capital
maintenance and incentive regulation Incentive regulation requires that a firm is financially
rewarded for pursuing objectives which the regulator desires such as providing better quantity or quality of services at lower cost
incentive regulation requires windfall gains or losses
Regulator does not have to set the RAB and the depreciationin such a way as to precisely ensure FCM but must ensurethat any deviations from FCM induces desirable incentives
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The roll forward approach What is the roll forward approach?
Under the roll forward approach, at the end of the period the
regulator observes the out-turn capex and then updates theRAB using a formula similar to the formula above
closing RAB = opening RAB + capex allowance depreciation
allowance
Depending on how the regulator rolls forward actualversus forecast capex and actual versus forecast
depreciation determines the power of the incentive to
reduce capital expenditure
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The roll forward approach The roll forward regime could have:
Low-powered incentives to reduce capital expenditure
if the regulator rolls forward actual capex and forecast depreciation(i.e., closing RAB = opening RAB + actual capex forecast depn)
Medium-powered incentives to reduce capital expenditure
if the regulator rolls forward actual capex and actual depreciation
(i.e., closing RAB = opening RAB + actual capex actual depn)
This is the approach of the ESC in Victoria (and possibly other state
regulators)
High powered incentives to reduce capital expenditure
if the regulator rolls forward forecast capex and forecast depreciation
(i.e., closing RAB = opening RAB + forecast capex forecast depn)
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Is more power always better? High-powered incentives to reduce capital
expenditure may be undesirable Might induce the firm to reduce service standards
Might induce the firm to substitute opex for capex
Might induce the firm to act strategically to obtain atarget capex (or closing RAB) higher than was forecast.
When combined with weak incentives for service standardsstrong incentives to reduce expenditure could result in over-forecasting of capex requirements ex ante and under-spending ex post.
Power of the incentive to reduce capex should betailored to ensure a balance of incentives overall
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The revaluation approach What is the re-valuation approach
Under the re-valuation approach at the end of the period
the RAB is set equal to some methodology such as DORC
As before FCM requires that:
But now since the closing RAB is fixed, this equation shows that
depreciation must be set as follows:
Closing
RAB
Opening
RAB
Actual (out-
turn) capital
expenditure
Forecast
deprec-
iation+ -=
Forecast
closing RABOpening
RAB
Forecast
capital
expenditure
Forecast
deprec-
ia
tion
+ -=
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The revaluation approach In other words, FCM requires that the depreciation
must be set in a way which anticipates the expected
future changes in the end-of-period RAB. When the depreciation is set in this way:
(a) the revaluation approach is identical to a roll forward
approach based on forecast capex and forecast depn
this yields high-powered incentives for reducing capital expenditure(which may not be appropriate)
(b) however the regulated firm is also subject to risk that the
actual revaluation will differ from the forecast
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Interim summary Under the roll forward approach:
The depreciation is set first and then the closing RAB is set in
such a way as to preserve FCM
the incentive to reduce capital expenditure can be tailored to
ensure a balance of incentives overall
Under the revaluation approach The closing RAB is set using some methodology and the
depreciation is set in a way which preserves FCM The firm still faces some risk that actual closing RAB will not
equal forecast closing RAB
The incentive to reduce capex is high and cannot be varied
The firm has a strong incentive to act strategically to achieve a
higher closing RAB (and a higher capex target)
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Allocation of Sunk Costs Does one of these two approaches lead to a better
amortisation of sunk costs? i.e., a better path of
revenues / prices over time? It is important to recognise that the concept of
DORC valuation has no particular economic merit
The view [that DORC has some economic significance]
has been recited to the point that its validity is widelytaken for granted albeit without demonstration or
acknowledged authority (Johnstone, Abacus 2003)
There is no economic grounds for a link between
DORC and the price charged by an efficient new entrant
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Allocation of Sunk Costs Does the DORC approach lead to fewer or no price
shocks (i.e., a smooth path of revenue over time)?
the maintenance of revenue streams over time at a levelthat is consistent with a DORC asset valuation willminimise the likelihood of significant shocks to tariffs asthe replacement of assets becomes necessary (draft SRP,
page xi)
While the DORC approach may lead to less price shocksthan straight-line depreciation, it does not necessarilylead to less price shocks than an approach in which thedepreciation is set in a way which anticipates higherreplacement costs
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Allocation of Sunk Costs Some capital expenditure may not be fully reflected in
a change in the DORC valuation, and so must be
expensed (i.e., treated as opex) E.g., refurbishment expenditure (changing the engine in a
used car has no effect on the cost of buying a new car)
Or legacy upgrade effects (the cost of adding services to a
hypothetical optimal network may be less than the cost ofadding services to the actual network)
SPI PowerNet and ElectraNet recognised this and sought to
include refurbishment expenditure as opex in their revenue
cap applications
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Allocation of Sunk Costs
If the capex is $400, but the
DORC valuation only
increases by $50, all the
remainder of the capex must
be expensed (i.e., not
amortised). This could lead to
large fluctuations in the path
of revenue
Opening RAB 500
Capex 400
Closing RAB 550
Depreciation 350
E.g., A major capital expenditure which has little/no
effect on the ORC must be reflected in the depreciation,
leading to a jump in the allowed revenue
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Final summary Pros and cons of roll-forward
The long-term path of revenues/prices over time dependson how the level of depreciation is chosen over time over
which there is substantial flexibility. Path of depreciation can be chosen to so that path of revenues
reflects planned or unplanned stranding, changes in demand or intechnology
The incentives for minimising capital expenditure depends
on how the amount rolled into the RAB depends on thecapex out-turn
The regulator can tailor these incentives as necessary to ensurethey are balanced with the incentive to promote/maintain servicestandards and the incentive to minimise operating expenditure.
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But is it too late?
The Commission is considering adopting the policy
that at the end of the period the RAB will be updated
using the roll forward approach
But, in any case in revenue cap decisions to date thedepreciation has notbeen set in a way which anticipates
future end-of-period revaluations
Instead, depreciation has in practice been set on a straight
line basis. In these circumstances revaluing the asset base at the end
of the current period would violate the principle of
financial capital maintenance
Has the decision already been made, in effect?
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The Way Forward The way forward is clear:
There are strong economic arguments and strong support
in the submissions for the roll forward approach The details of the roll-forward approach need to be
specified
Issues that need to be addressed include:
The incentives to select (or the selection of) desirable projectsand the role of the regulatory test in this process
The power of incentives to carry out those projects at least cost
including the handling of capital over-spend or under-spend and
the handling of forecast versus actual depreciation