helena s. valderrama, ph.d. professor, cesar e. a. virata ...there are no material barriers to entry...
TRANSCRIPT
Helena S. Valderrama, Ph.D. Professor, Cesar E. A. Virata School of Business
University of the Philippines Diliman
BSP – UP Professorial Chair Lectures 24 May 2013
Study Objectives Provide an overview of the rate-setting methodologies
for the transmission and distribution businesses in the Philippines
Analyze the rationale in the use of the optimized depreciated replacement cost (ODRC) method in the valuation of transmission and distribution assets of Philippine utilities
Background • The Philippines embarked on a comprehensive
restructuring program for its power sector with the passage of the Electric Power Industry Reform Act (EPIRA) in 2001.
• Main Elements of Restructuring Unbundling Competition in generation and supply Privatization Open Access and Retail Competition
The Market After Restructuring Unbundled Generation and
Transmission Functions Unbundled Tariffs Generation Prices Market
Driven Open Access Presence of Competition Choice for large industrial
customers (1MW & above) Choice for small users in the
long run Transmission and distribution
continue to be regulated businesses
Customers
TRANSCo
DUs
Suppliers
GENCo / IPPs
Market Operator
Source: PSALM
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10
Residential Electricity Rates (MMla) 2000 to 2010
PhP/Kwh
June 2001 EPIRA passed
into law
Pre-EPIRA average: P5.35/kwh
Post-EPIRA average: P8.63/kwh Compound annual growth rate (2001-2010): 7.7%
Source: Valderrama (2011)
Note: Data for a residential consumer consuming >400 kWh/mo in Meralco franchise area
0
1
2
3
4
5
6
7
PhP
Movements of Major Components of Power Cost (2003-2010)
Generation Rate Transmission Rate Distribution
Transmission average: P0.88/kwh
Generation average: P4.67/kwh min: P3.19/kwh max: P6.77.kwh
Distribution average: P1.74/kwh
Source: Valderrama (2011)
Generation and Distribution Costs 2008 to 2012
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2
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200
400
600
800
1000
1200
1400
1600
Distribution Generation
CAGR = 9.98%
CAGR = 9.64%
Dis
trib
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r 400
kWh
cons
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Generation cost per
kWh
Rate Setting for Transmission and Distribution EPIRA (RA 9136 Sec. 43 (f)) empowers ERC to prescribe the
rate-setting methodology for transmission and distribution. The methodology shall: “(Take) into account the efficiency or inefficiency of the
regulated entities “allow recovery of just and reasonable costs and a reasonable
return on rate base (RORB) to enable the entity to operate viably
“ensure a reasonable price of electricity “be non-discriminatory “promote efficiency”
As mandated, ERC promulgated rules for the setting of rates for T&D as follows: For Transmission
Transmission Wheeling Rate Guidelines in 2003 (amended in 2009; now called Rules for Setting Transmission Wheeling Rates or RTWR )
For Distribution Guidelines for the Setting of Distribution Wheeling Rates in 2004
(amended in 2006 and 2008; now called Rules for Setting Distribution Wheeling Rates or RDWR)
ERC prescribed the “performance-based rate methodology” for the T&D sectors, replacing the Return on Rate Base or cost of service approach used pre-EPIRA.
Rate Setting for Transmission and Distribution
RORB and PBR: How Similar? Both methods reimburse utilities for “prudent and
efficient costs of service” Operating expenses (operating and maintenance
costs; customer-related costs) Taxes Depreciation of the regulatory assets (a.k.a. “return of
capital” Return on capital
RORB and PBR: How Different? Note: Corporate income tax in revenue requirement is set to zero in ERC rate decisions, pursuant to a SC ruling
Source: ERC Case no. 2005-041 dated 12 July 2010
The Impact of Rate Base Valuation NGCP (2010-2015) Meralco (2012-2015)
ARR BUILDING BLOCK Amount
(Peso MM, real 2010)
% Amount
(Peso MM, real 2012)
%
return on capital 126,612.86 64% 79,853.30 42% opex 29,369.35 15% 61,214.90 32%
return of capital/regulatory depreciation
30,670.39 15% 23,348.70 12%
other taxes 3,935.27 2% 981.10 1% subtotal 190,587.87 96% 165,398.00 87%
net efficiency adjustment (5,666.73) -3% Under-recoveries , 2nd regulatory
period 10,836.67 5% 24,158.80 13%
others 2,869.85 1% total 198,627.66 100% 189,556.80 100%
The Optimized Depreciated Replacement Cost Approach
Source: ERC (2010), Valuation Handbook for Optimized Depreciated Replacement Cost Valuation of System Fixed Assets of Privately Owned Distribution Utilities Operating Under Performance-Based Regulation (Third Regulatory Period)
How Replacement Costs are Established Indexation method – historical costs are adjusted for
inflation using suitable indices (e.g., retail or consumer price index)
Replacement cost method – establishing the recent costs of similar assets
Modern equivalent asset (MEA) method – current market buying price, current reproduction or replacement cost of a “modern equivalent asset”, defined as “an asset that, in the normal course of a transmission entity’s business, would be used to replace an existing asset”
The Optimized Depreciated Replacement Cost Approach
ODRC Rationale “The ODRC method … determines a hypothetical value of
the assets which is a surrogate for market value in circumstances where it is not possible to determine values for specialized assets using a market comparison approach.
…the ODRC method assumes a hypothetical operating environment where the relevant market is contestable and there are no material barriers to entry into that market by an alternative service provider or an efficient new entrant.
… allows DUs to earn a reasonable (risk adjusted) return on their investment capital provided that the market continues to value the services produced from the capital invested. ”
Source: ERC (July 2010), Valuation Handbook for Optimized Depreciated Replacement Cost Valuation of System Fixed
Assets of Privately Owned Distribution Utilities Operating Under Performance-Based Regulation (Third Regulatory Period), Sec. 2.2 p. 11
Problems with ODRC Gale and McWha 2000
Price is not the only barrier to entry – incumbent’s response and access rights are other substantial barriers to entry
Can be a deterrent to new investment if cost of technology declines quickly
Johnstone 2003 No market to purchase assets at ODRC Significant uncertainty regarding response to new entrant by
incumbent Method not needed to ensure optimal asset use or promote
new investment Inability to measure ODRC in an objective and independent
manner ODRC provides a “free lunch” to existing asset owners
Insight from Financial Reporting FAIR VALUE “Fair value is the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions (i.e. an exit price) regardless of whether that price is directly observable or estimated using another valuation technique.”
- IASB (2011), International Financial Reporting Standard 13 para. 24.
ODRC is NOT fair value.
Measured the returns of a hypothetical utility under 2 cases: case 1 – RAB valued at acquisition cost, and case 2 – RAB revalued (appraised upwards) at the beginning of the regulatory period
All variables constant (working capital, annual operating expense, annual capital expenditure, WACC, capital structure) except for RAB valuation
Cost of debt is 6%, cost of equity is 18%
ODRC Effect on Utility Returns
ODRC Effect on Utility Returns Historical cost-
based RAB Revalued RAB Difference
Equity beginning 33,000.00 33,000.00 - Appraisal increase
9,342.80 9,342.80
Income 82,045.92 88,194.73 6,148.81 Addl investments
for capex 100,000.00 100,000.00 -
Dividends 152,736.45 164,806.66 12,070.21 Equity end 62,309.47 65,730.87 3,421.40
IRR of equity holders
17.23% 20.19%
Conclusions 1. ODRC does not achieve the purpose of producing
electricity rates that would be obtained under competitive conditions. It does not represent the price at which bypass by a new entrant will be viable.
2. Fair value, as defined in International Financial Reporting Standards, reflects the utility’s capital on which an opportunity cost rationally applies. Depreciated replacement cost, computed using an index-inflated MEA value divided by a subjectively-determined economic life, is an invalid substitute for fair value.
Conclusions 3. Using the current MEA value for valuing the RAB
rather than the value of the prudent MEA at the time the investment was made can potentially and unfairly hurt an incumbent utility if technological progress rapidly lowers the replacement costs of the utility’s assets (Gale and McWha (2000)).
4. ODRC results in wealth transfers from electricity consumers to the utilities’ shareholders.
Epilogue
Thank you for your attention.