integration of capital expenditure in the price control · 1st educational workshop: energy capital...

www.erranet.org1st Educational workshop: Energy Capital Investment ProgramsMarch 5-6, 2018 //Budapest, Hungary

Integration of capital expenditure in

the price controlPrepared by

Andrew Tipping

Economic Consulting Associates

1st Educational workshop: Energy Capital Investment ProgramsMarch 5-6, 2018 //Budapest, Hungary

2

Outline

1. Introduction

2. Reminder of the price review process

3. Role of RAB and capital expenditure

a) Measuring RAB

b) Adjusting RAB: for capex, disposals, depreciation, inflation


3

Introduction


4

Who is ECA?

ECA provides economic consulting advice in infrastructure

services for utilities, investors, regulators, and governments

worldwide

40+Utilities and

regulators advised

65+Countries worked

in

20 yearsin business

24Consultants

60+ assignments

annually

15+ years average

experience

100%Employee owned

£6mAnnual

turnover

4Regional

representations


5

Reminder of the price review process


6

A refresher on the price review process

Existing

Assets

New CAPEX

Regulatory

Asset Base

(RAB)

Depreciation/

Capital

Maintenance

Reasonable

Rate of Return

Operating and

Maintenance

Expense

Allowed

Revenues

Target Return

on Assets

Tariff

Structure

=

+

x =

+=

Se

rvic

e S

tan

da

rds

Customer

Categories

+


7

Role of RAB and capital expenditure

Measuring RAB


8

Some reminders on the Regulated Asset Base

It has various names: Regulated Asset Base (RAB), Regulatory Capital Value (RCV), Regulatory Asset Value (RAV)

Assets used to carry out regulated activities

Determined by the regulator – may diverge from accounting values

How is it used in the allowed revenue calculation?

To cover financing costs of the regulated activities

To recover the capital costs of investment in assets necessary to carry out the regulated activities, over the useful life of the assets


9

Principles for measuring the Regulated Asset Base

The estimated number needs to satisfy:

Fairness to consumers (affordability)Consumers should not pay excessively – ‘used and useful’?

Operational efficiencyThe system should operate at efficient levels and generate price signals that encourage efficient investment

Fairness to utility/investorsInvestors need to earn a fair return on their investment

Additionally, the following are desirable:

Objectivity

Comparability

The objectives are often

conflicting! The

prioritisation of criteria

will determine the

method.


10

An overview of the asset measurement process

Establishing the value of every single asset cumbersome

Define broad asset categories

For each category, define:

Initial

RAB value

Remaining

asset life

Standard

asset life


11

There are a range of approaches to measure RAB

Cost–based approach

Most common, based on cost estimation of the assets

Historical cost: Focused on fairness – original purchase price less cumulative depreciation

Current cost: Focused on operational efficiency-investments needed to replace existing assets

Economic value measures

Based on the Net Present Value (NPV) of future earnings

Deprival value measures

The lesser of economic value and replacement cost

Notional value measures

A conceptual asset base, not based on physical assets

Calculated under a TotEx approach


12

How do we compare Historic and Current Cost Accounting?

Historic cost accounting

Value at the price paid for the assets (or approved at the time) when commissioned

Investors should recover, and customers should pay, the actual costs of the investment made

This is represented by the historic cost of purchasing the assets

Current cost accounting

Value at the current cost of purchasing the assets, ignoring their historic cost

Economic efficiency requires that customers pay the costs of providing the service at this point in time

Rapid cost and technology changes mean that historic costs of assets are a poor guide to their current costs


13

How do we set current costs?

Inflation indexation

Adjust historic asset values using a cost index (eg, CPI, PPI)

Replacement cost

Revalue at the current cost of purchasing the same asset – what is the cost that a new entrant would pay to enter the market? Is this a fair question?

Modern Equivalent Asset (MEA)

Revalue at the current cost of replacement with an asset of the same capability

Optimised replacement cost (‘reference utility’)

Determine the optimal network design required to deliver the same level of service and value this at current costs


14

Cost-based measures – Historical cost

Also known as depreciated actual cost: original purchase less cumulative depreciation

Costs actually incurred by the company. Apply when:

Significant scope for new entry

Charging methodology not flexible enough to produce efficient price signals

Pros Cons

objective data availability

data-based divergence from current market price over time due to inflation and technological progress

simple

audits easy if data available

avoids windfall gains or losses for the company


15

Cost-based measures – Replacement cost

Cost of replacing existing assets with different assets that provide same service and capacity

Hypothetical costs incurred by a new entrant

Most commonly used to value privately-owned utility businesses

Optimised replacement cost- adopt the replacement cost methodology with a focus on efficiency improvement, assumes a new entrant perspective

Pros Cons

theoretically, a close representation of asset market value

expert advice from engineers and accountants may be needed

subjective

Pros Cons

closer to the market value as the optimisation procedure mimics competitive market

subjective- often efficient to establish excess capacity that will take years to absorb


16

Economic value-based measures

Current economic value of the assets or ‘value in use’

What value does the asset generate for the utility?

For a given asset, determine the greater of the net present value (NPV) and the scrap value of the asset

Pros Cons

incentivises the scrappage of inefficient assets

requires estimates of future profits

circularity issue: anticipated revenueNPV of future profitsopening RABmaximum allowed revenue (MAR) anticipated revenue


17

Economic value circularity

0

2

4

6

8

10

12

14

16

OpEx

Returnoncapital

Returnofcapital

-120

-100

-80

-60

-40

-20

0

20

40

1 2 3 4 5 6 7 8 9 10 11 12

Economic value is the PV of future cash flows

Future cash flows comprise three parts

Two of those parts are based on the economic value


18

Deprival value measures

Compare replacement cost (RC) and economic value (EV) and choose the lower one

Optimised deprival value (ODV) – compare optimised replacement cost (ORC) and economic value (EV) and choose the lower one

Pros Cons

helps determine assets that cost more than their economic value

all issues of EV and RC

Pros Cons

ORC more realistic than RC all issues of EV and ORC


19

Notional value (TotEx) measures

Existing

Assets

New CAPEX

Regulatory

Capital Value

(RCV; RAB)

Depreciation/

Capital

Maintenance

Reasonable

Rate of Return

Operating and

Maintenance

Expense

Allowed

Revenues

Target Return

on Assets

Tariff

Structure

=

+

x =

+=

Se

rvic

e S

tan

da

rds

Customer

Categories

+

‘Slow money’

PAYG

Expenditure

(‘Fast money’)

TotEx

RCV/RAB

Run-off


20

Notional value (TotEx) measures

RAB as a ‘notional’ financial concept

Utility can choose whether to recover expenses in one year (‘fast money’), or over many years (‘slow money’)

Pros Cons

much easier to calculate RAB subjectivity in trade-offs between current and future customers

gives flexibility in determining trade-offs between expenses now and in the future

indirect relationship with financing so choices need to ensure financeability


21

Challenges in Replacement cost determination

Generally requires detailed asset register showing age and condition of all existing assets of the utility

Revaluation needs engineering consultants with comprehensive database and, for optimised values, power network planning tools

No two consultants will have the same views, making it more difficult to reach agreement on valuations

Difficult to transpose across countries (exchange rates, equipment specifications, design philosophies, environmental conditions, topography, service standards)


22

Comparing Historic and Current cost measures

Transparency Simplicity Risk to utility (stranded

assets)

Risk to customers

(over-payment)

Economic efficiency (prices =

marginal cost)

Historic cost accounting

✓✓ ✓✓ ✓✓ ✓

Current cost accounting

Inflation indexation ✓✓ ✓✓ ✓

Replacement cost ✓ ✓

MEA ✓ ✓

Optimised replacement cost

✓✓ ✓✓


23

The need for consistency between asset valuation and returns

If CCA is used, then the asset base is updated for changes in costs at each reset of allowed revenues

Therefore, the allowed return needs to be calculated in real terms (ie, excluding inflation)

The impacts of inflation have already been captured through the CCA adjustment to asset values

If HCA is used, then the allowed return needs to be calculated in nominal terms (ie, including inflation)


24

Some additional points on RAB measurement

How realistic is revaluation?

Likelihood is for something based on historic (actual) costs

Exclude grants or other assets the utility has not paid for (capital contributions)

Working capital: the regulator might decide to consider an allowance for working capital to meet the short-term obligations of the regulated companies


25

Role of RAB and capital expenditure

Adjusting RAB


26

Adjusting the Regulated Asset Base

Periodic adjustments to the RAB have a typical calculation:

Opening RAB

+ Approved Additions (capex or commissioned assets)

- Disposals

- Depreciation

± Inflation

= Closing RAB


27

How should we determine the depreciation profile?

From a regulator’s perspective, the depreciation allowance has two purposes:

Efficiency. Reflect the cost of customers’ consumption of assets—implies using the technical life

Financeability. Generate sufficient cash to service debts—implies using lives close to the term of loans used to fund the assets

These may conflict with each other

Technical lives of assets can be very long—for many network assets lives may be 40+ years

This is much longer than the term of most loans that will be available.

Therefore, avoiding financial difficulties requires either shortening the asset life or increasing the use of equity financing


28

There are different methods of depreciation from which to choose

most commonStraight line

• Assumes a linear relationship between accumulated depreciation and the age of the asset

• Involves systematic allocations that remain constant from year to year

front-loadedAccelerated• Front loaded, ie it is higher in early years, perhaps to assist finance repayment

• The reducing balance methodology yields allocations that decrease from year to year

based on asset utilisationPer Unit• Estimates total service provided by the asset and then allocates a charge each year

very rareProgressive• The depreciated amount increases each year

• Used to attract consumers to the business as tariffs low in early years of operation


29

Why use depreciation (v Capex, v financing)?

0

10

20

30

40

50

60

1 2 3 4 5 6 7 8 9 10

CapEx Depreciation Financing


30

Understanding accounting and regulatory depreciation

Accounting depreciation Regulatory depreciation

Set for tax reasons Based on the economic life of the assets (customers’ use of the assets)

May bear little resemblance to the actual useful lives of assets

Allocatively efficient – customers pay for the ‘true’ cost of the services being provided

Engineering consultancies often have large databases of asset life information from which to determine this

Accounting depreciation Regulatory depreciation

Set for tax reasons Based on the economic life of the assets (customers’ use of the assets)

May bear little resemblance to the actual useful lives of assets

Allocatively efficient – customers pay for the ‘true’ cost of the services being provided

Engineering consultancies often have large databases of asset life information from which to determine this


31

What is the purpose of inflation indexation in RAB adjustment?

Indexation refers to the process of adjusting the RAB for the effects of inflation

Inflation adjustment should be consistent with the method chosen for estimating RAB

If RAB is based on costs today, then it has an implicit inflation adjustment already

Allowed revenue adjustments should be on the same terms

Trade-off between a single general index and industry-based indices

Economy-wide index reflects changes in prices across the economy, so price changes will be comparable to a ‘bundle of goods and services’, so often a consumer-based index

Industry-based indices will be similar to the replacement cost approach


32

Which inflation index to use?

Regulators have tended to default to indexing costs to economy-wide inflation using the Consumer Price Index (CPI)

This is obviously not necessarily a good proxy for changes in the costs of, for example, distribution cables and towers

However, it has the advantages of

being compiled and calculated independently of the utility and the regulator

being publicly available, increasing transparency

avoiding the inevitable disputes and calculation difficulties that would arise if the regulatory tried to determine their own inflation index


33

Adjusting RAB for capex

Capex is added to the RAB when it is incurred/spent

OR

Capex is added to the RAB when it is commissioned, with the total value grossed up to account for returns on the asset during construction.

Easier to administer because

there are no complexities

related to capex being incurred

in one regulatory period but

not commissioned until the

next

Consumers won’t pay for

capex that is not yet

operational and will not be for

some years ahead

W

THANK YOU FOR YOUR ATTENTION!


Andrew Tipping

E-mail: [email protected]

Web: www.eca-uk.com

integration of capital expenditure in the price control · 1st educational workshop: energy capital...

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