A Review of the PBR Rules PBR

Review

Under Section 25, the retail rates charged by DUs to their captive market is subject to regulation by the ERC –

based on the principle of full recovery of prudent and reasonable economic costs incurred

or such other principles that will promote efficiency as may be determined by the ERC.

EPIRA Guiding Principles:

Also echoed in Sec 43 (f)

The rate-setting methodology so adopted -

must ensure a reasonable price of electricity.

shall be non – discriminatory.

The Objective of the PBR Regulatory Framework - to balance the interest of

network owners and users -

FAIR RETURN TO INVESTORS

REASONABLE POWER PRICE

TO CONSUMERS

Later amended under ERC Res. 24 in 2007 and ERC Res. No. 20 in 2008

The Response:

ERC Res. 12-02 Series of 2004 - “Adopting a Methodology for Setting Distribution Wheeling Rates.”

Under RDWR Sections 1.9.2 and 1.9.3, the Rules may from time to time be amended by the ERC.

Rules may be Changed -

Amend 2

Amendment 1

Any amendment should cover all entities under the PBR regime.

PBR

Complicated Driven by Foreign Consultants

Biased Against Consumers

Almost Always Guarantee Rate Increases

Difficult to Validate - Info Debatable and Driven by DUs

WHY REVIEW?

Objectives of the Review

Simple and less costly to Implement Transparent

No Apparent Biases

Validation

The Building

Block Principle

As part of the Regulatory Reset Process for each Regulatory Period, the ERC must determine the Annual Revenue Requirement (ARR) for each Regulated Distribution System covering each of the Regulatory Year in the subject regulatory Period. Based on a forward-looking analysis of forecast cash flow requirements and

Represent the optimal forecast revenue requirement for the period concerned

Annual Revenue Requirement (ARR)

RETURN OF CAPITAL

(Depreciation)

RETURN ON

CAPITAL

EFFICIENT OPERATING

COSTS

OTHER TAXES

CORPORATE INCOME TAX (Set to Zero)

The Building Blocks for Calculating Revenue

Requirements - Article IV, Section 4.7

of the RDWR

The ARR must reasonably compensate the Regulated Entity for the economically efficient costs and risks it incurs in providing Regulated Distribution Services in respect of that Regulated Distribution System.

When undertaking the economic and financial analysis to determine the ARR, the ERC will adequately compensate the relevant Reg. Entity for all identified and justifiable RISKS inherent in an electricity distribution business in the Philippines -

O C P o T S N T G S R I S K S

Efficient Operating

Costs

Return of Capital Other taxes

Return on Capital

Risk Mitigating Costs plus any Risk Premium

The Building Blocks Under the Position Paper:

OR

Proposals to Determining ARR

1.The forward-looking analysis of forecast

cash flows will be broken down into two segments:

- Economically efficient operating costs - Mitigating costs of Identified Risks

The economically efficient

operating costs shall be required to be reported on by the DU external auditors in terms of reasonableness in relation to the DU business, objectives and operating environment.

The management will be required to submit to the ERC a Risk Management Report that contains identifiable businss risks including a summary of mitigating measures including the costs of such mitigation.

Over compensation for such risks will be to the disadvantage of customers because it will permit unjustifiably high tariffs.

Under compensation for such risks will be to the disadvantage of the Regulated Entity and, ultimately to its Customers because this will adversely affect the viability of the Regulated Entity.

Management is Expected to Know the Risks, Mitigate and Manage It.

(Code of Corporate Governance)

The Building Blocks shall be aligned with the above requirements and presented as follows:

Efficient Costs Associated with the Provision of Distribution System Services:

+ Operating and Maintenance XXX + Taxes Other than Income Tax XXX

Regulatory Depreciation / Return Of Capital XXX

Reasonable Return on Capital XXX

Compensation for Identified and Justifiable Risks

+ Costs of Mitigation XXX + Identifiable Risk premiums XXX

Regulatory Assets

Valuation

Two distinct views on Asset Valuation which are both acceptable for Financial Accounting & Reporting Purposes as well as for Regulatory Purposes are: Historical Cost

Appraisal or Current Cost A well-defined asset valuation

methodology is required in order that the regulatory objectives of transparency and consistency are achieved.

Replacement Cost – which is the most economic cost required for the entity to replace the service potential of an asset (including the amount that the entity will receive from its disposal at the end of its useful life) at the reporting date. OR Deprival Value - Which is often known as the value to the owner or value to the business. By definition, it is an asset evaluation method that builds on the assumption that the value of an asset can be measured in terms of the loss or damage that the asset holder would incur if deprived of that asset.

Current Cost could be:

As part of the Regulatory Reset Process under the existing RDWR, the ERC must require RAB to either be RE-VALUED OR ROLLED FORWARD Revaluation of the RAB (material items) will be done either: At their Optimized Deprival Value, OR Using some other method of internationally - accepted valuation methodology as determined by the ERC Optimized Deprival Value - Is the lesser of the optimized depreciated replacement cost and their recoverable amount. The Recoverable amount is the greater of the assets’ economic value (Use value or value in use) and net realizable value.

The Rule can be depicted in a flow chart as follows:

OR The RAB is re-valued

Previous Value of RAB is Rolled

Forward

At their Optimized Deprival value

Using some other Methodology determined by the ERC

At their Recoverable Amount At ODRC Whichever

is LESSER

OR

OR

Economic Value

Net Realizable Value

OR Whichever is HIGHER

Valuing assets based on deprival value is not consistently straightforward and objective as different values can be figured out by different estimators, not to mention the significant diversion from market values. Furthermore, deprival value is often biased reflecting expectedly the view of the reporting firm.

Defeats Simplicity, Transparency, Validation and elimination of Bias

Requirements

Issues For Decision: To Re-Value RAB or Roll Forward Previous RAB (with or without modification) If Re Valued - Use Deprival Value Approach or some other Methodology (Historical or a Modification of both Historical and Replacement) Any Other Recommended Methodology

Depreciation

Financial Accounting Depreciation

In Accounting context, depreciation seeks to allocate an asset’s cost over its estimated useful life in a manner which reflects the pattern its economic benefits are consumed in generating revenues. The matching concept is adhered to, whereby an entity’s revenues are matched vs. their expenses in generating them.

Two Regulatory Views on Depreciation:

First view seeks to recover capital cost of investment in assets. Thus, depreciation is often referred to as capital recovery. These funds form part of the return of the equity of an entity and can be regarded as a return of capital.

The replacement view denotes a measurement of the investment by the firm in real assets and therefore, suggests that depreciation should be calculated on the basis of the current cost of the asset and thus, should finance over time expected expenditures for the renewal / maintenance of assets.

Second view is that it represents a replacement of capital or a charge for the replacement of assets consumed.

It is also argued that over a long time there should be a close approximation between renewals /maintenance expenditure and depreciation of asset. One can take the position that where current cost depreciation is adopted, maintenance expenditure should not be allowed in the revenue requirement as this expenditure should be catered for in the current cost depreciation charge.

Still Another Point of View:

Depreciation Alternatives

Depreciation at Historical Cost plus Allowable Maintenance Costs (Capital Recovery) Depreciation at Historical Cost plus Allowable Maintenance Costs plus Reserve for Increase in Asset Replacement Costs Due to Inflation Replacement Cost Depreciation Only (No Maintenance Costs in ARR) Asset Category A - Historical Cost Depreciation plus Maintenance Costs Asset Category B - Replacement Cost Depreciation (No Maintenance Cost)

In any Alternative, a Sinking Fund Will be Required to be Established, funded with the Cash Flows Generated from Depreciation Charges and which cannot be Used for Any Other Purpose except for the Replacement of Assets or Payment of Obligations incurred to purchase qualified assets.

OPTIMI- ZATION Optimization is undertaken on an incremental basis, where the focus is on removing redundant assets and over-capacity, as well as inefficient design and “gold-plated” engineering within the existing network. Optimization is still a suggested procedure but not necessarily as complicated and, may be done by local technical experts not foreign consultants.

Other Asset Related Issues: Adjustment in Asset Life (Prospective)

Fully Written Down Asset (With Service Life)

Obsolescence

Stranded Assets

Salvage Value and Cost of Removal

Weighted Average Cost of Capital Determination

Section 4.11 of the RDWR on the Final Calculation of the WACC still applies in principle. This provides that the ERC must retain a Regulatory Reset Expert for the purpose of assisting the ERC to determine the WACC during the regulatory reset process. The WACC so determined must be the same for all Regulated Entities and all Regulated Distributed Systems in an Entry group. However, since the WACC will be determined for each Entry Group, subject to Section 4.11.13 there may be differences in the figures used for different Entry groups.

Section 4.11.3 - The WACC (expressed in decimal, as opposed to percentage, terms) is to be calculated as follows:

WACC = [re x E/V] + [rd x D/V]

Where:

re = the cost of equity and is calculated in accordance with Section 4.11.4

rd = the cost of debt and is calculated in accordance with Section 4.11.10 E = the amount of equity funding assumed for regulatory purposes in the capital structure of a Regulated Entity, being 60% of V for the Third Regulatory Period.

D = the amount of debt funding assumed for regulatory purposes in the capital structure of a Regulated Entity, being 40% of V for the Third Reg Period.

V = E + D

3. Breakdown between Equity and Debt need not be on the ratio as prescribed of 60% Equity and 40% Debt.

4. Calculation of Investment Risk Premium

Issues Relating to WACC:

1. May require the use of experts. 2. The rate so determined for each

participant even in the same Regulatory Period may not necessarily be the same.