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E i t t
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4
Training on Regulation
A webinar for the European Copper Institute
Webinar 4: Revenue Requirements and
Regulatory Asset Base (RAB)
Dr. Konstantin Petrov / Dr. Daniel Grote30.11.2009
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Agenda
2. Revenue Components
4. Asset Valuation
1. Introduction
3. Regulatory Asset Base (RAB)
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1. Introduction
Price Control Regulatory Tasks
Setting revenuerequirements /
cost determination
Decision onregulatory regime
Setting annualefficiency target
Tariff design
Webinar 4 - Revenue Requirements and RAB
Webinar 3 - Price Regulation
Webinar 8 - Pricing
Webinar 6 - Efficiency Assessment
Calculation ofregulatory asset base
Rate-of-Return, Cap Regulation,Sliding Scale,
Yardstick Competition
Data Envelopment Analysis,econometric approaches,reference network models
Tariff structures,cost allocation
Webinar 5 Cost of CapitalCalculation of
allowed rate of return
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1. Introduction
Price Control Models
Rate-of-Return regulation
Prices / revenues based on operating costs plus fair return
Price Cap and Revenue Cap regulation
Upper limit (cap) on prices or revenues
Efficiency targets
Regulatory period (3-5 years)
Price reviews
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1. Introduction
Price Control Revenue Requirements
Regulators have to recognize the importance to regulated service providers of recovering sufficient levels of
costs. Failure to include adequate costs as part of the revenue requirements may discourage investments
and deteriorate quality of supply. However, it is important that the regulated service provider does not incur
excessive or unnecessary costs in providing services.
Operating Expenditures (Opex) Capital cost
Opex are the costs incurred by a regulated company in
providing the regulated services and maintaining and
operating the relevant assets
The recovery of opex does not provide any return toshareholders and debt holders, as they are paid out in
the form of salaries, ongoing operating and
maintenance costs, etc
Capital costs provide an annual recovery of the capital
expenditures (capex) undertaken by a regulated service
provider in providing the regulated services
Capital costs include depreciation allowance and return
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1. Introduction
Price Control Revenue Requirements
Opex Capital costs
Revenue Requirements
Regulatory Asset Base
(RAB)Rate of Return
Revenue Requirements = Opex + Depreciation + (RAB Rate of Return)
Operation andMaintenance
Network LossesFuel (in case of
regulatedgeneration)
Return on AssetsDepreciation
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2. Revenue Components
Operating Expenditures (OPEX)
OPEX usually split into: Controllable OPEX (costs the company can influence and decide upon) or Non-controllable OPEX (costs beyond the control of the company)Only controllable OPEX exposed to efficiency analysis
The split between controllable and not controllable costs depends on legal and regulatory
framework, technical standards and norms
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2. Revenue Components
Depreciation
Systematic allocation of the investment cost to purchase an asset (capex) over the period
in which the asset provides benefits to the regulated company (asset life)
There might be differences between depreciation for regulatory, financial accounting and
tax purposes
Depreciation can be calculated by using various asset valuation methods (see next slides)
Typical depreciation methods are:
Straight-line method which allocates equal amounts of depreciation to each accounting
period of the asset life
Accelerated method (e.g. declining-balance) which allocates decreasing amounts of
depreciation to each accounting period of the asset life
Most regulatory authorities apply straight-line method
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2. Revenue Components
Depreciation
time10 years 20 years
remaining asset value
Initial assetvalue
depreciation
straight-line method
declining-balance method
time10 years 20 years
remaining asset value
Initial assetvalue
depreciation
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2. Revenue Components
Return on Assets Regulatory Asset Base (RAB)
The Regulatory Asset Base (RAB) comprises the assets used to provide the regulated
services
Typically regulators apply the following principles for RAB:
It includes only assets necessary to provide regulated services
It is based on the residual (depreciated) value of fixed assets
It may include allowance for net working capital
It excludes any capital contributions (external funding, subsidies) from customers,
government or third parties
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2. Revenue Components
Return on Assets Rate of Return
The rate of return describes the return the regulated company is permitted to earn (alsoknown as the opportunity cost of investor capital)
It is based on a weighted average of the cost of debt and equity financing
There are several methods to calculate rate of return
The most prominent model to calculate the rate of return in practice is the Capital Asset
Pricing Model (CAPM)
The CAPM takes into account that investors need to be compensated for the time value of
money represented by the risk-free rate and risk premium (beta) measured by the
correlation between the returns of the regulated company and market returns
What is included in the costs of capital and how it can be calculated is addressed in detail
in webinar 5
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3. Regulatory Asset Base (RAB)
Components
RegulatoryAssetBase
Existing Assets
NewInvestments
RAB roll forward / revenue re-setting
Depreciation
CapitalContribution
WorkingCapital
ConstructionWorks inProgress
RAB Closing Value =
RAB Opening Value
+ Investments
Depreciation
Asset Disposal+/- Change of Working
Capital
+/-Change of Capital
Contribution
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3. Regulatory Asset Base (RAB)
Investments (1)
An investment is incurred when a business spends money either to buy fixed assets or toadd to the value of an existing fixed asset
Three types of investments may be considered:
Extension investments: investments needed for meeting the change of load and
generation patterns in the future
Replacements investments: investments related to replacement of aged (technically or
economically) equipment
Exceptional investments: investment resulting from new legal obligations for example
(e.g. if new labour safety rules require safety measures in substations or high voltage
pylons, this probably leads to investments)
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3. Regulatory Asset Base (RAB)
Investments (2)
Regulatory assessment of investments
ex-ante ex-post
Assessment of adequacy and efficiency of
companys proposed investment program for the
forthcoming regulatory period
Regulator asks regulated companies to submit their
capital expenditure projections
Companies get security that investment will be
approved by the regulator before investment is
carried out
Supplement to ex-ante investment reviews (identify
differences between allowed and actual investments)
Or undertaken without previous ex-ante approval
(e.g. hindsight efficiency assessment like in
Germany)
Companies face uncertainty of whether undertaken
investments will be recognised by regulator ex-post
Threat that investments may be rejected, or partially
disallowed - may provide an incentive to onlyundertake efficient investment, but may also
discourage investment
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3. Regulatory Asset Base (RAB)
Construction Work in Progress
Treatment of assets in construction Long debates between regulators and regulated companies on this issue
Some regulators include construction work in progress (CWIP) in the RAB only after
completion of construction
Other authorities base the inclusion of CWIP on other factors, such as
whether the construction projects are of short duration whether the investment in the project is so significant that its exclusion could impair
financing
whether the interest charged to construction represents a substantial portion of the
companys earnings
Some form of recognition of cost of capital committed during construction appears
appropriate
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3. Regulatory Asset Base (RAB)
Working Capital
If the time at which a particular cost is incurred is different from the time of its recovery (viatariff revenues), capital is required to cover the time lag which is associated with a cost
Working capital defined as current assets minus current liabilities
Regulatory treatment of working capital
Allowance for working capital to meet short-term obligations of regulated companies
Consideration should be given to the use of a good-practice target, to calculate a
working capital allowance designed to give companies an incentive to manage working
capital well
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4. Asset Valuation
Different Approaches
Asset ValuationMethods
Cost based Value based
Indexedhistoric cost
Replacementcost
Historiccost
Optimisedreplacement
cost
DCFvalue
Deprivalvalue
Marketvalue
Asset valuation must be considered with regard to functional adequacy and market value of
regulated assets
Different methods involve varying degrees of effort to calculate, give significantly different estimates
of the regulatory asset base (RAB), and also differ in their pricing and investment signals
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4. Asset Valuation
Historic Cost
Values assets at original purchase price (including any relevant set-up and financing costs) Advantages:
Administratively efficient, can be easily audited because the data should be available
from financial statements
Relatively inexpensive: does not require experts to determine costs
Objective because it relies on actual data rather than judgementsDisadvantages:
Understate asset prices in times of high inflation and overstate asset prices in times of
technological change
May lead to unstable prices (e.g. prices may rise when new, more expensive assets
replace existing assets)
Data may be inadequate (especially for assets that have been acquired a long time
ago)
Returns may be inadequate to support the funding of new investments
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4. Asset Valuation
Indexed Historic Cost
Historic asset values are adjusted upwards for the effect of inflationValue of the RAB is adjusted (increased or decreased) to reflect changes in the underlying
inflation index
Debate as to whether the index chosen should reflect price changes in the particular
industry under examination, or price changes in the economy as a whole
Advantages and disadvantages similar to historic costs
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4. Asset Valuation
Replacement Cost
Calculates the cost of replacing an asset with another asset (not necessarily the same) thatwill provide the same services and capacity as existing asset
Asset values are based on what it would cost to replace the asset today Advantages: Assets are valued in current prices, which may provide an incentive for efficient
investment decisions
Allows regulator to reduce value of assets once it becomes aware that a more efficientlow-cost alternative asset is availableDisadvantages:
Entails a degree of estimation and judgment Information is more expensive to collect than historic cost data because it may require
expert advice (e.g. from engineers and accountants) on a number of assets
May lead to higher prices and face political opposition
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4. Asset Valuation
Optimised Replacement Cost
Values RAB on the basis of replacement cost of optimised assets, which most efficientlyreproduce the capacity and service levels of existing assets
Removes inefficiencies in the RABs current asset configuration, such as duplication,
excess capacity and redundant assets
Advantages:
Eliminates inefficiencies in the existing assetsDisadvantages:
Relatively complex to implement, requires considerable input in terms of manpower and
financial costs
Requires a degree of subjective judgement about the optimum configuration of assets in
the RAB, and about the processes of optimisation
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4. Asset Valuation
Market Value
Values RAB on the basis of the price that would be obtained from selling the assets in acompetitive market
Advantages:
Uses the market to obtain the asset value
Avoids subjectivity in the asset valuation process
Disadvantages:
In many cases there is no indication of market value (share quotation) of regulated
companies / services
Even if there is a price indication based on a divesture / privatisation of a regulated
company, there may be no or insufficient competition
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4. Asset Valuation
DCF (Discounted Cash Flow) Value
Values RAB on the basis of the discounted cash flows of the regulated companyPredicts the cash flows that the company is expected to generate, and then discounts them
back to present values using the appropriate risk-adjusted discount rate
Disadvantages:
Requires assumptions and forecasting to estimate future cash flows
Circularity problem arises because the future cash flows will determine the value of theRAB, however the future cash flows depend on the value of the RAB
(RAB - > Return on assets -> Revenue -> Cash Flow)
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4. Asset Valuation
Deprival Value (1)
The deprival value of an asset can be defined as the lower level of its: Replacement cost (if it can be replaced) and
Recoverable value
The recoverable value of an asset can be defined as the higher level of:
The value that the company could receive for selling the assets (value in exchange)
The value that the company could create by using the asset within the business (valuein use determined by the future cash flows)
If the recoverable amount exceeds the replacement cost, and the company was then
deprived of the asset, it would buy another to replace it if possible.
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4. Asset Valuation
Deprival Value (2)
The replacement cost sets a maximum on the loss that the company would suffer throughthe deprival
Where the recoverable value is less than replacement cost, replacement of the asset would
not be justified
Advantages:
Discourages inefficient investment Provides information on the economic value of the RAB
Disadvantages:
Complexity
Requires assumptions and forecasting to estimate future cash flows
Circularity problem arises because the future cash flows will determine the value of theRAB, however the future cash flows depend on the value of the RAB
(RAB - > Return on assets -> Revenue -> Cash Flow)
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Experience you can trust.http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4
End of Webinar 4
KEMA Consulting GmbH
Kurt-Schumacher-Str. 8, 53113 Bonn
Tel. +49 (228) 44 690 00Fax +49 (228) 44 690 99
Dr. Konstantin Petrov
Managing Consultant
Mobil +49 173 515 1946E-mail: [email protected]
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