1. Training on Regulation A webinar for the European Copper Institute Webinar 4: Revenue Requirements and Regulatory Asset Base (RAB) Dr. Konstantin Petrov / Dr. Daniel Grote 30.11.2009

2. Agenda 2. Revenue Components 4. Asset Valuation 1. Introduction 3. Regulatory Asset Base (RAB)

3. 1. Introduction Price Control Regulatory Tasks Setting revenue requirements / cost determination Decision on regulatory regime Setting annual efficiency target Tariff design Webinar 4 - Revenue Requirements and RAB Webinar 3 - Price Regulation Webinar 8 - Pricing Webinar 6 - Efficiency Assessment Calculation of regulatory 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 Capital Calculation of allowed rate of return

4. 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

5. 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 to shareholders 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

6. 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 and Maintenance Network Losses Fuel (in case of regulated generation) Return on Assets Depreciation

7. 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

8. 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

9. 2. Revenue Components Depreciation straight-line method declining-balance method time 10 years 20 years remaining asset value Initial asset value depreciation time 10 years 20 years remaining asset value Initial asset value depreciation

10. 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

11. 2. Revenue Components Return on Assets Rate of Return

• The rate of return describes the return the regulated company is permitted to earn (also known 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 moneyrepresented 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

12. 3. Regulatory Asset Base (RAB) Components Regulatory Asset Base Existing Assets New Investments RAB roll forward / revenue re-setting Depreciation Capital Contribution Working Capital Construction Works in Progress RAB Closing Value = RAB Opening Value + Investments Depreciation Asset Disposal +/- Change of Working Capital +/-Change of Capital Contribution

13. 3. Regulatory Asset Base (RAB) Investments (1)

• An investment is incurred when a business spends money either to buy fixed assets or to add 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)

14. 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 only undertake efficient investment, but may also discourage investment

15. 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

16. 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 (via tariff 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

17. 4. Asset Valuation Different Approaches Asset Valuation Methods Cost based Value based Indexed historic cost Replacement cost Historic cost Optimised replacement cost DCF value Deprival value Market value

• 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

18. 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 judgements

• Disadvantages:

• • 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

19. 4. Asset Valuation Indexed Historic Cost

• Historic asset values are adjusted upwards for the effect of inflation

• Value 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

20. 4. Asset Valuation Replacement Cost

• Calculates the cost of replacing an asset with another asset (not necessarily the same) that will 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 efficient low-cost alternative asset is available

• Disadvantages:

• • 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

21. 4. Asset Valuation Optimised Replacement Cost

• Values RAB on the basis of replacement cost of optimised assets, which most efficiently reproduce 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 assets

• Disadvantages:

• • 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

22. 4. Asset Valuation Market Value

• Values RAB on the basis of the price that would be obtained from selling the assets in a competitive 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

23. 4. Asset Valuation DCF (Discounted Cash Flow) Value

• Values RAB on the basis of the discounted cash flows of the regulated company

• Predicts 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 the RAB, however the future cash flows depend on the value of the RAB

• • • (RAB - > Return on assets -> Revenue -> Cash Flow)

24. 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 (value in 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.

25. 4. Asset Valuation Deprival Value (2)

• The replacement cost sets a maximum on the loss that the company would suffer through the 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 the RAB, however the future cash flows depend on the value of the RAB

• • • (RAB - > Return on assets -> Revenue -> Cash Flow)

26. End of Webinar 4

• • • KEMA Consulting GmbH

• • • Kurt-Schumacher-Str. 8, 53113 Bonn

• • • Tel. +49 (228) 44 690 00 Fax +49 (228) 44 690 99

• • • Dr. Konstantin Petrov

• • • Managing Consultant

• • • Mobil +49 173 515 1946 E-mail: konstantin.petrov@kema.com