parthasarathy regulatory tools for capex review and ......whether opex or capex solution is more...

wwwwwwwwwwww. . . . erranet.orgerranet.orgerranet.orgerranet.org1st Educational workshop: Energy Capital Investment Programs1st Educational workshop: Energy Capital Investment Programs1st Educational workshop: Energy Capital Investment Programs1st Educational workshop: Energy Capital Investment Programs

MarchMarchMarchMarch 5555----6, 6, 6, 6, 2012012012018888 //Budapest, Hungary//Budapest, Hungary//Budapest, Hungary//Budapest, Hungary

Regulatory tools forCAPEX review and approval:

overview of European approaches

PreparedPreparedPreparedPrepared bybybyby

Dr Srini Dr Srini Dr Srini Dr Srini ParthasarathyParthasarathyParthasarathyParthasarathy

Principal, OxeraPrincipal, OxeraPrincipal, OxeraPrincipal, Oxera

1st Educational workshop: Energy Capital Investment Programs1st Educational workshop: Energy Capital Investment Programs1st Educational workshop: Energy Capital Investment Programs1st Educational workshop: Energy Capital Investment Programs

MarchMarchMarchMarch 5555----6, 6, 6, 6, 2012012012018888 //Budapest, Hungary//Budapest, Hungary//Budapest, Hungary//Budapest, Hungary2222

• what do regulators try to assess: objective and definitions

• issues with benchmarking CAPEX

• ways of measuring CAPEX

• menu of tools: top-down and bottom-up

• case studies

• key takeaways

OverviewOverviewOverviewOverview



YYYYKKKK

MMMMM

L, OPEXL, OPEXL, OPEXL, OPEX

Exogenous factors

• input minimisationinput minimisationinput minimisationinput minimisation

– what is the minimum level of input that the unit

could operate at, given the level of output?

• output maximisationoutput maximisationoutput maximisationoutput maximisation

– what is the maximum level of output that the

unit can produce, given the level of input?

KeyKeyKeyKey

Y outputs/outcomes

K capital

L labour

M materials

(or all other inputs)

CAPEXCAPEXCAPEXCAPEX

What regulators try to assess: optimal level of spend to What regulators try to assess: optimal level of spend to What regulators try to assess: optimal level of spend to What regulators try to assess: optimal level of spend to

meet meet meet meet outputs and outputs and outputs and outputs and outcomesoutcomesoutcomesoutcomes



Regulatory cost model: assessing Regulatory cost model: assessing Regulatory cost model: assessing Regulatory cost model: assessing efficiency and the efficiency and the efficiency and the efficiency and the

potential for cost reductionspotential for cost reductionspotential for cost reductionspotential for cost reductions

Z: country- or region-specific factors

(e.g. customer density, topography, regional wages)

L = labour

K = capitalK = capitalK = capitalK = capital

M = materials

and supplies

C, cost = w.x

w = input prices

Y = total energy delivered,

passengers transported,

water delivered, track

replaced, etc.

OutputsOutputsOutputsOutputsInputsInputsInputsInputs TransformationTransformationTransformationTransformation

Factors outside management controlFactors outside management controlFactors outside management controlFactors outside management control

X =

pppproduction frontierroduction frontierroduction frontierroduction frontier

output-oriented (OO) technical inefficiency:

output loss due to techncial inefficiency

input-oriented (IO) technical inefficiency:

the amount by which inputs can be

reduced without reducing output

inefficientinefficientinefficientinefficient

A production function describes the transformation relationship—a ‘black box’—

which converts inputs into outputs



Technical efficiency

• what quantityquantityquantityquantity of output can be

produced, given the inputs?

• how few inputs inputs inputs inputs are required, given the

outputs?

Scale efficiency

• are firms operating at the optimal operating at the optimal operating at the optimal operating at the optimal

scale sizescale sizescale sizescale size—i.e. are they exploiting

economies of scale in production

Economic efficiency

(technical + allocative)

• what is the lowest cost of lowest cost of lowest cost of lowest cost of

productionproductionproductionproduction, given the

outputs?

• generally, the focus of

utility regulation

Allocative efficiency

• whether the observed input (i.e. resources)

combination is the optimum given the relative

prices of inputs

Other types of efficiency: dynamic, revenue

and profit efficiency

• dynamic efficiency: what is the potential rate

of improvement in economic efficiency over

time?

Regulatory cost model: notions of efficiency focused onRegulatory cost model: notions of efficiency focused onRegulatory cost model: notions of efficiency focused onRegulatory cost model: notions of efficiency focused oncost or expenditure as a function of outputs and outcomes



Illustration of static and dynamic efficiency gainsIllustration of static and dynamic efficiency gainsIllustration of static and dynamic efficiency gainsIllustration of static and dynamic efficiency gains

Frontier shift vs catch-up

Inefficient

Efficient

0 5 TimeTimeTimeTime

Frontier

shift

Catch-up

CostCostCostCost

Overall

scope for

efficiency

CatchCatchCatchCatch----upupupup

• how relatively inefficient is the company?

– by how much of this gap can the

company catch up to current best

practice in a given timeframe?

– individual target set for each company

Frontier shiftFrontier shiftFrontier shiftFrontier shift

• what is the potential for best practice to

improve?

– new technology/management practices

– target applied to every company in the

industry

Some regulators set a ‘general’ or

a ‘combined’ productivity target

Frontier

shift







• case studies

• key takeaways




What do regulated companies spend their money on?What do regulated companies spend their money on?What do regulated companies spend their money on?What do regulated companies spend their money on?

• operations

– costs are generally predictable and well-explained by cost drivers

• maintenancemaintenancemaintenancemaintenance

– expenditure on maintaining existing assets; largely predictable

• renewalsrenewalsrenewalsrenewals

– expenditure on replacing assets that have reached, or are nearing, the end of

their useful lives

• enhancementsenhancementsenhancementsenhancements

– expenditure on new assets that expand the capacity or capability of the network

• ring-fenced fundsMost regulated companies are

capitalcapitalcapitalcapital----intensiveintensiveintensiveintensive

Therefore, capital costs typically account for a large

proportion of the cost base



Forecasting the efficient level of capital investment is Forecasting the efficient level of capital investment is Forecasting the efficient level of capital investment is Forecasting the efficient level of capital investment is

difficultdifficultdifficultdifficult————enhancementsenhancementsenhancementsenhancements

• determining the efficient cost of large

capital projects is inherently difficult

– they may be one-offs and company-specific

– projects take a long time to deliver

– large inefficiencies can be baked into the

high-level specification and/or the detailed

design of the project

– market or technical innovations may not be

pursued

– history is a poor indicator of future costs

– forecasting uncertainty

– how much allowance should be made for

risk?



Forecasting the efficient level of capital Forecasting the efficient level of capital Forecasting the efficient level of capital Forecasting the efficient level of capital maintenance could maintenance could maintenance could maintenance could

be equally difficultbe equally difficultbe equally difficultbe equally difficult————maintenance maintenance maintenance maintenance and renewalsand renewalsand renewalsand renewals

• capital maintenance and Renewals expenditure is more predictable than enhancement expenditure

• regulators still face difficulties in assessing the optimal level of capital maintenance and renewals

• examples of asset failure in most regulated sectors: Railtrack, air traffic control systems failures

(Ireland and UK), Northeast blackout 2003 (USA and Canada), Herne Hill floods…

• the impact on outputs and the probability of

failure of changing maintenance expenditure

may be unclear (particularly in the short term)

• companies typically have much better

knowledge of asset base/health

• possible bias towards higher-profile

enhancements projects

• what is the value of reliability and thus the

optimal level of asset risk?

Difficulties for regulatorsDifficulties for regulatorsDifficulties for regulatorsDifficulties for regulatorsThe costs of

failure can be

high!



Possible CAPEX biasPossible CAPEX biasPossible CAPEX biasPossible CAPEX bias

Separate CAPEX allowance or TOTEX approach?

• instead of separate treatment of CAPEX

and OPEX, regulators may focus on cost

assessment and recovery based on total

expenditure (TOTEX)

• key aim is to combat a perceived bias

towards capital investment

– company given freedom to determine

whether OPEX or CAPEX solution is more

appropriate in the long term

– also to mitigate issues with accounting accounting accounting accounting

treatmenttreatmenttreatmenttreatment of cost items, balancing incentivesbalancing incentivesbalancing incentivesbalancing incentives

across cost categories and avoiding setting

an inequitable benchmark inequitable benchmark inequitable benchmark inequitable benchmark by assessing costs

separately

How the TOTEX approach worksHow the TOTEX approach worksHow the TOTEX approach worksHow the TOTEX approach works

• a proportion (Y%) of TOTEX is

added to the RAB and recovered

over an assumed asset life

• (1-Y)% of TOTEX is recovered as

it is incurred

• since Y% is determined ex ante,

the company should be

indifferent between CAPEX and

OPEX solutions

• also allows for a single efficiency

assessment and incentive rate







• case studies

• key takeaways




Measuring CAPEXMeasuring CAPEXMeasuring CAPEXMeasuring CAPEX

Cash cost and capital stock approaches

CAPEX

Cash cost approach

Smoothed CAPEX

Unsmoothed CAPEX

Capital stock approach

Annuity

Depreciated historical cost

Cash cost approachCash cost approachCash cost approachCash cost approach

• simple to compute as based on outturn data

• may not take into account the long-lived nature of assets

• requires possible steady-state assumptions

• often ‘smoothed’ to account for differences in investment

profiles across comparator units (peers)

Capital stock approachCapital stock approachCapital stock approachCapital stock approach

• long-lived nature of the asset is recognised

• could be a more realistic approach to measuring CAPEX

• requires a range of assumptions and adds to the

regulatory burden

• outcome of assessment can be sensitive to the approach

taken and assumptions made




Cash cost approach

To smooth or notTo smooth or notTo smooth or notTo smooth or not

• regulators tend to smooth ‘lumpy’

patterns of CAPEX to reduce

fluctuations over time that may be

down to company need or

managerial decision

• period over which to smooth

(5 years, 10 years?) is debatable as it

may need to correspond with asset

lives

• smoothing can reduce degrees of

freedom by reducing sample size

• can introduce internal inconsistency

between inputs (smoothed CAPEX)

and outputs (outturn cost drivers)

• can result in different treatment of

OPEX and CAPEX that may not be

consistent with the objective of

TOTEX benchmarking

2012 2013 2014 2015 2016 2017

CA

PE

X

Year

A

CAPEX Industry average

2012 2013 2014 2015 2016 2017

CA

PE

X

Year

B


2012 2013 2014 2015 2016 2017

CA

PE

X

Year

C


2012 2013 2014 2015 2016 2017

CA

PE

X

Year

D





Capital stock approach

Annuity approachAnnuity approachAnnuity approachAnnuity approachDepreciated Depreciated Depreciated Depreciated historical historical historical historical

cost cost cost cost approachapproachapproachapproach

�� gross value of initial investment

x annuity factor � ��

� ��

�� = depreciation + depreciated asset value

x WACC ��

��

�

��

Return Depreciation

0

1

2

3

4

5

6

7

8

9

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 300

1

2

3

4

5

6

7

8

9

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Age of assetAge of assetAge of assetAge of asset

CA

PE

XC

AP

EX

CA

PE

XC

AP

EX







• case studies

• key takeaways




Assessing Assessing Assessing Assessing CAPEX efficiencyCAPEX efficiencyCAPEX efficiencyCAPEX efficiency

Top-down approaches

YC

CC

Benchmark unit cost = CC/YC

Inefficiency

Cost, C

Output, Y

C

A

Unit costUnit costUnit costUnit cost

Cost

Inefficiency

V

Efficiency frontier

FA

B

D

E

C

O

Data Data Data Data EEEEnvelopment Analysis (DEA)nvelopment Analysis (DEA)nvelopment Analysis (DEA)nvelopment Analysis (DEA)

Regression (OLS) adjusted for noiseRegression (OLS) adjusted for noiseRegression (OLS) adjusted for noiseRegression (OLS) adjusted for noise

Stochastic Frontier Analysis (SFA) Stochastic Frontier Analysis (SFA) Stochastic Frontier Analysis (SFA) Stochastic Frontier Analysis (SFA)

Standard regression model is extendedStandard regression model is extendedStandard regression model is extendedStandard regression model is extended

InefficiencyInefficiencyInefficiencyInefficiency

Cost

Output

C

A Ordinary least squares

(OLS)


Corrected OLS

(COLS)

Noise?Noise?Noise?Noise?

B

OLS shifted to the upper

quartile


Cost

Output, Y

C

AExpected cost

NoiseNoiseNoiseNoise

B

c = a + by +

‘inefficiency’ +

‘noise’;

Stochastic frontier



Assessing Assessing Assessing Assessing CAPEX efficiency CAPEX efficiency CAPEX efficiency CAPEX efficiency

Bottom-up approach—basket of works

• combine a group of activities in a ‘basket of works’ with the associated expenditure

compared with an ‘implied’ level of CAPEX for the complete basket of works

• avoid comparing on an activity-by-activity basis, which could be distorted by companies’

allocation policies and definitions of works

• the basket of works approach compares the unit expenditure on similar capital projects

with ‘standardised’ unit (replacement) costs

• the ‘standardised’ unit cost for each project can be set by using the lowest unit cost, or

average unit cost, or other benchmark. Some regulators apply adjustments to the unit

cost to normalise for exogenous differences (e.g. fixed costs, regional factors)

• stringency of benchmark should be proportionate to data comparability and quality

considerations and availability of suitable comparator data

• the rate of catch-up set by the regulator could be:

�� ∑ !"#$%��& ∗ �"%()��$��*�"+*�&&

∑ !"#$%��&& ∗ +*)�,)-,�+�,$��*�"+*�&

For company � and capital project .







• case studies

• key takeaways




Case studiesCase studiesCase studiesCase studies

Energiavirasto (Finnish Energy Authority)

Norwegian Water Resources and Energy Directorate

Council of European Energy Regulators

UK rail, health and telecoms regulators

Ofwat—Office of Water Services

Ofgem—Office of Gas and Electricity Markets



UKUKUKUK

Ofgem’s approach to assessing CAPEX prior to RIIO

• Ofgem used a mix of regression modelling and engineering expert analysis to review

CAPEX activities

• for example, in GDPCR1 (gas distribution price review before RIIO):

– engineering consultant reviewed the GDNs’ forecast costs to understand whether they were

based on appropriate assumptions, including justification for their workload forecasts,

assumptions for real price increases and productivity

– assessment of GDNs’ efficiency for specific CAPEX and replacement expenditure by

benchmarking costs against workload across GDNs using regression

– bottom-up analysis by PB Power to consider the appropriate costs for particular activities,

based on information submitted by the GDNs and its own engineering experience

– comparison was limited to the GB networks, which are subject to similar licence conditions and

obligations, to avoid comparability issues that might arise from using data outside a specific

data set

– Ofgem considered relevant network-specific factors that could be driving differences in the

reported costs of companies to enable an equitable comparison



UKUKUKUK

Ofgem’s approach in RIIO

RIIORIIORIIORIIO----ED1 and ED1 and ED1 and ED1 and

RIIORIIORIIORIIO----GD1GD1GD1GD1

• historical and forecast

data from the

companies

• pre-adjusted for

company-specific

issues (one- and two-

sided adjustments)

RIIORIIORIIORIIO----ED1ED1ED1ED1

• fastfastfastfast----tracktracktracktrack: 12.5%

weighting on each of

the top-down models,

and 75% weighting on

the disaggregated

model

• slowslowslowslow----tracktracktracktrack: 25%

weighting on each of

the top-down models,

and 50% weighting on

the disaggregated

model


• 25% weighting on each

of historical and

forecast data,

top-down and

disaggregated TOTEX

models

• middle-up results

ignored

RIIORIIORIIORIIO----ED1ED1ED1ED1

• 2 top-down TOTEXTOTEXTOTEXTOTEX

models (different cost

drivers)

• 1 disaggregated result

from a number of unit

cost and econometric

models


• 1 top-down TOTEXTOTEXTOTEXTOTEX model

(historical and forecast

data)

• 3 middle-up models

(OPEX, CAPEX, REPEXOPEX, CAPEX, REPEXOPEX, CAPEX, REPEXOPEX, CAPEX, REPEX)

(but not ultimately used)

• 7 activity-level

disaggregated models

(forecast and historical

data)

RIIORIIORIIORIIO----ED1 and RIIOED1 and RIIOED1 and RIIOED1 and RIIO----

GD1GD1GD1GD1

• upper quartile (UQ)

efficiency

adjustment

• cost threshold

based on 75:25

weighting on

Ofgem’s view and

companies’ forecast

respectively

• immediate catch-up

set and no time-

profiled efficiency

targets

Model inputsModel inputsModel inputsModel inputs ModelsModelsModelsModelsPredicting Predicting Predicting Predicting

future costsfuture costsfuture costsfuture costsTriangulationTriangulationTriangulationTriangulation

Efficiency Efficiency Efficiency Efficiency

challengechallengechallengechallengeBaselineBaselineBaselineBaseline

Reverse cost Reverse cost Reverse cost Reverse cost

adjustmentsadjustmentsadjustmentsadjustments

RIIORIIORIIORIIO----ED1 ED1 ED1 ED1

• modelled business

plan data directly

alongside historical

data


• apply coefficients

from historical data

and modelling first

2 years of business

plan data to forecast

cost drivers

RIIORIIORIIORIIO----ED1 and ED1 and ED1 and ED1 and RIIORIIORIIORIIO----GD1GD1GD1GD1

• pass-through of

‘special factors’

allowance

Predicted future Predicted future Predicted future Predicted future

efficient cost levelefficient cost levelefficient cost levelefficient cost level

Fro

ntie

r F

ron

tier

Fro

ntie

r F

ron

tier sh

iftsh

iftsh

iftsh

ift

an

d R

PE

s ove

rlay

an

d R

PE

s ove

rlay

an

d R

PE

s ove

rlay

an

d R

PE

s ove

rlay

Efficiency Efficiency Efficiency Efficiency

targetstargetstargetstargets

Special factorsSpecial factorsSpecial factorsSpecial factors

CompanyCompanyCompanyCompany----specific specific specific specific

factorsfactorsfactorsfactors

Estimation approach, model Estimation approach, model Estimation approach, model Estimation approach, model

specification and selectionspecification and selectionspecification and selectionspecification and selectionAggregating Aggregating Aggregating Aggregating

resultsresultsresultsresults

Use Use Use Use of forecast of forecast of forecast of forecast

(BP) (BP) (BP) (BP) data data data data

Level Level Level Level of of of of

aggregationaggregationaggregationaggregation

Frontier shift Frontier shift Frontier shift Frontier shift



UKUKUKUK

Ofgem’s approach to assessing CAPEX in RIIO

• Ofgem used a combination of top-down (regression, unit cost) and bottom-up (unit cost, basket of

works) approaches to assess CAPEX of energy networks

• to account for different investment profiles across the modelling period, 7-year smoothed CAPEX

was used

• CAPEX cost drivers (workload volume) were normalised over similar periods

• to ensure comparability, apart from smoothing, certain costs were excluded where:

– these costs could not be sufficiently explained by the cost drivers used in the CAPEX models.

Such costs were either assessed separately or added back as an adjustment

– there was a substantial change in the nature of the activity between price reviews

– these were company-specific and not comparable across companies

• composite scale variables (CSVs) were often used to simplify the models to assess expenditure

– these were weighted geometric means of various scale and activity drivers

• costs were normalised for differences in operating circumstances and regional labour prior to

modelling

– density/urbanitydensity/urbanitydensity/urbanitydensity/urbanity: applied a 15% productivity adjustment to the labour cost element of REPEX

and CAPEX mains reinforcement and connections, based on the proportion of work that is

carried out within the M25



UKUKUKUK

Ofgem’s approach in RIIO-GD1

Cost areaCost areaCost areaCost area SubSubSubSub----cost cost cost cost categorycategorycategorycategory DriversDriversDriversDrivers

TopTopTopTop----down TOTEXdown TOTEXdown TOTEXdown TOTEX OPEX +7-year smoothed CAPEX CSV of MEAV, REPEX workload, mains reinforcement and

connections workload, external conditions reports, maintenance

MEAV and emergency servicing CSV. and time trend

MiddleMiddleMiddleMiddle----upupupup TOTEXTOTEXTOTEXTOTEX

(ultimately not used)(ultimately not used)(ultimately not used)(ultimately not used)

OPEX CSV of MEAV, external condition reports, maintenance MEAV and

the emergency CSV

CAPEXCAPEXCAPEXCAPEX CSV of MEAV, connectionCSV of MEAV, connectionCSV of MEAV, connectionCSV of MEAV, connections workload and mains reinforcement s workload and mains reinforcement s workload and mains reinforcement s workload and mains reinforcement

workloadworkloadworkloadworkload

REPEX Weighted average REPEX workload

BottomBottomBottomBottom----up regressionsup regressionsup regressionsup regressions Work management MEAV

Emergency service CSV based on customer numbers and external condition reports

Repairs External condition reports

Maintenance Maintenance MEAV

Mains reinforcement Mains reinforcement Mains reinforcement Mains reinforcement Weighted averageWeighted averageWeighted averageWeighted average workload (calculated by multiplying the work workload (calculated by multiplying the work workload (calculated by multiplying the work workload (calculated by multiplying the work

volume for each pipe diameter by an industry average unit cost for volume for each pipe diameter by an industry average unit cost for volume for each pipe diameter by an industry average unit cost for volume for each pipe diameter by an industry average unit cost for

each diameter)each diameter)each diameter)each diameter)

ConnectionsConnectionsConnectionsConnections Weighted average workloadWeighted average workloadWeighted average workloadWeighted average workload

Tier 1 REPEX Weighted average tier 1 workload

Ofgem used a ‘toolkit’ approach to assess the costs submitted by the GB GDNs in their

business plans, with relatively greater emphasis placed on econometric modelling



UKUKUKUK

Ofgem’s approach in RIIO-ED1

Cost areaCost areaCost areaCost area SubSubSubSub----cost cost cost cost categorycategorycategorycategory DriversDriversDriversDrivers

TopTopTopTop----down TOTEXdown TOTEXdown TOTEXdown TOTEX

(macro model)(macro model)(macro model)(macro model)

OPEX + 7-year smoothed CAPEX CSV of MEAV and customer numbers using a statistical approach

and time trend

TopTopTopTop----down TOTEX down TOTEX down TOTEX down TOTEX

(bottom(bottom(bottom(bottom----up model)up model)up model)up model)

OPEX + 7-year smoothed CAPEX CSV of MEAV, units distributed, network length, customers, faults,

spans cut and customer numbers using industry spend proportions

and time trend

BottomBottomBottomBottom----up regressionsup regressionsup regressionsup regressions Tree cutting Spans cut, spans inspected

Trouble call Faults

Closely Associated Indirects (project

management, network policy, vehicles &

transport, system mapping, etc.)

MEAV and value of network additions

Business support costs (finance & reg, IT,

CEO and management, etc.)

Ratio benchmarking using MEAV

NonNonNonNon----op CAPEX (property, IT&T, small tools op CAPEX (property, IT&T, small tools op CAPEX (property, IT&T, small tools op CAPEX (property, IT&T, small tools

& equip, etc.)& equip, etc.)& equip, etc.)& equip, etc.)

Ratio benchmarking usingRatio benchmarking usingRatio benchmarking usingRatio benchmarking using MEAVMEAVMEAVMEAV

20+ other disaggregated models:20+ other disaggregated models:20+ other disaggregated models:20+ other disaggregated models:

connections, reinforcement, asset connections, reinforcement, asset connections, reinforcement, asset connections, reinforcement, asset

replacement, I&M, etc.replacement, I&M, etc.replacement, I&M, etc.replacement, I&M, etc.

Ratio benchmarkingRatio benchmarkingRatio benchmarkingRatio benchmarking or regressionor regressionor regressionor regression




Energiavirasto








UKUKUKUK

Ofwat’s approach in the 2004 price review (PR04)

Econometric Econometric Econometric Econometric models models models models

Maintenance expenditure was split into four categories, three of which were modelled using statistical analysis. For

example on water, the following models were developed:

• water distribution infrastructure

– log unit cost model with length of mains as the scale driver and properties per length of mains as a key cost

driver

• water distribution non-infrastructure

– log unit cost model with booster pumping station capacity as the scale driver and ratio of storage capacity to

pumping station capacity as a key cost driver

• water management and general

– log cost model with total number of billed properties as the scale driver and proportion of billed properties

that are non-household as a key cost driver

Adjustments to costs were made after modelling to account for leakage expenditure, company-specific factors and

deviations in future expenditure

Cost Cost Cost Cost base (basket of works)base (basket of works)base (basket of works)base (basket of works)

Ofwat compiled a dataset of the unit costs for 120 standardised projects and used the basket of goods approach to

compare cost predictions. The benchmark was set at the most efficient company

Setting allowanceSetting allowanceSetting allowanceSetting allowance

Results from the two approaches were weighed equally. In determining the allowance, Ofwat assumed that companies

would close 40% of the gap to the econometric benchmark and 50% to the cost base benchmark over the price control

period



UKUKUKUK


Econometric models were dropped from the efficiency analysis and the focus was instead

on the cost base approach

The benchmark was relaxed from the frontier company to the median company. Where data

comparability might have been an issue, a company only had to close 50% of the gap

The Capital Incentive Scheme (CIS) was introduced to encourage robust business plans and

incentivise target outperformance. This involved:

• setting the baseline level of expenditure

• comparing a company’s forecast to the baseline and using this to calculate an expenditure

allowance

• providing an incentive for further outperformance which declines as the ratio of a company’s

forecast to baseline increases

• calculating ex post rewards/penalties as the difference between allowed and outturn expenditure

multiplied by the incentive rate

Ofwat noted that CAPEX menu regulation increased the quality of the data available for the analysis and

limited the need to set a stringent, one-company-based benchmark



UKUKUKUK


Full

TOTEX

COLS

2

(50%)

(50%)

Triangulate

Refined TOTEX

RERefined

TOTEX

top-down

1

Triangulate Base

Refined

base RE

Refined

base COLS

Enhancements unit

costs

Enhancements

unmodelled costs

Add

Add

Add

(50%)

(50%)

(33%)

(33%)

TriangulateWater

TOTEX

TOTEX

bottom-up

3

(33%)

Source: Ofwat (2014), ‘Final price control determination notice: policy chapter A3 – wholesale water and wastewater costs and revenues’, December.

Refined TOTEX

OLS

TOTEX = OPEX + 5555----year average year average year average year average

CAPEXCAPEXCAPEXCAPEX

Base TOTEX = OPEX + 5555----year year year year

average maintenance CAPEXaverage maintenance CAPEXaverage maintenance CAPEXaverage maintenance CAPEX



UKUKUKUK


Ofwat modelled three types of capital enhancement expenditure. Certain exclusions/adjustments (e.g.

grants and contributions) were removed from data prior to modelling

Four different ways to model unit costs were

used:

• average of the unit costs for each company

• weighted average of the unit costs for each

company

• OLS regressions of costs against volume

• OLS regression of log costs against log volumes

A significant proportion of enhancement expenditure could not be modelled ‘adequately’, so an uplift

of 8.4% was considered. This was calculated by:

a) finding the industry total modelled enhancement expenditure

b) finding the industry total unmodelled enhancement expenditure

c) finding the ratio of b) to a)

Source: Ofwat (2014), ‘Basic cost threshold model Appendix C Enhancement modelling’, December.

Enhancement expenditureEnhancement expenditureEnhancement expenditureEnhancement expenditure VolumeVolumeVolumeVolume measuremeasuremeasuremeasure

Enhancements to the supply–

demand balance (e.g. building

a new reservoir to cope with

increased peak demand)

Total enhancement to the

supply–demand balance

Lead reduction Number of lead pipes replaced

New developments Number of new connections




Energiavirasto








UKUKUKUK

Other regulators’ approach to assessing CAPEX (I)

Office of Rail and Road (ORR), 2013 price reviewOffice of Rail and Road (ORR), 2013 price reviewOffice of Rail and Road (ORR), 2013 price reviewOffice of Rail and Road (ORR), 2013 price review

• PR13 econometric analysis used a subset of the Lasting Infrastructure Cost

Benchmarking (LICB) data set developed and maintained by the International Union of

Railways (UIC) for 14 European rail infrastructure managers (IMs), including Network

Rail, for the period 1996 to 2008

• CAPEX (renewals expenditure) is measured as annual reported costs plus a ‘steady-state’

adjustment to ensure comparability of historical costs across international IMs

• the adjusted cost is the renewals expenditure that would have been incurred had

Network Rail renewed 2.5% of its track. This was necessary as there had been systematic

underinvestment in renewals historically

• the analysis considered a total of 21 econometric models, including a variety of

approaches (simple to advanced)



UKUKUKUK

Other regulators’ approach to assessing CAPEX (II)

National Health Service Improvement (NHSI), MonitorNational Health Service Improvement (NHSI), MonitorNational Health Service Improvement (NHSI), MonitorNational Health Service Improvement (NHSI), Monitor

• top-down econometric models with a particular focus on advanced econometric models

to assess CAPEX

• TOTEX modelled based on reference reference reference reference costscostscostscosts. The following factors were controlled for in the

model: hospital hospital hospital hospital outputs outputs outputs outputs (case mix-adjusted hospital activity, the degree of specialisation in

Trusts, and the quality of service based on NHS staff surveys); TrustTrustTrustTrust----specific specific specific specific driversdriversdriversdrivers

(including local disease prevalence, demographics of the patient population, the

proportion of emergency admissions, and a market forces factor); location location location location and type of and type of and type of and type of

Trust Trust Trust Trust (that control for differences in trust categorisation and former Strategic Health

Authority regions)

OfcomOfcomOfcomOfcom

• used advanced econometric models to assess TOTEX of BT’s Openreach activities

• using publicly available information, BT was compared with the US local exchange carriers

(LECs) by normalising BT’s data to be comparable with that of the US companies

• CAPEX was measured using the depreciated historical cost approach (depreciation and

cost of capital)




Energiavirasto








• TSOs have a natural and legalised monopoly

• tariffs need to be based on efficient rather than incurred cost

• no or limited domestic peer companies in most countries

• input is TOTEX = OPEX + annuitised CAPEX

Council Council Council Council of European Energy Rof European Energy Rof European Energy Rof European Energy Regulatorsegulatorsegulatorsegulators

Pan-European benchmarking of gas and electricity TSOs (I)

Source: Sumicsid, Swiss Economics (2016), ‘Benchmarking European Gas Transmission System Operators’, Project E2Gas, June.



Restricting the costs/functions of a TSO can help in comparability across TSOs, but can also introduce

errors

• OPEX

– grid planning, grid construction, grid maintenance, gas transport and metering, and

administrative support

– included costs: labour costs of direct personnel, cost of third-party services, indirect cost of

management and other costs

– labour costs are adjusted to reflect country-specific input prices (wages)

• CAPEX

– investment streams are annualised using a standard annuity factor

• all costs are subject to inflation adjustment (CPI) and currency conversion

– the average exchange rate is used and national currencies are converted into euros. PPP is

used as a sensitivity

• additional discussions on cost construction underway

– e.g. a depreciated historical cost approach to measuring CAPEX could be considered and

benefit of doubt (i.e. higher of resultant efficiency values) could be set on TSOs


Pan-European benchmarking of gas and electricity TSOs (II)



• cost driver selection based on engineering expertise and statistical analysis

• the core model includes only three cost drivers:

– normalised normalised normalised normalised gridgridgridgrid

– grid length adjusted by various complexity factors to account for land use, sub-surface

features, topography and soil humidity

– normalised grid is clearly an important variable, but there does not appear to be any

sensitivity analysis with respect to its definition

– total number of connection total number of connection total number of connection total number of connection pointspointspointspoints

– grid capacitygrid capacitygrid capacitygrid capacity

• additional discussions on cost drivers underway

– can three variables capture the key differences between TSOs? What is missing?

How can this be mitigated?

– does the normalised grid adequately take into account firm-specific factors relating to the

environment?

• modelling approaches: top-down methods, in particular, optimisation approaches such as DEA

and econometric techniques such as SFA, are the main methods used


Pan-European benchmarking of gas and electricity TSOs (III)




Energiavirasto








NorwayNorwayNorwayNorway

Three-stage approach

• separate regulation of networks between 33kV and 132kV (86 companies – regional

distributors), and local distributors from 0,230kV to 22kV (136 companies)

• three-stage process for arriving at allowed revenue – revenue cap method

Benchmarking

(DEA) models

Adjustment

for operating

environment

Calibration

processCost norm

C***C***C***C*** C**C**C**C** C*C*C*C*




Modelled cost

• benchmarking analysis benchmarking analysis benchmarking analysis benchmarking analysis –––– CCCC************

– top-down approach (DEA)

– constant returns to scale (CRS)

– the frontier is estimated using 5-year-averaged data

• the modelled cost Ct (inputinputinputinput) is:

( ) tttttt

tttt WACCRABDEPPL

CPI

CPIVOLLOMC ×++×+×+= −−−

−−− 222

222 )(

Where:

OMt-2= operating and maintenance costs in year t-2

VOLLt-2 = value of lost load (customer interruption costs) in year t-2

CPIt= consumer price index in the year t

CPIt-2= consumer price index in the year t-2

Lt-2 x Pt = value of network losses in MWh, year t-2, considering local area prices at Nord Pool Spot in year t

DEP t-2= depreciation in year t-2

RABt-2 = regulatory asset base, considering book value in year t-2

WACCt = weighted average cost of capital in year t




Treatment of CAPEX

RABRABRABRAB

• since 2007, there has been strong criticism of using the book value of the RAB as the

measure of CAPEX

• two companies with equivalent assets, maintenance costs and efficiencies will have

different DEA scores if the timing of investment differs

Replacement costReplacement costReplacement costReplacement cost

• in 2012, NVE considered moving to a replacement cost measure of CAPEX

• while it may offer a more ‘correct’ measure of CAPEX, it was deemed inapplicable in a

regulatory framework as it gave too strong an incentive to reinvest

Reducing the age effect while maintaining incentivesReducing the age effect while maintaining incentivesReducing the age effect while maintaining incentivesReducing the age effect while maintaining incentives

• elements of the third stage of calculation changed in order to reduce the age effect

• in the first stage (DEA), a higher RAB punishes a company, while in the third stage (cost

calibration) a higher RAB rewards a company




The DEA model

Outputs of the DEA modelOutputs of the DEA modelOutputs of the DEA modelOutputs of the DEA model

• the weighted values take into account different costs of each type of grid component,

while the costs of transformers, switches and compensation devices include the value

of substations

• there is recognition that some of these outputs may technically be under management

control, but they are practically exogenous since many decisions are determined by

other regulations

Local distributorsLocal distributorsLocal distributorsLocal distributors Regional distributorsRegional distributorsRegional distributorsRegional distributors

Length of HV network (km) Weighted value of overhead lines

Number of network substations Weighted value of ground cables

Number of subscriptions (customers) Weighted value of sea cables

Weighted value of substations




The Norwegian Water Resources and Energy Directorate

• calibration calibration calibration calibration reaching C*reaching C*reaching C*reaching C*

• further further further further calibration for deviation between actual and expected costs (with twocalibration for deviation between actual and expected costs (with twocalibration for deviation between actual and expected costs (with twocalibration for deviation between actual and expected costs (with two----year lag):year lag):year lag):year lag):

– at this stage the Z factor-corrected DEA scores are ‘calibrated’ to set the aggregate of cost

norms equal to the sum of the observed costs in the sector. The savings in the sector come

through the distributors’ incentives for cost reduction

– the calibration is as follows:

Where:

Ci* = cost norm of distributor i, considering the cost of capital defined by NVE

Ci** = cost norm adjusted for operating environment

RABi = regulatory asset base of distributor i

��∗ = ��

∗∗ + ∑ �� ∑ ��∗∗

�/012

∑ /0122

• final calibration between proposed costs and cost norm to accommodate possible modelling

limitation and balance trade-off between cost-reduction incentive and rent transfer to the

end-customer

• there is no specific requirement of efficiency. This is because if a DSO improves its position relative

to the average, it will have a higher rate of return. This is the main feature of the model that aims

to encourage efficiency in operation, usage and development of the distribution network




Energiavirasto








Finland Finland Finland Finland

Energiavirasto

Up until 2011 the efficiency score was calculated as an average of scores from two models:

an NDRS DEA model and a linear SFA model

The input to the models was:

TOTEX = OPEX + CAPEX + DCO

Where:OPEX = controllable operating costs

CAPEX = straight-line depreciation from the replacement value of t network

DCO = a monetary disadvantage caused by outage for electricity customers

• for 2012–15, an advanced econometric method, stochastic non-smooth envelopment of data

(StoNED), was used to assess TOTEX

• CAPEX was dropped from the efficiency target and investment was monitored separately

• only half of DCO was added to OPEX to generate TOTEX



Finland Finland Finland Finland

Energiavirasto

• in the fourth (2016–19) and fifth (2020–23) regulatory periods, the efficiency challenges will

continue to be estimated using the StoNED method, as informed by the regulator

• the input–output variables and the operating environment variable are modified as follows:

• DCO has moved as an undesirable output

• modelled cost (input) is limited to OPEX only

• CAPEX (based on replacement value) is used as a fixed input fixed input fixed input fixed input in that an efficiency challenge is only

set on OPEX, however the impact of investment on OPEX (i.e. the trade-off) is still captured

• the Z variable is still intended to capture differences between urban and rural networks using a

connection density measure defined as number of connections per metering point

Source: Energiavirasto (2015), ‘Regulation

methods in the fourth regulatory period of 1

January 2016 – 31 December 2019 and the

fifth regulatory period of 1 January 2020 – 31

December 2023’, October.







• case studies

• key takeaways




HighHighHighHigh----level messages (I)level messages (I)level messages (I)level messages (I)

• CAPEX construction: plethora of approaches but with limited understanding of CAPEX construction: plethora of approaches but with limited understanding of CAPEX construction: plethora of approaches but with limited understanding of CAPEX construction: plethora of approaches but with limited understanding of

the gapsthe gapsthe gapsthe gaps

– UK energy and water regulators tend to use a cash cost approach where outturn

CAPEX is ‘smoothed’ or left unsmoothed over a sufficiently long period to mitigate

volatility and differences in investment profiles

– among EU regulators, the capital cost approach seems to be preferred. Two

approaches are taken to measuring CAPEX—annuity and depreciated historical

cost

– all approaches appear to have limitations. For example, asset condition/health, as

well as service quality measures, are often ignored, while the inflation measure

and the WACC assumptions affect the capital cost approaches

– cash cost approach will also require careful consideration of the state of the

networks, investment profile and base year of analysis



HighHighHighHigh----level messages (II)level messages (II)level messages (II)level messages (II)

• CAPEX assessment: no agreed approach among European and UK regulators CAPEX assessment: no agreed approach among European and UK regulators CAPEX assessment: no agreed approach among European and UK regulators CAPEX assessment: no agreed approach among European and UK regulators

– CAPEX assessment is inherently difficult and regulators tend to be relatively

conservative

– in a number of regulatory applications, assumptions underlying the assessment

approach do not appear sufficiently justified (e.g. the correspondence between

CAPEX and its drivers)

– moreover, there could be inconsistencies in the treatment of CAPEX in the

benchmarking exercises and how a TSO is remunerated, which governs its

investment decisions

– different approaches to measuring and treatment of CAPEX should be examined,

to ensure outcomes are not skewed by assumptions or limitations with particular

approaches

– similarly, more disaggregated, bottom-up or operational evidence is often used as

a cross-check in a regulatory context

– lastly, any benchmarking exercise rests on certain simplifications and assumptions

and due allowance must be made for a ‘margin of error’

W

THANK YOU FOR YOUR ATTENTION!


MarchMarchMarchMarch 5555----6, 6, 6, 6, 2012012012018888 //Budapest, Hungary//Budapest, Hungary//Budapest, Hungary//Budapest, Hungary

Srini ParthasarathySrini ParthasarathySrini ParthasarathySrini Parthasarathy

EEEE----mail: mail: mail: mail: [email protected]@[email protected]@oxera.com

Web: Web: Web: Web: www.oxera.comwww.oxera.comwww.oxera.comwww.oxera.com

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