Transcript Regulatory Asset Base: Roll-Forward or Re

Updating the Regulatory Asset
Base:
Roll-Forward, Re-Valuation
and Incentive Regulation
Darryl Biggar
Consulting Economist
Australian Competition and Consumer Commission
2 April 2004
1
What is the issue?
• The 1999 statement of regulatory principles seems to
propose the “revaluation” approach
– “The Commission will conduct a DORC valuation to
establish the maximum value of the asset base” (Statement
S4.2)
– “Depreciation will be linked to changes in RAB … [taking
into account] likely changes in a DORC-based valuation of
the RAB” (Statement S5.5).’
• The discussion paper raises the issue of whether or not
to move to a “roll forward” approach….
2
Updating the RAB
•
How the regulatory asset base (“RAB”) is updated at
the end of the a regulatory period is one of the
fundamental questions in the design of a regulatory
regime
–
a)
b)
c)
d)
How the RAB is updated affects issues such as:
The principle of “financial capital maintenance” (“FCM”)
Incentives to select efficient capex projects
Incentives to carry out capex projects at least cost
How the sunk costs of investments are amortised or spread
over time
3
FCM and incentive regulation
• Many submissions emphasised the importance of FCM
– FCM ensures that a firm is able to recover in revenues
exactly what it spends on operating or capital expenses
• There is a tension between “financial capital
maintenance” and “incentive regulation”
– Incentive regulation requires that a firm is financially
rewarded for pursuing objectives which the regulator desires
• such as providing better quantity or quality of services at lower cost
• incentive regulation requires “windfall” gains or losses
– Regulator does not have to set the RAB and the depreciation
in such a way as to precisely ensure FCM but must ensure
that any deviations from FCM induces desirable incentives
4
FCM, capex and depreciation
• So what does FCM imply?
– In the context of the building block model, “strict” or
“ex post” FCM requires that the closing RAB and the
depreciation be set in such a way that the following
equation holds:
Closing
RAB
Opening
= RAB
+
Actual (outturn) capital
expenditure
-
Forecast
depreciation
5
The “roll forward” approach
• What is the “roll forward” approach?
– Under the roll forward approach, at the end of the period the
regulator observes the out-turn capex and then updates the
RAB using a formula similar to the formula above
closing RAB = opening RAB + capex allowance – depreciation
allowance
• Depending on how the regulator “rolls forward” actual
versus forecast capex and actual versus forecast
depreciation determines the “power” of the incentive to
reduce capital expenditure
6
The “roll forward” approach
• The “roll forward” regime could have:
– Low-powered incentives to reduce capital expenditure
• if the regulator rolls forward actual capex and forecast depreciation
(i.e., closing RAB = opening RAB + actual capex – forecast dep’n)
– Medium-powered incentives to reduce capital expenditure
• if the regulator rolls forward actual capex and actual depreciation
(i.e., closing RAB = opening RAB + actual capex – actual dep’n)
• This is the approach of the ESC in Victoria (and possibly other state
regulators)
– High powered incentives to reduce capital expenditure
• if the regulator rolls forward forecast capex and forecast depreciation
(i.e., closing RAB = opening RAB + forecast capex – forecast dep’n)
7
Is more “power” always better?
• High-powered incentives to reduce capital
expenditure may be undesirable
– Might induce the firm to reduce service standards
– Might induce the firm to substitute opex for capex
– Might induce the firm to act strategically to obtain a
target capex (or closing RAB) higher than was forecast.
• When combined with weak incentives for service standards
strong incentives to reduce expenditure could result in “overforecasting” of capex requirements ex ante and “underspending” ex post.
• Power of the incentive to reduce capex should be
“tailored” to ensure a balance of incentives overall
8
The “revaluation” approach
• What is the “re-valuation” approach
– Under the “re-valuation” approach at the end of the period
the RAB is set equal to some methodology such as DORC
• As before FCM requires that:
Closing
RAB
=
Opening
RAB
+
Actual (outturn) capital
expenditure
-
Forecast
depreciation
• But now since the closing RAB is fixed, this equation shows that
depreciation must be set as follows:
Forecast
depreciation
=
Opening
RAB
+
Forecast
capital
expenditure
-
Forecast
closing RAB
9
The “revaluation” approach
• In other words, FCM requires that the depreciation
must be set in a way which anticipates the expected
future changes in the end-of-period RAB.
• When the depreciation is set in this way:
(a) the revaluation approach is identical to a roll forward
approach based on forecast capex and forecast dep’n
• this yields high-powered incentives for reducing capital expenditure
(which may not be appropriate)
(b) however the regulated firm is also subject to risk that the
actual revaluation will differ from the forecast
10
Interim summary
• Under the “roll forward” approach:
• The depreciation is set first and then the closing RAB is set in
such a way as to preserve FCM
• the incentive to reduce capital expenditure can be tailored to
ensure a balance of incentives overall
• Under the “revaluation” approach
• The closing RAB is set using some methodology and the
depreciation is set in a way which preserves FCM
• The firm still faces some risk that actual closing RAB will not
equal forecast closing RAB
• The incentive to reduce capex is high and cannot be varied
• The firm has a strong incentive to act strategically to achieve a
higher closing RAB (and a higher capex target)
11
A one-off revaluation?
• Some submissions argued for a one-off revaluation….
– Is there ever a case for a one-off adjustment not linked to
either the roll forward or revaluation approaches?
– Revaluations may be linked with rewards for achieving
desirable outcomes (such as service quality, efficiency)
• We should ask: what is the objective designed to be achieved by the
revaluation?
– One possible objective is preserving the legitimate
expectations of investors in a privatisation process…
• But only in the case where those investors were given specific
guidance as to how a valuation would be carried out and where that
guidance was not followed in practice.
12
Allocation of Sunk Costs
• Does one of these two approaches lead to a “better”
amortisation of sunk costs? i.e., a “better” path of
revenues / prices over time?
• It is important to recognise that the concept of
DORC valuation has no particular economic merit
– “The view [that DORC has some economic significance]
has been recited to the point that its validity is widely
taken for granted albeit without demonstration or
acknowledged authority” (Johnstone, Abacus 2003)
– …There is no economic grounds for a link between
DORC and the price charged by an efficient new entrant
13
Allocation of Sunk Costs
• Does the DORC approach lead to fewer or no “price
shocks” (i.e., a smooth path of revenue over time)?
– “the maintenance of revenue streams over time at a level
that is consistent with a DORC asset valuation will
minimise the likelihood of significant shocks to tariffs as
the replacement of assets becomes necessary” (draft SRP,
page xi)
– While the DORC approach may lead to less price shocks
than straight-line depreciation, it does not necessarily
lead to less price shocks than an approach in which the
depreciation is set in a way which anticipates higher
replacement costs
14
Allocation of Sunk Costs
• Some capital expenditure may not be fully reflected in
a change in the DORC valuation, and so must be
“expensed” (i.e., treated as opex)…
– E.g., refurbishment expenditure (changing the engine in a
used car has no effect on the cost of buying a new car)
– Or “legacy upgrade effects” (the cost of adding services to a
hypothetical optimal network may be less than the cost of
adding services to the actual network)
– SPI PowerNet and ElectraNet recognised this and sought to
include refurbishment expenditure as opex in their revenue
cap applications…
15
Allocation of Sunk Costs
• E.g., A major capital expenditure which has little/no
effect on the ORC must be reflected in the depreciation,
leading to a jump in the allowed revenue
– If the capex is $400, but the
DORC valuation only
increases by $50, all the
remainder of the capex must
be “expensed” (i.e., not
amortised). This could lead to
large fluctuations in the path
of revenue
Opening RAB
500
Capex
400
Closing RAB
550
Depreciation
350
16
Final summary
•
Pros and cons of revaluation approach
–
The long-term path of revenues/prices over time depends
on the methodology for revaluation.
•
•
–
There is no economic grounds for the belief that determining the
path of the RAB via DORC has particularly desirable economic
properties
The use of DORC could lead to the need to “expense” major items
of refurbishment or augmentation expenditure, leading to large
variations in revenues
The power of the incentive to reduce capital expenditure is
high and cannot be varied…
•
•
These incentives may not be properly balanced with the incentive
to promote service standards in the long run.
Incentives for acting strategically to inflate the RAB are strong
17
Final summary
•
Pros and cons of roll-forward
–
The long-term path of revenues/prices over time depends
on how the level of depreciation is chosen over time – over
which there is substantial flexibility.
•
–
Path of depreciation can be chosen to so that path of revenues
reflects planned or unplanned stranding, changes in demand or in
technology
The incentives for minimising capital expenditure depends
on how the amount rolled into the RAB depends on the
capex out-turn
•
The regulator can tailor these incentives as necessary to ensure
they are balanced with the incentive to promote/maintain service
standards and the incentive to minimise operating expenditure.
18
But is it “too late”?
• The Commission is considering adopting the policy
that at the end of the period the RAB will be updated
using the “roll forward” approach
– But, in any case in revenue cap decisions to date the
depreciation has not been set in a way which anticipates
future end-of-period revaluations
– Instead, depreciation has in practice been set on a “straight
line” basis.
– In these circumstances revaluing the asset base at the end
of the current period would violate the principle of
financial capital maintenance
– Has the decision already been made, in effect?
19
The Way Forward
• The way forward is clear:
– There are strong economic arguments and strong support
in the submissions for the “roll forward” approach
• The details of the roll-forward approach need to be
specified
– Issues that need to be addressed include:
• The incentives to select (or the selection of) desirable projects
and the role of the regulatory test in this process
• The power of incentives to carry out those projects at least cost
including the handling of capital over-spend or under-spend and
the handling of forecast versus “actual” depreciation
20