Part of a short course on finance and regulation presented by the Centre for Competition, Regulation and Economic Development, Sept 2015

1. SHORT LEARNING PROGRAMME
Financial Analysis for Economic Regulation
Asset Valuation and Regulatory Tariff
Setting
Dr Stephen Labson
slabson@sleconomics.com
10 September 2015
www.competition.org.za

2. Session outline
• Regulatory Asset Value is a key determinant of revenue and prices in the predominant forms of
tariff regulation. .
• In South Africa this covers sectors ranging from ports, petroleum pipelines, airports, and Eskom's
generation, transmission and distribution of electricity. (to name a few)
• In this session we examine approaches to regulatory asset valuation applied in determination of
regulated revenue and tariffs. The broad outline of material to be covered includes
• A brief review the role of asset value in regulation of revenue and tariffs as contrasted to
statutory reporting of financial accounts.
• Overview of the predominant approaches to asset valuation observed in regulatory practice.
• An example of how asset valuation methods are sometimes applied in support of regulatory
and industry reform initiatives.
• NB With a brief discussion of administrative issues if time permits.
©slEconomics Pty Ltd 2015

3. Accounting standards & revenue regulation
Revenue regulation
• Standards and guidelines
• Jurisdictional and sector based.
• Role of asset valuation
• Revenue determination - Measure
of invested capital to be recovered
from tariffs through. return of and
return on capital). .
• Measurement
• Historic cost
• Indexed historic cost
• Trended Original Cost
• Replacement cost / Modern
Equivalent Asset Value
• Line in the sand
• And others to be discussed
Accounting standards
• Standards and guidelines
• International and jurisdictional based conventions.
E.g. IAS 16: Property Plant & Equipment
• Role of asset valuation
• Information- To provide a consistent means of
reporting on an entity's investment in PPE and
changes in asset value
• Measurement
• PPE initially recognized at cost. (After initial recognition
choice of methods).
• Cost - less accumulated depreciation &impairment; or
• Revaluation - fair value less accumulated
depreciation and impairment.
(NB a survey of some 1500 UK and German firms showed
3% choose to use replacement cost for PPE).
• Nikolaev and Christensen, Does Fair Value Accounting fr Non-Financial Assets Pass the Market Test?, April 2013.
The fields of accounting and finance provide a deep history of thought and experience in valuation of assets
– albeit having a very different purpose than applied in the determination of regulated revenue and prices.

4. Regulatory asset value, revenue allowances and pricing
Regulatory asset value drives two
important components of the
revenue requirement:
1. The return on capital -
calculated as the product of
the RAB and the Weighted
Average Cost of Capital
(WACC).
2. The return of capital – Equal
to allowed depreciation of the
regulatory asset base.
Building blocks of cost of service regulation
Operations Qualifying expenditures
+
Return on capital Post tax WACC x RAB
+
Return of capital Depreciation of RAB
+
Tax
Tax adjusted for shield on interest
in post tax WACC, or embedded in
use of pre tax WACC
=
Revenue requirement
Determines allowed revenue,
tariffs and charges
The ‘building blocks’ model below illustrates the basis of cost of service regulation and how
asset value enters into the regulatory equation for setting allowed revenue and tariffs*.
* See the following regulatory methodologies
• ;NERSA, “Tariff Methodology for the Setting of Tariffs in the Petroleum Pipelines Industry, 5th Edition”
• Ports Regulator, “Regulatory Manual for Tariff Year 2015/16 – 2017/18”.
• Regulating Committee “Draft Permission to Levey Airport Charges” (2015);,
• NERSA “Multi-Year Price Determination Methodology 1st Edition”...

5. Cost of service regulation, revenue and price dynamics
• When (fully) recovering invested capital on the basis of return on assets and depreciation (i.e.
building blocks) revenue and averaged prices have a time profile different from what we expect
from market based outcomes:
Operating expenditures and tax
Return of and on capital
Time
A few questions:
1. Should we care? And if so, what can we do about it?
2. Should we expect regulated prices to ‘mimic’ competitive markets? Can
regulated prices mimic competitive markets?
3. Would consumers prefer a smoothed, albeit higher price level? What if NPV
neutral?
4. Can investment occur under these dynamics?
NB. Asset
value and
return drives
this dynamic in
cost of service
regulation.

6. Approaches to regulatory asset valuation
• A number of approaches to asset valuation are used by regulators ranging from those based on
the company’s statutory reports – through to sector or entity specific arrangements determined by
government policy or legislative instruments.
• Approaches more commonly observed in regulatory practice include the following:
• Depreciated Indexed Cost
• Trended Original Cost
Depreciated Historic Cost
• Modern Equivalent Asset Value
• Depreciated Optimised Replacement Cost
Depreciated Replacement Cost
• Acquisition cost
• Economic value
Line in the sand

7. Historic cost and application issues
The HC approach references the original construction cost of the asset ideally working from asset
register level data.
• When applied within a cost of service approach HC valuation:
• Just recovers the return of and on invested capital expected for investments of similar risk
characteristics; and
• Provides (real) financial capital maintenance to the investor or entity assuming re-investment of
returns.
• The HC approach has the potential to provide an objective basis for calculation of asset value.
• However, for long lived assets it may be difficult to source original costs. NERSA summed up their
experience in representative assessments in consultation on petroleum storage facilities as follows:*

8. Trended Original Cost
• A close variant of HC is the “Trended Original Cost”.
• Return on capital = Real WACC * Indexed RAB
• Return of Capital = Depreciation on indexed RAB
• In a simplified model of no tax, TOC and HC (using a nominal rate of return) provide equivalent
outcomes with respect to the net present value of return of and on investment; but it does change the
time profile of returns.*
8* Applied in Transnet Petroleum Pipelines System Tariffs, and Transnet Gas pipelines tariffs among others.
**The long term equivalence of approaches does not hold exactly when tax is considered,
0
5,000,000
10,000,000
15,000,000
20,000,000
25,000,000
10 year assumed asset life
Returnofandoncapital
Randofthedayprices
(R'000)
Real revenue approach
Nominal revenue approach
Real revenue approach 18,400,000 18,304,000 18,170,880 17,997,824 17,781,850 17,519,802 17,208,339 16,843,927 16,422,829 15,941,092
Nominal revenue approach 22,000,000 20,800,000 19,600,000 18,400,000 17,200,000 16,000,000 14,800,000 13,600,000 12,400,000 11,200,000
Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10
1) HC attached to a
nominal rate of
return.
2) TOC attached to
a real rate of return
NB Both provide a
for financial capital
maintenance w.r.t.
inflation if
appropriate return
values are applied.

9. Profile of Returns – TOC and HC approaches
1. TOC provides for depreciation on an indexed asset base – but obtains a relatively
reduced return on capital (i.e. real WACC x indexed RAB)
CASHFLOWS
Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10
Real approach - Return Of andOn Capital
ReturnonCapital(WACC) 8,000,000 7,488,000 6,922,240 6,299,238 5,615,321 4,866,612 4,049,021 3,158,236 2,189,710 1,138,649
Depreciation 10,400,000 10,816,000 11,248,640 11,698,586 12,166,529 12,653,190 13,159,318 13,685,691 14,233,118 14,802,443
Total Cashflows in Randof the day 18,400,000 18,304,000 18,170,880 17,997,824 17,781,850 17,519,802 17,208,339 16,843,927 16,422,829 15,941,092
Nominal approach - Return Of andOn Capital
ReturnonCapital(WACC) 12,000,000 10,800,000 9,600,000 8,400,000 7,200,000 6,000,000 4,800,000 3,600,000 2,400,000 1,200,000
Depreciation 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000
Total Cashflows in Randof the day 22,000,000 20,800,000 19,600,000 18,400,000 17,200,000 16,000,000 14,800,000 13,600,000 12,400,000 11,200,000
2. And as expected – TOC provides a higher depreciated asset value than for the HC
approach – although with depreciation much less than replacement cost for aged assets.
Closing"Real"RAV 93,600,000 86,528,000 78,740,480 70,191,514 60,832,645 50,612,761 39,477,953 27,371,381 14,233,118 0
Closing"Nominal"RAV 90,000,000 80,000,000 70,000,000 60,000,000 50,000,000 40,000,000 30,000,000 20,000,000 10,000,000 0

10. Replacement cost methods in practice
Indexed Historic Cost
• Asset base escalated by a cost index
reflecting cost of the asset in current Rand
• In this context it can be seen as a proxy for
replacement cost.
• A challenge in applying IHC is in identifying
a suitably robust index that tracks changes
in replacement costs, inclusive real and
nominal variation in costs in domestic
currency terms.
• Approaches observed in practice range
from:
• Industry or commodity specific indices,
to
• General indices such as PPI, CPIX, or
CPI.
Modern Equivalent Asset Value
• Modern Equivalent Asset (MEA) is defined
as an asset having a similar service
potential as the subject asset, judged by its
comparative performance and output, not its
physical characteristics
• The MEAV approach typically builds from
the bottom up in what might be loosely be
characterised as an ‘engineering based’
assessment.
• In calculating MEAV values, one would
ideally work from the asset register and
map to market prices. .
• In practice (for long lived assets) rather
broad aggregates of the asset register
are used due to limitations on
cost/price data.
Two of the more often used proxies for replacement cost are Indexed Historic Cost and Modern
Equivalent Asset Value.(MEAV).

11. Replacement cost
Replacement cost approaches have gained some level
of acceptance in South Africa - with Eskom’s MYPD
providing an example.
• In determination of Eskom’s regulated revenue allowance
a proxy associated with Modern Equivalent Asset Value* is
used in forming a starting value of the asset base, which is
to be revalued at the next regulatory control period.
• The approach provided in calculation of Eskom’s
revenue allowance is unique in that (as we
understand it) it is a hybrid of RC and TOC whereby a
real WACC is applied to the revalued (starting) asset
base:** i.e.
• Return on Capital = Real WACC x Revalued
(starting) RAB
• Return of Capital = Depreciation on starting RAB
(not indexed).
• NB. Provides a regulatory asset value aligned to
replacement costs at each revaluation of the asset base –
but does not provide for financial capital maintenance or
the NPV equivalency .
NERSA “Multi-Year Price Determination Methodology 1st Edition” and NERSA, “Eskom Holdings Limited: Revenue Application – Multi
Year Price Determination 203/14 to 20117/18 (MYPD3)” Reasons for Decision.
SA Electricity Pricing Policy:
“The revenue requirement for a
regulated licensee must be set at a
level which covers the full cost of
production, including a reasonable
risk adjusted margin or return on
appropriate asset values.
The regulator, after consultation
with stakeholders, must adopt an
asset valuation methodology that
accurately reflects the replacement
value (emphasis added) of those
assets such as to allow the
electricity utility to obtain reasonably
priced funding for investment; to
meet Government defined
economic growth”.

12. Replacement cost and tariff setting
• RC methods have been applied in various sectors countries such as Ireland, New Zealand and
Australia.
• In assessing RC methods applied to electricity network pricing, Ireland’s regulator had the
following view on price signalling and investment.*
• (the MEAV form of RC) “ensures the RAB is directly linked to the costs of constructing a new
Transmission system” and that “it provides a better indication of changes in market value”
(presumably as compared to original actual cost).
• The statements selected above are (at best) an opaque representation of the role of asset
valuation in regulation of prices.
• For example, while RC and MEAV by definition links to the cost of constructing a new system – the
relevance to regulation and pricing is not at all obvious.
• Unlike statutory reporting, information on its own is not central to the regulatory process - it is
only on application of the revenue formula that the RAB has an effect (e.g. RAB x WACC and
depreciation on the RAB).
• This is not simply a matter of semantics as in moving to the revenue formula it becomes
difficult to maintain “the link” to the cost of a new system.
* CER, Decision on TSO and TAO Transmission Revenue f 22011 to 2015, Nov 2010.

13. Replacement cost and economic efficiency
• The following statement by the CER
again motivates a broader discussion
of issues one faces in choice of
valuation methodology:.
“Using some form of replacement
value has a very strong economic
foundation.
A precise valuation results in tariffs
that provide an accurate price signal
of the cost of using the transmission
network. ,,,,,
Thus, taking a replacement cost
approach is more likely to result in
the correct level of network
investment.”
The “strong economic foundation” of RC valuation is
perhaps overstated.
• Economists typically view efficient pricing rules in
terms of short run and long run marginal costs.
• Prices set to SRMC will not recover fixed
costs of production – something rather central
to is subject.
• The concept of LRMC is not applicable to
situations of ‘lumpy’ capital additions – again
a characteristic of the industries one would
expect regulation to apply to.
• There is no formalized meaning to the
concept of being ‘relatively close’ to the
optimality conditions of an (efficient) Pareto
optimum.**
• Bertram, “The Optimised Deprival Value Methodology and the Objectives of Utiluty Sector Reform in New Zealand”, 2000.
** Lipsey and Lancaster, The General Theory of Second Best, The Review of Economic Studies Vol. 24, No. 1 (1956 - 1957),
In review of New Zealand’s experience with RC valuation - G. Bertram summed up the matter of
investment well in stating that :
“The crucial incentive requirement is that all new capital expenditure is rolled into the ratebase at
actual prudent cost so that a competitive return can at all times be reasonably expected on a going-
forward basis”.

14. ‘Line in the sand’ valuation methods
As explained by the Australian regulator IPART :
“Under the RAB approach it is common practice for regulators to apply a ‘line-in-the-sand’
to determine the initial value of the RAB, (which essentially locks in the past rate of return
on previous investments). It can then be updated each year, based on capital additions,
disposals and deprecation”
• The line in the sand approach can be placed in the category of deprival value / NPV methods, and
breaks the often cited circularity problem by first establishing price, and then working backwards
to determine the asset value.
• While perhaps rather arbitrary – when applied to State Owned Enterprises the line in the sand
approach can be used to:
• Support the trade sale of assets (e.g. UK privatisation of Electricity supply assets).
• Achieve policy objectives on price outcomes, or long-term financial sustainability.
• Allow for the ‘regulatory write down’ of non-performing assets.
• With practical applications found in:
• Water
• Rail
• Ports (channels)
• Electricity networks

15. Line in the sand: Industry and regulatory reform
• The approach is often applied in establishing new regulatory regimes in a sector - perhaps in
parallel with market and industry structures such as corporatisation of state owned entities.
• For example, in implementing cost of service regulation across the Australian water sector a ‘line-
in-the-sand’ approach to valuing assets has been used for SOEs to determine revenue
requirements under a cost of service approach:
• The objective of drawing a ‘line in the sand’ may be to maintain prevailing prices (or minimise
price increases) in shifting towards a RAB pricing approach.
• Where a ‘line in the sand’ has been drawn, assets constructed or acquired prior to the date
where the line has been drawn (perhaps a date established for the new regulatory regime )
are deemed to be sunk and written down to a level that reflects their income earning potential
that can be incorporated into an opening RAB..
Put more directly:
• Non-commercial legacy investments can be written down in terms of their impact on regulated
charges.*
• Going forward, capital investments can be subjected to the rigour of investment case planning and
commercial criteria and thresholds.
• Financial performance can be monitored without the overhang of non-commercial legacy
investments.
* The write down we are referring to is for regulatory purposes only, and statutory accounts would typically not be
adjusted in this manner.

16. Line in the sand for establishment of
regulated charges
• In situations where policy directs the establishment of objective regulatory methods the line in the sand
approach can be used to establish starting asset values for an initial price control period, and then
rolled forward for subsequent control periods:
16
Set line in the sand
value e.g. - value on
corporatization;
achieves target revenue
/ tariffs, etc.
Roll forward to set
starting RAB (e.g. start
of new regulatory
controls)
Develop rules for roll
forward of starting RAB
during control for
determination of
allowed revenue.
Develop rules for re-set across regulatory control periods.
E.g.. reconciliation of variance of forecast to actual capex,
optimization, etc)
Annual roll forward of the RAB
• Index up for inflation if using TOC
• Transfer in qualifying assets (NB:
define qualifying assets and treatment of
WUC (i.e. recognised in the RAB as
spent or as commissioned.)
• Transfer out disposals
• Depreciate asset base (TOC or HC
basis).
 Decide rules for re-set of starting RAB
for next control period,( e.g. RC; TOC;
HC)
NB. May or may not be same approach as for roll
forward of initial to starting values

17. Short list of RAB administration issues
Administrative aspects of asset valuation and roll forward (short list only) .
• Definition of qualifying assets
• Prescribed services
• Government contributions and equity injections (noting terminology and meaning varies
across usage).
• Developer contributions
• Recognition of capital expenditure into the RAB (i.e. as spent, or as commissioned)
• Differential treatment for specific assets?
• Depreciating none, some or all assets prior to commissioning?
• Remaining life of assets and depreciation: e.g.
• Average remaining life for aggregate RAB, or disaggregation of asset categories.
• Straight line or alternative approaches to depreciation. (e.g. accelerated or deferred)
• RAB re-sets across control periods
• Ex ante or ex post optimization of the asset base (i..e . disallowance of assets from the RAB).
• Capex (i.e. reconciliation of variances in forecast to actual expenditures)
• Inflation (i.e. variance in forecast to actual in indexing up the RAB)
• Periodic DRC reviews ? (e.g. updating replacement cost)
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18. END OF SESSION