Training Module on Electricity Market Regulation - SESSION 4 - Revenue Requirements and Regulatory Asset Base

Experience you can trust.
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 Grote
30.11.2009

30.11.2009 1
Agenda
2. Revenue Components
4. Asset Valuation
1. Introduction
3. Regulatory Asset Base (RAB)

30.11.2009 2
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

30.11.2009 3
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

30.11.2009 4
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

30.11.2009 5
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
AssetsDepreciation

30.11.2009 6
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

30.11.2009 7
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

30.11.2009 8
Depreciation
time
10 years 20 years
remaining asset value
Initial asset
value
depreciation
straight-line method
declining-balance method
time
10 years 20 years
remaining asset value
Initial asset
value
depreciation

30.11.2009 9
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

30.11.2009 10
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
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

30.11.2009 11
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

30.11.2009 12
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)

30.11.2009 13
Investments (2)
Regulatory assessment of investments
ex-ante ex-post
• Assessment of adequacy and efficiency of
company’s 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

30.11.2009 14
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
company’s earnings
• Some form of recognition of cost of capital committed during construction appears
appropriate

30.11.2009 15
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

30.11.2009 16
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

30.11.2009 17
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

30.11.2009 18
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

30.11.2009 19
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

30.11.2009 20
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 RAB’s 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

30.11.2009 21
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

30.11.2009 22
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)

30.11.2009 23
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.

30.11.2009 24
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)

Experience you can trust.
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

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