1 Updating the Regulatory Asset Base: Roll-Forward, Re-Valuation and Incentive Regulation Darryl Biggar Consulting Economist Australian Competition and Consumer Commission 2 April 2004

2 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….

3 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 –How the RAB is updated affects issues such as: a)The principle of “financial capital maintenance” (“FCM”) b)Incentives to select efficient capex projects c)Incentives to carry out capex projects at least cost d)How the sunk costs of investments are amortised or spread over time

4 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

5 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 (out- turn) capital expenditure Forecast deprec- iation + - =

6 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

7 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)

8 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 “over- forecasting” of capex requirements ex ante and “under- spending” ex post. Power of the incentive to reduce capex should be “tailored” to ensure a balance of incentives overall

9 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: But now since the closing RAB is fixed, this equation shows that depreciation must be set as follows: Closing RAB Opening RAB Actual (out- turn) capital expenditure Forecast deprec- iation + - = Forecast closing RAB Opening RAB Forecast capital expenditure Forecast deprec- iation +- =

10 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 But now since the closing RAB is fixed, this equation shows that depreciation must be set as follows:

11 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)

12 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.

13 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

14 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

15 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…

16 Allocation of Sunk Costs –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 RAB500 Capex400 Closing RAB550 Depreciation350 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

17 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

18 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.

19 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?

20 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