1 RORB Return on Rate Base

Legal Basis  Section 43, (f) of Republic Act No Section 43. Functions of the ERC – x x x (a) x x x (f) x x x “The rates must be such as to allow the recovery of just and reasonable cost and a reasonable return on rate base (RORB) to enable the entity to operate viably. x x x.” l 2

Legal Basis  Supreme Court Decision in Republic vs. Medina (41 SCRA 643) The Supreme Court upheld the Public Service Commission in authorizing an increase in rates on the basis that a public utility should receive a reasonable return on its investment, equivalent to 12% on the rate base. l 3

How does the Return on Rate Base Methodology set your rate?  Determine Annual Revenue Requirement  Based on a historical test year OPERATING EXPENSES OPERATING EXPENSES PAYROLL RETURN OF INVESTMENT RETURN ON INVESTMENT OTHER REVENUE ITEMS  necessary, legitimate, prudent, continuing, normal  includes operating and maintenance expense and taxes  updated salaries plus allowable benefits  12 % of rate base  value of used and useful assets + working capital  depreciation 4  Revenues arising from asset - based operations should be shared by DU

5  Net plant in service - Utilities existing plant pertaining to capital projects in place as of test year based on appraised value  Composed of assets that are existing as of the test year  Seek assistance of COA (Commission on Audit) to verify the asset registry, books, records and accounts  Conduct ocular inspection to ascertain ownership, used/usefulness and existence of asset as well as percentage of CWIP (Construction Work In Progress) that were placed in service  Working Capital - cash requirements based on an estimated net lag in the cash flow of a distribution utility  Rate of Return - allowed Return to generate “reasonable earnings” and cover interest payments of debt How are Capital Projects considered? RETURN ON INVESTMENT = Rate of Return x NPS or Asset Base + Working capital

6 PBR Performance Based Regulation

7 Adoption of PBR As authorized under Section 43(f) of the Electric Power Industry Reform Act (EPIRA), the ERC, promulgated the Performance Based Regulation (PBR): –In May 2003, thru the Transmission Wheeling Rates Guidelines (TWRG), later amended as Rules for Setting Transmission Wheeling Rates (RTWR) in September 2009 –In December 2004, thru the Distribution Wheeling Rates Guidelines (renamed as Rules for Setting Distribution Wheeling Rates, RDWR).

PBR - Annual Revenue Requirement  Determine forecasted Annual Revenue Requirement (referred as Building Blocks) for a Regulatory Period OPERATING EXPENSES OPERATING EXPENSES TAXES RETURN OF INVESTMENT RETURN ON INVESTMENT INCOME TAX  operating and maintenance expenditures  property taxes, business taxes  Weighted Average Cost of Capital (WACC) X rate base  value of optimized used & useful assets + working capital  depreciation  set to zero 8

The investor expects a return on its investment; The return is a mixed of Debt (thru loan) or Equity (investor-infused capital); Usually the interest rate in Debt is higher than the Equity Based on an optimal value of the Regulatory Asset Base plus allowed Working Capital 9 RETURN ON INVESTMENT = ( WACC ) X Regulatory asset base + Working capital PBR – Building Blocks

 ERC to determine the value of the regulatory asset base (RAB)  Requires a valuation of the regulatory asset base, ERC appoints valuation experts (independent valuation, but with utility sign-off)  Optimized depreciated replacement cost (ODRC) method used  Revaluation results must be presented in a Valuation Report in accordance with the Valuation Handbook (developed in accordance with Clause 4.8 of the RDWR)  ERC will review the valuations as described in the Valuation Handbook 10 RETURN ON INVESTMENT = ( WACC ) X Regulatory asset base + Working capital How are Capital Projects considered?

 RAB going forward will be based on initial opening value and the approved efficient CAPEX.  ERC will review CAPEX requirements of utilities, based on:  information provided by the utilities on historical CAPEX  CAPEX forecasts provided by utilities  Justification of CAPEX  Analysis by independent expert(s) on the information provided by utilities and the levels of efficiency implied  Other information at the ERC’s disposal 11 RETURN ON INVESTMENT = ( WACC ) X Regulatory asset base + Working capital How are Capital Projects considered?

Return ON Investment 12 ItemsRORBPBR What will form part of the rates? Return on Investment What is the basis of the investors’ return? Net Plant in Service or Asset Base Regulatory Asset Base (RAB) Rate of Return (12%)Weighted Average Cost of Capital (WACC) How is Asset Base Determined? Appraised ValueOptimized Depreciated Replacement Cost (ODRC) How is return determined? Fixed amount (12%) at the time of the rate review Adjusted based on most current economic indicators (Inflation, Forex, Market Risk Premiun, T- bill rate etc.)

RORB vs PBR 13 ItemsRORBPBR How are Capital Projects treated? Based on assets that are present at the time of the rate review Based on assets that are present at the time of the rate review plus the approved efficient capital projects What happens to implemented projects in between rate review? Not considered in the rates - Will not form part of the Return ON nor Return OF Will form part of the rates - The Return ON and Return OF What will be the impact on the Return ON and Return OF (Principal + Interest) The Return ON and OF may not be enough to cover the Principal + Interest Utility is only given enough revenue to cover for the capital (principal) and reasonable return (interest). An updated Principal + Interest PBR Implementation