MEMORANDUM. Re: Technical input to the ACCC submission relationship between the regulatory asset base and the renewals annuity

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1 MEMORANDUM To: Peter McGahan From: Jeff Balchin Director Date: 4 July 2008 Re: Technical input to the ACCC submission relationship between the regulatory asset base and the renewals annuity A. Introduction and overview Purpose The purpose of this memorandum is to comment on the Australian Competition and Consumer Commission s (ACCC) apparent view in a recent report 1 that having a regulatory asset base is inconsistent with using a renewals annuity to recover the cost of renewals expenditure. Structure of memorandum The structure of this memorandum is as follows. First, we explain how we interpret the renewals annuity concept, and how it compares to what has been referred to as the regulatory asset base approach. This provides background to the succeeding discussion. Secondly, we summarise briefly the ACCC s argument as to why having a regulatory asset base is inconsistent with the renewals annuity approach. Thirdly, we evaluate the ACCC s argument and respond. Summary of advice In our view, the ACCC s view that having a regulatory asset base is inconsistent with the renewals annuity approach is based on a simple misconception, namely that the initial stock of assets is funded in advance by customers. Logically, this cannot be the case. Prior to the initial assets being constructed, there are no customers from which to fund those assets. More generally, the renewals annuity approach should be designed to recover only the cost of renewals, and hence could not recover the original cost of the asset. Similarly, the annuity should not be designed to recover the cost of augmentations or improvements (again, these are not renewals). Rather, under a standard renewals annuity approach, these items typically would be treated as 1 ACCC, 2008, Issues Paper: Water Charging Rules for Charges Payable to Irrigation Infrastructure Operators, May.

2 capital, included in the regulatory asset base and recovered through return on assets and (possibly) depreciation. The ACCC s misconception arises from two errors (and inconsistencies) that occur in its technical appendix. First, the ACCC s derivation of the renewals annuity amount assumes that the opening regulatory asset base is included in the calculation, as well as all future capital expenditure. 2 However, this is not how renewals annuity allowances are calculated only renewals expenditure is included in the renewals annuity calculation, both the opening regulatory asset base and expenditure that is treated as capital (i.e., augmentations and improvements) are excluded. If it was the case that the opening regulatory asset base and all capital expenditure were included in the renewals annuity calculation, then this issue would be semantic as the renewals annuity by definition would include all expenditure rather than merely a subset. However, the ACCC s technical derivation of the renewals annuity actually demonstrates that, if the opening regulatory asset base and all capital expenditure were included in the renewals annuity derivation, then there would be a regulatory asset base for the asset at each point in time. 3 Secondly, the ACCC asserts that the basic difference between the renewals annuity and regulatory asset base approaches are that the former leads to customers paying in advance for expenditure, while under the latter the asset owner finances the expenditure and recovers its financing cost over time. However, this distinction is simplistic. As noted above, the initial assets cannot be paid for in advance by customers there are no customers prior to the asset existing and hence the renewals annuity cannot finance this. : Where governments pay for assets and treat them as a gift (i.e., not earn a rate of return), then this government decision will imply a zero regulatory asset base (i.e., lower bound pricing). However, where there is an intention to recover the cost of investments (as there should be) then the value of the investment will need to be recovered from the users over time, which requires a positive regulatory asset base value. While for renewals customers may (on average) pay in advance under the renewals annuity approach, this need not be the case, but will depend upon the time pattern of renewals requirements. That is, if there is a large renewals requirement early in the annuity period and less little later in the period, the asset owner will be required to pay for the renewals and recover the cost over 2 3 ACCC, Op. Cit., Equation 7, p.55. Refer to: ACCC, Op. Cit., penultimate equation on the bottom of p.55. 2

3 time from customers in this case, the renewals annuity approach would deliver a similar outcome to the regulatory asset base approach. More generally, we think the ACCC has overstated the theoretical distinction between the renewals annuity and regulatory asset base approaches. In our view, the renewals annuity approach derives from defining the fundamental unit of property widely (e.g., as the integrated system of channels, weirs etc.), 4 which in turn results in most of the asset-related expenditure being classified as operating expenditure rather than capital expenditure. The annuity is used merely to smooth the payments for renewals over an extended period of time. The units of property for water irrigators are wider (or larger) than is common in electricity and gas, but similar to how units of property (and the split between operating and capital expenditure) in rail. We note that it is accepted in the rail sector that an approach equivalent to a renewals annuity approach can be used together with a (positive) regulatory asset base value. Lastly, once it is acknowledged that there should be a value assigned to the assets in place at the start of formal regulation, there is no strong case for setting a lower value merely because the renewals annuity approach had been used in the past. B. Background the renewals annuity approach Units of property, the regulatory asset base and renewals annuity approaches In our view, the regulatory asset base and renewals annuity are not fundamentally different methods for determining the allowed revenue for a utility. Instead, the two methods represent opposite ends of a spectrum of how expenditure on maintaining physical assets is classified as either capital or operating expenditure and, consequently, the time periods over which the costs are recovered. Whether the maintenance expenditures recovered by a utility are classified as capital expenditures or operating expenditures depends on how the utility defines the units of property that form the utility s assets. A replacement (or improvement) of a whole unit of property is classified as capital expenditure, but a replacement of only part of a unit of property is classified as operating expenditure. Therefore, if a unit of property is defined at component level, expenditure on renewing the individual components will generally be classified as capital expenditure. If the unit of property is defined as the whole asset, expenditure on renewing individual components will generally be classified as operating expenditure. 4 A unit of property is the definition of the fundamental asset, which in turn drives the classification of expenditure between operating and capital and the life used for depreciation purposes. In general terms, a replacement of part of a unit of property that maintains its originally expected life is operating expenditure, and the replacement of a whole unit of property is capital. By way of example, when a car is purchased as a business input, the whole car is depreciated over the expected life of the car, rather than the tyres and spark plugs being depreciated separately, and so when tyres and spark plugs are replaced, it is classified as operating expenditure. 3

4 Different approaches to defining the basic unit of property have been taken in different utility industries. In the electricity and gas distribution sectors, units of property have been defined at component level. By way of example, the common practice in electricity distribution (for accounting and regulatory purposes) is for individual poles to be treated as a unit of property, as well as each transformer and so on. The results are that: assets are depreciated over finite periods of time for each component asset (for example, over 20 years for poles and 20 to 40 years for transformers); and as a consequence, there is substantial ongoing expenditure in the renewal of each component asset that is capitalised. In contrast, the standard approach in the rail sector is to define the unit of property as the whole rail asset; that is, as a complete rail segment (including stations, rail track, sleepers, signals etc.). It is further commonly assumed that, if the assets are properly maintained, they will last forever, and hence are not depreciated. Under this definition of the unit of property, the periodic replacement of sleepers and rail track is treated as operating expenditure (typically referred to as major periodic maintenance ) and little or no expenditure is treated as capital expenditure. The renewals annuity approach used in the water sector stems from defining the units of property as the whole asset, akin to the approach taken in the rail sector. Thus, the whole of a dam or irrigation scheme is defined as a unit of property, and so expenditure on major works for renewal of components of the asset is treated as operating expenditure. Operating and capital expenditure and the annuity When regulated prices are set, the reason why the distinction between operating and capital expenditure is important is because operating expenditure (or a forecast thereof) is normally passed through to customers in the year in which it occurs, whereas capital expenditure is added to the regulatory asset base, financed by the asset owner and recovered over time through prices (i.e., as a return on assets and depreciation allowance). The annuity component of the renewals annuity is merely a smoothing of the annual renewals expenditures (equivalent in present value terms) in order to present customers with a flatter path of prices over time. Even so, the difference between the regulatory asset base approach and renewals annuity approach may not be substantial. In particular, when setting regulated prices, it is common to set a smooth price path for 5 years at a time, which has the same effect of doing a renewals annuity over that 5 year period. Practical difference between the regulatory asset base and renewals annuity approach In the situations where the majority of the asset renewals are some time in the future, there is an important practical difference between the regulatory asset base and renewals approaches, namely that: 4

5 under the regulatory asset base approach, the asset owner finances expenditure and recovers the cost after it has been incurred; whereas under the renewals annuity approach, customers finance renewals largely in advance of their need (and the asset owner obtains a stock of cash in advance from which it then pays for renewals expenditure when required). Whether one of these approaches is to be preferred to the other depends on the view taken as to whether it is desirable for the regulated business to charge in advance (and possibly well in advance) for renewals expenditure. However, this matter is outside of the scope of this memorandum. 5 Opening regulatory asset base All of the discussion above related to how the cost of expenditure subsequent to the initial investment is recovered. Under a standard application of the renewals annuity approach, the cost of the initial asset is not included in the calculation or the renewals annuity. Moreover, it is impossible for the cost of the initial assets to be recovered in advance prior to the initial investment, there are no customers (and no charges) from which this could be recovered. In the irrigation sector, it has been common for governments to pay for the initial investments and to treat these as a gift (i.e., not recover the costs). Giving effect to this policy decision would require the initial regulatory asset base to be set to zero. 6 However, in all other cases, the cost of the original assets must be recovered from customers. The means through which the cost of the initial investment is recovered is by assigning a positive regulatory asset base to the assets and including a return on assets and (possibly) depreciation allowance in the revenue requirement, along side of the renewals annuity line-item. C. ACCC s views on the compatibility of the renewals annuity with a regulatory asset base In the text of its Issues Paper, the ACCC asserts without supporting argument that, for the regulatory asset base and renewals annuity approaches to deliver revenue streams with the same present value: 7 The initial regulatory asset base needs to be valued at zero at the time of regulation. The ACCC placed a caveat on this conclusion, however, noting as follows: For completeness, however, we do consider there to be benefits for customers and the irrigation provider from the regulatory asset base approach. In Victoria, the government s policy decision was to have the expenditure that it made treated as a gift, but for certain debt that was raised for past expenditures to be recovered from customers. This required the initial regulatory asset bases to be a positive value, such that the debt would be recovered. ACCC, 2008, Op. Cit., p.23. 5

6 This is consistent with an operator that finances all of its capital expenditure under a renewals annuity. Where capital has been financed outside the renewals annuity using, for example, debt finance, the opening value of the regulatory asset base may be greater than zero. The ACCC repeated these propositions in more detail as follows: 9 That being said, it was noted in section that, for consistency to be achieved, the opening value for assets for a comparable business that has previously financed all of its capital under a renewals annuity should equal zero. This is because the renewals annuity represents a current contribution by customers to the future renewal of assets, not a contribution by the operator yet to be recovered through prices. The unique nature of the renewals annuity (where customers provide the financing for future renewals) means that a valuation of assets of greater than zero will result in customers providing compensation to the operator for assets in the ground that were originally financed by the customer and not the operator. Where an operator has undertaken to finance capital investments outside the renewals annuity and has utilised debt financing or an equity contribution, there may be a case for establishing an opening value for assets of greater than zero. A technical appendix (Appendix D) was referred to as support for this proposition. The ACCC s interpretation of the annuity method set out in the technical appendix was as follows: 10 Under the annuity approach, the regulated firm eschews debt finance in favour of directly accumulating contributions from customers. This means that the regulator must determine a forward looking estimate of the net present value of the stream of investments that the regulated firm is likely to make over its life. D. Assessment of the ACCC s position Error in the ACCC analysis The basic misconception in the ACCC s argument is its assumption that the original investment in assets would have been financed in advance by customers, implying that an investment had not been made by the asset owner. It is logically impossible for the original investment to have been funded by customers in advance through the renewals annuity because prior to the initial assets being constructed, there would not have been any customers from whom these advance contributions could be taken. It follows that the exception the ACCC noted namely that there could be a regulatory asset base where the asset owner has financed this outside of the renewals annuity is not an exception but the typical case. That is, an asset owner could not finance the initial investment through the renewals annuity. ACCC technical appendix The ACCC s technical appendix contains a derivation of the required revenue formulae under both the renewals annuity approach, as well as the regulatory asset base approach. However, an implicit assumption in the ACCC s derivation of revenue under the renewals annuity approach is that the initial cost of the investment is included in the annuity calculation. This can be observed in the equation that sets ACCC, Op. Cit., p.23, n.73. ACCC,, Op. Cit., p.24. ACCC, Op. Cit., p.54. 6

7 up the calculation (equation 7), where the ACCC says that the task of the regulator is to derive a constant path of revenue (RA) that satisfies (emphasis added): 11 T CAPEX t RA RA RA RAB + = + + L+ (7) 0 t 2 T t= 1 (1 + r) (1 + r) (1 + r) (1 + r) Clearly, if the initial cost of the asset is included in the calculation of the renewals annuity, then the cost of this investment will be recovered (indeed, if all asset related expenditure was included in this calculation, then the renewals annuity would permit the recovery of all asset related costs). However, in practice, the original cost of the asset is not included in the renewals annuity calculation the renewals annuity calculation includes (or should include) the cost of renewals only. It follows that the renewals annuity calculation will not permit the asset owner to recover all of the asset related costs incurred namely, it would not permit recover of the cost of the initial investment, and nor would it permit the recovery of any asset expenditure that was not a renewal, such as augmentations or service improvements. The ACCC s apparent objective of permitting all costs to be recovered would only be met if the asset owner is permitted to recover the cost of these non-renewal expenditures. The appropriate means of permitting this recovery is by permitting a regulatory asset base that reflects the value of the original investment and all augmentations and service improvements thereto. There are two further observations on the ACCC s technical appendix that are relevant. First, even under the ACCC s (mistaken) derivation of the renewals annuity, it does not follow that there would not be a regulatory asset base for the asset at the commencement of regulation, as the ACCC assumes. Rather, the ACCC s formulae demonstrate that, where an asset was regulated under the ACCC s version of the renewals annuity, there may well be a positive regulatory asset base at the commencement of regulation indeed, the ACCC provides the following formula for this (emphasis added): 12 RAB t = ( 1+ r) RABt 1 ( RA CAPEX t ) Secondly, it is also not correct for the ACCC to conclude that a central feature of the ACCC-version of the renewals annuity is firms eschew debt and finance expenditure from customers in advance. Under the formulae derived by the ACCC, the original investment is financed by the asset owner (which presumably would be a mixture of debt and equity, although the source of finance is irrelevant) and would recover this cost over time. What is the difference between the renewals annuity and regulatory asset base approaches? As discussed in section above, our view is that the renewals annuity (if implemented correctly) and regulatory asset base approaches are merely different ACCC, Op. Cit., p.55. ACCC, Op. Cit., p.55. 7

8 approaches to recovering a subset of asset related expenditure (renewals). At the heart of the difference is a different split in the classification of expenditure between operating and capital expenditure central to the renewals annuity approach is a very wide definition of a unit of property, which results in a large share of expenditure being classified as operating expenditure. The annuity addition is used to smooth out the lumpy annual operating expenditure that results (albeit over an extended period). In contrast, under the regulatory asset base approach, a larger share of asset related expenditure is typically classified as capital, and hence included on the regulatory asset base and recovered through return on asset and depreciation charges. That said, the difference between approaches is only one of degree even under the annuity approach, some asset related expenditure is (or should) be classified as capital (namely the initial investment and augmentation and service improvement expenditure), and hence included in a regulatory asset base. It follows that, in our view, there is nothing inherent in the renewals annuity approach that requires the regulatory asset base to be zero, and nor is the question of whether assets are financed with debt a relevant matter. Indeed, we note that methods that are akin to a renewals annuity are typically used in rail in Australia (where renewal is referred to as major periodic maintenance and recovered as operating expenditure) and for the water pipeline networks of the UK urban water businesses. In neither of these cases has it been claimed that a regulatory asset base cannot coexist along side the renewals allowance. We are aware that, in practice, the renewals annuity for irrigation infrastructure in Australia has commonly been implemented with a zero regulatory asset base. However, this practice has nothing to do with the choice of the renewals annuity approach, but rather reflects the relevant government policy position that the initial (public) investments in irrigation infrastructure should be treated as a gift (i.e., not recovered). There is no reason that the same outcome should be carried over to situations where these investments have earned returns (e.g., from industrial customers) or in cases where this policy is relaxed (i.e., if there is a transition to upper bound pricing). Lastly, we note that the renewals annuity has often resulted in irrigation businesses recovering the cost of renewals well in advance of the cash expenditure requirements. We are aware of views (to which we have contributed) that the regulatory asset base approach may have desirable features over the renewals annuity approach this case for both the irrigation company and its customers. However, the debate about whether the cost of renewals should be recovered largely in advance or as capital is not relevant to the question of whether a value should be assigned for regulatory purposes to the initial assets. Initial asset valuation under the renewals annuity Lastly, a point that needs to be addressed is how the value of the initial assets should be determined where a renewals annuity approach has been used. At first sight, it could be considered that the renewals annuity approach would mean that customers would already have paid for part of the initial assets, and so a lower value should be set. However, this conclusion need not follow. 8

9 We agree with the ACCC s discussion that asset valuation for regulatory purposes is a vexing matter, given that economic principles provide only a range for this value. However, certain stakes in the ground are often are relied upon, which are discussed below. First, it has been common for regulators to place weight on the asset value that would be implied if the firm was operating in a competitive market, of which the optimised depreciated replacement cost is an estimate. The outcome of a competitive market depends upon what a new entrant would charge in a market, and so whether customers have contributed to the incumbent s assets in the past is irrelevant. Secondly, in certain circumstances, regulators have placed weight on the principle that the asset value should be set at the value that would permit the asset owner to recover all of its costs over the life of the asset (that is, the implied residual value). Critical to this method is knowledge of how costs have been recovered in the past (accounting depreciation methods would almost certainly overstate this), and so in the majority of cases, it is inapplicable. However, if the regulatory asset base and renewals annuity approaches had been applied correctly from the start of an asset s life, then it would be observed that: Under the renewals annuity approach, there would be less (but not no) capital expenditure being added to the regulatory asset base, which would imply a lower regulatory asset base than under the regulatory asset base approach, all else constant. However, it is also likely that the assets would be depreciated over a longer life indeed, under the renewals annuity approach, it is common to assume that the assets are infinitely lived, and hence not to charge depreciation. This would imply a higher regulatory asset base than under the regulatory asset base approach, all else constant. Thus, the implied residual value may he higher or lower under the renewals annuity approach than under the regulatory asset base approach. In conclusion, once it is acknowledged that there should be a value assigned to the assets in place at the start of formal regulation, there is no strong case for setting a lower value merely because the renewals annuity approach had been used in the past. 9