Regulated Asset Base

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
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-4
Experience you can trust.
Agenda
1. Introduction
2. Revenue Components
3. Regulatory Asset Base (RAB)
4. Asset Valuation
30.11.2009
1. Introduction
Price Control Regulatory Tasks
Decision on
regulatory regime
Setting revenue
requirements /
cost determination
Setting annual
efficiency target
Tariff design
Webinar 3 - Price Regulation
Rate-of-Return, Cap Regulation,

Sliding Scale,
Yardstick Competition
Webinar 4 - Revenue Requirements and RAB
Calculation of
regulatory asset base
Webinar 5 Cost of Capital
Calculation of
allowed rate of return
Webinar 6 - Efficiency Assessment
Data Envelopment Analysis,

econometric approaches,
reference network models
Webinar 8 - Pricing
30.11.2009
Tariff structures,
cost allocation
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
1. Introduction
Price Control Revenue Requirements
Operating Expenditures (Opex)
Opex are the costs incurred by a regulated company in
Capital cost
Capital costs provide an annual recovery of the capital
providing the regulated services and maintaining and
expenditures (capex) undertaken by a regulated service
operating the relevant assets
provider in providing the regulated services
The recovery of opex does not provide any return to
Capital costs include depreciation allowance and return
shareholders and debt holders, as they are paid out in

the form of salaries, ongoing operating and
maintenance costs, etc
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.
30.11.2009
1. Introduction
Price Control Revenue Requirements
Revenue Requirements = Opex + Depreciation + (RAB Rate of Return)
Revenue Requirements
Capital costs
Opex
Operation and
Maintenance
Network Losses
Fuel (in case of

regulated
generation)
Return on
Assets
Depreciation
Regulatory
Asset Base
(RAB)
30.11.2009
Rate of Return
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
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
Depreciation
Initial asset
value
remaining asset value
depreciation
straight-line method
10 years
Initial asset
value
declining-balance method
20 years
time
remaining asset value
depreciation
10 years
20 years
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time
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
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
10

Components
Existing Assets
RAB Closing Value =

RAB Opening Value
Depreciation
Capital
Contribution
Regulatory
Asset
Base
Working
Capital
Construction
Works in
Progress
RAB roll forward
/ revenue re-setting
+ Investments
Depreciation
Asset Disposal
+/- Change of Working
Capital
+/-Change of Capital
Contribution
New
Investments
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11

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
12

Investments (2)
Regulatory assessment of investments
ex-post
ex-ante
Assessment of adequacy and efficiency of
companys proposed investment program for the
forthcoming regulatory period

Regulator asks regulated companies to submit their
capital expenditure projections
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 get security that investment will be
Companies face uncertainty of whether undertaken
approved by the regulator before investment is
investments will be recognised by regulator ex-post
carried out
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
13

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

companys earnings
Some form of recognition of cost of capital committed during construction appears

appropriate
30.11.2009
14

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
15
4. Asset Valuation
Different Approaches
Asset Valuation
Methods
Value based
Cost based
Historic
cost
Optimised
Indexed
Replacement
replacement
historic cost
cost
cost
Market
value
DCF
value
Deprival
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
16
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
17
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
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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
19
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 RABs 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
20
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
21
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)
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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
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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)
30.11.2009
24
End of Webinar 4
Dr. Konstantin Petrov
Managing Consultant
Mobil +49 173 515 1946
E-mail: konstantin.petrov@kema.com
KEMA Consulting GmbH
Kurt-Schumacher-Str. 8, 53113 Bonn
Tel. +49 (228) 44 690 00
Fax +49 (228) 44 690 99
Experience you can trust.

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Training on Regulation

A webinar for the European Copper Institute

Experience you can trust.

Webinar 3 - Price Regulation

Rate-of-Return, Cap Regulation,

Webinar 4 - Revenue Requirements and RAB

Webinar 5 Cost of Capital

Webinar 6 - Efficiency Assessment

Data Envelopment Analysis,

Price Cap and Revenue Cap regulation

Upper limit (cap) on prices or revenues

Operating Expenditures (Opex)

Opex are the costs incurred by a regulated company in

Capital costs provide an annual recovery of the capital

providing the regulated services and maintaining and

expenditures (capex) undertaken by a regulated service

operating the relevant assets

provider in providing the regulated services

The recovery of opex does not provide any return to

Capital costs include depreciation allowance and return

shareholders and debt holders, as they are paid out in

Fuel (in case of

Accelerated method (e.g. declining-balance) which allocates decreasing amounts of

Most regulatory authorities apply straight-line method

remaining asset value

remaining asset value

Typically regulators apply the following principles for RAB:

It includes only assets necessary to provide regulated services

It is based on a weighted average of the cost of debt and equity financing

There are several methods to calculate rate of return

3. Regulatory Asset Base (RAB)

RAB Closing Value =

3. Regulatory Asset Base (RAB)

Three types of investments may be considered:

Replacements investments: investments related to replacement of aged (technically or

3. Regulatory Asset Base (RAB)

forthcoming regulatory period

Supplement to ex-ante investment reviews (identify

Or undertaken without previous ex-ante approval

Companies get security that investment will be

Companies face uncertainty of whether undertaken

approved by the regulator before investment is

investments will be recognised by regulator ex-post

Threat that investments may be rejected, or partially

3. Regulatory Asset Base (RAB)

Other authorities base the inclusion of CWIP on other factors, such as

whether the construction projects are of short duration

whether the interest charged to construction represents a substantial portion of the

Some form of recognition of cost of capital committed during construction appears

3. Regulatory Asset Base (RAB)

Working capital defined as current assets minus current liabilities

Regulatory treatment of working capital

Relatively inexpensive: does not require experts to determine costs

Returns may be inadequate to support the funding of new investments

Advantages and disadvantages similar to historic costs

will provide the same services and capacity as existing asset

Removes inefficiencies in the RABs current asset configuration, such as duplication,

Requires a degree of subjective judgement about the optimum configuration of assets in

Uses the market to obtain the asset value

In many cases there is no indication of market value (share quotation) of regulated

Even if there is a price indication based on a divesture / privatisation of a regulated

Experience you can trust.

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