REPLACEMENT COST ASSET VALUATION AND …

1 INTERNATIONAL SERIES 8 REPLACEMENT cost ASSET VALUATION AND THE REGULATION OF ENERGY INFRASTRUCTURE TARIFFS - Theory and Practice in Australia David Johnstone The University of Bath School of Management is one of the oldest established management schools in Britain. It enjoys an international reputation for the quality of its teaching and research. Its mission is to offer a balanced portfolio of undergraduate, postgraduate and post-experience programmes, research and external activities, which provide a quality of intellectual life for those involved in keeping with the best traditions of British universities. REPLACEMENT cost ASSET VALUATION and the Regulation of Energy Infrastructure Tariffs - Theory and Practice in Australia - CRI International Series 8 David Johnstone Desktop published by Jan Marchant The University of Bath All rights reserved ISBN Centre for the study of Regulated Industries (CRI) The CRI is a research centre of the University of Bath School of Management.

2 The CRI was founded in 1991 as part of the Chartered Institute of Public Finance and Accountancy (CIPFA). It transferred to the University of Bath School of Management in 1998. It is situated on the 8th floor of Wessex House (North), adjacent to car park H. The CRI is an interdisciplinary research centre investigating how regulation and competition are working in practice, both in the UK and abroad. It is independent and politically neutral. It aims to produce authoritative, practical contributions to regulatory policy and debate, which are put into the public domain. The CRI focuses on comparative analyses across the regulated industries. CRI activities and outputs include: Regulatory statistics, information and analysis Discussion papers and Occasional papers Regulatory Briefs, Reviews and International series Research Reports and Technical papers Seminars, courses and conferences Direct links with regulated industries, the regulators, the academic community and other interested parties are an important feature of the work of the CRI.

3 The CRI is non-profit making. Its activities are supported by a wide range of sponsors. BAA CIPFA Department of Trade and Industry Environment Agency National Audit Office NERA National Grid Transco Network Rail OFWAT RSM Robson Rhodes Royal Mail Group Thames Water United Utilities Wessex Water Further information about the work of the CRI can be obtained from:- Peter Vass, Director-CRI, School of Management, University of Bath, Bath, BA2 7AY or CRI Administrator, Jan Marchant, Tel: 01225 383197, Fax: 01225 383221, e-mail: and from the CRI s web site, which includes events and the publications list. CRI Publications and publications list can be obtained from Jan Marchant as above. Preface The CRI is pleased to publish REPLACEMENT cost ASSET VALUATION and the Regulation of Energy Infrastructure Tariffs Theory and Practice in Australia in its International Series.

4 It is by Professor David Johnstone of the Department of Accounting and Finance, University of Wollongong, New South Wales, Australia. He challenges current practice and conceptual developments in Australia, and this is of considerable interest because the legitimacy, and accountability, of regulators is based on having a demonstrably sound foundation and methodology for setting price controls and access prices. As one UK regulator put it, having a good story to tell . International comparisons of theory and practice contribute to knowledge, and the improvement of regulation. The CRI would welcome comments on the paper, which is number 8 in the series, and these should be addressed to: Peter Vass, Director CRI, School of Management, University of Bath, Bath, BA2 7AY.

5 The CRI publishes work on regulation by a wide variety of authors, covering a range of regulatory topics and disciplines, in its International, Occasional and Technical Paper series. The purpose is to promote better understanding and debate about the regulatory framework and the processes of decision-making and accountability. Enquiries or manuscripts to be considered for publication should be addressed as above. Peter Vass Director, CRI January 2003 iii iv Contents Preface iii Introduction 1 The regulators tariff equation 4 Theoretical foundations of the tariff equation The method of depreciation Example calculations Private sector rejection of RC VALUATION as too subjective 10 DORC is unauditable Bureaucratic suppression of criticism The regulators argument for DORC 13 The regulators theory corrected 16 Dynamic reconstruction of DORC Implied depreciation Effect on tariffs New entrant IRR Bell and Peasnell (1997)

6 More practical considerations 22 Broader economic arguments against REPLACEMENT cost 24 DORC not necessary to ensure continued optimal ASSET use DORC harms downstream allocative efficiency DORC provides existing ASSET owners with a free lunch DORC not necessary to promote new investment The treatment of DORC revaluation 29 The treatment of easements 32 Conclusion 35 References 37 v Author s Abstract In Australia, access tariffs (rental charges) paid by third party users to the owners of energy transmission assets (eg, gas pipelines) are determined by regulators on the basis of their depreciated optimised REPLACEMENT cost (known as DORC). Reliance on the REPLACEMENT cost , rather than actual cost , of existing assets inflates tariffs and incites the criticism that ASSET owners earn a return on investments of a scale never made.

7 The economic rationale of the regulators model is that it emulates the workings of a contestable market, by setting tariffs at a level just short of that required to motivate a new entrant (system duplication). Properly reconstructed, this model constitutes a dynamic and internally consistent theory of REPLACEMENT cost VALUATION and depreciation. Its mathematical consequences, however, especially with regard to the VALUATION of sunk assets with long times to expiry, are shown to be practically and politically unpalatable. In particular, the implied tariff levels for such assets are very close to those that would apply to new infrastructure assets built today at today s prices. Regulators unwilling to accept this economic consequence of their proffered new-entrant-exclusion logic are left with no alternative theoretical framework for DORC.

8 July 2002 Professor David Johnstone vi Acknowledgements This research has been completed with the financial support of BHP Petroleum Pty Ltd and the Australian Research Council (Small Grant Scheme). Discussions with Eric Groom (IPART), Murray Wells (Emeritus Professor, University of Sydney), John Trowell (University of Wollongong), Ken Peasnell (University of Lancaster) and Graeme Dean (University of Sydney) are acknowledged with appreciation. Professor David Johnstone, Department of Accounting and Finance, University of Wollongong, New South Wales, Australia 1 Introduction In Australia, the owners of energy transmission infrastructure assets (gas pipelines and electricity grids) are natural monopolists safe from any practical economic risk of private sector investors or governments replicating the main trunks of their transmission networks.

9 Following the principles set down in the Report on National Competition Policy (Commonwealth of Australia 1993), federal and state governments have established access regimes to enable other companies, including downstream users and competitors in energy supply markets, to access (ie, rent) part of the capacity of these otherwise monopolised assets. Arrangements between ASSET owners and ASSET users are on an artificially commercial basis, intended to bring about competition in energy supply markets and reduce downstream energy costs: An access regime is a set of procedures for allowing a third party to use services provided by significant infrastructure facilities owned or operated by another party on fair terms..Common types of infrastructure include electricity transmission lines, gas pipelines, telecommunications networks and rail track.

10 For example, Energy Australia can sell electricity to a customer located in another distribution area, owned by, say, Integral Energy..The common benefits of competition are lower prices, choice of service provider, more innovative and better quality services and a more efficient utilisation of a network. Competition will improve productive efficiency as service providers minimise their operating costs to provide services at the lowest possible price. In turn this will increase the competitiveness of the downstream goods and services markets that use the infrastructure (IPART 1999a, p5). In exchange for access to their networks, infrastructure owners ( service providers ) are paid transmission tariffs in amounts determined by independent regulatory agencies, including primarily the ACCC (Australian Competition and Consumer Commission), ORG (Office of the Regulator-General, Victoria) and IPART (Independent Pricing and Regulatory Tribunal of New South Wales).