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Darryl Biggar Consulting Economist Australian Competition and Consumer Commission 2 April 2004
The discussion paper raises the issue of whether or not to move to a roll forward approach.
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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
Closing RAB
Opening = RAB
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
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Power of the incentive to reduce capex should be tailored to ensure a balance of incentives overall
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But now since the closing RAB is fixed, this equation shows that depreciation must be set as follows: Forecast depreciation Opening RAB
(b) however the regulated firm is also subject to risk that the actual revaluation will differ from the forecast
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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
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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.
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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
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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.
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