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The pricing of capital services under regulation
The pricing of capital services under regulation Anna P. Della Valle and G. Campbell Watkins
This paper discusses the pricing of services for long-lived capital-intensive energy projects. Its purpose is to offer alternatives to rate structures associated with traditional accounting methods and rate-of-return regulation. These result in front-end loading of costs, leading to inefficiencies and discouraging development. Several alternative rate structures are proposed to mitigate inefficiencies. Theory suggests an ‘optimal annual charge’ for capital equipment to reflect the annual economic value of capacity. Zmplementation of optimal charges may involve major changes in accounting methods and the use of innovative financial instruments. From a practical standpoint, a phasing-in procedure may be desirable. Keywords:
Rates; Depreciation;
Phase-in
During the early 198Os, a number of papers and conferences focused on ways to resolve the front-end loading of tariffs associated with capital-intensive projects (eg, gas pipelines) under conventional ratemaking practices in North America. Various forms of tariff levelling were proposed. Ironically, by the mid-1980s, the very concerns addressed receded: inflation declined markedly and emerging weaknesses in oil and gas prices saw the demise or deferral of big energy projects with large up-front investments, the very projects which had excited interest in developing new regulatory techniques. Thus, interest in such topics by and large languished in the 1980s. However, recently renewed activity in large-scale energy projects, for example, in the case of North America, expansion of the Trans Canada Pipeline to serve the US north-east
Anna P. Della Valle is Senior Consultant,
National Eco-
nomic Research Associates, Inc, 1166 Avenue of the Americas, New York, NY 10036, USA; and G. Campbell Watkins is President, DataMetrics Limited, 44&1201-5th Street SW, Calgary, Alberta TZR 0Y6, Canada.
36
market and frontier natural gas proposals have revived interest in tolling methodology. Such revival has also been stimulated by deregulation, with more attention now given to competitive price formation. And while inflation has receded from double digit figures, the maintenance of oil and gas prices at relatively low levels compared with the early 1980s has made tariffs more prominent in overall energy cost structures, and hence deserving of more attention.
The problem and the approach The problem It has been well demonstrated’ that the application of conventional tariff regulation (based on original cost rate base and straight-line depreciation) results in a time pattern of tolls that is front-end loaded: high in early years and falling thereafter. Such cost-of-service style regulation dominates tariff setting by the Canadian National Energy Board, Canadian provincial regulatory boards, and regulatory agencies in the USA. Investment in long-lived capital projects (such as pipelines and large electric generating plants) tends to be lumpy and concentrated at the beginning of the project life. For such projects, front-end loading of rates tends to be particularly pronounced. The key problem with front-end loading of rates is that it can reduce the likelihood that long-lived capital-intensive projects will be built, even if on a present value basis they are economic. Moreover, if a project does proceed, early customers will pay more than later customers, raising an intergenerational equity problem. And of course such pricing patterns bear little or no resemblance to trajectories generated by competitive markets. This feature has become prominent in the light of deregulation intended to encourage or mimic competition, especially in the petroleum industry. Indeed, traditionally set tariffs are likely to move over time in a direction precisely opposite to that of economically efficient tariffs. Prices will be highest
0957-l 787/92/010036-07 0
1992 Butterworth-Heinemann
Ltd
The pricing of capital services under regulation
in the early years, discouraging use even though there is excess capacity; and prices will be lower in later years when the project is closer to full capacity _ contrary to what economic efficiency dictates. Front-end loaded tariffs have at least two other negative impacts: price discrimination between old and new projects and inter-generational inequity. Price discrimination can arise if a new project were built to serve the same general market area as an old one. Both projects may provide the same service to consumers, but, under regulation, differences in asset vintage dictate higher tariffs for the new than for the old pipeline. While such competition is seldom the case within the Canadian pipeline market, it certainly has arisen and will continue to arise in US markets. Price discrimination in terms of facilities serving similar markets would not arise under competition. Front-end loading of tariffs favour later users and penalizes early users. For example, in the case of pipelines, ‘second-tier’ producers who begin to ship several years into the pipeline’s life will pay substantially lower tariffs than early shippers, both because accounting depreciation will have reduced the rate base and because increasing shipments will spread the cost of service over a larger volume of gas. Of course, a producer can always choose to defer production until a later date (by which time tariffs will have decreased), so no shipper can have ‘unfair’ treatment forced upon him. However, the powerful economic incentive to be a ‘second-tier’ rather than a ‘first-tier’ shipper could be fatal to a large pipeline project. All producers will hope to get a ‘free ride’ by shipping later. Consequently, a project could either fail to start or could start later than is economically desirable. These ‘free rider’ problems cannot be dealt with effectively under traditional rate-ofreturn regulation. To the extent that the high tariffs on new projects are attributable to the front-end loading proclivities of conventional regulation, the cure obviously involves techniques that will alter the trajectory of tariffs over time. Two broad approaches have been put forward. One relates to basing tariffs on ‘economic’ depreciation;2 the second is based on uniform ‘real’ tariffs. This paper will focus on the former approach - it is more piecemeal and, therefore, more amenable to implementation in a regulated framework. However, note that under certain conditions the two approaches are equivalent.’ The approach Theoretically, total over the productive
UTILITIES
revenue asset’s
POLICY January
requirements life should
1992
collected add up to
original cost plus return to the investors’ capital plus operation and maintenance (O&M) costs, ie to a specific nominal rate of return (ROR) associated with the asset over its life. Of course there are innumerable revenue schedules which add up to the same ROR and therefore are ‘financially’ equivalent. The ‘economic’ problem is then to devise criteria for choosing among the various revenue streams. Since the pattern of (regulated) prices is determined, among other things, by the depreciation schedule adopted, it follows that different depreciation schedules will generate different market signals. In this framework, then, the choice of a depreciation policy is itself vitally important for the investment decision in that it can directly influence consumption patterns. The profitability of an investment as well as its financial and political viability depends crucially upon the pricing pattern for its output. This is especially true for highly capital-intensive projects. Correct specification of depreciation policy in effect chooses an efficient way of allocating capital costs in the price of output. We propose that a depreciation policy based on ‘economic depreciation achieves this goal. ‘Economic’ depreciation measures the change in the value of an asset over time. Investment theory and microeconomic theory both teach us that the economic value of an asset is equal to the present value of its future net cash flows. Thus, at the beginning of a year, an asset is worth the present value of the future cash flows attributable to it. At the end of that year, the same relationship holds. The difference between the two present values so computed is the asset’s economic depreciation for that year. The computation of the depreciation charge under traditional regulation is totally unrelated to the underlying change in the value of the asset over time. In fact, it is only by fortunate coincidence that conventional straight-line accounting depreciation would match the economic change in asset value during any year.
Alternative rate structures We discuss two methods for choosing a more efficient price pattern for the use of long-lived capital assets. The first approaches the problem from a theoretical standpoint. It derives the optimal intertemporal price pattern for the use of capital equipment under a number of simplifying assumptions.4 This is the price pattern that is based on ‘economic’ depreciation and that results in the most efficient allocation of resources.
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The pricing of capital services under regulation Table 1. Revenue requirement
stream using economic depreciation.
Rate base beginning of year
Year Prior yr (1)
Annual’ rental charge
Real return on rate base
Economi8’ depreciation
(i-p)x(l)
(2)-(3)
O&M costs Prior year
Revenue requirement (3)+(4)+(5)
(5)x(l+p-A
xO+p) -prior yr (4) (1) $500.00 $499.95 $493.89 $480.43 $457.95 $424.53 $377.94 $315.53 $234.24 $130.46 $500.00
(4) $50.05 $56.06 $62.85 $70.52 $79.21 $89.05 $100.20 $112.85 $127.20 $143.51
(3) $25.00 $25.00 $24.69 $24.02 $22.90 $21.23 $18.90 $15.78 $11.71 $6.52
(2) $75.05 $81.06 $87.54 $94.54 $102.11 $110.28 $119.10 $128.62 $138.91 $150.03
(6) $85.05 $91.86 $99.20 $107.14 $115.71 $124.97 $134.97 $145.76 $157.42 $170.02
(5) $10.00 $10.80 $11.66 $12.60 $13.60 $14.69 $15.87 $17.14 $18.51 $19.99
0 1 2 3 4 5 6 7 8 9 Net present
value:
Notes: “The depreciation Assumptions original cost:
annual rental charge, the depreciation charge and the resulting revenue requirement are end-of-year values. ‘Economic is calculated as a residual, by subtracting the real (net of inflation) return on rate base from the annual rental charge. used in Tables 1 through 3: rate of return (i): 15.00%; inflation rate @): 10.00%; rate of technological progress 0: 2.00%; $500.00; first year O&M costs: $10.00; expected life (n): 10 years.
We recognize that the optimal price structure may be difficult to implement for two reasons: first, it requires significant changes in the accounting practices of rate-of-return-regulated companies; and, second, it may require innovative forms of project financing. Bearing this in mind, we propose an alternate method which approaches the problem from a practical standpoint. This consists of ‘phasing-in’ the asset over a number of years. While not ‘optimal’, this method is certainly more efficient than the price pattern that results under conventional rate-of-return regulation. Method
1: the optimal
intertemporalprice
structure
The price or revenue requirement associated with the use of a capital asset in a given year t consists of three components: 1. 2. 3.
return on depreciated rate base in year t; depreciation in year t; and O&M outlays in year t.
We can show that if: (a) the return is set equal to the regulated company’s real (net of inflation) cost of capital; and, (b) depreciation is set equal to ecoy1omic depreciation in each year, the resulting stream of revenue requirements will be ‘optimal’ in the sense that it will be welfare maximizing.’ Theoretically, an optimal intertemporal price structure is one which maximizes aggregate (consumer plus producer) welfare subject to the tools available to regulators as well as the constraints to which they are subject. The optimal price per unit of output during year t is equal to the sum of marginal
38
O&M costs for that year plus a capital charge.’ The optimal capital charge is precisely equal to the opportunity cost of having the equipment available this year rather than the next. This, in turn, is equal to a return on the undepreciated value of the asset in year t plus the change in the value of the asset between year t and year t + 1. This change in value is the economic depreciation for that asset in year t. We can compute the optimal capital charge for the use of capital equipment, called the ‘annual rental _ _ charge’, AT,’ as follows: A* =(1+i)“(l+p-f)‘(i-p+f) t (1 + i)” - (1 + p - fl”
vo w
(1)
where: i
= company’s cost of capital = allowed rate of return n = expected life of equipment annual rate of inflation ; 1 index of ‘neutral’ technological advancementX b-$= original cost of the asset Table 1 shows how AT is calculated for a hypothetical capital asset whose original cost is $500 and service life is 10 years. To simplify the calculation we assume constant rates of return, inflation and technological change of lo%, 2% and 15% respectively throughout the asset’s life. We also assume that the return allowed on rate base is equal to the market rate of interest, and there are no taxes. O&M costs
UTILITIES
POLICY January 1992
The pricing Table 2. Revenue requirement
stream under traditional
Rate base beginning of year
Year Prior yr (1) -prior yr (3)
(1) $500.00 0 $450.00 1 $400.00 2 $350.00 3 $300.00 4 $250.00 5 $200 .oo 6 $lSO.OO 7 $100.00 8 $50.00 9 Net present value: $500.00
regulation.
Nominal return on rate base iX(l)
Straigbtline depreciation Original cost/n
Annual Capital charge (2)+(3)
O&M costs Prior year
Revenue requirement (2)+(3)+(s)
(2) $75.05 $67.50 $60.00 $52.50 $45.00 $37.50 $30.00 $22.50 $15.00 $7.50
(3) $50.00 $50.00 $50.00 $SO.OO $50.00 $50.00 $50.00 $50.00 $50.00 $50.00
(4) $125.00 $117.50 $110.00 $102.50 $95 .oo $87.50 $80.00 $72.50 $65.00 $57.50
I:;x(l+p-fl $10.00 $10.80 $11.66 $12.60 $13.60 $14.69 $15.87 $17.14 $18.51 $19.99
(6) $135.00 $128.30 $121.66 $115.10 $108.60 $102.19 $95.87 $89.64 $83.51 $77.49
start at $10.00, rise at a rate equal to the difference between the rates of inflation and technical change and are incurred at the end of each year. The resulting revenue requirement (column 6) starts at $85.05 in the first year of operation and increases to $170.02 by the last year of the asset’s life. The annual rate of increase is (I + p - fl, or S%/year. The depreciation charge starts at $50.05 and increases to $143.51 by the end of the asset’s life. Table 2 derives the corresponding stream of revenue requirements under conventional regulation. Prices start at $135.00 and decline to $77.49 by the end of the asset’s service life. The straight line depreciation charge is constant, at $50/year. Thus, setting revenue requirements equal to A: eliminates the front-end loading problem. Note that the present value of the stream of capital charges (ie, revenue requirements net of O&M costs) in both Table 1 and 2 sums to the original cost of the asset ($500). What differs is the time stream of prices. From an overall investment perspective the two streams of revenues are equivalent.” However, as mentioned earlier, they have greatly divergent implications for such issues as allocative efficiency, intertemporal equity and financial viability. Properties of the unnual rental charge formula. First, simple observation of the expression for A: shows that the nominal annual rental charge rises with the rate of (expected) inflation and falls with the rate of (expected) neutral technological progress. Second, A: satisfies the ‘investment’ requirement, ie, the present value sum of annual rental charges over the equipment’s life “’ is equal to original cost, ie: n-l
1 i
I+i
UTILITIES
’
2 A: t = 0 (1 + i)’
=K”
of capital services under regulation
0
i POLICY January 1992
(2)
Third, derivation of the formulae assumes that the annual rate of inflation p, technological change f and the rate of interest i are known ex ante and remain constant throughout the life of the capital equipment. This is not a necessary assumption. All that has to be known with certainty are the underlying values for p, f and i for the year in question. The annual rental charge in year t is then calculated by treating the problem anew in each year. That is, A: is derived as the rental charge for a new asset whose starting value (original cost) is equal to the remaining value of the existing capital asset in year t with an expected remaining life of n - t years. A,* is then computed on the basis of the new forecasted values for p, f and i and reflects the new opportunity cost associated with such values. Thus, A: can be derived from what Baumol” calls a ‘myopic decision rule’, ie, a rule which allows us to compute the correct annual charge on the basis of a single year forecast. Method 2: phase-in As discussed previously, it may not be feasible to set price equal to the optimal annual rental charge because of institutional and financial constraints. Thus, we recast the solution in terms of the practical problem at hand: avoiding excessive up-front rate increases. The solution is to defer or ‘phase-in’ revenues from earlier to later years. Regulators in North America are used to the mechanics of deferring revenues thanks to their long love affair with AFUDC accounting. For example, the asset could be phased-in over a three-year period, with onethird being added to the rate base in each of the three years. The portion that did not go into the rate base would be capitalized, ie, it would earn a return which would be added to the total cost of the plant and would eventually be included in rate base at the end of the phase-in period. Another possibility
39
The pricing of capital services under regulation Table 3. Revenue requirement
Year
0 1 2 3 4 5 6 7 8 9 Net present
stream with three-year
phase-in.
Nominal return on phased-in rate base ix(l)
Carrying charge on deferred balance
(1)
(4
$166.67 $316.67 $448.15 $487.00 $417.43 $347.86 $278.29 $208.72 $139.14 $69.57 value: $500.00
$25.00 $47.50 $67.22 $73.05 $62.61 $52.18 $41.74 $31.31 $20.87 $10.44
(3) $50.00 $32.50 $12.38
Rate base” Beginning of year
Depreciationb (1)iremaining life (4) $16.67 $35.19 $56.02 $69.57 $69.57 $69.57 $69.57 $69.57 $69.57 $69.57
Annual capital charge
Revenue requirement
(2)+(4)
O&M costs Prior year
(5) $41.67 $82.69 $123.24 $142.62 $132.19 $121.75 $111.32 $100.88 $90.44 $80.01
I:lx(l+p$10.00 $10.80 $11.66 $12.60 $13.60 $14.69 $15.87 $17.14 $18.51 $lY.YY
(7) $51.67 $93.49 $134.90 $155.22 $145.79 $136.44 $127.18 $118.02 $108.95 $100.00
(2)+(4)+(6)
Notes: “In year 0, rate base = original cost/3 = $167; in years 1-2, rate base = prior year (1) - prior year (4) + an additional $167 of phased-in costs; in year 3, rate base = prior year (1) + sum of carrying charges on deferred balances - prior year (4); in years 4-9, rate base = prior year (1) - prior year (4). ‘Depreciation is based on costs that arc included in rate base.
would be to exclude from the current rate base costs attributable to excess capacity, allow them to accumulate under AFUDC accounting, and add the costs to rate base only as the capacity is required. How much to defer and over what time period depends upon a number of factors: first, the financial condition of the utility - deferring revenues cuts cash flow, and, therefore, interest coverage; second, the tax consequences of the deferral; and, third, the effect on demand for services rendered associated with the deferral. Table 3 derives the stream of revenue requirements under a three year phase-in plan for the same capital asset shown in Tables 1 and 2. One-third of the original cost of the asset is added to the rate base in each of the first three years. A carrying charge equal to the rate of return (15%) is applied to the deferred balance that is not in the rate base (column 3). At the end of the three years the carrying charge on the deferred balances is added to the rate base. The resulting stream of revenue requirements starts at $51.67 in the first year and increases to $100.00 by the end of the asset’s life. The first year charge is actually lower than under economic depreciation but grows faster over the next five years of the asset’s operation. Thereafter, revenue requirements decline as under traditional regulation. Finuncial implications earlier to later years
of deferring
revenues from
Attempts to alter the trajectory of cost-of-service style tariffs all entail some postponement of returns from earlier to later years. This has important implications for financial markets. Indeed, it has been suggested that the objections of the financial com-
40
munity are crucial in any attempt to implement some kind of tariff levelling. And certainly there is no doubt that in any such scheme there are potential problems in matching cash flows and debt interest requirements. Whether one looks at uniform real tariffs, tariffs based on economic depreciation, or phasing-in of large toll increases by AFUDC accounting arrangements, all techniques involve deferral of revenue in contrast with conventional cost-of-service tariffs. Deferral has important impacts on cash flow, investor coverage, investor risk, taxes and the like. Our discussion now focuses on risk, forms of financing and mentions possible solutions. Risk considerations Although rates based on economic depreciation ultimately will generate the same expected return to investors over the life of the project, the deferral of revenues is never appreciated by the financial community. Thus, investors will probably perceive any pricing scheme that involves deferring revenues as being inherently more risky than one that does not. In the case of a gas pipeline, the deferral of revenues increases investors’ exposure to the risk that in the future a low-cost substitute for gas may appear, making it impossible to charge the higher tariffs for the later years of the project’s life. The increased risk will increase the interest rate demanded by lenders and may also lead to requirements for higher equity participation, which in turn entails a higher rate of return. Certainly moving only partially towards economic depreciation or levelized real tariffs would ease the financing problem but could still leave intact incentives for producers to delay pro-
UTILITIES
POLICY
January
1992
The pricing
duction in order to get a free ride relative users of the system. Ability to finance of financing
the project with conventional
to initial
forms
Another major obstacle to implementing rates based on economic depreciation is the scarcity of debt instruments that have a pattern of interest payments similar to the pattern of depreciation charges. If a capital project were financed through conventional debt, the same size interest payment would be due each year, while the revenue stream would defer revenues from earlier to later years. This mismatch of revenues and debt obligations may strain interest coverage, thereby increasing the cost of debt. Possible solutions There are at least two solutions to these financing problems: defer a little less or issue bonds that have a payment pattern similar to the deferred revenue pattern. The solution of deferring a little less focuses on the practical issues at hand: what we want to achieve is a more efficient stream of revenues. If adopting a full-fledged ‘economic depreciation’ scheme strains the company’s financial indicators (interest coverage, cash flow), thereby significantly increasing its cost of capital, then the resulting solution will not be efficient. Under these circumstances, deferring a little less may achieve the dual goal of maintaining the company’s financial indicators healthy in the early years of the project’s life as well as resulting in a pattern of rates that is more efficient than under conventional price setting. It may also ease transition problems of windfall gains and losses associated with changes in regulatory regimes discussed by Myers, Kolbe and Tye.12 Another solution is to try to finance the project through ‘trended’t” bonds. Trended bonds are bonds whose interest payments are indexed so as to result in lower payments in early years and higher payments in later years. The index itself could be set equal to the general inflation rate, an industryspecific inflation rate or the projected rate of increase in revenue requirements. In either case, the pattern of interest payments will more closely match the pattern of revenues. How much to trend the bonds or whether to trend them at all again depends upon the effect of the deferred revenue scheme on the company’s financial indicators and, ultimately, on its cost of capital. While indexed bonds are fairly common in Europe, they tend to be a novelty in North America. Nonetheless, the presence of other novel types of debt obligations such as floating rate
UTILITIES
POLICY
January
1992
of capital services under regulation
notes, dutch auction preferred stocks, deep discount and zero coupon bonds indicate that there may be a market for ‘trended’ bonds. But when all is said and done large-scale projects not enjoying cost-of-service style revenue collection mechanisms have been financed. In this light, financing problems should not be a fundamental impediment to redefining revenue trajectories under regulation.
Concluding
remarks
In developing trended or phased-in methodologies, we have been and are sensitive to balancing the interests of all the parties involved. We specifically seek to develop a rate structure that is efficient, equitable and financially sound. This involves weighing the interests of ratepayers, regulators, stockholders and bondholders. We recognize that this is not an easy task. Economists tend to suggest pricing solutions that are strictly ‘efficient’ in an economic sense - ie, involve the most efficient use of resources. In the real world, a purely ‘efficient’ solution may neither be possible nor even desirable. Efficiency must be considered alongside with equity, practicality and a number of other constraints. Institutionalizing inflation through regulation may not be seen as desirable. Setting rates based on the economically correct depreciation may result in a pattern of rates that is inconsistent with available forms of financing. We have suggested two solutions to this type of problem: trend a little less or finance the project with trended bonds.
‘Sallv Hunt Streiter, ‘Trending the rate base to reflect inflation: how’, and G. Campbell Watkins, ‘Perspectives on the regulation in R.N. Morrison and R.J. Shultz. eds. of uineline tariffs’. Pip&w Regulatiorl and Inflation: An Evaluation of Tariff Levelling, Proceedings of Conference sponsored by the National Energy Board of Canada and McGill University. Montreal, Canada, November 1982. ‘Formulating tariffs on the basis of economic depreciation is related to the trended original cost (TOC) method of defining the rate base. For careful discussion of the TOC methodology vis-a-vis the original cost methodology (what we refer to as conventional tariff regulation), see Stewart C. Myers, A. Lawand rate of return rence Kolbe and William B. Tye, ‘Inflation regulation’, Research in Transportation Economics, Vol 2, 1985. sp x3-1 19. ‘National Economic Research Set G. Campbell Watkins, Associates and DataMetrics Limited proposals on tariff formulation - a reconciliation’, mimeo, 19X2. “The simplifying assumptions make the derivation of the optimal price structure easier to follow and do not detract from the general form of the solution once the assumptions are relaxed. ‘For ease of presentation we include only our conclusions here. They arc derived in an Appendix available from the authors on request. ‘See Anna P. Della Valle, ‘Intertemporal pricing for the use of
41
The pricing of capital services under regulation capital in production and its relationship to investment and replacement policy’, PhD Dissertation, Columbia University, ‘Optimal depreciation policy: 1984; and William J. Baumol, pricing the products of durable assets’, The Bell Journul of Economics and Managemenr Science, Vol 2, No 2, Autumn 1971, pp 638-656. A: IS computed as an undiscounted end-of-year value. “f is chosen as an index of ‘neutral’ technical change, ie, it reduces capital and labour costs by the same amount so that the capitallabour ratio remains constant. For a more complex (and realistic) form of technical change set Della Vallc, 01’ tit, Rcf 6. ‘As long as the company’s cost of capital does not change as a
42
result of the switch from straight-line to economic depreciation. “‘Note that A; is, by definition, an end-of-year value. Thercforc, to compute the present value of the sum we need to sum the discounted A:s and then discount the sum back one period to the present. “Baumol. up cil, Ref 6. “Myers. Kolbe and Tye, op cil. Rcf 2. %ally Hunt Streiter and Anna P. Della Valle, ‘Indexed bonds and other issues’. presented at the Regulation of Pipelines in an Inflationary Era Conference, sponsored by The National Energy Board of Canada and McGill University, Montreal. Canada. November 1982.
UTILITIES
POLICY January
1992
This paper discusses the pricing of services for long-lived capital-intensive energy projects. Its purpose is to offer alternatives to rate structures associated with traditional accounting methods and rate-of-return regulation. These result in front-end loading of costs, leading to inefficiencies and discouraging development. Several alternative rate structures are proposed to mitigate inefficiencies. Theory suggests an ‘optimal annual charge’ for capital equipment to reflect the annual economic value of capacity. Zmplementation of optimal charges may involve major changes in accounting methods and the use of innovative financial instruments. From a practical standpoint, a phasing-in procedure may be desirable. Keywords:
Rates; Depreciation;
Phase-in
During the early 198Os, a number of papers and conferences focused on ways to resolve the front-end loading of tariffs associated with capital-intensive projects (eg, gas pipelines) under conventional ratemaking practices in North America. Various forms of tariff levelling were proposed. Ironically, by the mid-1980s, the very concerns addressed receded: inflation declined markedly and emerging weaknesses in oil and gas prices saw the demise or deferral of big energy projects with large up-front investments, the very projects which had excited interest in developing new regulatory techniques. Thus, interest in such topics by and large languished in the 1980s. However, recently renewed activity in large-scale energy projects, for example, in the case of North America, expansion of the Trans Canada Pipeline to serve the US north-east
Anna P. Della Valle is Senior Consultant,
National Eco-
nomic Research Associates, Inc, 1166 Avenue of the Americas, New York, NY 10036, USA; and G. Campbell Watkins is President, DataMetrics Limited, 44&1201-5th Street SW, Calgary, Alberta TZR 0Y6, Canada.
36
market and frontier natural gas proposals have revived interest in tolling methodology. Such revival has also been stimulated by deregulation, with more attention now given to competitive price formation. And while inflation has receded from double digit figures, the maintenance of oil and gas prices at relatively low levels compared with the early 1980s has made tariffs more prominent in overall energy cost structures, and hence deserving of more attention.
The problem and the approach The problem It has been well demonstrated’ that the application of conventional tariff regulation (based on original cost rate base and straight-line depreciation) results in a time pattern of tolls that is front-end loaded: high in early years and falling thereafter. Such cost-of-service style regulation dominates tariff setting by the Canadian National Energy Board, Canadian provincial regulatory boards, and regulatory agencies in the USA. Investment in long-lived capital projects (such as pipelines and large electric generating plants) tends to be lumpy and concentrated at the beginning of the project life. For such projects, front-end loading of rates tends to be particularly pronounced. The key problem with front-end loading of rates is that it can reduce the likelihood that long-lived capital-intensive projects will be built, even if on a present value basis they are economic. Moreover, if a project does proceed, early customers will pay more than later customers, raising an intergenerational equity problem. And of course such pricing patterns bear little or no resemblance to trajectories generated by competitive markets. This feature has become prominent in the light of deregulation intended to encourage or mimic competition, especially in the petroleum industry. Indeed, traditionally set tariffs are likely to move over time in a direction precisely opposite to that of economically efficient tariffs. Prices will be highest
0957-l 787/92/010036-07 0
1992 Butterworth-Heinemann
Ltd
The pricing of capital services under regulation
in the early years, discouraging use even though there is excess capacity; and prices will be lower in later years when the project is closer to full capacity _ contrary to what economic efficiency dictates. Front-end loaded tariffs have at least two other negative impacts: price discrimination between old and new projects and inter-generational inequity. Price discrimination can arise if a new project were built to serve the same general market area as an old one. Both projects may provide the same service to consumers, but, under regulation, differences in asset vintage dictate higher tariffs for the new than for the old pipeline. While such competition is seldom the case within the Canadian pipeline market, it certainly has arisen and will continue to arise in US markets. Price discrimination in terms of facilities serving similar markets would not arise under competition. Front-end loading of tariffs favour later users and penalizes early users. For example, in the case of pipelines, ‘second-tier’ producers who begin to ship several years into the pipeline’s life will pay substantially lower tariffs than early shippers, both because accounting depreciation will have reduced the rate base and because increasing shipments will spread the cost of service over a larger volume of gas. Of course, a producer can always choose to defer production until a later date (by which time tariffs will have decreased), so no shipper can have ‘unfair’ treatment forced upon him. However, the powerful economic incentive to be a ‘second-tier’ rather than a ‘first-tier’ shipper could be fatal to a large pipeline project. All producers will hope to get a ‘free ride’ by shipping later. Consequently, a project could either fail to start or could start later than is economically desirable. These ‘free rider’ problems cannot be dealt with effectively under traditional rate-ofreturn regulation. To the extent that the high tariffs on new projects are attributable to the front-end loading proclivities of conventional regulation, the cure obviously involves techniques that will alter the trajectory of tariffs over time. Two broad approaches have been put forward. One relates to basing tariffs on ‘economic’ depreciation;2 the second is based on uniform ‘real’ tariffs. This paper will focus on the former approach - it is more piecemeal and, therefore, more amenable to implementation in a regulated framework. However, note that under certain conditions the two approaches are equivalent.’ The approach Theoretically, total over the productive
UTILITIES
revenue asset’s
POLICY January
requirements life should
1992
collected add up to
original cost plus return to the investors’ capital plus operation and maintenance (O&M) costs, ie to a specific nominal rate of return (ROR) associated with the asset over its life. Of course there are innumerable revenue schedules which add up to the same ROR and therefore are ‘financially’ equivalent. The ‘economic’ problem is then to devise criteria for choosing among the various revenue streams. Since the pattern of (regulated) prices is determined, among other things, by the depreciation schedule adopted, it follows that different depreciation schedules will generate different market signals. In this framework, then, the choice of a depreciation policy is itself vitally important for the investment decision in that it can directly influence consumption patterns. The profitability of an investment as well as its financial and political viability depends crucially upon the pricing pattern for its output. This is especially true for highly capital-intensive projects. Correct specification of depreciation policy in effect chooses an efficient way of allocating capital costs in the price of output. We propose that a depreciation policy based on ‘economic depreciation achieves this goal. ‘Economic’ depreciation measures the change in the value of an asset over time. Investment theory and microeconomic theory both teach us that the economic value of an asset is equal to the present value of its future net cash flows. Thus, at the beginning of a year, an asset is worth the present value of the future cash flows attributable to it. At the end of that year, the same relationship holds. The difference between the two present values so computed is the asset’s economic depreciation for that year. The computation of the depreciation charge under traditional regulation is totally unrelated to the underlying change in the value of the asset over time. In fact, it is only by fortunate coincidence that conventional straight-line accounting depreciation would match the economic change in asset value during any year.
Alternative rate structures We discuss two methods for choosing a more efficient price pattern for the use of long-lived capital assets. The first approaches the problem from a theoretical standpoint. It derives the optimal intertemporal price pattern for the use of capital equipment under a number of simplifying assumptions.4 This is the price pattern that is based on ‘economic’ depreciation and that results in the most efficient allocation of resources.
37
The pricing of capital services under regulation Table 1. Revenue requirement
stream using economic depreciation.
Rate base beginning of year
Year Prior yr (1)
Annual’ rental charge
Real return on rate base
Economi8’ depreciation
(i-p)x(l)
(2)-(3)
O&M costs Prior year
Revenue requirement (3)+(4)+(5)
(5)x(l+p-A
xO+p) -prior yr (4) (1) $500.00 $499.95 $493.89 $480.43 $457.95 $424.53 $377.94 $315.53 $234.24 $130.46 $500.00
(4) $50.05 $56.06 $62.85 $70.52 $79.21 $89.05 $100.20 $112.85 $127.20 $143.51
(3) $25.00 $25.00 $24.69 $24.02 $22.90 $21.23 $18.90 $15.78 $11.71 $6.52
(2) $75.05 $81.06 $87.54 $94.54 $102.11 $110.28 $119.10 $128.62 $138.91 $150.03
(6) $85.05 $91.86 $99.20 $107.14 $115.71 $124.97 $134.97 $145.76 $157.42 $170.02
(5) $10.00 $10.80 $11.66 $12.60 $13.60 $14.69 $15.87 $17.14 $18.51 $19.99
0 1 2 3 4 5 6 7 8 9 Net present
value:
Notes: “The depreciation Assumptions original cost:
annual rental charge, the depreciation charge and the resulting revenue requirement are end-of-year values. ‘Economic is calculated as a residual, by subtracting the real (net of inflation) return on rate base from the annual rental charge. used in Tables 1 through 3: rate of return (i): 15.00%; inflation rate @): 10.00%; rate of technological progress 0: 2.00%; $500.00; first year O&M costs: $10.00; expected life (n): 10 years.
We recognize that the optimal price structure may be difficult to implement for two reasons: first, it requires significant changes in the accounting practices of rate-of-return-regulated companies; and, second, it may require innovative forms of project financing. Bearing this in mind, we propose an alternate method which approaches the problem from a practical standpoint. This consists of ‘phasing-in’ the asset over a number of years. While not ‘optimal’, this method is certainly more efficient than the price pattern that results under conventional rate-of-return regulation. Method
1: the optimal
intertemporalprice
structure
The price or revenue requirement associated with the use of a capital asset in a given year t consists of three components: 1. 2. 3.
return on depreciated rate base in year t; depreciation in year t; and O&M outlays in year t.
We can show that if: (a) the return is set equal to the regulated company’s real (net of inflation) cost of capital; and, (b) depreciation is set equal to ecoy1omic depreciation in each year, the resulting stream of revenue requirements will be ‘optimal’ in the sense that it will be welfare maximizing.’ Theoretically, an optimal intertemporal price structure is one which maximizes aggregate (consumer plus producer) welfare subject to the tools available to regulators as well as the constraints to which they are subject. The optimal price per unit of output during year t is equal to the sum of marginal
38
O&M costs for that year plus a capital charge.’ The optimal capital charge is precisely equal to the opportunity cost of having the equipment available this year rather than the next. This, in turn, is equal to a return on the undepreciated value of the asset in year t plus the change in the value of the asset between year t and year t + 1. This change in value is the economic depreciation for that asset in year t. We can compute the optimal capital charge for the use of capital equipment, called the ‘annual rental _ _ charge’, AT,’ as follows: A* =(1+i)“(l+p-f)‘(i-p+f) t (1 + i)” - (1 + p - fl”
vo w
(1)
where: i
= company’s cost of capital = allowed rate of return n = expected life of equipment annual rate of inflation ; 1 index of ‘neutral’ technological advancementX b-$= original cost of the asset Table 1 shows how AT is calculated for a hypothetical capital asset whose original cost is $500 and service life is 10 years. To simplify the calculation we assume constant rates of return, inflation and technological change of lo%, 2% and 15% respectively throughout the asset’s life. We also assume that the return allowed on rate base is equal to the market rate of interest, and there are no taxes. O&M costs
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POLICY January 1992
The pricing Table 2. Revenue requirement
stream under traditional
Rate base beginning of year
Year Prior yr (1) -prior yr (3)
(1) $500.00 0 $450.00 1 $400.00 2 $350.00 3 $300.00 4 $250.00 5 $200 .oo 6 $lSO.OO 7 $100.00 8 $50.00 9 Net present value: $500.00
regulation.
Nominal return on rate base iX(l)
Straigbtline depreciation Original cost/n
Annual Capital charge (2)+(3)
O&M costs Prior year
Revenue requirement (2)+(3)+(s)
(2) $75.05 $67.50 $60.00 $52.50 $45.00 $37.50 $30.00 $22.50 $15.00 $7.50
(3) $50.00 $50.00 $50.00 $SO.OO $50.00 $50.00 $50.00 $50.00 $50.00 $50.00
(4) $125.00 $117.50 $110.00 $102.50 $95 .oo $87.50 $80.00 $72.50 $65.00 $57.50
I:;x(l+p-fl $10.00 $10.80 $11.66 $12.60 $13.60 $14.69 $15.87 $17.14 $18.51 $19.99
(6) $135.00 $128.30 $121.66 $115.10 $108.60 $102.19 $95.87 $89.64 $83.51 $77.49
start at $10.00, rise at a rate equal to the difference between the rates of inflation and technical change and are incurred at the end of each year. The resulting revenue requirement (column 6) starts at $85.05 in the first year of operation and increases to $170.02 by the last year of the asset’s life. The annual rate of increase is (I + p - fl, or S%/year. The depreciation charge starts at $50.05 and increases to $143.51 by the end of the asset’s life. Table 2 derives the corresponding stream of revenue requirements under conventional regulation. Prices start at $135.00 and decline to $77.49 by the end of the asset’s service life. The straight line depreciation charge is constant, at $50/year. Thus, setting revenue requirements equal to A: eliminates the front-end loading problem. Note that the present value of the stream of capital charges (ie, revenue requirements net of O&M costs) in both Table 1 and 2 sums to the original cost of the asset ($500). What differs is the time stream of prices. From an overall investment perspective the two streams of revenues are equivalent.” However, as mentioned earlier, they have greatly divergent implications for such issues as allocative efficiency, intertemporal equity and financial viability. Properties of the unnual rental charge formula. First, simple observation of the expression for A: shows that the nominal annual rental charge rises with the rate of (expected) inflation and falls with the rate of (expected) neutral technological progress. Second, A: satisfies the ‘investment’ requirement, ie, the present value sum of annual rental charges over the equipment’s life “’ is equal to original cost, ie: n-l
1 i
I+i
UTILITIES
’
2 A: t = 0 (1 + i)’
=K”
of capital services under regulation
0
i POLICY January 1992
(2)
Third, derivation of the formulae assumes that the annual rate of inflation p, technological change f and the rate of interest i are known ex ante and remain constant throughout the life of the capital equipment. This is not a necessary assumption. All that has to be known with certainty are the underlying values for p, f and i for the year in question. The annual rental charge in year t is then calculated by treating the problem anew in each year. That is, A: is derived as the rental charge for a new asset whose starting value (original cost) is equal to the remaining value of the existing capital asset in year t with an expected remaining life of n - t years. A,* is then computed on the basis of the new forecasted values for p, f and i and reflects the new opportunity cost associated with such values. Thus, A: can be derived from what Baumol” calls a ‘myopic decision rule’, ie, a rule which allows us to compute the correct annual charge on the basis of a single year forecast. Method 2: phase-in As discussed previously, it may not be feasible to set price equal to the optimal annual rental charge because of institutional and financial constraints. Thus, we recast the solution in terms of the practical problem at hand: avoiding excessive up-front rate increases. The solution is to defer or ‘phase-in’ revenues from earlier to later years. Regulators in North America are used to the mechanics of deferring revenues thanks to their long love affair with AFUDC accounting. For example, the asset could be phased-in over a three-year period, with onethird being added to the rate base in each of the three years. The portion that did not go into the rate base would be capitalized, ie, it would earn a return which would be added to the total cost of the plant and would eventually be included in rate base at the end of the phase-in period. Another possibility
39
The pricing of capital services under regulation Table 3. Revenue requirement
Year
0 1 2 3 4 5 6 7 8 9 Net present
stream with three-year
phase-in.
Nominal return on phased-in rate base ix(l)
Carrying charge on deferred balance
(1)
(4
$166.67 $316.67 $448.15 $487.00 $417.43 $347.86 $278.29 $208.72 $139.14 $69.57 value: $500.00
$25.00 $47.50 $67.22 $73.05 $62.61 $52.18 $41.74 $31.31 $20.87 $10.44
(3) $50.00 $32.50 $12.38
Rate base” Beginning of year
Depreciationb (1)iremaining life (4) $16.67 $35.19 $56.02 $69.57 $69.57 $69.57 $69.57 $69.57 $69.57 $69.57
Annual capital charge
Revenue requirement
(2)+(4)
O&M costs Prior year
(5) $41.67 $82.69 $123.24 $142.62 $132.19 $121.75 $111.32 $100.88 $90.44 $80.01
I:lx(l+p$10.00 $10.80 $11.66 $12.60 $13.60 $14.69 $15.87 $17.14 $18.51 $lY.YY
(7) $51.67 $93.49 $134.90 $155.22 $145.79 $136.44 $127.18 $118.02 $108.95 $100.00
(2)+(4)+(6)
Notes: “In year 0, rate base = original cost/3 = $167; in years 1-2, rate base = prior year (1) - prior year (4) + an additional $167 of phased-in costs; in year 3, rate base = prior year (1) + sum of carrying charges on deferred balances - prior year (4); in years 4-9, rate base = prior year (1) - prior year (4). ‘Depreciation is based on costs that arc included in rate base.
would be to exclude from the current rate base costs attributable to excess capacity, allow them to accumulate under AFUDC accounting, and add the costs to rate base only as the capacity is required. How much to defer and over what time period depends upon a number of factors: first, the financial condition of the utility - deferring revenues cuts cash flow, and, therefore, interest coverage; second, the tax consequences of the deferral; and, third, the effect on demand for services rendered associated with the deferral. Table 3 derives the stream of revenue requirements under a three year phase-in plan for the same capital asset shown in Tables 1 and 2. One-third of the original cost of the asset is added to the rate base in each of the first three years. A carrying charge equal to the rate of return (15%) is applied to the deferred balance that is not in the rate base (column 3). At the end of the three years the carrying charge on the deferred balances is added to the rate base. The resulting stream of revenue requirements starts at $51.67 in the first year and increases to $100.00 by the end of the asset’s life. The first year charge is actually lower than under economic depreciation but grows faster over the next five years of the asset’s operation. Thereafter, revenue requirements decline as under traditional regulation. Finuncial implications earlier to later years
of deferring
revenues from
Attempts to alter the trajectory of cost-of-service style tariffs all entail some postponement of returns from earlier to later years. This has important implications for financial markets. Indeed, it has been suggested that the objections of the financial com-
40
munity are crucial in any attempt to implement some kind of tariff levelling. And certainly there is no doubt that in any such scheme there are potential problems in matching cash flows and debt interest requirements. Whether one looks at uniform real tariffs, tariffs based on economic depreciation, or phasing-in of large toll increases by AFUDC accounting arrangements, all techniques involve deferral of revenue in contrast with conventional cost-of-service tariffs. Deferral has important impacts on cash flow, investor coverage, investor risk, taxes and the like. Our discussion now focuses on risk, forms of financing and mentions possible solutions. Risk considerations Although rates based on economic depreciation ultimately will generate the same expected return to investors over the life of the project, the deferral of revenues is never appreciated by the financial community. Thus, investors will probably perceive any pricing scheme that involves deferring revenues as being inherently more risky than one that does not. In the case of a gas pipeline, the deferral of revenues increases investors’ exposure to the risk that in the future a low-cost substitute for gas may appear, making it impossible to charge the higher tariffs for the later years of the project’s life. The increased risk will increase the interest rate demanded by lenders and may also lead to requirements for higher equity participation, which in turn entails a higher rate of return. Certainly moving only partially towards economic depreciation or levelized real tariffs would ease the financing problem but could still leave intact incentives for producers to delay pro-
UTILITIES
POLICY
January
1992
The pricing
duction in order to get a free ride relative users of the system. Ability to finance of financing
the project with conventional
to initial
forms
Another major obstacle to implementing rates based on economic depreciation is the scarcity of debt instruments that have a pattern of interest payments similar to the pattern of depreciation charges. If a capital project were financed through conventional debt, the same size interest payment would be due each year, while the revenue stream would defer revenues from earlier to later years. This mismatch of revenues and debt obligations may strain interest coverage, thereby increasing the cost of debt. Possible solutions There are at least two solutions to these financing problems: defer a little less or issue bonds that have a payment pattern similar to the deferred revenue pattern. The solution of deferring a little less focuses on the practical issues at hand: what we want to achieve is a more efficient stream of revenues. If adopting a full-fledged ‘economic depreciation’ scheme strains the company’s financial indicators (interest coverage, cash flow), thereby significantly increasing its cost of capital, then the resulting solution will not be efficient. Under these circumstances, deferring a little less may achieve the dual goal of maintaining the company’s financial indicators healthy in the early years of the project’s life as well as resulting in a pattern of rates that is more efficient than under conventional price setting. It may also ease transition problems of windfall gains and losses associated with changes in regulatory regimes discussed by Myers, Kolbe and Tye.12 Another solution is to try to finance the project through ‘trended’t” bonds. Trended bonds are bonds whose interest payments are indexed so as to result in lower payments in early years and higher payments in later years. The index itself could be set equal to the general inflation rate, an industryspecific inflation rate or the projected rate of increase in revenue requirements. In either case, the pattern of interest payments will more closely match the pattern of revenues. How much to trend the bonds or whether to trend them at all again depends upon the effect of the deferred revenue scheme on the company’s financial indicators and, ultimately, on its cost of capital. While indexed bonds are fairly common in Europe, they tend to be a novelty in North America. Nonetheless, the presence of other novel types of debt obligations such as floating rate
UTILITIES
POLICY
January
1992
of capital services under regulation
notes, dutch auction preferred stocks, deep discount and zero coupon bonds indicate that there may be a market for ‘trended’ bonds. But when all is said and done large-scale projects not enjoying cost-of-service style revenue collection mechanisms have been financed. In this light, financing problems should not be a fundamental impediment to redefining revenue trajectories under regulation.
Concluding
remarks
In developing trended or phased-in methodologies, we have been and are sensitive to balancing the interests of all the parties involved. We specifically seek to develop a rate structure that is efficient, equitable and financially sound. This involves weighing the interests of ratepayers, regulators, stockholders and bondholders. We recognize that this is not an easy task. Economists tend to suggest pricing solutions that are strictly ‘efficient’ in an economic sense - ie, involve the most efficient use of resources. In the real world, a purely ‘efficient’ solution may neither be possible nor even desirable. Efficiency must be considered alongside with equity, practicality and a number of other constraints. Institutionalizing inflation through regulation may not be seen as desirable. Setting rates based on the economically correct depreciation may result in a pattern of rates that is inconsistent with available forms of financing. We have suggested two solutions to this type of problem: trend a little less or finance the project with trended bonds.
‘Sallv Hunt Streiter, ‘Trending the rate base to reflect inflation: how’, and G. Campbell Watkins, ‘Perspectives on the regulation in R.N. Morrison and R.J. Shultz. eds. of uineline tariffs’. Pip&w Regulatiorl and Inflation: An Evaluation of Tariff Levelling, Proceedings of Conference sponsored by the National Energy Board of Canada and McGill University. Montreal, Canada, November 1982. ‘Formulating tariffs on the basis of economic depreciation is related to the trended original cost (TOC) method of defining the rate base. For careful discussion of the TOC methodology vis-a-vis the original cost methodology (what we refer to as conventional tariff regulation), see Stewart C. Myers, A. Lawand rate of return rence Kolbe and William B. Tye, ‘Inflation regulation’, Research in Transportation Economics, Vol 2, 1985. sp x3-1 19. ‘National Economic Research Set G. Campbell Watkins, Associates and DataMetrics Limited proposals on tariff formulation - a reconciliation’, mimeo, 19X2. “The simplifying assumptions make the derivation of the optimal price structure easier to follow and do not detract from the general form of the solution once the assumptions are relaxed. ‘For ease of presentation we include only our conclusions here. They arc derived in an Appendix available from the authors on request. ‘See Anna P. Della Valle, ‘Intertemporal pricing for the use of
41
The pricing of capital services under regulation capital in production and its relationship to investment and replacement policy’, PhD Dissertation, Columbia University, ‘Optimal depreciation policy: 1984; and William J. Baumol, pricing the products of durable assets’, The Bell Journul of Economics and Managemenr Science, Vol 2, No 2, Autumn 1971, pp 638-656. A: IS computed as an undiscounted end-of-year value. “f is chosen as an index of ‘neutral’ technical change, ie, it reduces capital and labour costs by the same amount so that the capitallabour ratio remains constant. For a more complex (and realistic) form of technical change set Della Vallc, 01’ tit, Rcf 6. ‘As long as the company’s cost of capital does not change as a
42
result of the switch from straight-line to economic depreciation. “‘Note that A; is, by definition, an end-of-year value. Thercforc, to compute the present value of the sum we need to sum the discounted A:s and then discount the sum back one period to the present. “Baumol. up cil, Ref 6. “Myers. Kolbe and Tye, op cil. Rcf 2. %ally Hunt Streiter and Anna P. Della Valle, ‘Indexed bonds and other issues’. presented at the Regulation of Pipelines in an Inflationary Era Conference, sponsored by The National Energy Board of Canada and McGill University, Montreal. Canada. November 1982.
UTILITIES
POLICY January
1992