tew (12.10.18) - Facilitating network investments through rab

1. 1
Facilitating Network Investments
Through RAB
Fatih Kölmek, PhD.
Senior Electricity Advisor
USAID Energy Markets Development (EMD) Project
Energy TransparencyWeek
Kyiv, October 12, 2018

2. 10/17/2018 2
Presentation Outline
• EMD Project brief
• Setting the revenue requirement
• Depreciation and return
• Treatment of RAB
• Financing network investments
• Utilization of network development plans
• Investment and tariff scenario
• Remarks on tariff making

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Energy Markets Development (EMD) Project
• Two objectives:
• the provision of technical assistance for the implementation of the law on the
electricity market as well as the implementation of secondary legislation and the
development of a competitive electricity market
• the provision of legal, technical, financial and transactional assistance to the Kyiv
City State Administration for the municipal district heating utility
• Duration: February 2018 - February 2019
• Budget: $5 million
• Implemented by

4. 10/17/2018 4
Revenue Requirement
• Tariff making can simply be categorized by two approaches
– Cost-based (e.g. cost-plus)
– Incentive based (e.g. price/revenue cap)
• General revenue requirement (RR) formula consists of capital and operational expenditures
(plus taxes if needed)
RR= O + D + RABt *r + T
O : Opex (Operational expenditures)
D : Depreciation
RABt : Regulatory asset base
r :Allowed rate of return
T :Taxes

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Revenue Requirement (cont.)
• Incentive tariff scheme includes targets for Opex, encouraging utilities to reduce the
costs with the motivation of earning extra profit.
Regulatory
Asset Base
(RAB)
Return on
Investment
(ROI)
Regulatory
Return
Depreciation
CAPEX
OPEX
Revenue
Requirement
(RR)
Efficiency
Targets

6. 10/17/2018 6
Depreciation and Return on Investment
• Inclusion of depreciation and return on investment in the revenue requirement formula
serves for covering the costs of;
– investment through depreciation
– financing (i.e. using equity or loan borrowing) through return
• Therefore,“regulatory depreciation” is different from “depreciation for accounting purposes”
– if the cost of an asset is not paid by the utility then there is no need to recognize a
depreciation cost for this asset in the revenue calculation.
– providing depreciation cost for an asset not included in the RAB is inconsistent
with the RAB approach.

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Treatment of RAB
• RAB is the value of assets used in providing regulated
services (used & useful)
• Opening (ORAB) and closing values (CRAB) of RAB
for a tariff year (t) depends on investment made and
assets disposed in that year in addition to
depreciation
• ORAB and CRAB plays a key role on calculation of
the return on investment
• Common practice is to use a mid-year RAB value in
the revenue requirement formula
RR= O + D +RABt*r + T
where RABt = (ORABt+ CRABt)/2
Opening RAB
(ORAB)
Investment
Closing RAB
(CRAB)
Depreciation
Asset
Disposal

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Financing Network Investments
• Total cost of an investment is paid through the tariffs via;
– depreciation (value of an asset is paid in years during the depreciation period, which
is not necessarily equal to the lifetime of that asset – in general shorter)
– allowed return (i.e.WACC) to account for the cost of equity and loans (in general
calculated via capital assets pricing methodology – CAPM)
• An investment is the cost of a new asset, which can be due to expansion (i.e. totally new
network component) or replacement (of an existing network component) as long as it is
approved in the network development/investment plan
• Tariffs should accommodate the “real” financing conditions for investments in a “fair” and
“transparent” scheme for consumers

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Financing Network Investments (cont.)
• Operators need money to make the investments (using equity and/or loan)
• Several factors needs consideration to have sound conditions for financing
– return on investment (recognition of capital costs – real vs. nominalWACC)
– depreciation period (payback period vs. useful lifetime)
– including assets under construction in RAB (i.e. providing income for the cost of investments to
be completed during the year)
– tax issues (tax due to accelerated depreciation) - RR= O + D + RABt *r + T
• Multi-year network development plans can play a key role
– preparation and approval of the investment program
– determination of ORAB and CRAB values for RAB implementation
– improvement of the service quality and cost structure that directly benefit the consumers
through incentive tariff mechanisms (e.g. via setting loss and performance targets for utilities)

10. 10/17/2018 10
Utilization of Network Development Plans
• Scenario
– 5-year regulatory period
– 500 M $ new investment (e.g. 100 M $ each year) – the utility prepared its multi-
year development/investment plan considering the demand scenarios and the
performance targets (losses, cost-efficiency, etc.) set by the regulator, the plan was
approved
– Cost of existing network has been fully paid by the consumers through the tariffs in
the past (i.e. start with a clean slate – “0” initial RAB value)
– 10-year depreciation period to facilitate investments (different than asset life-
times/depreciation periods for accounting purposes)
– Assets under construction are included in the RAB (not wait for their
commissioning) to facilitate financing of the investments
– WACC set as 10 % (real)

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Calculations for RAB, Depreciation and Return
• Proposed scenario leads to following calculations
Tariff Implementation (Regulatory) Period
RAB Calculations (M USD) Year 1 Year 2 Year 3 Year 4 Year 5
Opening RAB 0 90 170 240 300
Investment 100 100 100 100 100
Depreciation 10 20 30 40 50
Closing RAB 90 170 240 300 350
Mid-Year RAB 45 130 205 270 325
WACC 10.00% 10.00% 10.00% 10.00% 10.00%
Regulatory Return 4.5 13 20.5 27 32.5
Depreciation + Return 14.5 33 50.5 67 82.5
Opening
RAB
(ORAB)
Investment
Closing RAB
(CRAB)
Depreciation
Asset
Disposal

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Calculations for RAB, Depreciation and Return (cont.)
• Long-term look to depreciation of the investment in first regulatory period (i.e. 5 years)
1. Tariff Implementation (Regulatory) Period 2. Tariff Implementation (Regulatory) Period 3. Tariff Implementation (Regulatory) Period
RAB Calculations (M USD)
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 Year 13 Year 14 Year 15
Opening RAB 0 90 170 240 300 350 300 250 200 150 100 60 30 10 0
Investment 100 100 100 100 100 0 0 0 0 0 0 0 0 0 0
Depreciation 10 20 30 40 50 50 50 50 50 50 40 30 20 10 0
Closing RAB 90 170 240 300 350 300 250 200 150 100 60 30 10 0 0
Mid-Year RAB 45 130 205 270 325 325 275 225 175 125 80 45 20 5 0
WACC 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00%
Regulatory Return 4.5 13 20.5 27 32.5 32.5 27.5 22.5 17.5 12.5 8 4.5 2 0.5 0
Depreciation + Return 14.5 33 50.5 67 82.5 82.5 77.5 72.5 67.5 62.5 48 34.5 22 10.5 0

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Important Issues for Proposed Scheme
• Operational costs of “old” assets (not included in RAB) continues to be covered through
OPEX in tariffs
• When accelerated depreciation is utilized to support investments for upgrade of the
distribution grid, then an additional tax component can be included in the revenue formula to
account for taxes due to “income-cost gap” as a result of accelerated depreciation
• Assets under construction are included in RAB (i.e. utilities start to recover the cost of
investments during their construction).Therefore ex-post investment audits are needed to
ensure that investments are made and revenues for the following years are adjusted
downwards in case some investments are not completed (with some interest to account for
the real value of the provided capital)
• Revenue adjustments are made for return on investment due to inflation (since realWACC was
provided for investment comfort)

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General Remarks for Tariff Making
• Network service is a natural monopoly. Setting network tariffs is very important considering their
impacts on end user prices.
• “Incentive based tariffs” implies an approach leaving regulated entities “flexible” in their operations
while being “accountable” via tariffs with “performance targets”
• Performance targets should not be limited to penalties and include rewards as well
• Benchmarking is an helpful tool for improving cost efficiency. Simple or sophisticated methods are
available (e.g. Data EnvelopmentAnalysis or Stochastic Frontier Analysis)
• Multi-year network development plans can serve for several goals (e.g. reliability, efficiency, losses,
investment plan, revenue requirement, etc.)
• Regulatory audits are key to ensure service quality, consumer satisfaction and proper tariff making
• Market liberalization is “for the benefit of consumers”.Tariffs and related regulations are meaningful as
long as they aim to provide “reliable” and “affordable” energy in a fair scheme.

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Thank you!
Fatih Kölmek, PhD.
Senior Electricity Advisor
USAID Energy Markets Development (EMD) Project
fatihk@unops.org