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Letters to Regulatory Directors
RD08/06 26 April 2006 Dear Regulatory Director REGULATORY CAPITAL VALUES 2006-10 1. Introduction The regulatory capital value (RCV) is one of the critical components underlying price limits. We published in RD07/05 (21 April 2005) the RCVs for 2005-10 following the 2004 determination. This letter updates those RCVs for the changes in inflation. The remainder of this letter explains how we use and calculate companies' RCVs. This is unchanged from RD07/05 but is repeated for completeness. 2. The role of the regulatory capital value The RCV has been developed for regulatory purposes and is primarily used in setting price limits. One of the elements we consider in assessing the revenues that companies need is a return on the capital invested in the business. The value of the capital base of each company for the purposes of setting price limits is the RCV. The value of the RCV to investors and lenders is protected against inflation by increasing the value each year by RPI. The RCV is remunerated through price limits at a cost of capital that we set each time at periodic reviews. We introduced the concept of RCVs in our 1992 consultation paper 'Assessing capital values at the periodic review'. It was developed during the MMC referrals for gas and water companies between 1993 and 1995. The RCV is now widely used by the investment community as a proxy for the market value of the regulated business and has, in some instances, become enshrined in bond covenants. Increasing interest in the RCV has led to pressure for greater transparency of our calculations and judgements, and hence the publication of future RCVs.3. Basis of calculation We have set price limits at periodic reviews in accordance with our duties under the Water Industry Act 1991 (WIA 1991). One of our primary duties is "to secure that companies are able (in particular by securing reasonable returns on their capital) to finance the proper carrying out of the functions of such undertakers". There is no definition of 'capital' in the WIA 1991. The current replacement cost (Modern Equivalent Asset or MEA) valuation of companies' assets at privatisation was around £195 billion (at today's prices). The proceeds from privatisation of the water and sewerage companies was of the order of £8 billion (today's prices). The RCV starts with a direct measure of the value placed on each company's capital and debt by the financial markets following privatisation. This initial RCV is calculated as the average of the market value of each water and sewerage company for the first 200 days for which the shares were listed plus the total value of debt at privatisation. A proxy for the initial market value was used for the water only companies that were not privatised in 1989 (and hence no market information was available). This initial value was taken as the opening value of the RCV for 1990. This initial value is rolled forward each year. The RCV is recalculated annually in outturn prices. The closing value from the previous year is adjusted by the movement in RPI. This inflated figure gives the opening value for the year. Capital expenditure to enhance and maintain the network which is assumed in setting price limits is added to the RCV. Any capital grants or contributions towards the cost of the new assets are deducted. Current cost depreciation (based on the MEA value of the assets) which is assumed in setting price limits is deducted from the RCV each year. Expenditure in any one year to maintain and replace infrastructure assets (infrastructure renewals expenditure [IRE]) is not directly added to the RCV but compared with the infrastructure renewals charge (IRC). The balance, the infrastructure renewals accrual/prepayment, is added to or deducted from the RCV each year. This reflects the extent to which more (or less) money has been spent on maintaining the infrastructure asset base than assumed in price limits. Thus increasing (or decreasing) the value of the capital base to be remunerated. For the period 1990-95, the net additions to the RCV were based upon the assumptions made by the Secretaries of State in setting price limits for the period immediately following privatisation. For all years from 1995 onwards the movements in RCVs are based on the assumptions we make in setting price limits. The assumptions about net new expenditure which we made at the 2004 periodic review (PR04) for each company, are set out in annex 1. They are split between:
4. Outperformance of regulatory assumptions A company has incentives to outperform our regulatory assumptions and earn a higher level of profit than we assumed when setting price limits. Within a five-year cycle, the company had greater incentives to outperform early in the price setting period and to keep the benefits of its efficiencies for longer, before these are returned to customers. This caused unnecessary distortions to the timing of efficiency savings. At the 1999 periodic review (PR99) we introduced a mechanism to provide incentives for each company to improve its efficiency and outperform our regulatory assumptions throughout the five-year price setting period; MD145 – 'The framework for setting prices' (March 1999). We retained this mechanism for the 2004 review. This mechanism, the "rolling incentive allowance", allows the company to keep the benefit of outperformance in any given year for five full years before it is passed on to customers and hence removes the distortions caused by the cycle of price reviews. The RCV is the mechanism used to reflect past capital outperformance and hence transfer the benefit of this to customers through lower price limits. In broad terms the level of outperformance is assessed by comparing net actual capital expenditure and depreciation in the year with our projections. The outperformance adjustment is deducted from the RCV. The reduction in the RCV reduces the capital base on which investors earn a return resulting in lower bills for customers. In effect the benefits of the outperformance are passed on to customers five years after they have been made. The outperformance adjustment is shown as a separate line for each company in annex 1. The calculation therefore reflects companies' outperformance over the period 2000-2001 to 2003-04. The outperformance adjustment is calculated by comparing the capital expenditure (excluding IRE but net of grants) actually incurred in a given year with that assumed in setting prices (plus any agreed logging up for new legal obligations – see section 5). This difference is then adjusted for depreciation using an average asset life for the industry. The difference between the infrastructure renewals expenditure actually reported in the year and that assumed in setting price limits is the final element of the calculation. This is a change from the 1999 review where we instead used the difference between the movement in the infrastructure renewals accrual actually reported and that assumed in price limits. The outperformance adjustment is calculated separately for the water and sewerage services. Provided that in total the company's capital expenditure was less than that assumed in previous determinations, for PR04 we calculated the annual adjustments as set out above and then smoothed these on a Net Present Value (NPV) basis. Where the total actual expenditure for the period exceeded that assumed in setting price limits, the actual expenditure over and above the amount we assumed is not automatically included in the RCV. Where expenditure exceeded the projected level for the service but, at a company level, aggregate expenditure was less than projected, the company was required to explain why the additional expenditure (above the service level) should be included in the RCV. This explanation is needed to both justify the work carried out and to show that the costs involved would stand scrutiny by comparative analysis. Where expenditure exceeded the projected level for the company as a whole, then the company needed to provide clear and incontrovertible evidence to show why the additional expenditure should be included in the regulatory capital value. At the 2004 review some companies underspent against the level of infrastructure renewals expenditure that we determined at the 1999 price review and overspent against the level of maintenance non-infrastructure, within the same service. For these companies, where they provided adequate justification for this in terms of the serviceability of their assets, we allowed a virement of expenditure to maintenance non-infrastructure using the logging up mechanism. This means that companies were not penalised for re-prioritising maintenance expenditure within a service. A small number of companies have a positive outperformance adjustment. This can occur when a company outperformed the 1994 assumptions over 1995-00 but did so with such a profile that there was technically an overspend in 1999-00. This means that a positive adjustment is then made. 5. Basis of the RCVs included in annex 1 The RCVs in annex 1 are in 2005-06 prices. The reconciliation of the opening and closing RCVs uses year end RPI to index from 2004-05 prices to 2005-06 prices. The average RCV is presented using year average RPI to index to 2005-06 prices. The average RCV cannot therefore be calculated as the simple average of the opening and closing RCVs. The indices which have been used to inflate the RCVs to 2005-06 prices are:
We will continue to publish RCVs in this format every year. The values presented will be updated to reflect an additional year's inflation. Change to the RCV between periodic reviews only occurs if a company has an interim determination of its price limits. We will publish RCVs in April each year once the interim determination process is complete and the March RPI is known. Yours sincerely Keith Mason Director of Regulatory Finance and Competition  |
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