ROR – Part 1

Principles and Techniques of Using ROR Instruments

Background

Regulators frequently assess company’s earnings in regulating rates. This may be done to determine ‘fair and reasonable’ rates under rate of return regulation, to set initial prices for price cap regulation, to evaluate performance during price reviews, and to measure earnings for incentive schemes such as sliding scale. This section describes the principles and tools of assessing rate of return (ROR). The focus is on treatment of capital investment and determination of rate base (also called asset base or regulatory capital) and revenues required to achieve target earnings.

Ways of Using ROR Tools

To constantly monitor company earnings and allow price adjustments to keep the realized rate of return in line with what is allowed.

The Federal Communications Commission in the US practiced ROR regulation by:

• Having companies forecast next year’s costs and demand
• Setting prices that would cover the forecasted costs, given the demand
• Having companies report actual costs, demand, and revenue every three months
• Adjusting prices downward and requiring refunds to customers if profits during the three months were greater than the cost of capital
• Adjusting prices upward if profits during the three months were lower than the cost of capital and if low profits were expected to continue

To adjust price levels in a rate case setting

To adjust price levels in a rate case setting, state commissions in the US practice ROR regulation by having a price review if a utility asked for a price review because its profits were lower than its cost of capital. The commission or a consumer group asked for a price review because they believed the utility’s profits were higher than the cost of capital.

To review past efficiency assumptions during a price review.

UK regulators use rate of return tools in their price cap regulation (PCR).The regulator forecasts earnings and establishes price indices that would allow the company to receive its cost of capital

To set initial prices for PCR.

Some regulators use ROR tools for setting initial prices when going into PCR, to ensures that the initial prices cover the cost of capital.

To keep net present value (NPV) of cash flows earning a particular rate of return.

Manila in the Philippines has two 25-year concessions for water and sewerage. In these concessions, the assets remain in the public sector. The regulator enforces a price cap in which prices rise automatically with inflation. There are price reviews every five years. The concession stipulates that the NPV of cash flow is to be zero over the life of concession.

Elements of rate of return tools

ROR regulation combines a company’s costs and allowed ROR to develop a revenue requirement. This revenue requirement then becomes the target revenue for setting prices.

The basic formula for determining revenue requirement is:

R = B • r + E + d + T

where:

R = revenue requirement
B = rate base. The amount of capital or assets the utility dedicates to providing its regulated services. Accumulated depreciation is subtracted from gross assets to arrive at the rate base.
r = allowed rate of return. The cost the utility incurs to finance its rate base. This includes both debt and equity.
E = operating expenses. Costs of items such as supplies, labor (not used for constructing plant), and items for resale that are consumed by the business in a short period of time -- for example, less than one year.
d = annual depreciation expense. Annual accounting charge for wear, tear, and obsolescence of plant.
T = taxes. All taxes not counted as operating expenses and not directly charged to customers. May or may not include income taxes depending on accounting rules for income taxes. For example in the US, depreciation and other items are treated differently for income tax purposes than for regulatory purposes. As a result, income taxes are normalized for regulatory purposes, meaning that they are included in revenue requirement before they are actually paid.

Example

Rate base (B) $500,000

• Allowed rate of return (r) 12%
• Allowed return (B • r) $60,000
• Expenses (E) $120,000
• Depreciation expenses (d) $25,000
• Taxes (T) $3,000
• Revenue Requirement (R=E+d+T+B•r) $208,000

Note that these elements can be placed in different orders to fit a country’s regulatory system.

For example, Actual rate of return = (Revenue-E-d-T)÷B.