UK Approach for Using Rate of Return Tools in Price Cap Regulation

Three-Step Process

1. Determine rate base for year t, where t is the first year of the new pricing plan
   
2. Project cash outflows (Capex, operating expenses (Opex), and non-operating expenses (Nopex), and unit sales for each year of the new pricing plan
   
3. Choose X factor that will result in revenues that, when discounted, will have a present value that is equal to the discounted cash flows

Example

Offer’s Transmission Price Control Review of the National Grid Company, November 1995

In their 1995 report on Scottish Hydro-Electric plc (HE) the MMC used estimates of operating costs, capital expenditure, asset values and the cost of capital to model the revenues which HE’s distribution business would require over the price control period.

Table 1 shows the MMC’s present value calculation for HE’s price control for the period 1995/96 to 1999/2000. The first three lines contain its allowances for operating costs, network capital expenditure and non-operational capital expenditure. These cash flows were discounted at 7 percent (the MMC’s assumption about the cost of capital) which came to £457.9 million. The MMC then added the present value of the opening less closing asset values of the distribution business, which represented another £128.2 million, giving a total of £586.1 million.

Table 1

MMC’s Calculation of HE’s Distribution Business Costs (1994/95 Prices).

Discussion of Table 1

Asset values were calculated by taking an opening balance in 1990/91 and rolling this forward by adding net distribution network capital expenditure. This was defined as network capital expenditure less depreciation. By the end of 1994/95 this gave a total of £563 million and by the end of 1999/2000 £610 million. The latter figure had a PV in 1995/96 of £434.8 million.

The opening balance of £523.4 million in 1990/91 was consistent with the figure used by the Government in setting the original price control and the initial market value of HE. Table 2 shows the roll forward of the opening balance to £563 million at the start of the price control period in 1995/96.

The total of £586.1 million in Table 1 represented the present value of the revenue that the MMC considered HE would need to raise in order to cover its allowable cash out flows and earn a 7 percent return on its asset value. The MMC calculated that the continuation of the existing price control would raise revenue with a PV of £462.1 million, which fell short of this amount. However, in the case of HE’s distribution business there was an additional source of revenue, the hydro benefit, which could be transferred from the generation business in accordance with Schedule 7 to HE’s license. Taking this into account the MMC decided that an appropriate relationship would be established and maintained if HE’s price control required it to reduce prices by 0.3 percent in 1995/96 followed by reductions of 2 percent a year for the next four years. Table 3 shows the MMC’s projections of distribution business revenue. The PV of revenue and hydro benefit is £586.1 million, which is equal to the PV of costs and return on assets shown in Table 1.

Table 2

MMC’s Calculation of HE’s Distribution Asset Base (1994/95 Prices).

Table 3

MMC’s Projections of HE’s Distribution Business Revenue (1994/95 Prices).

(Source: Appendix D of Offer’s “Transmission Price Control Review of the National Grid Company, November 1995")