Building block model

The building block model is a form of public utility regulation that is common in Australia. Various forms of the building block model are currently used in the regulation of electricity transmission and distribution companies, gas transmission and distribution, railways, postal services, and irrigation infrastructure. A version of the building block model is expected to shortly be applied in the regulation of telecommunications services. The building block model is so-called due to the way that the allowed revenue of the regulated firm is built up from underlying components or building blocks consisting of the "return on capital", the "return of capital" or depreciation, and the operating expenditure.

Origin

Although the ideas behind the building block approach can be found in many other regulatory regimes around the world (especially the UK), the first use of the term in Australia was in 1998, when the Essential Services Commission of Victoria established the framework for the regulation of electricity distribution networks in Victoria . Subsequently, the Australian Competition and Consumer Commission adopted a building block approach in its 1999 draft Statement of Regulatory Principles for the regulation of electricity transmission businesses.

The Basic Model

The building block model, in its simplest form, is a tool for spreading or amortizing the expenditure of a regulated firm over time. The building block model ensures that the firm earns a revenue stream with a present value equal to the present value of its expenditure stream. Put another way, the building block model, in its simplest form, ensures that over the life of the firm, the cash-flow stream of the firm has a net present value equal to zero.

The building block model makes use of the concept of the regulatory asset base. The regulatory asset base represents the amount that the firm has, in effect, borrowed from its investors in the past (that is, the amount to which its past expenditure has exceeded its past revenue) and is therefore the amount that must be paid back to investors over the remaining life of the firm.

In its simplest form, the building block model can be expressed as two equations, the "revenue equation" and the "asset base roll forward" equation.

The "revenue equation" is an expression which relates the allowed revenue of the regulated firm to the sum of the return on capital (the appropriate cost of capital multiplied by the regulatory asset base) plus the return of capital (also known as the depreciation) plus the operating expenditure (in addition, in many applications of the building block model there are other terms, such as compensation for tax liabilities):

$Rev_{t}=WACC\times RAB_{t-1}+Dep_{t}+Opex_{t}$

The "asset base roll forward equation" is an expression which relates the closing regulatory asset base at the end of the period to the opening asset base at the start of the period plus any new capital expenditure less any depreciation.

$RAB_{t}=RAB_{t-1}+Capex_{t}-Dep_{t}\,\!$

In the above expressions, the regulator retains discretion over either the choice of the path of the regulatory asset base, or the choice of the path of depreciation, or the path of the allowed revenue of the firm over its life. Provided the regulator chooses a path of the regulatory asset base which starts at zero before the firm incurs any expenditure and ends at zero after the end of the life of the firm (or, equivalently, provided the sum of the allowed depreciation each period adds up to the total capital expenditure of the firm) then the resulting path of allowed revenue given by the equations above has the property that the net present value of the cash-flow of the firm (that is, the revenue less the expenditure) is precisely zero.

The model works equally well whether the values in the model are chosen to be in real or nominal terms, and whatever value is chosen for the length of the relevant period (provided the cost of capital / discount rate is chosen to match).

The building block model is only useful as a tool for amortizing the expenditure of a regulated firm over time. In almost all cases there is an infinite number of ways of carrying out that amortization - which are reflected in the building block approach in the discretion of the regulator over the choice of the path of the regulatory asset base or the path of depreciation. The building block model does not determine the "efficient cost" of providing a particular service in a given year.

In addition, the building block model does not determine individual prices. Once the building block has been used to determine a particular choice of the revenue allowance of the firm in a given year, the regulator must use some other process or mechanism to yield individual regulated prices). Usually those prices are chosen in such a way that, when using those prices, the regulated firm is forecast to recover a revenue stream equal to that given by the building block model.

Variations and extensions

In practice, the building block model is modified in various ways - particularly to create desired incentives on the regulated firm. These variations include adapting the model to a five-year regulatory period and the introduction of various explicit incentive mechanisms.

One common variation of the standard building block model is the introduction of an inflation adjustment to the asset-base roll forward equation, as follows:

$RAB_{t}=(1+inflation_{t})\times RAB_{t-1}+Capex_{t}-Dep_{t}$

This variation is usually combined with an equal-and-offsetting change in the revenue equation (specifically the use of a real rather than nominal cost of capital / discount rate) so as to have no effect overall.

Incorporating incentives

The building block model can be implemented in such a way that the regulated firm receives a revenue stream just equal in value to the firm's out-turn expenditure. However, this is usually considered undesirable since it would result in the firm having no incentive to improve its overall efficiency or to increase the volume or quality of the services it provides. To overcome this problem the building block model is usually implemented in such a way that allows the firm financial rewards for pursuing desirable objectives - such as reducing its expenditure.

Cost of capital

Main article: Cost of capital

The building block model is a tool for amortizing the expenditure of a regulated firm in such a way that the expected net present value of any new investment is zero. For this to be achieved the regulator must choose the cost of capital in the revenue equation to be the correct cost of capital or discount rate for the associated cash-flow stream of the firm.

The building block approach versus index-based approaches

For many years there has been an on-going debate in Australia over whether or not the building block approach to regulation should be replaced with an approach to regulation in which the allowed revenue of the regulated firm is determined on the basis of its past revenue allowance together with productivity changes for the regulated industry as a whole. This latter approach has been known as a Total Factor Productivity or Index-Based approach to regulation.

Advocates of the TFP or index-based approaches to regulation have claimed that it would result in more powerful incentives and lower regulatory costs.

External links

• example.com