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 Australia in the regulation of electricity transmission and distribution companies, gas transmission and distribution, railways, postal services, urban water and sewerage services, and irrigation infrastructure. The Australian Competition and Consumer Commission is currently consulting on the introduction of a version of the building block model in the regulation of fixed-line 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 (Victoria)|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 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 (with interest) 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

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):

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

Here: $Rev_{t}$ is the target allowed revenue of the regulated firm in the current regulatory period, $WACC_{t}$ is the appropriate cost of capital (also known as the discount rate) for the cash-flow stream of the firm during the current regulatory period, $RAB_{t-1}$ is the closing regulatory asset base at the end of the previous period (the product of the cost of capital times the asset base is also known as the "return on capital"), $Dep_{t}$ is the regulatory depreciation (also known as "return of capital") in the current period, and $Opex_{t}$ is the expected or forecast operating expenditure of the firm in the current regulatory period.

The revenue equation is embodied, for example, in the "Post Tax Revenue Model" spreadsheet used by the Australian Energy Regulator.

The asset base roll forward equation

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.

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

Here: $RAB_{t}$ is the closing asset base at the end of the current period, $RAB_{t-1}$ is the closing asset base at the end of the previous period, $Capex_{t}$ is the capital expenditure of the firm in the current period, and $Dep_{t}$ is the regulatory depreciation during the current period.

The asset base roll forward equation is embodied, for example, in the "Roll Forward Model" spreadsheet used by the Australian Energy Regulator.

The regulator may choose either the choice of the path of the regulatory asset base, 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 building block model can be applied with all inputs expressed in nominal or real terms, provided the cost of capital is also expressed in consistent nominal or real terms. Similarly, the building block model can in principle be applied over any length of regulatory period provided the cost of capital is set consistently.

The building block model is only useful as a tool for amortizing the expenditure of a regulated firm over time. In almost all applications 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 most applications regulators simply choose a path for depreciation without consideration of the effect on the overall path of allowed revenues. This is a form of cost allocation which has been criticised by economists as having no particular economic significance.

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.

The building block model treats operating expenditure and capital expenditure symmetrically in that the allowed revenue is sufficient to cover both types of expenditure. In this sense the classification of expenditure into operating expenditure or capital expenditure is of no long-term consequence. However if, as is often the case, the regulator implements the building block by choosing a path for depreciation, any change in operating expenditure results in an immediate change in the allowed revenue of the firm whereas a change in capital expenditure is spread (amortized) over time.

Variations and extensions

In practice, the building block model is often 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.

Inflation adjustment of the asset base

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:

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

Where $inflation_{t}$ is the rate of change in a price index over the previous period. 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 or 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.

The simplest way to introduce incentives to reduce expenditure in the building block model is to set the allowed revenue on the basis of the forecast operating expenditure and capital expenditure, and to not "claw back" any over-spend or under-spend at the end of the regulatory period. However, this creates strong incentives to defer capital expenditure - even at the risk of sacrificing service quality. Regulators tend to be wary of creating strong incentives to defer capital expenditure and therefore tend to tolerate weaker incentives to reduce capital expenditure. One common approach is to allow the regulated firm to "roll in" the out-turn capital expenditure into the regulatory asset base at the end of the regulatory period. Problems still remain, however, with the incentive to substitute between capital expenditure and operating expenditure. Many regulatory frameworks also give the regulator a role in assessing the prudency of new capital expenditure.

In addition, where the regulator takes into account past expenditure out-turn information when setting the expenditure target for the next regulatory period, the regulated firm has weaker incentives to seek expenditure savings - especially as the end of the regulatory period approaches. In an attempt to offset weaker incentives at the end of the regulatory period attempts have been made to seek alternative ways to set the expenditure targets in the next regulatory period. One such approach - although not the simplest - is through an "efficiency benefit sharing scheme".

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