Regulatory Treatment of Inflation: Estimation and Compensation in Framework

1. Regulatory treatment of inflationStamford Plaza, Sydney Airport 14 June 2017

2. Regulatory treatment of inflation Service providers have, the AER’s discussion paper advises, raised two broad questions concerning the regulatory treatment of inflation: Does the current method of estimating expected inflation produce the best estimate? Is there appropriate compensation for inflation in the framework of the AER’s post tax revenue model and the asset base roll forward model? There has been, and will continue to be, much discussion of how best to forecast inflation My focus will be on the second of these questions: Is there appropriate compensation for inflation in the current framework?

3. Principal conclusion The current framework of the Roll Forward Model, Post-Tax Revenue Model and price control mechanism delivers the “correct” compensation for inflation when forecast and actual are the same If actual inflation used in the Roll Forward Model for a given regulatory period is different from the forecast of inflation used in the Post-Tax Revenue Model when it was applied to determine allowed revenue for that regulatory period, the return of capital built into allowed revenue and tariffs will be different from the return of capital built into the roll forward of the Regulatory Asset Base The possibility arises of the service provider under-recovering or over-recovering from users the original cost of its investment

4. Current framework Effects of inflation are explicitly taken into account in three parts of the current framework for determining the revenues earned by providers of regulated services: Roll Forward Model (RFM) Post-Tax Revenue Model (PTRM) Price Control Mechanism Interactions between these three parts of the framework mean that there is more to the regulatory treatment of inflation than how best to forecast inflation

5. Roll Forward Model “Rolls forward” the regulatory asset base (RAB) from the beginning of the current regulatory period to the beginning of the next Actual capital expenditures, in nominal dollars, made during the current regulatory period are added to the RAB Depreciation for the current period is deducted: depreciation is input in real terms but re-expressed, in nominal terms, in the RFM, using actual inflation RAB at the end of the current regulatory period, as calculated by the RFM, is the opening RAB for use in forecasting allowed revenue (using the PTRM) for the next regulatory period

6. Post Tax Revenue Model Models a forecast of the revenue to be allowed to a service provider during the next regulatory period Revenue forecast “built up” from five building blocks: return on the projected RAB depreciation of the projected RAB estimated cost of corporate income tax efficiency gains or losses forecast operating expenditure Each of these building blocks incorporates inflation: current market data used to estimate the nominal rates of return on equity and on debt used to forecast return on projected RAB embed expectations of future inflation explicit forecast of inflation used in calculating depreciation and in forecasting capital and operating expenditures

7. PTRM: smoothing Annual building block revenue requirements calculated in the PTRM vary from one year to the next during the regulatory period, and are “smoothed” within the model In the smoothing process: discounting at the allowed rate of return effectively removes expected and forecast inflation incorporated in the revenue building blocks, along with an implied real rate of return inflation expectations and forecasts incorporated in the building blocks are effectively replaced by an explicit inflation forecast provided as an input to the PTRM This removal and replacement of inflation is not precise expectations of inflation embedded in the return on equity and the return on debt are not known, and cannot be assumed to be the same as the explicit inflation forecast used in the PTRM Smoothing of building block revenue requirements effected using a series of X factors

8. Price control Typically, the revenue which a service provider is allowed to earn in the first year of the next regulatory period is the smoothed revenue from the PTRM The allowed revenue in the second year is then the allowed revenue in the first year adjusted by a smoothing factor X, and by actual inflation: the revenue in the second year is the revenue in the first year multiplied by the product of (1 – X) and (1 + actual inflation) The allowed revenue in each subsequent year is similarly calculated by adjusting the allowed revenue in the preceding year by the smoothing factor for the year, and by actual inflation

9. Summarizing Expectations of inflation are incorporated in the nominal rates of return used in the PTRM The PTRM also uses an explicit forecast inflation for re-expressing capital and operating expenditure forecasts in nominal terms The RFM and the price control mechanism use measures of actual inflation Any re-examination of the regulatory treatment of inflation should consider the interactions between forecast and actual inflation within the framework of the RFM, PTRM and price control mechanism

10. Preliminary observations (1) The current framework of the RFM, PTRM and price control mechanism delivers the “correct” compensation for inflation when: actual inflation, for which compensation is provided through the price control mechanism, is the same as the expectations of inflation thought to be embedded in the rates of return on equity and debt used in the PTRM actual inflation, for which compensation is provided through the price control mechanism, is the same as the forecast of inflation used in the PTRM to calculate depreciation actual inflation, for which compensation is provided through the price control mechanism, is the same as the forecast of inflation used in the PTRM to forecast nominal capital and operating expenditures actual inflation, for which compensation is provided through the price control mechanism, is the same as the forecast of inflation used in the smoothing process of the PTRM

11. Preliminary observations (2) Compensation for inflation “correct” in the sense that the revenue earned by the service provider: is the allowed revenue forecast using the PTRM recovers, over the life of the regulated asset, the investment in – the original cost of – the asset delivers returns on equity and on debt at rates which are the rate of return on equity and rate of return on debt components of the allowed rate of return recovers forecast operating expenditure When actual and forecast inflation are not the same, the current framework of the RFM, PTRM and price control mechanism may not deliver the correct compensation for inflation

12. Compensation for inflation via RFM and PTRM (1) The depreciation calculations of the PTRM use a forecast of inflation: the forecast of inflation used in the PTRM determines the return of capital built into the allowed revenue - and tariffs - for the regulatory period for which the PTRM is applied The depreciation calculations of the RFM use actual inflation: the measure of actual inflation used in the RFM determines the return of capital built into the roll forward of the RAB If actual inflation used in the RFM for a given regulatory period is different from the forecast of inflation used in the PTRM when it was applied to determine allowed revenue for that regulatory period, the return of capital built into allowed revenue and tariffs will be different from the return of capital built into the roll forward of the RAB

13. Compensation for inflation via RFM and PTRM (2) If actual inflation during the regulatory period is less than the forecast of inflation previously made for application of the PTRM, the depreciation in the RFM will be higher than the depreciation in the PTRM: the return of capital built into allowed revenue and tariffs will be less than the return of capital assumed for subsequent roll forward of the RAB The possibility arises, in these circumstances, of higher depreciation in the RFM lowering the RAB at the start of the next regulatory period below the level consistent with the return of capital built into allowed revenue and tariffs: the possibility arises of the service provider being precluded from recovering the original cost of its investment

14. Compensation for inflation via RFM and PTRM (3) Conversely, if actual inflation is greater than the forecast previously made for application of the PTRM, the return of capital built into allowed revenue and tariffs will be greater than the return of capital assumed for subsequent roll forward of the RAB The possibility arises of the service provider recovering from users and amount greater than the original cost of its investment These are issues to which APA Group has recently drawn attention, in proposed revisions to: Access Arrangement for the Roma to Brisbane Pipeline Access Arrangement for the Victorian Transmission System

15. Compensation for inflation via RFM and PTRM (4) Roma to Brisbane Pipeline Source: Roma to Brisbane Pipeline: Access Arrangement submission (Public), September 2016, page 204 The difference between the forecast of inflation used in the PTRM for the period 2012-13 to 2017-18 and actual inflation as used in the RFM, resulted, APA advised, in a loss in value of $10.03 million

16. Compensation for inflation via RFM and PTRM (5) Victorian Transmission System Source: Victorian Transmission System: Access Arrangement submission , 3 January 2017, page 120 APA noted that, as a result of the use of forecast inflation in the PTRM, and actual inflation (for the same period) in the RFM, it was precluded from recovering some $23.9 million of investment in the VTS

17. Compensation for inflation via RFM and PTRM (6) Is the problem – potential under-recovery or over-recovery of the service provider’s investment – corrected through the operation of the price control mechanism? No: the price control mechanism works inconsistently with the inflation adjustment of depreciation in the RFM and the PTRM When actual inflation is lower than forecast inflation, the return of capital is accelerated and depreciation in the RFM is higher than depreciation in the PTRM: the return of capital through the allowed revenue of the PTRM is too low This might be corrected through the operation of the price control mechanism, but that mechanism usually operates to lower the revenue earned by the service provider when inflation is lower

18. Compensation for inflation via RFM and PTRM (7) Conversely, when actual inflation is higher than forecast inflation, the return of capital is deferred and depreciation in the RFM is lower than depreciation in the PTRM: the return of capital through the allowed revenue of the PTRM is too high The price control mechanism usually operates, in these circumstances, to increase the revenue earned by the service provider, when it should lower revenue and lower the service provider’s return of capital Is the problem – potential under-recovery or over-recovery of the service provider’s investment – corrected in the long run? No: the average of actual inflation over the life of the regulated asset may equal the average of forecast inflation and, in some circumstances, the return of capital may equal the original asset cost

19. Compensation for inflation via RFM and PTRM (8) But, assisted by the operation of the price control mechanism, cash flows will be different, regulatory period by regulatory period, resulting in a rate of return on equity, over the life of the asset, which is different from the allowed rate of return on equity

20. Concluding comments There are a number of ways in which the under-recovery or over-recovery of investment, resulting from differences between the forecast of inflation used in the PTRM and actual inflation used in the RFM, might be corrected APA Group noted, in its revisions proposal for the Roma to Brisbane Pipeline, that the flexibility now in the AER’s PTRM to accommodate annual updating of the return on debt could be used, with minimal changes, to also accommodate the annual updating of inflation, so that any difference between forecast and actual inflation was kept small Another option would be to “correct” for the difference between forecast inflation (in the PTRM) and actual inflation (in the RFM) when establishing the opening RAB (in the PTRM) for the next regulatory period

21. Concluding comments Each of these has implications for: the revenue a service provider is allowed to earn whether that revenue recovers, over the life of a regulated asset, the original cost of the asset the rates of return delivered to equity investors and suppliers of debt Better forecasts of inflation should reduce the extent of any under-recovery or over-recovery of investment, but will not solve all of the problems inherent in the current regulatory framework providing compensation for inflation