Regulatory treatment of
inflation
Stamford Plaza, Sydney Airport
14 June 2017
Regulatory treatment of inflation
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Service providers have, the AER’s discussion paper advises, raised two broad questions
concerning the regulatory treatment of inflation:
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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?
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There has been, and will continue to be, much discussion of how best to forecast
inflation
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My focus will be on the second of these questions: Is there appropriate compensation
for inflation in the current framework?
Principal conclusion
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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
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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
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The possibility arises of the service provider under-recovering or over-recovering from
users the original cost of its investment
Current framework
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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:
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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
Roll Forward Model
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“Rolls forward” the regulatory asset base (RAB) from the beginning of the current
regulatory period to the beginning of the next
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Actual capital expenditures, in nominal dollars, made during the current regulatory
period are added to the RAB
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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
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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
Post Tax Revenue Model
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Models a forecast of the revenue to be allowed to a service provider during the next
regulatory period
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Revenue forecast “built up” from five building blocks:
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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:
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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
PTRM: smoothing
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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
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In the smoothing process:
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This removal and replacement of inflation is not precise
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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
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
Price control
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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
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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)
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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
Summarizing
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Expectations of inflation are incorporated in the nominal rates of return used in the
PTRM
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The PTRM also uses an explicit forecast inflation for re-expressing capital and operating
expenditure forecasts in nominal terms
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The RFM and the price control mechanism use measures of actual inflation
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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
Preliminary observations (1)
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The current framework of the RFM, PTRM and price control mechanism delivers the
“correct” compensation for inflation when:
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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
Preliminary observations (2)
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Compensation for inflation “correct” in the sense that the revenue earned by the
service provider:
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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
Compensation for inflation via RFM and PTRM (1)
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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
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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
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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
Compensation for inflation via RFM and PTRM (2)
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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
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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
Compensation for inflation via RFM and PTRM (3)
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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
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The possibility arises of the service provider recovering from users and amount greater
than the original cost of its investment
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These are issues to which APA Group has recently drawn attention, in proposed
revisions to:
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Access Arrangement for the Roma to Brisbane Pipeline
Access Arrangement for the Victorian Transmission System
Compensation for inflation via RFM and PTRM (4)
Roma to Brisbane Pipeline
$million, nominal
AER forecast inflation rate
Indexation reflected in
Regulatory Depreciation
Out turn inflation rate
Indexation reflected in Roll
Forward Model
Difference
2012-13
2013-24
2014-15
2015-16
2016-17
Total
2.55%
2.55%
2.55%
2.55%
2.55%
10.65
10.64
10.60
10.51
10.42
2.50%
2.93%
1.33%
1.31%
2.00%
10.44
12.27
5.66
5.72
8.70
42.79
-0.21
1.63
-4.94
-4.79
-1.72
-10.03
52.82
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
Compensation for inflation via RFM and PTRM (5)
Victorian Transmission System
$m nominal
2013
2014
2015
2016
2017
Total
Roll forward model (APA VTS 2016): actual inflation
Inflation
Regulatory depreciation
1.66%
1.33%
1.31%
1.30%
2.00%
2.3
17.7
20.3
23
14.2
2.50%
2.50%
2.50%
2.50%
2.50%
4.9
10.4
12.1
14.8
11.3
77.5
PTRM (AER November 2013)
Inflation
Regulatory depreciation
53.6
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
Compensation for inflation via RFM and PTRM (6)
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Is the problem – potential under-recovery or over-recovery of the service provider’s
investment – corrected through the operation of the price control mechanism?
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No: the price control mechanism works inconsistently with the inflation adjustment of
depreciation in the RFM and the PTRM
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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
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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
Compensation for inflation via RFM and PTRM (7)
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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
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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
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Is the problem – potential under-recovery or over-recovery of the service provider’s
investment – corrected in the long run?
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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
Compensation for inflation via RFM and PTRM (8)
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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
Concluding comments
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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
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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
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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
Concluding comments
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Each of these has implications for:
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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 overrecovery of investment, but will not solve all of the problems inherent in the current
regulatory framework providing compensation for inflation