Financial Capital Maintenance and Price Smoothing

Financial Capital Maintenance and Price Smoothing

  • Information Paper
  • Project Information

The QCA released the Financial Capital Maintenance and Price Smoothing information paper on 4 February 2014.

Using a mathematical model, this paper illustrates the implications for depreciation and the evolution of the asset value when the NPV=0 principle is applied. An understanding of the principle leads to consideration of how different depreciation profiles can impact prices and raises the issue of the optimal pattern of prices over time.

The principle highlights the importance of considering the allowances for return on and return of capital as a single capital charge and assessing its impact on the profile of charges over the regulatory period.

This paper also found that, in applying smoothing, there can be abrupt and largely arbitrary changes in prices between regulatory periods, depending on the choice of depreciation method adopted when the building blocks revenue is calculated.  This issue may be exacerbated when demand is growing over time.

This paper finds that price smoothing itself does not ensure that prices are optimal over time.

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The project explores the financial capital maintenance (or NPV=0) principle and its implications for depreciation and the evolution of the asset value. It examines the building blocks approach as applied by us and the impact of different depreciation profiles (e.g. straight-line depreciation) on regulated prices.

This project also documents and examines the methods of price smoothing that have been applied by us. A key question is whether price smoothing can be used to produce optimal prices over time.

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