The QCA paper has explored the financial capital maintenance principle (also known as the NPV=0 principle) and has documented methods of price smoothing that have been applied by the QCA. This work was motivated by the need to document methods we have applied and to highlight a number of issues that may arise in the context of determining price paths over time.
The financial capital maintenance (or NPV=0) principle refers to the requirement that the present value of expected regulated returns for an asset over its economic life should be equal to the initial asset value or purchase cost. This principle forms the basis for the building blocks model of regulation as applied by the QCA.
A smoothed revenue or price path is typically obtained by regulators adjusting the building blocks annual revenue requirement.
This project analyses the approach that we have applied for ensuring the NPV=0 principle is met, and methods of price smoothing that have been applied by us.
The paper shows how different depreciation profiles can impact prices and discusses the issue of the optimal pattern of prices over time.
The QCA released an information paper on the financial capital maintenance and price smoothing 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.
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.