Building block model
The building block model is a form of public utility regulation that is common in Australia. Variants of the building block model are currently used in Australia in the regulation of electricity transmission and distribution, gas transmission and distribution, railways, postal services, urban water and sewerage services, irrigation infrastructure, and port access. The Australian Competition & Consumer Commission has stated that it intends to use a version of the building block model to determine indicative access prices for fixed-line telecommunications services. The building block model is so-called because the allowed revenue of the regulated firm is equal to the sum of underlying components or building blocks consisting of the return on capital, the return of capital, the operating expenditure, and various other components such as taxes and incentive mechanisms.
Origin
Although the principles behind the building block approach are very similar to the principles in many other regulatory regimes around the world, the first use of the term in Australia was in 1998 by the Office of the Regulator General in Victoria. The ORG issued a consultation paper on the framework for setting price controls under the 1995 Victorian Electricity Supply Tariff Order, to apply to electricity distribution networks in Victoria from the beginning of 2001. The Tariff Order required the ORG to "utilise price based regulation adopting a CPI-X approach and not rate of return regulation". In a subsequent application for judicial review in the Supreme Court of Victoria, the regulator described the 'building block approach' that it had used to drive the X factor as follows:The court accepted that this 'building block approach' was not rate-of-return regulation:
The ACCC adopted a building block approach in its 1999 draft guideline on how it would set electricity transmission revenue caps under the 1998 National Electricity Code. The approach was subsequently adopted in other sectors regulated by the ACCC and by other state regulators around Australia. Following the replacement of the National Electricity Code with the National Electricity Rules in 2005, the building block approach was confirmed in a 2006 review carried out by the Australian Energy Market Commission. The National Electricity Rules were amended in 2006 to provide that the annual revenue requirement for a regulated electricity transmission network must be determined using a 'building block approach' under which the 'building blocks are:
A similar provision has applied to regulated electricity distributors from 1 January 2008. In 2010, the ACCC issued a draft report proposing to adopt a form of the building block model in the regulation of fixed-line telecommunications services.
The 1998 National Electricity Code did not allow the ACCC to roll forward automatically the value of the regulatory asset base from one regulatory period to the next. By current National Electricity Rules and National Gas Rules, the regulatory asset base is locked-in using the asset base roll forward equation below. The telecommunications regime has also been amended from 1 January 2011 to allow the ACCC to make access determinations that include 'fixed principles'. The amendment will allow the ACCC to lock-in the value of the asset base across regulatory periods.
Basis
The building block model is a tool for spreading or amortizing the expenditure of a regulated firm over time. The building block model, when applied correctly and consistently over time, 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 – which is related to the capital stock of the regulated firm – represents the amount that the firm has, in effect, borrowed from its investors in the past and is therefore the amount that must be paid back to investors 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.
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 plus the return of capital plus the operating expenditure :Here: is the target allowed revenue of the regulated firm in the current regulatory period, is the appropriate cost of capital for the cash-flow stream of the firm during the current regulatory period, is the closing regulatory asset base at the end of the previous period, is the regulatory depreciation in the current period, and 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.
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 that occurs during the regulatory period less any depreciation during the regulatory period.Here: is the closing asset base at the end of the current period, is the closing asset base at the end of the previous period, is the capital expenditure of the firm in the current period, and 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 primary reason for using the building block model can be stated as follows: 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 and provided the regulator chooses a value for the WACC which reflects the firm's true cost of capital 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 is precisely zero.
Description
Early implementations of the building block model in Australia in respect of electricity networks permitted the regulatory asset base to be periodically revalued, using a valuation methodology such as the depreciated optimised replacement cost. This approach does not in general ensure that the regulated firm will achieve an overall net present value of zero. A net present value of zero can, in principle, be achieved on average if the expected or forecast revaluation is anticipated in the depreciation chosen at the start of the regulatory period. In practice, the depreciation has not been set in this way. Periodic revaluation of the regulatory asset base exposes the regulated firm to material risk, creates strong incentives for lobbying for a higher valuation, and may create a problem of under-compensation for upgrade or maintenance capital expenditure. Periodic revaluation of the asset base has replaced been replaced in the current National Electricity Rules by the "lock in and roll forward" approach embodied in the asset-base-roll-forward equation set out above.The building block model is 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.
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 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 with the length of the regulatory period.
The building block model treats operating expenditure and capital expenditure symmetrically in that the allowed revenue is sufficient to cover the sum of both types of expenditure. In this sense, the classification of expenditure into operating expenditure or capital expenditure is of no long-term consequence. If, as is often the case, the regulator implements the building block by first 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 over time.
The building block model is usually applied with a regulatory period lasting several years. The allowed revenue is usually profiled over this five-year regulatory period using a "CPI-X" smoothing mechanism - that is the revenue is allowed to adjust from year to year at the rate of inflation less a constant factor. In this context the X factor is merely a smoothing factor and has no impact on the incentives of the regulated firm. This mechanism ensures smooth real revenues during the regulatory period but since, in practice, jumps in revenues have been allowed between regulatory periods, smooth real revenues are not necessarily achieved overall.
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: