Regulatory asset base model

Pinsent Masons
Tue 13th November 2012

Description and overview

The finance cost for infrastructure depends upon the cost of capital (the cost of debt and debt premium and the cost of equity) and that in turn depends upon the allocation of equity risk.

Therefore financing cost depends a great deal upon whether the regulatory system and the role of government are designed to hold down the cost of capital.

In the regulated utilities this is achieved through the Regulated Asset Base (RAB). The RAB is a number which represents past investments, comprising what investors paid when the assets were originally privatised plus subsequent capital expenditure adjusted for depreciation.

Once assets are in the RAB there is nothing that management can do to change their value.

The RAB is an accounting number, protected by the duty which is placed upon regulators to finance the business, including the RAB.

This duty gives rise to an effective guarantee that the regulated company's investment will be recovered over time from consumers.

This guarantee contributes towards making investments in regulated utility companies relatively low risk.

The equity risk in the RAB for the regulated company is zero as the risk has been transferred to consumers who are obliged to pay for the RAB.

If the RAB is guaranteed then it can be financed by debt and the debt is effectively guaranteed by the regulator's financing duty.

Therefore the cost of financing the RAB should be close to that for financing government borrowing. Can the RAB concept be generalised? Particular RABs can be thought of as guarantees that the sunk costs of particular projects can be recovered.

It can be seen as a commitment by future consumers to cover current investment.

Seen this way the RAB model could be extended to pay for the carbon reduction obligation and potentially also roads instead of current users covering the cost on a "pay as you go" basis.

Roads, for example, would need a sale of existing assets to the regulated company.

However, a possible disadvantage of the RAB model is affordability issues arising from passing the risk of sunk costs to consumers and particular impacts upon specific groups of consumers. Social housing has some similarities to the RAB model.

However the HCA as regulator does not have a duty to ensure that the RAB (housing) is financed.

This is achieved instead by the contractual landlord and tenant relationship. Rents are regulated and affordability issues may make the application of RAB difficult.

There may be losses of competition.

The application to social infrastructure may be difficult as consumers of the service generally do not pay for the service.

A transfer of the guarantee to the taxpayer will have inevitable balance sheet implications. Equity is not removed as a consequence of RAB. It is important that undertaking capital expenditure remains sufficiently incentivised.

The capital project itself will be financed by equity and project finance in advance of being sold into the RAB. 

Pinsent Masons – regulatory asset base

Advantages

  • Regulator ensures certainty of cashflows;
  • RAB enables reduction in the cost of capital;
  • User/consumer prices are regulated;
  • Equity still has a role;
  • Regulated company can be "not for profit" so that profits are recycled eg Glas Cymru (Welsh Water).

Disadvantages

  • Focussed only on economic infrastructure/utilities with end users/consumers;
  • Requires a large scale transfer of assets to regulated company;
  • Potential impact on competition within markets;
  • Possible consumer affordability issues;
  • Cost of establishing regulatory function.

Conclusions

The RAB model underpins the utilities industry in the UK.

The assets reside in the private sector and the role of the regulator ensures security of cashflows thereby reducing the cost of capital.

It could be extended to other areas of economic infrastructure although this will require a significant transfer of assets.

The regulatory requirement must be simple and transparent.


Contact Pinsent Masons for more information.


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