NSP Inputs for Use in Economic Benchmarking AER Economic Benchmarking Workshop #3 20 March 2013...

NSP Inputs for Use in Economic Benchmarking

AER Economic Benchmarking Workshop #3

20 March 2013

Denis Lawrence and John Kain

www.economicinsights.com.au 2

Data requirements

• Require data on the price and quantity (and hence value) of all outputs and inputs and on the quantities of operating environment variables (noting that output prices may be shadow prices where the output is not explicitly charged for).

• This then allows any of the key economic benchmarking methods to be implemented.

• Given its tops-down nature, it is important to concentrate on a relatively small number of key outputs and inputs in economic benchmarking

• Desirable to have robust and consistent data • Data backcasting may be possible and facilitate early use


Different types of inputs

• Non-durable versus durable inputs• Opex (labour, materials and services) versus capital (lines,

cables and transformers)• Different treatment of these inputs required in economic

benchmarking studies• Obtaining price and quantity of non-durable inputs is relatively

straightforward• But obtaining accurate annual cost and quantity of capital

inputs is more challenging• Capital service flow is the quantity of capital inputs’

contribution to production each year• Annual user cost is cost of using capital inputs each year


• An asset’s capital service flow will depend on its physical depreciation profile

• If there is no physical depreciation over asset life then the profile is said to be ‘one hoss shay’ or ‘lightbulb’ type

• If there is more physical depreciation over time then profile could be of the geometric, straightline or hyperbolic type

• Distinction between physical depreciation profile and regulatory depreciation profile

• Capital service flow is unobservable so need proxy measures – usually assume it to be proportional to the capital stock

• Best aggregate capital service flow proxy will depend on physical depreciation profile of components, robustness of data used, whether aggregate profile mirrors components

Capital input quantities


• Annual user cost of capital consists of: depreciationplus opportunity costminus capital gains

• Equivalent building block concepts are return of capital (depreciation less inflation allowance) and the return on capital (opportunity cost)

• Building blocks also implicitly include concept of ex-ante financial capital maintenance based on RAB and WACC

• Preferable to have (approximate) consistency between the ways annual capital costs are calculated in building blocks and economic benchmarking

Annual user cost of capital


• Relevant capital input measures for economic benchmarking are capital service flow and annual user cost of capital

• Capex only measures additions to capital stock each year• It is therefore not appropriate to use capex (nor ‘totex’) as an

input in economic benchmarking studies• Focus of economic benchmarking will be on the efficiency of

operating and maintaining the network • Therefore NSP inputs used for the construction of capital

assets should be excluded to avoid double counting • Some grey areas such as treatment of pole replacement

Items excluded


1) input coverage is comprehensive and non–overlapping

2) measures of capital input quantities are to accurately reflect the quantity of annual capital service flow of assets employed by the NSP

3) capital user costs are to be based on the service provider’s regulatory asset base (RAB) and should approximate the sum of the return of and return on capital components used in building blocks, and

4) be consistent with the NEL and NER

Input selection criteria


OPEX INPUTS


Opex coverage

• Are separate data on labour, materials and services available?

• Given extent of contracting out, generally use aggregate opex

• Diverse composition requires deflating opex by a price index to derive the quantity of opex inputs indirectly

• Sometimes need to remove accounting adjustments that do not reflect opex input usage that year

• Need uniform treatment of asset refurbishment and allocation of corporate overheads

• Need some consistent disaggregation of opex to allow consistency checking and to provide more information

• Do we need to allow for differing system structures and opex coverage across NSPs?


Opex price index

• Around 60% of opex is typically made up of labour costs• Remainder covers operational, office and professional

services and consumables• NSP-specific price indexes generally not available • Use ABS broad EGWW sectoral and economy-wide price

indexes instead • Ongoing debate over whether labour price index should

be AWOTE or LPI• Use combination of Producer price indexes for rest of

opex – reclassification by the ABS often necessitates index splicing

• Do opex input price levels vary across NSPs? • How representative are the high level price indexes of the

price changes NSPs actually face?


Opex specification

Quantity Cost Price

Nominal opex / Weighted average price index

Opex (adjusted to remove accounting items not reflecting input use that year)

Weighted average of an ABS labour price index and several ABS producer price indexes

Advantages- Uses readily available data- Unlikely to be any practical alternativesDisadvantages- Dependent on changes in ABS sectoral and economy-wide price indexes accurately reflecting changes in opex prices faced by all NSPs- Assumes all NSPs face the same levels of opex component prices- Assumes the same range of opex coverage and functions for all NSPs


CAPITAL INPUTS


Capital input quantities

• Capital service flow is not directly observable – have to use proxy measures instead

• No proxy measure will be perfect – all have pros and cons

• Best proxy measure will depend on: Physical depreciation profile of constituent assets Robustness of the data used to form the proxy – the

more accurate the better and the fewer assumptions that have to be made, the better

Whether depreciation profile of the aggregate mirrors that of the components


Physical depreciation profiles

• Important to distinguish between physical and financial regulatory depreciation

• Asset physical ‘carrying capacities’ can have one of four different physical depreciation profiles: one hoss shay (no reduction in carrying capacity

throughout the asset’s life) hyperbolic (small decline in early years, larger decline

in later years of the asset’s life) straight–line (ie equal absolute reduction each year of

the asset’s life), or geometric (equal percentage decline over lifetime, ie

bigger absolute falls in early years and smaller absolute falls in later years)


NSP asset physical depreciation

• NSP assets subject to little physical deterioration over their lifetime provided they are properly maintained

• Failure rates may be higher towards the end of asset life leading to Weibull distribution of asset ages

• But service flow relatively constant over the asset’s life meaning one hoss shay depreciation is closest

• Can approximate service flow under one hoss shay by using physical measures (eg MVA-kms) or gross capital stock in constant prices

• Using constant price depreciated asset value proxies assumes depreciation profile other than one hoss shay

• If the decay of the asset over time is overestimated by the proxy then efficiency will also be overestimated


Data robustness

• Critical to have accurate input quantity measures• Best to minimise reliance on indirect measures where

quantities derived by deflating value by a price index• Capital goods price indexes are particularly problematic• EGWW sector prices may not be close to prices actually

paid by NSPs• Also small sample and lumpiness problems• Starting asset value data may not be consistent and often

adjusted – particularly a problem for long lived assets• Asset value proxies assume constant asset lengths of life

but regulatory depreciation rates have varied widely through time for some NSPs, across NSPs and sources

• Asset register data likely to be the most accurate data available


Asset aggregation

• US BEA advanced ‘portfolio effect’ example in support of its use of geometric depreciation and a constant price depreciated asset value for macro productivity data

• But the US BLS is the main US productivity agency and it has been at the forefront of using a ‘productive capital stock’ proxy based on the hyperbolic physical depreciation profile

• ABS and SNZ also use the BLS hyperbolic model which is closer to one hoss shay for structures

• Aggregation issues also not likely an issue for NSPs given more bunched nature of network roll-outs and few NSPs

• Include 4 asset categories: overhead lines, underground cables, transformers and other capital

• Use MVA-kms to aggregate up lines and aggregate up cables, KVA to aggregate up transformers


RAB depreciation as a proxy

• AER Issues Paper raised possibility of using real RAB depreciation as a proxy for service flow

• This has some similarities to a physical quantity based one hoss shay proxy

• But it would need to be converted to capital goods constant prices rather than the CPI constant prices used in RAB calculations

• It would have the same limitations as other indirect proxies, namely differences in the basis of initial valuations, differing assumed asset lives across NSPs, over time and across sources, and the need to rely on sectoral capital goods price indexes that may not well approximate the prices paid by NSPs


Conclusion on capital quantities

• While no capital service flow proxy will be perfect, the use of physical quantity based proxies appears best on a number of grounds:They reflect the one hoss shay physical depreciation

profile of individual NSP assetsAsset register data is likely to be the most accurate

data available and will more accurately reflect actual asset lives

They are the available proxy that comes closest to approximating the hyperbolic profile used by leading statistical agencies for aggregate structures

• The constant price RAB depreciation proxy is likely to be the second best proxy – this option is subject to further investigation


Capital annual user costs

• Annual user cost can be measured either directly or indirectly

• Direct approach applies formula taking in depreciation rate, opportunity cost rate and rate of capital gains

• This produces an exogenous measure of the ex ante or shadow annual user cost

• Most exogenous formulas used to date differ from building block return of and return on capital calculations

• Indirect approach simply takes residual of revenue minus opex as the annual user cost

• It is an ex post measure of the annual user cost and will not be FCM-consistent except by chance

• The annual user cost used in economic benchmarking should be similar to the building blocks return of and return on capital components


Alternative capital specifications (1)

Quantity Annual user cost Price

O/H MVA-kmsU/G MVA-kmsTransformers & other KVA

Return of & on O/H capitalReturn of & on U/G capitalReturn of & on Trf & other capital

O/H AUC/MVA-kmsU/G AUC/MVA-kmsTrf & other AUC/KVA

Physical proxies

Advantages- Reflects individual component carrying capacities- Uses the most robust data available and captures actual asset lives- Approximates productive capital stock used by leading statistical

agencies for aggregate structures

- Ensures consistency with building blocks calculationsDisadvantages- Small amount of extra data required- May not fully reflect aggregate depreciation profile




Nominal RAB depreciation/ABS CGPI

Return of & on capital AUC/Const price RAB depreciation

RAB depreciation proxy

Advantages- Potentially reflects individual component carrying capacities- Potentially approximates productive capital stock used by leading

statistical agencies for aggregate structures

- Uses existing regulatory dataDisadvantages- Assumes consistency of treatment over time and across NSPs- May not capture actual asset lives- Dependent on accuracy and consistency of initial capital base values- Dependent on ABS CGPI accurately capturing prices paid by NSPs




Nominal depreciated RAB/ABS CGPI

Revenue minus opex AUC/Const price depreciated RAB

Depreciated RAB proxy

Advantages- Easy to implement- Uses existing regulatory dataDisadvantages- Unlikely to reflect carrying capacities of assets- Dependent on accuracy and consistency of initial capital base values- Assumes consistency of RAB treatment over time and across NSPs- May not capture actual asset lives- Dependent on ABS CGPI accurately capturing prices paid by NSPs- Unlikely to be consistent with financial capital maintenance

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NSP Inputs for Use in Economic Benchmarking AER Economic Benchmarking Workshop #3 20 March 2013...

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