DEPRECIATION & CAPITAL RECOVERY UNDER LIBERALIZATION ITU/BDT ARAB REGIONAL WORKSHOP ON “SECTOR REFORM & LIBERALIZATION” MARCH 9-11, 2004 DR. ALY ELFAR, PROFESSIONAL ENGINEER FARCONSULT INC. OTTAWA, CANADA TEL. 613-825 6611 alyelfar@rogers.com

WILL DISCUSS THE FOLLOWING: REVENUE REQUIREMENT COST/REVENUE ASSIGNMENT DEPRECIATION STRANDED INVESTMENT

REVENUE REQUIREMENT (RR) USED MAINLY WITH WHAT IS CALLED RATE-OF-RETURN (ROR) REGULATION. TWO BASIC STEPS IN THE REGULATION OF PRICES. FIRST STEP IS DETERMINING TOTAL ALLOWABLE REVENUES OR REVENUE REQUIREMENT (RR), I.E. TOTAL COST OF SERVICE. SECOND STEP IS ESTABLISHING OF INDIVIDUAL RATES OR RATE SCHEDULES THAT WILL YIELD THE AMOUNT DETERMINED IN THE FIRST STEP.

RR IS DETERMINED BASED ON EITHER OF: RR = OPERATIONS EXPENSE + DEPRECIATION EXPENSE + TAXES + (RATE BASE*RATE OF RETURN). RATE BASE IS EQUAL TO GROSS VALUATION MINUS ACCUMULATED DEPRECIATION. USUALLY RATE BASE IS BASED ON HISTORICAL COST. RR = OPERATIONS EXPENSE + DEPRECIATION EXPENSE + TAXES + INTEREST PAID ON DEBT + DIVIDENDS ON PREFERRED SHARES + (COMMON SHAREHOLDERS’ EQUITY * RATE OF RETURN ON COMMON EQUITY). REPLACING ROR REGULATION WITH PRICE-BASED (INCENTIVE REGULATION) STARTED IN THE UK IN 1983 & LATER ADOPTED IN THE U.S. & CANADA. REFERRRED TO AS PRICE CAP REGULATION. VARIOUS STEPS ARE GENERALLY NECESSARY TOWARDS ADOPTION OF INCENTIVE REGULATION. EXAMPLES INCLUDE RATE REBALANCING & SPLIT RATE BASE.

COST/REVENUE ASSIGNMENT TO BUSINESS SEGMENTS & SERVICES ACCOUNTING SEPARATION OF THE COMPANY’S REVENUES, INVESTMENT & COSTS TO BROAD SERVICE CATEGORIES (BSC) RECONCILES TO THE COMPANY’S FINANCIAL STATEMENT. ADJUSTED FOR REGULATORY PURPOSES ACCORDING TO REQUIREMENTS IS A TOOL TO DETECT AND QUANTIFY CROSS-SUBSIDY BETWEEN BROAD SERVICE CATEGORIES ASSIGNMENT METHODOLOGY SHOULD SATISFY REGULATORY & MANAGEMENT NEEDS BSCs COULD BE ACCESS, MONOPOLY LOCAL, COMPETITIVE TOLL, COMPETITIVE NETWORK, COMETITIVE TERMINAL MULTILINE & DATA, COMPETITIVE TERMINAL, OTHER & COMMON

STUDY PRODUCES TWO PRINCIPAL REPORTS. AVERAGE NET INVESTMENT BASE REPORT. EQUIVALENT TO BALANCE SHEET FOR THE BSCs REVENUE SURPLUS/SHORTFALL REPORT. EQUIVALENT TO INCOME STATEMENT FOR THE BSCs. SURPLUS/SHORTFALL IS AN INDICATOR OF CROSS-SUBSIDY BETWEEN CATEGORIES.

DEPRECIATION DEPRECIATION MAY REFER TO : DECREASE IN VALUE A COST ALLOCATION PHYSICAL IMPAIRMENT

DEFINITION & OBJECTIVES OF DEPRECIATION DEPRECIATION IS THE EXPIRATION OR CONSUMPTION, IN WHOLE OR IN PART, OF SERVICE LIFE OR UTILITY OF PROPERTY RESULTING FROM THE ACTION OF ONE OR MORE OF THE FORCES OPERATING TO BRING ABOUT THE RETIREMENT OF SUCH PROPERT FROM SERVICE THE FORCES SO OPERATING INCLUDE WEAR & TEAR, DECAY, ACTION OF THE ELEMENTS, INADEQUACY, OBSOLESCENCE, AND PUBLIC REQUIREMENTS. THE TWO TRADITIONAL OBJECTIVES OF DEPRECIATION ACCOUNTING ARE : (1) TO DETERMINE THE EXPENSES ATTRIBUTABLE TO EACH YEAR’S OPERATION; AND (2) TO RECOVER THE CAPITAL INVESTED IN DEPRECIABLE PLANT OVER ITS USEFUL LIFE

DEPRECIATION EXPENSE & RESERVE IN CAPITAL INTENSIVE INDUSTRIES, DEPRECIATION MAY ACCOUNT FOR UP TO 30% OF OPERATING EXPENSES. DEPRECIATION IS A MAJOR DETERMINANT OF: 1- INTERNALLY GENERATED FUNDS 2- BOTTOM LINE INCOME FIGURES 3- REVENUE REQUEREMENTS 4- PRODUCTS & SERVICES PRICES 5- INVESTMENT COMMUNITY LOOK AT THE ENTERPRISE

STRANDED INVESTMENT UNDERDEPRECIATED OBSOLESCENT PLANT WITH NO OR LITTLE FUTURE REVENUE GENERATING CAPABILITIES RECOVERY OF NET CARRYING AMOUNT IS DOUBTFUL VALUE IS LESS THAN NET CARRYING AMOUNT PRESENT VALUE (PV) OF FUTURE CASH FLOWS IS < NBV, OR = PV OF EXPEXTED CASH FLOWS UNDER “FAIR” REGULATION MINUS EXPECTED CASH FLOW UNDER COMPETITION WHEN THE NET CARRYING AMOUNT OF A CAPITAL ASSET, LESS RELATED ACCUMULATED PROVISION FOR FUTURE REMOVAL & SITE RESTORATION COSTS AND FUTURE INCOME TAXES, EXCEEDS THE NET RECOVERABLE AMOUNT, THE EXCESS SHOULD BE CHARGED TO INCOME

CAUSES OF STRANDED INVESTMENT THESE CAUSES ARE NOT MUTUALLY EXCLUSIVE PRICES DECREASE AMOUNT OF OUTPUT DECREASES DURATION OF OUTPUT DECREASES SIGNIFICANT TECHNOLOGICAL DEVELOPMENTS MARKET DECLINE FOR SERVICE OR PRODUCT DUE TO COMPETITION OR OTHER FACTORS INABILITY TO COMPLETE A CAPITAL ASSET UNDER DEVELOPMENT OR CONSTRUCTION CONTRACTUAL, REGULATORY OR LEGAL OBLIGATION. (FUEL, PURCHASED POWER, NUCLEAR DECOMMISSIONING)

MEASUREMENT BOTTOM UP. ASSET BY ASSET APPROACH ASSET NBV MINUS ASSET MARKET VALUE . ONE APPROACH IS TO CALCULATE THE DIFFERENCE BETWEEN CURRENT BOOK VALUE RESERVE USING REGULATORY LIVES & THEORETICAL RESERVE USING “ECONOMIC LIVES” TOP DOWN. LOST REVENUE APPROACH. REVENUE THAT CUSTOMER WOULD HAVE PAID MINUS COMPETITIVE MARKET REVENUE

MITIGATING METHODS WORK HARDER AT DEPERECIATION STUDIES REFLECTING FUTURE USAGE PERIODS & PATTERNS AS WELL AS MARKET & TECHNOLOGICAL CHANGES RATE MAKING PRICING FREEDOM COMPETITIVE TRANSITION CHARGES RENEGOTIATE CONTRACTS