Rate-regulated activities

Date recorded:

This was an educational session where staff wanted to highlight the key issues and gain some thoughts and questions from members in preparation for a meeting on Friday 26 July 2013 with the Consultative group.

Background

In March 2013, the IASB published the Request for Information (RFI) – Rate Regulation. The objective was to gather high level overviews of the type of rate regulation currently in force in order to provide factual evidence and examples that will be used to help determine the scope of a discussion paper. In turn this would flag consequences of rate regulation that would be most useful for users of IFRS financial statements and whether to develop specific guidance for accounting for the consequences of rate regulation.

Responses were received from a variety of countries and different industries, all of which tended to be providers of public goods or services. Respondents welcomed the IASB’s decision to investigate a wide variety of rate regulatory schemes; they cautioned the IASB against developing rule based guidance applicable to only certain types of schemes. This is consistent with the Exposure Draft (ED) Rate regulated activities, published in July 2009. The ED focused on a specific type of rate regulation which is becoming less common due to an increasing trend towards incentive based rate regulatory mechanisms. Consequently, respondents encouraged the IASB to identify broader principles that can be applied to a range of regulation. Guidance produced should be sufficiently principle based so an entity will be able to identify when a change in accounting policy is required and what the change would be when a rate regulator makes changes to the rate regulation.

The two types of rate regulation the paper looks at are cost based (commonly known as ‘cost-of-service’ or ‘return-on-base-rate’ regulation); and incentive-based (including price-cap or revenue-cap regulation).

The cost based formula focuses on the entity’s actual input and incorporates the following details:

  • the specific operating costs of providing the regulated goods or services;
  • the specific capital costs of the assets used to provide the regulated goods or services;
  • a specific targeted rate of return on the entity’s capital investment; and
  • variance or deferral accounts of the entity’s deviations between actual and estimated costs and revenue included in the approved rate.

The incentive based formula used to calculate the rate focuses on targeted outputs. The starting point for setting the initial rate is usually ‘benchmark’ or target costs, expenditure and a return rate. The target input measures are then adjusted for inflation and for a variety of output-based objectives, with incentives or penalties applied through the rate formula; and few items are tracked for variances between actual and estimated amounts. Consequently, the risk of changes in demand and input costs is retained by the entity.

From the survey it was evident that schemes do not fall neatly into any one of these categories. A large proportion had aspects belonging to both schemes. In addition, the types of industries identified as subject to rate regulation varied. Within these categories there are further subdivisions and particular industries could be broken down in separate stages. Different levels of rate regulation may then apply to different stages.

Some respondents saw rate regulation as a substitute to competition regulation however staff highlighted that rate regulation had many objectives. The high level objectives are to:

  • protect the interests of consumers by:
    • controlling the price charged to customers; and
    • providing rate stability;
    • maintain the (public) service; and
    • provide investors with a ‘fair rate of return’.

Other qualitative objectives included:

  • improvements in the quality and efficiency of service;
  • increased customer satisfaction;
  • increases in supply capacity and reliability;
  • achievement of environmental goals/reductions in emissions;
  • development of innovative technologies/use of alternative resources;
  • encouragement of competition; and
  • decreases (or increases) in customer demand or usage.

These increasingly complex and cross-cutting objectives lead towards an incentive based regulatory scheme.

The rights and obligations created by rate regulation usually reflect both the objectives of the rate regulation and the public-service nature of the supply. Typically, entities subject to rate regulation have a monopoly right and operate in a predetermined geographical service territory. There may be an explicit right to operate in an area, the cost of which may not be significant however the rate regulation may impose significant obligations on the supplier. Such obligations may require significant expenditure by the supplier, for which regulators may provide the opportunity to recover the cost and earn a fair return. Consequently, the rate-setting mechanism used by the rate regulator must reflect this and provide a reasonable assurance that the supplier will recover its costs and earn a fair return, although it does not guarantee recovery. The reason is that the rate is usually based on expected costs and expected demand. In response, respondents felt the use of deferral/variance accounts would increase assurance that amounts within these accounts could be reversed/recovered. The use of these accounts tracks unexpected variations to provide a further opportunity for the rate-regulated entity to recover the tracked costs (or for the excess recovery to be reversed). This is usually achieved by adjusting the future rate or by making a temporary change to the rate by charging consumers a ‘rate rider’ or ‘rate tracker’ surcharge.

The other issue raised in the survey was that rate-regulated entities cannot cease, suspend, restructure or transfer operations without the approval of the rate regulators, which tends to be explicitly disclosed in the licence.

Discussion

The discussion in the meeting on 24 July started with members commenting on the scope of the project being difficult to determine and re-iterated that schemes did not fall into the two broad categories but had features that would be relevant to both.

One member was keen to understand how material the balances in the deferral or variance accounts are and also if specific accounting guidance was needed. In response, staff stated from the responses received the balances do tend to be material, particularly in the United States of America. Also, rate regulation is an important area to develop guidance for, which is the main purpose of the meeting on Friday with the consultative group.

Another member explained when looking at the rate-setting methodology for services on electricity there are a number of models. The most important aspect is the recovery of costs and more so the timely and prudent recovery of costs, especially in a politically challenging environment. Staff highlighted here that investors tend to invest in companies where they have a regular stream of dividends and rate regulation provides that as it gives a predicted value of cashflows over a period.

Members also highlighted a number of challenges they envisaged. These have been listed below:

  • many entities will have simple transactions;
  • the project on cost based failed in the 2009 ED because it was based on the notion of expectation;
  • the scope needs to be broadened even beyond incentive based mechanisms;
  • there are more and more entities that are subject to rate regulation and to cover all of these the guidance would have to be much wider;
  • rates are based on an estimated amount rather than actuals; and
  • regulation imposes the amount companies can charge.

To integrate all of these factors into a proposal by the end of the year will be extremely difficult. The members wanted to understand what alternative is available to publish something by the end of the year. Staff noted this difficulty and will raise the issue at the meeting on Friday to get some clarification on the exact aspects the paper should deal with.

Another issue emphasised was that accounting standards should consider the implications where governments impose no change to rates. There was also a discussion on the exclusion of some rate regulated industries such as the health care sector, in particular hospitals and nursing homes.

There was much deliberation and the conclusions from the discussion were to focus on the scope for the meeting on Friday, as this is the most critical element of this topic. The aim of this whole exercise is to create general purpose financial statements and to achieve this, focus should be on core principles of rate regulation. To include each and every scenario will be an onerous task, as there will be a large proportion of companies that will be affected by some form of rate regulation.

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