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Rate-regulated activities

Date recorded:

Rate-regulated Activities – Developing the basis for the model - Agenda paper 9

Background

This was an education session.

The paper largely discusses how the characteristics of defined rate regulation support the conclusion that the supplementary rights and obligations created by the rate adjustment mechanism in a regulatory agreement meet the definition of assets and liabilities in the Conceptual Framework. The Staff also reiterate why they think it is appropriate to structure the model as an IFRS 15-supplementary model instead of applying an intangible asset approach. These aspects have been discussed previously.

Staff analysis

The Staff preliminarily describe defined rate regulation as having the following characteristics:

  1. It establishes a basis for setting the regulated rate chargeable by an entity to its customers;
  2. It includes a rate adjustment mechanism;
  3. It is binding on both the entity and the rate regulator;
  4. It establishes minimum service levels or other service requirements; and
  5. It imposes limitations on entry into an industry (and exit from it).

Consistent with previous discussions, the Staff believe that the rate adjustment mechanism is an essential feature of defined rate regulation. The binding nature of the regulatory agreement ensures that the supplementary rights and obligations to charge a higher or lower price in the future created by the rate adjustment mechanism have the potential to:

  • provide economic benefits to the entity that are not available to other entities, and
  • oblige the entity to transfer economic resources that it would otherwise not have had to transfer.

The rate adjustment mechanism also differentiates defined rate regulation from normal competitive markets and from market regulations. In normal competitive markets, the right to set prices does not produce economic benefits beyond those available to all other parties, and any market constraints on setting prices do not impose an obligation on the entity to decrease prices. As for market regulations, the regulator’s intervention is usually restricted to imposing a cap on the price that can be charged for the specified goods or services, without establishing the total amount of revenue or profit that an entity can earn.

The establishment of minimum service levels ensures that an entity cannot reduce service levels to nullify the effect of a future reduction in the regulated rate.

The limitations on entry into an industry ensure that the entity’s supplementary rights have the potential to produce economic benefits beyond those available to all other parties. This is because if the regulated services were open to competition, other parties would also have the right to charge an increased rate in the future.

Next steps

The Staff will discuss what combination of the above characteristics is sufficient to determine the scope of the model in a future paper.

In addition, the Staff will discuss how the regulatory assets and liabilities recognised under the model should be presented on the statement of financial position, as well as how the regulatory adjustments should be presented in the income statement in a future meeting.

Discussion

Several Board members were still not completely satisfied that the regulatory rights and obligations meet the definition of assets and liabilities in terms of the revised CF.

A Board member who voted against the publication of the July 2009 Exposure Draft Rate-regulated Activities repeated at length the objections he had raised at that time. His objection lay in the view that it is difficult to establish a direct link between the regulatory right or obligation and the entity’s future cash flows. This is because the pattern of cash flows is often complicated by the time lag between the submission and approval of the rate changes; differences between expected and actual transaction volumes; different classes of customers subject to different rates; and activities that are subject to different regulations.

Another Board member who also objected to the publication of the ED agreed that the concerns raised then are still valid now but admitted that he could get to a different answer. He did, however, pose the following scenario for consideration: assume a non-rate regulated entity enters into a contract with a customer and promises to adjust the price of a future contract, if there be one, depending on the actual outcome of the current contract. Assume further that the entity is the sole supplier of the good/service and the item is essential to the customer’s business. Under the existing Standards, the entity would not be able to recognise an asset or a liability for the future price adjustment arising as a result of the current contract. How is a rate-regulated entity different then? The regulator does not ensure future demand. In neither case is there a guarantee that the entity will sell more goods in the future to enable it to charge a higher (or lower) price. The question is then this: does the presence of a regulatory agreement change the economics of the two entities sufficiently to justify the recognition of an asset and a liability for the regulatory rights and obligations respectively? Several other Board members seconded his question and the Staff agreed to explore this further.

In response to the lack of a direct link between the cash flows and the regulatory rights and obligations, the Staff said that from their review of many regulatory agreements, they could see that it is common for the agreements to stipulate detailed mechanisms for tracking the base rates used and the regulatory adjustments.

Another Board member asked the Staff to analyse further how the characteristics of defined rate regulation support the conclusion that the regulatory rights meet the definition of an asset, especially with regard to the control criterion. Yet another member asked why the licence to operate the rate-regulated activity is not recognised as an intangible asset. The Staff replied that in terms of IAS 38, intangible assets are initially recognised at cost and assuming that the licence was granted for free, there is nothing to recognise. A follow-on question about whether the revised definition of an asset would alter the validity of that view was rejected by the Staff on grounds of moving beyond the scope of the project.

The Board also raised high-level questions on scope, measurement uncertainties, as well as the nature and presentation of the regulatory adjustments in profit or loss. These are all items that the Staff had already indicated in the paper that they will bring back for future discussion.

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