Agenda Papers 9–9B

Background

The Board has been discussing an accounting model (the ‘model’) that aims to provide useful information about the rights and obligations that are created by defined rate regulation. So far, the Board has reached tentative decisions on proposals for the scope of the model, unit of account, the recognition of regulatory assets and regulatory liabilities, the measurement of regulatory assets and regulatory liabilities and the presentation and disclosure objectives and requirements.  

The model will use a cash-flow-based measurement technique, which reflects discounted estimates of future cash flows arising from these assets or liabilities. At its July 2018 meeting, the Board tentatively decided that a ‘reasonable’ discount rate should be used and acknowledged that in many cases, the interest or return rate established in the regulatory agreement would be reasonable to use for discounting. The Board also asked the staff to develop guidance on factors to consider when determining a ‘reasonable rate’. Accordingly, the purpose of this paper is to discuss the characteristics of the discount rate.  

Staff analysis

The staff analysis distinguishes between three types of regulatory timing differences.

Regulatory timing differences that relate to items forming part of the regulatory operating expenditures (‘reg opex’)

Reg opex are expenditures that are intended to pass through into the rate in the same period as the expenses are incurred with typically no interest rate or margin applied. However, timing differences can arise when the recovery of reg opex is not passed through the current period’s rate. The staff is of the view that an appropriate discount rate would reflect the characteristics of the cash flows that will result from those timing differences, including (i) the compensation/charge for time value of money, (ii) the risk premium to provide compensation for bearing uncertainty in the cash flows, and, for regulatory liabilities, (iii) the credit profile of the regulated entity. In many cases, the amounts resulting from using discount rates reflecting such characteristics would not differ materially from the amounts resulting from discounting using the interest rates or return rates set by the regulator.

Regulatory timing differences that relate to items forming part of the regulatory capital base (‘RCB’)

The RCB represents amounts invested in assets utilised in providing regulated goods and services on which the regulatory agreement provides a return. That return provides compensation for the time value of money and for costs of bearing the uncertainty inherent in the cash flows relating to the assets or liabilities within the RCB. It also provides compensation for fulfilling the regulatory objectives of the entity (‘other factors’). The staff considered that this additional return should not be recognised as a ‘day 1 gain’ in profit or loss and instead should be recognised as it is charged to customers, using one the following three approaches:

• Approach 1: Include only the estimated cash flows needed for recovery of the originating regulatory asset together with an interest rate reflecting the time value of money and the risks inherent in the cash flows and discount at the rate that reflects compensation for only those characteristics. Any excess reflecting the compensation for other factors is recognised in profit or loss as it is included in revenue, i.e. included in the rate charged to customers.
• Approach 2: Include all the estimated cash flows reflecting both recovery of the originating regulatory timing difference and the overall return and discount at the regulatory overall return rate.
• Approach 3: Include only the estimated cash flows reflecting the originating regulatory timing difference and discount at 0%—i.e. exclude the cash flows reflecting the overall return and recognise it in profit or loss as it is included in revenue, i.e. included in the rate charged to customers.

The staff considered that Approach 1 would be too complex compared to the benefits it would bring to the users of financial statements and that Approach 2 would not reflect the characteristics of the regulatory asset. Accordingly, the staff view is that Approach 3 should be preferred.  

Regulatory timing differences that relate to expenses or income that will be included in/deducted from the future rate(s) when cash is paid/received

Some regulatory timing differences arise when an entity recognises an expense or income in the current period, but the regulatory agreement will not include that item in ‘allowable expenditures’ until a future period when the entity pays or receives the related cash. Examples include pension costs, deferred taxation, asset retirement obligations, environmental clean-up provisions and derivatives used for hedging.

Although the entity is not separately compensated for the time lag between the recognition of the expense or income and the payment or receipt of cash for those items, there is implicit interest. In the staff’s view, a regulatory asset is similar to an indemnification or reimbursement asset and therefore should be accounted in a similar way, i.e. measured on the same basis as the underlying liability. This view extends to cases when the discount rate used to account for the underlying items is zero. For example, a regulatory asset or liability related to deferred taxes should not be discounted either.

Staff recommendations

The staff made the following recommendations for regulatory timing differences that relate to items forming part of the regulatory operating expenditures:

• The discount rates used should reflect compensation for the time value of money and uncertainty inherent in the resulting cash flows;
• When the regulatory interest rate or regulatory return rate provides an additional return, but the entity has no clear evidence that the excess relates to an identifiable transaction or event, the entity should discount the estimated cash flows arising from the regulatory timing difference at the regulatory interest or return rate.

For regulatory timing differences that relate to items forming part of the regulatory capital expenditures, the staff recommended that an entity should discount the estimated cash flows reflecting the originating regulatory timing difference at a rate of zero per cent and should exclude the cash flows reflecting the regulatory overall return and recognise that overall return in profit or loss.

For regulatory timing differences that relate to expenses or income that will be included in/deducted from the future rate(s) when cash is paid/received by the entity, the staff recommend that an entity should use the same discount rate to measure the regulatory asset or liability as the discount rate it uses to measure the underlying liability or underlying asset. When the regulatory asset or liability is subject to risks that are not present in the underlying item, the entity should include its estimate of the effect of those risks in the estimates of the cash flows from the regulatory asset or liability and adjust the discount rate to reflect the price for bearing the uncertainty that the ultimate outcome of those risks may differ from the effect included in the estimated cash flows.

Board discussion

Regulatory timing differences that relate to items forming part of the regulatory capital base

The discussion focused mostly on the regulatory timing differences that relate to items forming part of the regulatory capital base (‘RCB’). Some Board members opposed the staff’s recommendation to include only the estimated cash flows reflecting the originating regulatory timing difference and discount at a rate of zero per cent. The arguments put forward by those Board members against this recommendation included:

• The approach does not reflect the economics of the regulatory agreement (which provides a rate of return) and is not consistent with the conclusion that there is a significant financing component.
• The approach does not reflect the market reality (which demands a return for the time value of money and inherent risks).
• The approach results in an unusual outcome when there is a gap between the period in which the returns accumulates for regulatory purposes and the period when it is included in the rate charged to customer. In such instances, if there is no additional compensation for the time lag, applying the approach recommended by the staff results in not recognising a profit in the year or years of the time lag. The staff acknowledged this issue but considered that the costs of using a more complex approach would outweigh the benefits given that such time lags are usually short, one or two years at most.

Board members who were in favour of the staff’s recommendation agreed that this was the simplest and most cost-effective approach. One Board member raised the need for additional disclosures in relation to this requirement.

Most of the Board members who opposed the staff’s recommendation were in favour of the second approach described in the agenda paper, i.e. they were of the view that an entity should include all the estimated cash flows reflecting both recovery of the originating regulatory timing difference and the overall return and discount at the regulatory overall return rate. One Board member also suggested another approach which would be to determine the effective interest rate over the period. The Board member noted that in most circumstances, the outcome would be similar to the second approach, however it would differ in instances when there is an anomaly in the way the rate of return has been calculated, for example when there is a time lag as noted above.

Regulatory timing differences that relate to items forming part of the regulatory operating expenditures

For regulatory timing differences that relate to items forming part of the regulatory operating expenditures, following several questions from Board members, the staff clarified their recommendations. The first step is to consider whether the regulatory interest rate or rate of return provides sufficient compensation for the time value of money and for the risks inherent in the cash flows. If it does not, then the entity would discount the estimated cash flows using a discount rate that reflects the characteristics of the cash flows from the regulatory asset and recognise the resulting loss immediately. If the rate provides sufficient compensation as well as an additional return, then the second step is to consider whether that additional return relates to an identifiable transaction or event. If it does not, then the entity should discount the estimated cash flows at the regulatory interest or return rate.

Regulatory timing differences that relate to expenses or income that will be included in/deducted from the future rate(s) when cash is paid/received

One Board member did not support the staff’s recommendation, considering that the underlying asset or liability is not relevant to account for the rights and obligations reflected by the regulatory asset or liability, with the potential exception of deferred taxes. The staff noted in response that, in the example of a regulatory asset recognised in relation to an environmental liability, the regulatory asset reflects the reimbursement right. It would therefore seem natural to measure the two amounts in the same way.

Another Board member asked to make it clear that if it is known at inception that an entity will not be compensated enough to cover the underlying liability, this should be treated as a risk of the regulatory asset that is different from the risk in the underlying liability.

A number of Board members expressed concerns about how the staff’s recommendations would apply to particular cases, and in particular the recommendation not to discount regulatory assets or liabilities related to deferred taxes. As a result, the Board asked the staff to perform more analysis on that question before considering further the staff’s recommendations.

Other matters

Two Board members expressed their concerns about using different methods for different types of regulatory timing differences, noting that this could be quite complex to apply.

Several Board members raised the question as to whether the discount rates recommended by the staff in the agenda paper would be the same for regulatory liabilities. One Board member noted that the rates set by regulators tend to be the same for regulatory assets and regulatory liabilities because of the expectation that there will be offsetting cash flows. However the implications of using the same discount rates for regulatory liabilities should be considered further and the Board asked the staff to provide further analysis on this question.

Board decisions

13 Board members approved the staff’s recommendations for regulatory timing differences that relate to items forming part of the regulatory operating expenditures, namely that:

• The discount rates used should reflect compensation for the time value of money and uncertainty inherent in the resulting cash flows
• When the regulatory interest rate or regulatory return rate provides an additional return, but the entity has no clear evidence that the excess relates to an identifiable transaction or event, the entity should discount the estimated cash flows arising from the regulatory timing difference at the regulatory interest or return rate

For regulatory timing differences that relate to items forming part of the regulatory capital expenditures,
8 Board members supported the staff recommendation that an entity should discount the estimated cash flows reflecting the originating regulatory timing difference at a rate of zero per cent and should exclude the cash flows reflecting the regulatory overall return and recognise that overall return in profit or loss.

For regulatory timing differences that relate to expenses or income that will be included in/deducted from the future rate(s) when cash is paid/received by the entity, only 6 Board members agreed with the staff recommendations. Given the concerns raised, in particular in relation to the recommendation not to discount regulatory assets or liabilities related to deferred taxes, the Board asked the staff to perform further analysis before reconsidering these recommendations.