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Rate-regulated activities

Date recorded:

Cover Paper (Agenda Paper 9)

In July 2019, the Board gave the staff permission to start the balloting process for the publication of an Exposure Draft (ED) for the accounting model for regulatory assets and regulatory liabilities (the model).

When developing the model, the Board discussed ‘total allowed compensation’ and its components. However, in drafting the ED, the staff observed that the earlier Board discussions were not detailed enough to determine whether some components included in the regulated rates in a period form part of total allowed compensation for the goods or services supplied by an entity in the same period or in a different period.

In particular, the discussions were not explicit about whether the following elements of target profit included in the regulated rates for a period form part of the total allowed compensation for to the goods or services supplied in the same period: (a) regulatory returns; and (b) performance incentives. Therefore, the staff has prepared a set of papers that provide further clarification and specific recommendations on this aspect of the model.

Background and Regulatory Capital Base (RCB) (Agenda Paper 9A)

This paper provided background information about total allowed compensation and analyses how to determine whether regulatory returns on regulatory capital base (RCB) for a period should be regarded as forming part of total allowed compensation for goods or services supplied in that period or in a different period. The answer to this question will determine when those returns affect profit.

This paper did not ask the Board to make any decisions. However, it provides analysis that is used further in Agenda Paper 9B.

At the meetings held in 2019, the Board discussed the following description of total allowed compensation: “The total allowed compensation is the amount that an entity is entitled to charge customers for the goods or services supplied.” Total allowed compensation is a key concept in the model because it is compared with the amounts already charged to customers in a reporting period, that is amounts that an entity recognised as revenue in that reporting period in accordance with IFRS 15. That comparison determines whether the entity:

  • (a) has not charged all or part of the compensation to which it is entitled for the goods or services it already supplied and, consequently, whether it has a present right to include outstanding compensation in determining the regulated rate(s) in future period(s); or
  • (b) has already charged customers compensation for goods or services it has not yet supplied and, consequently, whether it has a present obligation to deduct that compensation in determining the regulated rate(s) in future period(s).

At meetings held in 2019, the Board discussed the components of total allowed compensation as follows:

  • (a) allowable expenses and chargeable income
  • (b) target profit, the main elements of which are:
    • i. margins on allowable expenses
    • ii. regulatory interest
    • iii. performance incentives (ie bonuses and penalties); and
    • iv. regulatory returns on the regulatory capital base (RCB).

The Board´s previous discussions did not explicitly address a general principle for when target profit and one of its elements (regulatory returns on RCB) should be regarded as forming part of total allowed compensation for goods or services supplied.

The staff is of the view that the fact the regulatory agreement entitles an entity to charge customers target profit in a specified period (by including those amounts in the regulated rates to be charged for the period), establishes that that target profit relates to goods or services supplied to customers in that period, unless there is a compelling reason to link it to goods or services supplied in a different period.

Board discussion

Many Board members supported the staff’s recommendation. Those who spoke found the clarification of the general principle useful and liked that the ED will make clear where it departs from the general principle. While agreeing with mirroring what is proposed for the expense side for the income side, one Board member found that this aspect of the ED would add a layer of complexity without adding much useful information. In her view, the guidance relied too much on how an agreement is written, rather than the economic reality. Another Board member highlighted practical difficulties with this approach. One Board member would have preferred a simpler solution to the issue, but conceded that it is needed in this complexity.

The Board did not make a decision.

Regulatory returns on construction work in progress base (Agenda Paper 9B)

This paper continues the analysis in Agenda Paper 9A and applies it to a specific situation—that is, whether regulatory returns on a construction work in progress (CWIP) base included in the regulated rates charged to customers during the construction period should be regarded as forming part of total allowed compensation for goods or services in the construction period, or of total allowed compensation for goods or services supplied when the asset is being used in supplying goods or services to customers.

Entities that are expected to have regulatory assets or regulatory liabilities often undertake construction work for long periods of time to build up the infrastructure necessary for the supply of goods or services. Long construction periods imply that significant amounts of capital are tied up in construction for many years. As compensation for that capital, regulatory agreements typically provide entities with regulatory returns applied to a base that consists of CWIP. Two approaches commonly used by regulators for including regulatory returns on CWIP base in the regulated rates are as follows:

  • (a) regulatory returns accumulate during the construction period and are included in the regulated rates charged to customers after the construction works have been completed—i.e. during the operating period of the asset; or
  • (b) regulatory returns are included in the regulated rates charged to customers during the construction period of the asset.

The staff analysed both fact patterns and recommended the following principles for when target profit and regulatory returns should be regarded as forming part of total allowed compensation:

  • (a) Target profit that a regulatory agreement entitles an entity to charge customers for a specified period forms part of total allowed compensation for goods or services supplied in that period.
  • (b) Regulatory returns on an RCB that a regulatory agreement entitles an entity to charge customers for a specified period form part of total allowed compensation for goods or services supplied in that period.
  • (c) Regulatory returns on a CWIP base that are included in the regulated rates during the construction period form part of total allowed compensation only during the operating period(s) of the asset (i.e. when goods or services are being supplied with the asset to which those regulatory returns relate (i.e. over its useful life)).

Board discussion

Board members welcomed the staff’s effort to enhance the model. Revenue recognition would not be accurate under the general principle. Several Board members highlighted that the staff should also analyse a case in which the useful life of the assets is different for IFRS and regulatory purposes.

Board members asked whether the construction is considered a service in this approach. The staff confirmed it would not be a service as it is not delivered to the customer. This would be clarified in the ED. Board members raised some concerns about whether construction could always be clearly distinguished from other goods and services. The Vice-Chair named the example of maintenance and repairs. The drafting would have to be clear to avoid ambiguity.

Performance incentives (Agenda Paper 9C)

This paper discusses when performance incentives form part of total allowed compensation and gives special consideration to incentives for construction-related activities of the entity.

During this project, the Board has learnt that performance incentives are a common feature of rate regulation in many jurisdictions. Incentive-based regulation will often incorporate financial rewards and penalties in the basis for setting the regulated rates to induce an entity to achieve desired regulatory objectives.

In July 2019, the Board discussed performance incentives—bonuses for achieving (or penalties for failing to achieve) specified performance criteria (e.g. targeted levels of service quality or reliability, customer satisfaction, etc.) and how the model would apply when, at the financial reporting date, it is not yet certain whether an entity will become entitled to such a bonus (or liable for such a penalty). The incentives discussed in July 2019 were those of an operational or non-construction-related nature.

The staff’s analysis presented in July 2019 concluded that non-construction-related performance incentives form part of total allowed compensation for goods or services supplied during the period to which the performance incentive relates—that is, the period in which the performance criteria for the performance incentive are monitored and evaluated.

In the staff’s view, aligning the treatment of when amounts for non-construction-related and construction-related performance incentives form part of total allowed compensation has the following advantages:

  • (a) It provides more useful and understandable information to the users of financial statements than using different approaches to reflect compensation for different types of incentives—having different requirements may only add confusion for users and not result in any added information value.
  • (b) It means lower costs for preparers from not having to develop and implement different policies and processes to account for performance incentives according to their type (except those construction-related incentives that are conditional on satisfying requirements when supplying goods or services in future periods).

Therefore, the staff recommended that performance incentives, whether construction-related or non-construction-related, should form part of total allowed compensation for goods or services supplied in the period when the relevant performance criteria are monitored and evaluated.

Board discussion

Board members generally agreed with the staff recommendation with one Board member suggesting to add an example in the ED to illustrate the logic.

One Board member asked whether the recommendation is consistent with the general principle if goods and services have not been supplied and it the entity has therefore no right to the bonus. The staff replied that if there was a condition attached to the bonus, then the entity should recognise the part of the bonus that relates to the ongoing business in the operating period. However, the staff did not want to be overly prescriptive and not provide a bright line for this. Board members agreed with this approach.

Another Board member asked whether IFRIC 12 would have to be applied first. The staff confirmed this.

Summary of staff recommendations (Agenda Paper 9D)

This paper set out the following staff recommendations relating to agenda papers 9A–9C prepared for the meeting and asked the Board related questions.

Recommendation 1 (Agenda Paper 9A): Target profit that a regulatory agreement entitles an entity to charge customers for a specified period forms part of total allowed compensation for goods or services supplied in that period.

Recommendation 2 (Agenda Paper 9B): Regulatory returns on a RCB that a regulatory agreement entitles an entity to charge customers for a specified period form part of total allowed compensation for goods or services supplied in that period.

Recommendation 3 (Agenda Paper 9B): Regulatory returns on a CWIP base that are included in the regulated rates during the construction period form part of total allowed compensation only during the operating period(s) of the asset (i.e. when goods or services are being supplied with the asset to which those regulatory returns relate—i.e. over its useful life).

Recommendation 4 (Agenda Paper 9C): Performance incentives, whether construction-related or nonconstruction-related, form part of total allowed compensation for goods or services supplied in the period when the relevant performance criteria are monitored and evaluated.

Board decision

Recommendation 1: 13:1 Board members support this recommendation.

Recommendation 2: 13:1 Board members support this recommendation.

Recommendation 3: All Board members support this recommendation.

Recommendation 4 [with the suggestions around allocation and specific drafting of monitoring and evaluating]: 12:2 Board members support this recommendation.

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