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Rate-regulated activities

Date recorded:

Rate-regulated Activities [Agenda paper 9]

Background

IFRS 14 allows a first-time adopter of IFRS to continue to account, with some limited changes, for ‘regulatory deferral account balances’ in accordance with its previous GAAP, if the entity is adopting IFRS after 1 January 2016.  IFRS 14 was issued as a temporary solution pending a more comprehensive review of rate regulation by the IASB. The Board has been considering whether entities that operate in rate-regulated environments should recognise assets and liabilities arising from the effects of rate regulation, and issued a Discussion Paper in September 2014. The Board has been developing an accounting model, but has yet to decide whether to issue a second discussion paper or develop an exposure draft.

At this meeting the Board will discuss the scope of the recognition and measurement model and the criteria for recognising regulatory assets and regulatory liabilities.

Background and summary of decisions to date [Agenda paper 9A]

Staff analysis

This paper summarises the discussions already held by the Board. 

Scope of the model [Agenda paper 9B]

Staff analysis

In this paper the staff analyse the scope of the activities the proposed model should be applied to and conclude by recommending a definition of defined rate regulation.

The analysis on the scope of the model focuses on identifying which of the features of defined rate regulation are both necessary and sufficient for the origination of regulatory assets and regulatory liabilities. The staff have been using the term ‘defined rate regulation’ as a label for a form of economic regulation established through a formal regulatory framework that: (a) is binding on both the entity and the rate regulator; (b) establishes a basis for setting the regulated rate chargeable by the entity to its customers (P) for the transfer of specified goods and/ or services that comply with minimum quality levels or other service requirements (Q); (c) includes, as part of the basis for setting the regulated rate, a rate-adjustment mechanism that creates and reverses timing differences when the regulated rate in one period includes amounts related to specified activities the entity carries out in a different period; and (d) imposes limitations on entry into an industry (and on exit from it).

Binding on both the entity and the regulator

The regulatory framework in which defined rate regulation is applied typically consists of legislation, regulations or regulatory agreement and regulatory decisions, and subsequent court rulings on those decisions that interpret the legislation and the regulations. The regulatory agreement may take the form of a contractual licensing agreement or may be imposed through statute. Regardless of its form, the terms of the regulatory agreement bind both the entity and the regulator. Those binding terms establish rights and obligations for the entity that have commercial substance because they clearly have a discernible effect on the economics of the regulatory agreement.

The staff think that the existence of terms that bind both the regulator and the entity is a necessary feature for the origination of regulatory assets and regulatory liabilities and hence should be included in the criteria that establish the scope of the model. This means that activities subject only to ‘self-regulation’ would not be included in the scope of the model.

Some entities may need to exercise judgement to assess whether the process for setting and enforcing the rates is subject to sufficient external oversight and/or approval through statute or regulation that creates terms binding both the entity and the regulator.

Basis for setting the regulated rate

The existence of a basis for setting the rate within the regulatory agreement is a necessary feature for activities to be subject to rate regulation. However, on its own, it may not be a sufficient feature to differentiate defined rate regulation from other types of rate regulation.

The staff conclusion is that the basis for setting the rate is a necessary but not a sufficient feature for the origination of regulatory assets and regulatory liabilities.

Rate-adjustment mechanism

The inclusion of a rate-adjustment mechanism that creates a direct cause-and-effect relationship between the entity’s past transactions or other events and the rate the entity will charge for goods or services delivered to customers in the future is a necessary feature for the origination of regulatory assets and regulatory liabilities. Consequently, this feature should be included in the criteria that establish the scope of the model.

Limitations on entry and on exit

Defined rate regulation is typically introduced for services that governments consider essential for a reasonable quality of life for their citizens and for which there are significant barriers to effective competition for supply. In many cases, limitations on effective competition for supply arise from the existence of natural monopolies.

Respondents to the Discussion Paper, and the Consultative Group concluded that a limitation on entry into a market is not a necessary condition for the origination of regulatory assets and regulatory liabilities. For the origination of regulatory assets and regulatory liabilities, it is necessary and sufficient only that entities entering the industry and the regulator are bound by the terms of a regulatory agreement. In addition, that regulatory agreement needs to establish a basis for setting the rate and that basis needs to include a rate-adjustment mechanism that creates timing differences between when an entity fulfils service requirements and when it includes the related compensation in the rate(s).

Limitations on exit from a market may not be essential for the obligation to provide goods or services at a lower rate to be unavoidable. This is because the regulatory agreement already gives the entity an unconditional obligation to provide goods or services in the future at a lower rate than it would have been able to charge had it not already received economic benefits that provided compensation for them. Consequently, the staff conclude that a limitation on exit from a market is not a necessary condition for the origination of a regulatory liability.

Staff recommendations

The staff are recommending that the Board define defined rate regulation as:

Defined rate regulation

A form of economic regulation established through a formal regulatory framework that:

(a)    is binding on both the entity and the rate regulator; and

(b)    establishes a basis for setting the rate that includes a rate-adjustment mechanism that creates, and subsequently reverses, rights and obligations arising from timing differences when the regulated rate in one period includes amounts related to specified activities the entity carries out in a different period.

Discussion

One Board member was concerned that striking out the words related to entry and exit criteria without having some replacement criteria, such as a commitment of the regulator to maintain the financial viability of the regulated companies. Others disagreed noting that it is the continuation of the service that the regulator is concerned with and although this supports the entity that is an outcome and not an objective. 

The consultative group wanted objective criteria and only criteria that were necessary. They questioned how to assess the extent to which a regulator supports the financial viability. The Vice-Chair asked those calling for a financial viability criteria whether the existence of the rate adjustment mechanism was the factor that acted to capture financial viability. Others agreed with where the staff had landed and would not support bringing in criteria that are likely to be redundant or require significant judgement.

This is the first time the word binding would be used. Do they mean enforceable? There is well developed guidance on enforceability, so if it is another word for enforceable then that term should be used. If it means something more than enforceable that should be made clear.  One member thought that the scope should state that the agreement must be binding on both parties, and enforceable. Others agreed.

One member said that the scope should refer to specific goods or services and, for example, specified time frames. The term specified activities is too broad and should be replaced by “specified goods or services the entity delivers”. One member disagreed because the regulated entity is often required to do things that relate to the delivery of goods or services that are a condition of the regulation.  

One member said that the document should state that, and explain why, rate regulation should not be confused with a price cap. More generally, the background paragraphs should be written more affirmatively.

One member was concerned about removing the criteria focused on limiting entry into an industry. 

Board decision

The Board supported the general direction if the scope definition (13:1), noting the comments Board members had made.

Recognition [Agenda paper 9C]

Staff analysis

In this paper, the staff assess what criteria should be met for the recognition of regulatory assets and regulatory liabilities arising from timing differences created by the operation of the rate-adjustment mechanism established in the regulatory agreement.

The staff think that the terms of the regulatory agreements are typically clear enough to identify most timing differences that qualify to be included in the rate-adjustment mechanism. The terms of the agreements typically are also clear about the time period over which specified types of timing differences are scheduled to reverse and the rate of any compensation or charge for the time lag between origination and reversal. The time period set for reversal takes into account the anticipated effect of the approved change in the rate on the expected level of demand for the regulated goods or services (goods or services). They generally also have detailed record-keeping requirements that entities have to fulfil to enable identification and tracking of individual timing differences from origination to the unwinding through amounts billed to customers.

As a consequence of the design of the rate formula and the oversight procedures, once a timing difference has been identified as creating a regulatory asset or a regulatory liability (ie an asset or liability exists) there is typically a high probability that an inflow or outflow of economic benefits will flow from the regulatory asset or regulatory liability and there is typically little measurement uncertainty. The explicit terms detailed in the regulatory agreement, together with the detailed record-keeping requirements needed to provide supporting evidence would enable a reasonable estimate to be made of the effect on the regulated rate.

Existence uncertainty

When a regulator has regulatory assets or liabilities there is no existence uncertainty. However, if the regulator has not formally approved before the entity finalises its financial statements the entity will need to apply judgement. There will be some uncertainty.

The staff assessed timing differences that relate to ‘automatic’ rate adjustments that are mentioned explicitly in the regulatory agreement and timing differences that are not mentioned explicitly in the regulatory agreement.

The staff make two recommendations about the recognition threshold. The first is that the criteria should be symmetrical. It is typical for there to be frequent communication between the entities and the regulators. As a result, entities can usually obtain preliminary (non-binding) views from the regulator to help them assess the probability of approval of timing differences that create regulatory assets or regulatory liabilities. There is no basis for having a higher threshold for assets relative to liabilities. The second is that the threshold should be set at ‘more likely than not’. This is consistent with how the staff understand IFRS 14 Regulatory Deferral Accounts is applied and how reporting requirements established by other standard-setters are applied.

Once an entity has concluded a regulatory asset or regulatory liability exists, there is a high probability that an inflow or outflow of economic benefits will follow. Consequently, the staff do not think that the model should include specific requirements for entities to assess whether to recognise regulatory assets or regulatory liabilities if the probability of an inflow or outflow of economic benefits is low. Similarly, the nature of the regulatory frameworks means that if an entity has a regulatory asset or regulatory liability they should be able to make a reasonable estimate of its measurement.

The staff think the costs of recognising regulatory assets and regulatory liabilities will be low because entities already need to fulfil detailed record-keeping requirements for regulatory purposes.

Staff recommendations

The staff are recommending that the model require the recognition of regulatory assets or regulatory liabilities when it is more likely than not that they exist.

Because of the nature of rate regulation, if an entity has determined that a regulatory asset or regulatory liability exists, the entity does not need to assess whether the probability of an inflow or outflow of economic benefits is low or whether a reliable estimate can be made.

Discussion

Board members were generally supportive of the recommendation. One member asked the staff to note, for future discussions to keep measurement in mind and that it should not involve creating different sets of data. One member is concerned that more likely than not will create a problem when it comes to impairment assessment and derecognition.

The staff noted that in most cases the regulations create conditions where there is a high probability that assets and liabilities exist. The proposed threshold is consistent with the Framework. The staff emphasised that the Board can set different thresholds in an individual Standard and that is an appropriate

Board members also noted that some of the uncertainty will be related to measurement. There might be some uncertainty about how the asset should be measured because the entity might have to bear quantity risk. One member was concerned that if there was a low probability of an inflow that this should be considered an existence issue rather than measurement. The member gave an example of Japan and the withdrawal of nuclear power and that this should be considered an existence question. The staff said that there could be certainty about price and uncertainty about quantity and still have existence. A member was nervous about proceeding on this basis and said that if they do decide that it is only uncertainty about price they need to be very careful, and clear, about how that is explained. Other members were supportive of focusing only on price when considering uncertainty. The staff said that the Framework says that the Board should think about whether you should recognise an asset when there is a low probability and that is what this discussion has done.

The staff also clarified that quantity comes in twice. Initially a transaction creates the timing difference that then relies on a future quantity.

Board decision

The Board supported the recommendation, but with amended wording.

The Board decided that the model require the recognition of regulatory assets or regulatory liabilities when it is more likely than not that they exist and not include a threshold to assess the probability of an inflow or outflow of economic benefits or measurement uncertainty.  

Correction list for hyphenation

These words serve as exceptions. Once entered, they are only hyphenated at the specified hyphenation points. Each word should be on a separate line.