Part Two: General Overview of the ODV Valuation Approach
Introduction
2.1 The mandatory valuation approach set out in Part Three is based on the application of the Optimised Deprival Value (ODV) methodology. The approach applies to both local line businesses and to Transpower.
2.2 The aim of applying the ODV methodology is to value the assets at the level at which they can be commercially sustained in the long term, and no more. The resulting value should be equal to the loss to the owner if they were deprived of the assets and then took action to minimise their loss.
2.3 It is recognised that the value of the assets derived in this way may differ from their current book value. Book value is typically based on expenditures made over the years and may bear little resemblance to the ODV value.
The Optimised Deprival Valuation Methodology
2.4 The ODV of system fixed assets is the minimum of Optimised Depreciated Replacement Cost (ODRC) and Economic Value (EV). The ODRC is the replacement cost of the existing system fixed assets which have been optimised from an engineering standpoint and depreciated according to their age. In some cases, because of constraints on tariffs, it may not be possible to make a normal rate of return on segments of the network when the segment assets are valued at ODRC. That is the segment is not self-sustainable in the long term. In such cases the EV value, a value lower than the ODRC, is applicable to the segments. The approach to calculating EVs is described later.
2.5 The ODV methodology involves the following steps:
- Calculation of Optimised Depreciated Replacement Cost (ODRC)
- preparing a detailed asset register
- calculate the Replacement Cost (RC)
- assessment of depreciation (DRC)
- system optimisation
- determination of Optimised Depreciated Replacement Cost (ODRC)
- determination of Economic Value (EV)
- determination of the ODV as the lesser of the ODRC and the EV.
Optimised Depreciated Replacement Cost (ODRC)
2.6 The ODRC measures the cost of replicating the system in the most efficient way possible, from an engineering perspective, given its service capability and the age of the existing assets.
Preparing a Detailed Asset Register
2.7 The basis for undertaking an ODV valuation is the collation of a comprehensive asset register of the ELB's system fixed assets and their configuration. Such asset registers should contain data on the quantity, location, physical condition, age and maintenance of the ELB's assets.
Determination of Replacement Cost (RC)
2.8 The next step is to value the network at replacement cost. The replacement cost is determined as the cost of replacing assets with Modern Equivalent Assets (MEA). It is important that objective values be applied consistently across the industry, and accordingly Part Three prescribes maximum values for assets that are to be used.
Assessment of Depreciation to Determine Depreciated Replacement Cost (DRC)
2.9 Once the quantities and replacement costs of assets have been determined, costs need to be depreciated in cases when the existing asset's remaining life is less than the life expected from a new asset. The depreciation recognises the limited Remaining Life (RL).
2.10 The RL of an asset can be determined as the (Total Life (TL) - Age of Asset). Part Three prescribes maximum TLs for assets that are to be used. This is done to prevent aged assets being over-valued.
System Optimisation
2.11 Optimisation attempts to answer the question:
2.12 The idea of optimisation is to determine a value of system fixed assets that is the counterpart to the market value of the assets of a business in a competitive market - that is the value of the assets on which such a business could earn a normal rate of return commensurate with the risk that business faces.
2.13 Optimisation consists of determining an appropriate network configuration and appropriate design and rating of sub-systems or segments of the network taking into account factors such as usage, likely future usage and security of supply, as well as the assets already in place. In theory, in considering re-configuration it would be possible to consider the "green fields" design of an entirely new network. In practice such an exercise would generally not be warranted, because of the time and cost involved, and because of the constraints imposed by factors such as the given positions of points of supply and historical supply authority boundaries.
2.14 It should be stressed that optimisation is not concerned with improving the system from its current state. The system should not be notionally re-designed to be better than it is (whether in terms of capacity, or other standards) where this would cost more. Optimisation leads only to reductions in the cost of the system for valuation purposes.
2.15 Economies of scale in larger systems will be reflected automatically in the valuation through the configuration of the optimal network.
2.16 Where optimisation has taken place there is the question of what depreciation to apply to the notional replacement assets. Part Three specifies that the notional replacement assets be depreciated assuming that they have the same proportion of their TL remaining as do the assets they are replacing.
Determination of Optimised Depreciated Replacement Cost (ODRC)
2.17 To determine the Optimised Depreciated Replacement Cost it is necessary to exclude from the valuation those network assets which have been optimised and include the modern equivalent optimised depreciated assets.
Economic Value (EV)
When to Apply
2.18 EVs are applied to assets that are worth less than their ODRC. This occurs when the maximum revenue that the lines in a network segment can earn, less capital and operating expenditure required to maintain the lines in the long run, would be insufficient to give a normal rate of return on the segment assets valued at ODRC. The maximum revenue is determined from assessing the maximum long run sustainable tariffs, with these being those at a level such that with any higher tariff the consumers would disconnect. It is most likely to be in rural areas with remote, lengthy lines that EVs will be applicable to network segments.
How to Determine the EV Value
2.19 When current line connections are not economically sustainable, without any externally imposed constraint, ELBs have the incentive to remove these connections in due course. At the time of such removal, the value of the connections, that is the EV, is the Net Realisable Value (NRV) of the assets.
2.20 However, ELBs (except Transpower) are subject to the constraint imposed by the Electricity Act 1992 for all existing line connections to be maintained until 2013, unless consumers agree to disconnection. Thus unless an ELB (except Transpower) believes it can gain the agreement of its consumers to disconnect, the earliest it can value the assets at NRV is 2013.
2.21 The EV is in theory therefore the Present Value (PV) of the maximum revenue the network segment can earn, less capital and operating expenditure, in order to maintain the segment up to disconnection plus the PV of the NRV at the prospective time of disconnection.
2.22 It should be noted that the expenditure required to maintain the segment in the period to disconnection would generally be less than that required in the alternative case in which the segment was kept operating in the long run with no disconnection.
2.23 Part Three allows that, unless disconnection is envisaged within the next 5 to 6 years, given the discounting effect inherent in PV calculations, a satisfactory approach is to calculate the EV under the assumption that the network segment will be required to be sustained in perpetuity.
Putting ODRCs and EVs Together
2.24 As indicated above the ODV of the system fixed assets is the minimum of the ODRC and the EV. Figure 2.1 summarises how the decisions for determining EV and making the choice between EV and ODRC, discussed in the preceding paragraphs, fit together.
2.25 The decisions between ODRC and EV have to be made on a network segment basis. The overall system ODV is determined by the aggregation of the ODRCs for those segments to which an ODRC valuation is applicable, and the EVs for those segments for which an EV valuation is applicable.
Figure 2.1 Determination of ODV
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