Part Three: Practical Valuation and Mandatory Procedures
Introduction
3.1 The valuation procedures presented here in Part Three differ from those given in Part Two in that more steps are included. This is in recognition of both the practicalities of undertaking valuations and the requirements of regulation 20 of the Electricity (Information Disclosure) Regulations 1999.
3.2 Regulation 20, and Form 7 require, among other things, that the following items be disclosed in valuation reports and/or the certificates which must accompany ODV and valuation disclosures:
- replacement cost of the network
- depreciated replacement cost of the network
- optimised depreciated replacement cost of the network
- ODV of the network.
3.3 Disclosure of the individual items listed in paragraph 3.2 is designed to provide for transparency of the valuation process carried out by individual ELBs by making clear the effect of both optimisation and the application of EVs on the final ODV valuation.
Valuation of the System Fixed Assets at Replacement Cost (RC)
3.4 There are two steps in the determination of replacement cost:
- preparing a detailed asset register
- valuing the assets.
Preparing a Detailed Asset Register
3.5 All ELBs should have a comprehensive database for their assets. Ideally, for the purposes of carrying out optimisation and the application of EVs, the database should be computerised to facilitate sorting and reporting according to various numbers and levels of sort key (e.g. asset type, voltage level, capacity, network segment or location).
3.6 To be able to carry out adequate optimisation and application of EVs it will generally be necessary that the network register is built up from or can be divided into relatively small segments.
3.7 Appendix A gives the minimum classification of system fixed assets expected to be used by local ELBs.
3.8 As well as system fixed assets, stores and spares of network equipment should be valued as part of the ODV. ELBs should have a record of stores and spares, preferably in a computerised ledger system. In cases where complete records are not kept, or are unreliable, it may be necessary to undertake a stocktake for valuation purposes.
3.9 Asset registers should be checked for consistency and sample checks should be carried out in the field to verify that the quantities and ages recorded are accurate within reasonable limits. Guidance as to what constitutes "reasonable limits" should be taken from the significance of each item and its effect on the accuracy of the overall valuation.
Exclusion of Assets
3.10 Assets such as head office buildings, office furniture and equipment, motor vehicles, tools, plant and machinery, works under construction, and non-network land and stores and spares should not be included in the asset register of system fixed assets that is used as a basis for preparing the ODV valuation of system fixed assets. Also consumers' meters and consumer-based load control relays should be excluded.
Accessibility of Information
3.11 The system fixed asset register should be in a form that facilitates scrutiny of the register and a ready understanding of how it is composed. Spreadsheet presentations are appropriate.
Valuing the Assets
3.12 The system fixed assets are to be valued using the Replacement Costs (RC) of Modern Equivalent Assets (MEA) that would be installed today in order to provide the same level of service as the assets in place. The MEA should not reflect improvements required by legislative changes made since the assets were first built or installed, if such improvements result in higher replacement costs and if the existing assets have not yet had to comply with the additional requirements e.g. where grandfathering provisions apply. The maximum values for MEA for ELBs which are to be applied are set out in tables in Appendix B. Lower values can be applied but the maxima are not to be exceeded except as provided for in Appendix B. Appendix B also contains other details regarding the valuation of particular types of assets.
3.13 When determining MEA there are indicators that can be used to determine what asset to select for costing. Such indicators include:
- number of faults/100km of line/year
- voltage complaints/100km of line/year
- proven reliability of the technology
- functional compliance with modern operating requirements
- meeting statutory and industry safety requirements
- least lifetime costs (taking account of all aspects of performance e.g. losses)
3.14 When the tables in Appendix B do not provide guidance on how to value particular major assets such as switchgear, Valuers should obtain cost estimates from manufacturers or suppliers. Valuers should explicitly identify in the valuation report each asset which does not fall within Appendix B, together with the replacement cost and the total life assumptions which have been used.
3.15 Construction cost estimates should be based on knowledge of the work involved, and on efficient industry practice with competitive costs such as would be charged by private contractors.
3.16 Any grants or contributions that have been received should be ignored as it is the valuation of assets that is required.
3.17 Aggregation of the RCs for all the system fixed assets will produce the network RC as required by regulation 20.
Valuation of the System Fixed Assets at Depreciated Replacement Cost (DRC)
Approach to Depreciation
3.18 Asset replacement costs should be depreciated when the existing asset's remaining service life is less than the life that would normally be expected from a new asset. The depreciation effectively recognises the limited Remaining Life (RL). The MEA costs should be depreciated according to the RLs of the existing assets.
3.19 The straight line method of depreciation should be used such that the Depreciated Value (DV) is determined as:
where: UDV = Undepreciated Value (i.e. Replacement Cost (RC))
It is clear from the above that both the Total Life and the Remaining Life need to be assigned for assets.
Determining Asset Total Lives
3.20 The maximum TLs of Modern Equivalent Assets (MEA) which are to be used are set out in the tables in Appendix B. These maxima are not to be exceeded except as provided for in the appendix. The appendix also contains other details regarding the TLs to be used for particular types of assets.
3.21 TLs lower than the specified maxima may be used and may be appropriate in certain circumstances such as specified in Appendix B.
Determining Asset Remaining Lives
3.22 The basic procedure for determining RLs is to subtract the age of assets from their TLs.
3.23 The age of assets should be determined for initial ODV valuations, either from records establishing the age, or where necessary from engineering assessments of the age.
3.24 In cases where engineering assessments of the age have been carried out for one valuation, the age in successive valuations should also be based on that earlier engineering assessment - reassessments of the time of installation of the asset are not allowable.
3.25 In cases where materiality of the value of assets is not an issue, and where data availability and calculation complexity would not warrant the determination of age and RL of individual assets, grouping of assets and the assessment of weighted average RLs is acceptable.
3.26 Appendix B provides procedures for assessing RLs in cases where assets have been refurbished, and in cases where an asset (or group of assets) has reached its TL.
3.27 When an asset may be retired early from service because it may become redundant as part of a development of the system, this should not be taken into account in assessing the RL of that asset. However, when a class of assets is routinely replaced as part of the evolution of the system before its technical life expires, then this should be taken into account in assessing the TL for that class of assets.
Assets with Residual Value
3.28 In some cases assets will have a Residual Value (RV) at the end of their TL, or after allowing for the costs of recovery a Net Residual Value (NRV). When this is the case an adjustment is required to the formula given in 3.19. With the adjustment the Depreciated Value (DV) is determined as:
3.29 Generally the NRV of ELB fixed system assets, once the cost of recovery is netted off, is low and can be set aside as not of material value.
Determining the Depreciated Replacement Cost (DRC)
3.30 Aggregation of the DVs for all the system fixed assets will produce the network DRC as required by regulation 20.
Optimisation: Valuation of the System Fixed Assets at Optimised Depreciated Replacement Cost (ODRC)
Introduction
3.31 Optimisation of ELBs' system fixed assets should be carried out to ensure that only "used and useful" assets (or elements thereof) are valued. The resulting ODRC valuation should be based on an optimal network, built to modern efficient design, that:
- to the same remaining meets the same expected service requirements as the existing network; and
- is depreciated life as the existing network.
3.32 Optimisation consists of three stages:
- identifying any stranded assets;
- optimising the system configuration; and
- optimising elements in the system.
Constraints on Optimisation
3.33 The optimisation should be carried out subject to the following constraints.
- the security of supply should be assumed to remain at the existing level;
- the location of points of supply should be assumed to be fixed. However,where a point of supply can be by-passed and this allows a saving in ELB assets, then that point of supply should be deleted for valuation purposes;
- the location of customers should be assumed fixed;
- the existing boundaries of the ELB should be assumed fixed;
- the existence of new investment contracts or other relevant contracts.
Future Load Growth
3.34 In performing the optimisation regard should be given to current maximum load capacity and projected future changes in demand and load characteristics. This should be done in accordance with time horizons used in efficient system planning - 10 years for transmission and subtransmission systems, zone substations and distribution systems. Allowances should be made, where possible, for different growth rates in different parts of the network.
3.35 However, future projected load growth is relevant only for determining whether or not there may be excess capacity in the existing system. In no circumstance should the optimisation process lead to system capacity greater (or more costly) than is currently in place.
Identifying Stranded Assets
3.36 Any system fixed assets that, because of past reductions in demand or any other reason, are no longer needed to supply line services should be identified - such assets have effectively become stranded.
Optimising the System Configuration
3.37 Optimisation of system configuration should be carried out in conjunction with the ELB's Planning Engineer with a view to considering what alternative configurations may be able to match the existing security of supply and other standards.
3.38 Relevant aspects of standards are:
- the degree of security (or redundancy) in different circumstances/localities - proportions of customers subject to interruptions, the number and duration of outages and types of customers affected (e.g. urban and rural, residential, commercial and industrial);
- voltage stability;
- levels of electrical losses.
3.39 The degree of security may be assessed by reference to the level of in-built redundancy, i.e. as (n) or (n-1) or (n-2) or greater component redundancy. (An (n) security level implies no component redundancy so that if a component fails, then customer supply is lost. An (n-1) security level is one in which customer supply is not interrupted in the event of any single component outage etc.)
3.40 In the case of Transpower account should be taken of prudent standards and practices followed in overseas countries, such as those adopted in Australia and the United Kingdom, views of the users of the transmission system on the overall system reliability where these views are expressed within the contractual relationship between Transpower and the connected party(ies) or as might be set as Transpower's performance requirements in supporting the operation of the electricity market.
3.41 In the process of optimising the system configuration, certain assets or groups of assets may become excess to requirements, while other new assets may also need to be notionally brought in. Issues with the optimisation of the system configuration for ELBs are discussed further in Appendix C.
Optimising Elements in the System
3.42 After the overall design of the system has been optimised the elements within it should be optimised by considering whether lower rating elements would be adequate to deliver the same security of supply and other standards.
3.43 In assessing what equipment is appropriate, relevant security of supply and other standards will include those of 3.38, but also safety standards may be of importance at the individual asset level. Issues with the optimisation of elements of ELB systems are discussed further in Appendix C.
Determining the Optimised Depreciated Replacement Cost (ODRC)
3.44 Once the optimised system has been determined those parts of the system which are different from the existing un-optimised system need to be re-evaluated. This entails applying adjusted replacement cost values and ensuring these are appropriately depreciated.
3.45 Any stranded assets should be valued at Net Saleable Value (NSV) (sale value less recovery costs), and their value assigned to that of "other businesses". This is consistent with the Avoidable Cost Allocation Methodology (ACAM) rules. Since stranded assets are "avoidable" by the ELB, NSVs associated with their disposal should not be assigned to the system fixed assets, nor to any other assets of the line business.
3.46 When assets become excess to requirements as a result of optimising the system configuration they should be valued at nil. This is because they are of no real value to the system. However, the optimisation is only notional so they cannot be disposed of to obtain an NSV. On the other hand any new assets that are notionally brought into the system through optimisation should be valued at their replacement cost, with reference to the costs in the Appendix B tables.
3.47 When as a result of optimising elements it becomes clear that certain assets are over-designed or have excess capacity, they should be notionally replaced by lower rating assets at their replacement cost, with reference to the costs specified in Appendix B. Thus the over-design or excess capacity is effectively valued at nil.
3.48 When the optimisation leads to individual assets being replaced, the replacement asset should be depreciated for the same proportion of its TL as the existing asset was depreciated. When the optimisation involves groups of assets being re-configured, the replacement assets should be depreciated as a group to reflect the RL of the existing group as a proportion of that group's TL, this being calculated on a weighted average basis.
3.49 Aggregation of the DVs of the fixed assets in the optimised system will produce the network ODRC as required by regulation 20. In addition, for those parts of the network where optimisation has occurred it will be possible to record both the DRC and the ODRC, as also required by regulation 20.
Summary of the Optimisation Process
3.50 Figure 3.1 summarises the steps that should be taken in carrying out optimisation and shows how they fit together.
Figure 3.1: System Optimisation
Valuation of the System Fixed Assets at Optimised Deprival Value (ODV)
Introduction
3.51 Once ODRC has been determined it is necessary to establish which segments of the network cannot, because of constraints on sustainable tariffs, earn a normal commercial rate of return on their ODRC value. The assets for these segments should be valued at EV not ODRC.
3.52 The process for determining which segments should have EV values, what those values should be, and the final network ODV, has the following steps:
- partitioning the network into segments and the selection of segments for EV analysis;
- determining the maximum long run sustainable tariffs for those segments subject to EV analysis;
- determining whether EVs or ODRCs should be applied to those segments subject to EV analysis;
- for those segments where EV applies, determining their EV values;
- aggregation of segment values (whether ODRC or EV) to produce the network ODV.
Partitioning the Network
3.53 Generally networks should be partitioned into relatively small segments for EV analysis. It is difficult to give specific rules for such partitioning but the separability of assets into groups with:
- limited inter-group dependency;
- significantly different cost characteristics;
should be considered.
3.54 As will become apparent, determining to which segments to apply EVs can be complex and time consuming. Thus there is a necessity to avoid as far as possible testing all segments to see whether an EV valuation might be appropriate. Those segments which are least likely to be able to support an ODRC valuation should be tested first - that is those segments with high costs and/or consumers that could choose to disconnect at relatively low tariffs. In some instances a projected future fall in consumption (perhaps because of closure of a major consumer) may indicate that an ODRC valuation may not be supportable.
3.55 When the outcome of the calculation on the initially selected segments is known, this may indicate that further segments should be selected and tested for EV applicability.
Determining Maximum Long Run Sustainable Tariffs
3.56 The maximum tariffs for network segments should be determined as those such that with any higher tariff the consumers would disconnect. They should be assessed as being at a level equivalent to the unit cost of the next best alternative source of energy, taking into account all operating and capital costs of alternatives.
3.57 A range of alternative sources of energy should be considered including:
- disconnection from the network and electricity supply from a local generator;
- substitution of all or part of the electricity supply with other fuels; and for local ELBs:
- direct supply from the transmission grid or from a neighbouring ELB.
3.58 When assessing the maximum line charge tariff care is needed to ensure that the comparison of using the network with the costs of alternatives is carried out correctly - it should be carried out on a delivered energy cost basis. Thus the network maximum unitised line charge, as set by an alternative, is the full unitised cost of the alternative less the unit energy charge when using the network.
Determining Whether to Use EV or ODRC
3.59 Once the maximum long run sustainable tariff (or tariffs) has been determined this enables the long run annual revenue earning power of the network segment to be assessed. This should then be put together with the long run annual costs for the network segment to determine the annual Net Operating Profit After Tax (NOPAT):
3.60 Historical accounting information on operating costs may need to be referred to in order to estimate future operating costs of the segment. Historical information on average network operating costs is likely to include elements of fixed operating costs that are unavoidable by the core network, even if the network segment under study were to close. Any such fixed costs, if material, should be deducted from average costs to estimate operating costs for the segment.
3.61 Depreciation for the network segment is obtainable from the workings to calculate ODRC for the segment. Income tax should be calculated at the corporate tax rate of 33%.
3.62 How to value the segment depends on whether the segment is sustainable in its own right, that is whether NOPAT is enough to give a normal rate of return on the segment assets valued at ODRC. The decision rule is
where WACC = Weighted Average Cost of Capital for the business.
3.63 Appendix D gives details on the meaning of WACC and outlines how it may be determined for an ELB.
Determining EVS
3.64 If a network segment is not in its own right economically sustainable, then the ELB will have a commercial incentive to close it. Such closure should not necessarily be made immediately because there may be a period during which the lines could be profitable with earnings higher than short run costs (because short run maintenance and capital costs are less than such costs for long run sustainability).
3.65 However, the Electricity Act 1992 requires that all line connections be maintained until 31 March 2013 unless consumers agree to disconnection. Thus the ability to gain consumer approval to disconnect, and when this might be effected, is of crucial importance for the determination of EVs and potentially for ELB profitability.
Lines Not Subject to Closure in 5 to 6 Years
3.66 Unless an ELB has plans for closing a segment within the next 5 to 6 years (for which it believes it can gain consumer approval), then for the purposes of determining an EV valuation, it should be adequate to assume that the lines in question will remain in operation in perpetuity (apart from the uncertainty of closure more than 5 to 6 years ahead, discounting far ahead cash flows limits their impact on the resulting EV estimate).
3.67 It is acceptable for EV valuation purposes to allow for tariffs below the maximum sustainable level, although an ELB may wish to have them tracking up to this level over a period of years.
3.68 In cases when it is assumed that a segment will remain in operation in perpetuity the EV should be determined as:
where the revenue component of NOPAT may be subject to tariffs below the maximum long run sustainable level, and the relevant discount rate is the WACC.
3.69 Given the difficulties of determining EVs with any precision, the above approach is considered acceptable. However, a more detailed cash flow analysis, such as presented in the following section (for lines with planned lives of less than 5 to 6 years), is not precluded for lines planned to remain in operation for more than 5 to 6 years.
Lines to Close in 5 to 6 Years
3.70 For lines when agreement can be reached with consumers, and arrangements made for disconnection within 5 to 6 years, a detailed cash flow analysis is needed to determine when to disconnect and to determine the associated EV value. (If a major consumer is projected to close then presumably agreement of the consumer would not be needed to disconnect.) What is required is to maximise the Present Value (PV) of the net earnings to closure of the network segment plus the PV of the Net Residual Value (NRV) at closure. If immediate closure is possible then the EV = NRV. More generally:
where FCF = Free Cash Flows (dealt with in more detail below) and the discount rate to determine the PV is the WACC.
3.71 The aim is to determine the actual cash flows for the network segment for the period up to and including closure, and to avoid having the valuation distorted by notional allowances for capital expenditure through depreciation. The estimated cash flows should be prepared on an after tax basis so that the PV can be determined using the nominal post-tax WACC used throughout this handbook. Accordingly the FCF are given by:
3.72 An economic planning exercise will be required for the network segment to estimate the forward FCF. If such an exercise is to be based on historical accounting information, care is needed in converting normal accounting items in to FCF. In particular it should be noted that only system fixed costs that can be avoided as the result of closing the network segment should be attributed to the segment in an FCF analysis. Other adjustments, such as are normally made in converting income statement and balance sheet information into a cash flow analysis, are also required.
3.73 If assets left at the closure of a network segment are of no value then:
3.74 If assets left at the closure of a segment are potentially useful as spares for the network then:
This is providing that the movement of the assets into store would not lead to the total level of such spares exceeding a reasonable level for the network.
3.75 If assets left at the closure of a segment are potentially of value, but excess to the requirements of the network, then the
3.76 It should be noted that the NSVs of assets considered excess in EV analysis may be included in the EV valuation. This is in contrast to the procedure for NSVs of stranded assets. The circumstances in each case are different.
3.77 Since stranded assets are "avoidable" by the line business their NSVs should be attributed to "other businesses" and not the line business. Stranded assets may in some cases have high NSV values.
3.78 In general, assets made excess in EV analysis are likely to be required for a year or two to provide line services before becoming redundant - such assets are not "avoidable" - they form a worthwhile part of the system fixed assets, albeit for a limit period. Also it should be noted that such assets are likely to be nearing the ends of their lives and have relatively low NSVs.
3.79 The issue of how to treat NSVs of assets made excess in EV analysis may not be entirely clear-cut but, taking the above considerations into account, it has been decided that it is acceptable for these NSVs to be incorporated in EV valuations.
Negative EVs
3.80 In some extreme cases, the maximum revenue (including any relevant NRV) from a network segment may be insufficient to cover costs (indeed revenue may be insufficient to cover operating costs alone) and the resulting EV will be negative. The negative EV should be applied. Clearly in cases such as this the ELB will have a strong incentive to reach agreement with consumers on closure as early as possible. The ELB may wish to give consideration to assisting consumers switching to an alternative source of energy. If costs are associated with such support it is acceptable to include these costs in the determination of the EV.
Determining the Network ODV
3.81 Aggregation of the values (whether ODRC or EV) of the network segments post-optimisation and post-economic value analysis will produce the network system fixed assets ODV as required by regulation 20. In addition, for those parts of the network where EV values have been applied it will be possible to record both the ODRC and the EV, as also required by regulation 20.
Back to Top