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 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 at Modern Equivalent Asset (MEA) value, 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.
2.5 The ODV methodology involves the following steps:
- Calculation of Optimised Depreciated Replacement Cost (ODRC)
- preparing a detailed asset register
- calculating Replacement Cost (RC) using Modern Equivalent Asset values
- 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, using Modern Equivalent Asset values, 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 that are not to be exceeded.
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). It is important that objective lives be applied consistently across the industry, and accordingly Part Three prescribes maximum lives for assets that are not to be exceeded.
System Optimisation
2.11 The objective 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.
2.12 Optimisation consists of removing any surplus assets or excess capacity from the network configuration and the network elements, given the required level of service and network capacity.
2.13 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.
2.14 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)
2.15 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
2.16 System fixed assets are valued at their economic value when it would not be possible for them to earn sufficient long-run profits to provide an appropriate return on the ODRC of the assets. That is, the assets are not commercially sustainable in the long run.
2.17 Generally networks should be partitioned into segments for EV analysis. It is important that economic value tests be applied consistently across the industry. Accordingly, Part Three prescribes the minimum approach to segmentation and to performing the economic value analysis of system fixed assets.
2.18 The revenue that can be derived from system fixed assets is determined from assessing the profit maximising long-run line tariffs that could be applied to consumers. It is important that objective profit-maximising long-run line tariffs be applied consistently across the industry, and accordingly Part Three prescribes the maximum line tariff that can be applied.
How to Determine the EV Value
2.19 The economic value ("EV") of any system fixed assets in a segment of the network is the maximum of the net realisable value and the present value of the after-tax cashflows attributable to that segment, less any initial investment in non-system fixed assets and working capital associated with the asset. The items comprising the Present Value are:
- the after-tax operating cashflows;
- less any capital expenditure performed on the segment;
- plus the proceeds from any disposals of assets on the segment;
- less any increase in working capital;
- plus the estimated economic value of the system fixed asset at the end of the period of analysis;
- less any initial investment in working capital; and
- less any initial investment in non-system fixed assets.
That is, the principal PV equation is:
Where k is the period of analysis for the segment being valued and WACC is the weighted average cost of capital for the ELB.
Putting ODRCs and EVs Together
2.20 As indicated previously 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.
2.21 The overall system ODV is determined by the aggregation of the ODRCs for those assets to which an ODRC valuation is applicable, and the EVs for those assets for which an EV valuation is applicable.
Figure 2.1 Determination of ODV
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