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, and the information to be included in valuation reports about the optimisation and economic valuation procedures.

3.2 Disclosure of the individual items listed in regulation 20 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. The process of optimisation and the application of EVs must be backed up by disclosed criteria for the quality of supply and forecasts for load growth, together with details of the optimisation and economic valuations undertaken.

Valuation of the System Fixed Assets at Replacement Cost (RC)

3.3 There are two steps in the determination of replacement cost:

preparing a detailed asset register;
valuing the assets at Modern Equivalent Asset costs.

Preparing a Detailed Asset Register

3.4 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 computerized 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).

3.5 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.

3.6 Appendix A gives the minimum classification of system fixed assets expected to be used by local ELBs.

3.7 As well as system fixed assets, stores and spares that can be connected to the network in place of existing network equipment may be valued as part of the ODV. ELBs must have a record of stores and spares, preferably in a computerised ledger system. In cases where complete records are unreliable, it may be necessary to undertake a stocktake for valuation purposes. The quantities of items held in stock must be consistent with the historical reliability of the equipment, the number of items installed on the network and an ELB's disclosed quality criteria. Stores and spares must be shown as a separate line item in the valuation report.

3.8 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.

3.9 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.

Exclusion of Assets

3.10 Assets such as head office buildings, office furniture and equipment, motor vehicles, tools, plant and machinery, works under construction, consumers' meters and consumer-based load control relays, 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.

Valuing the Assets

3.11 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 not to be exceeded are set out in tables 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.

3.12 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)

3.13 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.

3.14 Any 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.

3.15 Any grants or contributions that have been received should be ignored as it is the deprival value of the assets that is required, not the actual investment.

3.16 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

3.17 Asset replacement costs should be depreciated when the existing asset's remaining service life is less than the total life (TL) 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.

3.18 The straight line method of depreciation should be used such that the Depreciated Value (DV) is determined as:

Formula

where:	UDV	=	Undepreciated Value (i.e. Replacement Cost (RC))
	RL	=	Remaining life
	TL	=	Total Life.

It is clear from the above that both the Total Life and the Remaining Life need to be established for all assets.

Determining Asset Total Lives

3.19 The maximum TLs of Modern Equivalent Assets (MEA) 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.

3.20 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

3.21 The life of each asset commences when the equipment is commissioned. The basic procedure for determining RLs is to subtract the age of assets from their TLs.

3.22 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.

3.23 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 unless clearly documented historical evidence can be presented to the valuer.

3.24 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.

3.25 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.

Refurbishment

3.26 Appendix B provides procedures for assigning RLs in cases where assets have been refurbished.

Fully Depreciated Assets

3.27 In some cases assets which have not been refurbished may still be in service at the end of their TL. In such cases the asset will have been fully depreciated over its life, but may have a Net Realisable Value (NRV) equal to its scrap value after costs of disposal. The value of such assets is their NRV. Generally the NRV of ELB system fixed assets, once the cost of disposal is netted off, is low and can be set aside as not of material value.

Determining the Depreciated Replacement Cost (DRC)

3.28 Aggregation of the DVs (and any NRVs) 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

3.29 Optimisation should be undertaken only after the RC and the DRC of the existing network asset base have been calculated.

3.30 Optimisation of the ELB's system fixed assets must be carried out to ensure that only assets (or elements thereof) that would be required and fully used in an optimised design of the network are valued. The resulting ODRC valuation should be based on an optimal, modern efficient design that:

provides a quality of supply similar to that which currently exists and which does not exceed the ELB's standard quality of supply criteria;
has sufficient capacity to meet existing demand and, where appropriate, allowed future load growth; and
is depreciated to the same degree as the existing assets.

3.31 Optimisation consists of three stages:

identifying stranded assets;
optimising the system configuration; and
optimising elements in the system.

3.32 The determination of the MEA that would replace existing individual network components is NOT part of the optimisation process. This must be done prior to calculating the RC and, for most network components, has already been taken into account in the maximum replacement costs given in Appendix B.

Constraints on Optimisation

3.33 The optimisation must be carried out subject to the following constraints:

the optimised network must not exceed the existing level of supply security and no part of the network may exceed the ELB's disclosed quality of supply criteria unless non-standard contracts with customers exist that guarantee an enhanced quality of supply;
the location of points of connection to other networks should be assumed to be fixed. However, where a point of connection can be by-passed and this allows a reduction in the replacement value of ELB assets, then that point of connection must be deleted for valuation purposes;
the location and number of existing customers should be assumed fixed; and
the existing boundaries of the ELB should be assumed fixed.

The Process of Optimisation

3.34 Optimisation of the network should be undertaken on a systematic basis. The optimisation process must ensure that all excess capacity that will materially affect the replacement value of the network is optimised out. Optimisation must be undertaken systematically on the following parts of the network:

points of connection to other networks;
zone substations;
subtransmission lines;
each individual high voltage distribution feeder. For the purposes of these rules a feeder includes the distribution network supplied by a single high voltage connection to a distribution substation or to a high voltage switching station, under normal operating conditions; and
the low voltage distribution system;
stores and spares.

Future Load Growth

3.35 The maximum capacity of any part of the optimised network shall be determined by the forecast load growth at the end of the relevant planning period. However, in no case shall optimised capacity exceed existing capacity.

3.36 In order to assure compliance with paragraph 3.35, ELBs must disclose, in the valuation report, both existing loads and the load growth forecast used as a basis for optimisation. As a minimum, existing and forecast loads must be provided for each point of connection, each zone substation and each distribution feeder. Clear justification and a detailed derivation of the load growth forecasts are required. Both the existing maximum demand, and the forecast maximum demand at the end of the planning period, are required. Allowances should be made, where possible, for different growth rates in different parts of the network. Existing loads may be estimated where metering is not available.

3.37 The planning periods over which future load growth can be allowed for shall not exceed the following:

for transmission networks (being networks with a voltage above 33 kV) and points of connection to a transmission network, 10 years;
for sub transmission networks and zone substations, 10 years;
for HV and LV distribution, and other network assets 5 years; and
for distribution transformers no future load growth is permitted. Distribution transformers must be optimised in terms of capacity utilisation, based on current network loadings.

Quality of Supply

3.38 The optimised network must be designed to supply the existing load, and allowed load growth, with a quality of supply that matches the level that currently exists for each part of the network except where this is greater than the disclosed quality of supply criteria.

3.39 An ELB is required to disclose, in its valuation report, the quality of supply criteria that it currently uses as a basis for network design. This should be based on the ELB's analysis of customer requirements and its assessment of network maintenance requirements and costs.

3.40 Relevant quality of supply standards include:

the degree of security (redundancy) in different circumstances or localities;
target reliability indices for different areas of the network (CBD, urban, rural);
voltage regulation criteria;
levels of electrical losses.

3.41 The degree of security shall be disclosed 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.) It is recognised that some ELBs are now analysing the degree of security on a probabilistic, rather than a deterministic basis. However, it is nevertheless necessary for an ELB to express its degree of security criteria in such a way that the optimisation process is transparent and can be shown to have been applied consistently across all parts of the network.

3.42 For distribution ELBs, the level of security used as a basis for optimisation shall not be greater than (n-1). Furthermore, an ELB's disclosed quality of supply criteria shall provide for a maximum load, and allowed future load growth on any urban feeder which is normally operated in a closed loop with another feeder of not less than 50% of the optimised feeder rating. In the case of an urban feeder normally operated in a radial configuration the quality of supply shall provide for a maximum load and allowed future load growth under normal operating conditions of not less than 67% of the optimised feeder rating. An urban feeder is one that has a load density greater than 300 kVA per km. A higher level of security is permitted where a specific customer non-standard contract exists or where the network supplies a CBD area. In such cases the higher level of security used as the basis for optimisation must be disclosed in the valuation report.

3.43 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, relevant decisions of the Grid Security Committee (GSC) and the contractual relationship between Transpower and its connected customers.

3.44 Existing assets that provide a quality of supply greater than that disclosed by the ELB must be optimised out, except where the assets are required in order to meet the ELB's contractual obligations to provide an improved level of security to specific customers.

Identifying Stranded Assets

3.45 Any system fixed assets that are not required to supply line services to customers should be identified and excluded from the optimised network. Such assets are known as Stranded Assets.

Optimising the System Configuration

3.46 Optimisation of system configuration should be carried out in conjunction with the ELB's Planning Engineer or other suitably qualified person. A good current knowledge of electrical system planning is required as optimisation is concerned with the redesign of the system configuration, where the existing configuration exceeds the disclosed optimisation criteria, and not just with the replacement of individual components.

3.47 Optimisation of system configuration must be carried out by considering alternative configurations subject to the constraints on optimisation and in accordance with the relevant criteria relating to the quality of supply declared by the ELB. The optimised configuration is the one that satisfies the relevant optimisation criteria at minimum overall replacement cost.

3.48 In optimising the configuration of the high voltage distribution system, the routes of existing distribution lines should be considered to be fixed, provided they are still required to give supply to existing customers. However assets over and above those required to meet the disclosed quality of supply criteria must be optimised out.

3.49 In the process of optimising the system configuration, certain assets or groups of assets may become excess to requirements and should be valued at nil, while other new assets may need to be notionally brought in. Issues with the optimisation of the system configuration for ELBs are set out in Appendix C.

Optimising Elements in the System

3.50 After the configuration of the system has been optimised, the elements within it must be optimised by considering whether lower capacity elements with a lower replacement cost would be adequate. When optimising the elements within the system the ELB must individually consider all high voltage distribution feeders and the material assets within them. Issues with the optimisation of the system elements for ELBs are set out in Appendix C.

Optimising Network Equipment Spares

3.51 Network equipment spares may be included in the ODV as long as the spares are the same as assets installed in the network. Further, the quantity of the spares to be valued in the ODV must not exceed a reasonable quantity required to meet the ELB's disclosed quality of supply criteria.

3.52 Stranded assets may be valued as network spares, subject to the criteria set out in paragraph 3.51.

Determining the Optimised Depreciated Replacement Cost (ODRC)

3.53 Once the optimised system has been determined those parts of the optimised network that are different from the existing network must be re-evaluated. This entails applying the cost of the modern equivalent assets as set out in Appendix B and ensuring that these are depreciated to reflect the service potential of the existing assets.

3.54 Stranded assets that are not required as network equipment spares, shall be assigned zero value for the purposes of ODV. It is permissible to assign the NRV of such stranded assets to the "other businesses" owned by the ELB. This is consistent with the Avoidable Cost Allocation Methodology (ACAM) rules. Since stranded assets are avoidable by the ELB, NRVs associated with their disposal should not be assigned to the system fixed assets.

3.55 When assets are notionally brought into the system through optimisation they should be valued at their replacement cost, with reference to the costs in the Appendix B tables.

3.56 When optimisation leads to existing assets being notionally replaced, the replacement asset shall 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 shall 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.

3.57 Aggregation of the ODRCs of the fixed assets in the optimised system will produce the network ODRC as required by regulation 20. In addition, for those assets 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

3.58 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 Economic Value (EV)

Introduction

3.59 It is necessary to identify the assets on the network that cannot earn a commercially appropriate rate of return (WACC) on their ODRC value. Such assets must be valued at EV and not ODRC. Earnings from such assets may be constrained because the profit maximising revenue that they could generate is insufficient to cover all cash costs and still allow an appropriate return to be made on the ODRC of the assets. Thus, if the EV of an asset is less than its ODRC, the ODV of the asset is its EV.

3.60 The process for determining which assets should have EV values, what those values should be, and the final network ODV, has the following steps:

identifying the segments for EV testing;
determining the profit maximising line tariffs for consumers on the segments to be tested;
calculating the EV based on these profit maximising line tariffs; and
where the EV of the assets in a segment is less than the ODRC of the assets, valuing the assets at EV.

Definition of Segments for EV Testing

3.61 Segments are to be defined by reference to feeders and spurs (for local ELBs) and points of supply (for Transpower).

3.62 Feeder: For the purposes of these rules, a feeder includes the distribution network supplied by a single high voltage connection to a distribution substation or to a high voltage switching station, under normal operating conditions.That is, feeders are separated from each other by switches that are normally open and which are only closed during fault conditions. For the purposes of EV analysis, the incremental substation assets associated with a particular feeder are included. The spurs radiating from feeders are part of the feeder.

3.63 Spur: For the purposes of these rules, a spur is defined as a section of a feeder where there is only one route for the supply of electricity. That is, if supply is interrupted on a section of a spur, supply cannot be restored to points downstream of the interruption via an alternate route. Generally, spurs will occur at the outer extremes of a network, but there may be instances of spurs occurring within the interior of the "meshed" network.

3.64 Point of Supply (Transpower):For the purposes of these rules, a point of supply is defined as any point where the transmission network is connected to a network or facility owned by any party other than the transmission owner. Such points are commonly referred to as grid exit points (GXPs).

3.65 Segmentation on the basis of tariffs or tariff areas is not permitted.

Identifying the Segments for EV Testing

3.66 It should not be necessary to test all the segments to see whether an EV valuation might be appropriate. Those parts of the network that are least likely to be economic should be delineated by segment from the rest of the network.

General Criteria

3.67 Some of the characteristics of parts of a network that are least likely to be economic are:

Other parts of the network have limited dependence on the segment. This means that the segment is not required for:

delivery of electricity to customers in other parts of the network; and/or
reliability, availability and security (e.g. back-up delivery)for customers in other parts of the network.

The segment is likely to have a relatively high cost of supply, relative to other parts of the network. High cost segments may:

have low customer density; and/or
have low load usage relative to capacity;
(This may be the case now or it may be anticipated in the future. For example, where large customers are lost due to industry rationalisation, closures or relocation, where bypass has occurred, or where large feeder lines have been installed in anticipation of future loads which have not occurred); and/or
be at a remote part of the network.

The prices that can be charged on the segment are likely to be relatively low because of the:

availability of low cost substitute fuels; and/or
opportunity for low cost by-pass, or occurrence of actual by-pass, of the segment; and/or
risk of customer disconnection; and/or
constraints imposed by existing contract conditions.

3.68 Segments that should be identified for EV tests may have any number or combination of these characteristics. These are most likely to occur in semi-rural or rural areas. It is not expected that feeders in urban areas will have these characteristics.

3.69 If those parts of the network that are least likely to be economic prove in practice to be uneconomic, then the next tier of segments must be identified and tested. This process must be repeated until uneconomic segments are no longer found.

Specific Criteria

3.70 The following are specific criteria for identifying segments where the EV of the segment must be calculated for all ELBs. The process follows a sequence whereby the evaluation starts with the feeders, then the spurs off the feeders.

Feeders

The EV of a feeder must be calculated if there is an average of 3.0 ICPs or less per km and an average of less than 20 kVA installed capacity per ICP over the length of the feeder, including its spurs.
If the EV of the feeder, including its spurs, is less than its ODRC, the feeder, including its spurs, must be valued at its EV. In these circumstances, the spurs off that feeder do not have to be evaluated separately.
Where the number of feeders, valued at EV, emanating from a substation is sufficiently large so that the substation should be valued at its EV; the analysis must be extended further into the network. This will involve analysis of the feeder(s) supplying the substation and by iteration may require the EV analysis to be extended to zone substations and grid exit points.

Spurs

The EV of a spur must be calculated if there is an average of 3.0 ICPs or less per km and an average of less than 20 kVA installed capacity per ICP over the length of the spur, including any branch spurs.
If the EV of the spur, including its branches, is less than its ODRC, the spur, including its branches, must be valued at its EV.

Points of Supply (Transpower)

An EV analysis must be performedon all points of supply which have been:

subject to submissions regarding "excessive costs" and possibility of by-pass; or
otherwise identified as "high cost"; or
identified as in a revenue constrained situation.

An EV analysis must be performed onthe HVDC link.

3.71 It should be noted that feeders and spurs, where minimum criteria do not hold, might still have uneconomic sections. It is not practical to specify a rule to cover all circumstances and so the above rules are minimum criteria. Line owners are encouraged to perform a more rigorous analysis of their network.

Determining the Profit Maximising Tariffs

3.72 Having identified the segments for which EV must be calculated, the next step is to determine the profit maximising revenue that could be earned from each segment. The revenue that could be earned must be based on the (long run) profit maximising tariffs that could potentially be charged. If actual tariffs or tariffs less than the (long run) profit maximising tariffs are used, then the EV for those segments may be understated. Where this results in an EV less than ODRC it will result in an understatement of ODV.

3.73 The profit maximising line tariff is the tariff that would maximise the ELB's profit derived from a segment of assets. By definition, the profit maximising tariff can be no greater than the maximum sustainable tariff, because at any tariff higher than the maximum sustainable tariff consumers would disconnect, and profits from these consumers would fall to zero.

3.74 In determining profit maximising tariffs, 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.

3.75 When assessing the profit maximising line 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.

Maximum Values

3.76 The following constraints are imposed on the profit maximising line tariff that may be used for EV:

The profit maximising line tariff must not exceed 30¢/kWh for local ELBs (this tariff excludes energy costs but includes transmission costs).
The profit maximising line tariff for Transpower must not exceed 6¢/kWh.

Calculating the EV of a Segment

3.77 The economic value ("EV") of the system fixed assets in a segment of the network is the maximum of the net realisable value of these assets 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. Thus the economic value of the system fixed assets in a segment of the network is:

Formula

3.78 The EV test should be calculated by applying an avoidable (incremental) cost allocation methodology (ACAM). Under ACAM each segment is treated as "incremental" to the rest of the network (including other segments, which are tested separately). The rest of the network is treated as the "stand-alone" business.

3.79 The avoidable cost allocation methodology makes an assessment of the expenses, revenues, assets, and liabilities that would be avoided by the line owner if it did not operate its "incremental" (the segment) business. These components are allocated to the segment. Revenue is adjusted from its actual level to its profit maximising level.

Net Realisable Value

3.80 The NRV of an asset is its value in its best alternative use. This is commonly viewed as the scrap value of the asset and is the proceeds, less the costs, of realisation. If the NRV of an asset exceeds the present value of the cashflows that can be obtained from the asset, then the economic value of the asset is its NRV.

3.81 Section 62 of the Electricity Act 1992 requires existing consumer connections to be maintained until 31 March 2013, unless consumers agree to disconnection. Therefore, the EV of the assets in a segment can only be valued at their NRV if the consumers connected to those assets have agreed to disconnection. If disconnection has occurred these assets are effectively stranded.

Present Value of the After-Tax Cashflows and Initial Investments

3.82 The components of the present value of the after-tax cashflows and initial investments are:

the after-tax operating cashflows;
less any capital expenditure on the segment;
plus the proceeds from any disposals of assets from the segment;
less any increase in working capital;
plus the estimated economic value of the system and non-system fixed assets and working capital at the end of the period of analysis;
less any initial investment in non-system fixed assets; and
less any initial investment in working capital.

That is, the principal PV equation is:

Formula (1)

Where:

PV is the economic value today (i.e. at time t = 0) of the system fixed assets in the segment;
ATOCF is the expected or forecast after-tax operating cashflows and equals (revenue - operating expense) - tax(revenue - operating expense - depreciation);
CapEx is expected new capital expenditure on the network segment;
Disposals are the expected after-tax proceeds of asset sales or disposals;
WCis the expected change in working capital over time;¹
EV_k is the expected economic value at time t = k of the system fixed assets in the segment;
NSFA_k is the non-system fixed assets at time t = k that are incremental to the network segment;
WC_k is the working capital at time t = k that is incremental to the network segment;
NSFA is the opening non-system fixed assets that are incremental to the network segment;
WC is the opening working capital that is incremental to the network segment;
WACC is the weighted average cost of capital; and
k is the period of analysis for the segment being valued (i.e. from t = 1 to k);
the subscript t is time, and this allows the EV to be calculated for any expected life of the segment.

Components of the Present Value Calculation

Revenue

3.83 This item consists of all revenue from the profit maximising line tariffs that could be derived from the consumers on the segment. This revenue does not include any interest income. This revenue is not to be based on current line tariffs unless these are demonstrably the profit maximising line tariffs, nor should the revenue be graduated from current to profit maximising line tariffs levels.

3.84 Revenue may be adjusted for future load growth, which can occur through the increased consumption of existing consumers or the addition of new consumers. Any adjustments for future load growth must comply with the rules in paragraphs 3.36 and 3.37.

3.85 Capital contributions are generally regarded as revenue and taxable income and so should be included in the segment's revenue. If capital contributions are included they must not be offset or deducted from the related capital expenditure.

Operating Expenditure

3.86 Operating expenditure only includes the cash operating expenses that are directly related (incremental) to the segment of network being valued. Operating expenditure does not include any expenditure that cannot be specifically linked to the segment, or expenditure that could not be avoided if the segment was removed from the network. Operating expenditure does not include:

depreciation, as this is not a cash expense;
any amortisation of any intangibles, as these are not cash expenses;
interest expense (this is not an operating expense - it is a cost of funding).

Depreciation

3.87 Depreciation is included in the analysis because of its tax effect. The depreciation expense must be that allowed for taxation purposes. This will differ from that based on ODV where the tax and ODV asset values and their tax depreciation and economic lives differ.

Tax

3.88 The after-tax operating cashflows are specified as:

ATOCF	=	(revenue - operating expense)
	-	tax(revenue - operating expense - depreciation)

3.89 If the revenue from a segment is insufficient to offset the cash operating expenses plus the tax depreciation expense, a tax loss will be attributable to the segment. Assuming any tax loss can be used to reduce taxable income derived elsewhere on the network, the tax loss represents a positive cashflow as it reduces tax payments. The amount of the reduction in tax payments equals the tax loss multiplied by the tax rate. Mathematically:

if revenue < operating expense + depreciation

then the tax loss = revenue - operating expense - depreciation

and

the reduction in tax payments = - tax(revenue - operating expense - depreciation)

3.90 That is, the reduction in tax payments is a positive cashflow on the assumption that these losses can be used to offset income elsewhere. Thus the specification of after-tax operating cashflows above, correctly treats the economic impact of tax losses without any further adjustment.

3.91 The tax rate must be the corporate tax rate applying in New Zealand.

Capital Expenditure

3.92 Capital expenditure includes all cash outlays on the segment that are not classified as operating expenditure. It includes capitalised replacements of assets and extensions to the segment.

Disposals

3.93 Disposals refer to the after-tax proceeds (if any) from the removal and sale of any assets on the segment. It includes the ODRC of any assets transferred to spares (note that if such transfers result in an excess of spares, the ODRC is zero). Disposals may have a negative value.

Working Capital

3.94 The working capital items are those associated with the segment. They include accounts receivable attributable to consumers on the segment and accounts payable associated with operating expenses incurred on the segment. Changes in these working capital items should be included to correctly represent actual cashflows. For example, an increase in accounts receivable (which increases working capital) means that less cash was actually received in the period than indicated by the revenue figures. As such there has been an investment of capital and this should therefore be treated as a cash outflow.

3.95 For the purposes of calculating the EV of a segment, it may be reasonable to assume that in periods of low inflation, and no growth in electricity demand and consumer numbers, that changes in working capital items will be zero. In these circumstances, the term (WC_t in equation (1) is zero.

Non-System Fixed Assets

3.96 These are the fixed assets for which the valuation is not covered by this handbook and that are directly related (incremental) to the segment of network being valued. The allocation of non-system fixed assets to the segment does not include any items that cannot be specifically linked to the segment, or items that could not be avoided, if the segment was removed from the network.

Discount Rate

3.97 The after-tax weighted-average cost of capital (WACC) is used as the discount rate. In most cases the WACC for the segment will be the same as the WACC for the line business overall.

3.98 The EV must be calculated on an after-tax basis. Although it is theoretically possible to perform the analysis on a pre-tax basis, in practice it is very difficult to derive the correct pre-tax discount rate. One cannot normally gross up the after-tax discount rate to a pre-tax rate and discount the pre-tax cashflows.

Simplifications to the General Model and Equation (1) for a Segment to Be Maintained in Perpetuity

3.99 The following section simplifies equation (1) where the segment is intended to remain in operation in perpetuity and certain assumptions can be reasonably made. Note that the present value of EV_k, NSFA_k and WC_k is effectively zero in these circumstances as the period analysed is perpetual.

Assumption 1: Changes in working capital are zero. This may be a reasonable assumption in periods of low inflation and little or no change in the expected growth of the network segment.

Assumption 2: The expected after-tax operating profits are constant in each period.² Thus the expected after-tax operating cashflows can be re-expressed as:

ATOCF	=	(revenue - operating expense- depreciation)
	-	tax(revenue - operating expense - depreciation) + depreciation
	=	NOPAT + depreciation

where: NOPAT is the expected net operating profit after-tax and is calculated by including depreciation for taxation purposes as a deductible expense.³

Assumption 3: Expected capital expenditure on the segment will occur uniformly through time and offsets expected depreciation and disposals of the assets on the segment. The capital expenditure should be sufficient to maintain the operating assets of the network segment in perpetuity. Thus, the after-tax cashflows ("ATCF") are:

ATCF	=	NOPAT + depreciation- CapEx + Disposals
	=	NOPAT

Equation (1) can now be written as:

Formula (2)

When expected NOPAT is assumed constant over time (i.e. assumption 2), equation (2) can be re-expressed as:

Formula (3)

A Simple EV Test

3.100 The above analysis (equation (3)) yields a simple test to determine whether or not the assets in a segment that is to be maintained in perpetuity, should be valued at ODRC or EV:

if NOPAT < WACC x (ODRC + NSFA + WC)

then ODV = EV, otherwise ODV = ODRC.

Minimum Acceptable EV Method

3.101 The simple EV test specified in paragraph 3.98 is the minimum acceptable method to be used in calculating the economic value of the assets comprising a segment of the network. More detailed approaches that relax some or all of the specified assumptions may be used, but if such alternate approaches are used, the valuer must be satisfied that the alternate approach will produce a more accurate result. However, whatever approach is used, the EV must be calculated on an after-tax basis.

3.102 The EV methodology used to test segments must be disclosed in the ODV report.

Determining the Network ODV

3.103 Aggregation of the values, whether ODRC or EV, of the network assets will produce the value of the network system fixed assets at ODV as required by regulation 20.

¹∆WC will be negative if working capital is expected to decrease.

²It is also implicitly assumed that expected tax depreciation on fixed assets is constant over time

³In calculating NOPAT interest expense is excluded from operating expenses.

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Printed: 26/11/2009