Building block model
The building block model is a form of public utility regulation that is common in Australia. Variants of the building block model are currently used in Australia in the regulation of electricity transmission and distribution, gas transmission and distribution, railways, postal services, urban water and sewerage services, irrigation infrastructure, and port access. The Australian Competition and Consumer Commission has stated that it intends to use a version of the building block model to determine indicative access prices for fixed-line telecommunications services. The building block model is so-called because the allowed revenue of the regulated firm  is equal to the sum of underlying components or building blocks consisting of the return on capital, the return of capital (also known as depreciation), the operating expenditure, and various other components such as taxes and incentive mechanisms. Origin. Although the principles behind the building block approach are very similar to the principles in many other regulatory regimes around the world (especially the UK), the first use of the term in Australia was in 1998 by the Office of the Regulator General (ORG) in Victoria (the predecessor of the Essential Services Commission of Victoria). The ORG issued a consultation paper  on the framework for setting price controls under the 1995 Victorian Electricity Supply Tariff Order, to apply to electricity distribution networks in Victoria from the beginning of 2001. The Tariff Order required the ORG to "utilise price based regulation adopting a CPI-X approach and not rate of return regulation". In a subsequent application for judicial review in the Supreme Court of Victoria, the regulator described the 'building block approach' that it had used to drive the X factor as follows: The court accepted that this 'building block approach' was not rate-of-return regulation: The Australian Competition and Consumer  Commission adopted a building block approach in its 1999 draft guideline on how it would set electricity transmission revenue caps under the 1998 National Electricity Code. The approach was subsequently adopted in other sectors regulated by the ACCC and by other state regulators around Australia. Following the replacement of the National Electricity Code with the National Electricity Rules in 2005, the building block approach was confirmed (with various modifications) in a 2006 review carried out by the Australian Energy Market Commission. The National Electricity Rules were amended in 2006 to provide that the annual revenue requirement for a regulated electricity  transmission network must be determined using a 'building block approach' under which the 'building blocks are: A similar provision has applied to regulated electricity distributors from 1 January 2008. In 2010, the ACCC issued a draft report proposing to adopt a form of the building block model in the regulation of fixed-line telecommunications services. The 1998 National Electricity Code did not allow the ACCC to roll forward automatically the value of the regulatory asset base from one regulatory period to the next (in contrast to the 1997 National Third Party Access Code for Natural Gas Pipeline Systems). however, under  both the current National Electricity Rules and National Gas Rules, the regulatory asset base is locked-in using the asset base roll forward equation below. The telecommunications regime has also been amended from 1 January 2011 to allow the ACCC to make access determinations that include 'fixed principles'. The amendment will allow the ACCC to lock-in the value of the asset base across regulatory periods. The basic model. The building block model is a tool for spreading or amortizing the expenditure of a regulated firm over time. The building block model, when applied correctly and consistently over time, ensures  that the firm earns a revenue stream with a present value equal to the present value of its expenditure stream. Put another way, the building block model ensures that over the life of the firm, the cash-flow stream of the firm has a net present value equal to zero. The building block model makes use of the concept of the regulatory asset base. The regulatory asset base – which is related to the capital stock of the regulated firm – represents the amount that the firm has, in effect, borrowed from its investors in the past (that is, the amount to  which its past expenditure has exceeded its past revenue) and is therefore the amount that must be paid back to investors (with interest) over the remaining life of the firm. In its simplest form, the building block model can be expressed as two equations, the "revenue equation" and the "asset base roll forward" equation. The revenue equation. The revenue equation is an expression which relates the allowed revenue of the regulated firm to the sum of the return on capital (the appropriate cost of capital multiplied by the regulatory asset base) plus the return of capital (also known as the  depreciation) plus the operating expenditure (in addition, in many applications of the building block model there are other terms, such as compensation for tax liabilities): Here: formula_2 is the target allowed revenue of the regulated firm in the current regulatory period, formula_3 is the appropriate cost of capital (also known as the discount rate) for the cash-flow stream of the firm during the current regulatory period, formula_4 is the closing regulatory asset base at the end of the previous period (the product of the cost of capital times the asset base is also known as the "return on capital ), formula_5 is the regulatory depreciation in the current period, and formula_6 is the expected or forecast operating expenditure of the firm in the current regulatory period. The revenue equation is embodied, for example, in the Post Tax Revenue Model" spreadsheet used by the Australian Energy Regulator. The asset base roll forward equation. The asset base roll forward equation is an expression which relates the closing regulatory asset base at the end of the period to the opening asset base at the start of the period plus any new capital expenditure that occurs during the regulatory period less any depreciation during  the regulatory period. Here: formula_8 is the closing asset base at the end of the current period, formula_4 is the closing asset base at the end of the previous period, formula_10 is the capital expenditure of the firm in the current period, and formula_5 is the regulatory depreciation during the current period. The asset base roll forward equation is embodied, for example, in the "Roll Forward Model" spreadsheet used by the Australian Energy Regulator. The primary reason for using the building block model can be stated as follows: Provided (a) the regulator chooses a path of the regulatory asset base  which starts at zero before the firm incurs any expenditure and ends at zero after the end of the life of the firm (or, equivalently, provided the sum of the allowed depreciation each period adds up to the total capital expenditure of the firm) and (b) provided the regulator chooses a value for the WACC which reflects the firm's true cost of capital then the resulting path of allowed revenue given by the equations above has the property that the net present value of the cash-flow of the firm (that is, the revenue less the expenditure) is precisely  zero. The building block model and incentives. The building block model can be implemented in such a way that the regulated firm receives a revenue stream just equal in value to the firm's out-turn expenditure. However, this is usually considered undesirable since it would result in the firm having no incentive to improve its overall efficiency or to increase the volume or quality of the services it provides. To overcome this problem the building block model is usually implemented in a way that allows the firm financial rewards for pursuing desirable objectives – such as reducing its expenditure, or  maintaining or improving service quality, and sometimes for selecting efficient capital investments, or promoting innovation. It is common in regulatory frameworks that make use of the building block model, to incorporate additional factors which reward the regulated firm for maintaining or improving service quality. Examples include the Essential Service Commission's S-factor scheme or the ACCC's Service Target Performance Incentive Scheme. Historically much interest has focussed on the incentives on the regulated firm to enhance efficiency – that is, incentives to reduce its expenditure while maintaining a given quantity and quality of output. In principle, the building block model  can be designed so as to yield either very low-powered incentives to minimise expenditure (which is sometimes known as cost-of-service or rate-of-return regulation) or very high-powered incentives. The building block model can be implemented in such a way as to yield very high-powered incentives to reduce expenditure by (a) setting the operating and capital expenditure inputs in the building block model on the basis of forecasts which are independent of the regulated firm's own actions, and (b) not "clawing back" any over-spend or under-spend at the end of the regulatory  period. However, very high-powered incentives create their own problems – they create strong incentives on the firm to cut expenditure or defer capital expenditure – even at the expense of reducing service quality. In addition, high powered incentives expose the regulated firm to higher levels of risk and give rise to strong incentives to lobby the regulator for a higher target level of revenue. Economic theory does not support the use of very high-powered incentives and, in practice, almost all practical regulatory regimes tend to involve medium-powered incentives. Although details vary across regimes, the most common approach to creating  incentives to reduce expenditure is to use a regulatory period consisting of many years. The allowed revenue is set once at the beginning of the regulatory period and there is no clawback of over-spend or under-spend at the end of the regulatory period – thereby allowing the regulated firm to keep some or all of the cost savings it makes during the regulatory period. The operating expenditure input to the building block model is usually based closely on the observed operating expenditure at the end of the previous regulatory period. This approach ensures reasonably strong incentives to reduce operating  expenditure in the early years of a regulatory period but can, in principle, lead to weak incentives to reduce operating expenditure in the later years of a regulatory period. One way to solve this problem is to base the operating expenditure not just on a single "test year" of the previous regulatory period but on the average of the previous years. In practice this problem is, instead, often addressed with some form of "efficiency carry-over" or "efficiency benefit sharing" scheme. When it comes to incentives to reduce capital expenditure, concerns arise relating to the strength of the incentives and  the possibility for inefficient substitution between opex and capex. Stronger incentives to reduce capex tend to create strong incentives to defer needed network upgrades with possible consequences for long-term service quality. Ofgem in the UK has experimented with improving measures of asset quality and combining capex and opex into a single "totex" expenditure measure. One common approach to handling capital expenditure is simply to allow the regulated firm to keep the depreciation allowance on any higher forecast capital expenditure and simply to "roll in" the out-turn capital expenditure into the regulatory asset base at the end of the  regulatory period. Many regulatory frameworks also give the regulator a role in assessing and approving new capital expenditure in what is known as a "prudency" or "used and useful" test. Variations and extensions. In practice, the building block model is often modified in various ways – particularly to create desired incentives on the regulated firm. These variations include adapting the model to a five-year regulatory period and the introduction of various explicit incentive mechanisms. The building block model and uncertainty. Most regulated firms continue to face some risk or uncertainty in their financial outcomes, due to uncertainty in the demand  they face or in their expenditure. Some of this exposure to risk is deliberately created by the regulatory regime in order to ensure the regulated firm faces desirable incentives (such as incentives to minimise its expenditure). Most of the time this risk is handled through relatively minor changes to the building block model. Specifically, in the simplest case the regulator must ensure that the revenue the firm receives is on average equal to the return on capital (calculated using an appropriate risk-adjusted cost of capital) plus the return of capital plus the average or "expected" operating expenditure. The regulator  can achieve this outcome either by ensuring that the regulated firm is compensated for uncertain events "ex post" or by ensuring the regulated firm receives sufficient compensation "ex ante". As an example of the former, many regulators allow the regulated firm to "pass through" cost events which are largely or entirely outside their control (such as changes in other regulated charges, or changes in some labour rates). On occasion, it is not feasible to rely on ex post compensation for a risk faced by the regulated firm. This might arise, for example, where the regulated firm faces a risk that  demand will drop (or will fail to materialise) in the future, limiting future earnings. Where this risk is material the regulator has no choice but to ensure the regulated firm is adequately compensated on average ex ante. As a general rule, where the regulatory framework ensures that the regulated firm is adequately compensated on average it must be the case that if there is some positive probability that the out-turn return of the firm is below the allowed cost of capital there must be a positive probability that the out-turn return of the firm is above the allowed  cost of capital so that, on average, the firm expects to receive the allowed cost of capital. The loss capitalisation model. In some circumstances, especially where the future demand for the services of the regulated firm is uncertain, there is a risk that the regulator will choose a path for depreciation which results in an allowed revenue in a given year which cannot be achieved by the regulated firm (perhaps because demand in that year is lower than expected). If the out-turn revenue of the regulated firm falls short of the allowed revenue in a given year and  this is not recognised in the regulatory framework, there is a risk that the regulated firm will not be allowed to earn a cash-flow stream with an NPV of zero overall (in other words, the investors in the firm will be left under-compensated). To overcome this possibility it may make sense to allow the regulated firm to "capitalise" any short-fall in out-turn revenue relative to allowed revenue in a given year by simply adding the shortfall into the regulatory asset base. This approach is equivalent to allowing the firm to defer some of its depreciation in  years in which demand is lower than expected. This approach, which has been termed the "loss capitalisation model" has been considered by the ACCC in the context of the regulation of access to rail track infrastructure in Australia. Cost of capital. The building block model is a tool for amortizing the expenditure of a regulated firm in such a way that the expected net present value of the cash-flow of the firm is zero. For this to be achieved, the regulator must choose the cost of capital to reflect the correct cost of capital or discount rate for the  associated cash-flow stream of the firm. This is usually carried out by estimating a weighted average cost of capital for the cash-flow stream of the firm as a whole. Under the standard regulatory approach in Australia where the tax liabilities of the firm are handled as an additional element in the firm's revenue equation, the appropriate weighted average formula is the simple "plain vanilla" formula, consisting of a weighted average of the cost of capital for the firm's equity and the cost of capital for the firm's debt. The cost of capital for the firm 's debt is usually estimated by observing the currently prevailing return in the market for corporate bonds of a similar credit rating and duration. The cost of capital for the firm's equity is usually estimated using the capital asset pricing model. There has been some controversy in Australia over the correct timeframe for the cost of capital. The ACCC and some academics have argued that the correct term for the cost of capital should be the length of the regulatory period (normally five years). Regulated businesses have argued, however, for a longer term - equal to the term of the  longest normally-available government bonds (which is usually ten years). The Australian Competition Tribunal in 2003 held that the use of a long-term rate was appropriate and the common practice in Australia has been to use a ten-year rate since. The building block approach versus index-based approaches. Almost from the start of the current period of public utility regulation in Australia (dating from the late 1990s) commentators have argued against the use of the building block model and in favour of a regulatory approach in which a regulated firm's revenue allowance is set primarily on the  basis of an industry-wide change in an index of productivity. This latter approach has been known as a total factor productivity or Index-Based approach to regulation. Advocates of the TFP or index-based approaches to regulation have claimed that it would result in more powerful incentives to reduce expenditure and lower regulatory costs. Supporters of the current regime have argued that the building block framework is capable of accommodating higher-powered incentives if that is desired, that higher-powered incentives are not necessarily desirable, and that, in practice, almost all regulatory regimes in use around the world involve  periodic resetting of allowed revenues to out-turn expenditure - in a manner similar to the current practice in Australia. There does seem to be common ground that there is greater scope for benchmarking - that is inter-firm comparisons of efficiency - in regulatory practice in Australia. The Australian Energy Market Commission is currently carrying out a review of the possible role for total factor productivity in electricity distribution regulation in Australia.