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Unlocking the “lock-in” RAB regulation

The locking-in under RAB regulation prevents over- or under- recovery of costs, particularly for legacy assets, and thus promotes efficient investment decisions to provide high quality services at fair prices to the consumers.

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Globally regulators use different approaches to impel monopolies towards greater efficiency and fairer prices. Regulatory asset base (RAB) is one such approach which is being increasingly used for regulating infrastructure based industries/sectors. Though its use is relatively new in telecommunications, it has been used for a long time in other sectors including electricity transmission and distribution, gas transmission and distribution, water and sewerage, railways, aviation and postal services.

The RAB approach, also known as regulatory capital value (RCV) or regulatory asset value (RAV) approach, provides certainty to the access providers, access seekers and consumers. Under this approach the initial value of the RAB is established in the first regulatory period depending on past compensation of assets and asset lives. This value is locked-in and rolled forward to future regulatory periods. In each period RAB is used to find the required revenue (to cover the depreciation costs and additional network investments along with earning a reasonable return on capital) which is obtained using an appropriate costing/pricing structure. The locking-in ensures that access providers are able to recover their actual costs and access seekers and consumers only pay for the incurred costs.

The RAB approach was initially developed in the UK by Ofwat (the England and Wales regulator for water and sewerage). In its 1994 review Ofwat determined price limits ensuring that the interests of the customers were protected and the companies could operate on a “sound financial basis” while earning reasonable returns. Subsequently RAB was widely adopted by several sectors in the UK, Australia, New Zealand and a number of EU countries.

In the last few years the RAB approach has also gained some popularity in regulating wholesale access services in the telecommunication sector. Traditionally the regulation in this sector was dominated by the long-run incremental cost (LRIC) approach which uses forward-looking costs to revalue the assets in each regulatory period based on their optimised replacement costs. With technical developments constantly bringing efficiency improvements in telecommunications LRIC was believed to be the most suitable approach which would send “build-or-buy” signals to the access seekers and regulate prices based on the costs incurred by an efficient access provider to build a modern network today. As an example the Australian Competition and Consumer Commission’s (ACCC’s) 1997 Australian Pricing Principle Guide noted:

…in telecommunications where technology advances rapidly, historically incurred expenditures often have little relationship with (and generally overstate) the true economic costs of replicating an asset’s service potential. As such, it will often inflate the access price and encourage inefficient by-pass.

However telecommunications regulators have recently started realising that LRIC is not an ideal approach. For example in 2009 the ACCC initiated a review of its access pricing principles outlined in the 1997 Guide. Though the review was eventually suspended due to legislative changes, the ACCC issued a draft report in 2010 with the following reasons to discontinue the use of total service long-run incremental cost (TSLRIC+) for Australian fixed line services:

  • the uncertainty in asset prices due to ongoing asset revaluation, and the risk of over- or under- recovery of costs by the access provider.
  • the possibility of not considering previous depreciation of assets resulting in over-recovery of costs as assets are revalued at optimised replacement cost
  • the difficulty in finding appropriate values for modern equivalent assets (MEA) which are required for estimating the forward-looking costs of providing the service
  • the enduring bottleneck characteristics of the existing access network and increasing cost of bypassing the network leading to decrease in investment prospects by the access seeker
  • the use of nodes from the existing network (or scorched node approach) to model the network resulting in higher access prices compared to an efficient analysis using nodes from an ideal network built without any constraints from the existing network (or scorched earth approach).

In 2010 the ACCC proposed to replace the TSLRIC+ approach by the building block model (BBM). RAB was used in the BBM to issue the final access determination (FAD) for fixed line services in 2011. The ACCC concluded that BBM using a locked-in RAB promotes efficient investment decisions along with meeting the interests of both access providers and access seekers:

Locking-in a value for the RAB will promote predictable revenue and price paths and minimise the prospect of windfall gains or losses. It will reduce the risk that efficient expenditure will not be recovered, which will in turn promote efficient investment in infrastructure and promote competitive entry and competition in the relevant markets.

Another recent example of RAB endorsement in telecommunications is by the European Commission (EC). The EC’s Recommendation of 11.9.2013 specifies the methodology for setting the regulated wholesale access prices ensuring “operators can cover costs that are efficiently incurred and receive an appropriate return on invested capital”. It aims at sending “build-or-buy” signals to achieve twofold benefits:

  • promote competition by providing incentives to access seekers for efficient new entry
  • enhance broadband investment by encouraging access providers with significant market power (SMP) to invest in faster, newer and better broadband services.

The methodology outlined in the EC’s Recommendation suggests a combination of the bottom-up long-run incremental cost (BU LRIC+) and RAB approaches. Competition from cable, fibre and fixed wireless networks in Europe is pushing access providers to upgrade their copper networks and replace them with next generation access (NGA) networks. Hence BU LRIC+ approach is recommended for costing technical equipment and transmission medium as “no operator would today build a pure copper network”.

In contrast the deployment of engineering assets (such as ducts, trenches and poles), which forms a large part of the total costs, is not replicated by the access seekers if the existing assets can be reused. Consequently the EC’s Recommendation advocates the use of the RAB approach to avoid over-recovery of reusable legacy assets. It is suggested that regulatory accounting value should be considered for the initial RAB, which can be calculated by using depreciation, relevant price index, already recovered costs and elapsed economic life of the assets. The initial RAB should then be locked-in and rolled forward to the subsequent regulatory periods until the total value is recovered:

The locking-in of the RAB ensures that once a non-replicable reusable legacy civil engineering asset is fully depreciated, this asset is no longer part of the RAB and therefore no longer represents a cost for the access seeker, in the same way as it is no longer a cost for the SMP operator. Such an approach would further ensure adequate remuneration for the SMP operator and at the same time provide regulatory certainty for both the SMP operator and access seekers over time.

Although adoption of the RAB approach is a recent phenomenon in the telecommunication sector, its increasing popularity can be attributed to the certainty it provides to access providers and access seekers. The locking-in under RAB regulation prevents over- or under- recovery of costs, particularly for legacy assets, and thus promotes efficient investment decisions to provide high quality services at fair prices to the consumers.

July 2014

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