Replacement depreciation and price regulation

Abstract

Price regulation occurs quite commonly amongst natural monopolies which frequently include public utilities. In South Africa and in certain countries in Africa, there has recently been a revival of price regulation in certain industries and enterprises, where competition is limited or non-existent. Price regulation can be applied in a multitude of ways. Because of the importance of the price levels (historical and replacement) in the price setting exercise, the focus in this paper will be on the issue of depreciation to arrive at the final prices. The electricity utility industry was historically viewed as a highly mature and heavily regulated natural monopoly. In many parts of the world, electricity utilities have already been deregulated to a large extent and in the United States the process was preceded by a process of unbundling or ringfencing of the main divisions, i.e. generation and distribution. Even the network component of transmission, traditionally seen as natural monopolies, was deregulated to a large extent. The deregulation process, whether fully or partially, emphasised the requirement for a detailed explanation for a specific price level. The need for acceptable and transparent selling prices has, therefore, not disappeared. Regulatory pricing is consequently a vital component of pricing at this stage and in the restructured industry it will continue to play an important role because of a limited number of participants. In other sectors of the South African energy industry too, the deregulation process has either not started or has not been completed. Price regulation is presently and will in future be applicable to the liquid fuels industry, which includes the pipeline of Petronet as well as gas pipelines. Other industries which are being price regulated at the moment include water, medicine, telecommunication (fixed lines) and postal rates. Although the economic regulation for these industries may differ substantially, the principles applying to depreciation calculations would be similar. Replacement depreciation produces lower profit figures during periods of inflation. Quoted companies often oppose this system because of a lack of taxation recognition on income and the adverse effect on earnings per share. This paper covers the calculation of depreciation by price regulators where assets are not diversified (single assets). Shorter depreciation lifetimes based on historical cost result in an automatic provision for replacement depreciation. The extent of the provision would be a function of the difference between the actual and selected lifetimes, income tax rates, re-investment rates and the extent of the financial gearing ratio. Provision for replacement depreciation may be reduced significantly, if not reduced completely, by reducing depreciation lifetimes.