Project Identification, Screening and Appraisal

Box 3: Importance of Assessments that Account for Technological Changes: European Stranded Assets in the Utility Sector, 2010–2015

The development of the European utility industry since 2010 offers valuable lessons about how quickly and dramatically seemingly stable industries can change, and what implications this can have for investors. In 2005 the utility sector in Europe was highly profitable. In most integrated power utilities, the generation business represented a majority of earnings, the power plants were seen as the core assets of the company, and mergers and acquisitions resulted in large players that forecasted a steadily growing demand—based on the assumption that 1 percent gross domestic product (GDP) growth would result in an increased electricity demand of 0.5 percent to 0.8 percent. The reality looked different.

For the large utility players in Europe, a combination of falling energy prices, a push for renewable energy, advances in renewable power technology, energy efficiency improvements, and an economy that was weakened by the economic crisis in 2008 and 2009 created a toxic mix of negative growth, low utilization of large-scale power plants, and substantial margin pressure. Total impairment for the 10 largest power utilities was €129 billion from 2010 through 2015, and accelerated at a rate of 24 percent per annum. Of these 10 power utilities, six have seen a share price drop of more than 55 percent, from 2010 to 2016. If this development had been predicted at least partly just a few years earlier, construction of new fossil plants would have been stopped earlier, and enormous value would have been saved. It is sometimes argued that this was not a black swan event, and that a large part of what happened was actually predictable. Although the financial crisis and the decrease in coal and CO2 prices was difficult to foresee, the policy makers’ push towards decarbonization and renewable power was largely predictable, and the changing electricity/GDP growth ratio should also have been foreseeable.

Source: SEI (Stockholm Environmental Institute) and Material Economics. 2018. Framing Stranded Asset Risks in an Age of Disruption.

Regulatory Asset-Based Approach (RAB) - Does a RAB provide a better protection against asset stranding in comparison to the PPP model?

As mentioned above, one concern related to long-term PPP arrangements is that they may not be flexible enough to deal with unforeseen technological changes, in particular if they trigger structural changes in the market and asset stranding. Another model for private sector financing of infrastructure that has emerged and is sometimes discussed in this context is the Regulatory Asset-Based Approach (RAB).

For many years, many regulated companies, such as utilities, have used this approach. Under the generic RAB approach, the regulated company owns, invests in, and operates the infrastructure asset. It receives revenue from users and/or subsidies to fund its operations and recoup the investment costs. An economic regulator sets the tariffs to be charged by the regulated company to end users of the infrastructure. In order to identify an appropriate tariff, the economic regulator monitors both the company’s operating costs and the capital investments which it makes in respect of the infrastructure asset. The regulator then includes, in the tariff, an amount to cover the allowed operating and maintenance costs, plus financing cost of the capital investments (the cost of equity and debt, including an allowed return). Tariffs are reviewed and adjusted periodically by the regulator. Regulators have developed different models and introduced performance-based frameworks that encourage innovation between reviews (see also Box 7: United Kingdom: Office of Gas and Electricity Markets (Ofgem)—Framework for Price Control Incentivizes Innovation).

In the context of disruptive technology the RAB model has in particular advantages regarding the renegotiation of tariffs versus the PPP mode. The RAB model in the framework of price cap regulation represents a regulatory contract in the form of a license -- with a string of renegotiations, I.e. price reviews. These allow adjustments to the changing environment without weakening the ex-ante commitment of the bidders or influencing the future expectations of investors. Renegotiations of a PPP contract are invariably less structured than in a RAB model, primarily, because there is no economic regulator in the background.

However, while the RAB approach has been successful with regard to utilities it has also drawbacks that are explained in more detail in the sources listed below. One of the disadvantages is that the asset base of a regulated utility contains a collection of assets, with the result being that the individual assets are not subject to the same cost discipline as would apply to a PPP project. In addition, the effectiveness of the RAB depends on the quality of the regulator who needs to have the capacity and experience to control and monitor a number of infrastructure assets in order to set the right tariff, which may sometimes lack in developing countries.

Sources:

The Regulatory Asset Base Model and the Project Finance Model: A comparative analysis, International Transport Forum 2015.

Resetting price controls for privatized utilities : a manual for regulators. Economic Development Institute of the World Bank, 1999 .

Restoring Confidence in Public–Private Partnerships - Reforming Risk Allocation and Creating More Collaborative PPPs, ADB 2020.