Application Martin No: gr9902 Jones Contents

Working Capital

Epic objected to the Commission’s proposed amendment in relation to working capital. According to Epic, the need to account for working capital arises because at the time Epic acquired the MAPS, there was an initial period during which payments were required in advance of revenue being received. This ‘gap’ was financed by an initial injection of working capital. This must be recognised, and the cost of that working capital must be taken into account, irrespective of the timing of subsequent receipts and payments.⁴⁸

Epic disagrees with the Commission’s argument that working capital should not be included in the capital base on the basis that all revenues are modelled as accruing to Epic at the end of each year, when in reality, revenues accrue to Epic frequently throughout the year. According to Epic:⁴⁹

The Commission’s determination of required revenue does not proceed from cash flow and present value considerations. It proceeds from determination of a cost of service, and one of the costs of providing service is the cost of the working capital required to bridge an initial gap between receipts and payments. It must be included in the cost of service.

Commission’s considerations

The Commission believes that Epic has not understood its arguments for not including working capital in the capital base. The Commission’s determination of required revenue under the cost of service approach does in actual fact centre around cashflow modelling. In recent correspondence, Epic stated that it was not clear from the Commission’s Draft Decision why it would receive a cashflow timing benefit, in excess of the amount of working capital proposed by Epic.⁵⁰

The inclusion of working capital in the asset base is incompatible with the Commission’s approach to cashflow modelling. If the Commission included working capital in the capital base, then it would need to revise its approach to cashflow modelling in order to maintain internal consistency. As can be seen in the following example, such a shift would be detrimental to Epic.

Epic proposed an amount of $820,000 to be included in the capital base for working capital. Depreciation over a year (2001) for the MAPS is in excess of $3 million. The Commission calculates Epic’s required revenue for 2001 on the opening balance of the capital base and assumes revenue is received at year-end. However, if the Commission was to be more precise it would model cashflows to more accurately represent their actual timing. In the case of depreciation, this would involve calculating the average capital base over the year rather than the opening capital base. The impact of depreciation alone in this calculation would be to subtract in excess of $1.5 million from the capital base, nearly double the amount Epic is requesting to be included for working capital. Depreciation is just one example of the benefits accruing to Epic as a result of modelling cashflows on an annual basis, and assuming that cashflows occur at year-end.

The Commission could model Epic’s cashflows on a monthly basis rather than an annual basis, which would remove the benefits accruing to Epic as a result of the time value of money. Under this scenario, it would be appropriate to include an amount for working capital. However, the example given above clearly indicates that Epic’s required revenue as determined by the Commission would certainly be less as a result of more detailed cashflow modelling. The Commission has however adopted a light-handed approach to regulation and for this access arrangement has calculated the required revenue on an annual basis. Therefore, Epic’s proposal to include an amount for working capital in the capital base is not accepted.

Amendment FDA2.

For the access arrangement to be approved, the Commission requires that the working capital component not be included in the value of the capital base for the purpose of calculating Epic’s capital charge (return on capital assets).

Commission’s capital base roll-forward

The Commission’s approach to adjusting the initial capital base for forecast capital expenditure, is to roll that expenditure into the capital base as it is scheduled to occur over the access arrangement period. At the commencement of the next access arrangement period, only that part of forecast capital expenditure that was actually spent in the previous period would be included in the capital base.

In addition to rolling in capital expenditure, the book value of the capital base is adjusted for forecast inflation and depreciation over the access arrangement period. Adjusting the capital base for capital expenditure, inflation and depreciation over the access arrangement period is referred to as ‘rolling forward’ the capital base.

The Commission’s calculation of the net change in the value of the asset base from year to year over the access arrangement period is shown in Table 2..

Table 2.: Commission’s capital base roll-forward ($million)

As at 1 January	2001	2002	2003	2004	2005
Opening Asset Value	353.0	351.0	349.8	347.4	344.7
Nominal Depreciation^(a)	3.1	3.5	3.9	3.4	3.7
Normalisation factor (extra depreciation)	1.4	1.5	1.7	1.8	2.0
Capital expenditure	2.6	3.8	3.2	2.6	2.6
Asset value carried forward	351.0	349.8	347.4	344.7	341.6
Return on capital @ 9.10 per cent^(b)	32.1	32.0	31.8	31.6	31.4