Information Paper

Issues in the Application of

Annuities
February 2014
 We wish to acknowledge the contribution of the following staff to this report:
Ralph Donnet, John Fallon and Kian Nam Loke

© Queensland Competition Authority 2014

The Queensland Competition Authority supports and encourages the dissemination and exchange of information.
However, copyright protects this document.

The Queensland Competition Authority has no objection to this material being reproduced, made available online or
electronically
691370 ver 1but only if it is recognised as the owner of the copyright
2 and this material remains unaltered.
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Queensland Competition Authority Table of Contents

Table of Contents

EXECUTIVE SUMMARY IV

THE ROLE OF THE QCA – TASK AND CONTACTS V

1 FINANCIAL CAPITAL MAINTENANCE 2

1.1 RAB building blocks versus annuity 2
1.2 Regulatory precedence 3
1.3 Summary 4

2 ANNUITY 5
2.1 The annuity approach 5
2.2 The use of a capital annuity for funding assets 8
2.3 Using a capital annuity to compare annual costs for a defined period 15
2.4 Renewals annuities 16
2.5 Rolling Annual Annuities 23
2.6 Summary 29

APPENDIX A : ANNUITY CALCULATIONS 30

GLOSSARY OF ACRONYMS, TERMS AND CONDITIONS 33

REFERENCES 34

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Queensland Competition Authority Executive Summary

EXECUTIVE SUMMARY

The concept of ex ante financial capital maintenance is relevant in the economic regulation of utilities. Ex
ante financial capital maintenance refers to the extent to which investors can expect to realise a return on
capital, consistent with the opportunity cost of capital, as well as to recover their original capital
investment in the form of a return of capital. In the context of economic regulation, the ex ante financial
capital maintenance concept is equivalent to the net present value neutrality (NPV=0) principle, where
prices or allowed revenues are set by the regulator such that the initial investment is expected to be
recovered in present value terms, with the discount rate set equal to the expected rate of return on
capital. This ensures that investors of a regulated firm are adequately compensated for their capital
investment, hence efficient investment will be made in the future, and at the same time customers pay
reasonable prices to access these essential services such as water and electricity.
There are two common approaches for recovering the return on and the return of capital:
(a) the RAB building blocks approach, which derives an allowed annual return on capital and an annual
return of capital separately in accordance with the regulated asset base (RAB) of a business.
Together, these components constitute the annual capital revenue requirement for price setting
purposes; or
(b) the annuity approach, which provides a series of annual capital charges (either constant or indexed
over time) covering both the return on and the return of capital. This differs from the RAB building
blocks approach where the two components of the annual capital revenue requirement are derived
separately.
This paper analyses and compares the application of annuities in lieu of the RAB building blocks approach
for pricing purposes. Based on the analysis of simple examples, the paper demonstrates that both
approaches can be defined to achieve an identical PV of the revenue requirement and hence identical
prices.
The paper also discusses a number of issues associated with using annuities for pricing, including the use
of capital annuities to recover the cost of existing assets and new or replacement capex, the application of
renewals annuities, misconceptions associated with annuities, the implications of annuities for long-life
assets, and a potential shortcoming associated with rolling annual annuities.

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Queensland Competition Authority The Role of the QCA – Task and Contacts

THE ROLE OF THE QCA – TASK AND CONTACTS

The Queensland Competition Authority (QCA) is an independent statutory authority to promote

competition as the basis for enhancing efficiency and growth in the Queensland economy.
The QCA’s primary role is to ensure that monopoly businesses operating in Queensland, particularly in the
provision of key infrastructure, do not abuse their market power through unfair pricing or restrictive
access arrangements.
In 2012, that role was expanded to allow the QCA to be directed to investigate, and report on, any matter
relating to competition, industry, productivity or best practice regulation; and review and report on
existing legislation.

Task
This information paper considers various issues in the implementation of an annuity approach to recover
the cost of capital.
The paper was motivated by the need to document methods the QCA has applied and to highlight a
number of issues that arise in the context of determining price paths over time.

Contacts
Comments and enquiries regarding this paper should be directed to:
ATTN: Kian Nam Loke
Tel (07) 3222 0582
research@qca.org.au
www.qca.org.au

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Queensland Competition Authority Financial Capital Maintenance

1 FINANCIAL CAPITAL MAINTENANCE

This chapter explains the financial capital maintenance principle and examines two possible
approaches for setting the required returns for capital recovery.
Regulators adopt one of two approaches for recovering the capital cost component (return on
capital and return of capital) of the annual revenue requirement (ARR):
(1) the regulated asset base (RAB) building blocks approach
(2) an annuity approach.

1.1 RAB building blocks versus annuity

Financial capital maintenance (FCM) is the maintenance of the financial value of an investment
measured by the value of assets at the time of investment.1 In the regulatory context, FCM is
applied in an ex ante sense meaning that investors of a regulated firm can expect to recover the
opportunity cost of their capital and the nominal value of their initial investment over time.
This is referred to as the FCM principle. As long as the present value (PV) of future regulated
returns, calculated on the basis of an appropriate opportunity cost discount rate, is equal to the
prevailing value of the regulatory asset base (RAB) at any point in time, the FCM principle is
adhered to. The FCM principle in an exact sense is often referred to as the NPV=0 principle.
Typically, regulators adopt one of two approaches for recovering a sunk investment:
(a) The RAB building blocks approach, which derives an annual return on capital and an
annual return of capital separately in accordance with the regulated asset base (RAB) of a
business.
(b) The annuity approach, whereby the capital costs of assets are translated into a series of
constant or indexed annual charges applicable over the full life of the assets. Each series
provides both a return on capital and a return of capital for a particular asset over a
defined period. For regulatory pricing, there are two important types of annuity:
(i) Capital annuity—a series of annual (or periodic) payments to fund (or repay)
future investment (or existing assets) over a defined time period.
(ii) Renewals annuity—a series of annual (or periodic) payments to fund the present
value of forecast periodic asset maintenance, asset refurbishment and asset
replacements over the full life cycle of a system of assets.
It is important to note that these different forms of annuity are not mutually exclusive.
In other words, both types of annuity can be applied simultaneously to recover separate
components of the regulated firm’s cost base. These annuities are further examined in
Chapter 2.
Under the RAB building blocks approach, where the return on and the return of capital are
derived separately, regulators typically apply a straight-line approach for calculating the return
of capital (depreciation). The straight-line approach leads to an allowance for return of capital
that is constant over time in real or nominal dollar value terms, as defined at the start of the

1
For a detailed explanation of financial capital maintenance, refer to QCA (2014).

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regulatory period. Other methods used to calculate return of capital include front-end loaded,
back-end loaded, and one-hoss shay.
QCA (2014) shows that if a regulator gives priority to the FCM principle and there is no risk in
terms of reneging on this commitment, the choice of the method for calculating return of
capital under the RAB building blocks approach becomes irrelevant. This follows because, over
the life of each asset, the PV of annual amounts of the return on and return of capital
associated with the asset is identical and equal to the initial asset value, irrespective of the
method of depreciation used (QCA 2014). That is, alternative methods for calculating return of
capital, such as straight line, front-end loaded, and one-hoss shay, can all be defined to achieve
the FCM principle over the life of each asset.
As pointed out by the QCA (2014) paper on financial capital maintenance and price smoothing,
different depreciation methods result in different time patterns of capital charges (the sum of
the return on and return of capital). For example, when straight-line depreciation is applied,
the yearly capital charge associated with the asset declines over time, although the return of
capital (depreciation) is constant. This means that under such a depreciation profile (and some
other profiles), there is a potential inter-generational equity issue as existing customers are
paying higher prices than future customers for the use of the asset.2 In addition, price
smoothing does not address this issue when it is limited to the ARR of a specific period (typically
the regulatory pricing period) rather than the full life of the longest-life asset, and may cause
abrupt and largely arbitrary price changes between periods.
Similarly, QCA (2014) also shows that the FCM principle can also be achieved under the annuity
approach. That is, over the life of an asset, the PV of an annuity (either constant or indexed)
can be identical to the initial value of the asset. Such an approach, which is the focus of this
paper, provides a viable alternative to the RAB building blocks approach and has its pros and
cons.

1.2 Regulatory precedence

Regulators in Australia and the United Kingdom have used both annuity and RAB building blocks
approaches for calculating the capital cost component of the revenue requirement for regulated
businesses.
In Queensland, the QCA has accepted the annuity approach for water businesses for SunWater
(QCA 201 2) and Seqwater (2013), whereas other regulated entities such as ports, rail, and
urban and industrial water supply are subject to the RAB building blocks approach.
Prior to 2006, the Independent Pricing and Regulatory Tribunal in NSW (IPART) required State
Water to apply the annuity approach. However, since 2006 the RAB building blocks approach
has been applied (IPART 2006). IPART justified its change on the basis of economic efficiency
and regulatory effectiveness (IPART 2006). IPART uses the RAB building blocks approach for
pricing urban water, sewerage and stormwater drainage services. IPART also uses the RAB
building blocks approach for pricing gas.
The Essential Services Commission of Victoria (ESC) has adopted the RAB approach for all water
industry assets constructed since 1 July 2006, although some regulated entities have retained
the annuity method for pre-1 July 2006 assets (NWI 2007). In 2005, Goulburn-Murray Water

2
In practice, regulated prices paid by the customers typically do not fall (in real terms) over time because there
are new assets included and changes in other components of the building blocks ARR, although the return on
and return of capital associated with existing assets are indeed falling over time.

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ended its annuity approach (Goulburn-Murray Water 2005), while in 2013 Southern Rural Water
decided to transition from the annuity approach to the RAB approach (Southern Rural Water
2013). ESC cited the reason for the change as the re-configuration of rural irrigation systems,
which means that it was unlikely that existing assets would be replaced with like assets (ESC
2006).
The Economic Regulation Authority of Western Australia (ERA) (2013) applied the RAB building
blocks approach in its inquiry into efficient costs and tariffs for the Water Corporation, Aqwest
and Busselton Water Board in 2013. However, the Western Australia Railways (Access) Code
2000 (Western Australia Legislation 2010), administered by ERA, provides for the use of an
annuity for calculating the return on and of capital.
The Australian Energy Regulator (AER) has approved the use of the annuity approach for the
calculation of the capital allowance for Aurora’s public lighting, whereas it has adopted the RAB
building blocks approach for metering services (AER 2012).
OFWAT has adopted a position that the RAB building blocks approach should be applied to
above-ground assets, whereas an infrastructure annuity charge is applied for under-ground
assets (OFWAT 2009).

1.3 Summary
Economic regulators use both the annuity and RAB building blocks approaches to calculate the
capital component of the annual revenue requirement for regulated businesses.
Irrespective of the method used to calculate the return of capital (i.e. straight-line, front-end
loaded, or one-hoss shay), the RAB building blocks approach can be defined to ensure the FCM
principle is achieved. Likewise, the annuity approach can also achieve such a principle. The key
requirement for achieving the FCM principle is to ensure that the PV of all regulated returns
defined to recover capital costs matches the present value of the existing asset and future
investments.
If the sole objective is to follow the FCM principle and there is no risk in such a regulatory
commitment, regulators and their stakeholder entities should be indifferent to the use of either
approach. However, as noted in the next chapter, the annuity approach has not always been
applied in a consistent manner and this may have influenced positions adopted by the various
parties in choosing between the annuity and RAB building blocks approaches in the past.
Chapter 2 examines the application of an annuity in lieu of the RAB building blocks approach in
more detail.

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Queensland Competition Authority Annuity

2 ANNUITY

This chapter examines the practical application of capital and renewals annuities, in lieu of the
RAB building blocks approach, for calculating the capital components of the regulatory pricing
revenue requirement.
The chapter also reviews a number of issues associated with annuities, including the use of
capital annuities to recover the cost of existing assets and new or replacement capex, the
application of renewals annuities, misconceptions that the application of an annuity will result in
a lower annual capital revenue requirement, and the implications of annuities for long-life
assets.
Finally, the chapter shows that the use of a rolling annual annuity is problematic, as it may cause
a significant under-recovery of capital over the original term of the annuity. The application of
an aggregated rolling annuity can avoid this problem.

2.1 The annuity approach

As noted in Chapter 1, two common approaches for calculating the annual capital revenue
requirement are:
(a) the RAB building blocks approach
(b) the annuity approach.
An annuity is a series of annual (or periodic) payments. There are several types of annuity,
including capital, renewals, investment and pension annuities. The focus of this paper is on
capital and renewals annuities.
An annuity embodies both the return on and the return of capital that are derived for each
period under the RAB building blocks approach. A capital annuity, as referred to in this paper, is
designed to recover the present value cost of assets (either existing or planned) typically
through either a constant or indexed annual charge. In contrast, a renewals annuity, which is
explored in detailed later, is used to fund the forecast periodic asset maintenance, asset
refurbishment and asset replacement over the full life cycle of a system of assets. Both types of
annuities can be applied simultaneously to recover separate components of a regulated firm’s
cost base.
In simple terms, a capital annuity is identical to a typical housing loan, whereby a loan (of a
specified initial value) is repaid by making either equal or indexed periodic payments over a
specified time. Each payment consists of interest and capital repayment, with the interest
component being higher in the early years of the repayment schedule but declining over time.
In the context of economic regulation, the interest and capital repayment are the return on and
return of capital respectively. Figure 1 demonstrates the respective return on capital and return
of capital components of a constant capital annuity over time.3

3
The example is based on a constant annuity using a PV of $100, discount rate of 10 per cent and a term of five
years.

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Figure 1 Components of a constant capital annuity

$30

$25

$20

$15

$10

$5

$0
1 2 3 4 5

Return on Capital Return of Capital

The proportion of return on and return of capital will vary according to the term of the annuity
and the interest rate applied. For example, if a 20-year term applied to the capital annuity, the
return on capital would represent a more dominant proportion of the annuity during its early
years relative to a five-year term.
As noted previously, a capital annuity may be calculated as a constant or an indexed amount.
The annuity formulae presented below are applicable to both nominal and real analysis. For a
nominal analysis, the annuity is calculated using a nominal discount rate, while for a real
analysis, the annuity is calculated using a real discount rate. Note that the Fisher equation
defines the relationship between a nominal rate and a real rate.4
Details for the calculation of a constant annuity and an indexed annuity are as follows (see
Appendix A for the detailed derivation of these formulae):
(a) Constant capital annuity—the annuity is specified as a constant amount over time (i.e.
not escalated annually). The formula for calculating the constant periodic amount is:

where:
= annuity payment per period
= present value of assets (existing assets and/or future capex)
= discount rate (real or nominal) applicable
= term of the annuity.

4
Fisher equation: , where is the nominal discount rate, is the inflation rate,
and is the real discount rate.

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(b) Indexed capital annuity—the annual payment is escalated annually by a specified

indexation rate (such as the CPI) beginning from the first year of the annuity. The annuity
amount for a given period is expressed as follows:5

where:
= annuity payment per period
= present value of assets (existing assets and/or future capex)
= discount rate (real or nominal) applicable
= escalation rate for the annuity
= term of the annuity
= the period of interest.
As mentioned previously, an indexed annuity is typically escalated at the CPI, such that
is set to equal the expected inflation rate. However, with a zero indexation rate ( )
the constant and indexed capital annuity formulae are identical. This implies that the
constant annuity formula can be interpreted as a special case of the more general
indexed annuity formula. The annual amount derived from the indexed formula is
constant over time (i.e. ) when the escalation rate applied is 0 per cent.
Figure 2 compares a constant and indexed annuity. This example is based on the following
assumptions:
(a) = $100
(b) = five years
(c) = 10.0 per cent
(d) = 2.5 per cent
(e) All calculations are in real values.

5
The PMT function in Microsoft Excel calculates a constant annuity consistent with the constant annuity
formula but does not allow for direct calculation of an indexed annuity. Nevertheless, an indexed annuity
can be derived using the Excel PMT function by replacing the applicable discount rate with an adjusted
discount rate and subsequently escalating the initial charge (derived from the Excel PMT function) by the
specified escalation rate . Refer to Appendix B for further details.

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Figure 2 Comparison of a constant and indexed annuity ($ real)

$28.5
$28.0
$27.5
$27.0
$26.5
$26.0
$25.5
$25.0
$24.5
$24.0
$23.5
1 2 3 4 5
Constant Annuity $26.4 $26.4 $26.4 $26.4 $26.4
Indexed Annuity $25.2 $25.8 $26.5 $27.1 $27.8

Figure 2 shows that the first payment under the indexed annuity is initially less than that under
the constant annuity ($25.21 vs. $26.38), but it increases over time to be greater than payments
of the constant annuity in the latter years of the asset life. Both annuities have been defined to
have the same PV of $100.
An indexed annuity is sometimes referred to as a tilted annuity (Deloitte 2011). NERA (2009)
once proposed a tilted annuity, whereby the annual amount was escalated annually at the same
rate as the escalation rate applicable to the capex to be funded by the annuity. Any escalation
rate is valid as long as it maintains PV equivalence.

2.2 The use of a capital annuity for funding assets

A key difference between a capital annuity and the RAB building blocks approach is that the
former can enable the building of a financial reserve to fund future capital expenditure while
the latter requires an investor to first commit funds when capital expenditure is made and then
recover the sunk investment over time.
The examples below expand on the differences and similarities between a capital annuity and
the RAB building blocks approach, and address some misconceptions about the application of
annuities, To simplify, the ARR is assumed to comprise only the capital costs (i.e. the annual
amount under the annuity approach and the return on and return of capital under the RAB
building blocks approach).

Recovery of existing assets

Consider the following example to compare the annuity cost of recovering the cost of an
existing asset versus the RAB building blocks approach:
(a) Initial cost of asset = $100
(b) Life of asset = five years
(c) Real return on capital = 10 per cent
(d) Constant demand of 10 units per year
(e) All calculations are in real values.
Details of the ARR and smoothed ARR for the annuity approach are presented in Table 1.

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Table 1 ARR and smoothed ARR under the annuity approach ($ real)6

Year 1 Year 2 Year 3 Year 4 Year 5

Annuity for recovery of the cost of an existing asset

Opening asset value (at the $100

beginning of year)

Annual annuity amount $26 $26 $26 $26 $26

ARR $26 $26 $26 $26 $26

Present value of ARR $100

Smoothed ARR $26 $26 $26 $26 $26

Breakdown of the annual annuity amount

Return on capital $10 $8 $7 $5 $2

Return of capital $16 $18 $20 $22 $24

Total $26 $26 $26 $26 $26

Table 1 shows that the closing value of the annuity account in year five is zero, indicating that
the asset has been fully funded in accordance with the objective of the annuity — financial
capital maintenance is achieved.
Details of the ARR and smoothed ARR for the RAB building blocks approach, based on straight
line depreciation, are presented in Table 2, together with details of the annual return on and
return of capital.
Also note from Table 2, that the RAB account has a closing value of $0 in year five, indicating
that there has been a full return of capital. Thus financial capital maintenance is also achieved
in this instance.
Table 2 ARR and smoothed ARR under the RAB building blocks approach ($ real)7

Year 1 Year 2 Year 3 Year 4 Year 5

RAB approach for an existing asset:

Return on capital $10 $8 $6 $4 $2

Return of capital $20 $20 $20 $20 $20

ARR $30 $28 $26 $24 $22

Present value of ARR $100

Smoothed ARR $26 $26 $26 $26 $26

RAB account

Opening asset value $100 $80 $60 $40 $20

Return of capital $20 $20 $20 $20 $20

Closing value $80 $60 $40 $20 $0

6
All values are rounded.
7
All values are rounded.

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Differences in the ARR, the PV of ARR and the smoothed ARR between the two approaches are
presented in Table 3.
Table 3 Differences between an annuity vs. the RAB building blocks approach for an existing
asset ($ real)

Differences Year 1 Year 2 Year 3 Year 4 Year 5

Difference in ARRs (annuity (13.7%) (6.1%) 1.4% 9.0% 16.6%

minus building blocks in %)

Difference in PV of ARR $0

Difference in smoothed ARRs $0 $0 $0 $0 $0

Under the constant capital annuity approach, the ARR is constant over time, whereas under the
RAB building blocks approach the ARR declines over time. The constant capital annuity ARR is
initially 13.7 per cent lower than the RAB building blocks ARR in the first year, but finishes with a
value 16.6 per cent higher than the RAB building blocks approach. However, with revenue
smoothing, the annual revenue under the RAB building blocks approach can be defined to be
constant over time, as is already the case under the annuity approach. This is because the
annuity automatically results in a smoothed ARR (if the ARR only consists of capital costs).8

Common misconceptions about the ARR derived under the annuity approach
As indicated in Table 3, the initial ARR under the constant annuity is significantly less than for
the RAB building blocks approach (13.7 per cent difference in period 1). Such a result has led to
a common misconception that the adoption of the annuity approach will result in a lower ARR
and prices.
For example, in 2007 the Productivity Commission (2008) reported that using the annuity
approach results in lower prices and decreased reported profitability. Also, in 2009, the AER
(2009) noted that the upfront costs of the building block approach will be slightly higher for all
parties than the annuity approach.
However, as shown in Table 3, in the latter years of the asset life, the use of capital annuity
results in an ARR that is significantly higher than that of the RAB building blocks approach, a
point which has often been overlooked.
It is also important to note from Table 3 that the PV of the ARR for an annuity is identical to that
for the RAB building blocks approach. With revenue smoothing, final prices and revenue under
the building blocks approach match their counterparts under the annuity approach.
However, if an annuity is not calculated over the life of the longest life asset in the RAB, as
occurs in many regulatory pricing assessments, the annuity may be artificially low as it will not
reflect the full cost major long-life assets. This may also contribute to the misconception that
an annuity gives a smaller ARR than the RAB building blocks approach. If the annuity is not
calculated over the life of the longest life asset, there may be a significant increase in the

8
Note that an annual annuity is identical to the smoothed annual revenue requirement of the RAB building
block approach, provided smoothing is over the life of the asset. Therefore, with constant demand, the
annual prices derived from the annuity will be identical to the annual prices derived from the RAB building
blocks smoothed revenue. However, if demand varies over time, it is necessary to calculate smoothed prices
independently, based on the PV of the annual revenue requirement, for both the capital annuity and RAB
building blocks approaches.

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succeeding annuities when the replacement of major long-term assets is included in the
annuity.
Also, differences may arise between the two approaches if the annuity is configured to recover
periodic maintenance and refurbishment costs (as occurs with a renewals annuity) in addition
to or separately from capital costs.

Recovery of new or replacement asset

When a capital annuity is used to fund only new or replacement assets, in lieu of funding by the
firm and subsequent recovery by the RAB building blocks approach, there may be material
differences in the capital cost component of the ARR. The magnitude of these differences will
depend on the timing of the expenditure, as an annuity can be made effective from the
beginning of a planning period whereas traditionally under the RAB building blocks approach,
the return on and the return of capital only commence from the year of commissioning new
assets. However, as shown in the results below, differences in any ARRs between the two
approaches are attributable to the manner in which they are applied for pricing, not the
approaches per se.
This issue is of particular significance where jurisdictions have drawn ‘a line in the sand’ (IPART
2004, NWI 2010) to define a value for existing assets (often zero value for irrigation schemes). If
the value of the existing assets (opening RAB) is in fact zero, under the RAB building blocks
approach there would be no capital cost revenue requirement until an asset was replaced or a
new asset commissioned. However, under a capital annuity approach, the cost of a
replacement or a new asset forecast to be commissioned in the future would be recognised and
included in the ARR calculation commencing from the initial year of the planning period.
When the capital cost component of the revenue requirement is based on a typical planning
period of five years, there may be material differences in the ARR, and hence prices, between
an annuity and the RAB building blocks approach, immediately following the drawing of the ‘line
in the sand’.
For example, if the capex was scheduled for the end of year five, no return on or return of
capital would apply under the RAB building blocks approach until year six, whereas an annuity
approach would result in a revenue requirement from year one. If five-year planning periods
were used for pricing, there would be a significant difference in the ARRs, and hence prices,
between an annuity and the RAB building blocks approach for each of the two pricing periods.
It is important to note that if the revenue requirement was assessed over the period to the end
of the life of the asset (year ten for the example above), the PV of the capital annuity would be
identical to the PV of the RAB building blocks approach. That is, despite the capital annuity
applying only from year one to five, and the RAB building blocks approach revenue requirement
applying only from year six to ten, the PV for both approaches calculated over the ten-year
planning period would be identical.
Consider the following example to demonstrate the impact on smoothed revenue for pricing for
two independent five-year pricing periods with revenue smoothing for each based on a five-
year period, or with revenue smoothing for each pricing period based on a ten-year period:
(a) Value of asset = $100.
(b) Year of commissioning of asset = end of year five.
(c) Life of asset = five years, with no replacement.
(d) Maximum planning period of ten years (to the end of the life of the replacement asset).

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(e) All calculations are in real values.

Under the capital annuity approach, an annuity would be applied during each of the first five
years to accumulate funds to allow replacement at the end of year five, whereas under the RAB
building block approach, the new or replacement asset would be recognised in the opening RAB
for year six and be subject to a return on and a return of capital over the next five years. Note
that this example assumes financial capital for the original asset has previously been fully
recovered, or subject to a ‘line in the sand’ zero valuation, meaning that the opening RAB value
is zero.
For a comparison of the ARR and the smoothed revenue for pricing for a capital annuity and the
RAB building blocks approach, refer to Tables 4 and 5.
Table 4 includes details of the capital annuity account, showing that the annuity fully funds the
capex by the end of year five.9

9
The capital annuity account is essentially a bank account that shows annual cash receipts and payments,
including interest calculated on the opening balance of the account and the required return on capital.

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Table 4 ARR and smoothed ARR under the capital annuity approach ($ real) 10

Year

1 2 3 4 5 6 7 8 9 10

Capital annuity approach

Replacement $100
(at the end of the
year)

PV for annuity $62

Annuity $16 $16 $16 $16 $16 $0 $0 $0 $0 $0

ARR $16 $16 $16 $16 $16 $0 $0 $0 $0 $0

PV of ARR $62 $0

Five-year smoothed $16 $16 $16 $16 $16 $0 $0 $0 $0 $0

ARR

10-year smoothed $10 $10 $10 $10 $10 $10 $10 $10 $10 $10
revenue

Fund accumulation—5-year planning period

Opening value $0 $16 $34 $54 $76 $0 $0 $0 $0 $0

Interest (at WACC) $0 $2 $3 $5 $8

Annuity $16 $16 $16 $16 $16

Expenditure $100
(at the end of the
year)

Closing balance $16 $34 $54 $76 $0 $0 $0 $0 $0 $0

11
Fund accumulation—10-year planning period

Opening value $0 $10 $21 $33 $47 ($38) ($32) ($25) ($18) ($9)

Interest (at WACC) $0 $1 $2 $3 $5 ($4) ($3) ($3) ($2) ($1)

Annuity $10 $10 $10 $10 $10 $10 $10 $10 $10 $10

Expenditure $100
(at the end of the
year)

Closing balance $10 $21 $33 $47 ($38) ($32) ($25) ($18) ($9) $0

As shown in Table 4, when pricing is based on two independent five-year planning periods, the
ARR for the annuity approach is identical to the smoothed revenue requirement for each year.
For the first five years, the capital annuity amount and smoothed revenue are $16 for each year.
For the second five-year period, the capital annuity amount and smoothed revenue for each
year are zero (although if the asset was replaced at the end of year 10, the revenue
requirement for the second five years would be identical to that for the first five years). In the
absence of replacement, there would be an abrupt change in ARR, and hence prices, between

10
All values are rounded.
11
Note that the closing balance for the final year (year 10) of the 10-year annuity is zero.

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the two five-year price paths (although with replacement, ARR and prices would be uniform
over the two periods).
However, if a ten-year planning period was used to derive the smoothed revenue under the
capital annuity approach, a constant smoothed revenue would apply to each of the ten years.
That is, with constant demand, smoothed revenue, and hence prices, would be uniform over
each of the two five-year price paths.
Table 5 shows the corresponding outcomes from the RAB building blocks approach.
Note in Table 5, the RAB account has a zero closing value in year 10, indicating that there has
been a full return of capital. Thus financial capital maintenance has been achieved.
Table 5 ARR and smoothed ARR under the RAB building blocks approach ($ real)12

Year

1 2 3 4 5 6 7 8 9 10

RAB building blocks approach

Replacement $100
(at the start of the
year)

Opening asset $0 $0 $0 $0 $0 $100 $80 $60 $40 $20

Return of capital $0 $0 $0 $0 $0 $20 $20 $20 $20 $20

Closing value $0 $0 $0 $0 $0 $80 $60 $40 $20 $0

Return on capital $0 $0 $0 $0 $0 $10 $8 $6 $4 $2

ARR $0 $0 $0 $0 $0 $30 $28 $26 $24 $22

PV of ARR $62 $100

(evaluated
separately at the
beginning of year 1
and the beginning of
year 6)

Five-year smoothed $0 $0 $0 $0 $0 $26 $26 $26 $26 $26

revenues

10-year smoothed $10 $10 $10 $10 $10 $10 $10 $10 $10 $10
revenue

12
All values are rounded.

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Table 6 contains a comparison of the differences in ARRs and the differences in smoothed
revenues for the two approaches, based on smoothing over five years and ten years (where ten
years equals the life of the asset).
Table 6 Difference between the RAB building blocks approach vs. the annuity approach for a
new/replacement asset ($ real)13

Year

1 2 3 4 5 6 7 8 9 10

Difference

Difference in ARR $16 $16 $16 $16 $16 ($30) ($28) ($26) ($24) ($22)
(annuity minus
building blocks)

Difference in five- $16 $16 $16 $16 $16 ($26) ($26) ($26) ($26) ($26)
year smoothed
revenue

Difference in 10- $0 $0 $0 $0 $0 $0 $0 $0 $0 $0
year smoothed
revenue

For the RAB building blocks approach, when pricing is based on two independent five-year
planning periods, the ARR and smoothed revenue for each of the first five years is $0, whereas
for the second five-year period the ARR varies from $30 in year six to $22 in year ten, with a
constant smoothed revenue of $26 for the second pricing period. That is, under the RAB
building blocks approach, there would also be abrupt changes in ARR, and hence prices,
between the two five-year pricing periods. Critically, the ARR, and hence prices, for each pricing
period would be significantly different to those applicable under the annuity approach.
If a ten-year planning period was used to derive the smoothed revenue requirement for the RAB
building blocks approach, a smoothed revenue of $10 would apply to each of the 10 years. That
is, with constant demand, smoothed revenue would be uniform over each of the two five-year
price paths.
Therefore, it can be concluded that if smoothed pricing is based on five-year planning periods
immediately following the drawing of a ‘line in the sand’, there may be significant differences in
the ARR between the annuity and RAB building blocks approaches. The RAB building blocks
approach would have a zero revenue requirement during the first five-year pricing period with a
significant revenue requirement in the second pricing period, whereas the annuity approach
would have a moderate revenue requirement for the first planning periods and zero during the
second planning period.
In reality, capital annuity calculations are generally based on planning periods that are less than
the life of the longest life asset, and therefore may significantly under-recover the true capital
costs, in the current regulatory period, as they exclude major long-term replacements from the
annuity base.

2.3 Using a capital annuity to compare annual costs for a defined period
It is possible to use a capital annuity as a basis for comparing the annual costs associated with
maintaining the service capacity of an asset for different periods of time.

13
All values are rounded.

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Such comparisons may be relevant for assessing the maximum period of time that customers
can afford to maintain the service capacity of an asset. Using an annuity to compare the annual
cost of maintenance over different time periods may have relevance where the cost of replacing
a major asset would result in an annuity cost in excess of customers’ capacity to pay (for
example, identifying the remaining affordable life of an irrigation distribution system, where
capacity to pay is an issue).
Consider the following example in which a capital annuity cost, expressed as $/ML of water
allocation entitlement (WAE), is calculated for maintaining an irrigation distribution scheme for
three alternative time periods:
(a) Customers’ assessed capacity to pay for fixed asset refurbishment and replacement costs,
after allowing for other fixed and variable costs $55/ML WAE.
(b) Annuity costs for maintaining system assets for next 100 years $100/ML WAE.
(c) Annuity costs for maintaining system assets for next 50 years $50/ML WAE.
(d) Annuity costs for maintaining system assets for next 30 years $35/ML WAE.
Under these circumstances, a decision could be made to maintain the scheme assets for the
next 50 years on the understanding that if capacity to pay did not increase during that time, the
scheme would have a terminal life at about 50 years from now. However, if capacity to pay
deteriorated to below $35/ML WAE, it would be necessary to reduce the terminal date of the
scheme to about 30 years from now.

2.4 Renewals annuities

A renewals annuity is a variant of a capital annuity. There is a need to understand the
complexities of a renewals annuity and the need for consistency in the treatment of costs when
comparing the revenue requirement between a renewals annuity and the RAB building blocks.
In particular, there are four issues associated with renewals annuities that need to be addressed
in relation to regulatory pricing:
(a) the technical differences between a renewals annuity and a capital annuity. In many
cases, capital annuities are incorrectly labelled as renewals annuities
(b) the misconception that the application of a renewals annuity will result in a lower
revenue requirement than the RAB building blocks approach
(c) the impact of asset refurbishments designed to maintain the value of assets and extend
their effective lives
(d) the treatment of assets that have an indefinite life.

Difference between a renewals annuity and a capital annuity

(a) A capital annuity is a series of annual (or periodic) payments to fund the present value of
asset (existing and/or future) over a defined time period.
(b) A renewals annuity is a series of annual (or periodic) payments to fund the present value
of forecast periodic asset maintenance, asset refurbishment and asset replacement
expenditures over the full life cycle of a system of assets in order to maintain their
service potential.
While a capital annuity may be used to fund future capex that expands the production capacity
of the regulated firm, a renewals annuity is used only to fund future replacement of existing

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assets. When a renewals annuity approach is applied, it is necessary to separate the existing
system of assets that are to be subject to the renewals annuity from other assets, including
those associated with expansion of existing capacity. The recovery of capital costs associated
with other assets, including expansion assets, may be undertaken using a separate capital
annuity or a RAB building blocks approach.
Essentially, a renewals annuity is designed to provide for the future cost of replacement of all
assets within defined system of existing assets. In addition to recovering the cost of capital
(return on and return of) for all asset replacements during the life cycle of the system, which
may span 100 or more years, it also recovers the costs of forecast periodic maintenance and any
refurbishments undertaken to extend the life of individual assets beyond their original
estimated life.
The cost of scheduled periodic repairs, maintenance and refurbishments included in the
renewals annuity would normally be costed as repairs and maintenance needed to maintain a
specified service potential under the building blocks approach.
A renewals annuity should have a term equivalent to the full life cycle of a system of assets.
Importantly, a renewals annuity should not include any forecast expenditure designed to
increase the service or productive capacity of the existing asset base.
Any comparison of a renewals annuity and the RAB building blocks approach should reflect
identical costs. That is, over the life of an asset, there should be no difference in the total costs
used for calculating the total revenue requirement between the two methods in present value
terms. Under the RAB building blocks approach, the ARR over the life of an asset would recover
the sunk cost of the asset plus return on capital over the term of its productive life, plus the
annual costs of repairs, maintenance and refurbishment as they occur annually. To ensure a
like-for-like comparison, repairs, maintenance and refurbishment costs that are included in the
calculation of the renewals annuity must be included when calculating the revenue requirement
under the building blocks approach.
If a particular asset has an indefinite or perpetual life, as a result of periodic refurbishment, then
no return of capital may be necessary. However, there is a need to allow a return on capital for
such assets. The treatment of single long-life assets is covered in more detail further below.
In 1997, the Standing Committee of the Agriculture and Resource Management Council
(SCARM) (2007) recommended the adoption of renewals annuities for water infrastructure
assets that are system assets which are essentially renewable rather than replaceable. These
SCARM Guidelines were subsequently endorsed by the Agriculture and Resource Management
Council of Australia and New Zealand (ARMCANZ). The use of renewals annuities for water
businesses has subsequently been incorporated into the NWI pricing principles (NWI 2010).
A renewals annuity approach is generally considered to be valid for infrastructure assets that
satisfy the following criteria:
(a) The asset system is renewable rather than replaceable. In other words, the components
of the system will be replaced according to useful lives, but the operating capacity of the
system as a whole will be maintained.
(b) For the foreseeable future, demand is such as to warrant continual renewal of the asset
system so that the assumption of an infinite or very long asset life is warranted.
As with a capital annuity, a renewals annuity may be calculated as a constant annual annuity, or
an indexed annual annuity.

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A robust asset management plan is an essential requirement for determining renewal annuities,
as their calculation requires high quality information about the total asset system. That is, there
must be good information about scheduled maintenance, refurbishment and the expected
timing for replacement of each component asset of the system.
By definition, a renewals annuity should be calculated over a term equivalent to the longest life
asset in the RAB or in perpetuity. This was noted by the NWI Steering Group on Water Charges
(2007) when it stated that 'in theory the term should capture the full asset cycle for the
business'.
In reality, the term ‘renewals annuity’ is misused (technically) as the annuity is rarely calculated
over the full life cycle of a system of assets and does not always include the forecast cost of
periodic maintenance and refurbishments. For water businesses, renewals annuities are
generally determined over 20- or 30-year periods (QCA 2012 and QCA 2013). However, there
are some exceptions, such as Murray Irrigation (2012) and Murrumbidgee Irrigation Ltd (2012),
which have adopted an annuity term of 100 years.
The NWI Steering Group on Water Charges (2007) noted that as there are significant peaks or
troughs in annual expenditures beyond the chosen time horizon, the term of the assessment
may be extended to avoid a future spike in annuity charges between pricing periods.
Where the term for a renewals annuity is shorter than the term of the longest life asset in the
RAB, an under- or over- estimate of the annual capital costs applicable to an asset may occur,
depending on the timing of the calculation within the life cycle of the asset. As such, caution
should be exercised when interpreting the outcomes of a 'renewals' annuity, as in reality it is
likely to be a capital annuity for a defined term, rather than a true renewals annuity.

Misconception about the adoption of a renewals annuity approach in lieu of the

RAB building blocks approach
As with capital annuities, there is a common misconception that adoption of renewals annuities
will result in a lower revenue requirement and prices. However, as explained above, over the
life of the asset the PV of the revenue requirement for a capital annuity is identical to that for
the RAB building blocks approach, albeit that there are differences in the magnitude of the
ARRs. Differences may occur though, if the renewals annuity and RAB building blocks
calculations are based on a planning period less than the life of the longest life asset.
Differences may also arise if the renewals annuity is recovering planned refurbishment
expenditure to maintain the service potential (and value) of an asset that is not included in the
RAB building blocks costs.

Understanding the impact of asset refurbishments

For many assets, it is possible to undertake refurbishments designed to maintain the value of
the asset and to extend the effective life of the asset. When asset refurbishments occur it is
important to ensure that their impact is correctly reflected when calculating the revenue
requirement for a renewals annuity or the RAB building blocks approach.
It is sometimes argued that a renewals annuity has a lower cost than the RAB building blocks
approach as it involves refurbishment to extend the life of assets in lieu of scheduled
replacement. However, if a feasible refurbishment strategy can be identified and costed, it
should also be reflected in the RAB building blocks approach by extending the expected life of
the asset plus the increase in repairs and maintenance costs to reflect the planned

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refurbishment costs. That is, both the costs to maintain service potential and asset lives applied
in each approach should be consistent.
Consider the situation where the life of an asset can be extended by refurbishment:
(a) Value of asset = $100,000.
(b) Life of asset = five years.
(c) Option for refurbishment in year four to maintain the existing value of the asset (which
defers the timing for further recovery of return of capital):
(i) annual cost of refurbishment = $15,000
(ii) maximum number of refurbishments = five
(d) Constant annual demand.
(e) All calculations are in real values.
As the annual cost of refurbishment ($15,000 pa) to defer any further the loss in the value of
the asset is less than annual return of capital ($20,000 p.a.), the option to refurbish would be
cost-effective and should be adopted to achieve a least-cost outcome. Table 7 shows that the
PV of the refurbishment option is $110 versus the PV for replacement of $123.
Table 7 Comparison of annual costs and PV of replacement vs. refurbishment ($ real)

Year

1 2 3 4 5 6 7 8 9 10

Replacement: $20 $20 $20 $20 $20 $20 $20 $20 $20 $20
return of capital

PV $123

Refurbishment: $20 $20 $20 $20 $15 $15 $15 $15 $15 $20
return of capital
and refurbishment

PV $110

A comparison of the RAB values, respectively without and with refurbishment over a 10-year
period is shown in Figures 3 and 4.

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Figure 3 RAB with return of capital and replacement (end of year values)

$90,000
$80,000
$70,000
$60,000
$50,000
$40,000
$30,000
$20,000
$10,000
$0
1 2 3 4 5 6 7 8 9 10

Depreciation and Replacement (end of year values)

Figure 3 shows the typical pattern for the end of year value of the RAB over time, with straight-
line return of capital. The value of the initial asset declines to zero by the end of its productive
life, at which time it is replaced.
Figure 4 RAB with return of capital and refurbishment (end of year values)

$90,000
$80,000
$70,000
$60,000
$50,000
$40,000
$30,000
$20,000
$10,000
$0
1 2 3 4 5 6 7 8 9 10

Return on Capital, Refurbishment and Replacement (end of year values)

Figure 4 shows how the value of the RAB is maintained from year 4 to year 9 with annual
refurbishments of the asset. That is, the refurbishments have doubled the life of the original
asset.
The ARRs for the annuity and RAB building blocks approach for the refurbishment option are
shown in Tables 8 and 9 respectively, together with the smoothed revenue requirement
calculated over the full life of the asset.

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Table 8 Capital annuity approach for refurbishment ($ real)14

Year

1 2 3 4 5 6 7 8 9 10

Capital annuity approach

Refurbish & $100 $0 $0 $0 $15 $15 $15 $15 $15 $0

replacement
(start of year)

PV for annuity $139

Annuity $23 $23 $23 $23 $23 $23 $23 $23 $23 $23

ARR $23 $23 $23 $23 $23 $23 $23 $23 $23 $23

PV of ARR $139

Smoothed revenue $23 $23 $23 $23 $23 $23 $23 $23 $23 $23
15
Annuity account

Opening value $0 ($87) ($74) ($58) ($42) ($38) ($34) ($30) ($26) ($21)
16
Expenditure ($100) ($15) ($15) ($15) ($15) ($15)

Interest ($10) ($9) ($7) ($6) ($4) ($4) ($3) ($3) ($3) ($2)

Annuity $23 $23 $23 $23 $23 $23 $23 $23 $23 $23

Closing balance ($87) ($74) ($58) ($42) ($38) ($34) ($30) ($26) ($21) $0

14
All values are rounded.
15
The annuity account shows the value and timing of expenditures, interest on the opening balance of the
fund, and revenues for the term of the annuity. The account is used to confirm that the annual annuity
income is sufficient to fully fund expenditures over the term of the annuity. Note that the fund commences
with a zero opening balance and has a zero closing balance at the end of its term.
16
Capital expenditure of $100 occurs at the beginning of year 1, whereas refurbishment expenditures of $15
occur at the end of the year.

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Table 9 RAB building blocks approach for refurbishment ($ real)17

Year

1 2 3 4 5 6 7 8 9 10

RAB building blocks approach:

Replacement $100
(start of year)

Opening assets $100 $80 $60 $40 $20 $20 $20 $20 $20 $20

Return of capital $20 $20 $20 $20 $0 $0 $0 $0 $0 $20

Closing value $80 $60 $40 $20 $20 $20 $20 $20 $20 $0

Return on capital $10 $8 $6 $4 $2 $2 $2 $2 $2 $2

Refurbishments $0 $0 $0 $0 $15 $15 $15 $15 $15 $0

ARR $30 $28 $26 $24 $17 $17 $17 $17 $17 $22

PV of ARR $139

Smoothed Revenue $23 $23 $23 $23 $23 $23 $23 $23 $23 $23

Table 10 shows details of the differences in the annual and smoothed revenue requirements
between the capital annuity and RAB building blocks approaches.
Table 10 Difference between the RAB building blocks approach vs. an annuity approach for
refurbishment ($ real)18

Year

1 2 3 4 5 6 7 8 9 10

Difference

ARR (annuity minus ($7) ($5) ($3) ($1) $6 $6 $6 $6 $6 $1

building blocks)

PV of ARRs $0

Smoothed revenue $0 $0 $0 $0 $0 $0 $0 $0 $0 $0

It can be seen from Table 10 that while there are differences in the ARRs for the two
approaches, with those for the annuity being lower during the first four years than for the RAB
building blocks approach, the PV of the ARR and the smoothed revenue requirements are
identical.
The results in Table 10 demonstrate that, provided the revenue requirement is smoothed over
the full life of an asset, there is no difference in smoothed revenue (and therefore prices)
between the annuity and RAB building blocks approach.

Renewals annuities and single long-life assets with indefinite lives

When calculating renewals annuities (or capital annuities), a special case arises for single assets
that have an indefinite life. Such assets include long-life assets such as a dam, where the service
capacity of the asset may be maintained in perpetuity (say in excess of 150 years) with periodic

17
All values are rounded.
18
All values are rounded.

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refurbishments. Where such an asset is subject to a renewals annuity a planning period of up to

150 years would typically be applied to include the full range of periodic refurbishments
expected to be applied to the asset. However, there would be no asset replacement as the full
service capacity of the asset would have been maintained. That is, without replacement there
would be no provision for return on or return of capital in the annuity.
Where the replacement of an existing long-life asset has not been included in the calculation of
the renewals annuity, the regulated business entity would be entitled to a full return on capital
for that asset. If the life of the asset can be extended in perpetuity by periodic refurbishments,
the return on capital would be calculated in perpetuity. With such an asset, a question arises
about the return of capital. However, as long as the asset is maintained at its current service
potential and there is sufficient long term demand, the asset would still maintain its value, so
that return of capital was not strictly required in the annuity calculation.

2.5 Rolling Annual Annuities

Rolling annual renewals annuities have been used in recent pricing investigations for SunWater
(QCA 2012) and Seqwater (QCA 2013a). A rolling annual annuity involves the calculation of a
separate new annuity path for each year of the price path (typically five years), based on the
closing value of the annuity fund for the previous year and the PV of the forecast capex for the
term of the annuity (typically 20 years). The annuity is calculated at the start of the pricing
period to achieve a zero closing annuity balance at the end of the term (20 years). This process
is repeated for each subsequent pricing period. The term rolling refers to the progressive
annual iterative process whereby the annuity calculation is moved forward annually.
However, as noted above, the term of a renewals annuity should reflect the life cycle of the
asset system. So technically, where the term of the annuity is less than the life cycle of the
asset, and/or does not include periodic maintenance and refurbishment costs, it is not a
renewals annuity, but rather a simple capital annuity. There is therefore a need to ensure
methodologies are correctly described.
The use of a rolling annual annuity is based on an objective of reflecting the impact of capex
occurring progressively over time. That is, if an annuity is calculated for the first year of a price
path, the annuity fund is rolled-forward to the commencement of the next year and a new
annuity is re-calculated to reflect the impact of incremental capex for the next year beyond the
term of the initial annuity.
For example, for a five-year price path, the annuity should be calculated for an initial term of
say 20 years and then be rolled-forward annually such that a 20-year annuity is calculated for
each of the subsequent five years of the price path.
An analysis of the rolling annual annuity approach indicates that it is flawed, as it does not result
in revenue adequacy over the initial term of the annuity because the term for recovery of the
remaining annuity fund balance is continually extended as the annuity calculation is
progressively rolled-forward over time. Further, because of this outcome, the cost of assets
may not be fully recovered within their lifetime.
Consider the following example based on a typical rolling annual indexed annuity approach:
(a) Annuity term of 20 years.
(b) WACC of 8.5 per cent (i.e. discount rate and interest rate for annuity fund).
(c) Expected rate of inflation of 2.5 per cent.

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(d) Capex of $100,000 (current value), commissioned at the end of year 15, with a life of 20
years.
(e) A nominal value analysis.
Based on this example, Table 11 summarises the rate of capital recovery over 100 years for a
20-year rolling indexed annual annuity, based on an annuity fund with a zero opening balance.
Table 11 Summary annual rolling annuity fund – 20-year annuity ($ nominal)

Year

1 10 20 30 40 50 100

Opening balance $0 $47,423 ($40,003) ($38,700) ($37,440) ($36,220) $30,694)

Interest $0 $4,031 ($3,400) ($3,290) ($3,182) ($3.079) (2,609)

(WACC)

Annuity income $3,762 $3,651 $3,532 $3,417 $3,306 $3,198 $2,710

Closing balance $3,762 $55,106 ($39,871 ($38,572) ($37,316) ($36,101) ($30,593)

Table 11 shows the opening balance of the annuity fund, plus the amount of interest credited or
charged on the opening balance, plus the value of the annuity receipts credited to the fund, to
arrive at a closing balance for the fund at the end of each of a selected number of years.
At the end of 20 years, the term of the original annuity, the annuity fund has a shortfall of
$39,871, or $7,799 in PV terms. Normally, it would be expected that the closing value of the
annuity fund in year 20 would be zero, indicating that the cost of capex to be recovered by the
annuity had been fully recovered.
Figure 5 shows the PV of annuity receipts over 100 years from a rolling annual annuity with a
term of 20 years, expressed as a percentage of the PV of capex.
Figure 5 PV capital recovery from a 20-year rolling annual annuity

100%
95%
90%
85%
80%
75%
70%
65%
60%
55%
50%
10 20 30 40 50 100
20 yr Annual Rolling Annuity

Based on the analysis of a rolling annual indexed annuity for the example above, the relevant
values and outcomes are:

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(a) Nominal cost of commissioned capex at the end of year 15 is $144,830 and the PV of that
capex is $42,600.
(b) Over the first 20 years of the rolling indexed annual annuity the PV of annuity revenue
would be $34,801, or about 82 per cent of the PV of the cost of the cost of the asset.
(c) The actual shortfall in funding from the annuity fund at the end of year 20, the term of
the annuity, is $39,871.
(d) Over a period of 35 years, the time to the end of the life of the 20 year asset
commissioned at the end of year 15, the PV of annuity revenues would be $40,417, or
about 95 per cent of the PV cost of the capex. That is, the cost of the capex has not been
fully recovered by the time of its scheduled replacement.
(e) Critically, by year 100 the value of the capex expenditure would not have been fully
recovered, albeit that only PV $9 or 0.02 per cent, of the balance remains outstanding.
The reason for the short-fall in capital recovery is that the rolling indexed annual annuity is
recalculated for each year (but at the start of the pricing period). As such, a rolling annuity
continues to run in perpetuity and not for a defined time period. In the single asset example,
each new annuity is based on the closing balance of the previous year which is re-cast
progressively for recovery over the next 20 years. This process results in a marginally
diminishing balance for recovery each year without ever actually reaching a true terminal value
of zero.
While it is possible to apply a capital annuity to cover the full term of the rolling annual annuity,
or extend the rolling period to five years to coincide with the regulatory pricing period, the
under-recovery problem is not avoided as there is still a need to re-calculate the annuity at the
commencement of the next regulatory pricing period.
Clearly, the application of a typical rolling annual annuity approach will not provide for the full
cost of capital replacements on a timely basis. However, revenue adequacy can be achieved by
using an aggregated rolling annual annuity.

An Aggregated Rolling Annual Annuity

An aggregated rolling annuity involves first calculating a series of successive annual annuities
that are calculated independently based on separate capital components, and then calculating
an aggregated annual value as the sum of the individual annuities for each year. After
calculating the initial annuity, each successive annuity is based on recovery of only expenditure
for the next year of the planning period beyond the term of the initial annuity. The calculation
is done at the start of each pricing period.
To demonstrate the calculation of an aggregated rolling annuity for a five-year pricing period,
consider a 24-year planning period. In year zero, an annuity path (denoted path A) is calculated
based on the opening RAB and all forecast capex for the next 20 years. This annuity path
spreads the recovery cost (as the annual capital revenue requirement) across the next 20 years
(year 1 to year 20). In year one, the ARR would be the year one annuity identified in path A.
At the end of year one, a new annuity path (path B) is calculated, but this annuity path only
captures the forecast capex expected to incur in year 21 and spreads the cost across the next 20
years (year two to year 21). Hence, in year two, the total ARR would be the sum of year two
annuity from path A and the year two annuity from path B. This contrasts to the calculation of a
rolling annual annuity, which after deducting the value of the first year annuity recalculates
recovery of the remaining balance of path A capex, plus capex for year 21, over the next 20

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years. That is, under the rolling annual annuity, the recovery for path A capex is progressively
extended each year, and does not fully recover the path A capex within the first 20 years.
At the end of year two, a new annuity path (path C) is calculated which captures the forecast
capex for year 22, and spreads the cost across the next 20 years (year three to year 22). For the
third year of the aggregated rolling annuity, the total ARR would be based on summing the
value of the year three annuity from path A, plus the value of the year three annuity from path
B, as well as the value to year three annuity from path C.
This process would be repeated for each year of the price path, resulting in full recovery of
capex within the defined term for each annuity path (20 years in the example).
For more about the aggregated rolling annuity methodology, refer to Table 12, which is based
on the previous example for a rolling annual annuity, with additional expenditures and
assumptions as follows:
(a) $50,000 at the end of year 21
(b) $75,000 at the end year 24
(c) nominal analysis.

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Table 12 Process for calculating a rolling aggregated annuity ($'000 nominal)

Year

1 2 3 4 5 ~ 15 ~ 20 21 22 23 24

Capex in years 1–20 0.0 0.0 0.0 0.0 0.0 ~ 145 ~ 0.0

Annuity path A— applicable in 3.8 3.9 4.0 4.1 4.2 ~ 5.3 ~ 6.0
years 1–20

Capex in year 21 84

Annuity path B—applicable in 1.5 1.5 1.5 1.6 ~ 2.0 ~ 2.3 2.3
years 2–21

Capex in year 22 0

Annuity path C—applicable in 0.0 0.0 0.0 ~ 0.0 ~ 0.0 0.0 0.0
years 3–22

Capex in year 23 0

Annuity path D—applicable in 0.0 ~ 0.0 ~ 0.0 0.0 0.0 0.0

years 4–23

Capex in year 24 136

Annuity path E—applicable in 2.3 ~ 3.0 ~ 3.4 3.5 3.6 3.7 3.7
years 5–24

Aggregated annuity 3.8 5.3 5.4 5.6 8.1 ~ 10.3 ~ 11.7 5.8 3.6 3.7 3.7

Smoothed revenue 6.2 6.3 6.5 6.7 6.8 ~ 8.8 ~ 9.9 10.2 10.4 10.7 10.9
requirement (indexed)

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Note that for pricing, revenue smoothing would be applied over the full planning period of 24
years.
Under an aggregated rolling annuity approach, each successive annuity runs its full term and
achieves revenue adequacy. That is, the revenue generated over the term of the annuity is
sufficient to fully fund (exactly) the cost of expenditure identified for recovery by the annuity.
For pricing, a smoothed revenue requirement (with annual indexation) would be calculated
using the aggregated annuities for the full planning period of 24 years.
A further summary of calculations for an aggregated rolling annual annuity, at five yearly
intervals, for years one to 24 is shown in Table 13.
Table 13 An aggregated annual rolling annuity fund—20-year annuity ($ nominal)

Year

1 5 10 15 20 24

Opening annuity balance $0 $22,529 $83,867 $182,669 $137,952 $121,575

Capex $0 $144,830 $135,654

(new/replacements)

20-year annuity $3,762 $4,152 $4,698 $5,315 $6,014 $0

(calculated on capex years
1–20)

Year 1 annuity $0 $1,562 $1,767 $2,000 $2,263 $0

(capex year 21)

Year 2 annuity

(capex years 22) $0 $0 $0 $0 $0 $0

Year 3 annuity $0 $0 $0 $0 $0 $0
(capex year 23)

Year 4 annuity $0 $2,343 $2,651 $3000 $3,394 $3,746

(capex year 24)

Aggregated rolling $3,762 $8,085 $9,117 $10,315 $11,670 $3,746

indexed annuity

Interest on opening $0 $1,915 $7,129 $15,527 $11,726 $10,334

balance

Closing annuity balance $3,762 $32,501 $100,113 $63,681 $161,348 $0

Smoothed revenue $6,195 $6,838 $7,737 $8,753 $9,904 $10,932

requirement for pricing

In Table 13, note that by the end of year 24, the last year of data for a 20-year rolling annual
annuity applied for a five-year price path, and the last year for scheduled capex, the annuity
fund balance is zero. This means that the full cost of scheduled capex has been fully funded
within the defined term of the annuity. That is, the aggregated rolling annual annuity provides
for financial capital maintenance.
While the aggregated rolling annuity approach involves extra complexity in calculating the total
annuity for each year of the price path, it correctly funds planned expenditure.
Administratively, it would be necessary to identify and justify any unders or overs in actual
expenditure, as compared to the forecast expenditure used to calculate the initial annuities,
prior to the commencement of the next regulatory pricing period. Based on actual expenditure

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acceptable to the regulator, the original annuity(ies) would need to be re-calculated for the
remaining term of the annuity(ies) to ensure revenue adequacy. In this way, the price impact of
actual expenditure versus estimated expenditure would be fully transparent.
For pricing, the aggregated rolling annuity would be smoothed over the full term of the annuity
calculations, to achieve a PV equal to the PV of the aggregated annual annuities.

2.6 Summary
The key outcomes of this section can be summarised as:
(a) A capital annuity has a lower ARR during the early years of the life of an asset when
compared to the RAB building blocks approach with straight-line return of capital, but in
the latter years of asset life the annuity results in a higher ARR than the RAB building
blocks approach. However, over the full life of an asset, the PVs of the AARs are identical
for both approaches. That is, where revenue or price smoothing is applied over the life
of the asset, smoothed annual revenue or prices will be identical under both approaches.
(b) A capital annuity approach can be used to recover the cost of existing assets plus forecast
capex for replacements and expansion, in lieu of the RAB building blocks approach.
(c) Following the drawing of 'a line in the sand' for the value of existing assets, there may be
significant differences in ARRs between the annuity and RAB building blocks approach if
planning periods used for pricing are less than the full life of new or replacement assets.
(d) A renewals annuity is a variant of a capital annuity that incorporates the annual costs
associated with scheduled repairs, maintenance and refurbishments for the purposes of
maintaining the current service capacity.
(e) The application of a rolling annual annuity typically results in a material under-recovery
of expenditure during the defined term of the annuity. The under-recovery can be
avoided by applying an aggregated rolling annual annuity.
(f) Where revenue smoothing is applied, there is no difference in the smoothed revenue
outcomes between a rolling annual annuity and a simple capital annuity calculated over
the full term of the rolling annuity.
Over the life of an asset, a capital annuity generates an ARR that is identical to the smoothed
revenue requirement for the RAB building blocks approach. Therefore, if calculated over the
full life of an asset, the smoothed prices will also be identical for each of the approaches.

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APPENDIX A: ANNUITY FORMULAE

The mathematics for the calculation of a constant annuity and an indexed annuity is presented below.

Constant Annuity
By definition, the PV of a constant annuity equals the value of the initial principal.
Therefore, the starting point for deriving the formula for an annuity to is to express the PV of an annuity
as a series of equal annual cash flows (Brealey, Myers, Partington & Robinson 2000):

(1)

where:
= initial principal
= annuity payment
= discount rate (real or nominal) applicable
= term of the annuity.
The focus here is to solve for , the constant annuity payment.
Firstly, let:

and .

Formula (1) can then be expressed as:

(2)
Multiplying both sides by gives:
(3)
Subtracting (3) from (2) gives:
(4) )
Substitute for and a:

(5)

Multiplying both sides by gives:

(6)

Divide both sides by :

(7)

Re-arrange to simplify the formula for a constant annuity:

(8)

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Indexed Annuity
An indexed annuity is also referred to as growing annuity (Brealey, Myers, Partington & Robinson 2000) or
a tilted annuity (Deloitte 2011) and (NERA 2009).
(Brealey, Myers, Partington & Robinson 2000) provide the following expression for a growing/declining
(indexed) annuity:

(9)

where:
= present value amount
= annuity payment
= discount rate (real or nominal) applicable
= term of annuity
t = year within the term of the annuity (1, 2, ..., n-1, n)
= rate of indexation.
Note that Equation (9) can be simplified as follows:

(10)

Firstly, let:

and .

Equation (10) can then be expressed as:

(11)
Following the same approach as above for the constant annuity, Equation (11) can be re-stated as:
(12)
Substitute for and :

(13)

Multiplying both sides by gives:

(14)

Divide both sides by :

(15)

The indexed annuity for period , denoted , is expressed as:

(16)

(17)

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Note that with a zero indexation rate (i.e. , Equations (8) and (17) are identical. This implies that
the constant annuity formulae can be interpreted as a special case of a more general formulae Equation
(16), where the annuity derived from the latter becomes constant over time (i.e. ) when the
annual escalation rate applied is 0 per cent. Also note that in this formulae, the annuity charge for period
1, , is equal to .
Note that the PMT function in Microsoft Excel does not allow for direct calculation of an indexed annuity.
Nevertheless, it can be shown that an indexed annuity can be calculated using the Excel PMT function by
replacing the discount rate with an adjusted discount rate .
To begin with, is defined as

Next, note that

Equation (15) can be re-defined as:

(18)

The indexed annuity for period , denoted , is expressed as:

(19)

Note that Equation (19) is similar to the constant annuity formulae Equation (8), but the discount rate
applied is rather than . Since the Equation (8) is embedded in Microsoft Excel, it is possible to derive
the PMT for an indexed annuity by first finding the adjusted discount rate and applying this discount
rate to the Excel function.

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Queensland Competition Authority Glossary of Acronyms, Terms and Conditions

GLOSSARY OF ACRONYMS, TERMS AND CONDITIONS

A
ARR Annual Revenue Requirement

C
CPI Consumer Price Index
Capex Capital expenditure

F
FCM Financial Capital Maintenance

N
NPV Net Present Value

P
PV Present Value

Q
QCA Queensland Competition Authority

R
RAB Regulatory Asset Base

W
WACC Weighted Average Cost of Capital

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Queensland Competition Authority References

REFERENCES

Australian Energy Regulator (AER) 2012, Final Distribution Determination for Aurora Energy Pty Ltd 2012–
13 to 2016–17, Final Decision, April.

Australian Energy Regulator 2009, New South Wales Distribution Determination 2009–10 to 2013–14,
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Brealey R, Myers S, Partington G and Robinson D 2000, Principles of Corporate Finance, McGraw-Hill Irwin,
New York.

Council of Australian Governments (COAG) 1995, Expert Group for the Working Group on Water Resource
Policy, Report on Asset Valuation Methods and Cost-Recovery Definitions for the Australian Water
Industry, February.

Deloitte 2011, Bottom-Up Modelling for the Water Industry—A Report for OFWAT, April.

Economic Regulation Authority (ERA) 2013, Inquiry into the Efficient Costs and Tariffs of the Water
Corporation, Aqwest and the Busselton Water Board, January.

Essential Services Commission (ESC) 2006, 2008 Water Price Review Consultation Paper—Framework and
Approach, December.

Goulburn–Murray Water 2005, Goulburn-Murray Water Announces 2005/06 Prices, June.

Independent Pricing and Regulatory Tribunal (IPART) 2004, Bulk Water Prices 2005–06, Issues Paper,
September.

Independent Pricing and Regulatory Tribunal 2006, Bulk Water Prices for State Water Corporation and
Water Administration Ministerial Corporation from 1 October to 30 June 2010, September.

Murray Irrigation 2012, Network Service Plan 2012–30 June 2017.

Murrumbidgee Irrigation Ltd 2012, Network Service Plan 1 July 2012– 30 June 2017.

National Water Initiative (NWI) 2010, Pricing Principles.

National Water Initiative 2007, Steering Group on Water Charges, Water Storage and Delivery Charges in
the Rural Water Sector in Australia.

NERA Economic Consulting 2009, Review of ACCC’s Fixed LRIC Cost Model—Prepared for Telstra, March.

OFGEM 2010, RPI-X@20: Providing Financeability in a Future Regulatory Framework—Final Report, May.

OFWAT 2009, Future Water and Sewerage Charges 2010–15, Final Determinations.

Productivity Commission 2008, Financial Performance of Government Trading Enterprises 2004–05 to

2006–07.

Queensland Competition Authority (QCA) 2012, SunWater Irrigation Price Review: 2012–17, Final Report
Volume 1, May.

Queensland Competition Authority 2013, Seqwater Irrigation Price Review 2013–17, Final Report Volume
1, May.

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Queensland Competition Authority References

Queensland Competition Authority 2014, Financial Capital Maintenance and Price Smoothing, Information
Paper, February.

Western Australia Legislation 2010, Railways (Access) Code 2000, February.

Southern Rural Water 2013, Water Plan 3—2013 to 2018.

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