CASE STUDIES

AVOIDING THE INFLATION OF DAMAGES WITH “MONEY MACHINES”

“Money machines” that artificially inflate claims in damages disputes should be avoided. For example, consider the counterfactual scenario where in the absence of the alleged ‘damage’, the Claimant is assumed to borrow an extra $50mn to invest in additional new production facilities at an interest cost of 10% p.a.. The Claimant’s equity cost of capital for the overall business is assumed to be 14%.

In a poorly argued submission, the equity cost of capital may then be erroneously assumed to be the relevant rate at which returns are generated from the new production facilities on the basis that the cost of equity is the same as the required return for equity. However, in this example, this assumption makes it possible to borrow at 10% to generate returns of 14%; a money machine has been created. In practice, in competitive markets new entry occurs to drive returns down to the level of the marginal cost of capital (which in this case is 10% given that the new investment is entirely debt funded). Any excess returns need to be justified by competitive advantages or other considerations and not simply generated by assuming a “money machine”.

ALLOWING FOR PORTFOLIO EFFECTS IN  DAMAGES ESTIMATION

It can be critical in the assessment of a claim to consider not just the immediate effects of the alleged damage but also any potential wider impacts on the Claimant’s business. These could be positive or negative.

Consider the impact on a Claimant that suffers the outage of one of its power stations. The Claimant incurs the loss of revenue from the affected power station for the duration of the outage.  But at the same time the power station outage by reducing the supply of generating capacity in the market may serve to drive up market prices. This in turn means that the revenues received by the Claimant’s other power stations that continue to operate may be higher than they would otherwise be but-for the outage. However, at the same time the Claimant’s related retail electricity business, may suffer a reduction in revenues sales due to the response of their final consumers to such price increases (that are passed through to them). In these circumstances, determinism whether 'knock-on' effects in a claimant's related businesses may be taken into account in overall damages estimation is potentially very important.

HOW TO ASSESS COUNTERFACTUAL COSTS

Estimating ‘lost’ profits in a claim from cash-flow analysis requires projecting the level of not just additional counterfactual sales but also additional counterfactual costs. These additional costs may be estimated by determining which costs vary with production (known as variable costs) and then multiplying the estimated variable cost per unit by the number of additional units being produced in the counterfactual scenario. Variable costs may be estimated:

• “Top-down” by considering how overall of costs have varied as output has varied over time; and

• “Bottom-up” by summing up estimates of how specific cost items may vary in order to produce additional units of output.

Top-down estimates tend to suffer from ‘errors of inclusion’ and as such exaggerate the scale of variable costs, while bottom-up estimates tend to suffer from ‘errors of exclusion’ and as such under-estimate the scale of variable costs. In practice, it is necessary to consider both top-down and bottom-up approaches in order to reach robust estimates of variable costs.

SHOULD AVOIDED INVESTMENT BE ‘CLAWED BACK’ BY REGULATORS OR TREATED AS AN EFFICIENCY GAIN?

Future investment plans are based on projections of additional capacity requirements to meet increases in expected demand and the replacement of existing capacity for which maintenance has become more expensive. But in practice it may become possible to cancel or defer planned investment for a range of reasons; these include where out-turn demand is less than expected or equipment degradation has not occurred as quickly as anticipated or smaller scale investments have improved the scope for capacity utilisation. In such cases, regulated firms may benefit from a ‘surplus’ revenue allowance given that it is no longer necessary to fund investment to the extent previously envisaged.

In this situation, regulators have often been under pressure to ‘claw-back’ what is seen to be an excessive revenue allowance. But this risks eliminating incentives to achieve productive efficiency; regulated firms that anticipate claw-back may simply spend their revenue allowance and not bother with schemes to manage demand better or improve equipment utilisation. So, the first regulatory response should be to seek to penalise ‘game-playing’ by regulated businesses that artificially inflate their projected investment expenditure. This is in part dependent on the regulator herself forming a robust view on likely future investment expenditure requirements which in turn may require more onerous information submissions from the regulated business.

Second, regulators need to calibrate carefully the frequency of regulatory determinations that set revenue allowances. More frequent reviews will reduce the scale of any regulatory gain from deferred or cancelled expenditure. These need not be applied to the entire 

business; re-determinations could apply to ring-fenced areas of projected expenditure that are especially uncertain.

Third, the regulatory framework should provide rewards for out-performance not just in terms of reduced expenditure (relative to plan) but also for improved outputs. This should mitigate incentives on businesses to under-spend on their assets for the sake of maximising short-term returns that is at the expense of performance.

REGULATORY INCENTIVE MECHANISMS  THAT LAG BEHIND COMMERCIAL DEVELOPMENTS

Regulators are increasingly using market-based incentive mechanisms to drive desired policy outcomes. An example of this comprises the introduction across Europe of Capacity Markets in the power sector to correct for what is commonly seen as the inability of spot power markets by themselves to remunerate adequately new generating stations and as such to risk the occurrence of risk power shortages. Capacity markets correct for this ‘market failure’ by delivering additional revenue to generating stations through the award of capacity contracts that are competed for in periodic auctions.

However, by giving as much ‘free-rein’ as possible to auction mechanisms – so as to avoid inefficiently constricting market behaviour - regulators often expose their own inability to keep up with market developments. This was revealed in the UK where the Capacity Market auctions unexpectedly attracted substantial participation from small scale diesel gensets that were able to gain further competitive advantage by exploiting incentives for embedded generation in regulated network charges. This then stimulated a further regulatory review of the economic efficiency of network charging arrangements.

The key point to note from this experience is that regulatory mechanisms tend to lag commercial developments. This means that regulators need to recognise such lags as an inherent component of regulatory incentive mechanisms and to ensure that market participants understand that incentive mechanisms may be re-calibrated at frequent intervals.  The alternatives are either to tolerate regulatory-induced inefficiencies or to make only periodic and, as such, potentially unexpected corrections to incentive mechanisms which then risks causing commercial distress and undermining investment incentives.