Regulatory Assets

Legend of the hidden ledger

Balance Sheet of Power

In most businesses, expenses are immediately recorded in the income statement. If this expense is not met through the revenue, the company’s profit for the said period is reduced.

The power sector, particularly in distribution, operates under a unique financial practice. Distribution companies (Discoms) are permitted to defer booking certain expenses, especially large or unexpected ones. This practice stems from the direct link between a Discom's recorded expenses and consumer electricity prices.

When a Discom incurs an expense, it must ultimately recover that cost through the tariffs charged to consumers. However, if all expenses were immediately recorded and reflected in pricing, it could lead to sudden and significant increases in electricity rates—a phenomenon known as "tariff shock."

What is a Regulatory Asset

To mitigate the risk of tariff shocks and to maintain price stability for consumers, regulators allow Discoms the flexibility to book their extraordinary expenses under a special head known as regulatory asset. Basically here the regulator (during tariff approval¹ and true-up process²) allows the Discom to book these expenses as an asset in the balance sheet, similar to how it would record the purchase of an equipment or property.  

The process of collecting the money bit by bit over a long time is identified as amortization. The process of approval of such amount of the specifics of adjustment/amortization is the task of the specific regulatory commission approving the Discom’s tariff.

The Challenge

Provisioning of expenses as assets could have worked out well, if it was limited in time and amortization was carried out fairly. However, the continuous practice of unrealised expenses being reworked as assets without an outlet, has led to a grim scenario. These regulatory assets or revenue gaps as they have now been aptly reworded, have accumulated to substantial amounts over time.

As per the government data, the cumulative revenue gap/regulatory assets of Discoms in the country as on date stands at Rs. 1.57 lakh crores. It also records that, Tamil Nadu, Rajasthan, and Delhi contribute significantly to this gap, accounting for Rs. 89,735 crores, Rs. 47,833 crores, and Rs. 9,009 crores.

As we discussed in an earlier post, this is one of the major reasons for the immense financial strain on discoms. The slow pace of cost recovery affects the Discoms’ ability to invest in infrastructure and maintain service quality. It also ties down the funds, creating working capital shortages.

To manage cash flow issues, Discoms often resort to high-cost borrowing, further exacerbating their financial woes. Compounding the problem, some state regulators have allowed large regulatory assets to accumulate without specifying clear recovery trajectories, violating established guidelines.

“8.2.2. The facility of a regulatory asset has been adopted by some Regulatory Commissions in the past to limit tariff impact in a particular year.
This should be done only as exception, and subject to the following guidelines: a. The circumstances should be clearly defined through regulations, and should only include natural causes or force majeure conditions. Under business as usual conditions, the opening balances of uncovered gap must be covered through transition financing arrangement or capital restructuring; b. Carrying cost of Regulatory Asset should be allowed to the utilities;
c. Recovery of Regulatory Asset should be time-bound and within a period not exceeding three years at the most and preferably within control period;
d. The use of the facility of Regulatory Asset should not be repetitive.
e. In cases where regulatory asset is proposed to be adopted, it should be ensured that the return on equity should not become unreasonably low in any year so that the capability of the licensee to borrow is not adversely affected.”

Balancing the Scales

The government is now focussed on prohibiting ‘regulatory assets’, and has directed the State Regulatory Commissions to come up with concrete solutions towards amortization and collection of these expenses.
Some of the directives and solutions proposed are:-

a. States/DISCOMs to ensure any regulatory assets/uncovered revenue gap created in the past are liquidated in seven years in accordance with the Tariff policy by Ministry of Power dated 28th January 2016.

b. States/DISCOMs to ensure that no new Regulatory Assets/uncovered revenue gaps are created in future as per the Tariff Policy.

c. States/DISCOMs, which are part of RDSS, to include liquidation of existing regulatory assets/uncovered revenue gap under financial sustainability category with adequate weightage in the Result Evaluation Framework.

d. States/DISCOMs, which are not part of RDSS, to outline a road map for liquidation of regulatory asset and convey to Ministry of Power.

e. DISCOMs to submit implementation status of liquidation of Regulatory Asset annually to Nodal Agencies and Ministry of Power.

The government has gone on to very clearly state that there is no provision for anything like regulatory assets in law and therefore creation of any such assets shall not be permissible.

Having said that, realisation of old revenue gaps will take time. We are looking at some spurts of tariff increases, a move that's both politically sensitive and economically challenging for consumers.

1. At the beginning of each year, the Discom has to submit an application for approval of its proposed expenditure before the Regulator. This proposed expenditure is called the Aggregate Revenue Requirement or ARR.

2. ‘Truing up’ is the process of adjustment of expenses incurred by the Discom against the estimated/projected amounts determined under the ARR. The truing up exercise is meant to fill the gap between the actual expenses at the end of the year and anticipated expenses in the beginning of the year.