аЯрЁБс>ўџ @Bўџџџ?џџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџџьЅС7 №ПU$bjbjUU .L7|7|U џџџџџџlиииииииTмммм ш T›Ж$Q qŠ@и@ЎииUЎЎЎ:ииЎЎlЎииє pgƒ;№ЅЧTˆмP^k0›ћЎћЎь<(,иииийDear Mr Mason, Thank you for your letter of 5th April, in response to our email of 19th February to Regina Finn, to which we had attached our paper, "Fundamental Flaws in the Current Cost Regulatory Capital Value Method of Utility  Pricing", published in the Fraser of Allander Quarterly Economic Quarterly, vol. 31, no.3. On a point of detail first of all: in your first paragraph, you state that we had sent you an identical paper last June, in response to your consultation on Financing Networks. This is not strictly true. While the basic modelling is the same in the two papers, the later paper gives much more detail than last June's paper, particularly in identifying flaws in various arguments that have been put forward in support of current cost regulatory capital value pricing. You set out in your letter seven areas in which you disagree with the conclusions of our paper. We deal with each of these areas below, (numbering is as in your letter). But in summary, your arguments on each of these points are flawed. 1.         You state that almost all of the water and sewerage companies in England and Wales are cash flow negative, and claim that this is entirely at odds with the situation described in our analysis. However, the definition of cash flow, as used in the publication to which you refer, is Net cash flow from operating activities, less interest, less dividends, less taxation, less investment. In other words, dividends are netted off in the definition of cash flow which you have chosen. Given this, it is nonsensical to use negative cash flow as an indicator that a company's profits are not excessive. No matter how large a company's profits were, it could make itself cash flow negative by paying out a large enough dividend - and in your logic, this would show that the company's profits were not excessive. In any event, companies with large investment programmes would normally be borrowing, and hence have negative cash flow: so negative cash flow is a meaningless test. For both these reasons, the use of this particular indicator as a test for whether profits are excessive or not is nonsensical: and your argument on this point carries no weight. 2.         You have mis-stated our argument on this point: we did not say that utilities are price takers: but that they are price makers: - which they clearly are, in that the costs associated with the capital charge based on current cost regulatory capital value (CCRCV) are passed on to the consumer, rather than being borne by the producer within a budgetary constraint. Our argument is that this throws the normal opportunity cost mechanism into reverse: instead of having an incentive to minimise the capital charge, (which is how a price taker would react, funding the capital charge within a fixed budget), the incentive on the price maker operating under CCRCV pricing is to maximise the revenue the capital charge will yield, by maximising capital investment within the constraints set by the regulator. We have never implied that it would be easy to set up the mechanisms that would enable consumers to make the opportunity cost decisions which, logically, should rest with them. But before you prejudge what consumer reactions would be, we suggest that it would be appropriate to explain to consumers how the present system works, and in particular, the extent of the costs that they, the consumers, are actually bearing, and the size of the returns being paid out in dividends, relative to the capital actually raised by equity issue. 3.         You state that deducting historic cost depreciation rather than current cost depreciation from the regulatory capital value would mean that the RCV is higher, and therefore the absolute level of return would be higher, recognising the increased allowance for a return on capital that would occur. In fact, if you refer to our paper, you will see that we are not advocating the simple introduction of historic cost pricing, but rather a more careful decomposition of the funding sources of CCRCV, and a more rational basis for deciding which of these sources need to be remunerated, and how. As regards your specific comment - this is nonsense: you seem to imply that we are proposing that the CCRCV system should be tinkered with, by subtracting off historic cost rather than current cost depreciation, but otherwise rolling on CCRCV as at present. This sort of partial tinkering would make no sense, and we have never proposed anything like this. 4.         You state that "your approach to calculating the 'financial surplus' appears to ignore the fact that companies are financed by debt and equity". This is only true in the sense that the financial model we developed quite deliberately described the characteristics of a utility operating in a steady state, and financed entirely by debt. There are two big advantages associated with dealing with this simple case in the modelling: a.         to keep the algebra simple. b.            because this "debt finance only" situation illustrates graphically how, even for a company with no equity finance, then in the presence of inflation the CCRCV will be significantly greater than the total debt of the company. In other words, even when the only source of finance available is debt, a significant part of CCRCV will be "funded" by the operation of inflation. You will see that in the generality of our paper, and when we are discussing the implications of our basic model, we are perfectly well aware of the different funding sources of CCRCV: in fact, we carefully distinguish four such funding sources, namely, debt, equity, retained profits, and inflation. We regard your statement, that companies are funded by debt and equity, as being overly simplistic and highly misleading. Statements such as yours contribute to the common misapprehension that that part of CCRCV which is not debt must have been funded by equity. This misapprehension has led to the current situation where the capital charge on the whole of non-debt CCRCV, (even on those parts funded by retained profits and inflation) is available to reward the equity owners: this has been the major contributor to the excessive returns actually paid in dividends, relative to the amounts of equity capital actually injected into the companies. 5.         To say we dismiss analysis of MEAs is misleading. Our main thesis relates to the generic effects of current cost pricing and does not depend on which particular method of calculating asset values at current prices is actually applied. 6.         You do not seem to realise the circularity in your own position. The market valuation of the company's shares is largely a function of your decision to allow the company to charge customers the cost of a market rate of interest return on the whole of CCRCV. Given that the market valuation is therefore a function of your pricing policy, you are simply indulging in circularity if you attempt to justify that pricing policy by reference to the market valuation. The way that we have looked at returns is the appropriate way - reflecting the return earned on the equity resources actually put into the business. 7.         The lack of transparency refers to the funding sources of CCRCV, not to how CCRCV is calculated. As we have explained above, implying, as OFWAT commonly does, that CCRCV is funded only by debt and equity, is highly misleading: and this is the largest contributory factor to the current overcharging, to the excess dividend returns relative to equity capital actually raised, and indeed to potential distortion in the capital investment programmes of the companies. You will see from the above, therefore, that we reject each of your criticisms of our paper: and indeed, we regard your arguments as lending additional credence to the views expressed in our paper. Please note that we will be publishing this reply, (and your original letter), on our website at  HYPERLINK "http://www.cuthbert1.pwp.blueyonder.co.uk" www.cuthbert1.pwp.blueyonder.co.uk ,where it will appear with a copy of our original paper. We are also copying this to Ms. Finn, the recipient of our email of 19th February. Yours sincerely, Dr. James R. Cuthbert Mrs. M. Cuthbert 18 May 2007 $#%#\#]##€#U$њњїњ0J jUDљ! $H$I$U$§§§§§§U$§,1hА‚. АЦA!А"А# $ %ААФАФ Ф i8@ёџ8 NormalCJ_HaJmH sH tH <A@ђџЁ< Default Paragraph Font.U`Ђё. 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