The building blocks of a regulated utility's revenue, one year, with the indexation that most first models get wrong.
Under a regulatory asset base model, allowed revenue is the sum of four building blocks: a return on the RAB at the allowed WACC, regulatory depreciation of the RAB, the share of spending recovered in the year, and a tax allowance. On an illustrative utility with an opening RAB of 1,000, 3.0 per cent inflation and a 4.0 per cent real WACC, allowed revenue is 172.98. Inflation is paid by indexing the RAB, not through the WACC, and confusing the two overstates revenue by almost a fifth.
Worked in full in The Infrastructure Investment Analyst by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The case is one regulatory year for an illustrative network utility under an indexed RAB regime of the kind used for UK water and energy networks: the RAB is uplifted for inflation each year and earns a real return. Figures are in millions and every parameter is illustrative, not a regulator's determination.
| Input | Value |
|---|---|
| Opening RAB, in last year's prices | 1,000 |
| Inflation for the year | 3.0% |
| Allowed total expenditure (totex) | 200 |
| Pay-as-you-go ratio (fast money) | 40% |
| RAB run-off rate (regulatory depreciation) | 4.0% |
| Allowed real WACC | 4.0% |
| Tax allowance | 9.0 |
1. Index the opening RAB: 1,000 x (1 + 3.0%) = 1,030.0
2. Split totex: fast money = 200 x 40% = 80.0; slow money added to the RAB = 120.0
3. Regulatory depreciation: 1,030.0 x 4.0% = 41.2
4. Closing RAB: 1,030.0 + 120.0 - 41.2 = 1,108.8
5. Return on RAB: average RAB (1,030.0 + 1,108.8) / 2 = 1,069.4; x 4.0% = 42.78
6. Allowed revenue = 42.78 + 41.2 + 80.0 + 9.0 = 172.98
In Excel, with the opening RAB in B2, inflation B3, totex B4, pay-as-you-go B5, run-off B6, WACC B7 and tax B8: closing RAB =B2*(1+B3)*(1-B6)+B4*(1-B5), revenue =(B2*(1+B3)+B9)/2*B7+B2*(1+B3)*B6+B4*B5+B8 with the closing RAB in B9.
| Block | Amount | Share |
|---|---|---|
| Return on average RAB | 42.78 | 24.7% |
| Regulatory depreciation | 41.2 | 23.8% |
| Fast money (expensed totex) | 80.0 | 46.2% |
| Tax allowance | 9.0 | 5.2% |
| Allowed revenue | 172.98 | 100% |
The RAB grows from 1,000 to 1,108.8, or 10.9 per cent: 30.0 of indexation and 7.7 per cent of real growth because the 120.0 of slow money exceeds the 41.2 of run-off. The investor's nominal return for the year is the 42.78 earned in cash plus the 30.0 of indexation credited to the RAB, 72.78 in all, and the indexation is realised only through future depreciation and return, or at sale.
The two levers that matter most are the allowed WACC and the run-off rate. They act very differently.
| Case | Return | Depreciation | Revenue | Change |
|---|---|---|---|---|
| Real WACC 3.5% | 37.43 | 41.2 | 167.63 | -5.35 |
| Base: WACC 4.0%, run-off 4.0% | 42.78 | 41.2 | 172.98 | 0.00 |
| Real WACC 4.5% | 48.12 | 41.2 | 178.32 | 5.35 |
| Run-off 3.0% | 42.98 | 30.90 | 162.88 | -10.09 |
| Run-off 5.0% | 42.57 | 51.50 | 183.07 | 10.09 |
A 50 basis point change in the WACC moves revenue by 5.35, or 3.1 per cent, and that is value: it changes what the investor earns on the same asset. A one-point change in run-off moves revenue by twice as much, 10.09, but it is mostly timing: faster depreciation brings cash forward and leaves a smaller RAB, so the present value at the allowed WACC barely changes. Regulators use run-off to manage bills between generations; investors should model it as cash-flow timing, not as a gain.
The WACC is the value lever; run-off and the pay-as-you-go ratio are timing levers. A change in run-off flatters near-term cover ratios and dividends without changing what the RAB is worth at the allowed return.
This is also why regulated assets are quoted as a premium or discount to RAB. A buyer paying exactly the RAB, financed at exactly the allowed WACC, earns the allowed return and nothing more. A premium is justified only by something the building blocks do not capture: beating the cost allowances, incentive rewards, financing cheaper than the regulator's assumption, or an expectation of RAB growth at a return above the cost of capital. Each of those should be modelled as a separate line, so that the price paid can be traced to the assumption that supports it.
The classic error is applying a nominal WACC to an indexed RAB. A nominal rate built from the same assumptions is (1 + 4.0%) x (1 + 3.0%) - 1 = 7.12 per cent. Applied to the indexed average RAB of 1,069.4 it gives a return of 76.14 and revenue of 206.34, an overstatement of 33.37, or 19.3 per cent. The excess is inflation, grossed up by the real return, on the average RAB: 1,069.4 x 3.0% x (1 + 4.0%) = 33.37. The model pays inflation twice, once through the RAB indexation of 30.0 and again in the rate. The rule is simple: an indexed RAB earns a real rate; an unindexed RAB earns a nominal one. Never mix them.
The related error in valuation is discounting the resulting cash flows at a rate that does not match how they were built, real cash flows at a nominal rate or the reverse; the mismatch compounds over every remaining year of the asset's life.
Index the RAB, add slow money, deduct run-off, earn the real WACC on the average, then add fast money and tax: 172.98 here. The cash return is 42.78 and the rest of the investor's return sits in the RAB as indexation. The book values a regulated utility end to end, with the rate matched to the cash flow, in the free workbooks for this book, and the article on whether a constant WACC overstates value shows the next trap in the same model.
It depends on the regime; many regulators use the average of the opening and closing RAB within the year, so that capex added during the year earns a return for about half of it. On the illustrative utility the average indexed RAB is 1,069.4, and the return at a 4.0 per cent real WACC is 42.78.
Total expenditure is split by a pay-as-you-go ratio. Fast money is recovered in the year through revenue; slow money is added to the RAB and recovered over decades through depreciation and return. With totex of 200 and a 40 per cent pay-as-you-go ratio, 80 is fast money and 120 is added to the RAB.
It scales with the RAB, not with revenue. On the illustrative average RAB of 1,069.4, cutting the real WACC from 4.0 to 3.5 per cent reduces allowed revenue by 5.35, or 3.1 per cent. For equity, which funds only part of the RAB, the effect on returns is geared up by the leverage.
This article is one calculation from The Infrastructure Investment Analyst. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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