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Economic RegulationSome examples of how economic regulation is applied in Australia

Dr Luke WainscoatUniversity of Sydney11 August 2016

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Overview

• Introduction to competition policy and economic regulation

• Airport regulation• Railway regulation• Electricity networks regulation• Access regulation

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Competition policy and economic regulationWhat is it and how does it affect us all?

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What is competition policy?

• Improves the economic welfare of Australians…

• by making markets work as well as they can› by making markets be as competitive as possible,

compelling businesses to be more efficient eg prevent monopolies from forming by firms merging

› by ensuring that markets work for consumers eg consumers understand what they are buying

‘policies and laws which ensure that competition in the marketplace is not restricted in a way that is detrimental to society’ Massimo Motta

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AIM

HOW ACHIEVED

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Several elements to competition policy

• Government policies› eg ensuring that government policies don’t raise unnecessary

barriers to entry• Interaction between government businesses and

private sector› eg how ABC competes with private sector

• Competition law › eg laws regarding which mergers are allowed to occur

• Structural reform and regulation of monopolies› eg regulation of electricity networks

• Access to third party infrastructure› Accessing railways, ports, airports etc

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Economic regulation is government intervention in markets• Intervention by the government to affect

› structure of an industry, eg, number of firms› conduct of firms, eg pricing, investment and quality eg terms on which access is provided to other firms

• These sorts of decisions are not usually directly affected by government policies

• Economic regulation may be combined with other types of regulation, eg environmental or social policy

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‘Government-imposed restrictions on firm decisions over price, quantity, and entry and exit’ Viscusi et al

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Ex post competition law and ex ante economic regulation• Competition law prohibits certain conduct -

assessment of whether the law has been broken is ex post› In essence: do whatever you like, as long as you don’t break

the law› ACCC (or other) will investigate and prosecute ex post if law

is broken• Economic regulation typically describes detailed

rules that are set ex ante› In essence: do exactly what I tell you› Conduct must be consistent with detailed rules – much less

freedom› Eg regulator sets prices ex ante

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Two problems addressed by economic regulation

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Airport

Airline A Airline B Airline C

Natural monopoly

Potentially competitive market

Airport A

Airline A

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When should ex ante regulation be used?

• Significant and enduring market power is present• Very likely that market power will be used to the

detriment of consumers• Regulation is feasible• Benefits of regulation outweigh costs, relative to

having competition law alone

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Costs and benefits of competition law and ex ante regulation approaches• Costs

› Administration cost of ex ante regulation is greater because it requires much more work to set detailed rules In contrast, threat of action (deterrence effect) may prevent

anticompetitive conduct in ex post approach› Cost and likelihood of errors is greater with regulation because More decisions in regulatory approach Less information available ex ante

› Lose dynamic benefits from competition• Benefits

› Both approaches can help to lower prices (towards the efficient level) and increase service delivery But competition law and regulation are not perfect substitutes

› Competition law focuses on conduct that increases market power or abuses market power But it does not prevent a monopolist from charging monopoly prices

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Lighter forms of regulation are better when market power is lower

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Airports RailwayElectricity distribution

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Alternatives to traditional economic regulation

• Competition for the market› Eg Port of Singapore

• Contestability/threat of entry• Competition law

• Negotiated settlements› Eg federal energy regulation in USA and

Canada• Monitoring

› Eg airports in Australia

• State ownership› Eg NBN and some electricity distributors

state owned but these are also regulated

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No regulation

Light-handed regulation

Government control

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Airport regulationAn example of market monitoring regulation

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Characteristics of airports• Very large fixed sunk costs• Significant economies of scale (up to a point)• Need to be integrated into transport infrastructure• Important part of Australian economy• Monopoly (sometimes)

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Some airports have substantial market power

• Barriers to entry are high (sunk costs)• Potential for substitution depends on type of

passengers and whether there are other airports nearby

• Brisbane, Melbourne, Perth and Sydney found to possess a high degree of market power in domestic markets because› High proportions of business travellers› No close alternative to air travel (10 hour road trip anyone?)› Few alternative airports nearby

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Potential effects of market power

• Charge airlines higher prices (leading to lower consumption)› Note: harm is lower consumption, not higher prices

• Reduce quality• Allow costs to increase

• Price and cost increases only affect consumers indirectly and airport charges are only small part of cost of flight

• Airlines may price discriminate to reduce or eliminate any effects on consumption

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BUT

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Brief history

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1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Major airports owned by the

Federal Airports

Corporation

Airport privatisation

begins

The Productivity Commission (PC) found that price regulation faced information challenges and:

Prices regulated by the ACCC

using CPI-X

‘Light-handed’ price and

service monitoring

replaced price regulation

• distorted production• chilled investment

• discouraged commercial negotiation

• sent poor price signals • increased compliance costs

PC found• increase in

investment• no evidence of

use of market power

• satisfactory quality

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Current regime

• ACCC monitors and reports annually on prices and quality of service at Sydney, Melbourne, Perth and Brisbane

• Self-administered monitoring scheme for Canberra, Darwin and Gold Coast

• Government can direct ACCC to undertake a public inquiry if monitoring indicates that further investigation is required – could result in reintroduction of price controls

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Recent history of monitoring reports

• 2012-13: higher margins and low investment› Higher margins underpinned by growth in traffic volumes› Insufficient investment to accommodate growth and improve

service quality› Particular congestion in landside infrastructure

• 2014-15: lack of competitive pressure facilitates high profit margins› Increased profit margins on aeronautical and car parking

revenue (up to 50% and 73% respectively)› Service quality unimproved despite profit levels› Record-level investment in aeronautical assets may lead to

future improvements in service quality

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But no action taken or recommended by the ACCC so far

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Limitations to monitoring

• What exactly is being monitored?› How prices, profits and quality changes over time› Not assessing returns against long run costs› Airport that was already setting monopoly prices would only

gradually raise prices• It is very difficult to assess whether profits are

‘excessive’• Monitoring cannot distinguish between reasons for

changes in profits (efficient operation or poor service level)

• What is the trigger for public inquiry?

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Railway regulation

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Characteristics of rail services

• Above rail – operate the trains› Pay below rail operator› Revenue from transporting freight and passengers› Potentially competitive

• Below rail – operate the track› operate and manage track› charge above rail users

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Example – Hunter Valley Coal Network (2017)

• 867 km of regulated network• $2.2 billion asset value• $523 million revenue• 201 million tonnes of coal

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Below rail operators have market power in some instances• Natural monopoly

› Large fixed costs, very low variable costs – therefore economies of scale

• Some competition from road and sea transport• Significant market power in some instances

› High prices› Foreclosure of above rail operators if above and below rail

are vertically integrated

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Allow negotiated prices within limits

• Regulated price is not flexible› Could be too high when there is competition from road› Preclude commercial negotiation

• Solution: Allow negotiation of prices within certain limits

• Ceiling price› Stand alone cost of providing the service, ie, price above

which entry would be profitable (with no barriers to entry and only one provider)

• Floor price› Marginal cost of providing a service to each customer

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Advantages of floor and ceiling approach

• Price is never below marginal cost› Reduced risk of foreclosure

• Revenue is never above cost of a new entrant› Monopoly pricing is prevented

• Prices can be negotiated› Reduced administration cost

• Prices can fall to competitive level when there is competition from road

• Price discrimination is possible

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Price discrimination can increase welfare

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Average cost

Marginal cost

Demand

Welfare loss

$

Q

P1

P2

Welfare loss if must break even with linear price

Q2 Q1

AC1

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Price discrimination can increase welfare

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Average cost

Marginal cost

Demand

Welfare loss

$

Q

P3

P4

Price discrimination allows price to customers with lower willingness to pay to be reduced, whilst still breaking even

Charge these customers P3

Q2 Q4

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Wide variety of methods for valuing assets

• Capital cost is very substantial proportion of below rail costs› So valuation of assets has substantial effect on allowed revenues

• Backward looking estimates› Depreciated actual cost - a written down value of actual asset

purchases, using an economic treatment of depreciation• Forward looking estimates

› Gross replacement value - full economic cost of modern equivalent assets required to provide the services

› Depreciated optimised replacement cost – the economic value of the existing assets, given the opportunity to replace them with modern equivalent assets

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Ceiling price is costs that new entrant would incur if assets are valued using GRV approach

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Electricity distribution

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Electricity supply chain

• Electricity generation and retail have been deregulated because competition can be effective in these sectors

• Transmission and distribution are regulated as they are natural monopolies

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Characteristics of electricity distribution

• Supply side› Assets comprise primarily of poles and wires Ausgrid: 500,000 power poles and 50,000 km of cables

› Very high fixed costs› Very low marginal costs› Strong economies of scale› Natural monopoly

• Demand side› Electricity is essential to vast majority of consumers and

businesses› Safe and reliable supply of electricity is critical to economic

performance and consumer welfare

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What is the problem?

• Electricity distributors are natural monopolies• Very substantial and enduring market power• Essential service• High willingness to pay• Low elasticity of demand

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Very high risk of market power being used to the detriment of consumers

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Revenue cap based on a forward looking assessment of efficient costs • Firms have total revenue caps each year (for 5 year

period)• Cap is determined by estimate of efficient costs,

based on› demand projections› requirements to maintain reliability

• Firms can set their own prices (subject to certain rules)

• Firms keep profit earned by reducing their costs (over the five year period)

• Firms cannot earn additional revenue if costs were higher than expected

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Benefits from cost savings

• Previous system› Electricity distributor kept benefits from cost savings but then

lost them in the next regulatory period› Result - strong (weak) incentive to reduce costs at beginning

(end) of period• Current system

› New schemes such that benefits from cost savings are the same in each year of regulatory period

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Some cost increases can be passed on

• Risk to firms that costs go up whilst revenues do not• Costs that increase due to external standard

obligation can be ‘passed through’• Cost increases for major projects that are caused by

external factors can be passed through• Some risks remain

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Building block model used to determine revenue cap

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Operating expenditure

Return on capital (rate of return multiplied by value of capital)

Return of capital (ie, depreciation)

Capital costs

Others, eg, tax

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Regulatory asset base (RAB)

• RAB: value of assets• Lock in, and roll forward approach

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Initial RAB

Take away depreciation Add capex

Period 1

Period 2

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Application of the building block model to Ausgrid, current regulatory control period ($m, nominal)

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0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

Return onCapital

OperatingExpenditure

RegulatoryDepreciation

CorporateIncome Tax

Revenueadjustments*

Meters, ANSand ERWCosts**

AllowedRevenue

(unsmoothed)

$ m

illio

n (n

omin

al)

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Access regimeHow firms can access services provided by monopoly infrastructure

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Infrastructure services

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What is the problem?

• Monopolies in infrastructure services can inhibit competition in up or downstream markets through› denial of access (foreclosure) › monopoly pricing

• Occurs where access to infrastructure services is required to compete in upstream or downstream markets› Eg, airlines need to access airport services to compete

• Challenge is to balance› potential reduction in incentive to invest in infrastructure as a

result of access regulation with› allocative efficiency in dependent markets

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What is the access regime?

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Application for declaration

DeclaredNot declared

Negotiate prices

Prices set by ACCC

Agree prices

Negotiate prices

Declaration decisions made by the Minister on recommendation of National Competition Council. Decisions can be reviewed by the Australian Competition Tribunal and/or the Courts.

Cannot reach agreement

Prices set by negotiation

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Criteria for declaration

• Access would promote a material increase in competition in at least one dependent market

• Uneconomical for anyone to develop another facility

• Facility is of national significance• Access is not already available through other

regulation• Access would not be contrary to public interest

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Outcome of declaration applications

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Case study: Railways in the Pilbara

• Conflict over access to privately owned railways in Pilbara region• BHP Billiton and Rio Tinto operated railways to transport iron ore from

mines to the ports› BHP: Mt Newman and Goldsworthy lines› Rio Tinto: Hamersley and Robe lines

• Fortescue Metals Group (FMG), emerging as a major producer, sought access to run its own trains on these lines.

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Railways in the Pilbara (2011-12)

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Timeline

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2004 2006 2008 2010 2012 2013 2014

FMG begins applications to the NCC to declare ‘below rail’

services

Minister does not declare the

Mt Newman line. No further

appeals

High Court Decision.

Returns to Tribunal for “review for

which Act provided”

Australian Competition Tribunal Decision.

Declared Goldsworthy. Overturned declaration

of Hammersley andRobe

Federal Court upholds Tribunal’s

decision on Hammersley and

overturned on Robe

The Minister declares the Hammersley,

Goldworth and Robe

lines. BHP and Rio appeal

Second Tribunal decision. Hammersley and Robe lines should not be declared.

FMG opens its

own open-access railway

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Outcome after ten year process

• Only the Goldsworthy line declared› BHP has reported that no third party access, or requests for

access, have occurred. • High Court decision led to a Productivity Commission

review of the National Access Scheme (2014)› Found that the Regime should be retained but scope limited› Proposed that the declaration criteria altered to reflect the

role of natural monopoly

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