Date created: 12/4/07
Last modified:12/4/07
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John Quiggin

The monopoly game

Australian Financial Review

28 November 2005

The recent announcement that Victoria’s Essential Services Commission had scaled back proposed reductions in the price charged for electricity distribution, supposedly paving the way for billions of dollars in new investment, is a sing of the times. In disputes between regulators and monopoly infrastructure suppliers, the monopolists are winning, with the backing of courts and governments.

Some concessions to infrastructure owners are inevitable in the Australian regulatory process. The process begins with submissions from the infrastructure owner, commonly an ambit claim. Consumers, competitors, and access-seekers, sometimes also make submissions, but no individual consumer has enough at stake to make a major effort worthwhile. Competitors may well be regulated monopolists themselves in another region or another jurisdiction.

In draft reports, regulators typically apply fairly strict scrutiny to claims put forward by the infrastructure owner, rejecting those that are not backed up by clear evidence. The result, in many cases, is a recommended price well below the amount claimed by the regulated firm, and in some cases a reduction in existing charges.

Almost inevitably, the final report ends up with a price somewhere between the amount claimed by the infrastructure owner and that proposed in the draft report. Infrastructure owners have the chance to provide additional evidence to support their claims and usually get the benefit of the doubt.

Recently, the balance has tilted more clearly in favour of infrastructure owners. The crucial decision was the EPIC case, concerning access charges for the Dampier to Bunbury Natural Gas Pipeline. EPIC had paid $2.4 billion for the pipeline but the Independent Gas Pipelines Regulator valued it at only $1.2 billion. The Supreme Court of Western Australia found that the price paid by EPIC was a relevant consideration paving the way for the capitalisation of monopoly profits.

Trade in regulated assets reflects the expectation of favourable treatment. Monopoly infrastructure enterprises commonly trade at a premium of 40 per cent or more over the regulated value of their assets.

The main focus of dispute is on new investment and here the monopolists’ hand is even stronger. There is a pressing need for substantial capital investment in many areas of infrastructure and, in most cases, the only ones who can deliver that investment are the existing owners. Nothing is easier than for them to point to the unjust impositions of regulators as the reason why desperately-needed new investment is not going ahead.

Despite privatisation and corporatisation of infrastructure services, politicians are still held responsible for ensuring adequate and reliable service delivery. They have it seems been more effective at shifting the perceived responsibility for service prices to regulators and infrastructure owners. Thus, they bear the political costs of inadequate investment, but not the costs of higher prices.

This situation contrasts sharply with that under public ownership, particularly with direct ministerial responsibility. In this case, the government bears both the cost of inadequacies in infrastructure services and the costs and benefits of undertaking investment.

Debate has focused on the rate of return allowed to infrastructure owners. The central element in determining regulated rates of return in Australia is the Capital Asset Pricing Model. The main parameter in this model is the ‘equity beta’ which measures the riskiness of an equity investment compared to that of the market as a whole.

Using the threat of withholding investment, regulated infrastructure monopolists have demanded, and in most cases, received an equity beta equal to one. This implies that equity in regulated monopoly is as risky as the average investment in the stockmarket as a whole.

On the face of it, this is an absurd claim. These are firms that, by definition face little or no risk of competitors taking away their market. Under revenue cap regulation, the most common form, their revenues are guaranteed throughout the regulatory period. Even under the alternative price-cap approach, demand risk is minimal in most cases.

The minimal risk associated with regulated cash flows is offset to some extent by the fact that infrastructure enterprises are more highly geared than average. Typically the pricing model is based on an assumed capital structure with 60 per cent debt and 40 per cent equity. But even with this level of gearing, infrastructure bonds typically trade at BBB or A-. Investment-grade bonds of this kind are typically associated with fairly conservative capital structures, implying correspondingly low-risk for equity investors.

But the merits of the claim are of little relevance. Monopoly infrastructure owners stand to gain millions of dollars if they can increase their allowed rate of return by a few basis points. Through a combination of lobbying and the threat of withholding infrastructure investment, they can ensure that governments are supportive or at least neutral. No-one else in the system has a strong incentive to oppose them. The pressure on regulators, therefore, is all one way.

For most Australian households infrastructure reform has delivered little in the way of direct benefits. Although some substantial efficiency gains were achieved in the 1990s, the gains did not translate into reduced prices for households for services such as electricity gas and water. The reductions that might have occurred were counterbalanced by the removal of actual or perceived cross-subsidies from business to household consumers (presumably at least some the reduced costs for businesses flow indirectly to households through lower prices).

With cross-subsidies largely gone, it seemed reasonable to hope for some direct benefits to households. But it seems that the benefits from these sources will go mostly towards increasing the rates of return enjoyed by owners of monopoly infrastructure.

Proposals like those in the ESC draft report promised some of the first substantial price reductions for household consumers. By contrast, the reductions in the final report will barely be noticed. Still, perhaps consumers should be grateful they are getting anything at all.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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