The economics of regualtion - some examples of how economic regualtion is applied in Australia.

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Economic Regulation
Some examples of how economic
regulation is applied in Australia
Dr Luke Wainscoat
University of Sydney
17 August 2017

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HoustonKemp – we apply microeconomics to a
wide range of problems
• Competition – will this merger substantially lessen
competition?
• Finance – did shareholders lose money because a
company failed to disclose a piece of information?
• Regulation – what should the price be for an
electricity network?
• Policy – advice on sale of the Port of Melbourne
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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 regulation
What 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
Monopoly prices
Airport A
Airline A
Higher prices to
downstream
competitors

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When should ex ante regulation be used?
• Significant and enduring market power is present
› Market power has not been acquired through competition
• 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
• 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 Railway
Electricity
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 – some electricity distributors state
owned but also regulated
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No regulation
Light-handed
regulation
Government
control

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Airport regulation
An 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
• Natural monopoly (sometimes)
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Some airports have substantial market power
• Barriers to entry are extremely 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
1818
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
• 2015-16: “Quality of service improves as airports collect
substantially more money per passenger”
› Airports have collected $1.57 billion more in revenue from airlines than they
would otherwise have collected if average prices were held constant in real
terms
› Despite these much higher revenues per passenger, ratings of service quality
are not materially different from those seen a decade ago
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But no action taken or recommended by the ACCC so far. Productivity
Commission expected to review airport regulation next year

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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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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
• Market power not earned through competition
• 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
multiplies 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 on
Capital
Operating
Expenditure
Regulatory
Depreciation
Corporate
Income Tax
Revenue
adjustments*
Meters, ANS
and ERW
Costs**
Allowed
Revenue
(unsmoothed)
$million(nominal)

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Timeline for making a determination
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1
• AER publishes ‘Framework & Approach’ paper*
2
• TNSP gives notification to AER of approach to forecasting expenditure
3
• TNSP submits regulatory proposal for the forthcoming control period
4
• AER publishes issues paper identifying preliminary issues
5
• AER conducts consultation on regulatory proposal and issues paper
5
• AER issues draft regulatory decision
6
• TNSP submits revised regulatory proposal
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• AER conducts consultation on revised regulatory proposal and draft decision
8
• AER issues final regulatory determination
9
• (Potential) AER determination is appealed to the ACT under the limited merits review regime
Approximately30Months

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Access regime
How firms can access services provided by
monopoly infrastructure

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Infrastructure services
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What is the problem?
• Natural 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 and
Robe
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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