The+economics+of+regulation+2017+ +week+3+-+some+examples+final
- 1. HoustonKemp.com Economic Regulation Some examples of how economic regulation is applied in Australia Dr Luke Wainscoat University of Sydney 17 August 2017
- 2. HoustonKemp.com 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 2
- 3. HoustonKemp.com Overview • Introduction to competition policy and economic regulation • Airport regulation • Railway regulation • Electricity networks regulation • Access regulation 3
- 4. HoustonKemp.com Competition policy and economic regulation What is it and how does it affect us all?
- 5. HoustonKemp.com 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 5 AIM HOW ACHIEVED
- 6. HoustonKemp.com 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 6
- 7. HoustonKemp.com 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 7 ‘Government-imposed restrictions on firm decisions over price, quantity, and entry and exit’ Viscusi et al
- 8. HoustonKemp.com 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 8
- 9. HoustonKemp.com Two problems addressed by economic regulation 9 Airport Airline A Airline B Airline C Natural monopoly Potentially competitive market Monopoly prices Airport A Airline A Higher prices to downstream competitors
- 10. HoustonKemp.com 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 10
- 11. HoustonKemp.com 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 11
- 12. HoustonKemp.com Lighter forms of regulation are better when market power is lower 12 Airports Railway Electricity distribution
- 13. HoustonKemp.com 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 13 No regulation Light-handed regulation Government control
- 14. HoustonKemp.com Airport regulation An example of market monitoring regulation
- 15. HoustonKemp.com 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) 15
- 16. HoustonKemp.com 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 16
- 17. HoustonKemp.com 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 17 BUT
- 18. HoustonKemp.com 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
- 19. HoustonKemp.com 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 19
- 20. HoustonKemp.com 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 20 But no action taken or recommended by the ACCC so far. Productivity Commission expected to review airport regulation next year
- 21. HoustonKemp.com 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? 21
- 23. HoustonKemp.com 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 23
- 24. HoustonKemp.com Example – Hunter Valley Coal Network (2017) • 867 km of regulated network • $2.2 billion asset value • $523 million revenue • 201 million tonnes of coal 24
- 25. HoustonKemp.com 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 25
- 26. HoustonKemp.com 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 26
- 27. HoustonKemp.com 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 27
- 28. HoustonKemp.com Price discrimination can increase welfare 28 Average cost Marginal cost Demand Welfare loss $ Q P1 P2 Welfare loss if must break even with linear price Q2 Q1 AC1
- 29. HoustonKemp.com Price discrimination can increase welfare 29 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
- 30. HoustonKemp.com 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 30
- 32. HoustonKemp.com 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 32
- 33. HoustonKemp.com 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 33
- 34. HoustonKemp.com 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 34 Very high risk of market power being used to the detriment of consumers
- 35. HoustonKemp.com 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 35
- 36. HoustonKemp.com 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 36
- 37. HoustonKemp.com 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 37
- 38. HoustonKemp.com Building block model used to determine revenue cap 38 Operating expenditure Return on capital (rate of return multiplies by value of capital) Return of capital (ie, depreciation) Capital costs Others, eg, tax
- 39. HoustonKemp.com Regulatory asset base (RAB) • RAB: value of assets • Lock in, and roll forward approach 39 Initial RAB Take away depreciation Add capex Period 1 Period 2
- 40. HoustonKemp.com Application of the building block model to Ausgrid, current regulatory control period ($m, nominal) 40 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)
- 41. HoustonKemp.com Timeline for making a determination 41 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 7 • 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
- 42. HoustonKemp.com Access regime How firms can access services provided by monopoly infrastructure
- 44. HoustonKemp.com 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 44
- 45. HoustonKemp.com What is the access regime? 45 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
- 46. HoustonKemp.com 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 46
- 47. HoustonKemp.com Outcome of declaration applications 47
- 48. HoustonKemp.com 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. 48
- 49. HoustonKemp.com Railways in the Pilbara (2011-12) 49
- 50. HoustonKemp.com Timeline 50 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
- 51. HoustonKemp.com 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 51
- 52. HoustonKemp.com Sydney Level 40 161 Castlereagh Street Sydney NSW 2000 Phone: +61 2 8880 4800 Singapore 12 Marina View #21-08 Asia Square Tower 2 Singapore 018961 Phone: +65 6653 3420 Contact Us