Access Arrangements by Transmission Pipelines Australia

Submission to the ACCC

INTRODUCTION AND SUMMARY

The previously planned and integrated gas and electricity systems are now things of the past.  The systems no longer operate as legislatively protected monopolies.  Rival suppliers of lines and pipes are now permitted in Victoria.

The draft decisions of the ACCC and Victorian ORG on the Victorian gas pipelines are part of the new market arrangements.  Importantly, they propose a much lower pricing structure for gas carriage than that offered by the Victorian Government.  Those draft decisions have implications for all gas and electricity carriage businesses and potentially for other network providers like telecommunications and water.

A test in determining whether a regulated price for a sunk asset provides the correct incentives is to ask whether that price would have been sufficient to justify the investment had it been stipulated prior to the system being built.  The draft decisions would fail this test.  Had the proposed price regime been in place when the TPA pipeline was being planned, no commercial organisation would have considered the return sufficient to justify the risks of building it.

This however is not the most fundamental reason for seeking a review of the decisions by the regulatory authorities.  More important is the impact on the future competitive process.  In imposing a very low price for carriage through existing gas pipelines, the draft decisions will make it unprofitable for rival suppliers to emerge.  One irony therefore, of the decisions if they stand, is that the competition "watchdogs" will have done much to reduce the possibility of competition.  Competition or contestability is much superior to a regulator in bringing about efficient provision.  Indeed, the regulators' function is to make judgements that, in their view, correspond to those that would emerge in a competitive market.

The regulators see a major role for themselves in preventing possible price gouging by businesses controlling "essential facilities".  However, the Draft Decisions adopt mistaken premises that reticulated natural gas is not subject to competition and that competition for gas carriage is not possible.  Regulatory distortion of commercial decisions will follow from the application of these premises.

The adverse consequences of regulatory distortions are compounded if the decision is to apply to new pipeline extensions into areas not presently served.  Such an application operates from the incorrect assumption that extensions are inevitable and therefore can have a low price enforced upon them.

Setting a rate of return that assumes competitive market behaviour is impossible will therefore prove self-fulfilling.

With both existing and new pipelines, the Draft Decisions will bring inefficiencies and the total philosophy behind them should be reconsidered.  The potential for competition in network facilities is already evident in Victoria where rival electricity distributors are planning to drive new lines into each others' territories.

Further evidence of the potential is observable in the skill that AGL has shown over many years in pricing NSW pipeline charges at a level that allows the firm to profitably ward off rival facilities.  AGL has responded to competitive threats by reducing prices in areas where those threats have greatest potential.  The nightmare for a utility business is that if they adopt a hard-nosed approach to pricing and service this will call forth competition and leave the existing asset "stranded".  Fear of having "stranded" assets means that little by-pass is actually likely to eventuate.  But the control over excess prices that competition brings does not require that a competitor physically emerges.  Contestability for the market is quite adequate.

It might be said that if the price is set low, the customer would obtain benefits.  But, aside from pre-empting the possibility of competition and foreclosing many network extensions, prices set artificially low will prove inimical to customers' interests even with the existing built networks.  With low prices enforced, network suppliers will seek to incur only minimum expenditures to maintain and expand the facilities, which will eventually become less reliable.  And the wire or pipeline business will see no merit in spending money to give premium service and reliability to those customers who would pay for it.

A well structured competitive regime on wires and pipes would ensure all barriers to entry were removed and that the incumbent businesses are unable to block new rivals.  The New Zealand regime operates very successfully in this way without any price regulation (the events in Auckland are unrelated to this feature).

Some measure of control may be justified in moving from a system where the service provision and prices were set by Government direction to one that allows competitive provision.  Under the government monopoly, users incurred investments on the basis that the political process would prevent prices rising unpredictably.  This constituted a form of contract.  Price caps should be set consistent with this -- that is at the lower of the level presently prevailing and that nominated by the Government as owner of the facilities.  New providers should be free to offer lower prices and incumbents free to meet the competition wherever it emerges.

THE DRAFT DECISION OF THE ACCC

The decision covering the pricing of Transmission Pipelines of Australia (TPA) operating in Victoria essentially:

• accepted the proposed market structure based on market carriage rather than the more conventional contract carriage regime;
• reserved its position on whether or not the interconnect between EAPL and TPA should be regulated;
• broadly endorsed the proposal for a queuing arrangement to allocate spare capacity, though expressing preference for spare capacity to be auctioned;
• allowed augmentations to be treated as stand alone expenditures or rolled in with the other facilities:
• all extensions and expansions are within the service envelope unless the Commission determines otherwise;
• rolled in augmentations must obtain approval for their pricing and access;
• other extensions should also be subject to an access arrangement and those that are excluded services remain subject to regulation to the extent the Commission considers their prices to be "fair and reasonable";
• set reference tariffs and overall revenue levels on the TPA based on:
• a DORC valuation for the existing assets with optimisation bringing the value of those assets down by 9%;
• consistent with the Victorian Access Code, a DAC valuation adjusted for inflation for new facilities and for future reviews;
• O&M costs are to be reduced by 2.3% per annum over the next five years (the Government proposal was for a real annual reduction of 1.5%);
• a WACC at 7% compared to the value of 9.73% proposed by the Government;  this level is designed to apply both to the existing network and extensions;
• an X factor defining the increase in productivity required year by year and consequent price reduction of 3.7% (compared to the Government proposal of 3.4%, with the differences attributable to different inflation forecasts).

The ACCC estimates are that this will bring a price reduction of 17% on the proposal of the Victorian Government which itself was for a substantial price reduction.

The rates specified apply both to the existing pipes and to new connections and augmentations.

THE PREFERRED APPROACH TO REGULATING NETWORK FACILITIES

REGULATION AND MARKETS AS MEANS OF ENSURING EFFICIENCY

The Main Goal of Regulation

The main goal of regulation is to provide an outcome similar to that which would emerge from a competitive market but where natural monopoly prevents this occurring automatically.  Competition is not valued as an end in itself but as the means of promoting efficiency.  Competition prevents the waste inherent in sellers deliberately withholding supplies in order to allow higher prices and higher profits.  Commercial rivalry is also superior to other arrangements in driving costs down and ensuring the lower cost outcome is passed on to consumers in lower prices.  Competitive firms must constantly seek cost savings, and other ways of maintaining or improving their profits;  these cost savings are largely converted into consumer benefits as rival suppliers adopt similar techniques.

Competition is best regarded as having two functions of competition, one generating "dynamic" gains and the other "static" gains.

The "dynamic" gains from competition themselves have different facets.  Some stem from constant vigilance of many suppliers who need to cut costs and meet shifting market demands;  these actions prevent sloth and promote a multitude of incremental savings.  Other gains stem from what the Austrian economist, Schumpeter, referred to as "from the new commodity, new technology, new source of supply that strikes not at the margins of profits and the output of existing firms but at their foundations and very lives." These gains, according to many, are an order of magnitude more important to society's prosperity than the vast number of incremental savings.

Many transmission pipelines would fall into the category of new sources that radically transform markets, sources that usually involve considerable business risk and great skills to manage.

The dangers are that, in seeking to redistribute the "static" gains, regulators and policy makers will close off opportunities for the more radical "dynamic" gains.  For the latter gains to be achieved, the innovator must be confident that government action will not deprive him of the profits of success.  This means having secure property rights.  If policy and regulation results in property rights being impaired, this compromises a fundamental plank on which competitive efficiency is generated.  For this reason, one of Government's most important role is ensuring the certainty that property will not be taken from individuals.

Requiring a low price for supplying a service where the supplier has previously sunk its main costs can be, in US terminology, a regulatory "taking".  It markedly reduces the value and security of property rights.  The initial adverse effects of this are felt on the firm whose value is partly expropriated but wider effects follow in deterring other firms contemplating similar activities.

Models of Different Regulatory Approaches

There are three models under which network facilities might operate:

• the no-regulation option where market forces are left to determine price and service levels;
• the incentive based model under which some standard overall level of productivity is expected and price caps are set to allow any profits over and above this for the line business;
• a model where the regulator carefully examines all required expenditures of each line business and determines the necessary expenditure and, in effect, profit levels.

In adopting one of these models, assessments are necessary to determine the degree to which the service is contestable.  Clearly, wherever gas is reticulated it already competes with other fuels, especially electricity.  In addition it competes with LPG, the price of which is closely aligned to world prices.  Moreover, wherever more than one pipeline serves an area, there is competition even in the narrowest sense and no regulation is necessary.

If it is determined that an absence of competition warrants control, some form of incentive-based regulation is preferred over profit controls.  This allows the network provider the possibility of using entrepreneurial and other management skills profitably to reduce costs and increase its business.  Although the Draft Decisions purport to adopt incentive based regulation, in effect they apply profit control, which is the least acceptable form of regulation.

Inherent Deficiencies of Regulation

In general regulation is a poor substitute for market disciplines on efficiency because regulators are:

• ill-placed to determine the price and service levels that the market would prefer;
• call for vast amounts of information in an attempt to reconstruct the costs of provision and in doing so divert the most capable resources in the businesses from meeting consumer needs towards meeting their needs of regulators and seeking to outmanoeuvre them;  and
• become captive either of the businesses they regulate or of politico/consumer interests rather than those of overall economic efficiency.

For these reasons the no regulation model is the preferred approach but the issue is how practicable is it?  How much is the provision of gas services open to competition or contestable?

The following addresses these issues and the application of the above principles and the different regulatory models to the Draft Decisions.

APPLICATION TO DIFFERENT NETWORK SYSTEMS

Different Types of Network Systems

Pipes and wires are usually thought of as falling either within high pressure/high voltage transmission networks or low pressure/low voltage distribution networks.  In general the former are considered more difficult to duplicate at least in their entirety.  Even so, the fact is that transmission systems can be and are duplicated, or subject to competition from supplies of gas and electricity other than those they directly serve.

The most useful analytical framework for examining competitive potential and determining regulatory rules is by considering network systems from the perspective of those that already exist versus those that are being proposed.

Regulation of Existing Networks

For the existing systems, customer commitments were made on the basis of some predictable level of price trends that were controlled by political decisions.  These offered assurances that the network service provider (NSP) would not embark upon a process of raising prices once customers were captive.  An implicit contract was in place.  In spite of the fact that the networks themselves are now duplicable, this could justify a regulatory regime to restrain existing network owners' abilities to extract excessive profits.  In formalising that contract, the regulatory regime has to be devised so that the incumbent NSP is not vulnerable to "cherry picking" by a rival and left servicing only the least profitable customers and areas at price levels that are unsustainable.

Requiring lower prices than those set under the implicit regulatory contract of government ownership (or some lower level specified by the government-owner) is a distortion of the arrangements that have been established.  If the regulator requires such pricing action, he is seeking to redistribute the respective parties' long standing shares in the gains from trade.  This is not an appropriate role for regulators.  The distortions that follow from it will rebound on the overall levels of efficiency.

The approach proposed is a major departure from the much-vaunted "light handed" approach.  This would remove barriers to rival suppliers wishing to contest the market and offer incentives to NSPs to operate efficiently by lowering costs and winning new business.  The regulators' most appropriate role is to set rules that prevent a monopolist from unfairly preventing competitive entry.  Such rules would, for example, forbid the incumbent from combating potential new competitive threats by refusing to allow a connection or pricing a competitive connection at a level that effectively denies it.

Regulation beyond that is likely to have several adverse effects.  If the regulator attempts to control price to reduce the returns beyond a level that the incumbent considers appropriate, several adverse effects are likely to follow:

• the network provider will see little merit in maintaining the network to standards expected and the network reliability will progressively decline;
• the prices will be set so low as to prevent profitable by-pass and therefore competitive provision.

The ACCC was concerned to prevent uneconomic by-pass in its reasoning behind its decision.  Thus page 26 of the draft says,

"any value that is in excess of DORC may produce reference tariffs that will expose the service provider to being bypassed.  Moreover, to the extent that parts of the system are bypassed, some of this cost inevitably gets absorbed by the remaining customers who have no bypass option".

This statement mistakenly assumes the price allowed by the regulator is the minimum price.  In fact networks are at liberty to charge less to meet competitive pressures.  While exposure to by-pass may be the outcome of excessive prices, actual by-pass assumes a lack of business acumen on the part of the network owner.  As has been seen in the AGL system in NSW, the possibility of by-pass has been countered by lowering the price to the vulnerable customer base.  And, even if prices were to be subsequently loaded on to the remaining customer base, that too would be more vulnerable to by-pass.

The regulatory authorities should take steps to encourage rather than discourage competition in network services.  The present proposals do the opposite and will rebound on consumer welfare by reducing investment and maintenance of the existing network.

RECOMMENDATION

• The prices for the use of the existing network should be based on the lower of the level the Government has specified or its present level.
• If by-pass occurs and existing lines become stranded investments, some arbitration system could be developed to allow increased prices to the remaining customers who might otherwise cease to have access.

In adopting this approach, it is recognised that by-pass in practice may be difficult.  NIMMBY problems might prevent new easements and use of existing easements might have adverse impacts on the existing lines.

New Pipelines

The owners of the systems developed under Government franchise have the advantage of incumbency over other providers but they have no such advantage with augmentations.  The latter are totally open to competitive provision.  There are several businesses operating in Australia with the capability to develop new links even in areas that might have previously been regarded as the territory of one particular business.  In Victoria, the rivalry of Gascor and AGL to link the Murray Valley towns was one manifestation of this.

Concerns that regulation, in seeking to combat the detrimental effects of monopoly will create its own deficiencies are even greater with the regulation of new pipelines which are, by definition, contestable at the time of their being built.  Regulation of these facilities to reduce prices or enforce access terms that are against the wishes of the supplier will prove self defeating unless the regulator assumes total control of the networks -- an outcome that the competition reforms were designed to avoid.  Price regulation is likely to diminish providers' incentives to seek out new markets;  access regulation is likely to bring them to adopt over-cautious approaches to any expansions they may contemplate.  Both price and access regulation will also create disincentives that will foreclose opportunities for extensions.

For new proposals, regulation is likely to mean insecurities on the part of their sponsors that the authorities will prevent them making adequate returns.  Innovation is discouraged.  The level of innovation is distorted because there is an imbalanced risk/reward outcome;  the innovator gets slender benefit from success because other parties are given a share of the success by Government, while costs of an unsuccessful venture are sheeted home solely to the firm itself.  The Draft Decisions will have increased these fears and insecurities on the part of suppliers of potential new networks.

Yet, a new pipeline can only bring mutual gain to both the buyers and sellers of gas.  The pipeline owner has no monopoly and attempting to constrain the conditions under which he conducts business must reduce the amount of new building, thereby denying benefits to producer and consumer.

Regulation may also reduce efficiency if it prevents backward and forward linkages by requiring common carriage when risks may be reduced by integration.  Risk is the most important feature of major capital investments and can be reduced by forward and backward linkages as follows:

A Gas Producer Building a Pipeline

The gas producer will have good information that the size of his reserves is adequate to provide the necessary product stream.

If required to allocate "spare capacity" to competitors, the producer has every incentive to minimise the extent of that capacity and the facility is likely to be constructed with a sub-optimal capacity.  This will be all the more so to the degree that the producer-builder is required to offer capacity to a competitor at a price that he regards as likely to offer inadequate recompense.  And the deterrence factor in building a new pipeline would be further increased if a regulatory regime were introduced obliging him to displace his own product in order to carry that of his competitor.

The community is worse off if the producer is prevented from building such a pipeline for his exclusive use.

A Gas Retailer Building a Pipeline

A retailer may have greater certainty about the market size but have less knowledge than a producer about the extent of available supplies.

A retailer would have a natural incentive to operate a transmission pipeline with open access to producers as this puts downward pressure on the price he can negotiate.  Because no retailer now has a monopoly franchise, he too will be deterred from investing or will build a sub-optimal pipeline if this requires carriage, on terms not of his choosing, of rival retailers' product.

Again requiring common carriage at a regulated price is likely to prevent efficient new investment.

The Draft Decision is concerned to prevent excessive profits on the part of pipeliners.  The regulatory authorities do not deny that the pursuit of "excessive" profits or economic rents is a legitimate business goal that all firms strive towards.  It is the existence or possibility of competition that constrains this.  Having a regulator combat the pursuit of "excessive" profit may have merit where a facility is a genuine natural monopoly.  But there is no monopoly on a pipeline connection that does not yet exist.  This is one of many circumstances where the incentive of earning high rewards leads to efficiency inducing risk taking.  Suppressing the pursuit of high rewards will reduce worthwhile investment activity and such regulatory measures should therefore be confined to tightly defined and rare circumstances.

It follows that where no pipeline currently exists the regulation on a new line should be minimal.  There should be no specification of prices by the regulatory authorities.  The community can only gain from the new facility and the pipeliner is constrained in his pricing and other conditions by the ability of rivals to offer an alternative pipeline and by the pre-existing sources of energy.

In the absence of this approach, any new pipeline that might be built would not be built to maximise economic efficiency.  Thus, if the new pipeline is built on the basis of a significant contractual load, the owner entrepreneur will wish to avoid being hostage to prices determined by a regulatory agency, all the more so in view of the Draft Decisions.  If the price for the additional energy is to be regulated, the pipeliner faces a risk that the price will be inadequate and that the additional energy might even undercut the supplies of the contracted energy.  The contractee is particularly likely to seek to ensure that the capacity of the pipe does not allow such competition.  Accordingly, pipelines are likely to be built that have less than optimal capacity, especially since the capacity of a pipeline is related to the square of its diameter and the costs of building in incremental capacity are relatively low.

Many augmentations are committed in the context of a great deal of risk that the planned utilisation will not be achieved.  In such cases, the level of return for success is required to be correspondingly high.  The regulatory risk that the high returns for success in a risky venture will not be allowed means the more speculative projects will not proceed.

This highlights the fact that the notion of "excessive" profit is misplaced.  The high returns obtained by a successful private sector owner are no more than "normal" profits.  There is no monopoly on owning a pipeline (nor on duplicating it).  The various entrepreneurs weigh the different likelihoods of success and failure and, implicitly or explicitly, develop an array of possible profit outcomes.  An amalgam that yields an acceptable return allows the project to proceed.  Typically the array of possible profit outcomes will include very high returns as well as near total loss.  Ruling out the possibility of making very high returns by insisting upon a price cap/access regime will reduce the prior estimates of the project's viability.

RECOMMENDATION

• The regime covering pipelines should not normally be extended to new pipelines.
• Regulatory coverage should be withdrawn from all pipelines that are in competition with each other.
• There should be no strictures against pricing approaches like "front-ending" or preferred prices to "establishment customers", nor should the pricing horizon be limited to the five years presently stipulated.
• New pipelines should not be required to be common carriage and ownership by retailers or producers should be permitted.