As Hanson's Shouts Subside, Questions Remain

Anyone who writes an epitaph for the One Nation Party cannot forget the commentators who predicted its demise before, only to find egg on their faces a few weeks later.  Nevertheless, with One Nation currently engaged in a particularly farcical bout of self-destruction, it is a good time to ask whether the Pauline Hanson phenomenon achieved anything for the people who welcomed its appearance.

Of course, people were attracted to Ms Hanson for different reasons.  Clearly, some who dislike Asians and Aborigines saw her as a kindred spirit, however much she might claim to be colour-blind in her attitudes.  Her attacks on tariff reduction, foreign ownership and privatisation found many sympathisers, including people who otherwise saw her as a Great Female Satan.

Hanson's wholehearted patriotism also struck a respondent chord with those who think that Australia is a pretty good country, and who expect their leaders to be more forthright in expressing their pride in the nation's achievements, rather than apologising for its past.

But the ultimate basis of Hanson's appeal lay in her mettle, her willingness to talk about issues that arrogant elites and craven politicians had tried to rope off from public discussion, and her refusal to back down despite all the vitriol that was directed against her.  Many people who recognised that she was probably incapable of providing any real analysis of the nation's problems -- let alone answers -- or who strongly disagreed with her on key matters, still hoped that some benefits might result from the jolt she was giving to Australia's political culture.

These people, who included members of the Federal Coalition, thought that Hanson could open up a space which would make it easier to challenge the Labor-Democrat consensus on issues such as multiculturalism and Aboriginal affairs.  By staking out a radical position, she would effectively move the boundaries of public debate, allowing other conservative politicians to express the more moderate views of middle Australia without being denounced as bigots by the media.

That is not how things turned out.

Certainly, where Pauline Hanson's sentiments coincided with those of the caffe latte set, such as her attacks on "economic rationalism", people on the left were very happy to use One Nation's apparent ability to garner support on these issues to back up their own denunciations.  So Hanson and her party can probably claim some responsibility for the ALP's increased readiness to turn its back on economic reform.

In that sense One Nation has delivered something to those followers who were attracted by its economic views, although whether this is in the ultimate interests of Australia is a different question.  And One Nation's advocacy, however muddled, of concerns which stir up few passions in the metropolitan centres, such as the plight of rural and provincial Australia, has focused more attention on the problems than might otherwise have been the case.

But as far as opening up debate on topics covered by the umbrella of "political correctness" -- the issue which brought Pauline Hanson to prominence in the first place -- she and her party have been a dismal failure.  Questions such as the points of tension between cultural diversity and social harmony, or the costs and benefits of preferential treatment and affirmative action policies for racial and ethnic minorities, or the long-term economic and social effects of native title, are no more the subject of honest and wide-ranging public discussion than they were in Paul Keating's heyday.

There are a number of reasons for this failure.  The first is the unwillingness of One Nation to examine difficult and sensitive matters in an intelligent and constructive manner.  Hanson's standard approach, and that of her party, is to present a grab-bag of slogans and poorly digested facts and half-truths, wrapped up with occasionally worthwhile observations.  This approach may be sufficient when you are going along with the elites' favoured nostrums, but when you are fighting a cultural battle against them a lot more thought and effort is required.

This made it all the more easy for the beneficiaries of the Keating era to demonise Ms Hanson and One Nation.  While the intemperate and grossly disproportionate nature of their attacks increased One Nation's appeal to ordinary Australians, it frightened away many prominent people who might have wanted to take a more informed and responsible stand against the conventional wisdom of the elites.

False, but frequently repeated claims that John Howard and Aboriginal Affairs Minister John Herron had "caved in" to One Nation, and the Government's baffled and inept reaction to these charges also helped to ensure that the dead hand of "political correctness" would continue to stifle public debate.

The left would have vilified Hanson no matter how articulate and compelling her arguments may have been.  But as Victoria's maverick premier Jeff Kennett has shown, an astute and hard-working politician can readily overcome such hostility and even use it to create support that is more enduring than the nine day wonder that Pauline Hanson brought into being.

For many years Kennett was bitterly despised and ridiculed by the ABC, the Melbourne Age and the whole of the city's left establishment, and although some of the initial virulence has declined, he still incurs their considerable displeasure.  But now he is also the country's most popular, and arguably the most effective, political leader.  His critical but reasoned and civil response to Hanson was far more damaging to her in Victoria than the sanctimonious and sometimes violent wailing of her other opponents.

Despite its negatives, I think that the rise, and likely fall, of One Nation has brought one real benefit.  The shenanigans of the party's leading troika, not to speak of the antics of some of its lesser lights, have brought home an important lesson.  Australians who are tempted by the idea that some Joan of Arc can lead them out of bondage can now see that "anti" politicians are often more arrogant, foolish, and indifferent to public opinion than the ordinary kind.

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Can Coal Continue as the Primary Power Generation Source?

Address to National Summit on Power Generation,
Gold Coast, 25 February 1999

WORLD ENERGY CONSUMPTION

Coal supplies over one quarter of the world's primary energy, and over 46 per cent of that of Australia.  Although oil is a more significant energy source worldwide, consumption of it and gas are less important to Australia.

The following chart sets out the details.

CHART 1

Source:  BP

While hydro appears to be showing some growth worldwide, this is unlikely to persist.  Lack of suitable sites is a major reason.  Moreover, the forces which, rightly or wrongly, aborted the Franklin Dam have not lost sufficient clout in Australia to allow any real growth in hydro.

As for nuclear, over the past decade world output has grown 38 per cent and the fuel now accounts for 7 per cent of world energy consumption.  It now dominates electricity supply in several European countries and is a fast growing source in several Asian countries.

WORLD ENERGY AVAILABILITIES

In spite of most of us having been subjected to the Club of Rome nonsense forecasting an imminent run down in resources, the truth is that we face no shortages of the energy products on which we place greatest value.  Even oil, the product with the most likely shelf date has shown a stubborn trend to maintenance of reserves.  Oil and gas reserves at 41 and 64 years respectively are pretty much the same level as they were 20 years ago -- this is in spite of the fact that we have used up almost half the known oil reserves of 1977.

CHART 2

Source:  BP

In fact the reserves listed are, in most cases, simply a stock of known resources which may be brought into production when commercial circumstances are right.  This is amply demonstrated in the case of natural gas where Australia, according to the BP data, has only some 18 years supply.  In point of fact there is known to be a great deal of gas off the west coast the owners of which have not yet seen a reason to proved it up.

In the case of coal, the world has 233 years of proved resources at present consumption levels.  Australia is listed as having 327 years supply, but again that is a conservative number.  For Victoria, proven and probable reserves of brown coal amount to over 1,000 years supply of a product with no known uses other than on-the-spot power generation.

AUSTRALIAN ENERGY TRENDS

OVERALL TRENDS IN ELECTRICITY DEMAND AND SUPPLY

Australian electricity consumption has more than doubled over the past 20 years.  Plant capacity is some 40,000 megawatts (dominated by large thermal units having a capacity between 275 and 500 MW) and output some 179 million gigawatt hours.  Although energy demand is slowing, some 30% growth is expected over the next decade.  Chart 3 indicates the trends in electricity generation.

Chart 3

Source:  ABARE.  1 Pj =278 GWh

AUSTRALIAN PRICE TRENDS FOR GENERATED ELECTRICITY

A feature of the Australian market over recent years has been overcapacity.  This has resulted both from over-ambitious plant development and improved plant efficiency, particularly in the light of corporatisation and privatisation in Victoria.  In that State, the availability to run of the brown coal fired plants has been lifted from less than 70% to around 95%.

Systems in other States have also improved with the result that a reduced margin of reserve is now required.  (The operationalisation of the link between Victoria and NSW and the proposed link between NSW and Queensland also reduces the required reserve plant margin.)

The increased efficiency and the effective increase in available capacity has been readily apparent since electricity has been sold within a market rather than its production administered by integrated State monopolies, a change gradually brought about since late 1994.  Whereas the shadow prices of electricity in NSW and Victoria were formerly some $44.5 and $38 per MWh respectively, spot prices in both markets averaged $17 in the period from May 1997 to June 1998, rising to a heady $21 in the second half of the year.  In the month of January prices in NSW and Victoria have averaged rather more than this.

Both South Australia and Queensland have seen higher prices than this, though the SA prices have only been made available since the NEM December commencement.  Since the market opening, Queensland with its tight supply position has seen prices averaging around $35 while SA has seen average prices some $10 above this.

The low prices in the two largest States stemmed from cut-throat competition as a result of very low marginal costs in Victoria (where the fuel has no alternative uses) and marginal costs that were also low in NSW as a result of coal contracts being set on a take-or-pay basis.  Over recent months, as a result of higher cost capacity in NSW being mothballed, prices have tended to increase.

ENERGY COMPETITIVENESS OF NON-FOSSIL FUEL PLANT

AUSTRALIAN COST ESTIMATES

Prices, at least in NSW and Victoria, are far below those that would justify the construction of new plant.  The following chart is updated data derived from information in the main assembled by the Ecological Sustainable Development jamboree that the Hawke/Keating Commonwealth Government unleashed.

CHART 4

At the present time, Australia is more cost effectively served by coal fired generation than any other form.  Based on an 8% discount rate and reasonable information about capital, operation and fuel costs, new power stations could be built to produce baseload power at prices that range from just under $35 per MWh for black coal and a little over this for brown coal and for gas (at a gas price of $2.70 per Gj).  Coal fired generators may see prices lowered by some 15 per cent with the availability of coal gassification technology.  Wind could be produced at under $70 but its value would need to be heavily discounted as it could be neither baseload nor peaking capacity.

Nuclear would cost less than $50 per MWh.  Although this makes nuclear uncompetitive with coal, it would be close to competitive with a coal fired South Australian station.  The quality of South Australia's coal means a new station is estimated to require a price of $46 per MWh and would also face some additional transmission costs.  South Australia imports about one third of its requirements from Victoria.

A further difficulty with nuclear is the considerable size per unit.  No nuclear facility of less than 500 MW would be viable and facilities are normally at least 1000 MW.  Australia, coming as it has from a centrally planned direction, has a greater proliferation of large plant than would arise in a market founded on competition where plant flexibility commands a greater premium.  For this reason, with the exception of Queensland, which is the fastest growing Australian market and where governments have been slow to commission augmentations, most new plant is envisaged to be smaller co-generation facilities or gas turbines which require a lower capital cost and can be built in smaller increments.

In general, abstracting from any greenhouse considerations, Australia's abundant and easily mined coal and especially Victoria's 1000 year supply of non-transportable brown coal, mean coal is likely to remain the preferred source of high capacity baseload plant.  In the case of brown coal, research is already advanced on gas turbine technology.  This is presently proven as a cost saving source for new black coal stations and represents the next generation of brown coal plants, ensuring the fuel remains highly competitive.

GREENHOUSE CONSIDERATIONS

SPECIFIC AUSTRALIAN CONSEQUENCES OF KYOTO

Australia has been allocated an 8% increase in emissions by 2010.  Though far in excess of the levels the environmentalist lobby wanted to foist on us, this is not nearly enough to operate on a business-as-usual basis.  Energy, and more specifically, electricity is the key to future reductions.

The PM's statement of 20 November 1997 encapsulated the latest estimates of where Australia stands.  It also points to various market interventions.

The measures announced are designed to reduce emission growth, excluding land clearance, to 18 per cent by 2010.  This leaves a gap of 10 per cent to be filled on the 2010 business-as-usual estimates.

One measure designed to foster reduced emissions is the specialist renewable energy innovation investment fund.  This includes loans and grants totalling some $64 million for the subsidy of low greenhouse gas emiting electricity generation.  Conspicuously absent from mention were the two most greenhouse free sources of energy production:  nuclear and hydro.

Not costed in the P.M.'s November 1997 statement was a requirement that 2% additional energy from electricity is to come from renewable or specified waste-product energy sources by 2010.  This means some 20 per cent of new generation is to come from these sources.  It may be that such magnitudes of renewable supplies will be forthcoming as a result of improvements in technology by then.  But such dividends from technology have long been promised and have failed to materialise.

At present costs, requiring exotic renewable energy sources would more than double the price of the electricity supplied.  At two percent of electricity, it would require these doubled costs to be incurred for at least 4,000 GWhs of electricity, and on some interpretations considerably more than this.  Four thousand GWhs is about four fifths the size of the Snowy hydro output.  If the premium on this output is only 5 cents per KWh, this entails additional costs of some $200 million per annum.  However, if the notion of waste-product energy is extended to cogeneration, the cost premium may well be less than 5 cents (may even be zero).

TACKLING FURTHER REDUCTIONS

Further reductions can be forced by use of subsidies, taxes, allocating tradeable rights to emissions or by command-and-control.  Any such actions should avoid a focus on particular sources like thermal electricity.  There are likely to be many circumstances where increased use of thermal electricity may actually reduce emissions.  For example, where electricity replaces household coal or wood burning or where increased Australian electricity usage for transforming Australian raw materials means reduced energy used in transport and in transforming those same materials overseas.  While Kyoto may be said to have settled the issue on the latter point, focussing only on electricity is likely to mean some lower costs options are foregone.

Economic instruments, taxes or tradeable rights, generate and harness the information about costs from a vast number of users and producers.  They are, therefore, almost certain to bring about a more efficient outcome than if the control decisions were mandated by particular standards.  This is due to market instruments making use of the same cost paring and profit searching incentives that have provided the higher living standards evident in market based economies.

Taxes set the price of pollutant emissions;  the total amount of permits determine aggregate quantities of emissions, with individual permits being allocated initially on some basis such as current emission levels.  Both taxes and permits signal the costs of pollution by putting a price on emissions.  Taxes do so directly, by government decision, and permits indirectly, by forcing existing and would-be emitters to compete in the market for a limited supply of permits.

The alternative of using command-and-control regulation is inferior to market solutions for two principle reasons.  First, it requires that regulators have intimate knowledge of millions of productive processes and their alternatives so that an optimum regulatory structure can be set.  Secondly, it relies on decisions not being clouded by political exigencies.

Normally, the best way to estimate what will be the outcome of a regulatory action is to measure its effects as a tax.  With some minor reservations, a tax and conferring tradeable rights have the same economic impact.

THE LEVEL OF TAX REQUIRED

Estimating the effects of tax or equivalent changes on price and then output is difficult enough one year hence and it is well nigh impossible a dozen years into the future.  Even so, estimates must be made if we are to see where policy is leading us.

ABARE have estimated the tax required to stabilise Australian emissions at the Kyoto level to be $US34 per tonne of carbon dioxide in 2010.  This works out at $A208 per tonne of carbon.

The basic tax at $34 per tonne of carbon dioxide is likely to understate the real effect because it is based on an international trading regime whereby the abatement is undertaken by those who can achieve it most cheaply.  Although trade in carbon emissions, as with other goods, brings the most efficient outcomes, international trade has definitional and verificational difficulties.  Thus, if tradeable rights are conferred on the avoidance of a supposedly intended facility overseas, especially in a country which is not bound by the emission limitation regime, there is likely to be trades in phantom emissions.  These would amount to a business claiming to have installed more energy efficient plant in a particular country than had previously been intended.

EFFECT OF A CARBON TAX

The tax imposts required to abate Australian carbon dioxide outputs transform the economics of electricity generation.  More than doubling the cost of generation will lead to an increase in costs to customers of some 70%.  Electricity prices would still be low compared to those in many other countries but Australia would cease to be the low cost energy supplier that has attracted many processing industries.  Our disadvantage would be compounded to the degree that the developing countries were exempt from the controls.

The following two tables measure the cost of electricity generation with a taxes set at $A208 and $A104 per tonne of carbon.

Chart 5

Tax set at $104 per tonne of carbon

Chart 6

Tax set at $208 per tonne of carbon

At a tax of $104 per tonne of carbon, coal is totally displaced and gas becomes the preferred source of new power.  It is however likely that the price of gas would be pushed upwards by a rush of demand for it.  Nuclear would then become competitive.  Nuclear is clearly ahead at the tax rate of $208 per tonne of carbon.  Although wind appears in principle to be more cost competitive than coal, especially with a carbon tax at $208 per tonne, its episodic operational characteristics make it unlikely to prove capable of supplying more than a very small fraction of demand.

CONCLUDING COMMENTS

Absent any greenhouse gas measures, with Australia's abundance of cheaply mined coal will entail it remains the dominant fuel source for electricity.  Gas is likely to increase its share as the industry rebalances towards more flexible plant.  Nuclear power is the only serious contender for base load and unlikely to be viable, except perhaps in South Australia.  And in South Australia, the Pelican Point decision will have deferred any serious consideration of nuclear even if Australian governments had the stomach to resist the inevitable agitation.  With greenhouse gas taxes or its equivalence in tradeable emission rights, nuclear would become the lowest cost option.

Much depends on the merits of the greenhouse fear and, more importantly, the Government's reaction to these.  Greenhouse is far from an established phenomenon with severe effects on the planet.  Signing an agreement is different from putting it into practice.  An Australian Government has previously, with the 1992 Rio Treaty, agreed to reduce emissions of greenhouse gases under certain conditions and failed to do so.  Furthermore, the US position is crucial and the Senate has already rejected a treaty that does not incorporate emission reduction targets of developing countries by 95-0.

Serious reductions in greenhouse gas emissions would have a devastating effect on the coal industry including a total eradication of Victoria's brown coal resources (worth at least $12 billion).  Its knock-on effects would also require a massive restructuring away from resource processing.  Any emission control measures, while presenting opportunities for some generation sources, would be clearly alien to Australia's national interest.

The Economic and Market Benefits of By-Pass

An Address to the Second Annual Reliability & Quality Conference,
Melbourne, 24 February 1999

COMPETITION AND REGULATION

Over the longer term, successful economic performance requires market competition with established property rights.  Competition means a ceaseless striving to steal a march on rivals by cost-cutting and better pleasing the customer.  Established, secure property and contract rights offer the incentive of personal gain from searching out new and changing needs of consumers and continuously seeking ways to meet these more cheaply.  The socialist economies collapsed under the weight of bureaucratic controls and lack of incentives that are the inevitable corollary of attempts to improve upon the outcomes of market processes.

Stable institutions with the ultimate backing of law are essential to sustained growth in living standards.  Government intervention, whether through owning businesses, directing resources into favoured areas, or reviewing commercial decisions will detract from and possibly arrest this process.

At issue is the scope of government-backed rule of law.  As stable property rights and competition are the twin engines of prosperity, is there a role for government to intervene to promote competition?  If such a role exists, it is necessary:

• to examine where there might be a conflict between the exercise of private property rights
• and the assurances of workable competition;  B to determine, if such a conflict occurs, the criteria for overriding property rights;  and B to establish institutional arrangements that generate the minimum of waste and
• paperburden costs in addressing the issue.

Generally, the rationale for government intervention, aside from its wish to buy votes with benefits directed to certain parties from others which are either politically unimportant or unaware, is market failure.  Market failure is a rather misunderstood term.  It is a precise term in economics that refers to the inability of markets to provide the lowest cost solution because of the occurrence of monopoly.  It is sometimes used by regulators as a term to portray a market outcome that does not accord with what they expect to occur.

Competition is not valued as an end in itself but as the means of promoting efficiency.  Narrowing the scope for monopoly is at he heart of the Hilmer type reforms that are most evident in gas and electricity.  Monopoly is likely to mean a waste of resources because the producer's natural interest in maximising profit can be married with an ability to do so through forcing up the price by restricting supply.

While the remaining monopoly facets of gas and electricity facilities have pre-occupied policy over the past five years, the injection of regulatory agencies into the vacuum left by the disengagement of the political arm of government threatens to create new forms of inefficiencies.  These stem from poor decisions, a wish to ensure lower prices irrespective of costs and a massive increase in the paperburden.

While competition undoubtedly generates increased efficiency, will government intervention select the appropriate competitive model?  And will it lead to the diversion of entrepreneurial energies into avenues that are unproductive?

COMPETITION IN THE ELECTRICITY SUPPLY INDUSTRY

GENERATION AND RETAILING

Each of the jurisdictions in NSW, Victoria and South Australia have split up their generation businesses in a way that allows a considerable degree of free competition.  By and large within each electrical region, the spot price for electricity reflects supply and demand and is not normally subject to any one player being able to exercise market power.  This is a sweeping statement that needs to be mitigated somewhat by the limited number of competitors in both Queensland and SA but for the most part prices are the outcome of competitive forces.

With regard to the retailing part of the supply, the developments in Victoria and NSW have led to a great deal of customer migration from their host retailer, indicating a ready contestablilty of the market.  Out of State retailers report some considerable difficulty in cracking the Queensland market but it is early days there.

TRANSMISSION

In general, the development of market systems in Australia and elsewhere assumed that the "poles and wires" business would be a natural monopoly other than in exceptional circumstances.  The UK system had no provision for what we now call entrepreneurial links and the Californian system which was leading the pack in North America similarly assumed transmission would remain a regulated monopoly.

For the most part the Code took the view that interconnectors and network augmentations would be established following recommendations of the Inter-regional Planning Committee (IRPC).  The IRPC would develop a statement of opportunities and an annual review recommending augmentation options to NEMMCO (5.6.5).  Provision was made for augmentations that are not deemed justified by NEMMCO to be undertaken.  These provisions were spelled out more in the section covering interconnectors across regions (5.6.6).  But it was left, under clause 3.12.2, to NECA to establish rules for non-regulated interconnectors.

The relatively low share of transmission in total supply costs, the abundance of capacity for most purposes, and the inevitable co-mingling of electrons brought the general view that, aside from shallow connection and some other participant specific costs, the service should be charged as a compulsory levy on customers.  This has started to break down as:

• embedded generators object to having their customers pay for a service they do not require;
• participants substitute a regulated "free" good for one that they must pay for directly;  one notable example was the $104 million augmentation linking Tarong power station which was paid for by customers;
• the SANI debate and the recognition that the producer beneficiaries could be paid by customers, including customers that may be prejudiced by an augmentation;
• the TransEnergie proposal for an entrepreneurial link indicated that commercial opportunities are a potential option for the construction of new links.

The SANI case brought into full relief the fact that interconnection and generation are competing ways of supplying the market.  They are the difference between buying a product and transporting it over some distance and making it closer to the market.  If different regulatory rules and payment approaches are used, there is a considerable incentive for distortion.  Where a supplier can shunt off transmission payments to third parties he will tend to locate closer to the raw materials.

A considerable amount of ink has been spilled on the estimates of net benefits to customers in the SANI case in order to justify the construction of a regulated link.  But the adding of all the costs and benefits that is part and parcel of a regulated approach is not the same calculation that is undertaken with the construction of a merchant facility.

The proponents of a new plant do not seek to estimate the full benefits to society of their expenditure.  They simply estimate what their own costs would be, the likely price and quantity they will sell and proceed if they see a profit.

In addition to these private benefits, the proponents of a new regulated link would estimate the effect it has on customers generally in lower prices for the existing supplies which its construction will bring about.  A new generator, a new car plant or a new biscuit factory would have analogous effects on overall prices but it would not be able to claim these as part of its justification.

The potential distortion from applying different decision criteria to transmission and generation has brought increasing calls for the abandonment of all new regulated transmission links.  A NECA Working Group at the end of last year set down "Safe Harbour Provisions" under which entrepreneurial interconnectors could proceed with confidence.

DISTRIBUTION

In the case of distribution, State based regulation presently rules.  In Victoria, by-pass was not ruled out, but the likelihood of it occurring was thought to be negligible.  This has given rise to the claims by Citipower in its spat over the Melbourne development at Docklands that it had an exclusive franchise.

The regulator has been remarkably slow in adjudicating this matter and has thrown up a formidable series of questions.

These include fears that the outcome will be an increase in prices to existing customers.  This certainly would not eventuate where there is a close proximity of alternative lines.  In such circumstances, raising prices to existing customers is likely to be a prelude to the incumbent losing even more of the market and converting a partially stranded asset to one that is fully stranded.  It is far more likely that the two sources will provide on-going competition to the benefit of consumers.  In this respect, the evidence is that prices tend to be lower in those US locations where electricity is supplied by more than one line, than where a monopoly is mandated.

Similarly, the ORG seeks views on how the proposal will affect the financial viability of the industry.  This stems from section 157 of The Electricity Industry Act, which requires him, inter alia, "to facilitate the maintenance of a financially viable electricity supply industry".  But financial viability is not an issueoeshould a business face lower profits its capital value will be reduced.  The ORG's role is to act as a surrogate for a market outcome where competition is considered unlikely to provide this.  To frustrate the development of competitive provision is not only inimical to the ORG's charter but extends the Office's role into that of a central planner.

Again, the ORG ponders whether there might be too many competitors and whether the incumbents should be protected in some way.

But the ORG is not alone among government bodies seeking to seize a role in selecting the winners.

The ABARE Submission to NECA says, The scope for inefficient bypass could thus be reduced through a regulatory system which allows bypass only when it can be shown that the net public benefit of bypass is positive.  This will require that regulators be able to identify the costs and benefits of bypass proposals on a case by case basis.

Determining where by-pass is efficient opens up great vistas for the regulatory agencies to vet proposals and cast competitive provision in the image they prefer.  The scope for by-pass is a far more potent tool for bringing prices into line with costs than pushing new proposals through a regulatory adjudication process.  By-pass or its potential forces firms to bring prices into line with costs.  It also offers new players the opportunity to avoid high cost, low profit customer segments.  The ability of the incumbent to subsidise these customers is undermined, bringing pressure on governments to unwind them.

PRICE DECISIONS AND THE EFFECT ON COMPETITION

The ACCC and the ORG set prices on Victorian gas transmission and distribution below the levels sought by the Government and below the prevailing prices implied within the gas tariff.  Many would argue that the high price received for Westar/Kinetic justifies the decisions of the regulatory authorities.  But the point is that prices set too low will pre-empt the possibility of competitive provision.  Low prices will also reduce the incentive of the owner to undertake optimal maintenance expenditure.

It is certainly the view of the Victorian industry that the ORGs's 2001 price setting exercise is designed to anticipate all possible cost savings with the result that prices will be set so that the regulator rather than rival provision forces prices to a minimum.  The problem with this is the disincentives it brings to upgrade quality and maintain lines in area where the price squeeze is overdone.

The possibility of by-pass can have a significant effect in undermining politically determined prices that are excessive.  The Docklands issue has made all distribution businesses conscious of their own vulnerability to by-pass.  That vulnerability is threefold.  First, because distribution line prices are often uniform within each area, those parts close to major centres tend to subsidise those located more remotely.  Secondly, under the Code one half of the TUOS charges are postage stamped (in Victoria this is only one quarter), which gives rise to cross subsidies.  Thirdly, the political agenda in most jurisdictions involved a further cross subsidy of line charges to rural consumers.  In Victoria, the fixed charge was set at a maximum of $20,000 per MW.  As a result, users in low cost areas are overcharged.  This also meant some rural users, like those in close proximity to generators not being able to capitalise on their favourable location.

In Victoria the TUOS charge for the DBs was revised from the optimised charges as follows:

TUOS Equalisation Adjustments, 1994/95 $'000
	Uncorrected TUOS	Equalisation Adjustmentmnt	Corrected TUOS
CitiPower	21,070	5,920	26,990 (+28.1%)
Eastern Energy	17,640	(4,939)	12,701 (-28.0%)
Powercor	45,270	(19,011)	26,259 (-42.0%)
Solaris Power	14,180	5,171	19,980 (+36.5%)
United Energy	26,540	12,859	39,450 (+48.5%)

Thus, based on replacement costs, the capital component of United's charges are 48.5 per cent above the optimised replacement value, while that of Powercor incorporates a 42 per cent under-recovery.

Similarly, the write-up and -down of the distribution lines has created distortions as follows:  Thus, CitiPower charges were set at 26.7% above costs, while those of Powercor were set 20.8% below costs.  These subsidies were to be unwound over a period of 20 years.  This makes CitiPower and the other urban based distributors vulnerable to by-pass, because its charges are artificially boosted.

Asset Value Adjustments at Privatization (1994/95 values), $m
	ODRC Value	Adjustment	Adjustment %	Regulatory \Value
CitiPower	482	129	26.8%	$611
Eastern Energy	1046	(218)	(20.8)%	$828
Powercor	1227	(161)	(13.1)%	$1066
Solaris Power	361	61	16.9%	$422
United Energy	743	136	18.3%	$879

DUOS rebalancing can take place but is limited to 2% per annum.

These provisions mean that there is excess charges in some areas and undercharging in others.  Governments have sought to obscure the extent of the excess charge by not requiring specification of the breakdown of costs on bills.  Nonetheless, businesses on the periphery of predominantly rural businesses are able to discover the savings they might make if located only a few kilometres away and will seek out alternative arrangements.  Aware of this, with the possibility of by-pass, their host DBs will be forced to restructure prices to keep the business.

Hence, as well as forcing firms to keep their prices competitive, by-pass unravels the cross subsidies.  It means that the standard charges for regulated lines within any given region will be undermined.  The ability of a rival lines business to link up a customer within a particular distribution business's territory means we will see cherry picking.  This is already evident in telecommunications.

THE NATURAL GAS PIPELINE CODE

Gas pipelines remain regulated both with price caps and the requirement that the potential new links be put out to tender.

Price capping has already been referred to.  It is the epitome of the central planning which we are seeking to avoid.

In the case of a new line, approvals are necessary.  Thus, an entrepreneur is not allowed to spot an opportunity for profit, build a line and charge what the market will bear.  Instead the proposal must go to tender, with the line charges being developed based on the costs estimated by the lowest tenderer.  This creates considerable disincentives for a business to undertake the initial work of seeking out markets, assessing pioneer customers and building costs.

If a private business were to spot an opportunity and subsequently be required to tender for the right to provide the means to meet it, that business will have incurred costs on which other businesses would free ride.  To require the opportunity to be tendered would be analogous to placing similar requirements on the proposers of a new paper mill or smelter.  It would discourage market searching activity and innovation.

THE ISSUE OF NEW VERSUS EXISTING PIPELINES

Existing pipelines which serve as non duplicable facilities and which face no competition from other pipelines, present a case for regulation of some sort.  Where no pipeline currently exists, the regulation on a new line should be minimal.  Yet, in the draft Code, the onus is reversed.  A new entrepreneurial pipeline is required to prove that it should not be covered, and the Code itself would appear to offer few circumstances when this will be accepted.

The outcome of an entrepreneurial pipeline is seen in Goldfields where WMC/BHP/Normandy took the risks and built a pipeline to supply their own needs ⁽¹⁾.  Having done so, the consortium is relatively unconstrained in charging others, including Alinta Gas, a price that is close to what the market will bear.  This appears to be unacceptable under the Code.  Thus, under s.3.28, the arrangements are designed to preclude a pipeline from obtaining any greater profits than the regulator anticipated, and this is further amplified in s.3.33(e) which requires a tenderer to produce a policy regarding "additional revenue", a provision that does not seem to have a reciprocal arrangement where there is negative additional revenue.

Yet the Goldfields Pipeline was itself a form of by-pass.  The major motivation was to bring gas to the area so that the mining businesses could generate electricity locally to avoid the excessive charges imposed by SECWA.

WHERE THERE IS PIPELINE ON PIPELINE COMPETITION

The foregoing highlights a further issue.  Where there is adequate competition, no regulation is necessary -- after all, the regulation proposed is nothing other than synthesised competition.

In this respect, the provisions for revoking coverage are unclear.  Although s.1.30 says revocation must be recommended if it is no longer uneconomical to have another pipeline provide the services, the services are not defined.  Revocation is only unambiguous where another pipeline parallels the existing line and there is surplus capacity.  It would not therefore automatically apply to the Duke Energy Longford to Wilton line which provides competition to the Cooper Basin suppliers for the Sydney market.  It is likely that if the line is to be covered under the Code, its design and capacity would be affected.

If the Code is not to be an impediment to efficiency and to businesses striking their own deals as they do in other areas of commerce, it should ensure that regulatory oversight is confined to the core areas and does not attempt to provide an insurance to "fairness" or some other notion where rival suppliers are in place.  It follows that where there is more than one pipeline serving an area or passing relatively closely to the same area, unless one of the pipelines is unable to provide competition (because its capacity is trivial compared with the other) coverage should automatically be revoked.

CONCLUDING COMMENTS

The Hilmer recommendations (Hilmer et al., 1993) rightly focus upon the importance of competition in bringing about a more efficient and productive economy.

The codes covering access and pricing to gas and electricity networks are subject to requirements on price and access which presume that they are monopolies.  Yet recent events have demonstrated the potential for active competition in this area of supply.  In Victoria, rival electricity distributors are planning to drive new lines into each other's territory.  Further evidence of the potential is observable in the skill that AGL has shown over many years in setting its New South Wales pipeline charges at a level that allows it profitably to 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 it adopts too hard-nosed an approach to pricing and service, it will call forth competition and leave the existing asset "stranded".  Fear of having "stranded" assets means that little by-pass is 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.

No facility -- at least no facility unprotected by government franchise -- has untempered monopoly powers.  Many facilities can be by-passed and almost all others supply products, like gas, that compete with electricity.  That facilities have an element of natural monopoly is not cause of itself for the suppression of property rights.  Nor is it incompatible with the concept of access for others' product.  Where excess capacity exists, access can be marketed at a price which reflects the tremendous level of capital and expertise necessary to construct a large-scale system.  The alternative to a market based on the assignment of property rights may be under-investment, at a significant loss to suppliers and consumers.

Unfortunately regulators are notoriously reluctant to allow their powers to lapse and we won't see them willingly exit areas of control in favour of allowing by-pass to discipline the market provision.  But the task of regulating will become increasingly difficult as networks become multi-purpose.  Williams, one of the largest US gas pipeline businesses, is a major telecommunications carrier.  United and other electricity businesses in Australia have also entered this field.  Multi-purpose lines are is likely to be increasingly seen among the lines delivering gas, water and electricity into the household.

How then do we regulate what we define as the natural monopoly?  Some work has suggested we deduct that part of the cost of a facility that is not dedicated to providing the supposed monopoly services -- if $100 million out of a $500 million facility is estimated to be recouped from competitive services, the regulated prices would be set on the basis of a $400 million asset.  Such processes offer scope to the ingenuity of regulators seeking to hold their jobs.  But they are likely to prove unworkable in practice -- and unnecessary because competing utilities will do a much better job than regulators is establishing the "just price" which is the regulators' goal.

---

ENDNOTES

1.  In fact, following their original proposal going to tender.

Privatising Victoria's Electricity Distribution

Energy Forum Paper

THE IMPETUS FOR THE ELECTRICITY REFORM PROGRAM

In 1992 the then opposition Liberal National Coalition declared in its Energy Policy that "a Coalition Government will implement structural changes in the energy industry necessary to promote economic prosperity and job opportunities for more Victorians".  This foreshadowed the eventual de-integration and privatisation of the State Electricity Commission of Victoria (SECV).

The publicly owned vertically integrated monopoly utility, SECV was not generating the maximum benefits for its citizens or customers.  In particular a number of weaknesses had emerged such as poor capital investment decisions, over capitalisation of assets, low levels of plant availability and inefficient work practices.

In its final few years up to 1992, the State Labor Government had taken (or acquiesced in the SECV taking) energetic steps to reduce over-manning but the SECV continued to operate with excessive costs and poor performance.

In the late 1980's and early 1990's there were a number of reports dissecting the SECV performance by such as the Industry Commission, the Tasman Institute, the Business Council, and Public bodies Review Committee of the Victorian Parliament.  In addition there were clear trends overseas towards privatisation and the introduction of deregulation and market solutions to what was hitherto activities undertaken by public owned enterprise.  1991 also saw the first moves to define and establish a national grid following the Special Premiers Conference of that year.

In response to these reports and trends the industry itself expended considerable effort in pursuing greater efficiency.  Outsourcing, transfer pricing, downsizing, internal power pool arrangements all played their part, but whilst these efforts were dramatic in themselves they were being undertaken within the constraints of an integrated monopolistic industry structure.

October 1992 saw the election of the first Kennett Liberal National coalition Government.  It immediately set about pursuing its reform agenda.

THE NEW GOVERNMENT'S GROUNDWORK FOR REFORM

The new Government had a strong philosophical belief in the beneficial effects that capital markets could bring to a business as well as being attracted to the idea of transferring risk to private equity.  However the Government was equally conscious of getting the structure of the market right first.  All the experience and advice pointed to the need to spend careful attention to establishing a viable competitive and regulatory framework, which preserved efficiency incentives rather than necessarily maximising sale proceeds.  This lesson seemed best exemplified by the structural weaknesses in the UK wholesale generation market, which ensured that the two dominant suppliers were able to operate so that prices remained high.  Privatisation was therefore seen as the last rather than the first step in the reform process.

The program for reform would be by any measure a challenging task which would not only need to consider the almost infinite array of structural, ownership and market options but the timing and sequencing of such changes whilst ensuring that the industry "kept the lights on".  Importantly, the reform process faced considerable hostility from the unions, the Labor opposition and much of the media.

The first 12 months of the Government saw many of the options being canvassed, particularly through a team of external consultants.  The consultants' report recommended various options for horizontal and vertical integration.  These options included separation or integration of mines with generators, disagregation of generation down to individual power stations or portfolios, the choice of wholesale electricity market models, eg spot pool versus contract market and the degree of integration between the transmission sector and system/market operation.

In August 1993 the Government announced that it intended using the State Owned Enterprises Act to create three new "commercial" business out of the SECV to undertake generation, transmission and distribution/retail.  A Project Manager, by Dr Peter Troughton was appointed within the Office of State Owned Enterprises of Treasury to direct the implementation and ongoing reform policy for the industry.

The Government did not pursue two of the most contentious recommendations from the consultants namely the creation of two generation entities overseeing a portfolio of generation plant and secondly a power pool consisting of both an energy and capacity market.

In October 1994 the industry was again restructured largely into its final form.  National Electricity (Transmission) was disagregated into a non-commercial body VPX responsible for system operation and control, transmission planning and market operations;  and PNV responsible for transmission assets, maintenance and operations.  Five DB's were created and Generation Victoria disagregated down to four individual base load power stations (including Loy Yang B then under construction), one portfolio of hydro plant and one of intermediate and peaking gas plant.  During 1995-1997 all of these businesses, except the gas portfolio were privatised.  Proceeds amounted to $24B, some $13B in excess of the SECV's book value of assets recorded in 1993.

THE DISTRIBUTION SECTOR

By comparison with the transmission and generation sectors the structural and market issues surrounding distribution were perceived as far less problematic from a technical perspective.  This made distribution potentially the easiest of the three sectors to privatise.  However, distribution contains considerable practical and political difficulties and sensitivities.  Distribution is closest in proximity to customers thereby presenting the greatest challenges in terms of transitional arrangements and potential trade-offs for prices and competition, service delivery and structural change.

Distribution/retailing was encumbered with two particular "realities".  The first was a set of existing retail prices containing a complex array of cross subsidies including inter and intra class distortions and most significantly a uniform urban/rural tariff structure.  The second, was the fact that distribution and retailing was not undertaken solely by the SECV.  Eleven Municipal Electricity Undertakings (MEUs) operating under Orders in Council that pre-dated the establishment of the SECV in 1921 served the densely populated inner suburbs of Melbourne.  The MEU's represented approximately 10% of total distribution assets and served on average 23,000 customers.  Both the pricing and MEU issues would present significant political and practical challenges in introducing retail competition.

THE DISTRIBUTION SECTOR'S REFORM OPTIONS

STRUCTURAL ISSUES

Against this backdrop a series of structural options and public policy alternatives needed to be assessed by Government.  These were:

• whether the retail functions would be integrated or separated from the distribution wires functions;
• whether sub-transmission would form part of the distribution business or the transmission business;
• whether construction activities would be split out from the DB's;  the manner, sequence and timing of retail competition;
• the nature framework for regulation especially economic regulation;
• whether the distribution businesses would have an obligation to supply;
• the responsibility for metering;  and
• the size, number and borders of the potential future Distribution Businesses.

As with most other reform matters the policy makers were faced with having to balance a range of objectives including the long term objectives of competition, business viability, operational efficiency and the immediate trade-offs between sale proceeds and lower prices.  Unlike the current experience in gas it was the Victorian Government that had the sole responsibility for achieving the appropriate balance for taxpayers, consumers and future private owners.  This balance is currently being reassessed by the current Regulator General as part of the first distribution price reset.

The history of the policy debates and the solutions chosen is as much a story about process, project management and political decision making as about a strategy to solve simultaneously a set of reform equations.  Getting a strategic direction set, focusing on the major issues and harnessing the industry to solve much of the detail proved to be very effective in maintaining the reform momentum.  However, because of the dimensions of the reform options there was immense difficulty in providing an answer to the bottom line question, "What would the impact of all theses potential changes have on end prices to consumers"?

During the latter half of 1994 decisions on this taken by Government laying down a specific franchise tariff path (Maximum Uniform Tariffs "MUT's") to contestability.  This was to be contrasted to the UK approach of regulating or subjecting to competition the major elements of electricity prices rather than regulating the ultimate franchise tariff.

The Victorian approach was designed to deliver guaranteed real price reductions, unwind at an approximate level the larger known inter class cross subsidies (eg commercial to large business) retain the rural urban uniformity and provide some certainty as to prices until customers were contestable.

The final residual, which could be left "floating" till the last moment, was franchise fees.  For the three urban businesses these fees, payable to the Government for the life of the franchise, ie 2001, represented the annual economic rent generated by the MUT revenues less energy purchases (covered by vesting contracts with generators), network fees (consisting of transmission and distribution both separately regulated) and retail costs and an allowed 2% gross margin.

Whilst price certainty was an essential political requirement its level was as equally important, particularly given the historic uniform or equalised tariff structure between urban and rural areas of Victoria.  Politicians in rural seats needed to be assured that competition would benefit all Victorians.  This issue featured prominently in the debates on DB size and borders.  Ultimately a solution was found in a combination of financial engineering, with accountancy costs transferred between urban and rural DBs and within the DB structures themselves through a uniform tariff structure.  However, although shuffling paper values of assets can operate effectively where services are not contestable, once competitors can offer the service, prices have to track the true costs.

Debates about the DB's focused on three dimensions, size (customer numbers) borders and functional make-up (mostly whether retail should be included).  It was generally acknowledged that the economies of scope were not significant in distribution, but the optimal range of customers served included the IC's estimate of 300,000-400,000 the ESI Reform Consultants 400,000-500,000 and the SEC's view that 600,000 was the minimum efficient scale of DB compared to the average UK REC of 2.1M customers.  In the event, the creation and successful operations of Solaris and Citipower, both of which had less than 250,000 customers, demonstrated that the importance of scale economies was overstated.

The existence of 18 SECV customer service groups facilitated the analysis by allowing a building block approach to be used in analysing the various options.

In terms of DB make-up two broad options were identified.  First were a number of similar "pie-slice" distribution businesses.  As well as allowing for better comparability in size, customer types, load profiles these businesses would minimise (internalise) the need for equalisation payments, if cross subsidies and uniform pricing were to continue.  The second option would be to create similar metropolitan distribution businesses and multiple rural businesses, ie doughnut rings.  Although recognising the significant differences in supply economics this solution would expose most directly the requirement for cross subsidies.

Ultimately neither design option was pursued.  Instead a mixed option was created largely as a result of having to integrate the MEU's as discrete building blocks (for financial and legal reasons) and achieving a balance of customers, growth opportunities and more general financial viability objectives.  In the end the decision was taken to create 5 DB's.  Two rural DB's were established taking in fringes of the metropolitan area as well as the substantial growth corridors to the northwest and south east of Melbourne.  The two rural areas would be constituted entirely of former SECV customer service businesses.  Three urban businesses were created.  Apart from CitiPower, the CBD and inner suburbs distributor, Solaris (now AGL) and particularly United Energy would also be responsible for distributing to semi urban/rural areas.  Five MEU's were combined with one CSB to create Solaris.  Two MEU's were combined with three CSB's to create United Energy and finally four MEU's were combined with one CSB to create CitiPower.

The businesses themselves are outlined in the following chart.

DISTRIBUTION COMPANIES - A SNAPSHOT * United Energy The company's distribution network covers approximately 1,450 square kilometres in the south-eastern suburbs of the Melbourne metropolitan area, extending to the semi-rural and coastal resort area.  This region accounts for 26 per cent of Victoria's population.  The company distributes power to 520,000 customers, including 474,000 residential customers. Solaris The company distributes electricity to the north-western suburbs of Melbourne.  Its distribution network covers an area of approximately 956 square kilometres.  The franchise area covers over 232,500 customer sites. CitiPower The company's distribution area is the smallest of the 5 distributors, covering approximately 157 square kilometres.  The area includes the central activities district and the densely populated inner suburbs of Melbourne.  Citipower has the highest market share in the commercial sector, with 34 per cent of total commercial sales in Victoria. Eastern Energy The company is a rural-based distribution business comprising 80,000 square kilometres from the -Eastern Melbourne metropolitan area to the east coast and the Victoria/New South Wales border to the north.  Eastern Energy currently services around 471,000 customer sites, including 40,000 residential customers. Powercor The company is geographically the largest distribution business in Victoria.  Its distribution area covers approximately 150,000 square kilometres in central and western Victoria and accounts for over on third of Victoria's population.  The company distributes power to over 537,100 customer sites, including 446,000 residential customers.

The most significant functional issue that policy makers were required to address at the distribution level was whether the retail function should be integrated with the natural monopoly wires function.  Policy makers and the original reform architects had grappled with issue for some time.  The key uncertainty related to the unknown level of risk that the retailers would be exposed to and whether a retailing company would in fact be "privatisable".  Other issues were whether a combined entity would represent a barrier to entry for other retailers or whether breaking the entity would create operational difficulties with respect to such things as supply restoration, connection and public lighting.

The Government decided that the DB's would combine the functions of retailing and wires distribution.  Financially the businesses would be strengthened by the low risk regulated cash flows of the wires businesses.  Ring fencing of accounts would be put in place, although this was somewhat redundant due to the decision to establish a pre-determined MUT price path.  In any event commercial drivers and the form of regulation would minimise any tendency to cross-subsidise retail and distribution.

Experience to date has borne this fact out as the combination of retail and distribution has not become a barrier to entry and there has been no evidence of internal cross subsidisation to win customers in the competitive retail market.  This is not to say that at future distribution resets cost allocation issues will not feature, particularly if the methodology adopted by the Regulator-General is derived from cost of service principles.

Another important driver for Government combining retail and distribution was the fear that a single poles and wires company would in time become "regulatory dependent".  Although considered a natural monopoly subject to regulation, there was a strong feeling that the wires business needed to be subjected to commercial disciples and incentivised to focus on customer value and benefits by operating, albeit indirectly, in a competitive market.

Clearly a DB which wanted to retain customer loyalty in its retail market would also ensure that reliability and service were also promoted.  The same outcome was seen to be less certainly achieved by "contract" between a wires business and a retail business or a wires business and a regulator.  A further reason for integrating the two functions was the desire to incentivise the whole entity to responsible grow load through long-term economic development.  Splitting the functions would reduce the marketing synergies available to the DB's.

In any event it was felt that it should be the market and competition which should drive the optimal structure, indeed if there was in fact one.  This same argument also drove recommendations not to break out the construction activities from the DB's and create a services company that would be privatised.

TRANSITION TO FULL COMPETITION

To achieve an orderly transition to a fully competitive electricity market, the Victorian Government set in place a timetable for competition:-

• Customers with demand above 5 MW (about 47) were given choice in December 1994,
• customers with demand above 1 MW in July 1995 (about 330)
• in July 1996, choice was extended to customers consuming over 750 MWh of electricity each year (approximately 2,000).
• from 1 July 1998, choice was extended to customers consuming more than 160 MWh/yr (approximately 8,000+ customers)
• finally, from January 2001, all Victoria's electricity customers, including domestic customers, will be able to choose their electricity retailer (approximately 2,000,000).

SETTING PRICES

Although subsequent developments have tended to erode the certainty that poles and wires are a natural monopoly that cannot be duplicated, a key issue was and remains the regulatory approach for pricing of the "essential" facilities.  The model preferred is based on the UK CPI-X model.

In this model the process of determining regulated revenues is separated from the task of converting the revenue entitlement into individual network tariffs.  Regulated revenues would be based on the weighted average revenue yield approach, to be predicated on an assumed set of average price baskets.  These in turn would assume a set of network cost drivers, ie the cost of distributing KWh's at peak, off peak, high voltage, etc.  Network revenues would therefore be 100% variable to network energy distributed.

At the DB level this variability would be muted due to the MUT's.  The net effect being that Network revenues would however be variable to the energy distributed to contestable customers served within the DB licensed area.  Network tariffs applied to the franchise customers (as an internal charge) would simply be reflected in variations to the retail margin.

Overall network-regulated revenues would be based on an indexed rate of return model.  Although ultimately expressed as an average price cap variable to load, the underlying revenue entitlement would be calculated as the revenue required to provide an acceptable return on an underlying rate base, and to account for the financing requirements of the 5 year projected capital program and O&M over the same period.  X in this "CPI-X" model was, at least conceptually, a financially engineered residual, which smoothed the revenue requirements and equated the NPV of revenue to the cost requirements.  In this regard, the first controls were predicated on cost of service principles which was the only viable option given the circumstances of having to initialise a regime with no existing reference price path.

Whether cost of service principles or true incentive regulation using US style price capping is appropriate for the ongoing regime, is a subject of considerable controversy and debate as part of the first distribution review currently being undertaken by the Office of the Regulator General.

Network tariff construction also followed the UK model, modified to ensure some but not total compatibility with the existing retail tariff structure.  For example network tariffs to small residential customers would be entirely based on measured kWh together with a standing charge whereas demand metered customers would face a kWh, kW and standing charge tariff structure.  Decisions were ultimately taken which also determined that the applicable tariffs would be uniform across the distribution entity. ie postage stamping.  Price signals would come, not from the 40year annuitised asset (largely sunk) charge but the connection charge for new customers, which applied a uniform level of "tariff support" against the gross costs of connection.  The net charge represented the economic signal of locating in either high or low cost areas.

The industry also explored other alternatives to distribution pricing which attempted to reflect either the location or physical attributes of the network, eg electrical zones as a basis of pricing.  As we will see the conundrum of distribution pricing would not be solved until the manner in which equalisation could be carried out was decided.

At the heart of the problem was the political pressure to maintain uniformity of prices but to do so in a way that enabled competition to be successfully implemented, even on a transitional basis.  Cross subsidies would always be vulnerable to competition particularly at the retail level but also for distribution.

The approach adopted involved the concept of a single "one off" revaluation adjustment to the businesses.  The adjustment would be up in the case of the three urban businesses and down in the case of the two rural businesses.  The cross subsidy would in effect be capitalised as a one time adjustment but enable over time (until the existing asset base was fully depreciated) distribution prices to gradually become cost reflective.

Whether the "one off adjustment" would, as the rural politicians expected, "last for decades" or be more rapidly washed away because of the potential for network competition is an issue currently being contemplated by the Office of the Regulator General.  At the time of structuring the businesses for sale, there was little doubt that the underlying poles and wires businesses were anything other than natural monopolies.  The relevance of competition was seen to be confined largely to new connections and potentially at the borders or for new sites.  This natural monopoly notion was tested within two years by the proposal of one DB to install wires in the territory of another, an application that had not been fully adjudicated at the time of writing.

Having locked in the concept of an asset adjustment it was determined that the maximum differential should be set at 1.25¢ per kWh.  The final pricing model contained a series of one off adjustments and cross subsidies.  The DB's would be free to unwind the inter-class cross subsidies, largely from small to large customers, who were the most susceptible to "contestable" price shock.  The Tariff Order however limited the speed at which this could be done by capping any individual maximum increase to CPI +2%;  an increase, which has generally been fully utilised by the DB's since privatisation.

One cross subsidy could not be entirely removed however.  The Victorian high voltage large "Tariff H" consumers had enjoyed the lowest prices in the country.  These customers were given a special "safety net" deal.  They could remain on their existing tariffs to 2001 with a once only irreversible opportunity during this period to move to a contestable tariff.  In the event, low prices that followed the market opening meant that all these customers opted to leave the safety net.

At an aggregate level both financial "fixes" and the contractual fix were ultimately locked in through the Tariff Order, a subordinate legislative instrument applying largely to 2001 but in the case of the transmission cross subsidy, 25 years or 5 regulatory periods.

THE PRIVATISATION OUTCOME

By any standards the privatisation has been an immense success.

In terms of standards of service, regular reports by the Office of the Regulator-General have demonstrated that the private entities have improved performance in terms of reliability of supply and meeting customer demands for connections and response to problems.

All the DBs have considerably pruned and rationalised their workforce since privatization.  Although over-manning in the industry as a whole was considerable prior to privatisation, the staffing of the DBs continued to be excessive.

Numbers have been reduced from about 6,000 at the time of the creation of the five corporatised DBs to rather less than half of this.  One CBD distributor now employs only 40% of the staff it employed at the time of its sale, prior to which numbers had already been reduced.  Its rule of thumb has been that the employment saving has yielded a 30% cost saving with about 70% of the jobs being essentially outsourced.  Another Victorian business has outsourced much of its maintenance to an electrical contractor and made comparable savings.

With regard to the sale process itself, investors paid $8.3B for the 5 distribution businesses with initial ODRC valuations of $3.8B.  The first business sold, United Energy, was acquired by a consortium headed by Utilicorp and has since been partially floated.  Its sale price of $1594 million as well in excess of initial expectations but, at a PE Ratio of 10.9 on prospective 1996/97 earnings, it was acquired at a 20% discount on the average of the remaining businesses.

Proceeds From the Sale of the Distribution Businesses

	United Energy	Solaris	Eastern	Powercor	Citipower	Total
Sale Proceeds	$1,594	$943	$2,060	$2,128	$1,545	$8,270
Franchise Fees	$275	$137	$47		$173	$632
Total Proceeds	$1,869	$1,080	$2,107	$2,128	$1,718	$8,902
Proceeds in Excess of Book Value	$784	$539	$1,271	$1,107	$958	$4,659
1996/97 P:E Multiples	10.9	14.7	13.6	12.3	13.7

The Victorian Auditor General estimated the outcome in terms of savings to the State revenue at a net gain of $317 million for 1997/98 after taking into consideration revenue foregone and debt savings.  In addition, the reduction of State debt further enhanced State finances by contributing to an improved credit rating.

Regulatory Pricing and Access Issues

Energy Forum Paper

INTRODUCTION

The key issue in privatising infrastructure, and arguably the reason for it to be in public ownership, is the concern about natural monopoly.  A monopolist is able to extract high prices by reducing availability of supply or access.  This concern about "price gouging" and wasted supply is of long standing.

From modern economies' earliest stages, governments have exercised control over infrastructure pricing and access.  In their World Bank Note Back to the Future, Klein and Roger document the first monopoly franchises in gas and water starting in the 1820s with rates of returns on gas, water, and rail introduced by the mid 1850s in England and North America.

The issues for Victoria and Australia are:

• the structure and powers of the regulatory agencies
• the services to be regulated
• the standards that should be regulated
• the "just" price for the regulated services
• ensuring information is available to make satisfactory regulatory decisions without imposing undue cost on the businesses and regulators.

THE RELEVANT INSTITUTIONS AND THE REGULATED SERVICES

OVERALL REGULATORY ARRANGEMENTS

Australia's federal Constitution has brought regulatory tiers operating at the national and State levels.  Although the federal (Commonwealth) Government could probably assume overall regulatory control through its powers over trade and corporations, in practice inter-governmental agreements of 1995 have divided the regulatory tasks.

These agreements by the Council of Australian Governments (CoAG) established a National Competition Policy (NCP) for Australia.  They cover seven facets of reform:

• the review and, where appropriate, reform of all laws which restrict competition by the year 2000;
• the restructuring of public sector monopoly businesses;
• the introduction of competitive neutrality so that public businesses do not enjoy unfair advantages when competing with private businesses;
• access to nationally significant infrastructure services to promote competition in related markets;
• the extension of prices surveillance to government businesses to deal with those circumstances where all other competition policy reforms prove inadequate;
• the extension of the operation of the Trade Practices Act 1974 to government business enterprises and unincorporated businesses;  and
• the implementation of reforms agreed to by COAG covering the electricity, gas, water and road transport industries.

The centrepieces of the reform agenda were the opening of access for monopoly facilities, general deregulatory prescriptions and the insistence that governments ensure equivalent treatment for their own business enterprises with those that are privately owned.  The bulk of the documentation of the agreements covered specific matters on electricity, gas, water road transport.

VICTORIA'S REGULATOR

The Office of the Regulator-General (the Office) was established on 1 July 1994 under the Office of the Regulator-General Act 1994 (the Act).  The Office’s corporate objective is to give effect to the Government’s micro-economic reform agenda by regulating the electricity, water, gas, grain handling and ports industries and other industries which the Government may include within the Office’s mandate.

The regulatory framework ⁽¹⁾ sets both general and industry specific objectives for the Office is:

• to promote competitive market conduct;
• to prevent misuse of monopoly or market powers;
• to facilitate entry into the relevant markets;
• to facilitate efficiency in regulated industries;
• to ensure that users and consumers benefit from competition and efficiency.

Regulated industries comprise:

• The Victorian electricity industry which is regulated with respect to:
• price regulation
• standards and conditions of service and supply
• licensing market conduct
• access

• The Melbourne water and sewerage industries which are regulated with regard to
• standards and conditions of service and supply
• licensing
• market conduct

• Gas which is to be regulated with regard to:
• price regulation
• standards and conditions of service and supply
• licensing
• market conduct
• access

• The industry of facilitating export shipping of grain where regulations cover:
• price
• access

• Certain services in the ports of Melbourne, Geelong, Portland and Hastings where regulations cover
• price regulation
• standards and conditions of service and supply
• access
• Rail Track covering access

COMMONWEALTH REGULATORY AGENCIES AND RESPONSIBILITIES

Three institutions have been established to administer the National access regime (and the other elements of the National Competition Policy reforms):

• National Competition Council (NCC):  the Council is an independent advisory body for governments involved in implementing competition policy reforms.  In relation to access, the Council recommends to relevant Ministers which infrastructure services should be declared under the National regime.  It also considers whether other access regimes are effective (i.e. acceptable).
• Australian Competition and Consumer Commission:  the ACCC administers various parts of the Trade Practices Act and the Prices Surveillance Act.  In relation to Part IIIA, the ACCC can arbitrate the terms and conditions of access if, after a service is declared, the businesses involved cannot agree.  It also registers contracts arrived at by the businesses themselves.  And it decides whether or not to accept undertakings offered by infrastructure owners.
• Australian Competition Tribunal:  this body hears appeals on ACCC decisions regarding certain trade practices matters.  It also hears appeals on certain decisions made by relevant Ministers

In addition, there are other institutions with responsibilities which fall under the general oversight of the ACCC.  In the case of electricity, these are the National Electricity Code Administrator (NECA), which is the controlling authority for the code and rules governing the Market;  and the National Electricity Market Management Company (NEMMCO), which is the administrator of the Market.  The ACCC has authorised the general market rules and the access code.

COORDINATION AND DIVISION OF RESPONSIBILITIES BETWEEN COMMONWEALTH AND STATE REGULATORS

At both the State and Commonwealth levels, the regulators have been consolidated into single agencies so that they assume responsibility for all the regulated businesses.  This is to avoid what are seen to be inconsistent approaches from the UK arrangements where separate agencies handle gas, water, electricity and telecommunications.

Through the Australian Competition and Consumer Commission, (ACCC), the Commonwealth jurisdiction extends over telecommunications, airports, inter-State rail, and the transmission components of gas and electricity.  State jurisdiction is over ports, water, intra-State rail, and the distribution components of gas and electricity and in Victoria falls under the Office of the Regulator-General (ORG).  Roads also fall under State regulatory control but are not administered by the ORG.

Further to facilitate greater regulatory consistency between the different jurisdictional regulators, the heads of the State regulatory agencies are Commissioners of the ACCC.  In addition, the regulators have established a Public Utility Regulators Forum to bring about an integrated approach to regulation.  Establishing a pricing regime for Victorian gas distribution and transmission is the first matter covering both State and Commonwealth jurisdictional areas.  In their draft determinations the ORG and ACCC cooperated closely and came to a common view.

THE AUSTRALIAN ACCESS REGIME

The National access regime contained in Part IIIA of the Trade Practices Act sets out three mechanisms to assist businesses to obtain access to infrastructure services:

• declaration (and arbitration):  under this approach, a business which wants access to a particular infrastructure service applies to have the service "declared".  If it is, the business and the infrastructure operator are then required to negotiate terms and conditions of access.  If they fail to reach agreement, the terms and conditions are determined through legally binding arbitration.
• other "effective" regimes:  where an "effective" access regime already exists, a business seeking access must use that regime.
• undertakings:  this approach allows infrastructure operators to make a formal undertaking setting out the terms and conditions on which they will provide access to their services.  If accepted, these undertakings are legally binding, so other businesses can use them to gain access.

Under the declaration procedure, a third party may request the NCC to recommend declaration of the services of the facility to the Minister who, in deciding whether to declare, must be satisfied on certain matters, including that:

• access would promote competition in at least one other market;
• it would be uneconomic to develop another facility;
• the facility is of national significance;
• access would not be contrary to the public interest;  and
• the service is not already subject to an "effective" access regime.

Although the regime excludes a facility already covered by a State regulatory regime, in effect such a facility would be brought within the national regime if it departed markedly from the National principles.

The NCC recognised that access regulation can also entail costs if it is applied inappropriately or too widely:

• it may diminish incentives for businesses to invest in infrastructure facilities and thus limit, rather than enhance, overall competition and economic efficiency;
• compelling infrastructure owners to provide access to others necessarily can impinge on their private property rights;
• legislated access regimes may represent an overkill and engender further market distortions in some situations.

The NCC issued a guide to the National Access regime ⁽²⁾ which described "essential" infrastructure, like gas and water pipes and electricity wires, as a special case where competition is likely to be absent.  It saw such facilities as having substantial market power, which their owners could exploit by charging monopolistic prices to user businesses and hence consumers.

In addition, it saw the possibility of a business which operates essential infrastructure and a commercial arm in upstream or downstream markets discriminating against upstream or downstream competitors by denying them access or offering them access to its infrastructure only on unfavourable terms and conditions.

Structural separation of the industry is one solution to this.  This leaves the essential facility as a stand-alone business.  The issue of whether and how far to de-integrate the previously integrated monopolies is one of contention world wide.  In Victoria, the electricity supply was divided into three components:  generation, transmission and distribution/retailing.  In the case of gas, retailing and distribution have been structurally separated.  Disagreements between the Victorian Government and the regulatory authorities over the price base for the pipeline services delayed the privatisation of the gas industry.

Although structural separation offers greater certainties that a business will not abuse its monopoly over essential facilities to benefit an affiliated retailing arm, deintegration can impose administrative costs.  The benefits of requiring a separation of retailing and distribution, while conceptually present, are less apparent in practice.  In Victoria, there has been a remarkable absence of claims of the two arms of the same business in electricity colluding so that the retail arm wins business either by having an excessive amount of shared costs loaded on to the monopoly or by using information to its competitive advantage.

Further evidence of a lack of monopolistic abuse is seen in customer switching.  If the incumbent distributor/retailer were to enjoy strong market advantages, we would expect to see little change in market positions where customers are made contestable.  In fact, the experience in Victoria and the UK has been that some 40 per cent of customers have switched retailer once given the opportunity.

It may be that an even higher degree of churning would have occurred had the nexus between wires and retailing been forcibly severed.  But there have been few voices claiming this in Australia.  There is, in addition, no apparent call for such separation in either the US or UK.  Indeed, there has been little discussion of these matters in the material addressing the Californian nor the Federal US regulations.

REGULATION, THE INFERIOR SUBSTITUTE
FOR MARKET DISCIPLINES

FORCING COMPETITION OR MAINTAINING SECURE PROPERTY RIGHTS

Competition policy often means balancing property rights against a requirement on owners to make their property available to others.  It is therefore a conflict, clearly recognised by the NCC, between two facets of efficient operations involving capital assets:

• the incentive to minimise costs, seek out more valued uses and commit to capital expenditure that absolute control over a property offers individuals;  and
• the downward cost pressures and increased innovation that the rivalry of many different suppliers and many different customers brings.

In the past, government ownership provided the means of overcoming this conflict when inherent natural monopoly was perceived.  But the deficiencies of that ownershipÐhigh costs, lack of innovation, exclusion of alternative suppliersÐhas been the stimulus to privatisation and its cousin corporatisation.

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, few would argue for the regulated route to be used except as a last resort where competitive provision is not possible.  And the competition policy carefully limits the application to facilities that are not "economically feasible to duplicate", ⁽³⁾ where access is "necessary in order to permit effective competition in an upstream or downstream market" ⁽⁴⁾ and where "the facility is of national significance". ⁽⁵⁾

Many go further and argue against forced de-integration.  Thus, Crews ⁽⁶⁾ argues that electricity networks do not have natural monopoly characteristics anyway.  He maintains that the potential for competition in network industries is greater than is usually acknowledged, and that regulation for open access (ie mandatory separation of network businesses) is tantamount to an "uncompensated taking" of private property.  Crews’s major recommendation therefore is the abolition of monopoly franchises and the removal of regulation altogether.

In the same vein, Pleatsikas and Teece ⁽⁷⁾ argue that vertical integration allows greater control of production, better integration of the delivery of the final product, and reduced risk.  They develop their theme from the traditional "make or buy" decisions that all firms face noting that no firm does everything in-house nor do many firms subcontract all their output.  They recognise that costs will be shifted to competitors' outputs where there is monopoly, but consider the benefits outweigh these costs.

Similarly, several papers by us ⁽⁸⁾ have pointed out that regulation may also reduce efficiency if it prevents backward and forward linkages by requiring common carriage when risks may be reduced by integration.  These argue that risk is the most important feature of major capital investments and can be reduced by forward and backward linkages.

DEVELOPMENTS IN COMPETITIVE PROVISION OF INFRASTRUCTURE

The Victorian Office of the Regulator-General is examining a by-pass proposal by one distribution business seeking to push new competitive lines into the territory of another.  This is a potent discipline on a business to price its services at levels that reflect cost of service.  At the present stage the proposal has not been accepted due to doubts about the conditions under which the distribution assets were sold.

Even though by-pass is not forbidden and provides a strong market based discipline on providers, the ORG proceeded with excessive caution.  It asked such questions as:

• Would overlapping distribution areas impose an appropriate level of "competitive discipline"?
• Can the Office be satisfied that sufficient or effective competition will exist with more than one licensee approved to supply the Docklands area to enable the relaxation of price controls?
• What considerations need to be addressed in assessing the competition efficiency trade-off?
• Should the Office allow more than one network service provider to distribute electricity in the Docklands?
• Is the development of dual (or more) networks in the Docklands likely to be economically efficient?
• How will the approval or otherwise of Powercor's licence variation affect the financial viability of the industry?

These are early days in the Victorian electricity market and the nature of these questions indicates that the ORG is not yet convinced of the merits of competition as the superior regulator.  Instead of seeking to improve on competitive outcomes, the regulator should be simply saying, "We are in business to promote competition.  We are not about protecting one set of shareholders or second guessing whether a by-pass makes economic sense.  The ability to offer competition is the ultimate test of whether the regulated price is appropriate and the provider has every opportunity to selectively reduce price to meet competition.  An application for a new line is automatically accepted."  Hopefully, with greater experience the regulator will move to this position.

AUSTRALIAN REGULATORS' APPROACHES TO PRICING ISSUES

MODELS OF DIFFERENT REGULATORY APPROACHES

The main price and access regulatory decisions are to be made in future years.  Integral to the privatisation of electricity was a five year Government determination of the prices for the "essential" facilities.  For electricity, a post 2001 review is to establish prices on the basis set by a regulator rather than governments.

There are three models under which network facilities might operate:

1. the no-regulation option where market forces are left to determine price and service levels;
2. 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 (CPI-X); ⁽⁹⁾
3. a model where the regulator carefully examines all required expenditures of each line business and determines the necessary expenditure and, in effect, profit levels.

The no regulation model is the preferred approach but the issue is how practicable is it?  How much is the provision of infrastructural services open to competition or contestable?

Although there is no substantial regulation of generation or retailing, the networks were envisaged as indefinitely remaining natural monopolies.  This requires a regulator to determine the "just" price, one that mimics the outcome that would be expected to arise is the market were competitive.  As is being observed in the applications to bypass established facilities, the assumption of natural monopoly must be subject to doubt.

Nonetheless, the Victorian intent is to pursue a regulated price path.  The specific approach offered by draft proposals by the ORG ⁽¹⁰⁾ is for CPI-X price regulation, but the complexity and the forward looking and individual business based nature of the present proposal places it some way between the CPI-X price cap and the third model of profit regulation.  This approach, which tends to be that followed in the UK, will require considerably more information to be generated than one (referred to in Victoria as US style price capping) ⁽¹¹⁾ that sets future prices based on the overall industry trends.

RECENT DECISIONS ON PRICING

A pointer for the future philosophy of price setting is offered by the draft decisions of the Victorian ORG and the ACCC on the Victorian gas distribution and transmission systems.  Those draft decisions set reference tariffs and overall revenue levels 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 draft is estimated to reduce the value of the Victorian gas distribution businesses by some $800 million.

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

ADDRESSING THE APPROPRIATE
PRICE REGULATION PHILOSOPHIES

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 some 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.

Requiring lower prices than those set under the implicit regulatory contract of government ownership (or some lower level specified by the government-owner) could distort the arrangements that have been established.  If the regulator requires lower prices, 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 on gas has inevitable ramifications for all infrastructure.  The price path 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.

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, an outcome at variance with the basic goals set for the regulatory authorities.

In addresses to the Energy Forum Conference ⁽¹²⁾ Regulating Electricity Utility Monopolies, the Deputy Chairperson of the ACCC (Mr Asher) and the Victorian Regulator-General (Dr Tamblyn) stressed that the decisions on gas networks were draft decisions.  Mr Asher said that the 7% capped return on the Victorian gas network system may be realistic for that particular network given its established and stable throughput.  He said that:

• "new pipelines would be addressed quite differently from the well established Victorian system. .... Under the tender provisions of the National Gas Access Code, as replicated in the Victorian Access Code, a regulated WACC does not apply to the establishment of reference tariffs.  Instead the regulator merely monitors the competitive bidding process to ensure the bidder that offers the lowest expected tariff levels over the lifetime of the pipeline wins the contract. ... As such (the procedure) automatically takes account of any special risks that may be associated with a greenfields project."
• "the WACC derived for the Victorian access arrangements (need not apply) to other industries like telecommunications, airports, rail or electricity."  He said a case by case approach would be applied to provide the right incentive for investment.

The statements of the regulators clarifying their draft decisions on Victorian gas offer some comfort, but they do rely either on a competitive tender establishing a market price or a regulator having the same view of the risk/return requirements as a commercial entity.

In the first case, requiring competitive tenders rules out an entrepreneur simply spotting an opportunity and proceeding to profitably serve it.  A requirement for tenders is likely to reduce incentives to search out such opportunities.

As far as the regulator establishing a fair return is concerned, the draft decision setting a 7% WACC for the Victorian has not given investors a great deal of confidence in the regulators' commercial judgements.  And, notwithstanding the regulators' statements, the draft decisions inevitably have implications for all gas and electricity carriage businesses and extend into other network providers like telecommunications and water.  This is certainly perceived to be the case by investors, who have sharply marked down the share value of other carriers like United Energy.

WIDER IMPLICATIONS OF RECENT DECISIONS

The regulators see their role as the prevention of possible price gouging by businesses controlling "essential facilities".  However, the lines businesses in gas and electricity are not immune from competition, as is evident by the plans of rival Victorian electricity distributors to drive new lines into each others' territory.  The nightmare for a utility business is that 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 will obtain benefits.  But prices set artificially low will prove self-defeating.  Suppliers will seek to incur only minimum expenditures to maintain and expand the facilities, which will eventually become less reliable.  Artificially low prices also offer unfair advantages to existing generators facing possible competition from co-generators able to locate in areas where they avoid transmission charges.  And customers will not have an opportunity to seek out an alternative wire or gas source of supply, because the regulator's decisions ensure such sources will be unprofitable.

NEW NETWORK FACILITIES

Australian regulators have not always been keen to abandon controls even where there is adequate competition. ⁽¹³⁾  Where there is more than one facility or the possibility of more than one facility regulatory action should be a mere formality.  To date, the regulators have indicated a wish to maintain regulations even where supply is from two sources.

This is excessive.  Indeed, with an absence of exclusive franchises, there is no case for regulatory control over a new facility.  After all a new facility serves a market that by definition was previously unserved.  The customers of that facility can only be made better off.  And regulating a proposed new line may undermine its profitability and result in fewer pipelines being built or being built at a lower than optimal capacity.  The builder may not wish to be hostage in future to regulatory decisions over what is a fair price for carriage.

CONCLUDING COMMENTS

Pricing of "essential" facilities is likely to be the most controversial aspect of the Victorian privatisation process.  It is already requiring vast amounts of information and heated debate over the appropriate approach (setting prices based on industry averages versus business-by-business) and the appropriate rate of return.  These are issues of vast importance in view of the "sunk" nature of the costs of provision.

The key task for a regulator is to determine the "just" priceÐthe price that would emerge if the market were fully competitive.  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.  This can be supplemented by assessing the costs today of undertaking the sunk investment and deducting that part of the investment that has not proved appropriate.

Had the proposed price regime been in place when the gas pipelines were being planned, no commercial organisation would have considered the proposed 7% return sufficient to justify the risks of building them.  This is of crucial importance to the future competitive process and incentives to develop the systems.

Victoria's privatisations and utility de-aggregations have been an immense success in delivering lower prices and greater efficiency.  This success will be jeopardised if the regulatory arrangements suppress competition and divert firms' resources into combatting the regulator rather than better serving the market.

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ENDNOTES

1.  http://www.reggen.vic.gov.au/docs/about/offobj.htm

2.  The National Access Regime:  A Draft Guide to Part IIIA of the Trade Practices Act, August 1996.

3.  Competition Policy Agreement April 1995, Clause 6(1)(a).

4.  ibid, Clause 6(1)(b).

5.  ibid, Clause 6(1)(c).

6.  Clyde Wayne Crews Jr, "Why Open Access Can't Compete", April 1998, Cato Policy Institute, Washington DC

7.  Pleatsikas C. and Teece D, The Competitive Implications of Mandatory Vertical Disintegration in Network Industries, Ninth Annual Workshop of the Competition and Law Policy Review, July 1998

8.  Submission to the ACCC:  Access Arrangements by Transmission Pipelines Australia, Energy Forum Issues Paper no. 9, June 1998

9.  Usuallly attributed to Littlechild, S. Regulation of British Telecommunications' Profitability:  Report to the Secretary of State, February 1983.

10.  Consultation Paper No. 1 2001 ELECTRICITY DISTRIBUTION PRICE REVIEW, Framework and Approach, June 1998

11.  Kaufmann L, and Lowry M.N., Updating price controls for Victoria’s power distributors:  analysis and options, Laurits R. Christensen Associates, Sept. 1997

12.  The Shell Theatrette, Melbourne 24 July 1998.

13.  See Australian Competition Policy:  Deregulation Or Reregulation, Institute of Public Affairs, Melbourne 1998.