Aged Care

Few issues occupy the minds of baby boomers more than ageing.

The concern is not just with our own mortality and retirement, but also about what to do with Mum and Dad as they become increasingly dependent on us.

Of course, we are hardly the first or last generation to confront this dilemma.  It's just that there is so many of us;  our expectations are so high and so many of us are unprepared.  Also our parents, thanks to the wonders of modern medicine, live decades in retirement rather than the few years experienced by their parents.

While advances have been made in some policy areas notably retirement incomes, other policy areas in particular residential aged care has floundered.  Hopefully a series of studies launched this week by the Myer Foundation will spur debate and reform in this area.

One thing the studies make clear is that the status quo is not sustainable.  Unless thing change there simply will not be enough money available to maintain an acceptable level and quality of aged care services.  Moreover, while the studies are exploratory;  they make it clear that while governments should remain the dominate funders of age care, individuals need to make a greater contribution were they can.

More specifically the studies will rekindle debate about the need to use the family home to fund residential care.

Back in 1997 the Federal Government developed wide ranging reform to residential care including higher standards, greater investment and a rigorous accreditation process.  The Government had proposed that individuals in high level care aged homes be charged an asset tested capital bond and that the family home being included asset test.  A huge protest ensued lead in large part by the babyboomers who stood to inherit the home.  The reforms are now being implemented without the funding and providers are now exiting high level residential care.  The government has made up some of the short fall in funding but not all.

The studies show that many elderly have the capacity to contribute.  The average wealth of people over 65 years of age is around $225,000 per person and $400,000 per couple.  Most (71 per cent) owned their own home and the home is easily their most valuable asset.  Other studies show that people entering retirement home seldom return to the family residency and most sell, rent or give the home over to others.

The studies indicate that there are various mechanisms available to extract value from the family home to fund the capital bond without forcing the complete sale of the home.  The bond would not take all or even the majority of the retiree assets.

The study also highlights the need for long term incentives to save.  If people think that the states will pick up the bill, they will not save.  It is important therefore to send a signal to the pre-retirement population that they will be called on to contribute to their retirement cost.  Given that real estate is also the most importance investment vehicle for the young, it should be considered in the funding of their post retirement spending.

This will dismay many babyboomers, but its logic and fairness is overwhelming.

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An Enterprising Struggle: the Capacity to Manage Index

In the mid-1980s, considerable community debate began on a reform agenda for the Australian industrial relations system.  A central agreed principle emerged that workplace relations should be determined to the greatest extent possible at the enterprise level between the employers and employees.

The idea was that an enterprise focus would:  help erode the "them vs us mentality" that plagued Australian workplaces;  give workers an incentive to accept and gain from productivity improvements;  and provide management with a greater capacity to manage and compete.

While the labour movement was initially resistant, the benefits of greater enterprise focus were slowly accepted by all parties.  And enterprise-based agreements (EBAs) now govern the majority of large (100+ employee) workplaces.

Has the shift to enterprise based regulatory system produced the goods?  While, overall, reform has clearly generated major benefits including higher productivity, higher real wages, and fewer disputes as well as contributing to lower interest rates and greater employment, the contribution made by EBAs is unclear.  There have been a host of other reforms, which could account for the received gains such as the introduction of individual contracts, the reduction in award coverage to 20 allowable matters, and limits on the rights of unions.

My research published this month shows cause for concern about the effectiveness of EBAs.  The research which focused on two of the admittedly more troubled industries, food manufacturing and commercial construction, found that the majority (76 out of 85) of EBAs examined reduced the capacity of enterprises to respond to market demands and opportunities.  That is the majority of EBAs are more restrictive than relevant award (which was used as a benchmark) and the majority of clauses in EBAs restricted rather than enhanced the capacity of firms to respond to opportunities.  Moreover many clauses in EBAs seemed to neuter management in critical areas.  Some firms have negotiated EBAs which provide greater flexibility to management, but theses are few in number and the improvements comparatively small.

The EBAs examined varied tremendously in terms of flexibility with Grocon's national agreement being the worst and Rightway Electrics' NSW agreement being the most flexible.  Interestingly there were significant variations across agreements negotiated by individual firms.  For example Thiess's Victoria agreement was rated a negative 21 while Theiss's Queensland agreement was rated a negative 2.

The food industry fared better overall than construction industry.  Within the food sector, Nestle's Echuca agreement was found to be the least flexible and Sanitarium's Morooka agreement rated the highest.

Victorian based EBAs produce a significantly lower capacity to manage than agreements covering operation in NSW or Queensland.  Also non-union EBAs appear to result in greater capacity to manage than union EBAs, though the sample size of non-union EBAs in the study was small.

In short, EBAs appear to be failing one of their central functions, which is to enhance the flexibility of enterprises.  This is an important finding which much be addressed if Australia is to maintain its recent good form in productivity growth.  And it will need to be address soon as a large proportion of federal EBAs are due for renegotiation in 2003.

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Melbourne's Private Transport Move Just the Ticket

Public transport is seldom analysed with the same detachment seen with other service industries.  Its shortcomings have a high public profile and capacity for disruption of ever day activities.  Thus it was in Victoria where union militancy in the industry convinced the Kennett Government to include it within its privatisation agenda.  This culminated in selling different elements of the train, tram and bus systems to three separate private operators.  The buyer of the largest part of the system was National Express which has announced it will walk away from its tram and train operations.

Public transport privatisation added to the $30 billion raised by the Kennett Government's asset sales in gas and electricity, ports and gambling.  The prices many of those assets realised reflected considerable over-optimism on the part of the buyers.  At the same time the privatisation outcome virtually wiped out the State's debt.  The Bracks Government inherited the benefits of this in terms of its budgetary position and much improved management of the State's infrastructure assets.

Transport was no exception to the over-exuberant bidding for Victorian government infrastructure services.  As in most cities throughout the world, Melbourne's public transport does not pay its way.  At privatisation 57 per cent of costs were borne by the taxpayer.  This required an unconventional sales process.  Under the sale agreement, the Government retains ownership of the assets and agreed to a gradually reducing level of subsidy.  The Auditor-General estimated the deal with the three successful bidders was worth $3.4 billion compared to the costs that would have been incurred.

Estimating the worth of a loss-making enterprise is never easy.  Moreover, with Melbourne's public transport it was made more difficult because actual measures of the patronage and losses are clouded by great uncertainties, especially due to fare evasion.  This gave rise to on-going discussion about some details of the sale after the buyers' management was in place.  In February of this year a settlement was negotiated under which the Government agreed to pay an additional $110 million to the businesses over the next twelve years.  In return the businesses agreed to double their performance bonds to $210 (the National Express share was $135 million).

Hence, National Express will incur considerable penalties from the performance bonds and other sunk costs in, effectively, leaving its operations under government receivership.

In addition, the Government will see fewer cost savings.

Even so, the taxpayer and Melbourne public transport user has done well.  The system is much improved.  For the first time in fifty years, last year saw public transport increase its share of Melbourne's total transport market due to the improvements that have been brought about since privatisation.  These include a 35 per cent reduction in delays and cancellations, considerable new investment in better vehicles, and an extension of the network.

Even though the Kennett Government had already considerably cut costs, National Express clearly saw means of making additional savings.  Importantly, the system's bloated labour force had been trimmed from 19,000 workers in 1990 to 9,000 at privatisation.

Further cost savings would require some innovative working arrangements.  Such arrangements would entail making greater use of split shifts and part time workers.  National Express has such measures in the UK with considerable benefits to productivity, and in many cases to employee satisfaction.  But in the UK 15 years of "Thatcherism" had extracted the teeth of union militancy by the time such measures were introduced.  Although Victoria's private companies enjoy much better union relations than had been experienced under public ownership, they had little prospect of Victoria's unions acquiescing in such flexibility.  This would be particularly so after the demise of the Kennett Government.

While the privatisation of the Victorian public transport system has brought considerable benefits it would be preferable to avoid the management instability that follows a forced sale or exit.  One option on privatisation could have been to sell all the trains, all the buses and all the trams as three separate competing entities, rather than have businesses owning some but not all the trams and trains.  The option of having three rival owneres, each with a separate mode of transport is an outcome that might in fact emerge from the National Express departure.  Yarra Trams, owned 50/50 by Transfield and French owned Transdev, is certainly keen to buy National Express's M Tram business.  National Express itself is not considering walking away from its bus operations.  Another French company, the globally troubled Vivendi, owns the third (rail) business.

Whatever develops, the Victorian Government knows all about the shortcomings of government being the owner-manager of commercial enterprises.  It will seek to re-divest itself of the National Express tram and train business at the earliest opportunity.  It will do so recognising that the public transport system has made considerable economies and seen a new improved management introduced.  In this respect, the original sale is best viewed as a transition to a different structure not a blind alley to be renavigated.

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Victorian Libs must not give in to expediency

Probably no set of ideas will ever completely dominate an Australian political party, still less a government.  Nor will any victory last forever.  But the near 50-year history of the group known as the Dries chronicles a time when national policy came to be substantially influenced by a group of federal Liberal MPs and contains powerful lessons for today's Liberals.

A my new book, Dry:  In Defence of Economic Freedom, is invaluable contemporary history:  it is a fascinating insight into federal politics from the 1960s to the present era, a tour de force on the role of ideas in politics, an interesting statement of Dry principles and policies, and a practical politician's guide to what works in government-driven reform.

Its message on the importance of ideas is strong and immediate for Victorian Liberals.

Victoria has just been through an election in which the Liberal Party was routed.  For those who loudly and repeatedly repudiate the past achievements of their party, I recommend my discussion of the best approach for reform-driven governments.

Ever the practical person, I acknowledge that rapid and broad fundamental reform might cost some votes but I also make the point that the Kennett government's standing was highest when its reform agenda was most active.

Government is not an end in itself;  they lose power for many reasons -- not always reasons entirely under their own control.

The Kennett government's inheritance from Joan Kirner demanded radical redress.  Moving on as broad a front as we could manage divided our opposition.  Even formerly tightly organised groups such as the trade unions, faced with fundamental change on virtually every front, found it difficult to marshal effective opposition around any single issue.  Unable to fight on one front, in fact, they found it difficult to fight at all.

I characterise Jeff Kennett as believing "better a one-term premier than a failure".  Like most snapshots, this oversimplifies Kennett, but if those were the options, then I for one would make the choice I attribute to Jeff.

Much of what the Kennett government achieved is important.  Much of it cannot be undone.  In many cases, they gave people more power over their own lives and cut the power of vested interests.  They certainly consciously set out to do so.

It is not to agree with all my analysis to concede they made mistakes -- everyone does.  But I have no doubt that had the Kennett government adopted a gradualist and piecemeal approach, Victoria would be less prosperous and less free than it is today.

Those who want their community to be improved must take the opportunity they are given.  To defer doing the right thing is not only to abandon the trust people give when they elect a government but to risk never having the opportunity to implement what has been delayed.  Moreover, there is ample evidence that reforming on a wide front reduces effective opposition and neutralises the power of vested interests.

On the other hand, there is scant evidence that well-founded reform necessarily costs reforming governments office.  Political parties are more likely to fail if they are seen not to believe in anything, don't have a clear plan and appear opportunistic.

There are governments content to do little or nothing;  to attempt popularity by never risking antagonising anyone.  I believe that that is not a viable long-term political strategy.  The electorate has an innate good sense that sees through such abdication of responsibility and common sense.  It was never an option in 1992, and perhaps it was to Victoria's long-term good fortune that its political leaders of the time probably could not have governed like that anyway.

My colourful history makes similar points as the Dries stand true to their principles through the political expediency of successive Australian prime ministers.

Prime ministers do not fare well in the book.

I found surprising credit in Bob Hawke's record but am generally scathing about the expediency of Liberals and, especially, about Paul Keating.

The Dries' battles began with Robert Menzies.  I describe how, for his own ends, Menzies encouraged the Dry icon, Bert Kelly, to argue against 1966 tariff legislation, then, when his stand might have driven the Country Party from the Coalition, how Menzies "arose and descended on (Kelly) from a great height and gave McEwan the opportunity to do the same".

The political realist, I conclude "Such is politics", but neither Kelly nor the other Dries were dampened by such experiences.

I am especially critical of Malcolm Fraser, concluding two somewhat sardonic chapters thus:  "On March 5 (1983), one of Australia's less satisfactory governments came to its anticipated end".

I compliment Hawke (and, as treasurer, Keating) for implementing many Dry policies (with the marked exception of labour market reform).  But I am strident in my condemnation of Keating's cynicism on John Hewson's Fightback! package.  I acknowledge Keating's political gutter-fighting ability but pen a pithy epitaph:  "Keating traded the opportunity of a very honourable place in Australian political history for another term as prime minister".

The difference between the attitude to political principles of the Dries and that of the New South Wales Labor Right is writ large when one can easily imagine that, while Keating would want longevity and history, forced to choose, he would regard my conclusion as the better deal.

Mine is a timely warning against expediency and a powerful argument for sound policy founded in consistency to principles -- it works politically and it benefits the community.

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The Big Dry ... Our Saviour

Australia is today's true miracle economy.  In the past decade, our economy has gone from strength to strength.  After weathering the 1997-98 Asian financial storm, we're into the 21st century with sustained economic growth of up to 4 per cent, unemployment less than 7 per cent, inflation less than 3 per cent and record low interest rates.  The long downward trend in our living standards has been reversed.

What's more, Australia's remarkable economy has been achieved at a time when western Europe, the US and Japan are either recording low growth or mired in deep recession.  No wonder John Howard boasts that the Australian economy is "the envy of the industrialised world".

So whom should we thank for Australia's impressive economic performance in the face of a deteriorating international environment?  I suggest we thank the "dries", that group of economic thinkers who have fought the good fights to make the Australian economy less dependent on the nanny state and more competitive in an integrated global economy.  Also known as economic rationalists, the dries sought to replace the wets' high-taxing, big government agenda of the 1970s with a set of free-market policies such as deregulation, privatisation and tariff cuts.  By the mid-'90s, their agenda -- with the exception of labour market reform -- was substantially achieved.  The result?  Australia's miracle economy.

Following Gough Whitlam's defeat in 1975, Australians began to appreciate the philosophy of economic liberalism.  Yet little changed in the way we were actually governed.  In the Fraser years, 1975 to 1983, the dry ideal found many champions in and outside of federal parliament.  But despite his 55-seat majority, Fraser was a cautious, even timid prime minister who was terrified of vested interests.

Fraser's policies were a grab bag of popular measures including some that were inconsistent with the core undertakings to restore the economy to health, return the budget to responsible balance and reduce unemployment.  He failed to cut stifling regulations, tariffs and licences that favoured the few at the expense of the many.  And although he reduced the government deficit by raising taxes, he squandered even that gain by trying unsuccessfully to buy office with the 1982 budget.

But from 1983 onwards, the Hawke government embarked a period of genuine radical leadership, to an unusual degree taking the public into its confidence.  Chastened by the performance of the Whitlam government, the Hawke governments advanced the long-term national interest by deregulating the financial markets, floating the dollar, cutting import protection and privatising and deregulating inefficient state-run industries.

The attitude of the Coalition opposition was at least as remarkable.  After all, oppositions are usually much less responsible than governments.  But chastened by the performance of the Fraser government, the Howard and Andrew Peacock-led oppositions allowed the government to reform without political cost.

The Hawke administrations deregulated, reduced industry protection and privatised with a will that matched any government anywhere then, or at any time in Australian history.  It cut wasteful expenditure and produced substantial budget surpluses.  The opposition often led the debate.  Good policies were on the whole defended with economically rigorous argument -- Hawke's response to the Garnaut report on zero tariffs, for instance.  The leaders led, and the electorate returned Hawke several times at the height of his government's reforming zeal.

OF course, the decade of reform from 1983 to 1992 did not arise from the Pauline philosophical conversion of our political leadership.  It had known what it ought to be doing well before 1983.  But from the time of the Hawke government, both main political forces mustered the intestinal fortitude to accept advice from conventional sources to pursue policies, such as tariff and public deficit reduction, that could not yield public benefits and votes until well beyond the immediate elections.

Asserting that they would sooner not be elected than abandon policies that they knew were in the national interest, Labor, Liberal and National Party leaders defended them -- in short, they led.  Today's prosperity is largely due to those policies of the '80s.

But since those heady times, spooked by minor parties that filled the populist space that they had vacated, our leaders have been significantly more willing to compromise policies that they know to be in the long-term national interest.

In the '90s, the federal government's inclination for reform abated.  Federal politicians who once led the charge for economic freedom and generously supported a reforming Labor government have reverted towards, but not yet to the habits of, the Fraser years.

The defeat of John Hewson's Fightback! package in 1993 was to a disingenuous campaign.  Paul Keating's spending spree was like Fraser's a decade earlier, although at least he left us competition policy.

At least Victorian premier Jeff Kennett was about to give Victorians an economy that could again compete with rest of the nation.

As prime minister, Howard has not matched his promise in opposition in the '80s.  Still, he got the federal budget into good shape only to squander much of the gain and some additional GST revenue prior to the 2001 election.  And although he was not blessed with a co-operative opposition, Howard tried to reform the labour market.  But while he has attempted to reduce government favouritism in ethnic, employment and social welfare policy, he's increased the privileges available to several industries.

The benefits that Australia enjoyed in the past decade were only those that the "dries" predicted in the '70s and implemented in the '80s.  Our changed fortunes did not come about by chance and it's clear that the gains could all too easily be squandered.  Because today's policies determine tomorrow's living standards, it would be tragic if Australians forgot how today's miracle economy was achieved.

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Gas in the Parer Review

An address delivered to the conference:
Power in the South East,
Melbourne, 3 December 2002

The Parer report was fundamentally about the electricity market.  Gas and to an even greater extent environment and regional issues were tacked on.  Understandably, most commentators have not been disappointed at the quality of the electricity recommendations, but rather surprisingly in view of their secondary status, the environmental suggestions are also well thought through.  The many issues concerning gas market arrangements are, however, treated in an over-truncated form.

Regulation's role in the gas industry

As with electricity, gas is best analysed as comprising four elements:

• supply of gas (which unlike electricity might include storage),
• transmission along high pressure pipes,
• local distribution, and
• retailing.

Of the four elements of gas delivery, distribution alone is an uncontestable natural monopoly.  For the other elements control is normally best left to commercial market forces.

Once in situ a local network is unchallengeable except from alternative fuels.  Although there are occasional examples of a rival duplicating an incumbent's distribution network, this is unusual and probably socially wasteful.

While transmission and production might also have monopoly features, these are likely to be far less persistent than with distribution.  New sources of gas supply will usually be found if prices are attractive.  With transmission, rival networks can be built to contest an incumbent's market.  Such a possibility is, of course, reduced to the extent that regulation is in place and brings prices lower than those that would otherwise prevail.  Gas supply and transmission are also different from distribution in that their development decisions and final customers involve commercial parties capable of contracting with each other for long periods.

The 1994 CoAG decisions

In 1994, the Council of Australian Governments (CoAG) agreed to "free and fair" trade in natural gas both intra-and inter-state.  Part of this involved an agreement to create no additional exclusive franchises for retail, distribution and transmission and to make existing franchise arrangements more competitive.  Government sanctioned franchises were seen to be bringing inadequate incentives for pipelines to operate efficiently and to develop.  The monopoly status they created also gave rise to the need for considerable regulatory intrusion to prevent abuse.

The 1994 CoAG approach reversed previous practice under which gas pipelines were either exclusively owned by governments or were only permitted to operate with government approval.  The previous approach had seen the need to vest exclusive control over a market to a single pipeline.  This was based on the notion that there might otherwise be unnecessary duplication and therefore risks that investment returns might be harmed.

Under the previous approach, the transmission pipeline and distribution businesses were affiliated and prices were controlled either directly where the government owned the businesses, or indirectly where it franchised the activity.  The new policy approach was designed to make the gas industry more responsive to demand and to introduce greater entrepreneurship, risk taking and therefore innovation on the part of pipeliners.

THE GAS RECOMMENDATIONS

The CoAG Review's key recommendations on gas are

• introduce binding up-front "coverage" rulings
• offer 15 year economic regulation free periods for new transmission pipelines
• provide for up-front regulatory agreements
• change the governance and regulatory arrangements
• conduct an independent review of the Gas Code
• apply a code of conduct to non-covered pipelines to ensure a competitive market
• encourage greater competition through separate marketing
• include criteria to promote competition in acreage management regimes
• undertake a review of the industry's principles for access to upstream facilities.

The last three of these are about unravelling contracts or settling acreage on players who do not offer the best prospects of early discovery.  I won't address these essentially upstream issues but doubtless Esso/BHP, Santos and others will have things to say on them.

The middle three concern governance and more detailed review.  Importantly the review of the pipeline Code is overdue.  It has proven to be excessively bureaucratic in its operation.  The present framework has been developed on an ad hoc basis with often contradictory elements.  The more important features causing this development to be flawed have been:

• the extremely high hurdles that the regulatory authorities have established with regard to the number of competitors required before they allow unregulated markets to operate.  These hurdles would prevent almost any pipeline from being regarded as sufficiently disciplined by competition to allow for a withdrawal of regulatory control;
• a National Gas Code that is heavily weighted towards the assumption of the need for regulation with such features as a queuing policy (a role which price performs in the economy generally) and a very prescriptive cost-based guide to pricing which takes no account of market risk.

This aside, the different treatment of gas and electricity is likely to cause distortions in investment.  These differences include:

• Different VoLL levels;  the $10,000 per MWh in electricity is much different from the $800 a day per GJ for gas
• Bidding and rebidding is on a daily basis for gas and five minutes for electricity;  clearly the gas market needs to be more frequent.
• Setting regulated prices for gas and electricity on a consistent basis.  These are established on a revenue capping basis for electricity but a price cap is essentially the gas regime.  Revenue capping owes its popularity to environmentalists' pressures to prevent actions that might "waste" scarce resources.  It is claimed that a price cap would encourage the transmission business to sell more energy than was needed.  Such notions belong to an earlier era.  All businesses seek to persuade consumers to buy more of their product and the price system ensures the appropriate incentives are in place optimise increased sales with conservation of supplies.

Returning to the key recommendations of Parer, with the first three issues the draft is quite innovative and courageously so.

In looking for binding up-front rulings on coverage, the review recognises the importance of risk minimisation in achieving the optimal level of investment.  Such assurances are usually resisted by regulators, who wish to maximise their opportunities to re-visit decisions.  Parer rejects, or severely limits the NCC's wish to see scope for revocation of the binding.

The report is also to be commended for building on proposals, which we have previously made and which were endorsed by the Productivity Commission in its review of Part IIIA of the Trade Practices Act.  These include "regulatory holidays" for new transmission pipelines.

The only case for regulation of new pipelines, now that franchises are no longer part of the Australian regulatory regime, rests with their eventually becoming an "essential facility";  competitive conditions make this unlikely but the Review's proposal of a 15 year regulatory holiday would accommodate such possibilities.

Allowing provision for up-front regulatory arrangements is a variation of this.

In seeking to limit regulatory oversight, the Parer report recognises the disincentive that a regulator, always anxious to avoid being stigmatised as having been "captured" by the industry it regulates, will prescribe rates that are seen by the developer and risk taker as too onerous.

Since the implementation of the National Gas Code, a number of decisions made by the ACCC and other regulators have forced pipeline owners to accept prices that are lower than those that would have been voluntarily entered into by the interested parties in the market-place.  GasNet is the latest of those, with the ACCC setting a WACC return about 20 per cent below that sought by the company as well as reducing the company's allowable capital expenditure.

NEW PIPELINES

Parer recognises something that both the NCC and the ACCC have not always acknowledged, namely that when a regulator places obstacles in the way of a new facility being constructed, there is a loss to the economy.  The case for new pipelines to be free of price regulation is no less strong than that for new bakeries, car plants or any other facilities that have no government franchise.  Regulation that closes off market entry by insisting that incumbents underprice their services is just as harmful to a healthy economy as regulation that forbids competition.

Requiring new pipelines to be regulated is gratuitous and contrary to efficiency.  New pipelines enjoy no exclusivity and by definition have no franchise or monopoly.  For gas customers they can only bring benefits.  Unless or until a facility can be regarded as "essential", regulating it will impede its development and any redistributive changes the regulation might bring would not compensate for the reduced level of efficiency that regulation entails.  The new pipeline competes for customers in the same way as all other goods and services and has no lien on the consumer dollar.

While there is a case for pipelines originally built under franchise protection remaining under regulatory control until new competition emerges, this is not so with the post 1994 era pipelines.  Post 1994 era pipeline developers rely on market discovery and business acumen to profitably meet consumer needs, just like entrepreneurs contemplating any other investment.  Setting more onerous terms for new pipeline developments will bring sub-optimal levels of capital expenditure on them.

In this respect, the ACCC still has not got it.  They have a paper on Greenfield pipelines which stipulates the way allowable prices should be determined on such pipelines.

EXISTING PIPELINES

The CoAG Panel recognised the importance of avoiding regulation of new pipelines in its first three recommendations specifying 15 year holidays and similar regulatory relief.  However the regulatory arrangements also need to recognise that monopoly situations tend to be eroded, especially if regulators do not prevent new competition by setting prices at levels that are too low.

Even pipelines established in the pre-Hilmer era are showing signs of competitive pressures.  The regulatory authorities should be obliged to lift controls over existing pipelines covered by the National Gas Code when a credible competitive threat emerges.

The issue of when adequate competition is in place is a vexed one.  Clearly a multitude of competitors offers the best insurance against monopolistic price gouging, and US authorities generally regard five suppliers of similar size to be adequate to ensure no such power exists.

Nonetheless, robust competition can persist with even two competitors, especially if the competitive framework is one where other products or services offer some useful substitution or could rapidly enter the market.  Such conditions exist in the case of Coke versus Pepsi, Boeing versus Airbus or even Qantas versus Virgin.

Such a situation was accepted by the NCC with the Parmelia Pipeline in Western Australia;  the NCC however has erred in not accepting a similar outcome with the Duke and Moomba to Sydney (MSP) pipelines.  For the MSP, it bases the case for continued regulation on synthetically estimated prices undertaken by the ACCC that calculate the "competitive" price on the pipeline would be some 32 per cent lower than at present.  It is difficult to have greater faith in a synthetically constructed price than in one that emerges from competitive interaction.

In this respect it is worth bearing in mind that facilities like the seventeenth century ports and nineteenth century railways were the forerunners of today's "declared" facilities subject to regulation.  They eventually experienced changed competitive circumstances.  In some cases, the on-going regulation designed to promote fairness actually caused the bankruptcy of the regulated assets' owners.  The regulations remained in place in spite of the emergence of rival means of supplying their markets and seriously impeded their managements' abilities to respond to the different competitive situations.

PROPERTY RIGHTS TO TRANSMISSION

A second matter where the draft needs to be clarified concerns gas in Victoria.  Victoria's "market carriage" approach is inconsistent with the basic premise the Panel (correctly) sets for efficient pipeline operations, namely tradeable pipeline capacity;  Victoria's "market carriage" regime cannot have capacity trading since there is no ownership of capacity;  as a result, customers have less than optimal certainty, and the pipeline operator has diminished incentives to seek better use of capacity.

Under the Victorian model, gas shippers and suppliers make offers on a daily basis for gas they have contracted which is surplus to their requirements and for gas shortages they anticipate.  Although the market is efficient in that it clears at a price that reflects the scarcity value of the gas, it assumes that the carriage will always be available.

Events of July 22 2002 showed that the transport might not always be available and users were disconnected.  This rather devalues the VENCorp case made three days earlier that

"the market carriage regime established by the MSOR of itself reduces the need for long term certainty.  In particular, by removing the need for long term gas haulage contracts (and applying a spot market model instead), the MSOR establishes a market environment in which market participants have a reduced need for long term certainty"

Doubtless, the Victorian system can be made more efficient by the use of hourly locational prices but whether this is as efficient as a system that dispenses with the central planner and controller, VENCorp is doubtful.  The Victorian operating system is unique.  It reduces the incentives of the owner, GasNet, to find means of increasing capacity and to develop new products like hierarchies of gas availability.  It reduces the possibility of users to reduce risk by having tradeable rights to capacity.  And it increases risk for gas wheeled through the GasNet system to other pipelines.

Some consideration of how to move to a system that better allows the property right solution is required over the next few years.

CONCLUDING COMMENTS

Gas pipeline regulation requires some urgent attention.  The Parer Report offers some sound ways forward in:

• Ensuring reduction of regulatory risk for new pipelines
• Recommending a review of the National Gas Code

Other issues that need to be addressed include:

• A better stipulation of when regulations should be lifted on existing pipelines
• Bringing gas and electricity regulations into accord
• Ensuring the important Victorian pipeline system has the property rights to carriage that Parer rightly considers to be essential

Dry: In Defence of Economic Freedom

Book

How did Australia, which had suffered so much from the two oil shocks of the 1970s, shrug off the "Asian melt-down" of the 1990s so easily?

Dry is an account of the travails, successes and partial setback of an ideal concerning the proper conduct of public policy.

It influenced both sides of partisan politics and was adopted most completely by the Hawke and Kennett Governments.

This book argues that it was not by chance that during the 1990s the long downward trend of Australian's relative living standards was reversed.

This book is available in PDF format

Contents and Editorial Note

1. The Role of Dry Philosophy
2. From Chifley to Whitlam
3. Bert Kelly
4. The Dry Agenda around 1980
5. The think tanks
6. From Tariff Board to Productivity Commission
7. Voices Off Stage
8. The Fraser Years I
9. The Fraser Years II:  The policies, the micro economy and the consequences
10. The Hawke Years I
11. The Hawke Years II
12. From Fraserism to Fightback
13. Keating
14. The Kennett Revolution
15. The Howard Years
16. Backlash
17. Say not the Struggle ...

Unions Celebrate Their Past Amid Questions Over Their Future

Any business operating for 75 years deserves to be proud of achieving that milestone.  And as a holder of this badge of longevity the ACTU can indeed trumpet the success of heading a unique business franchise, the business of worker representation.

But in celebrating 75 years the path ahead for the ACTU-union business model is bleak and difficult.  The facts are stark.  Private sector union membership is less than 16% of the workforce.  Women and youth have limited representation and workers in the big growth, service industries show little desire for industrially organised representation.

On the surface the problems are many and varied but at its core the ACTU-union business model is structurally weak.  The revenue stream per member is insufficient to fund the level of services needed to retain and attract members.

This business fact has led to many union collapses hidden within ACTU coordinated amalgamations that were supposed to deliver resource consolidation and savings.  Union assets, mainly properties are routinely sold to cover recurrent expenses, a bad sign for any business.

Revenue streams from superannuation, redundancy, insurance and entitlement funds were supposed to fix financial shortfalls but the demands of modern unions and their ambitions appear to exceed the additional revenues.

The expansion of union legal privilege through friendly activists judiciary and the gift of power enhancing legislation mainly at State levels, delivers occasional technical legal victories for unions but little in commercial results.

The political alliances are beset with internal turmoil.  When elected to office, the once union friendly political allies often become foes when forced to respond to the demands of responsible government.

Indicators of revenue panic are setting in evidenced by the push to force non-members to pay "service fees" to unions.  This process of "third line forcing" would normally be illegal if not for the legal subterfuge delivered through industrial relations processes.

Many strategies to fix the revenue decline have been applied but the membership-revenue problem persists and was openly discussed, and new approaches canvassed at an ACTU 2002 conference in Newcastle.

The next wave of strategies are creative.  These include enhancement of alliances and sophisticated campaigns with international non-government activists organisations, designed to achieve domestic agendas by attacking the brand name vulnerability of big multi-national companies.

In line with these advanced pressure point tactics, appeals to the high moral ground, family values of Australians will dominate the public relations policy posturing.  Expect also strong campaigns to seduce Australian companies into adopting German style "works councils" as a prelude to achieving this agenda through legislation.

These packages of well-developed strategies indicate an abundance of talent, dedication, research and quality implementation capacity at the ACTU.  But for all the campaigning something is missing.

The membership revenue model has always been dependent on friendly cooperation with the apparent enemy, business in particular big business.  Class war was fought on the surface but underneath unions acted as part of the management structure.  In return management acted as union revenue collectors.  The system was imperfect but resultant business inefficiencies were cross-subsidised through tariff protection and government to business subsidies.  This has largely gone or is going!

The new union problem is really the pressure of competition to which businesses are now subject, explaining why unions campaign against competition policy.  The trauma of the demise of Ansett taught the ACTU that being in bed with the boss doesn't deliver protection from competition for either party.  Competition is hard for everyone!

As the ACTU and their union affiliates justly celebrate their first 75 years, they know that the dawn of their next 75 years for them is a brave new world.

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Defence: The Challenge of the 21st Century

Facts

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A Disappointing Monster

Rigged Rules and Double Standards:  Making Trade Fair
(Oxfam International, 2002)

It is disturbing and disappointing when a well-intentioned and respected organisation such as Oxfam publishes a confused and ill-informed study such as this 250-page monster.  The report argues that expanding international trade has assisted some developing economies to grow, but that more should be done to alleviate poverty by adapting WTO rules to give new preferences to all developing countries.  This implies that economic development would occur if only trade rules were suitably tailored, whereas benefits from trade depend most of all on a country's own economic policies and institutions.

When referring to the damage caused by EU, US and Japanese agricultural subsidies and protection of labour-intensive manufacturing (especially textiles and clothing), improved access would undoubtedly offer trade opportunities to many developing countries.  However, when proposing more "special and differential treatment" for developing countries' exports and hence for their domestic development, the Oxfam authors neglect the low tariffs already levied on most other OECD imports.  Moreover, economic research raises serious questions about the benefit of trade preferences to developing countries and whether the vested interests which are thus created impede further multilateral liberalisation.

The catch-phrase "fair trade" used throughout the report can mean almost anything, and nowhere does Oxfam define what it means.  "Fairness" is in the eye of the beholder!  Moreover, the term "fair trade" has been captured by uncompetitive industries in developed countries to justify anti-dumping and other contingency protection.

Not unexpectedly, the authors rediscover the spectre of exploitation by multinational enterprises, which they want to be tamed by requiring OECD governments to "enforce" internationally agreed guidelines on labour standards, foreign investment flows, income remittances, etc.  None of these are specifically covered in WTO articles -- and labour standards were specifically excluded from the WTO agenda at the Singapore Ministerial meeting!  The report also resurrects the idea of international financial supports to stabilise commodity prices, ignoring their bad record in the 1970s, the moral hazard they introduce and the absence of WTO articles covering such schemes.

In this context, "fair trade" is really about income transfers to developing countries by indirect and inefficient processes, because the authors reject conventional analysis of benefits from trade (chapter 5).  The case for free trade does not claim that the benefits will be distributed in ways consistent with perceptions of social equity or poverty alleviation, or according to any "moral" interpretation.  Welfare gains do occur from trade liberalisation, however, and global economic interdependence has reduced poverty and inequality.  On this topic the Oxfam report is deliberately evasive and even contradictory.  Bleating about "unfair" distribution does not require that gains from liberal trade should be sacrificed, only redistributed.

The verdict that the WTO is "indefensible" on moral and sustainability grounds (pages 4-5) raises serious doubts about the internal consistency of the report.  Elsewhere (chapter 9), amendments to WTO rules are proposed that depend on the institution becoming stronger.  How do the writers of this report believe that the world economy -- and poor, marginalised developing countries in particular -- would have fared without GATT/ WTO liberalisation since 1948?  This counter-factual position is not mentioned in the report.  As noted above, some of the changes to the WTO proposed by Oxfam are unexceptionable to anyone concerned about economic development.  This does not, however, mean that the changes will be easy to achieve.  The institutional structure of the WTO, with negotiated liberalisation and consensus decisions on rule changes, is easily manipulated to preserve the status quo.  Above all, amending WTO rules depends on changing political attitudes in member governments.

Other proposals in the report also show little understanding of the WTO and its processes.  Non-OECD countries have a very substantial majority among the WTO membership (over 100 out of 142 members).  One country, one vote, in an organisation where decisions are made by consensus, is a substantial blocking force.  Oxfam supports extension of the "differential and more favourable treatment" granted in GATT Part IV in 1965 and incorporated into the General Agreement by the "enabling clause" in the Final Act of the Tokyo Round in 1979.  Yet most analyses of these preferences cast doubt on their value to developing countries;  some even argue that this "concession" by OECD countries was used as an excuse for establishing, and progressively tightening, the multifibre arrangement (MFA) and the spread of other non-tariff barriers in the 1970s.

At several points, the report purposely misrepresents the effects of new agreements achieved in the Uruguay Round.  Oxfam joins the vocal NGOs in opposing liberalisation of services' trade in developing countries.  Yet to leave service sectors outside WTO liberalisation would exclude 80 per cent of employment in OECD countries from international competition, and around 50 per cent in developing countries.  Recently, earnings from services' exports by some developing countries have provided new growth sectors (for example, call centres and "new economy" services in India).  This is extending economic development, not exploiting developing countries.

The TRIPS agreement has been seriously criticised by developing countries' governments and by academics.  The flaws identified on humanitarian grounds show this agreement deserves to be reviewed in the Doha Round, especially with respect to access to pharmaceutical drugs.  At the same time, other issues, such as labelling GM foods, imposing geographical indications and introducing environmental standards on traded goods pose threats to the multilateral trading system overall, as well as to developing countries' trade and growth prospects.

By joining the "campaign of blame" against the WTO, Oxfam has failed to recognise the vital need for institutional and political change in developing countries, if they are to benefit from international economic integration.

Much of the poverty in sub-Saharan Africa and other marginalised areas results from civil unrest, authoritarian regimes and exclusion of much of the population from the market sector because of inadequate institutions and limited political systems.  Most of those living in poverty in any part of the world fall outside the direct reach of international trade.  Any alleviation of their poverty depends on channelling some part of the economic gains from liberal trade to them using domestic income transfers and redistributional mechanisms, which require effective domestic economic institutions.

It is inadequacies in political and institutional instruments that block changes in agricultural policies and other remaining areas of protection in OECD markets, too.  Witness the recent open letter to major European newspapers by seven EU Ministers of Agriculture that trumpeted the blessings of the CAP.  Subsequently, the French authorities have campaigned to preserve the present system until 2013!

Analytical unevenness and factual errors in the text also weaken its appeal.

This kind of emotionally committed report does little to resolve problems, while possibly misleading developing countries' governments into believing that their plight can be eased by international actions alone.  By advocating global management strategies, Oxfam, like most NGOs, avoids the difficult subjects, such as political and institutional reform in developing and developed economies.  In the summary (page 5), Oxfam asserts that "WTO rules reflect the power of vested interests", but arguing for more trade preferences will create even more vested interests against change.  Shifting decision-making to make it easier for the LDC majority to vote through changes will achieve nothing if OECD governments are not party to the decisions.  Reform of "rigged rules and double standards" requires more than arbitrary assignment of blame.

This is a disappointing report.  It is far too long because the editors have failed both to pursue a consistent line of argument and to edit out repetitions and irrelevancies.  It acknowledges economic benefits from trade liberalisation, but then tries to dispose of conventional trade theory.  It recognises the importance of domestic policies for trade policy, but blames WTO rules for shortcomings.  It treats "developing countries" as a uniform group, although the disparities and divergences create as many conflicts as common interests.  The inconsistencies, exaggerations and biases mean that this report does not strengthen the case for further preferences, which weaken the principles that underpin the multilateral trading system:  non-discrimination, reciprocity and transparency.

The future of the WTO will be decided in the Doha Round and its success will depend on a re-assertion of these principles.

Natural gas in Australia after the "Hilmer revolution"

Energy Forum Papers

SUMMARY ⁽¹⁾

CURRENT COMPETITIVE FRAMEWORK

Prior to the Hilmer reforms, ⁽²⁾ long distance gas transmission pipelines were exclusive franchises and therefore (legislated) monopolies.  Policy developments stemming from the 1993 Hilmer Report eliminated monopoly provision thereby changing the framework underpinning the way Australia's gas and electricity industries operate.

Gas transmission is now regulated under the National Third Party Access Code for Natural Gas Pipeline Systems (the National Gas Code).  The National Competition Council (NCC) normally determines whether a pipeline should be covered by the National Gas Code with the Australian Competition and Consumer Commission (ACCC) determining the terms under which a covered pipeline operates.  Gas access may alternatively be regulated by the ACCC accepting an undertaking by the pipeline under Part IIIA of the Trade Practices Act.

APPROPRIATE REGULATORY COVERAGE AND PRACTICE

National issues

Regulatory coverage seeks to prevent monopoly exploitation by an enterprise.  But, in replacing private control this will impact adversely on operational efficiency and incentives for efficient investment.  Regulation is most effective where it is designed to achieve the efficiency inherent in privately owned competitive network facilities.

To avoid discouraging new investment, the regulator should not require prices on existing pipelines to be set below, or services above, the levels consumers would be prepared to pay in a competitive market.  Successful innovative and uncertain investments commonly earn a risk premium above "normal" profits.  The regulator should include such a premium in the prices set for a firm -- even one that is well established -- that has pioneered markets that were previously unserved.  The ACCC, however, generally sets regulated prices at levels that offer inadequate recompense for costs and risk.

For new pipelines built without government protection or other favours, there is little basis for regulatory controls.  These pipelines, by definition, start with no monopoly and users are free to seek out the pipeline links that offer the best terms.  If provision is made for an asset built under such circumstances to become a regulated "essential facility", at some future time, the provision should be restricted to specific circumstances, and should be under constant review.

Furthermore, natural gas pipelines that pre-dated the Hilmer reform era are increasingly experiencing some competitive pressures since the removal of their franchise protection.  These pressures require revocation of the regulatory coverage of some pipelines.  Failure to revoke coverage where there is workable competition can seriously impede competitive development.  Where the regulation sets prices too low, this leads to inefficient imposts on pipelines and unsustainable subsidies to customers.

Victorian issues

Victoria is the major gas using state other than Western Australia.  The state's "market carriage" system for gas presents an additional regulatory matter.  Victoria's network involves the Government-owned VENCorp controlling pipelines and no user-rights to a specific capacity.  Most other pipelines are "contract" carriage under the pipeline owners' control with the capacity allocated to users.

The Victorian "market carriage" system offers too little incentive for the pipeliner to implement improvements and insufficient certainty for users.  It should be converted to a contract carriage system.

The present regulatory structure also has some anomalies with respect to gas and electricity.  For example, price caps are not presently aligned in Victoria.  To avoid distorting investment decisions between the two energy sources, the gas price cap (the Value of Lost Load) should be set at a similar level to that of electricity.

In addition, electricity transmission price regulation is based on a revenue cap, while that of gas is based on a price cap.  The latter is more efficient because it does not discourage efficient use.  Electricity price setting methodologies should be aligned with those of gas.

INTRODUCTION

REGULATION'S ROLE IN THE GAS INDUSTRY

As with electricity, gas is best analysed as comprising four elements:

• supply of gas (which unlike electricity might include storage),
• transmission along high pressure pipes,
• local distribution, and
• retailing.

Of the four elements of gas supply, distribution alone is an uncontestable natural monopoly.  For the other elements control is normally best left to commercial market forces.

Once in situ a local network is unchallengeable except from alternative fuels.  Although there are occasional examples of a rival duplicating an incumbent's distribution network, this is unusual and probably socially wasteful.  It would also be possible to avoid regulation of distribution if users signed long term contracts with the pipeline but this will be impracticable with highly dispersed household usage.  Some form of regulation of distribution is, therefore, probably inevitable.

While transmission and production might also have monopoly features, these are likely to be far less persistent than with distribution.  New sources of gas supply will usually be found if prices are attractive.  With transmission, rival networks can be built to contest an incumbent's market.  Such a possibility is, of course, reduced to the extent that regulation is in place and brings prices lower than those that would otherwise prevail.  Gas supply and transmission are also different from distribution in that their development decisions and final customers involve commercial parties capable of contracting with each other for long periods.

In general, Australian governments have not sought to be major suppliers of gas ex-mine.  Long term contracts with gas producers have been signed by government agencies.  There have been pressures to renegotiate those contracts (including by the competition authorities seeking to force consortia to have their different firms market separately).  However, governments have, quite rightly, been reluctant to break contracts, even those of long standing.

Transmission pipelines have been at the heart of recent policy concerns.  They have been a focus of changed sentiments on the nature of natural monopoly and whether any regulation is required in some cases.

THE 1994 COAG DECISIONS

In 1994, the Council of Australian Governments (CoAG) agreed to "free and fair" trade in natural gas both intra-and inter-state.  Part of this involved an agreement to create no additional exclusive franchises for retail, distribution and transmission and to make existing franchise arrangements more competitive.  Government sanctioned franchises were seen to be bringing inadequate incentives for pipelines to operate efficiently and to develop.  The monopoly status they created also gave rise to the need for considerable regulatory intrusion to prevent abuse.

However, particularly with those franchises owned by government, there was too little restraint on monopolistic abuse prior to 1994 and prices were high.  Even so, the taxpayer, as owner of those pipelines failed to benefit from this.  Instead, the excessive revenues from monopoly prices tended to be dissipated in excessive manning levels and other operational inefficiencies.  Hence, in the case of the Victorian system, privatisation brought a net increase in government revenue.  The private sector bidders were able to spot opportunities for saving costs and their bids reflected this, allowing the government to save more on debt retirement than it lost in net revenues foregone from its gas business.

The CoAG decision followed from the Hilmer Committee recommendations.  The impetus for and recommendations of the Hilmer report stemmed from a need to redress the competitive restraining effects of state government owned or controlled monopolies that were bottleneck "essential facilities" infrastructure.  The report made specific mention of gas transmission pipelines

Although Hilmer discussed wide notions of "essential facilities" where regulation could be contemplated, the authors were, "conscious of the need to carefully limit the circumstances in which one business is required by law to make its facilities available to another." (p.250).  The Hilmer Report returned many times to emphasise the need to avoid undermining property rights and, hence, investment incentives, (e.g. p.256, 258).  The Hilmer report and its consequent legislation sought to ensure the regulated aspects of these services were confined to the core "essential facilities".

With regard to the rationale for regulatory coverage, Hilmer said "While it is difficult to define precisely the nature of the facilities and industries likely to meet these requirements, a frequent feature is the traditional involvement of government in these industries, either as owner or extensive regulator".  In short, in Australia in the early 1990s the only "essential facilities" were government owned or those businesses which enjoyed government support or protection from competition

The 1994 CoAG approach reversed previous practice under which gas pipelines were either exclusively owned by governments or were only permitted to operate with government approval.  The previous approach had seen the need to vest exclusive control over a market to a single pipeline.  This was based on the notion that there might otherwise be unnecessary duplication and therefore risks that investment returns might be harmed.  Under the previous approach, the transmission pipeline and distribution businesses were affiliated and prices were controlled either directly where the government owned the businesses, or indirectly where it franchised the activity.

The new policy approach was designed to make the gas industry more responsive to demand and to introduce greater entrepreneurship, risk taking and therefore innovation on the part of pipeliners.

While clear improvements in gas supply, operational efficiencies and prices have followed, the conditions giving rise to the new policy have not stood still.  Partly due to the reforms introduced, transmission pipelines have become subject to greater competitive forces and the need for their regulation is passing -- and at least in the case of eastern NSW -- has passed.

CONTINUED IMPEDIMENTS PREVENTING
MARKETS FROM OPERATING

REGULATIONS INCONSISTENT WITH EFFICIENCY

The decision to replace the regulated approach with a more entrepreneurial solution meant that gas pipelines, like motor vehicle plants, would have no automatic rights to a particular market.  Nor would a gas source be immune from competition.

Once the integrated and protected franchise model was abandoned, the industry required a framework for its on-going development.  Where this entailed opening up previous monopolies, the new framework had a clear public benefit.

However, the present framework has been developed on an ad hoc basis with often contradictory elements.  The more important features causing this development to be flawed have been:

• the extremely high hurdles that the regulatory authorities have established with regard to the number of competitors required before they allow unregulated markets to operate.  These hurdles would prevent almost any pipeline from being regarded as sufficiently disciplined by competition to allow for a withdrawal of regulatory control;
• a National Gas Code that is heavily weighted towards the assumption of the need for regulation with such features as a queuing policy (a role which price performs in the economy generally) and a very prescriptive cost-based guide to pricing which takes no account of market risk;
• a transmission system in Victoria, the largest market, under which firm carriage cannot be arranged and which therefore introduces undue risk to actual and potential gas customers and insufficient incentive for pipeline companies to expand their pipelines or implement cost savings;
• transmission price regulation for electricity based on a revenue rather than price cap that encourages energy conservation rather than efficient use of energy and incompatibilities with price cap regulation;
• inconsistent price ceiling levels for gas and electricity.

Price setting criteria have been perhaps the most contentious.  These criteria have largely entailed questions about whether the authorities were establishing price settings that were too low, thereby offering inadequate returns and reducing the motivation to build new and enhanced facilities.

UNNECESSARY REGULATORY COVERAGE OF PIPELINES

Coverage of existing pipelines

The new arrangements included a requirement for the National Competition Council to determine whether a pipeline should be designated as covered (i.e. regulated) by the National Gas Code.  All such covered pipelines, unless they have no capacity for sale to non-affiliates, are required to have their rates approved by the ACCC.

There are inherent difficulties in estimating a synthetic price.  These aside, having a government agency specify the terms and conditions under which the pipeline may offer their services is asymmetrical between suppliers and customers.

This is because the essence of Australian regulation is to ensure productivity gains are reaped by customers rather than suppliers.  Regulation of existing pipelines with de facto natural monopoly is designed to pass along savings in improved productivity in lower prices.  These savings would automatically flow through to customers under perfect competition.  Even under the less stylised form of competition actually prevalent in most markets, only where firms maintained genuine innovatory gaps over their competitors would they tend to retain the "surplus" profits.

The customers of transmission pipelines are wholesalers or major users, and in both cases are capable of developing contracts to protect their interests.  They face every advantage where the price they pay for pipeline services cannot be increased since the regulators aim is to hand back to customers cost savings the pipeline makes.  Those without contracts -- new customers -- can simply refuse to buy if the terms are onerous.  Commonly, new customers have locational choices.

Hence, regulatory imperfections will almost certainly mean terms and conditions disadvantageous to the pipeliner, since it is impracticable to impose disadvantageous terms and conditions on most transmission pipeline customers, whereas the pipeliner has its costs sunk.

Regulation of profits is designed for situations where the monopolist would otherwise restrict output to ensure prices in excess of long run marginal costs.  However this definition of monopoly behaviour is less useful for markets where marginal costs are low.  It might, for example, justify a forced price reduction on pay-tv services, the outcome of which would be a severe reduction in any such new investment that entailed high fixed costs.

In the case of gas pipelines, the issue is not usually one of restricting output.  Rather it is about setting the prices of output that is either fixed or where demand is not influenced by its price. ⁽³⁾  Indeed, regulated pipelines are required to have a queuing policy to ration access rather than using price for this.  The risk, in such circumstances, is that the regulator may set prices too low in the knowledge that adverse implications in terms of reduced incentives to invest will be long term rather than immediate.

Since the implementation of the National Gas Code, a number of decisions made by the ACCC and other regulators have forced pipeline owners to accept prices that are lower than those that would have been voluntarily entered into by the interested parties in the market-place.  GasNet is the latest of those, with the ACCC setting a WACC return about 20 per cent below that sought by the company as well as reducing the company's allowable capital expenditure.

Setting inappropriately low prices will bring reduced incentives to maintain and upgrade existing pipelines.  Perhaps more importantly, this will discourage investment in new pipelines.  Indeed, some pipeline investors have made public statements that they will not invest further in the industry.

Coverage of new pipelines

Requiring new pipelines to be regulated is gratuitous and contrary to efficiency.  New pipelines enjoy no exclusivity and by definition have no franchise or monopoly.  For gas suppliers and customers they can only bring benefits.  Unless or until a facility can be regarded as "essential", regulating it will impede its development and any redistributive changes the regulation might bring would not compensate for the reduced level of efficiency that regulation entails.  The new pipeline competes for customers in the same way as all other goods and services and has no lien on the consumer dollar.

While there is a case for pipelines originally built under franchise protection remaining under regulatory control until new competition emerges, this is not so with the post 1994 era pipelines.  Post 1994 era pipeline developers rely on market discovery and business acumen to profitably meet consumer needs, just like entrepreneurs contemplating any other investment.  Setting more onerous terms for new pipeline developments will bring sub-optimal levels of capital expenditure on them.

That said, like other "essential facilities" through the ages, pipelines that have achieved a monopoly position, whether or not they were originally franchised, can be expected to be opened for general use, implicitly on terms that they might not have chosen for themselves.  This was the case with ports in the seventeenth century and with railways from the mid 1840s. ⁽⁴⁾  It is also the case with patents granted to new inventors.

Accordingly, it might be argued that at some stage a pipeline which was developed entrepreneurially in a competitive environment can become an "essential facility" requiring it to offer its services to all-comers.  However at the outset this cannot be the case:  the facility cannot be "essential" when life went on satisfactorily prior to its existence.

Withdrawal of coverage

The issue of when adequate competition is in place is a vexed one.  Clearly a multitude of competitors offers the best insurance against monopolistic price gouging, and US authorities generally regard five suppliers of similar size to be adequate to ensure no such power exists.

Nonetheless, robust competition can persist and perhaps continue indefinitely with even two competitors, especially if the competitive framework is one where other products or services offer some useful substitution or could rapidly enter the market.  Such monopolies exist in the case of Coke versus Pepsi, Boeing versus Airbus or even Qantas versus Virgin.  Even a single supplier can be sufficient.  The latter case occurs with the Microsoft operating system where its monopoly position is muted by the possibility of newcomers like Linux and by the competition it faces from previous sales of earlier versions of its software.

None of this is to deny the better outcomes that normally emerge when there are competitive offerings.  Moreover, the difficulties of customer "lock-in" that are the reason behind the "essential facility" concept are greater with reticulated gas and electricity than is the case with some of the other goods and service experiencing monopoly or duopoly.

Hence, it may be that at some future time a purely entrepreneurial facility may appropriately be redesignated as "essential" should no rivals emerge.  But even if a pipeline were to become regarded as "essential" and subject to regulation, this is likely to be transitory.

In this respect it is worth bearing in mind that facilities like the seventeenth century ports and nineteenth century railways, after having been "declared" and subject to regulation, eventually experienced changed competitive circumstances.  In some cases, the on-going regulation designed to promote fairness actually caused the bankruptcy of the regulated assets' owners.  The regulations remained in place in spite of the emergence of rival means of supplying their markets and seriously impeded their managements' abilities to respond to the different competitive situations.

The experience of railway regulation illustrates the need for the authorities to stand ready to remove facilities from regulatory control where competition emerges.  Judgements are required about whether or when to regulate a pipeline, and the law has to recognise that many pipelines will not achieve the monopolistic power that would warrant their regulation.  They will face actual or potential competition from other pipelines, or may never attain a sufficient share of the energy market to require control.

Generally, regulated access to essential facilities has been in place to ensure that downstream users are not squeezed by a bottleneck service.  In the case of the Moomba to Sydney Pipeline (MSP) the NCC also considered access necessary to protect upstream suppliers.  This is unfortunate.  Such businesses are commonly considered to be capable of safeguarding themselves through appropriate contractual arrangements and extending regulatory protection to them could open up a vast expansion of government oversight of the economy.

When a regulator places obstacles in the way of a new facility being constructed, there is a loss to the economy.  The case for new pipelines to be free of price regulation is no less strong than that for new bakeries, car plants or any other facilities that have no government franchise.  Regulation that closes off market entry by insisting that incumbents underprice their services is just as harmful to a healthy economy as regulation that forbids new competition.

AUSTRALIAN NATIONAL GAS REGULATION

Provisions of the National Gas Code

The National Gas Code itself is far from the "light-handed" regulation that was proposed.  It is highly prescriptive.

For example, as has previously been noted the regulatory implications of Coverage under the National Gas Code does not allow for the operation of the price mechanism, the means by which supply is rationed in market systems.  Thus, under s.3.14, the arrangements are designed to preclude a pipeline from obtaining any greater profits than the regulator anticipated, and this is further amplified in s.3.23(d)(ii) 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.

And, in line with regulators' decision frameworks, the pricing policy sets out to cover new pipelines (s. 8.13) that have no franchise and which can only be subject to competition -- their not having been built already provides assurances of this.

Shortcomings of this nature are probably inevitable with regulatory codes and add force to the need to avoid regulation wherever possible.

Regulators' approaches to the National Gas Code

Stated approach of the regulatory authorities

As well as deficiencies in the National Gas Code, there remains a predisposition for regulatory intervention in prominent regulatory circles.  Although proclaiming regulation to be inferior to markets, resourceful regulators will often find merit in regulatory outcomes that they see as superior to those that might unfold in markets.

Thus, in addressing some of these matters, the Chairman of the NCC, Mr Graham Samuel claimed that

"..., it is important to remember that not all investment is good investment.  Critics ignore the effects of NOT granting access -- what happens to investment in other markets if access is denied?  More broadly, investment is not desirable for its own sake, but rather for the benefits it brings in increasing living standards."

Mr Samuel argued that the Council's should prevent unnecessary duplication of infrastructure and employ a wide public benefit test rather than one that examines the issue from the private perspective. ⁽⁵⁾  This central planning approach to investment decision making is the pre-Hilmer model and should be avoided if investment in infrastructure is not to be discouraged by governments.

Mistrust of market mechanisms is also apparent in the June 2002 ACCC Draft Greenfields Guideline for gas transmission pipelines.  This envisages little scope for an unregulated pipeline to operate-such a pipeline would need to approach the ACCC with a proposed access arrangement and have this accepted.

The Greenfield Draft follows US practice, described in the next section, of requiring the pipeliner to submit its proposed charges to the regulator prior to receiving approval to levy those tariffs.  Unfortunately the ACCC proposals therefore attempt to graft approaches designed for free standing monopoly pipelines facing low risk to pipelines that face all the uncertainties of an entrepreneurial proposal.  The Productivity Commission in its Review of the National Access Regime recognised the shortcomings of the present approach in deterring investment and made some specific recommendations for improvement. ⁽⁶⁾  Among these was a proposal for a "regulatory holiday" to prevent stifling the incentives for new Greenfield facilities.

Regulatory actions

An early test of the ability of regulators to withdraw from intervening in a market where competition offered adequate discipline concerned the Duke Energy pipeline from Longford to Sydney.

This facility established to rival the existing Moomba to Sydney Pipeline (MSP) meant massive over-capacity and an ending of the conditions that first justified the regulation.  Indeed, a price war broke out before Duke's pipeline was completed.

However, with the ACCC publicly silent on the matter, the NCC argued that they should regulate both pipelines.  This was based on the premise that they did not traverse parallel routes and that, even if they did, regulation would still be necessary to prevent collusion.  Such analytical reasoning by the NCC gives regulatory agencies the opportunity to control virtually every economic activity in the country and was heavily criticised by us. ⁽⁷⁾

In the event, in 2001, the Australian Competition Tribunal (ACT) overturned the NCC's ambitions to regulate Duke Energy's pipeline.

The NCC accepted the Tribunal's decision and MSP therefore sought reciprocal treatment to escape its own regulatory prison.  But the NCC recommended continued coverage of the MSP, partly because it saw the original Tribunal decision on the Duke Energy pipeline as based on the on-going regulation of the MSP, which would automatically restrain the prices that Duke Energy could charge.

Among the other reasons the NCC gave in favour of continued price regulation of the MSP was an ACCC draft decision that proposed to reduce the price on the MSP further than it had fallen in the face of the competition from Duke.  The NCC saw this synthetic ACCC price as being more realistic than a market price emerging from competition.

Such mistrust of actual market outcomes is frequently seen in regulatory bodies.  It often stems from a disposition among regulators to assume prices of assets, once the assets have been sunk, should be based on a form of marginal cost, or at least not fully reflect replacement costs and the risk-adjusted return required of them prior to commitment.  As previously discussed such a regulatory price-setting framework must have a deterrent effect on other capital expenditures and bring reduced levels of economic growth.  The NCC recommendations on the MSP will be contested and it is likely that its regulatory status will come before the ACT.

The NCC adopted a more realistic approach to competitive provision in agreeing in 2002 to recommend regulatory coverage revocation of the Parmelia pipeline in Western Australia.  Consistent with its acceptance of the ACT decision on Duke Energy, it agreed that the pipeline does not have market power because it competes with the much larger Dampier to Bunbury pipeline and there is excess capacity.

The implications of the present attempt by the MSP to have its regulation removed may eventually bring into question the need for regulation on other pipelines.  Perhaps this might even extend to the VENCorp controlled GasNet system in Victoria, though the GasNet system, as a monopoly, would not expect early release from regulatory oversight.

Price decisions of regulators

Allowable investment returns

The ACCC has recognised a need to allow "generous benchmark returns that provide clear incentives for a service provider to achieve efficiencies grow demand for its services and outperform the benchmark return determined for the next regulatory period." ⁽⁸⁾  The ACCC estimates the return to equity it allows is 12.68 per cent compared with the average stock exchange return over the ten years to September 2002 of 11.2 per cent and 4.8 per cent over the last five years.

Even so, it has already been noted that regulated businesses clearly think the ACCC stipulated return to be inadequate compensation for their risks.  This is partly because they contest the basis of the estimates, for example claiming that the allowed return does not properly account for the replacement cost of the pipeline.

The ACCC in its cost estimates also does not allow pipelines or other facilities to retain the benefits of rapid depreciation on the dubious grounds that passing on these benefits directly to consumers mirrors the outcome in competitive markets.  This is rather simplistic.  If these benefits were in fact simply passed on, they would not, of course, be benefits to the industry.  The government would be under some misunderstanding in implementing the policies, perhaps to compensate for the tax code's inappropriately slow depreciation rates, with a view to bringing increased investment.  Indeed, on the ACCC's line of reasoning, the rate of depreciation or the tax rate itself would matter little since competition would simply return both to some "normal" level.

As discussed in the previous section, these issues have become prominent as a result of the NCC coverage recommendations on the Moomba to Sydney Pipeline (MSP).  The prices on the MSP, once it faced competition from Duke, fell from 71 cents/GJ to 66 cents/GJ.  This is consistent with the price the consultant, NECG, estimates would prevail under a cost base called the hypothetical new entrant test (HNET).  The ACCC estimates the synthetic price to be 50 cents/GJ (it is apparently still developing its thinking on the matter, having recently revised this from 47 cents/GJ due to a different treatment of deferred taxes).  Its consultant, NERA, puts the HNET at 51 cents/GJ.

The ACCC offered as evidence to the NCC's review of the Moomba to Sydney pipeline, work undertaken by NERA which suggested the appropriate amount of annual depreciation on the pipeline was $5.2 million. ⁽⁹⁾  This is on a facility with an agreed replacement cost value of one billion dollars, an 80 year engineering life and subject to considerable risk of by-pass (and the Duke Pipeline serving the Moomba to Sydney Pipeline's Sydney market is evidence of this) as well as risks of technological obsolescence. ⁽¹⁰⁾

Such measures mean prices set below the rates necessary for profitable operations.  They mean that the facility is protected from competition -- at the expense of its shareholders -- and that new facility building is deterred.

The estimate by the regulator of a lower "competitive" price than the one that has emerged is a key reason why the NCC recommends continued regulatory coverage.  Other concerns of the regulator are about the pipeline's market power over upstream supply sources and alleged incentives to collude with downstream affiliates. ⁽¹¹⁾

Competitive tendering

Pipeline regulations have provision for competitive tendering.  Under this approach, the ACCC automatically accepts the price implicit in the winning tender.  Even so, the ACCC may reject a tender process if it considers there to have been too little interest shown or if the bids exhibit insufficient competitiveness.  Moreover, the process is highly formalised, costly and time-consuming with the ACCC identifying fourteen separate stages in the process, including a public inquiry.

These matters aside, competitive tendering is only an option for an opportunity with well-known and high prospectivity.  This is rarely the case.  Normally an entrepreneur spots an opportunity which has not previously been taken up because of its riskiness.  Even if such opportunities could attract rival bids requiring them to proceed by that process would cause economic harm -- it would constitute a deterrence for firms to engage in marketing research since their rivals would be able to free-ride should they spot a promising opportunity.

NEW PIPELINE DEVELOPMENTS

Following the changes stemming from the 1994 CoAG decision and the National Gas Code, new pipelines that were not protected by a franchise were constructed or have commenced.  These included:

• Duke Energy's Eastern Gas Pipeline from Longford to Sydney
• The AGL Central West extension to Dubbo of the Moomba to Sydney Pipeline
• Duke Energy's Bass Strait to Tasmania link
• The Origin, International Power, TXU Otway to Adelaide link

However two of these pipelines, Duke's Eastern Gas Pipeline and the Central West, predated the promulgation of the National Gas Code.  Both of these have experienced disappointment in the light of regulatory attitudes to the pipelines' pricing regimes.  The latest new major development, the Otways to Adelaide link, appears to have been designed to avoid being covered by regulation, and perhaps less than optimally sized as a result, by having all the capacity booked by the joint owners.

The most active recent new pipeline builder, Duke Energy, has been among those developers which have publicly announced that they are unlikely to invest in any new pipelines as a result of the "chilling" effect of regulatory oversight.

The implications for reduced efficiency from the present intrusive arrangements were recognised by the Productivity Commission in its Review of the National Access Regime.  Although the Productivity Commission found that across-the-board abandonment of access regulation at this stage would be inappropriate, it argued that changes were required to facilitate efficient investment, one of which to be considered included provision for access holidays. ⁽¹²⁾

THE MANAGEMENT OF THE VICTORIAN GAS MARKET

THE US APPROACH TO GAS MARKET MANAGEMENT

Across the world, gas is mainly transported under contracts between transmission businesses and producers, customers, agents, retailers and others.  In the US, this approach, called the "contract carriage" model was spontaneously created following measures to require pipelines to operate on an open access basis.

Without anyone having planned it, producers, users and transporters buy and sell both gas and transport contracts to ensure they meet their long and short term balances.  The contracting points have evolved so that they centre on about 50 "hubs" -- normally points at which different pipelines interconnect.  Buyers, sellers and others seek to defray their risks by forward contracting with each other at these hubs.  This way the sellers and buyers both have certainty in the quantities produced and delivered, and in the price.

A few US pipelines are "common carriage".  These pipelines charge all customers the same rate and are obliged to expand capacity to meet reasonable demand.  Common carriage was not a model adopted in Australia and under the National Gas Code, pipeline companies cannot be obligated to expand capacity.

US gas pipeline regulation has been in place since the 1938 National Gas Act (NGA).  Its key control was, and remains, the "certificate of public convenience and necessity", which automatically gives some protection from competition, and which mandates a rate regime and obligation to serve.  Ostensibly, the approach is therefore contrary to the competition oriented regime adopted in Australia post 1994.

The NGA allowed transmission pipelines to own gas but regulated the price of that gas (but not gas from non-affiliates).  Following a series of developments under which transmission pipelines increasingly came to carry non-affiliates' gas, came Order 636 in 1992 under which pipelines were required to separate their own gas sales from their transportation service.  This has left the pipelines as pure transport businesses.

The US Federal Energy Regulatory Commission (FERC) assessment of proposed new pipelines has continued to focus on minimising their adverse effects on existing pipelines.  Although the conditions were somewhat relaxed in a policy statement of 1999, the paternalistic flavour remains:  FERC only approves a new pipeline if the potential benefits of "overbuilding" offset other costs like environmental disruption or a negative effect on an existing rival pipeline. ⁽¹³⁾

The procedure for approval of new pipelines in the US is highly formalised.  Proponents must declare an "open season" where users are invited to seek (unpriced) capacity on a basis of need.  There is a dual set of contracts on the part of the local distribution business or other large user, comprising product and carriage.

In addition to published rates for firm carriage, rates for interruptible service are also published.  Tariff rates must be approved by FERC and are normally strictly in line with costs, ⁽¹⁴⁾ which are full costs in the case of firm access and operating costs for interruptible.  The US approach effectively transfers the equity in the pipeline to the firm capacity holders.  These customers have the right to trade their capacity and are usually credited with 90 per cent of the excess revenue that is earned by the pipeline from interruptible shippers.

THE COORDINATION TASK OF PIPELINES

It is not difficult to arrange for gas to pass through the different parties between the well and the burner.  In the US, merchant pipelines developed and had other parties accept them as having the necessary skills to balance the line.  An open access pipeline system with contract carriage puts the responsibility for ensuring transport capacity as well as gas procurement on the customers.  Parties negotiate contracts simultaneously with the gas supplier for product and the pipeline for capacity.  In the process they may also have contracts with other intermediaries.

Referring to the changes then underway in the US, Jeff Makholm, one of the principle advisors to the Victorian Government in its gas restructuring noted: ⁽¹⁵⁾

"the landlords (that is the pipeline owners) and the tenants (mostly gas distribution companies) are fighting over who should be the beneficiary of the "found" floor space (valuable capacity that exists due to the acquired expertise in operating the various pipelines that comprise the network)."

Only if they have an incentive to do so will the "landlords" seek out the latent capacity in the existing system.  Makholm correctly maintains that for economic efficiency buyers must, "hold clear contractual rights to practically all existing ... capacity." Clear property rights that are transferable and valued offer appropriate incentives to uncover hidden value to those best able to do so.

THE VICTORIAN GAS SYSTEM

Coordination and development under market carriage

Rather than adopting the well proven contract carriage system, the Victorian Government has opted to establish a market with some novel features.  The Government structurally separated gas retailers from the pipe owning distributors, and made it mandatory for buyers and sellers to participate in a "spot" market, placing the transmission business under the operational control of a Government body, VENCorp.

In contrast to the US system of pipeline control, VENCorp, the publicly owned System Operator, determines the quantities the pipeline carries and makes its expansion decisions.  This has some features similar to the US common carriage system but leaves the pipeline owner as little more than a passive sub-contractor to VENCorp.

Under the Victorian market carriage system, as with common carriage, the retailer does not require carriage rights.  The advantage claimed of this is that retailers need not be concerned about their ability to obtain additional capacity when a customer changes supplier, since the supply rights, in so far as they exist, are automatically transferred with the contract.

The downside to this is that users cannot contract for carriage and thereby obtain priority for carriage on the pipeline.  Nor do they have a clear means of recourse in the event that they are denied delivery of the gas they have contracted.  VENCorp has no capability of signing contracts that offer such assurances and has legislative protection against any liability for its actions that might lead to delivery shortfalls or gas interruptions.

Under the Victorian model, gas shippers and suppliers make offers on a daily basis for gas they have contracted which is surplus to their requirements and for gas shortages they anticipate.  Although the market is efficient in that it clears at a price that reflects the scarcity value of the gas, it assumes that the carriage will always be available.  Events of July 22 2002 showed that the gas might not always be available and users were disconnected.

This rather devalues the VENCorp case made three days earlier that

"the market carriage regime established by the MSOR of itself reduces the need for long term certainty.  In particular, by removing the need for long term gas haulage contracts (and applying a spot market model instead), the MSOR establishes a market environment in which market participants have a reduced need for long term certainty". ⁽¹⁶⁾

The implications of the lack of property rights to carriage

The inability of users to obtain firm carriage access is likely to have contributed to several deferrals of gas fired new electric power plants to serve the Victoria/South Australia region.  These proposals included plants to be located in Maryvale (Paperlinx/Duke 200 MW) and South Ballarat (AES 500 MW).  One early outcome of deferrals is the intent signalled by the electricity market manager, NEMMCO, to seek to contract increased electricity capacity under its reserve trader provisions. ⁽¹⁷⁾

Market carriage also creates difficulties for firms wishing to contract gas through the Victorian system to other systems.  The shipper faces contractual uncertainty in selling gas that must be transported through a Victorian system within which he has no contractual rights.

A further risk of inefficiency is that the model used may reduce the incentives of the transmission pipeline, GasNet, to seek out economies.  GasNet simply does as it is instructed by VENCorp, which specifies how much gas is to be carried and how much is to be in the pipeline at the end of each day ("linepack").  This dampens GasNet's incentives to take actions with a view to increase capacity availability within its existing pipes.  Market carriage in general is likely to bring GasNet to adopt a more conservative business approach than might be optimal.

Of course, it is also true that under a regulated contract carriage approach, the pipeline's incentives are severely attenuated.  A pipeline that develops new capacity under such circumstances would have the price of that capacity reduced at the next "re-set" to bring the return on capital back to the regulator's target rate.  Hence a customer, unless it thought that future capacity would be in short supply, would not sign a contract at a premium price covering the period beyond that "re-set".  The customer would normally be confident that the regulator would reduce the price in view of the newly discovered capacity.

In addition, the difference between the two forms is reduced to the degree, as some maintain happens in South Australia, that the government is persuaded to intervene when shortages arise thereby nullifying the contracts users have with the pipeline.

Thus the difference may not be great between the two carriage methods from the perspective of incentives on the operator to find low cost augmentations or innovative means of better selling capacity.

Yet market carriage remains a system with additional shortcomings to those inherent in all regulated systems.  Its expansion is driven by a government agency.  Contract carriage is more directly responsive to commercial drivers.  Augmentations respond to the willingness of customers to incur costs and would also provide those customers with some form of rights (probably financial rights) over the capacity their contracts has created.  Thus a new gas fired generator would pay for an expansion and have rights to the increased capacity, thereby ensuring that the capital expenditure is highly responsive to commercial need.

If the Victorian system were to be changed to the conventional contract carriage approach, consideration of a non-disruptive way for this to occur would be required.  This would probably entail vesting users their existing implicit quantity and destination rights.  These would be tradeable, probably on electronic bulletin boards, and holders of firm capacity rights would not be able to hoard them.

Multiple entry and exit points complicate pipeline management.  In this respect, the Victorian system is somewhat more meshed than other Australian systems, though not more than many US systems that operate on contract carriage bases.  The more meshed nature of the Victorian system means the pipeline would require a body that ensures it is kept in balance.  If this were to be GasNet, that business -- in line with US practice -- would probably not be permitted to buy and sell capacity contracts since it could then favour its own resource over those of other businesses.

Regulation in general is having adverse effects in a great many ways.  What is really required is to remove the regulatory coverage at the earliest opportunity, that is as soon as competition has eroded the previous monopoly power.  Nonetheless, the move to a contract carriage is an interim step that will allow some efficiency improvements.

Operating costs of the Victorian system

A further disadvantage of vesting control of the facility by a body not motivated by profit maximisation is the excessive caution this brings.  VENCorp's incentive is to avoid the possibility of capacity shortages.  Such motivations in the past have led to goldplating.  They can also lead to perverted outcomes since in the future, a regulator is likely to take the view that capacity built in excess of needs is excessive and should not command the return envisaged of it.  But the instigator of that capacity overbuild, VENCorp, has no liability for its mistaken view.

This is likely to entail higher operating costs.  With respect to the Victorian system, VENCorp claims to operate in a highly cost-effective manner.  But it comprises an extra layer of management and board oversight compared with an integrated system.  And as a State owned body, it is unlikely to have the same cost saving imperatives as a private company that is profit-focussed and unencumbered with multiple objectives.

While we have no comparative benchmark, it does appear that the O&M costs of GasNet and VENCorp at 28 per cent of 2003 forecast revenue appears to be relatively high.

GAS AND ELECTRICITY MARKET ASYMMETRIES

DIFFERENT VOLL LEVELS

It is claimed that the market carriage system employed in Victoria brings gas and electricity into better alignment.

Establishing signals and other decision structures to promote optimal investment in electricity transmission has been highly contentious.  In Australia, unlike many other countries, vast distances tend to make transmission costs, especially transmission augmentations, far more important than in densely populated markets.  The UK approach has been to smear most electricity transmission costs across all users and suppliers and to build new lines as the regulator decides this is warranted.  This analogy with the planning and provision of roads may have merit in the UK where transmission forms only about five per cent of the total electricity bill and excessive expenditure may not result in serious distortions to the final consumer.  However, augmentation in Australia's "long stringy" system can be no less expensive than resolving a localised power shortage by building new generation.

As with gas, electricity faces considerable controversy over whether to adopt a centrally planned augmentation system or allow market provision.

These matters aside, the two markets are far from being aligned.  The gas market VoLL in Victoria is set at $800/ Gj, a level that coincidentally is similar to the $10,000/MWh electricity VoLL equivalent. ⁽¹⁸⁾  However, the gas price is in fact effectively capped at below $20/Gj, the cost of the last increment of supply that is presently available.  Recent shortage events have highlighted the risk, perhaps increasing risk, of this cap being reached.

In fact gas prices in Victoria, even on a day when there were forced disconnections averaged less than $10/GJ.  Those (generator) participants that were ordered to cease using gas were understandably reluctant to do so when the price of their electricity output was many times that level.  At least one of the generators has reported that it had contracts that it was forced to break at some considerable penalty.

There are clear benefits in aligning maximum market prices of gas and electricity since gas fired electricity will usually be the marginal source of supply.  Hence consistency and the avoidance of market distortion would require VoLL being allowed to rise to similar levels for the two commodities.

It may however be that permitting such high prices would not bring forward much additional capacity.  While this is certainly true in the short run, allowing prices to rise to several fold their existing level would bring great incentives for users and retailers to contract for additional storage capacity and perhaps more robust links between the markets.

DIFFERENT DURATION OF BIDS

With the gas market based on a daily price and electricity prices set at 5/30 minute periods there are major implications for efficiency.  Not only do the two prices need to be made consistent, but gas prices cannot be left remaining on a daily basis.

More frequent bidding and re-bidding provision (probably with locational features) may entail costs including those integral to the development of intra-day gas pipe injections and depletion profiles.  For most participants these may not be great in a market that is normally characterised by static prices.  But the need for such features will increase as the main GasNet pipeline achieves greater utilisation.  Indeed, if the VoLL price is to be better aligned to that of electricity, the likely means of price changes occurring smoothly would be via demand side bids.  These require intra-day bidding to be effective.

SETTING THE PRICE LEVELS FOR REGULATED FACILITIES

A further issue with the present arrangements in energy results from revenue capping of the electricity transmission businesses earnings.  Revenue capping rather than price capping owes its popularity to environmentalists' pressures to prevent actions that might "waste" scarce resources.  It is claimed that a price cap would encourage the transmission business to sell more energy than was needed.

Such notions belong to an earlier era.  All businesses seek to persuade consumers to buy more of their product and the price system ensures the appropriate incentives are in place optimise increased sales with conservation of supplies.

Placing transmission businesses without the incentive to pursue sales growth is likely to mean opportunities foregone.  These might include reducing the prospect of a joint approach of energy supplier and transport supplier to make offers to attract particular businesses.

Although GasNet has a revenue "target" this is more akin to a price cap and the business obtains the benefit of increased gas flow.  However, as gas and electricity are increasingly in competition, electricity's regulatory arrangements should be aligned to those of gas.

CHANGING THE VICTORIAN ARRANGEMENTS

Australia is suffering from energy market reform fatigue.  But as markets once introduced throw up new areas that require consequent change this seems inevitable.  The alternative of stopping the reform is likely to bring a return of many of the earlier inefficiencies.

The reforms to update the Victorian gas arrangements would not entail draconian change.

They might be accommodated by

• Making explicit the implicit carriage rights that existing users have and allowing the users to trade in their capacity (and possibly imposing a charge to offset the "gift" that the vesting might entail).
• Requiring all future users and those seeking increased use to have capacity as well as gas or to risk facing penalty charges by becoming financially interruptible.
• Have an independent body examine whether and under what conditions coverage might be revoked on the GasNet pipeline system
• Facilitating trade in capacity through electronic bulletin boards.
• Resetting the gas VoLL at a level that is consistent with the electricity market VoLL and introducing an intra-day gas market.

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ENDNOTES

1.  Max Kimber gave helpful advice and assistance in preparing this paper.

2.  Set out in National Competition Policy, Hilmer F.G., Rayner M.R., and Taperell, G.Q., AGPS, 1993.

3.  The demand for pipeline usage is a derived demand.  It depends on the demand for gas.  Thus if the elasticity of demand for gas is 0.3 (a doubling of price brings a 30 per cent fall in demand) and the pipeline comprises only 10 per cent of total costs, passing on a doubling of pipeline costs leads to only a 3 per cent fall in gas demand.  Of course, if supply is competitive, it is of little relevance whether demand is derived or not, since suppliers will take advantage of cheaper transport if it is available.

4.  For an authority who traces this aspect through the common law see Richard A. Epstein Principles for a Free Society, Perseus Books, Reading Mass, 1998.

5.  Address to Utilicon 2000, Melbourne August 7 2000.

6.  Review of the National Access Regime, Report No. 17, Productivity Commission, September 2001.  Specific proposals include:

RECOMMENDATION 11.1
Part IIIA should make provision for the proponent of a proposed investment in an essential infrastructure facility to seek a binding ruling on whether the services provided by that facility would meet the declaration criteria.  Where the Minister, after receiving advice from the National Competition Council, determines that they would not, the services concerned would be exempt from declaration.  A binding ruling should apply in perpetuity, unless revoked by the Minister on advice from the Council on the grounds of a material change in circumstances.  Such a revocation should be appellable to the Australian Competition Tribunal.

RECOMMENDATION 11.3
The Commonwealth Government should, through the Council of Australian Governments, initiate a process to refine mechanisms (additional to those provided for in recommendations 11.1 and 11.2) to facilitate efficient investment within the Part IIIA regime in particular and access regimes generally.  The mechanisms to be considered should include:

• fixed-term access holidays available to any proposed investment in essential infrastructure which is determined to be contestable;  and
• provision for a ‘truncation' premium to be added to the cost of capital that has been agreed between a project proponent and the regulator prior to investment.

This process should be completed in sufficient time to enable legislative implementation within Part IIIA no later than 2003.

7.  Review of Competition Policy, The Productivity Commission's Inquiry into Clause 6 of the Competition Principles Agreement and Part IIIA of the Trade Practices Act 1974.

8.  ACCC, Regional development of natural gas transmission pipelines, October 2002.

9.  NERA Report Commissioned by ACCC on Aspects of the Moomba-Sydney Pipeline System, http://www.ncc.gov.au/pdf/REGaMoCR-003.pdf, September 2002

10.  The pipeline has all its present sales contracted though its former affiliate, AGL.  In one sense, the ACCC price set therefore matters little but a forced price reduction on non-contracted sales puts pressure, including through "most favoured customer" clauses, on contract sales volumes and prices.

11.  Moomba to Sydney Pipeline:  Revocation Application under the , NCC November 2002

12.  Productivity Commission, Review of the National Access Code, Report No. 17, September 2001.

13.  FERC gives a certificate of public necessity and convenience if 25% of the pipeline proposed is contracted, especially if there is 10 year firm contracts for 100% of capacity.  Or if revenues under contracts exceed costs or if sponsors are fully at risk.  These policy guidelines were relaxed in 1999.  But it now also requires evidence of public benefits like bottleneck removal, competitive alternatives, lower cost to customers but a negative effect would still be seen if the new pipeline created potential excess capacity.  For expansions where it is less than 5% the cost is rolled in.  FERC would not allow incremental pricing where the cost of the roll-in is lower than the original build, since it sees this as best benefiting existing users.

14.  FERC uses the Hirfindahl-Hirschman index, (first applied by the United States Department of Justice following its 1986 report on gas pipelines).  This would normally require the equivalent of five similarly sized independent operators prior to a pipeline being allocated status to pursue "market-based" tariffs.  To date no pipeline has qualified for this.  However, the relatively mature pipeline system does mean potential rivalry, which keeps prices reflective of costs.

15.  Jeff D Makholm, Gas Pipeline Capacity:  Who Owns It?  Who Profits?  How Much?, Public Utilities Fortnightly, October 1 1994

16.  Vencorp Submission to the ACCC seeking the authorisation of the Market System Operating Rules, 18 July 2002, http://www.accc.gov.au/gas/fs-gas.htm

17.  The reserve trader provisions themselves are a market intervention that could leave the electricity market vulnerable to future inefficiencies by creating a dual market.

18.  As the $800/Gj is set as the average price for the day it is effectively much higher than the average electricity VoLL price which is based on a five minute spike.