LIES and Statistics

Following the Statistician's release of the 2001 trade union membership, ACTU President Sharan Burrow declared, "The long term trend of declining union membership appears to have stabilised with two years of net growth".

In fact, unionisation as a share of employees continued to fall.  Based on total employees of 7,800,000 union membership at 1,900,000 was 24.5 per cent in August of last year, down from 24.7 per cent on the previous year.  Twenty years ago union membership stood at 50 per cent.  Unfortunately for trade unions, they are losing market share faster than the Christian churches are losing Sunday worshippers!

Part of this is due to structural change.  People are always likely to be less inclined to join unions if their work is part-time.  And part-time workers have been generally increasing as a result both of individuals' preferences and the needs of businesses in meeting consumer demands.  Over the past five years, part-time employment increased by over a fifth, while full-time jobs increased by only one twentieth.

It may also be that the union's recruitment scope is declining because an increasing number of workers, currently over 20 per cent, are self-employed or employers.

This latter figure is not included within the "employee" category and also means the unionisation share tends to be inflated.  Instead of the workforce being 7,800,000, because around 20 per cent of those in work are not classed as employees, it is really 9,200,000.  Hence, unionisation is not 24.5 per cent but 20.7 per cent of workers.

The figures are even more interesting if unionisation is divided between the public and private sectors.  There are 690,000 trade union members working in the public sector, where 48 per cent of employees are unionised.  There are 1,200,000 union members out of 6,300,000 "employees" in the private sector, giving unionisation of 19.2 per cent.  However, those workers not counted as "employees" cannot be working within the public sector, where they would automatically have an employer.  They must, therefore, must be private sector workers.

This means that the number of private sector workers is actually 7,700,000.  And, since we know private sector union membership is 1,200,000, it also means that private sector unionisation is down below 16 per cent of the people actually in jobs and working.

With this perspective, the trade union movement is more accurately seen as representing nearly half of the people working for government with only a minor role in representing workers against private employers.  This is a strange twist in the movement's originally conceived role.

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Questions raised by workplace deaths bill

The recent blocking of the Victorian Government's controversial corporate manslaughter legislation by the state Opposition does not close the debate over liability for workplace deaths.  The Bill remains a government objective and similar proposals are under consideration in Queensland and Western Australia with NSW unions calling for action.

Every executive needs to monitor this debate because it is they who are under personal and direct threat from the proposals.  The central concern is the way this corporate manslaughter model changes key principles of criminal justice threatening basic liberties.

A lay person's understanding of criminal law is that a person is held responsible for the actions over which they have direct control.  The doctrine of criminal intent is central to the law, and only natural persons can have criminal intent.

Natural persons can steal, beat up, rape, blackmail, murder and so on, and they can do so in the context of seeking to further the interests of a collective, say a church or trade union or on orders from someone else in an institution.  But in every criminal case, individuals have to be the instruments of the criminal act and individuals are held responsible for their individual criminal actions.

The Victorian manslaughter model operates in reverse.  The Bill holds that a collective of persons is capable of criminal activity but chooses one legal form of a collective -- the corporation -- and declares that only it can act criminally.  The Bill excludes other collectives such as trusts, the public service, not-for-profit bodies and unions, and focuses on the corporate system as the instrument of criminal behavior.  It asserts that corporate culture and organisation commit criminal acts.  The first step in prosecution is to demonstrate this new criminality.  The second step is to find who within the corporation who will be punished (by way of fine or imprisonment) for the corporation's crimes.  The Bill declares senior officers as the "fall guys" to go to jail on the corporation's behalf.

The Bill raises questions of justice ignored by it's promoters.  How is it possible for a collective to have criminal intent?  What is so demonic about a corporation that it alone amongst collectives can have criminal intent?  What is so noble about government that it cannot, like a corporation commit a criminal act?  Could collective criminality be applied to religious, social, political or sporting organisations?  More specifically for corporate senior officers, could anyone know which of their actions would be criminal under this new and untested form of criminality?  What would be the new rules?

Many examples exist under current criminal laws where executives and directors of corporations have been found criminally liable for deaths where they had a direct hand.

The need for inventing new criminal law has not been proven.  For a society to function people need and deserve reliable application of consistent law.  The rewriting of criminal principles under the Victorian corporate manslaughter model fails this test.  The risk is corruption of justice, damage to commerce and diminishing of workplace safety.

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Give Smokers Some Respect

I smoke one cigar a year.  I know that smoking is harmful.  I know that by smoking I dramatically increase my risk of getting cancer as well as a list of other smoking-related ailments.

Yet I still choose to smoke.  What's more, I enjoy smoking.  I enjoy all those injurious little tars and resins.  It is my choice to smoke.  I have exercised my free will and accept the negative health consequences.  Yet in what constitutes the present debate about smoking, I am denied the simple courtesy of having my free choice recognised.

According to the anti-smoking lobby, I am an addict.  The addictive characteristics of nicotine are so overwhelming that I have lost my capacity to exercise my free will;  it's probably my addiction driving me to write this article.

Under this conceptualisation of addiction, addiction negates free will because it is argued that it results in the destruction of free will.  As I understand it, in the case on smoking handed down last week, when plaintiff Rolah Ann McCabe started smoking, the risks were not public knowledge, the information suppressed by tobacco companies.

Once a smoker, she was hooked for life and, as an addict, was not able to exercise her free will.  Of course cigarette smoking is difficult to quit, but it is possible to stop smoking.

After all, half of all non-smokers are former smokers.  There are patches, gum and pharmaceuticals that can assist, in addition to the more longstanding treatments.  Look around and there are invariably reformed smokers all over the place.  What's more, the evidence shows that people who quit enjoy better health.

The recent decision involving a smoker is symptomatic of a broader trend in Australian society to reject any notion of individual responsibility;  a trend to reject individual responsibility and instead seek to assign blame to the deepest pockets.  It's an ugly development that is having a serious effect on the fabric of life in Australia.  This development has been fanned, in no small part, by public liability lawyers who see this area as an extremely lucrative practice.

Looking at a recent landmark tobacco settlement in the US, it is easy to see why.  Lawyers acting for the plaintiffs received about $US8.2 billion ($15.3 billion).  It's time for a real public debate about smoking.  At the moment, this issue is being driven in the courts.  As I don't have much faith in our courts and the legal profession, I think it's time that we had a proper public debate about the rights of smokers in society.  I'm not talking about revisiting the past.

Make no mistake, the smoking debate has been lost for smokers.  All that remains is for smokers to hear their terms of surrender.  We haven't had a real debate about how society will accommodate smokers.  I'd like to know what anti-smoking activists see as the endgame for this issue.

Where are they driving this?  Are they seeking prohibition by legislation or do they plan to do this effectively by driving tobacco companies out of business?  So what happens to smokers like me?  As a citizen who smokes, what rights am I entitled to?  It's a reasonable question that no one is addressing.

If the anti-smoking activists say I have no rights, then I would like to hear this.  Governments, the anti-smoking lobby, the legal community and the media have to accept that a significant minority of society will always smoke and that they have a moral obligation to treat smokers with a degree of tolerance and accommodate their choice to smoke, and not treat smokers such as myself as criminals.

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Bashing via the Courts

The insurance industry is getting very picky over what it will insure.  And it's all down to lawyers, judges and individuals treating business as a cash cow and Aunt Sally to be bled and stoned to solve all manner of problems.

The pull out of Dexta Corporation from home warranty insurance is only the latest saga of the insurance crisis facing Australia.  Now that Dexta's reinsurer, Swiss Re, has pulled the plug saying that they can no longer afford to carry the losses, Australia is left with only one major firm willing to write insurance for house builders.

Coincident with the Dexta pull-out, we have a "dying granny" suing British American Tobacco saying their product caused her to contract cancer.  This begs the question, when does an individual bear responsibility for her own welfare?  Can anyone not have been aware over the past forty years that cigarette smoking causes cancer?  Is there not some obligation on the part of the individual to take measures to avoid harm instead of looking to raid the apparently deep pockets of a firm when things go wrong?

The common thread through these developments is business bashing through the courts.  Payouts from this create costs.  These require businesses to put up prices, increase production expenditures or exit the activity.  In the case of home building, there are reports of premiums increasing threefold yet still the cake was not worth the ha'penny to Dexta/Swiss Re.

Insurance industry problems are bringing action by State and Commonwealth Ministers.  Ministers want to put caps on payouts and to ensure that those who suffer losses are not themselves to blame.  Rather pointedly, the State Attorneys General have been left out of the action.  Too often they are captives of the plaintiff lawyers who have much to gain from litigation against business.

This is particularly evident with our very own Rob Hulls.  Mr Hulls actually wants to extend business bashing by jailing company directors following workplace accidents.  Rob Hulls blusters "One death in the workplace is one too many".  Well so it is, but what Mr Hulls did not tell us is that a death caused by Government negligence is more acceptable.

You see, Mr Hulls's proposal applies only to non-government company executives and directors.  It is only they who would be jailed for not being sufficiently aware that work practices in the businesses they own or control might lead to injury.  Government ministers, who are responsible for huge workforces, would be immune.  Why not include them?  Imagine Mr Hulls reaction from his Ministerial colleagues if he were to suggest that the Minister for Justice be made liable to be jailed for the death of a prison officer!

It all goes to show some politicians are quite happy to dish it out but refuse to take it themselves.

NSW Premier Bob Carr is leading the charge for reform to reduce business liability.  His reaction to Mr Hulls's proposals?  He'd be laying a welcome mat across the Murray for the firms streaming out of Victoria to relocate elsewhere.

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Expectations for a Competitive Retail Market in Tasmania

A Speech to the Utilicon TasPower Conference,
9 April 2002

WHAT HAS ENERGY MARKET DEREGULATION DELIVERED

Virtually all jurisdictions everywhere in the world are moving to the competitive energy market model.  The realisation that competition, preferably linked with private ownership, pays rich dividends in terms of efficiency has brought institutions like the World Bank to search for opportunities to apply the model even in markets smaller than Tasmania.  Fortunately for Tasmania, there is the opportunity of joining the national market which allows the State to take advantage of established means of improving efficiency and lowering electricity costs.  Whether Tasmania is positioning itself to allow itself to take full advantage of this is a matter I'll return to later.

The outcomes of deregulation around the world have not been comprehensively documented.  This is largely because the key outcome, prices to customers, has been obscured either by a phasing-in process, especially for the smaller customers, or because prices for competitive customers are not collected because they are confidential to the seller.  Moreover, prices of electricity, like those of other commodities, tend to be somewhat cyclical.

What we can be fairly certain of is some broad trends.  In the UK, NETA, the latest market model, has brought a claimed 15% price reduction (on top of the 30% real reduction 1990-2000).  In Australia, we saw prices for larger customers fall 28% 1996-1999 according to a number of surveys.  Prices for smaller customers were reduced by regulators.

Underpinning these price falls have been large increases in efficiency.  For example, in Victoria the generators since being moved into a more competitive setting (following corporatisation in 1994 and their subsequent privatisation) have seen their workforces shrink from about 11,000 to the equivalent of less than 2,500.  At the same time other efficiency measures like availability-to-run have been lifted from the high 70s to the mid 90s.  In terms of energy price equivalents this has seen an average spot, albeit in the context of a financially distressed generation industry, down from a level of about 44 cents per kWh to 25 cents.

On top of this we have seen improved efficiency further downstream.  Costs and staffing levels have been trimmed in retail activities and in distribution and transmission.  The privatised businesses in Victoria moved swiftly to take control of their labour relations, in the context of which workforces had long been padded and work practices ossified by union controls under the old SECV and its local municipal distributors.

In addition, we have seen a steady drop in minutes off line and in other indicators of improved service.

THE ROLE OF THE ELECTRICITY RETAILER

As retail margins are only about 5 per cent, some are perplexed by the prominent role given to the retailer in the judgements about the liberalisation of markets and, implicitly, about how they correspond to consumer benefit.

Under competitive circumstances, the retailer is the de facto agent of the consumer.  That role is assumed of necessity–if abandoned or neglected a rival will step in.  The retailer's activities, to ensure its on-going success and even its existence, must extend far beyond passively breaking down bulk and ensuring products are delivered at convenient locations.  It must extend to assisting in discovering what the consumer wants.  Unlike self selected (and often government financed) consumer "representational" bodies the retailer is compelled to be the agent of the consumer, as long as the consumer can move to an alternative agent if the retailer provides unsatisfactory service.

The retailer is an agent in a far more comprehensive sense than any representative body because it has to weigh up the needs against the available product inputs–and to do so correctly or face replacement.  The retailer is under great pressure to seek out inputs from all sources.

The homogenous nature of electricity does not negate this.  Electricity may be undifferentiable but its supply is from highly variable sources.  In terms of assembling inputs, the retailer must decide, based on its customers' and target customers' requirements:

• how much power to contract rather than buy at pool
• how much of different sorts of power (baseload, regular peak, needle peak) to buy
• how much price risk to take for the needle peak.

In addition, this basic product has to be metered correctly, bundled in profitable packages, promoted to consumers who may have little awareness of their needs and options, and priced appropriately.  The retailer also needs to examine economies of scope (or synergies) in bundling his goods together with other similar products, sharing services of specialists like meter readers, back office functions etc..

Competition between retailers does tend to ensure that, for a given quality, products are purchased from the cheapest producers and sold on to customers at margins that are not excessive in relation to efficient retailers' costs.  Competition is also, and perhaps fundamentally, a discovery process, whereby the competitors set out to ascertain the needs of customers, where those needs are not well defined by the customers themselves.

In this respect, retailer competition has played a vital role in guiding developments.  A competitive retail market forcing retailers to act in the interests of their customers, has meant a close focus on costs and product sourcing.  Competitive retailers has also meant experimentation with new marketing tools:

• more than one of the Victorian retailers is experimenting with direct debiting of customers' accounts;
• Energy Australia is insisting on interval metering as a condition for the installation of three phase systems for air conditioning.

Generally the greater customer orientation has meant retailers better focussed on needs and, in the current context, being prepared to pay more for peak power or fast start, thereby encouraging the development of such plant.

It bears repeating that retailers are not the agents of the consumer out of any sense of benignity but because they must act in such a role if they are to keep the business.  Their essential pre-occupation with profitability means they will raise prices to either discourage customers who impose to high a cost on the services they can offer or to better align the costs those customers entail with the prices they charge.

FRC EXPERIENCES

The foregoing indicates the dangers of simply treating electricity retailing as an automatic function that can be easily replicated by a smart regulator.  Joskow, Hogan and others ⁽¹⁾ have suggested that we can make do with a simple pass through tariff from wholesale and line charges to the customer.  This proposition has drawn a sharp response from Littlechild. ⁽²⁾

The pass through tariff is essentially what NSW's ETEF brings.  By fixing NSW wholesale prices, it stultifies competitive provision, while also imposing a risk, low but still palpable, of a colossal loss by government should pool prices zoom up for a lengthy period.  Over the longer term it will bring mismatches in energy requirements and availabilities as retailers have a much reduced incentive to signal needs by contracting forward for new supplies.

The ability of NSW consumers with annual loads of less than 160 MWh to take the fixed price means that the controls will continue to hamper market development in NSW for some time to come.  The most direct evidence of this is the tiny amount of retail churning we have seen in the State since the theoretical implementation of FRC.  Similarly, we have seen the growth of financial products being reversed.

In relation to the energy market, the turnover of contracts in NSW declined last year while that of Victoria increased fivefold.  Victorian retailers and generators were seeking out ways of defraying their risks but in NSW there was far less need to do so because the Government has mandated a form of insurance through ETEF.  The following chart is based on AFMA data, which is far from comprehensive but does depict an accurate contrast between the two major Australian markets.

In this respect the Parer Energy Market Review paper argued, "Government ownership of both electricity generation and retail businesses appears to provide a natural physical hedging opportunity, alleviating the need to maintain substantial financial contract positions to manage risk exposure.  This may restrict the volume of trading on financial markets and has the potential to hinder or distort the efficient and timely development of deep and liquid financial markets."

It might be argued, indeed is argued by those like Quiggin, that the market outcomes are entirely possible without retail competition.  And so they are.  The trouble is that in the absence of competition, those low cost, efficient outcomes never emerge or at least are never sustained.  It takes competition to jolt suppliers into undertaking the research and cost saving measures that serve consumer needs.

In the UK there has been much debate on the merits of full retail competition.  Although by no means opponents of competition, NERA have suggested that full retail competition in the UK has not been worth the price.  They argue that the associated IT costs of customer transfer and lack of metering at the small customer level requiring deemed load profiles means we cannot have true competition.  It is true that the arbitrary designation of load profiles severely detracts from the benefits of competition at the small customer end.  In fact it has a perverse effect in highly peaked markets like Victoria where retailers have an incentive to chase the high-usage domestic loads.  As this generally means those with air conditioning, it exacerbates the peak problem. ⁽³⁾

But to rule out competition for half of the load would mean jettisoning a vital entrepreneurial dimension to energy efficiency on a sustained basis.  This means the on-going role for regulatory oversight.  Our experiences with this have not been satisfactory.  It generally leads to institutions holding down retail prices.

Holding down retail prices

• reduces incentive and wherewithal of new players to emerge
• reduces the incentive of players to contract for new supplies
• at same time boosts demand

California here we come

The Victorian Government's decision on standing prices for below 160 MWh customers has produced levels of competitive activity below that expected in a full retail competition environment.  In aggregate, retail prices have been held down to levels much lower than those sought be the retailers who have faced a steep rise in wholesale prices.  And while price controls have their justification for monopoly services like distribution lines, they are not justified for those open to competition.

The upshot in Victoria has been only about 4,000 households have switched retailer over a three month period and the marketing activity of host retailers has been subdued.  This compares with a net 50,000 per week changing retailer in the UK.  And while churn is not the goal per se, it is an indicator of an active market.  More pointedly, the decision prompted the owner of one retailer (CitiPower) to announce that it is seeking a buyer, while it was doubtless a consideration in the decision of Pulse's owners to sell.

Unless prices are allowed to adjust to the underlying cost shifts, retailing will be seriously harmed and the consumer is the eventual loser.

In this respect, Victoria's recent decision also placed a 3% upper limit on the deviation from the average price allowed of the maximum price for individual customer classes This cements-in distortions, making it easier for new retailers to avoid those customer classes whose tariffs have become highly unprofitable.  Preserving cross subsidies is the outcome and intent of such glue being placed in the machinery.  The Victorian Government also gave a subsidy to rural consumers which is well and good as long as it comes from general revenue and is not a hidden charge on other consumers.  Unwinding of these cross subsidies is precisely the sort of outcome expected of markets and stymieing this blunts an important aspect of the efficiency promoting features of competition.  A further danger is that the host retailers will gradually be left servicing the highest cost customers.

All this said one might ask what is the relevance of the schedules to FRC such as the following?

Jurisdiction	Electricity	Gas
NSW	1 Jan 2002	1 Jan 2002
Victoria	13 Jan 2002	1 Oct 2002
ACT	Under review to be announced March 2002	1 Jan 2002
SA	1 Jan 2003	1 Sep 2002
WA	2005	1 July 2002
NT	2005 (subject to public benefit test)	n/a
Tasmania	2007	2007
QLD	No plans at this stage	Jan 2003 (subject to cost/benefit study)

At this point of time the NEM jurisdictions already have half of their load free to competition and ostensibly NSW and Vic are fully freed up.  But this is clearly of limited real value if there are measures in place like price caps or compulsory insurance that depress prices and undermine the creation of financial instruments on which competitive markets can prevail.

TASMANIAN IMPLICATIONS

Retail Contestability

Tasmania's proposed market opening was as follows (it was amended somewhat by the ACCC).

Table 3.1 The Tasmanian Retail Contestability Timetable

	Commencement (from Basslink start)	Expected Date	Contestability Limit	Approximate No. of additional uncontracted customers
Tranche 1	6 months	1 October 2003	20 GWh/yr	10
Tranche 2	18 months	1 October 2004	4 GWh/yr	54
Tranche 3	30 months	1 October 2005	0.75 GWh/yr	295
Tranche 4	42 months	1 October 2006	0.15 GWh/yr	1,030
Full contestability	54 months	1 October 2007	Under 0.15 GWh/yr	230,000

Source:  Meeting Tasmania's Energy Needs for the 21st Century:  A Competitive Future, Tasmanian Treasury.  November 2000, p41.

This probably puts inadequate pressure on Aurora but the nature of the State's contracts would arguably dictate such a timetable.

GENERATION

More important is the wholesale market and generation.  It is not possible to have retail competition operating effectively if there is no generation competition.  I want to go back to the words I used in preparing the part of the Nixon report that covered electricity.

"In any type of market, there is always a danger of one or two, usually large, generators exercising market domination.  Tasmania has 27 hydro electric power stations plus the irregularly used Bell Bay thermal station and power from Mt. Lyell.  But in terms of major storage, Great Lake and Lake Gordon accounted for over three quarters of the stored energy in 1996.  This raises the issue of controlling potential market power."

I went on to suggest that Tasmania could explore unitization of these dominant reservoirs, a procedure followed in oil.  And while arguing for privatisation of the HEC, I also argued that the generation business should be split into five different entities which roughly correspond to the catchment areas.

Those separate entities were as follows.

Catchment	Storage GWh	1996 energy GWh	Number of Power Stations	Capacity (MW)
Gordon-Pedder	4724	812	1	432
Derwent	1989	2726	10	514
South West	7299	1008	3	380
West Coast	340	2896	6	626
Northern	116	1687	7	308

Now there may be better ideas on how the HEC should be split up but it is clear that Tasmania will have inadequate competitive pressures if the one dominant firm is ensconced as a supplier.  And the control by that firm of Basslink prevents any competition other than that of Duke.  In the future we might see more robust competition with Bell Bay mark II at 234 MW on top of the repowered government owned facility.  But all this seems a long way off.

In the meantime the ability of the Hydro to constrain Basslink would not allow any mainland generator the ability to risk offering contracts in Tasmania.  That ability can mean driving up prices in the Tasmanian wholesale market in either the peak or off-peak by conserving water.  Nobody would enter into contracts in Tasmania without assurances about the hedge price and, especially where a competitor controls the transport medium, without a firm hedge.

On top of this electricity regime, the Government is not being helpful in facilitating competition with gas.  As a major competitor, gas can help place market disciplines on electricity supply.  But the Government has insisted on franchises for gas rather than letting retailer/distributors negotiate for wholesale supplies and proceed to roll out and sign up customers.  This has delayed roll out and might add further delays to the degree to which it requires franchisers to commit to a particular timetable.

Customers in Tasmania, as elsewhere, cannot be well served on an enduring basis if there is a monopoly.  And experiences in Australia and elsewhere in the world are that a government owned monopoly is even worse.  At least in the case of a private owned monopoly there are built-in pressures pare costs but a government body tends to be run by the employees and be subject to political rather than commercial forces.

It might be said that splitting hydro generation would reduce scale economies, detract from the abilities of the HEC to undertake consultancy services, and might impede the coordinated control of water supplies.  I don't believe any of these arguments are persuasive.  Splitting the HEC would still leave the component parts larger than many hydro concerns including Southern Hydro and many hydros, including Southern and Snowy, find ways to coordinate water that is jointly used.

The concerns about Tasmania that prompted the Nixon report have not abated since then, indeed the malaise in the State's economy has become even more apparent.  Hence, irrespective of National Market issues, Tasmanians should reflect on whether it is in their interest to retain electricity generation under a publicly owned monopoly.

It rarely serves the public interest for governments to be mesmerized by size in attempting to create national champions.  Iconic issues aside, preserving and on-selling Tasmania's hydro expertise is probably the most important reason for maintaining generation under a single business.  But the consultancy work of the Hydro is a modest contribution to the economy and in any event can travel just as well if it is housed in small units as in one larger firm, especially if the latter is cocooned from competitive pressures.

REFORM RECOMMENDATIONS

In short, Tasmania should break up the Hydro into 3-5 competing units, place Basslink on an independent and commercial footing (and, to the degree that commitments are in place, ensure that government reimbursement is open and clear) and re-examine its timetable for retail contestability.

It should sell off the different generation units as well as Aurora.

Its electricity policy should be supplemented by a hands-off gas policy.  No exclusive franchises should be given and no price assurances and roll out conditions should be put in place.  Gas is going to be a predator fuel for some time and the retailers will need to and be willing to give assurances to customers that locking in capital to use gas will not result in future squeezes.  Such assurances will emerge from market forces and need not require government.

---

ENDNOTES

1.  For example, Paul L Joskow, "Why do we need electricity retailers?  Or, can you get it cheaper wholesale?" Center for Energy and Environmental Policy Research, Massachusetts Institute of Technology, revised discussion draft, 13 January 2000

2.  Littlechild, S.C., Why we need electricity retailers:A reply to Joskow on wholesale spot price passthrough, The Judge Institute of Management Studies, University of Cambridge, September 2000.

3.  In Texas according to a McKinsey article, around 305 reduction took place where metering allowed charges (prices were not specified); see Power by the Minute, February 2002.  Faruqui et al report Georgia Power saw similar load reductions for their "most responsive' group with interval meters at prices of about 30 cents per kWh; see Regulation Fall 2001 Getting out of the dark.

Checking for Market Power in Electricity: The Perils of Cost Price Margins

Occasional Paper

INTRODUCTION

Concerns have been expressed around the world that the newly opened electricity markets have failed to be sufficiently competitive.  The competitiveness of electricity markets in the U.K. has been questioned almost since their inception. ⁽¹⁾  The California electricity market "meltdown" in the summer of 2000 brought with it numerous accusations and analyses of the role that inadequate competition played in creating price spikes and destabilizing the market. ⁽²⁾  Recently, Short and Swan have produced a thoughtful study of market power in the Australian electricity sector. ⁽³⁾  The study is especially valuable for clear and useful displays of bidding data.

There are sound theoretical reasons for believing that electricity markets may be unusually susceptible at times to the exercise of market power, compared to markets for other goods with otherwise similar competitive characteristics, e.g., measures of market concentration.  When it comes to the empirical assessment of market power, however, the approach taken in most of the analyses of market power in electricity, rests on a flawed application of a standard measure of market power -- the Lerner index, also known as the price-cost margin. ⁽⁴⁾

In a nutshell, the flaw in this measure, as it has been applied in these electricity market studies, arises because "marginal cost" in these price-cost margins is typically the average variable or operating cost of the "last" generator that would be dispatched to meet energy demand. ⁽⁵⁾  Let us call this the PAVC test, for "price-average variable cost". ⁽⁶⁾  As we will see, the PAVC standard for competitive pricing would imply that no generator would enter.  As Short and Swan put it,

[Competitive] behavior will give rise to the lowest market price that ensures that all generators are at least compensated for any short-run marginal costs incurred.  Under these conditions, the market price would reflect the short run marginal cost of the most expensive generation turbine called to supply into the market. ⁽⁷⁾

However, in any market, competitive or not, even this most expensive "marginal" generator has to expect that prices will, on average, cover not just its variable costs but its fixed capital costs as well. ⁽⁸⁾  If not, it would find entry unprofitable.  This can lead in simple cases to prices substantially above average variable costs in peak periods.  From that starting point, it is not difficult to imagine enough real-world noise in the form of uncertainty regarding demand, generator outages, and market bids, to arrive at outcomes similar to those found in these studies, without necessarily indicating market power.

THE INTUITION

The primary context in which market power might be exercised is when the industry is facing capacity constraints.  In that context, when one is trying to discover what the (short-run) competitive price would be in a market where capacity is limited, one would not compare price to the average variable cost of the marginal plant, or even the next one that might have been brought online.  In a simple model where there are only two levels of demand, peak and off-peak, one would predict that the peak price over the long run would equal that highest average variable cost plus the average capacity cost of the plant.  The actual level of the on-peak price in the short run would be above or below this value, depending on whether demand was higher or lower than that expected when the unit was constructed.

The measurement situation is even worse.  Over the life of a peak plant, demand will vary.  Some hours the demand will be high;  some it will be low.  Price will vary with demand, even if firms are price takers, while any measure of cost that one would want to use would remain constant.  Consequently, any measure of market power based on a relationship between price and marginal cost will have to fail.  A measure does not work if one can get different values while the underlying phenomenon -- in this case, failure to act like a price-taker -- does not change.  Either a price-based measure does not indicate the level of market power in such industries, or one is claiming that peak prices are somehow anticompetitive, and more so as demand rises.  Neither conclusion is acceptable.

With demand varying over time, the only way to know if these prices are inappropriately high relative to "marginal cost" would be to compare the discounted present value of revenues received from electricity sales from the unit to the total construction and operation costs of unit.  Even if that virtually impossible task could be carried out, it would be impossible to conclude simply on that basis that firms had been acting anticompetitively.  They may simply have underestimated demand when they constructed the units in the first place, or there may be regulatory rules that limit plant construction (or expansion).

Studies of market power based on price-cost margins reflect virtually no appreciation of these concerns.  Marginal cost is not the average operating cost of the most expensive natural gas plant, based on gas prices, emission permit prices (in parts of the U.S.) ⁽⁹⁾ and other variable costs.  Unless one posits that we have an overbuilt industry, in the sense that the peak plants are destined to lose money, peak plants are going to earn capacity rents. ⁽¹⁰⁾

Perhaps the best and least fortunate example is that the Federal Energy Regulatory Commission (FERC) has used the "highest average variable costs" standard in setting its wholesale price cap, explicitly saying that it will not allow higher prices so that firm could earn capacity rents. ⁽¹¹⁾  Under such a policy, in the long run no firm would build a peaking plant.  Moreover, no firm would enter the industry at all, if the firm with highest operating cost is not allowed to recover its capital expense.

HOTEL ROOMS

To get a feel for the flaw in the PAVC test, let us turn first to a more familiar industry -- resort hotels.  Imagine that in a seaside town, one can build hotels.  The optimal size for a hotel is 100 rooms.  Once built, it costs $50/day to maintain a room, including cleaning, electricity, water, and predictable wear-and-tear from usage.  The fixed annual capital costs for the hotel are $1,095,000 per year ($30/day/room, for 365 days and 100 rooms).  There is no relevant restriction on entry, i.e., if one thinks that one can profitably operate a 100-room hotel in this town, one can build it.  To make the example simple, we assume that the firms are acting competitively, i.e., take the going room rate as given in making decisions whether to build a new hotel.

Suppose first that demand to use this resort is roughly the same all year round.  In that case, hotels will enter up to the point where the price of a room is $80/day.  $50 of that $80 covers the cost of maintaining a room -- the average variable cost.  $30 of that $80 goes to cover the capital cost of the hotel.  At prices above $80, more hotels would be built.  If price were forecast to be below $80, say $50, no one would enter.  The PAVC test would fail to predict competitive prices in the market.

Next, imagine that demand for hotel rooms at this resort town is seasonal.  For three months out of the year, people really want to come to the beach.  The rest of the time, demand for rooms is weak.  In such a situation, a decision to build a new hotel will be predicated on filling it up during the summer season.  Accordingly, the price of hotels in the summer will be $170/day.  $50 of this rate is the average variable cost, and $120 is needed to cover the cost of the hotel entirely from summer occupancy.

Because every hotel gets to charge this rate during the summer, not only those hotels built to serve summer clients, they all will capture their capital costs at that time.  The price of a room off-season would then be only $50.  The PAVC standard would predict off-peak rates, but would fail on-peak rates.  Holding hotels to a PAVC standard would mean that not only that none would be built to serve summer visitors to the resort.  It would also imply that year-round hotels would be unable to recover their capital costs as well.

There is one case when the PAVC test might be relevant.  Suppose interest in visiting this resort fell dramatically after hotels were already built, e.g., because the water was found to be unsanitary leading to closed beaches.  (This has happened in the U.S.)  The hotels could not be "deconstructed", so to speak.  Hotels would compete through reduced prices until the hotels already constructed were full at a rate below $170 -- perhaps visitors want to sit on the beach, and not go in the water -- or prices fell to average variable cost, $50.  Only if the market had large amounts of excess capacity, defined in terms of the long-run unprofitability of a new entrant, might we expect a PAVC standard to apply.

BACK TO ELECTRICITY

Peak-load pricing principles that hold for hotels regarding peak-load pricing hold for electricity as well.  We will get to some important complications, but first imagine that there is only one kind of electricity generator with 100 megawatts of capacity, with average variable costs of (say) $30 per megawatt-hour (MWh).  Suppose also that of the 8760 hours in a year, demand is at peak for 450 hours, about 2% of the time.  Finally, suppose that the fixed annualized costs of building and maintaining the generator is $7.65 million, a figure chosen to come out to $170 per MW per peak hour.  (This is also about 30% of the total variable cost of running a plant full out.)  For simplicity, again, assume that at off-peak times capacity exceeds the amount of electricity demanded at $30/MWh.

By analogy with the hotel example, the price of electricity would be $30/MWh off peak and $200/MWh ($30 + $170) on peak.  Finally, then, assume that during peak periods, the demand for power would be 6000 MWh.  Were one to plot what the predicted price of electricity and average variable cost as a function of power demanded, one would then get the following graph:

Already we can see that during peak periods, price will be substantially above average variable cost.  However, a number of significant complications must be added to this stylized picture to get a more realistic view of what the competitive supply curve would look like.

#1. If a generator is going to be operated only at peak periods, one would expect that it would have a lower fixed-to-variable cost ratio.  Since a peak plant will have only a few hours of operation in which it could cover its capital costs, it will be more economical to use low capital/high variable cost technologies at peak periods, with high capital/low variable costs for baseload plants. ⁽¹²⁾  Thus, one would expect the average variable cost curve to slope upward to some extent as one approaches industry capacity.

#2. As noted above, the industry could be at peak capacity at different levels of demand.  This would produce observed price-quantity points to fill in the vertical line between the peak price of $200/MWh and $30/MWh.  The extra profits in these "shoulder" demand periods would induce entry, reducing the maximum peak price in this example.  However, the possibility of a super-peak demand, reached on fewer than 5% of all hours, would tend to increase the maximum price.  In any event, the supply curve would tend to have a vertical component as well as a horizontal one, forming a backwards "L".

#3. There is a separate set of fixed costs in electricity having to do with the costs of starting up and shutting down a generator altogether.  A generator may be constructed, but prices will have to exceed not just average variable costs, but produce enough revenue to cover startup and shutdown costs, before a generator will find it appropriate to meet demand. ⁽¹³⁾

#4. Perhaps most importantly, generators operate in an uncertain environment, in at least two important respects.  They do not have perfect knowledge as to what demand will be at a given time.  Neither need they know how many of their competitors' generators will be unavailable at full capacity due to scheduled maintenance or unforeseen shutdowns due to equipment failure, transmission congestion, fuel supply, or other contingencies.  Thus, one would expect to see generators guess that price may be above variable cost at times when actual supply ends up being below the full industry capacity.  This will tend to "fill in" that backwards L with observed quantity-price data points.  One would expect greater density of data points toward the boundaries of the "backwards L".⁽¹⁴⁾

Putting these together would give an observed set of quantity-price data points and an AVC graph that looks something like:

The numbers and arrows in the graph indicate the effects listed above.  The dotted area of price and quantity observations does not represent a precise prediction of prices and outputs we would observe.  The economics of peak load pricing with a bit of real-world noise could produce patterns like those observed by Short and Swan for Queensland and Victoria. ⁽¹⁵⁾

RESPONSES AND REJOINDERS

One response to these objections to price-cost based market power tests is that the capacity costs of the last generator in do not matter.  According to one view, generation companies own a portfolio of plants.  Profits from the baseload plants can cover the capital cost of the peaking plant.  But this seems to leave unanswered the obvious question of why such a company would own a peaking plant.  It would have higher overall profits if it were not to build a peaking plant, if that plant would not recover its capital costs.

A second reason that capital costs should be irrelevant might be that they are recovered in a separate capacity market.  If so, one needs at least to describe such a market, including the "strike price" at which the buyer or regulator could demand that excess capacity be brought online.  The returns from those sales would then need to be factored in to determine whether the marginal plant is making excessive profits because prices are too high.  PAVC based studies do not incorporate such an analysis.

If capital costs are left out, it should not be surprising that prices will exceed marginal costs, as defined by the average variable cost of the last firm in.  But that is consistent with competition.  If all firms were identical -- of course they are not -- price would have to equal minimum average total cost.  If capital costs are trivial, then one would not need rents to cover them.  Of course, that does not imply that capacity constraints would not be binding in between the time it takes to build plants.  Scarcity rents do not imply anticompetitive conduct or effect.  Again, the question should be not whether prices are higher than they would be if plants could be built instantaneously, but whether suppliers are withholding output to make the prices go even higher.

One possibility, of course, is that the industry is overbuilt, in the sense that the marginal plant is expected to lose money over the long term.  However, such an explanation is inconsistent with the theoretical reason for predicting that market power is likely in electricity just because supply and demand are so inelastic.  If there is excess capacity because of regulatory or ISO requirements, then the "price" of electricity on or off peak would have to include a capacity component of some kind.  These considerations are also typically not present in price-cost based studies.

THEORETICAL MARKET POWER CONCERNS

Mismeasurement does not imply that generators lack market power, particularly in peak periods.  Theory offers some suggestion that regulators might want to be on the lookout for the unilateral exercise of market power, particularly at peak periods. ⁽¹⁶⁾  To oversimplify a complicated subject, one can subdivide the possible models into those in which the firms choose prices, and those in which they choose quantities or outputs.

Models based on output may predict noncompetitive outcomes.  Such models have two variants, but both are problematic.  One variant involves firms undersizing plants to keep output low and prices high.  Since capacity choices are made over the long run, this outcome is possible only where fixed costs are large enough and the market small enough to support only a few competitors. ⁽¹⁷⁾  These conditions do not appear to hold in the U.S.  One would not expect them to hold in Australia, either, although in both places the legacy of franchise utility monopolies (in the U.S.) and public ownership (in Australia) could lead to concentrated markets absent divestitures to disaggregate ownership.

The second output-based type of model is short-run, taking the number of competitors in the market as given.  In this case, generators could make strategic choices to limit production in order to raise prices, taking the supply decisions of the other suppliers as given. ⁽¹⁸⁾  With a low elasticity of demand for electricity, this could lead to substantial price-cost margins, even with a relatively large number of competitors.  For example, if the elasticity of demand for electricity is -.2, ten identical generators would, in such a model, set prices equal to double marginal cost. ⁽¹⁹⁾

Such a strategy is not likely to be profitable at peak periods.  If we are talking about withholding output below capacity, the relevant marginal cost will be something like the AVC.  As we have seen, at peak periods one would expect prices to be set at many multiples of AVC.  Even excluding the prospect of longer-term entry, firms may be better off producing up to their capacity limits and taking the competitive price, at peak periods, rather than withholding output.  Such withholding may be more profitable off-peak, but one would expect the elasticity of demand for electricity to be greater off-peak as well, mitigating the incentive to withhold. ⁽²⁰⁾

With regard to price-based strategic models, the most important involve "dominant firms" that set prices assuming that competitors will take that price as given. ⁽²¹⁾  In these models, the price-cost margin at the profit-maximizing price is positively related to the market share of the dominant firm, and inversely related to the elasticity of demand for the product as a whole and the elasticity of supply of its competitors. ⁽²²⁾  Off-peak, with capacity exceeding demand, the elasticity of supply of the other firms is likely to be quite high. ⁽²³⁾  On peak, however, the elasticity of demand is likely to be very small, perhaps approaching zero.  With a small elasticity of demand as well, a firm with even a small market share may find it profitable to withhold output and set prices substantially above marginal cost. ⁽²⁴⁾

As with the quantity-based models, on peak we would expect substantial price-cost margins in any event, so we may not observe such an exercise of market power.  We might instead simply see everyone finding it optimal to supply up to capacity and charge prices exceeding marginal (or average variable) cost.  However, the possibility of very low supply and demand elasticities at peak periods implies that one cannot dismiss market power claims, even if a generation market "looks" competitive by conventional measures. ⁽²⁵⁾

QUANTITY-BASED EMPIRICAL APPROACHES

Some defend price-cost studies at least in part on the basis that critics have not suggested alternative tests for market power. ⁽²⁶⁾  This seems unfortunately to be too much like the "looking where the light is" punch line to the standard economist joke. ⁽²⁷⁾  But there are, if one focuses not on prices, which can exceed average variable costs, sometimes by orders of magnitude.  The focus should be not on price but on output, i.e., withholding.  Specifically, one should seek to identify generation capacity that would have been profitable to run at prevailing market prices, but was withheld from sale.

Econometric tools could offer some insight.  The increased profits achieved by withholding output accrue not just to the withholder, but to all electricity suppliers.  This suggests that all else equal, a power producer is more likely to withhold capacity the greater is its share of overall capacity in the market.  That, in turn, suggests a hypothesis:  If output is being withheld to exercise market power, one should observe "maintenance shutdowns" disproportionately among producers with larger market shares.

One might see this empirically in two ways.  If shutdowns are random, a firm with X% of capacity should see X% of shutdowns, all else equal.  A simple measure of concentration (e.g., the Herfindahl-Hirschmann Index, or HHI) ⁽²⁸⁾ of outages could exceed the measure of concentration of capacity as a whole.  More accurately, were one to regress likelihood of outages on firm characteristics, the coefficient of a term relating to market share should significantly exceed one.  The larger the firm, the even more likely it is that it would have a generator shutdown.

Finally, and perhaps most notably, would be direct examination of output, rather than indirect inferences using econometrics.  Few industries offer the level of firm-specific cost and output data available regarding the electricity generation sector.  If those data are reliable, one should not have to resort to statistics to infer market power.  One would not expect generators to be taken offline voluntarily when prices are at their peak.  If anticompetitive withholding is going on, the regulator ought to be able to "name names" -- identify those generators that have withheld electricity that otherwise would have been profitable to generate, if one were taking prices as given.  Regulators could investigate specific incidents of peak-period maintenance to see if the output reductions were warranted.

Such data will not be free from ambiguity. ⁽²⁹⁾  Generators frequently need to be taken offline for maintenance purposes and, as noted earlier, the costs of starting up and shutting down units may make generation companies less willing to operate than might seem immediately profitable.  Fox-Penner also notes that firms may end up holding capacity in reserve against outages, and such capacity may remain unsold even during a price spike. ⁽³⁰⁾  To meet an appropriate legal burden before enforcing any policies or punishments, one would need to evaluate other explanations for the withholding.  But this is a practical and I think better alternative than price-based approaches.  A helpful sign is that Joskow and Kahn, among those who have adopted the price-cost method criticized here, are giving more weight to output based studies. ⁽³¹⁾

CONCLUSION

Criticisms of the competitiveness of generation markets are widespread.  Unfortunately, many of these criticisms are based on comparisons of prices to average variable cost.  However, even in a competitive electricity market, one would expect to see prices substantially above average variable cost during peak demand periods.  Variation in demand, increasing average variable cost curves, and particularly uncertainty among generators regarding market demand and supplies from their competitors can give price-cost data patterns not unlike those used to support claims that the industry is not behaving competitively.  Last and not least, the prospect of entry could dampen market power over the longer term.

That said, low supply and demand elasticities for electricity, particularly at peak periods, support some degree of concern that generation markets may not be competitive.  Better tests for market power would look to quantities, not prices, e.g., by seeing if firms with larger market shares are disproportionately more likely to have outages.  Perhaps the best test, with the data available, would be for regulators to identify directly the suppliers that seem not to be generating nominally profitable electricity, and then see if any excuses are sound.

Finally, a philosophical observation:  The different approaches may arise out of different interpretations of what "market power" is about.  From the neoclassical perspective, questions about market power of looking for efficiency losses, which fundamentally are not based on price but on reduced output.  By that criterion, "market power" is fundamentally about withholding.  A less neoclassical perspective may focus on the distributive effect of higher prices.

To the extent one cares about distributive effects, one might be drawn more to price than to output.  If demand for wholesale power is perfectly inelastic, e.g., because retail prices are fixed by regulation (as was the case in California), one could observe higher prices without the output reductions characteristic of the exercise of market power.  I would include "price but no output reduction" effects as questions of "market design" or "gaming the auction", but not "market power", a term that I reserve for practices that lead to reductions in supply in order to raise prices and profits. ⁽³²⁾  But to the extent one combines those under the same heading, one might be drawn more to price tests for market power.  Unfortunately, they just do not work very well in addressing that specific concern.

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ENDNOTES

1.  Richard Green and David.  Newbery, "Competition in the British Electricity Spot Market", Journal of Political Economy 100 (1992):  929-53;  John Kwoka, Transforming Power:  Lessons from British Electricity Restructuring, Regulation 20 (1997), available at http://www.cato.org/pubs/regulation/reg20n3e.html.

2.  Paul Joskow, "The California Market Meltdown", New York Times, Jan. 13, 2001;  Severin Borenstein, James.  Bushnell and Frank Wolak, "Diagnosing Market Power in California's Deregulated Wholesale Electricity Market", Working Paper PWP-064, University of California Energy Institute (2000);  Paul Joskow and Edward.  Kahn, "A Quantitative Analysis of Pricing Behavior in California's Wholesale Electricity Market During Summer 2000", Working Paper No. 8157, National Bureau of Economic Research (2001).

3.  Christopher Short and Anthony Swan, "Competition in the Australian National Electricity Market", ABARE Current Issues (January, 2002).

4.  Formally, the Lerner index or price-cost margin is

(P - MC) / P,

where P is the price and MC is the marginal cost.  For a profit-maximizing firm, The Lerner index is typically equal to 1/E, where E is the elasticity of demand facing the firm.

5.  See, e.g., Joskow and Kahn, n. 2 supra at 5.

6.  Also to be clear, we should note explicitly that the problem is not that marginal or variable cost is increasing within the capacity range of the generator itself.  For simplifying purposes here, we can assume that average variable cost (hence marginal cost) is constant within a particular generator, up until it hits its capacity limit.

7.  Short and Swan, n. 3 supra at 2.  Short and Swan's discussion here is somewhat ambiguous, because just before these sentences, they state that "where marginal costs can increase quickly as demand approaches capacity limits, competitive prices can exceed the marginal cost of producing the required electrical energy".  However, they go on to state that prices must be less than "marginal cost of an additional unit of energy from another generator".  This is not correct, as we see below.

8.  This point is not new.  See Robert Dansby, "Capacity Constrained Peak Load Pricing", Quarterly Journal of Economics 92 (1978):  387-98, especially 394.

9.  Some natural gas power plants in Southern California had to purchase permits, to emit nitrous oxides, a pollutant that contributes to the formation of particulates and ground-level ozone.  Because the supply of such permits was fixed to limit nitrous oxide emissions, permit prices rose as electricity prices in California, so too did the permit prices, until regulators stepped in and substituted a fixed price for permits for the supply limitation.  Joskow and Kahn, n. 2 supra, treat the permit price as an exogenous price which should included in calculating the average variable cost of the marginal gas plant, in estimating their price-cost margin.  However, that permit price is not exogenous but endogenous.  Even if electricity were being withheld, one would think that the price of nitrous oxide permits would be driven up to the difference between the market price of electricity and the marginal cost of a gas plant, taking into account the marginal emissions of that plant.  That Joskow and Kahn find a difference between price and "marginal cost" (actually average variable cost of the marginal plant) even including these permit prices suggests that there is a difference between actual and measured marginal cost that their empirical procedures neglect.

10.  Marginal-cost based tests are not necessarily flawed, but the definition and measurement of marginal cost needs to be made carefully.  A marginal plant recovers its capital costs in a competitive market because at some point the marginal costs within the plant are increasing.  The example in the text -- a unit with constant marginal costs within the plant (not across plants!) up to a capacity constraint -- is an extreme example of that phenomenon.  More generally, one would expect marginal cost to go up as one gets closer to "full capacity", if for no other reason than one may run a greater risk of a breakdown of the unit down the road.  If so, those costs would need to be included in a Lerner index to see if prices are inappropriately high.  Calculating marginal costs based on fuel prices and average operating and maintenance costs, as is typical in these studies, does not recognize this phenomenon.  At peak periods, average variable cost is not a proxy for marginal cost, accurately conceptualized and measured.

11.  Federal Energy Regulatory Commission, Order on Rehearing of Monitoring and Mitigation Plan for the California Wholesale Electric Markets, Establishing West-Wide Mitigation, and Establishing Settlement Conference, EL00-95-031et.al., issued June 20, 2001.

12.  Michael Crew and Paul Kleindorfer, The Economics of Public Utility Pricing (Cambridge, MA:  MIT Press, 1986).

13.  When these, along with ancillary service revenues, are factored into profitability estimated, the decision whether a plant is profitable to operate at a seemingly high price becomes extraordinarily problematic.  See Scott Harvey and William Hogan, "Identifying the Exercise of Market Power in California", Dec. 28, 2001, available at http://www.ksg.harvard.edu/hepg/Papers/Hogan%20Harvey%20CA%20Market%20Power%2012-28-01.pdf , especially 11-26.

14.  One error avoided in some price-based studies of the California situation is that prices would be inflated by the prospect that bankrupt distribution utilities would not honor their promises to pay for wholesale energy, particularly when the courts mandated such sales to prevent blackouts.  On this basis, James Bushnell does not base market power claims on California price data during the winter of 2000-01, when prices were at their highest, despite off-peak demand.  James Bushnell, "What We Do and Do Not Know About How Electricity Markets Work", keynote address, NEMS/Annual Energy Outlook 2002 Conference, Crystal City, VA (Mar. 12, 2002), notes available at http://www.eia.doe.gov/oiaf/aeo/conf/pdf/bushnell.pdf.

15.  Short and Swan, n. 3 supra at 5, 6.  Their specific test for whether a market was not competitive if the median Lerner index over a given month exceeded .3.  They are right to suggest that the pattern for Victoria is more likely to be suspicious than that for Queensland, but not necessarily because Victoria has more observations a certain percentage above average variable cost of the marginal plant.  Rather, it is because the observations for Victoria appear to have more points farther above average variable cost and to the left of the vertical "capacity" or "maximum output" line.  Such observations require greater amounts of seemingly profitable electricity to remain unsupplied.  It is the quantity that matters, not the price.  We return to this point below.

16.  For a related discussion of the theory and other issues raised regarding market power in electricity, see Timothy Brennan, The California Electricity Experience, 2000-01:  Education or Diversion (Washington, DC:  Resources for the Future, 2001):  37-40.

17.  In some industries, firms may not enter even when prices are high because they would predict that the added competition resulting from their entry might result in prices so low that they would not recover sunk costs incurred by coming into the market.  This is especially true for industries in which fixed costs are so great that competition among just a few firms would generate too little revenue to cover them.  Hence, one cannot say as a matter of absolute generality that entry cures all ills, and the prices can never be sustainably above competitive levels.  However, the opening of electricity generating markets around the world has been predicated on the view that fixed costs and resulting economies of scale are not so large as to result in only a very small number of suppliers being viable.

18.  Limiting or withholding output could be accomplished either by simply not producing energy, or by offering to sell it only at prices above that which buyers are willing to pay.  On either account, the result, a reduction in supplies actually purchased in order to drive up prices, is the same.  We may also have situations in which prices are bid up, taking advantage of the design of the electricity market, but with no power being withheld.  Pure price manipulation situations should be analyzed as failures of the design of the market, and not as the anticompetitive exercise of market power.  Brennan, n. 16 supra at 33-35.

19.  The standard result for identical firms in a quantity-based model is that the price-cost margin (see n. 4 supra) equals 1/NE, where N is the number of firms and E is the absolute value of the elasticity of demand.

20.  Obviously, this is not necessarily true.  However, at any price, off-peak quantity demanded will be lower than on-peak quantity demanded at any price.  If the slope of the demand curve at that price is the same off peak as it is on peak, then the elasticity off-peak will be greater.  Of course, the off-peak demand curve could be steeper than it is on peak, producing an outcome counter to this intuition.

21.  William Landes and Richard Posner, "Market Power in Antitrust Cases", Harvard Law Review 94 (1981):  937-996.

22.  Formally, the expression is

(P-MC)/P = S/(E_D+[1-S]E_S),

where S is the firm's market share, E_D is the absolute value of the elasticity of demand, and E_S is the collective supply elasticity of the other firms.

23.  Because electricity is by and large a homogeneous good, when firms are choosing prices, the outcome is likely to be competitive, e.g. price equal to marginal cost, when capacity constraints do not intervene.  See Jean Tirole, The Theory of Industrial Organization (Cambridge, MA:  MIT Press, 1989).  To some extent, "electricity" might be a differentiated product, particularly if some consumers are willing to pay a premium for so-called "green" power.  See Timothy Brennan, "Green Preferences as Regulatory Policy", Discussion Paper 01-01, Resources for the Future (2000).

24.  For example, applying the equilibrium condition in n. 22 supra, we might observe a firm with 10% of the market (S = .1) setting price at about 50% (10/19) above its marginal cost if the elasticity of demand is .2 and the elasticity of supply of the other firms is .1.

25.  The prospect of profits exceeding competitive levels would be expected to attract entry.  But under the very low supply and demand elasticities associated with electricity at peak periods, it is not clear whether such entry would preclude the exercise of market power, even in the long run, or whether it would merely spread the profits among a larger set of firms.  If the latter is the case, entry might depress profits per firm, but not peak-period prices.

26.  Severin Borenstein, "The Trouble With Electricity Markets:  Understanding California's Restructuring Disaster", Journal of Economic Perspectives 16 (2002):  191-212.

27.  For those who may not know the joke, it begins with someone crouched under a streetlight at night, looking for something.  A second person walks over and asks, "Do you need any help?" The first responds, "I'm looking for my car keys".  "Where did you leave them?" "Over there", the first replies, pointing down the street.  "Why are you looking here, then?" "Because this is where the light is."

28.  The HHI is the sum of the squares of the market shares of sellers in the market.  In a monopoly market, where one firm has 100%, the HHI is 10,000.  In an atomistic market, as market shares approach zero, so will the HHI.  If there are N equal-sized firms in a market, the HHI will be 10,000/N.  For a discussion of how the HHI is used in electricity mergers in the U.S., see Federal Energy Regulatory Commission, "Inquiry Concerning the Commission's Merger Policy Under the Federal Power Act:  Policy Statement, Order No. 592 "Docket No. RM96-6-000 (December 18, 1996), especially Appendix A at 59-62, 74-79, available at http://www.ferc.fed.us/Electric/mergers/mrgrpag.htm#PolicyStatement.  The HHI has three theoretical rationales, none especially compelling.  A first, due to Stigler, is a model in which the likelihood that a firm in a cartel would detect that a loss of market share is the result of nonrandom price-cutting by someone else rather than random variation in where customers shop is a function of the HHI.  George.  Stigler, "A Theory of Oligopoly", in George Stigler, The Organization of Industry (Homewood, IL:  Irwin, 1968).  A second is that in a Cournot model, the HHI is proportional to the welfare increase attainable from increasing industry output by a fixed amount.  Robert Dansby and Robert.  Willig, "Industry Performance Gradient Indexes", American Economic Review 69 (1979):  249-60.  Third, in a Cournot model with constant demand elasticity in which firms have different marginal costs, the mark-up of price over a share-weighted average of marginal cost will be proportional to the HHI.

29.  For detail, see Harvey and Hogan, n. 13 supra at 47-71.

30.  Peter Fox-Penner, Comments Before the Federal Energy Regulatory Commission, Investigation of Terms and Conditions of Public Utility Market-Based Rate Authorization, Docket No. EL01-118-000 (Feb. 11, 2002):  44.

31.  Paul Joskow and Edward Kahn, "A Quantitative Analysis of Pricing Behavior in California's Wholesale Electricity Market During Summer 2000:  The Final Word", mimeo, Feb. 4, 2002.

32.  See n. 18 supra.

Submission to the COAG Energy Market Review

Submission

INTRODUCTION AND SUMMARY

Our approach to the Review

The Energy Market Review Issues Paper sets out six priority issues.  Three of these ⁽¹⁾ are not addressed in this submission, which concentrates on

1. Identifying any impediments to the full realisation of the benefits of energy market reform;
2. Identifying strategic directions for further energy market reform;
3. Examining regulatory approaches that effectively balance incentives for new supply investment, demand responses and benefits to consumers;

In addressing these matters we wish to offer information that:

• stresses the importance of private ownership and secure property rights in promoting greater efficiency;
• examines how to ease the tension between competitive prices and minimal regulation on vertically non-integrated or effectively ring fenced companies;
• explores how to facilitate access pricing regulation that avoids excessive intrusion and inflexibilities, reduces the current enormous paperburden, and allows businesses greater certainty on which to invest and grow;
• provides advice on the appropriate principles for establishing pricing regimes for regulated services;  and
• would facilitate a greater consistency of treatment of regulated facilities across Australia.

The electricity and gas industries

Electricity and gas are vital cogs in modern economies with an importance that is considerably understated merely by measuring their share in GDP (three per cent or so) the industry comprises.  Without power and light from electricity and gas few of our daily activities would be possible.  While gas and electricity are in competition with each other, gas is a significant fuel for electricity and many energy businesses have interests in both.

Aside from matters stemming from their ubiquity within the economy the industries' composition also creates policy issues.  The industries' four branches:  production, transmission, distribution and retailing, are interdependent.  Until the last decade or so they were usually integrated, although natural gas production has normally been separate from its transport and retailing.  The industries' disaggregation has been universally accepted as the best contemporary means of bringing greater efficiency.  This allows for competition to be more active within the industries.  As with all structural arrangements, these may not be optimal for all situations and, indeed, some retailers have acquired some generation.

Under the present policy framework, generation and retailing are treated as market-driven contestable sub-industries and transmission and retailing as natural monopolies that require some regulatory control.  The regulatory/competitive dichotomy is, of course, not hard and fast.  Some -- primarily small isolated -- regions may find it difficult to ensure sufficient competition in generation or retailing.  And there are developments, especially in transmission, which are eroding the previous monopoly over supply.

The interface of a regulated with deregulated parts of the industry poses considerable risks to efficiency and commercial viability..  Regulated output prices using inputs with deregulated prices can, as has been seen, quickly bring ruinous cost squeezes.  More commonly, unless the regulation is highly attuned to the true market position, it can lead to a gradual erosion of the incentives that are essential to drive efficiency in any industry.  This applies especially to industries with private ownership.

In this latter respect, there is also now a widespread, though not unanimous view that private ownership in energy industries is superior to public ownership.  We have been and remain a major participant in promoting the merits of privatisation

Private ownership itself adds another dimension to the regulatory agenda.  An industry that is privately owned, even in part, cannot internalise its transactions in the way that is possible within a government integrated monopoly.  This brings an illumination of costs and efficiencies that was previously hidden, facilitating means of promoting efficiency.

1. THE IMPORTANCE OF PRIVATE PROPERTY RIGHTS

For much of the twentieth century, public ownership and central planning enjoyed wide support as the best means of promoting efficiency.  There is now no reputable body of opinion that maintains such a view.

There is impressive empirical evidence gathered through hundreds of studies by the World Bank to demonstrate the greater efficiency of private ownership.  This is notwithstanding examples of successful government businesses.  Indeed, in the Australian energy industries there have been some aggressive marketing moves by some publicly owned retailers, notably Energex.  Similarly, energyAustralia has been highly innovative in seeking to ensure new domestic customers installing air-conditioning are charged their true costs.

Although government owned businesses are capable of considerable efficiencies, in the final analysis they suffer from four disabilities that tend to weaken their performance disciplines over the longer term.  These are:

• The lack of a market for the firm itself if others perceive its management is underperforming.  It is not possible for a rival to mount a take-over (or, unless the state privatises) for the owners to voluntarily leave the field to a different management that might perform better.
• The ownership by the state means some political influence is almost certain to be wielded, eventually perhaps in the form of tariff setting, perhaps in requiring the business to operate using the government's preferred form of labour relations.
• The difficulties of motivating the management with a comprehensive profit related stake in the business
• The lack of profit maximising shareholders who have alternative venues for their funds.

Low cost energy is one of Australia's key natural advantages, even if, as during the much vaunted resources boom of the 1970s, the advantage has from time to time been over-stated.  However, comparisons between Australian and international electricity and gas supply industries conducted during the 1980s demonstrated that our industries were lagging in competitiveness.  Poor management, political interference and union controls had left the industries with chronic over-manning, excessive development, and prices that failed to match costs.

All states, with the partial exception of Queensland shared in this malaise, but it was in Victoria that the problems were deepest seated.  Different studies by Victorian Government bodies ⁽²⁾ established the nature of the weakness and the Productivity Commission's predecessor body, the Industry Commission (IC) documented this more comprehensively. ⁽³⁾

The Commission set out a blueprint which included measures to ensure state based electricity businesses made use of competitive forces to bring about lower costs but also argued that private ownership was necessary to ensure gains are quickly taken up and become on-going.  The Commission was forthright in articulating its view that "Ownership clearly does matter." (Vol 2 p. 154).  Privatisation was recognised as being important in bringing disciplines of capital markets and "the sanctions provided by the possibility of take-over and the risks of insolvency.  Privatisation was also seen as a means of significantly reducing the scope for interference by governments." (Vol 2 p.147).

Gas production, transmission, distribution and retailing is now largely privately owned in Australia. ⁽⁴⁾  Electricity remains mixed and the NSW Opposition's policy announcement against privatisation in that State ⁽⁵⁾ is a setback for the reform process.  Appendix 1 examines the outcomes of the privatised Victorian industry against that of other states.  In general the data offers strong evidence to support the notion that privately owned businesses perform better than their government owned counterparts.

On-going government ownership of the energy industries continues to exercise a major suppressing effect on the industry's efficiency.  It does so notwithstanding the undeniable improvements that have followed from governments implementing corporatisation of their own business entities.

Private ownership's advantages are often said, correctly, to be less important where there is natural monopoly.  Natural monopoly occurs with large elements of transmission and distribution in both gas and electricity.  But even here there are persuasive reasons to move down the private ownership path.  These reasons include the fact that the natural monopoly might not prove enduring -- something now being seen in both gas and electricity transmission -- and because profit motivated cost reduction disciplines are so much more potent when under the control of private shareholders.

RECOMMENDATION 1

The Energy Market Review should recommend that governments develop privatisation programs for those energy businesses they continue to control.

2. DISTRIBUTION AND TRANSMISSION ISSUES

2.1 The regulatory approach

Among the four industry components, local distribution of electricity and gas is normally the most important component of price.  It also presents the most enduring regulatory issues, since as we shall argue, transmission is fast emerging from being correctly seen as a natural monopoly, though it is yet to escape the regulatory prison.

2.2 Essential facilities regulation

With any market, there is no doubting the importance of a legal framework in allowing efficient commercial interactions.  And although regulation is a short-sighted policy where markets are competitive, there is a strong case for the regulation of an essential facility

There is a key distinction between a facility that has been developed without any protection or support from government and one that has been developed under some sort of franchise (or, like much Australian infrastructure, by the government itself).  Where the monopolist has seized his position by spotting an opportunity and offering value, the government regulation is pure coercion.  Where the monopoly is created by law, the monopolist is clearly bound by the terms of the original grant which include the quid pro quo for that grant.  Those undertaking a development of the former kind need not and should not face regulation regarding access or price.

Professor Richard Epstein ⁽⁶⁾, one of the world's leading authorities on constitutional and property law, however does not consider the distinction between a franchise protected "essential facility" and one that developed without any privileges as being as crucial as this.  Much of his analysis (like the key English and American cases that established precedents) rests on the seventeenth century tract by Lord Matthew Hales de portabis mari ("concerning the gates of the sea").  In that tract, which was not published until the 1780s, Hales argued, that an asset (he was discussing cranes in ports) can be "affected with the public interest" either "because they are the only wharfs (sic) licensed by the queen" or "because there is no other wharf in that port".

Although not accepting a sharp dichotomy of approach between government supported and purely entrepreneurial infrastructure, Epstein argues "....regulation must be justified on the grounds that any monopolist charges too much and sells too little relative to the social -- that is the competitive -- optimum.  But even when true, the case for regulation is hardly ironclad.  The situational monopoly may confer only limited pricing power, and its durability could be cut short by new entry, or by technical innovation.  Regulation could easily cost more than it is worth, especially if the regulation entrenches present forms of production against the innovation needed to undermine its economic dominance." (p. 284)

But Epstein's view is that an essential facility will inevitably be regulated -- something observable with railways in England from the mid nineteenth century.  That being so, the issues remain to define the facility, at what point of time it is to be regulated, and how to ensure its owners have sufficient incentive to operate efficiently.  Judging by outcomes the world over with rail regulation the task is extremely difficult.  Appendix 2 offers further argument on these issues.

2.3 Regulatory decisions on price

In the final analysis, dominating the regulation debate is the prices that businesses are permitted to charge.  In the February 2002 edition of the publication of the Utility Regulators' Forum, NETWORK, Professor Fels argued that in separate research Mr Rod Sims and NERA have both indicated that regulation is providing more than healthy returns compared with unregulated businesses.  The work cited sought to demonstrate that regulatory outcomes in Australia were more favourable to the regulated businesses than those in the US and UK.

A paper prepared by NECG ⁽⁷⁾ carefully assesses the NERA analysis.  NECG's rigorous examination of regulatory decisions in Australia, the UK and elsewhere found comparisons that assumed all the regulated entities were of a "plain vanilla" variety is highly misleading.  With reference to the NERA analysis, they found that:

• the sectors analysed were atypical of the average levels of risk-free rates and equity risk premia, and when other regulated industries were included the averages were markedly higher;
• specific regulatory measures taken in the wake of the Maxwell scandal had artificially reduced the rates paid on UK government bonds, and the consequential risk free rate;  and
• the regulatory models used in the US and UK give investors greater certainty than those in Australia and hence require lower returns.

A variation of this final point was alluded to in a McKinsey report, which argued:

Regulators enjoy considerable discretion in determining prices for a forthcoming control period, so the outcome of the review is not easy to predict.  Uncertainty produces what the market perceives as regulatory risk.  This market perception must explain at least some of the increased cost of equity under the UK system.  The beta (a measure of risk) for UK utilities is around 0.9, whereas the corresponding figure for US utilities is around 0.5 when adjusted for similar levels of debt.  Thus the real allowed return in the United Kingdom must typically be more than 1 percent higher than the return in the United States.  The cost to the United Kingdom's economy is between $2 billion and $3 billion a year in higher utility charges. ⁽⁸⁾

It is also noteworthy that the Productivity Commission, in its Position Paper rejected the ACCC views that current comparative rates of return, together with the evidence of new investment plans in some regulated sectors, can be taken as strong evidence that the access regime has been benign in relation to investment. ⁽⁹⁾

Regulators' price decisions have required prices considerably below those sought by the regulated businesses.  Real WACC levels have also tended to decline over time.  The following chart summarises the more recent decisions.

Table 1

ISSUE	Regulator	Applicant charge	Determined charge	Date
AGL gas contract market	IPART	Annual revenue reduction from $140m to $128m	Annual revenue reduction to $99m	May 1997
Vic gas	ACCC/ ORG	9.7-10.2 return real post tax	7.75% return post tax	October 1998
Wagga gas (GSN)	IPART	Original 11.1% later offer 9.0%	7.75%	March 1999
Telstra Interconnect	ACCC	4.7c/minute	2.0c/min. with 1.6c suggested Sept 1999	June 1999
Adelaide Airport	ACCC	8.89% real pre-tax or $3.66/passenger	8.25% pre-tax or $3.45/ passenger	June 1999
Mildura gas	ORG	Tender at 9% real pre-tax	9% real pre-tax	June 1999
Albury gas	IPART	9.6%	7.75%	July 1999
NSW vesting contracts	ACCC	43.64 cents	no more than 40 cents	September 1999
NSW distribution prices	IPART		16% real price reduction 1999-2004 7.5% (7.75% AIE, AE) 15% O&M reductions (10% AE, 5% AIE)	2000 Final Determination
AGL Pipelines for the Central West Pipeline	ACCC	Real pre-tax WACC of 10% tariff increasing after 2001 at CPI+1.36%	Real pre-tax WACC at 7.5% meaning prices are frozen in real terms post 2001	September 1999 Draft Decision
AGL Pipelines for the Central West Pipeline	ACCC	Real pre-tax WACC of 9-9.5% tariff increasing after 2001 at CPI+1.36%	Real pre-tax WACC at 7.8% (10.55% post-tax nominal) tariffs as proposed for 2 yrs then to fall by real 0.06% p.a	July 2000 Final Decision
Victorian Electricity Distributors	ESC	Pre-tax real WACC AGL 8.6% CitiPower 8,5% Powercor 10.6% TXU 10.5% UE 9.7%	Pre-tax real WACC 7.1-7.4% draft 6.8-7.2% final Year 0 price reductions (%)         Original Final AGL         17.1  15.5 CitiPower 12.4  11.2 Powercor  19.6  14.5 TXU         21.8  18.4 UE          12.9    9.1	December 2001 Final Decision
Powerlink	ACCC		Pre-tax real 7.04%	July 2001 Draft Decision

The popularity of the recent film "A Beautiful Mind" has thrown into relief the importance of risk in decision taking and the application of game theory in reducing such risk, thereby offering mutual gains between parties as well as winner-takes-all zero sum gains.  The application is especially relevant to situations where parties learn from each others' behaviour and modify their actions accordingly.  While at first glance a regulator may take the view that disallowing certain costs as a part of the charge base brings gains to the consumer, second round outcomes are less certain.

The issues of comparative rates of return has featured in all seminars and conferences that examine the appropriate WACC or other measure of return.  Commonly those seeking a lower return would point to BHP and cite that company's return on capital of, say 7%, and argue that the regulator has been over-generous to the regulated entities in offering a return higher than this.

What this neglects is the fact that BHP has a number of entities that earn a great deal more than 7% and is a business successfully striving to improve its returns by divesting the underperforming parts and seeking to expand the better performing parts.  And the BHP activity closest to the regulated energy industries is Bass Strait gas where the business would earn a return on its investment of several hundred percent.

Moreover, the rate allowed in regulatory decisions is based on a risk-free situation.  Projects have levels of risk that different proponents will disagree upon.  Putting a maximum return at some average level computed from Stock Exchange data leaves little incentive to embark on riskier projects.  At the same time, it destroys the symmetrical nature of the average spread of returns by cutting off the upside, thereby automatically reducing the true return the business can make.

2.4 The efficiency of regulatory law and its effects on property rights

2.4.1 Regulation and efficiency

Unless they perfectly mimic market forces, regulations of the uses to which property rights may be put reduce the value of private property rights.  Such a reduction in the value of assets' output, as the Productivity Commission noted ⁽¹⁰⁾, tends to deter investment by raising hurdle rates.  This means that assets generally and their associated labour and raw materials are used less than fully productively on an economy-wide basis.

This is just one of the deleterious effects likely to follow from intervention into the rights that private owners have in the use of their property.  Also likely is a suboptimum level and pattern of operation and maintenance expenditures.

Any government action that might diminish the value of private property rights should, therefore, be introduced only after the government has assured itself of the existence of countervailing benefits.

Government intervention in the normal interactions between buyers and sellers and associated parties has the capability to undermine property rights and hence investment.  In addition, it can bring costs that distort on-going operational actions.

2.4.2 Paperburden costs

Governments should ensure that firms are not diverted from seeking to profitably meet consumer needs.  Regulatory certainty and stability are essential to allow this.  Where businesses confront intensive regulatory oversight, the risk premia they require to embark on activities that involve sunk costs are increased.  In addition they are constrained to set aside resources to counter adverse effects on them from the regulations.  Both of these outcomes entail costs that have no corresponding benefits.  Efficiency requires that governments minimise regulatory restraints on businesses whether they be privately owned firms or corporatised public firms designed to face similar disciplines and incentives.

Governments have created a plethora of regulatory agencies to control the energy industry.  At the Commonwealth level, regulatory agencies fall under acronyms that include ACCC, NCC, NECA, AGO and NEMMCO.  In addition, all states have their own regulatory agencies -- for Victoria alone, those overseeing the energy industry include Essential Services Commission (ESC), VENCorp, EIO and OCEI and OGS.  These agencies risk shifting the entrepreneurial activities of the industry's firms from a customer-directed to a regulator-pleasing perspective.

And none of these agencies, which collectively require some $200 million a year of public funds, actually produce anything.  Instead they provide directions, some of which are necessary, to the producers and sellers of electricity and gas on matters like:

• the prices they may charge,
• their permitted terms of dealing with each other,
• the fuel inputs they must use,
• the safety arrangements they must take, and
• the way they must treat their customers.

To do all this, the regulatory agencies have spawned a plethora of hearings, reports and decisions.  For electricity, Victoria's Essential Services Commission (ESC) alone has produced or caused to be produced hundreds of documents, comprising well over a million pages.

Regulation also brings costs far in excess of the sums expended on the regulatory authorities themselves.  As a rule of thumb, the paperburden of regulatory costs imposed on business is often quoted at twice the costs of administering the regulation by the government itself. ⁽¹¹⁾  This rule of thumb would almost certainly understate the resources involved in the energy industries where the regulatory framework is central to the various businesses.  Each of the hundreds of documents has some commercial impact -- actual or potential -- on a number of firms and requires consideration and responses.

The government/regulator is often increasingly driven to augment its demand for information once it commences along the path.  This may be because of a different view between itself and the facility owner over what constitutes commercial behaviour.  In most cases the demands for additional information would have required responses from all of the businesses even though they may be unnecessary or irrelevant for some.

Experience is demonstrating that the regulators' requirements on firms for the purpose of price setting are extraordinarily intensive.  Firms often claim that the information demanded of them is not normally collected or not available in the way that is sought.  These regulatory costs are especially high in the directly regulated "essential facility" businesses but also figure strongly in generation and retailing where government intrusion remains strong.

2.5 Outcomes of current access regulation

A number of submissions to the Productivity Commission's inquiry argued that regulators have adopted "pragmatic" rather than "efficient" pricing principles in practice, and that this necessarily reduces the likelihood that the theoretical benefits of price regulation will be attained.

However considerable uncertainty surrounds the question of whether, and to what extent, investments have been delayed, distorted or cancelled due to access regulation, with data being scarce and inadequate.  Submissions have included those that attempted to provide broad measures and others offering more specific, or anecdotal, evidence.  The submission of the ACCC is prominent in the former category.  We have already noted the Productivity Commission's rejection of its claim that new investment plans vindicate the ACCC's views that the current access regime does not discourage investment.

In this context, evidence regarding the impacts of access regulation on specific investment proposals must clearly be given weight.  The Productivity Commission's Position Paper cites a number of cases brought to its attention in the submissions, all but one of which suggest that access regulation has had disincentive effects.  While the "sample" of project specific information is small in size, it is notable that a preponderance of the cases cited argued that access regulation was a disincentive to investment.  Indeed, BHP was alone in arguing that an access regime had, in its case, facilitated a new infrastructure investment. ⁽¹²⁾

One particular instance that has come to our notice concerns TXU Networks, which sought a variation of its access arrangement to allow the profitable reticulation of gas into Barwon Heads in Victoria.  This expenditure was not originally forecast and hence required the ORG's authorisation.  The company sought a return on capital expenditure comparable to its internal hurdle rate for capital expenditure.  The variation was rejected by the ORG and TXU deferred the investment to supply gas to the area.  All parties were therefore losers:  consumers were denied early access to a new energy alternative;  the company was denied an ability to supply a profitable opportunity it had discovered.

Also of note in this context is the Melbourne Airport case, in which the ACCC sought to intervene in a case in which a voluntary agreement had already been reached between the facility owner and the access seeker.  In this case Melbourne Airport and Impulse Airlines had agreed on terms for access by the latter to the new Domestic Express Terminal.  In its submission to the Commission, Australia Pacific Airports Corporation (APAC) argued that:

"Ideally, users and providers should be able to agree on terms and conditions of supply free from intervention by the regulator.  This not only ensures that operators are receiving an adequate return, but it properly reflects on the value that users place on services provided." ⁽¹³⁾

The APAC submission argues that, by contrast, when regulators consider pricing mechanisms "the sole focus of attention is the provider of the service".  As a result:

"...the apparent willingness to pay of a customer was not even mentioned in the ACCC's draft decision."

Moreover, it is argued that, despite the voluntary arrangement between the parties ultimately surviving the regulatory intervention by ACCC, there has been a tangible result in terms of investment disincentives.  According to APAC:

"...as a result of the ACCC's conduct, the Board of APAC will now no longer approve investment in new aeronautical facilities until such time as a final pricing decision is available."

It is vital not to dampen the profit motivated efficiency drives including seeking out new opportunities that stems from private property rights and outcomes in terms of business decisions.

2.6. Benefits of adopting a more narrowly focused regime of access regulation

Much of the regulatory literature over recent decades has, inspired by the work of Stigler ⁽¹⁴⁾, featured the notion of regulatory capture by the regulated entities.  Yet, in more recent years at least, the risk has been in the opposite direction with the regulatory authorities engaging in what Shuttleworth ⁽¹⁵⁾ has called "regulatory opportunism" to reduce prices.

Regulatory opportunism tends to bring a bias in favour of insufficient rather than excessive supplier returns because the most important constituency for the regulator is the government and public opinion.  Generally, a regulator's decision will be more welcome to consumers the lower the price levels they bring.  Although setting a price that is too low will rebound on the system's development and eventually on the existing network's reliability, a self-interested regulator's time horizon will place a lower priority on the longer term.  By contrast, a business accountable to private shareholders has a combination of capital maintenance and current income as the focus of its self-interest.

The Chairman of the Productivity Commission, Gary Banks ⁽¹⁶⁾, has also given recognition of this phenomenon.  He says

As is well known, the traditional concern based on the American experience was of capture of regulatory agencies by industry incumbents, who have more incentive than anyone else to find ways of influencing how regulators interpret the rules in their particular cases.  But, depending on the institutional settings, quite different forms of influence can operate.  These include favouring the interests of current consumers (and electoral constituents) over the interests of future consumers;  which could lead to new entrants being favoured over incumbents.

The question of the impact of access regulation on investment has been widely discussed.  This discussion has included both theoretical considerations and attempts to analyze the impacts of the specific forms of access regulation currently implemented in Australia.

The potential for access regulation to have a "chilling" effect on investment almost certainly represents the major cost likely to be associated with it.  It is, by definition, not possible to observe investment that has not been undertaken as a result of regulatory disincentives.  However, the potential for regulation to lead to major dynamic inefficiencies due to distortions of investment behaviour is apparent.  Anything that reduces an investor's returns is some disincentive to invest.

Disincentives to investment arise from specific concerns as to the risks to returns from particular assets due to the operation of a given access regime.  They also stem from a general tendency to increased "sovereign risk" where governments are seen as overly willing to constrain private property rights.

A risk averse view is clearly required in such circumstances.  This is likely to be more damaging to general welfare where the importance of dynamic efficiency outweighs that of static efficiency.  In such circumstances the impact of access regulation is likely to bring income transfers, rather than income increases.

It follows that unless the investment need is stable, and we can be highly confident that the regulation will be benign, it is preferable to err on the side of failing to declare essential facilities, rather than on the side of declaring non-essential facilities.  This preference is heightened because other remedies, both in competition legislation and in other avenues, are available to address errors of omission.  By contrast, there are no immediate remedies identifiable to address errors caused by regulating unnecessarily.

Though all excesses of regulation will rebound on economic activity, they assume greater immediate importance where the access regulations have the effect of reducing expected values below those necessary to justify the investment.  Commonly regulators may try to excise the "economic rent" type of excess profits.  But doing so may reduce the potential upside gain which the project, to be viable, needs in order to counterbalance downside risk.  This is a matter that looms especially large in cases when new (rather than expanded) investment is under consideration and where demand is uncertain.

This argument for avoiding regulation has greater force, particularly in relation to the issue of the extensive information required to underpin effective and efficient price regulation.

2.7 Addressing costs in regulated businesses

The previous section argued for a narrowing in the scope of access regulation.  It is also essential that the form of access regulation should also be improved.  The key purpose of reform in this regard is to reduce the extent of the negative impacts of access regulation on incentives and on perceptions of regulatory risk.

Two matters of particular importance are discussed in the literature in respect of the best way to value regulated assets.  The first is whether to use forward or backward looking costs.  That is, whether to take previous investment costs as the basis for determining current prices or whether to take the future costs of the equivalent investment as the basis of current costs.  The difference is important because the future costs are often lower because of improvements in technology.

The second is whether to optimise investment by disallowing costs for investment that is unnecessary in the future.  Again, disallowing unnecessary costs brings lower present prices for consumers.

As with many other outcomes of regulatory approaches, the appropriate course is contrary to that initially presumed to be in the consumer interest.

While for facilities that are competitive, it is not possible for the supplier to charge for assets that are shown to be unnecessary, the regulated facilities are by definition not open to competition.  If such a firm were to be denied a component of prices that comprised costs that are either unnecessary or will be cheaper in future, an element of risk is added.  The firms themselves will require a higher investment premium for future expenditures or will delay undertaking such expenditures until they are urgent.

Similarly, a forward looking regime may unduly discourage new investment where costs are falling in real terms.  This effect can be at odds with the social optimum where demand is rising and some portion of the investment is underutilised in the initial years.

Of course, there is a contrary viewpoint.  The regulator in attempting to mimic the market does not want to reward poor decision making or premature investment.  And the regulator wants to avoid being in the position of forcing users to pay for "stranded" costs that are not efficient.  The dilemma will probably always be with us and is the main reason why "light handed" regulation which is not related to actual input costs (e.g. CPI-X as in its originally envisaged UK form) should always be the preferred model.

2.8 Consistency between access regimes

The form of access regulation -- where such regulation is applicable -- should be made consistent, as far as possible, across all sectors.  Thus, Part IIIA should form the basis for all access regulation, with industry specific access regimes being approved only where there are substantial industry-specific issues to be addressed.  All industry-specific regimes should be made fully consistent with the general principles embodied in Part IIIA.

In particular, industry specific access regulation should not substitute lower "thresholds" for applicability than those applied in Part IIIA.  In this context, we note as an example the submission to the Productivity Commission's inquiry of Australia Pacific Airports Corporation.  This argues that, by declaring certain facilities to be subject to Part IIIA, the Airports Act has the effect of lowering the threshold for its application, in particular in terms of the "national significance" aspect of the criteria for application.

The mechanism of "declaring" that an access regime applies to particular facilities clearly precludes the operation of the generic processes by which the NCC informs itself of the views of the parties and reaches a considered view as to whether the criteria for application have been met.  In so doing, it inevitably undermines the original Hilmer notion that access regulation is an unusual intrusion on property rights, which is to be used sparingly.

Finally, each industry-specific access regime should be subject to regular review to ensure its continuing need and that its form remains appropriate to the industry and the markets it faces.  This view is consistent with the general view that regular regulatory review is essential to ensure the maintenance of regulatory best practices in a dynamic sense.  More specifically, however, it is clear that many of the industries that are subject to access regulation will be characterised by rapid structural and technological change in the medium term.  This suggests both that the need for access regulation per se may change over time and that the requirements of industry specific access regimes may also be subject to major change.

The frequency of such reviews may vary between different industry access regimes, reflecting different expectations about the rate of change.  This has tended to increase.  Existing "sunsetting" and mandated review requirements for legislation in Australia tend to work on five to ten yearly cycles which suggests that a five yearly review period should form the starting point for consideration in relation to individual industry access regimes.

As important as the frequency of such reviews is the nature of the review process itself.  A fundamental consideration is that reviews must be conducted independently of the industry access regulator.  They should be conducted transparently, by a body with adequate expertise, such as the Productivity Commission.

RECOMMENDATION 2

• The on-going requirement for every facility's access regime should be reviewed on an regular basis against the need, due to potential anti-competitive outcomes in the absence of such a regime, and costeffectiveness.
• These reviews should be conducted by an independent, well-informed non-regulatory agency like the Productivity Commission.

2.9. Inclusion of pricing principles

2.9.1 Some issues with current approaches

Pricing principles, where specified in existing access regulation, are often poorly chosen, being based on pragmatic, rather than efficiency considerations.  In this respect the Freight Australia submission to the Review of the National Access Regime argues:

"Regulators should be mindful of the limitations and potential adverse effects that flow from a pragmatic, but poor, choice of pricing principles.  Pricing principles that dampen investor incentives or undermine investor confidence would detract from the efficiency objective of access regulation". ⁽¹⁷⁾

The submission to the Review of the National Access Regime of Energex similarly argued regulators have tended to follow poor pricing rules and that, for this reason, an approach based on the use of Section 46 of the Trade Practices Act may often yield superior results.

The choice of "pragmatic" pricing principles in practice is likely, in most cases, to be the result of recognition of the difficulty of obtaining the information required to implement "efficient" price regulation.  To the extent that this is true, the adoption of a "risk averse" approach, involving erring toward leaving monopoly rents uncaptured, is a necessary outcome.  Gans and King argue that:

"...the regulator will have to consider itself as leaving some monopoly rents with regulated service providers.  In this regard, the rents are simply an incentive bonus...and not monopoly profits per se." ⁽¹⁸⁾

Given the degree of imprecision involved, due to informational requirements, and the relatively "light handed" approach that recommends itself as a result, it is not clear that price regulation under an access regime would exhibit superior performance in practice to one based on prices surveillance legislation.  It is doubtful that there is any justification for extending the application of access regulation based on its superior performance in relation to monopoly pricing per se.  This, in turn, tends to support the adoption of a narrow view of the applicability of access regulation.

2.9.2 Some appropriate principles to use

As noted above, we believe that there is, in general, considerable scope for pricing principles to be undermined in practice by the regulator, via the exercise of his necessary discretion.  Consequently, pricing principles must be detailed and carefully specified if they are to be able to improve regulatory outcomes and enhance accountability on the part of the regulator, by providing an improved basis for the challenge of decisions by the regulated.

Therefore, we welcome the proposal made in the Productivity Commission's Position Paper that pricing principles should be inserted into Part IIIA.  We believe that the specific pricing principles proposed by the Commission in Proposal 8.1 are a useful starting point These are:

"The pricing principles in Part IIIA should specify that access prices should:

• generate revenue across a facility's regulated services as a whole that is at least sufficient to meet the efficient long-run costs of providing access to these services, including a return on investment commensurate with the risks involved;
• not be so far above costs as to detract significantly from efficient use of services and investment in related markets;
• encourage multi-part tariffs and allow price discrimination when it aids efficiency;  and
• not allow a vertically integrated access provider to set terms and conditions that discriminate in favour of its downstream operations, unless the cost of providing access to other operators is higher.

To these we would add provisions to meet two fundamental issues of price regulation.  The first is the need for the evolution of such regulation over time to be consistent with the provision of incentives for continuously seeking improved productivity and efficiency performance.  In order to deal appropriately with this issue, the following considerations must also be embodied in pricing principles:

• Pricing regulation should be "light handed" in its approach, both in terms of the extent of its attempts to capture monopoly profits and the information requirements imposed on the regulated;
• In pursuit of the above, it must be accepted that there should be some sharing of productivity gains between producers and consumers; ⁽¹⁹⁾
• There should be recognition that, in a competitive market characterised by high entry costs and high levels of specific expertise, "super-normal" profits can persist for some time and are likely to be necessary to provide adequate signals for the entry of new competitors;
• Use of CPI-X regulation, to be fully incentive compatible, should incorporate price resets calculated on the basis of price monitoring with the X factor reflecting industry TFP, rather than rates of return or cost-based building blocks.

In the above context, that the need for price regulation to be incentive compatible over time is acknowledged in the Productivity Commission's Proposal 8.2.

A second issue that requires reflection in pricing principles is the need for an approach that is "conservative", in the sense of erring towards allowing facility owners to retain monopoly profits, rather than toward risking "under-compensation".  The point to be underlined is that a conservative approach is required, not only to ensure investment incentives are maintained, in the positive sense, but to ensure "in the negative" that facility owners do not receive sub-normal, or even negative, returns as a result of failed attempts at a too "surgical" approach to price regulation.

Added weight is lent to this point due to price regulation being information intensive and, as a result, subject to a relatively high degree of error.

2.9.3 Building on existing experiences

Recent price re-sets for distribution and transmission have proven to be both acrimonious and resource intensive.  The re-sets in Victoria and NSW have squeezed out any surplus profits (more than squeezed them out if transaction prices for Powercor and the share price for United Energy are guides).

Access to the distribution or transmission facility per se is not an issue -- only one of the Victorian distributors (CitiPower, which is in the process of being sold) is not separated structurally from its retail arm.  Powercor/Origin and United/Pulse have different ownership structures for the two activities.  Across Australia, transmission is carried out in totally independent businesses.  The concerns about transmission or distribution businesses favouring affiliates has proven to be unfounded and there are ample means of addressing such concerns should they emerge.

Commenting on the deficiencies that the present "building block" approach to price setting, the Productivity Commission argued, ⁽²⁰⁾

"The approach is clearly highly information intensive and intrusive, which participants claimed reduces incentives for good performance.  Specifically, it requires the regulator to:

• seek extensive information about a facility's existing and forecast costs, including of any services not regulated (to prevent cost shifting);
• form judgements about whether costs such as operations and maintenance are based on efficient service delivery;  and
• seek information about planned capital expenditure and form judgements about whether that expenditure is justified.  This is because capital expenditure will increase the asset base and, therefore, the allowed dollar rate of return.

"The need to forecast future costs, and to validate proposed capital expenditure, could lead to the regulator having a significant influence over the running of the business."

These developments mean it is now timely to reduce the level of regulatory intrusion.  The originally conceived notion of CPI-X regulation has been gradually modified into a form of cost based price setting.  Recognising the appropriateness of the level of prices based on those presently in operation, an X-factor based on Total Factor Productivity should now be set in place.  There is ready information on levels of Total Factor Productivity trends that can be used to set such levels of aggregate price.  Within the average price level, businesses should be free to make variations to cater for different demands.

RECOMMENDATION 3

Implement future price settings based on CPI plus an externally developed Xfactor that incorporates Total Factor Productivity, with

• full flexibility within the overall price setting for shifts that reflect cost changes;  and
• to ensure investor confidence, place major restraints on future regulatory actions that might modify the basic CPI-X outcome.

2.10. Provision for "access holidays"

Access regulation can have significant disincentive effects on new investments in infrastructure through its impact in reducing ex ante expected rates of return.  This effect is clearly most pronounced where the construction of new facilities is being considered, as the degree of uncertainty as to the returns to the project will generally be greatest in these cases.

Following from the earlier discussion of property rights, we maintain that access regulation and price controls should not apply to infrastructure that is developed without the benefit of a government franchise, or other government support.  In the current Australian environment, the adoption of this approach would be likely, in effect, to exempt most new infrastructure investment from coverage by access regulation. ⁽²¹⁾

In the absence of a narrowing of access coverage, a "second best" amendment would be that access regulation be reformed to provide explicitly for the use of "access holidays" in relation to new infrastructure projects.  Those projects were certainly not "essential" when conceived because life went on without them.  But following earlier analysis, it can be persuasively argued that they progressively migrate into the "essential facility" category.

Equating an access holiday to a patent is a useful view of the concept.  It suggests that the access holiday constitutes an explicit recognition of the right of the facility provider to the return on his investment as the quid pro quo for his creation of new value.  It could also be married with the traditional common law concept of bottleneck facilities being "affected by the public interest", whether or not they were developed under a franchise.

The important point is that the access holiday should not represent a "concession" by the regulator.  Rather, as it applies to facilities developed with no or minimal government assistance, it is a recognition of the facility-owner's property rights.

Consistent with this reasoning, implementing access holidays using "null undertakings" may be inapprpriate.  The undertaking mechanism functions as one in which facility owners "voluntarily" cede access to their property on certain terms, under threat that arbitration by the regulator may yield less advantageous terms.  It was not envisaged as a means by which property rights may be positively affirmed.  Moreover, use of the undertaking mechanism may create a presumption -- or some pressure, at least -- toward the specification of "post holiday" access terms as part of the "null undertaking".  This would be misconceived because there is a the need for consideration of such matters to be made at a later date in the light of the history of the facility and the returns made on it.

There is also some doubt as to whether Part IIIA, as currently drafted, allows for the use of "null undertakings".  Amendments that would make explicit provision for access holidays would clearly be needed.  In this context, it seems preferable to establish such provision separately from the existing undertakings provisions, given the different fundamental purposes served.  Alternatively, it is arguable that provision of an access holiday is more closely equivalent to a "negative declaration", with the distinction (vis-à-vis existing declaration arrangements) that it would occur ex ante.

More important than the specific mechanism by which access holidays would be conferred is the question of the terms of the access holiday.  The broad terms of access holidays must be explicitly set out in legislation if the desired effect, of minimising regulatory uncertainty and disincentives, is to be attained.  This does not, however, prevent the inclusion of some element of flexibility to deal with different circumstances.  These may include:

• Provision for variation of the standard period of the access holiday should be symmetrical:  that is, it should also be open to the investor to propose that a longer than standard period is required due to the specific characteristics of the project;
• Any ability for the regulator to reject the holiday on the basis of the likely ex ante appearance of high profitability should be closely circumscribed, with a high standard of proof of both high profitability and relatively low risk (or uncertainty) being required; ⁽²²⁾  and
• Additional flexibility should be provided by enabling extensions or augmentations of existing facilities (or network related investments) to be subject to access holidays, but that such requests would be assessed without any presumption in favour of acceptance.

Comments from the ACCC indicate that they, too consider that the concept of access holidays may have merit. ⁽²³⁾  In this context, we support the ACCC view that

"The Commission does not want this process to be seen as one of picking winners.  By this we mean that it is one thing to grant a regulatory holiday for all entrepreneurial pipelines, but it is quite another for governments to pick and choose which projects are granted this status".

However, we would question the ACCC's presentation of the question in terms of when market power would arise and be "able to be exercised", rather than in terms of the need to ensure that investment is not deterred by limitations on ex ante expected returns.  The ACCC suggestion that there could be an ex post "deeming" that market power exists and the holiday is thus truncated would also have the potential to largely undermine the potential benefits of access holidays.

In sum, provision of access holidays would be a crucial "second best" mechanism for minimising investment disincentives, were the preferred option of exempting new investment that do not receive government assistance from coverage not to be accepted.  Such holidays should be approved in a "quasi-automatic" fashion is fundamental to the achievement of the goal of access holidays.  The use of a strong presumption in favour of a pre-set holiday period (say ten or perhaps twenty years) is equally important.

RECOMMENDATION 4

Access holidays or similar regulatory relief should be given to facilities deemed to be "essential" following a period of perhaps a decade of operation.

2.11 Competitive and entrepreneurial links

The notion of access holidays shades into the appropriate treatment for competitive links.  In distribution, although there is one such link (in the Docklands area of Melbourne) it seems unlikely that these will proliferate, at least under current regulatory arrangements.  For transmission, competitive provision is far more promising.

2.11.1 Gas

Already we are seeing competition in gas with the Duke pipeline to Sydney offering vigorous competition to the line from Moomba.  Unfortunately, the competition authority, the National Competition Council (NCC) in this case, has impeded rather than encouraged the competitive process.

During 1997 Australian Governments introduced the national gas Code.  The Code itself and its regulators pay lip service to the view that regulation is very much a second best approach to market competition.  Even so, supposed market imperfections invariably offer the opportunity to regulate.  Because of this, the Code has failed to herald a sought after new era of gas development.  The regulatory arrangements have, in fact, stifled new developments, morphing the key skills of gas firms from commercial into political entrepreneurship.  We are now seeing new pipelines being designed to avoid regulatory oversight even where this means higher costs.

One key criteria in the Code is that a pipeline should be regulated where this "would promote competition in at least one market".  The regulatory authorities invariably render this down into the question of whether pipeline prices will be cheaper under a regulated regime rather than under one that relies on normal commercial interaction.  Voluminous reports almost invariably produce the answer, "yes, a regulated price would be lower".

In the narrow context of a single pipeline, it would, in fact, be astonishing if a different answer were possible.  Pipeline costs are 95 per cent sunk.  Once pipelines are in the ground, price reductions will not force lower output, while the customers (and gas suppliers) can only gain by a lower haulage cost.  And to justify cutting the price, the regulators can always claim the pipeliner spent too much in building the asset, underestimated gas demand, or that future costs will be lower.  That way the regulators can claim they are not expropriating property rights.

But, when pipeline owners, observe such activity, they take steps to avoid repeat performances.  For, although government bodies can force down prices of existing assets, they are unable to force investors to build new assets.

With pipelines, as with other assets, where governments assume control over property rights and force owners to sell at prices they think are too cheap, investment dries up.  However, last year the Australian Competition Tribunal overturned the NCC's ambitions to regulate Duke Energy's pipeline from Bass Strait to Sydney on the grounds that competition was adequate.  Indeed, a price war had already broken out between the two facilities.

Disappointingly, the NCC refused to relinquish such an important opportunity for regulation up an opportunity for regulation.  It hired two American academics to write a report that said reciprocal treatment for the competing Moomba to Sydney pipeline (MSP) was not appropriate.  The academics also showed touching faith in regulators' business skills.  They maintained that because an ACCC draft decision proposed to reduce the price on the MSP further than it had fallen in the face of the competition from Duke, this proved the company was gouging the market!

In response to the regulatory decisions, we have two major prospective developments that are being tailored to ensure immunity from regulatory oversight.  One of these, SEA Gas, links fields in offshore Victoria with Adelaide;  the other, the Darwin to Moomba development would fulfil the Rex Connor's dream of bringing gas across the continent.  The developers in both cases propose to size the pipes to cater only for pre-booked gas haulage, so that they escape regulation.  This is in spite of the fact that pipeline economics mean costs per unit carried fall dramatically with size (for the Darwin to Moomba pipeline, capacity could be doubled at a cost increment of about 30 per cent).

2.11.2 Electricity

A recent report for NEMMCO by PriceWaterhouseCoopers and Clayton Utz ⁽²⁴⁾ suggests that we should build more common carriage interconnects with regulated returns.

This is premised on transmission costs being only 5-10% of electricity costs.  Hence, the authors argue, the benefits of greater competition and lower prices through generator competition are more than likely to outweigh any inefficiencies.

A major problem with this argument is it fails fully to recognise the scarcity of capital.  Moreover, the sort of interconnects we are talking about are longer and more sparsely used than the existing main body of transmission -- Latrobe and Hunter Valleys to the respective metropolitan centres -- and the 5-10 per cent is not an accurate guide.  SNI, linking SA to NSW for example, would cost $500 per kW in capital simply for transport, which is similar to the cost of an open cycle gas turbine or half the cost of a combined cycle gas turbine.

While conventional AC links are controlled by the laws of physics, DC links offer scope for a link to be controlled so that it is akin to a generator.  Australia (through Transenergie) has been the pioneer in developing totally unregulated links dependent on arbitraged prices between regions for their revenue;  some such lines are now under consideration in the US. ⁽²⁵⁾

This allows an entrepreneurial approach - competition in transmission, with charges paid by willing buyers.  It was the lack of such a service that dictated a consensus in favour of regulated links.  These, in traditional systems, involve several adverse effects:

• gold plating;  A notorious issue with government developed facilities is the tendency towards over-engineering.  The Victorian transmission system is a case in point.  The general consensus is that a private organisation would have been more parsimonious.  Government organisations are less disciplined than private organisations to these cost/benefit trade offs because the decision makers have little financial stake in the outcomes.  While excessive capitalisation is one result of government ownership, an alternative outcome is a squeeze on new developments where a government general budgetary position is strained.  The electricity industry throughout Australia has seen feasts, as governments have climbed on particular rationales for developments, followed by famines as a result of general budget constraints.  Such famines are rarer with the private sector since the absence of investment capacity by one firm would not prevent a rival stepping in.
• we also have a political response;  Government owned and regulated interconnects allow considerable scope for the pursuit of political goals using ostensibly commercial motives.  This obscures the merits of a particular proposal.  It leads to misallocation of production, often in the cause of regional development or saving of jobs of those whose votes are particularly valuable.
• finally, there is crowding out;  A regulated monopoly transmission is financed by a compulsory charge on consumers.  This differs from the alternative means of supplying the capacity:  new generation, and entrepreneurial interconnect or demand saving measures.  A compulsory charge is likely to crowd out those alternative measures, whether transmission or generation, and deny us the most economic industrial blend.

With competition now possible, it may be that the future will see no economic justification for anything other than a market provided entrepreneurial interconnected system, at least for major augmentations.  At issue, on whether a line should be regulated or entrepreneurial, is whether it is:

• to allow improvements in reliability, spending that would be difficult to cover in fees, or
• for an augmentation.

Only in the former situation should regulated links be permitted.  Welfare economics, on which planning rests, does not face the same incentives nor have the same quality of information on costs and risks that is found in the real market.  A regulated link will crowd out entrepreneurial provision -- which could be transmission, generation or demand side measures.

Moreover, the apparent benefits added in the welfare economics case are invariably greater than those in the market case.  This is because it is well nigh impossible to restrict all the benefits of a market development to those paying for it.  For example, the welfare economics calculus estimates the value people place on a new development and adds in all the "consumer" and "producer" surpluses.  Market outcomes are limited in this by all-comers paying the same price.  Hence, much of the value of a welfare justified development should be discounted if its merits are to be compared to a market development.  Otherwise it will divert capital to sub-optimal usages.

The Energy Market Review offers an opportunity to test these issues.

RECOMMENDATION 5

• In the case of gas transmission, access regulation should cease whenever there is competition, leaving any controls to general provisions of competition law which seek to combat collusion.
• For electricity, two opposing models are the UK national grid, which is a fully planned system;  and the PJM system with comprehensive nodal pricing designed to ensure market responses to constraints.

The Review should consider what, if any, circumstances could justify approval for a regulated interconnector financed by a compulsory charge on customers (or suppliers).

2.12. Improving access regulation

In general, the scope of access regulation should be narrowed as far as possible, consistent with its underlying purposes.  This is essential due to the general requirement in a liberal society for government to minimise its interference in private property rights and the more specific need to ensure that dynamic inefficiencies arising from the distortion of private investment incentives are minimised.  In particular, it is argued that access regulation should be:

• Limited in its application to vertically integrated facilities;
• Limited to cases in which the provision of access is necessary to create the conditions for workable competition in downstream markets; ⁽²⁶⁾
• Limited to cases in which the duplication of facilities is clearly not economically feasible;
• Not applied to infrastructure developed without the benefit of a government franchise or any other support.

This opens the way to the development of the following more comprehensive set of policy approaches which amplify those offered in Recommendations 4 and 5.

RECOMMENDATION 6

To develop policy in recognition of the twin importance of property rights and competition, and the need to avoid intervening in voluntary arrangements between parties these principles can be placed into a taxonomic framework addressing six important classifications of essential service or bottleneck infrastructure.  These are:

a) That which has been built without any market protection, especially that built since 1995 which is almost by definition "entrepreneurial" rather than regulated.  In this case the preference should be "no regulation" since the entrepreneur had no privileges in seeking to find the customers and their needs.

b) That which introduces new competition, even if this is not identical to existing facilities.  There is competition.  No regulation should be put in place and regulation on the existing facility should be removed.

c) Privately built infrastructure built prior to 1995 that enjoyed no government protection.  The onus here should be on the authorities to make a case for regulation

d) That which is owned by the private sector but was built under a regime that offered protection from competition.  This presents a clear case for regulation but one that needs careful handling to avoid shutting out future competition.

e) That which was owned by a government but has since been sold under contractual terms to the private sector.  These should be regulated according to the contracted terms.

f) That which was built by and remains owned by a government.  This if it is not to be privatised needs to be regulated though in a way that does not pre-empt rival facilities.

This would place access regulation rules much closer to those envisaged by the Hilmer Report than is presently the case.

Should a facility developed purely as an entrepreneurial facility assume the nature of a monopoly "essential facility" this should be addressed by regulating following an regulatory or access holiday.  As previously discussed, such a facility cannot be considered truly essential since life went on without it prior to an entrepreneur spotting a market need.  Rolling such facilities into the regulatory net constitutes a deterrence to firms searching for the needs and undertaking the risky activity of meeting them.

2.13 Ensuring a consistent approach between new and existing transmission

2.13.1 Laying the groundwork for future augmentation of transmission

Efficiency is achieved in commercial operations where there is

• known, tradeable and fully defined property rights
• obligations and gains from these property rights are clearly established
• competitive supply and demand to prevent monopoly prices.

The existing electricity transmission network is operated on an open access basis.  At present neither producers nor customers have any exclusive property right to the network.  All costs other than those that are firm-specific, are recouped from customers.  The transmission rights are non-existent, although ownership rest with the transmission business.  There are no requirements on the transmission business to operate in a way that least inconveniences the buyers and sellers of electricity.

Ideally, costs should be paid and benefits accrue to the party most able to take action to reduce them or to augment them in ways that offer increased value.

If others pay, parties benefiting will use more of the services than they need.  Thus, if generators are able to obtain access to markets with only the line losses counting as costs, they will avoid a great many of the costs associated with transport.  The classic case is where gas is a fuel option;  the gas generator must pay full haulage costs for the gas to the plant but will avoid the cost of hauling electricity from the generator to the market.  The clear incentive is to locate the gas generator close to the gas source, irrespective of whether transporting the gas would overall be a lower cost solution.

In addition, the lack of exclusivity means a generator must rely on being lower cost than other possible suppliers along a given transmission path if it is to be assured of running.

Similarly, if customers are paying for the transmission on a regulated basis, they may not be assured of obtaining the cheapest source of power.  The transmission business, as the owner of all the rights, has an incentive to economise on building new links as long as the market is fully supplied.  It would have no incentive to build a new line from a cheaper source if this would leave an existing line partly "stranded".

In Victoria, these potential inefficiencies are countered by separating transmission planning from ownership.  This is a sound approach but it would be even more preferable to have built-in incentives for the transmissions owner to operate with full efficiency.

Customer charges have a disincentive to efficient location similar to that of generators to the extent that the price they see is postage stamped over a large area.  This means that a customer would see little value in locating close to power or in areas over-supplied with transmission.

2.13.2 The Nature of the Transmission Network

Conceptually, the transmission system may best be thought of as having two components:  radial and meshed.  The first delivers power from one or a number of generators to a major load node.  The second delivers the power to the dispersed customers beyond the node.  This shades into the distribution system.

Customers and generators alike have vital interests in both aspects, as does the carrier.  However the interests are not identical along all parts of the network.

• Particular generators have a greater interest in the lines that connect their power to the node.
• Customers are most interested in ensuring that power is made available.  Although they wish to see this coming from the lowest cost sources, they are indifferent as to which sources these may be.

The differentiation of the transmission network into the radial and meshed network indicates the necessity for different charging and property rights approaches.  While customers in the meshed network must share usage of the network and agree or have imposed upon them a level of reliability and associated costs, generators have the overwhelming interests in particular radial lines.

2.13.3 Establishing rights

Some means of ensuring the transmission system is optimally operated is required.  This is best accomplished by defining property rights so that the optimisation is the outcome of the various parties seeking to promote their own interests.

The difficulties in defining property rights include:

• the rights will always be shared in the great bulk of cases;  hardly any lines connect just two related parties and the multiple users are likely to have different interests in upgrade, maintenance, timing of servicing;
• rights have already been allocated, often implicitly, especially in Victoria where there is private ownership of generation, transmission and distribution;
• definition of flow paths, loop flows etc.;
• definition of firm access and penalties for non-achievement;
• the expanded versus the sunk network and the difference between maintenance and new build;
• equity issues
• if existing businesses are freely given a right where that right was previously either not present or less firmly defined, they obtain a windfall gain to the disadvantage of currently non-existing businesses that need to pay for access
• giving a right to a business that previously had no such right (or an attenuated version of it) involves placing an imposition on another business.

These matters and others are to be considered under a review by NECA into transmission that is planned to commence shortly.  Implicitly, generators have been afforded some notion of firm rights to the node.  Under the vertically integrated systems that predated the national market, transmission and generation were built in lock-step.  Indeed, there was over provision of transmission reflecting the low marginal costs of building incremental capacity along a particular radial.

Even though transmission capacity is variable, a concrete definition of "firm" capacity is definable and this should be done.  As to the actual allocation and the payment, it is not possible to backtrack and re-allocate the implicit rights.  They are in place and should be made explicit and tradeable.  For radial lines to the various nodes, this capacity should be allocated at the level of capacity each generator held at the time of market commencement.

Any additional firm capacity should be offered through an auction system.  And transmission operators/owners should have incentives to find ways of augmenting firm and non-firm capacity

This would still involve generation being scheduled on the basis of bid merit order but would require a generator without firm rights that constrained off a generator with such rights to provide compensation for that part of the latter's bid quantity that was offered below the pool price.  A new or expanded generator would then have strong incentives to ensure adequate capacity augmentation or to buy rights from an incumbent.

This would then remove the incentive a generator has to free ride on existing facilities, where such facilities are scarce.  It would sheet home the true costs of building capacity and delivering it to market, thereby leaving no bias against new building of transmission capacity.

RECOMMENDATION 7

To avoid having planning of transmission favouring existing owners, that transmission ownership and planning be structurally separated businesses.

RECOMMEDATION 8

That the present Review recommend to the planned review of transmission by NECA that a means of defining tradeable property rights to existing transmission be devised with this fully to take into account de facto rights.

3. REGULATION OF COMPETITIVE INDUSTRIES

3.1 Markets and Efficiency

As previously addressed, promotion of efficiency in markets is predicated on two features:  strong property rights and vigorous competition.

Strong property rights are essential to ensure that sellers are able to keep the profits their activities generate.  As a corollary, they must also face the likelihood of losses from taking the wrong decisions, losses that can lead to bankruptcy in extreme situations.  This property rights perspective forces sellers at every stage of the market process to ensure that customers' needs are researched and met at the lowest cost.

Competition is essential as a discipline on this process.  Without a competitor fully able and anxious to step in to supply the incumbent's market, the latter's motivation to continually search out new needs and cheaper ways of meeting them is blunted.  Indeed, a seller with an entrenched monopoly will raise prices and reduce sales beyond the level at which additional revenue covers costs, secure in the knowledge that a rival would be unable to undercut the price.  It is for this reason that a surrogate for competition is deemed necessary with distribution.

This process of competition is now generally accepted as offering the best means of setting the price and quality mix that gives consumers the best value.  It operates in both the static sense of bringing about the lowest cost outcomes for a given set of demand and supply configurations and in the dynamic sense of encouraging a ceaseless search for improving upon this in the light of shifting demands and input costs.

All regulatory bodies claim that they are seeking to replicate this competitive outcome in the context of a market in which there are some natural monopoly elements that require synthetic costs to be developed.  Hardly any authority would nowadays claim that regulatory overrides offer superior outcomes to those of a free and competitive market.  Regulators simply do not have the capability to assemble and process the information that profit-driven suppliers routinely undertake.

Two areas of the electricity market generally considered to be amply constrained by competitive forces, at least in principal, are retailing and generation.

3.1 The Role of the Electricity Retailer

3.1.1 The retailer as the consumer's agent

Under competitive circumstances, the retailer is the de facto agent of the consumer.  That role is assumed of necessity -- if abandoned or neglected a rival will step in.  The retailer's activities, to ensure its on-going success and even its existence, must extend far beyond passively breaking down bulk and ensuring products are delivered at convenient locations.  It must extend to assisting in discovering what the consumer wants.  Unlike self selected (and often government financed) consumer "representational" bodies the retailer is compelled to be the agent of the consumer, as long as the consumer can move to an alternative agent if the retailer provides unsatisfactory service.

The retailer is an agent in a far more comprehensive sense than any representative body because it needs to weigh up the needs against the available product inputs -- and to do so correctly or face replacement.  The retailer is under great pressure to seek out inputs from all sources.

The homogenous nature of electricity does not negate this.  Electricity may be undifferentiable but its supply is from highly variable sources.  In terms of assembling inputs, the retailer must decide, based on its customers' requirements (and those of its target customers):

• how much power to contract rather than buy at pool
• how much of different sorts of power (baseload, regular peak, needle peak) to buy
• how much price risk to take for the needle peak.

In addition, this basic product has to be metered correctly, bundled in profitable packages, promoted to consumers who may have little awareness of their needs and options, and priced appropriately.  The retailer also needs to examine economies of scope (or synergies) in bundling his goods together with other similar products, sharing services of specialists like meter readers, back office functions etc..

Competition between retailers tends to ensure that, for a given quality, products are purchased from the cheapest producers and sold on to customers at margins that are not excessive in relation to efficient retailers' costs.  Competition is also, and perhaps fundamentally, a discovery process, whereby the competitors set out to ascertain the needs of customers, where those needs are not well defined nor even fully understood by the customers themselves.

3.1.2 Regulatory impediments to retail competition in Australia

With over two dozen Australian businesses in retailing, there is no lack of experienced competitors and few non-regulatory barriers to entry.  And, unlike services such as banking, there are no costs or inconveniences involved in changing retail supplier.  The notion that the energy supply incumbents are able to exploit their current monopoly is plausible in Australian retailing situations only to the extent that governments erect entry barriers.

There are clear dangers in overriding the forces of competition, dangers that intensify with the length of time the controls remain.  These dangers of seeking to replace or improve upon the market outcomes can be distilled into two primary failings related to where the regulator sets the controlled price too low.  Setting prices too low will:

• require cross subsidies and either bring an unravelling of the market balance and/or lead to financial distress among retailers and inadequate incentives for new investment;  an extreme outcome of these developments is evidenced in California;  and
• crowd out the competitive provision that is being sought forcing (reluctant) host retailers to continue serving unprofitable customers.

These considerations underline one matter on which pricing controls or guidelines must be ruled out:  the prevention of price increases on the grounds that consumers would prefer not to pay higher prices.  Already in Victoria prices are in place that have been regulated over the past six years with little provision having been made for the changing costs -- absolute and relative -- on which the prices were first justified.  Unless prices are allowed to adjust to the underlying cost shifts, retailing will be seriously harmed with the consumer being the eventual loser.

Indeed, as soon as full retail competition is in place, it is difficult to see any scope for price setting.  Any price that is set above market levels will mean customers will be won away from the incumbent supplier by a rival seeking to take advantage of a profitable opportunity.

In fact, an existing retailer may be vulnerable to a rival who is able to better its price because the target customers are complementary to others that it presently serves.  This might allow a rival to make price offers below the cost of the incumbent even if the latter is technically efficient.

In this respect, Victoria's most recent decision placed a 3% upper limit on the deviation from the average price allowed of the maximum price for individual customer classes This cements-in distortions, making it easier for new retailers to avoid those customer classes whose tariffs have become highly unprofitable.  The danger is that the host retailers will gradually be left servicing the highest cost customers.

A further distortion introduced was to confer a "one off" rebate of $118 million to rural consumers.  This subsidy had the merit of being clearly visible as a government rebate, even though it is a market distortion and likely to boost consumption in areas where supply is more expensive.  It would be a highly retrograde step if the Victorian Government were to seek to have the rebate absorbed within the charges set by distribution businesses thereby introducing a new system of cross-subsidies.

In addition, and of more immediate concern to the retailers, the Government's retail pricing decision put ceilings on the average price increases.  Rising energy costs in Victoria led electricity retailers to seek average price increases of between 15 and 21 per cent.  On the advice of the Essential Services Commission, the Government pared these back to between 2.5 and 15.5 per cent.

The upshot of the price restraints is that there has been little incentive for retailers to seek out new customers.  In Victoria, after two months of FRC only 7,500 small customers have switched retailer (but even this is ten fold the level of NSW).  To get to the UK benchmark of 38% of the market switching after 3 years would need upwards of three quarters of a million in Victoria and over a million in NSW.

Even more serious than these considerations is the danger to the retailing industry which faces unregulated energy costs but regulated prices to final consumers.  This was the potent brew that led to hitherto unprecedented bankruptcies in California.

Compared to setting the price too low, there are far fewer dangers of allowing excessive prices.  This is not the least because excessive prices bring their own remedy -- competitors find ways of winning the ostensibly captive markets.  The attention to this asymmetry in the context of "essential services" drawn by the Productivity Commission draft report on Part IIIA has previously been noted.  As discussed, it advocated erring on the side of allowing a higher price rather than risking an excessively low price.  These approaches are even more appropriate in retailing which does not have the long lived capital assets of network services and consequent ability temporarily to serve customers at marginal cost.

A further contemporary example of efficiency debilitating intervention in Australia and one that could not easily take place in a privatised system is the NSW Electricity Tariff Equalisation Fund (ETEF).  ETEF is a compulsory insurance system that holds the spot market price of electricity between narrow bands.  This imposes a low but palpable risk on the government as the owner of the businesses, of a colossal loss by should pool prices zoom up for a lengthy period.

More importantly, ETEF suppresses market signals for when new generation capacity, especially peak capacity, might be required.  Over the longer term it will bring mismatches in energy requirements and availabilities as retailers have a much reduced incentive to signal needs by contracting forward for new supplies.

A manifestation of the effect of ETEF can be seen in contract transactions.  In relation to the energy market, the turnover of contracts in NSW declined last year while that of Victoria increased fivefold.  Victorian retailers and generators were seeking out ways of defraying their risks but in NSW there was far less need to do so because of the Government mandated form of insurance.

In Victoria, a strong growth in financial derivatives during 2000/01 brought them to the equivalent of 1.6 fold the size of the physical market (even so, many commodity markets have a derivative:physical ratio of 7:1).  Significant in the derivative growth in Victoria was the popularity of "swaptions", a product that allows retailers the flexibility to make offers without having to commit to contracting the energy.  The following chart is based on AFMA data, which is far from comprehensive but does depict an accurate contrast between the two major Australian markets.

Chart 1

These contrasting developments have a bearing in regard to a statement in the Energy Market Review paper, which we fully support, that argued, "Government ownership of both electricity generation and retail businesses appears to provide a natural physical hedging opportunity, alleviating the need to maintain substantial financial contract positions to manage risk exposure.  This may restrict the volume of trading on financial markets and has the potential to hinder or distort the efficient and timely development of deep and liquid financial markets."

The effect of ETEF also impacts on the operations of private firms that compete with them.  New South Wales government retail businesses are shielded in much of their market from competition by other firms.

Not only might such shielding of government firms from competition bring risks and stunted market development in the "home" market, but the government firms' relative immunity from competition may allow them to compete unfairly in other, more open markets.  This has been a accusation levelled by the European Commission of the French Government's policy resulting in relative reservation of the French market for the government-owned Electricite de France.

3.1.3 Metering and its implications for Full Retail Competition

An issue of considerable contention in Australia and overseas is the lack of demand side response within the electricity market.  It is said that there are only a few hundred MW of demand in the SA/Vic market that can be controlled.  This is a very small share of the market.  Clearly one reason for firms not wanting to negotiate demand side contracts is that, smelters excluded, energy only constitutes 2-10% of costs and downing tools is more expensive than making a small saving.

In the case of households the lack of interval metering is a major factor.  Indeed, this lack and the consequent need for load profiling has a perverse effect.  Retailers would find those households who are the heaviest users to be the most attractive targets, notwithstanding that such households typically use air conditioning which has been a major factor in bringing greater peakiness and hence higher costs.

A debate which divides retailers, consumerists and economists is what to do about the lack of metering.  It all comes down to price of the meters and costs of reading them.  But according to McKinseys, ⁽²⁷⁾ household users exhibited considerable demand elasticity in a Texan study.  Without specifying the price changes involved, the study claims that an experiment with "dynamic pricing" through real time metering brought consumers to shift one third of their load out of peak periods.

Such a magnitude could vastly increase the savings from electricity markets and the importance of retailers in achieving these.  The issue remains the cost of roll-outs.  One firm, Email, is discussing a $60 meter if the volume is 400,000.  But this would seem to need additional expenditures for the meter to be a tool that can offer genuinely controllable usage.  The fact remains that notwithstanding all the potential gains and talk of mass roll-outs of interval meters nobody has yet done it.

The issue has featured strongly in the debate internationally.  We tend to the view adopted by Littlechild ⁽²⁸⁾, who has argued that with all its shortcomings, a profiled load and rivalry for the retail consumer is worth it.

RECOMMENDATION 9

Allow full scope for retail competition as early as possible with a rapid phase-in of the removal of all price controls.

3.2 Competition in generation

3.2.1 Market concentration

Throughout Australia, ESAA lists about two dozen generation businesses providing more than one percent of any of the four main markets.  This offers adequate competition for the market as a whole.  Nonetheless, there are concerns, noted in Section 2.3.4 of the Review's Issues Paper, of excessive concentration of electricity generation in all states other than Victoria.

These concerns are credible in view of the relatively minor degree of inter-linkage in the Australian electricity system.  And ABARE has published some research which gives added support to claims are exercising market power ⁽²⁹⁾ (though ABARE, rather surprisingly, claims to have detected abuse of market power in Victoria and not the other markets).

A test of claims that generators are driving up prices would come from an examination of their share prices.  Unfortunately most Australian generators are either government owned or not listed.  Loy Yang is the exception and, is one of the largest energy suppliers in Australia.  As a well run firm, it is therefore a decent bellwether for the industry in general.  Loy Yang's shares are trading at less than a quarter of their issue price, while its debt too is selling in secondary markets at a steep discount.  This is not the sort of outcome that might be expected of a firm that is exercising monopolistic powers or benefiting from such activity by other firms.

Market power is an elusive concept.  Almost all businesses in all markets enjoy some ability to raise prices by offering less.  Many firms promote differences, often trivial differences, in their brands in order to improve prices.  Others may find niches within markets in which they can, at least temporarily, charge higher prices than the basic costs would seem to justify.  Still others find themselves in a fortunate position of having supply available that is insufficient to meet demand -- perhaps because of a competitor's sudden failure, perhaps because of an unanticipated upsurge in demand.

Although there may be grumbles about "profiteering" in some such circumstances, actions to prevent the higher prices will normally rebound against the consumer's interest.  Without the ability to charge very high prices to cover rare events, firms may have inadequate incentives to operate so that they have capacity available at the right time.  In addition, these very high prices act as a means of rationing supply to those placing the greatest value on it (that is, demand side participation).

As is well known, wholesale prices have been remarkably low since the NEM and its Victorian predecessor commenced.  The average electricity spot prices in the four main markets are illustrated below.

Table 2:  Average Prices in Major National Electricity Markets ($)

Year	NSW	VIC	QLD	SA
1999 July-June	23.7	25.1	55	49.7
1999 - 2000	28.9	26.1	45.3	60.6
2000 - 2001	38.4	45.4	42.2	57.3
2001 July-December	27.4	26.7	28	26.4

Although prices may now be trending upwards, we have seen major falls from the $38-44 that prevailed prior to markets being introduced.  Underpinning these price falls have been large increases in efficiency.  For example, in Victoria the generators since being moved into a more competitive setting (following corporatisation in 1994 and their subsequent privatisation) have seen their workforces shrink from about 11,000 to the equivalent of less than 2,500.  At the same time other efficiency measures like availability-to-run have been lifted from the high 70s to the mid 90s.

RECOMMENDATION 10

Generation is essentially a competitive service.  The Review should examine changes in industry structure that may ensure that this potential is fully realized.  While market rules for generators are necessary as a result of the homogenous nature of the product, these should not extend to regulation of output nor of establishing a price (other than at a very high level).

3.2.2 Market design

Electricity shares a great many features with other commodity markets but its inherent non-storability does give rise to a need for a more structured market than is seen with any other commodity.  In a grid based system, the need for all suppliers to be scheduled, and for various ancillary services to be supplied to ensure the system operates efficiently, automatically requires a market manager.

Virtually all electricity industries are moving to a variant of a competitive based wholesale market, where suppliers (and occasionally demanders) make quantity bid offers up to a price capped at a very high level.  But there are some significant differences.

Under the new UK variant (NETA), the centralised market system pays the generator the price it is bid;  most other variants pay the price bid by the marginal supplier to all suppliers.  There is something to be said in auction theory for both approaches, though the UK approach requires considerably more investment in information technology systems.

In reality, however, all electricity markets are fundamentally contract markets (an exception was the failed Californian model where contracts were largely forbidden).  In Australia, the best guess is that 95-97 per cent of energy is bought under contract.  The reason for this is the strong risk aversion of retailers (and their financial backers) to high price excursions.  The spot market (or, in the UK, the balancing market) is therefore a market for "unders and overs" which settles the small amount of energy that was despatched and used without a contract cover.

Some markets incorporate a capacity payment to encourage high cost capacity to be made available.  While this has some ostensible appeal in the context of a market with variable demand, it also involves a central planner determining what capacity level should be made available and how much to pay for it.  Our own view is that the energy only market works better ⁽³⁰⁾ though, as with other market design issues, the matter is not settled.

These are just the more important matters exercising people's minds in the wholesale electricity market.  Doubtless we do not yet have the optimum set of rules but the market continues to emerge and the great many variations on the basic theme will continue to inform us as to what changes might best be made.

RECOMMENDATION 11

The Review process note the many variations of the wholesale market and broadly endorse it and the existing approach to effecting change to it.

4. GOVERNANCE ISSUES

In Section 2 we raised the issue of the great many regulatory institutions that are involved in the energy industry.  Concern regarding these are several fold:

• there is overlap -- for example NECA undertakes consultations on reviews to the national electricity code which are then passed to the ACCC which undertakes the same reviews de novo;
• although NEMMCO is supposed to be the market manager, it is also involved in certain elements of policy work;
• State Governments continue to have considerable control over the industry in their respective states;  this is evidenced in:
• decisions on FRC
• apparently vetoing the creation of new electricity transmission regions in defiance of Code provisions
• in insisting upon specific sorts of power, in particular "green" power.

In addition, State Governments appoint directors to NECA and NEMMCO.  There are suggestions that they use these directors to pursue particular policy approaches that might benefit their own states.

The electricity and gas industries continue to be viewed by governments as more sensitive than other industries and are therefore subjected to more intervention.  This has the potential to seriously harm the operation of market forces and therefore detract from efficiency.

RECOMMENDATION 12

• Governments should cease trying to manage energy industries with industry specific policies rather than using general industry policy.
• The regulatory arrangements should be rationalised to avoid duplication and be placed under fully apolitical controls.

APPENDIX 1

OUTCOMES OF PRIVATE OWNERSHIP OF ELECTRICITY IN VICTORIA

Much is made of the sums raised in energy privatisation -- $28 billion for Victoria and over $5 billion for South Australia.  Important though these have been to the fiscal health of these two states, more important is the outcome for the industries' efficiencies.  These have included cost savings and innovations which have brought great benefits to customers.

Cost Savings

Victorian distribution businesses since privatisation have shown marked increases in productivity and in customer service.  Personal communications with two companies revealed considerable savings post privatisation.  In the period between privatisation and mid 1999, Eastern Energy (TXU) made savings in operating costs of 22 per cent, while CitiPower, which inherited municipal council owned electricity businesses that were even less efficient than the SECV, made savings of 38 per cent.

Benchmarking United Energy against 104 US utilities, the Pacific Economics Group (PEG) found that the Victorian distribution business's standardised overall cost was 45% of that of the average U.S. firm.  The study's findings would have placed United Energy close to the frontier of efficiency.

The following table shows United Energy compared with the average in the sample compiled by PEG.

TABLE A1
AVERAGE VALUES OF VARIABLES IN THE BENCHMARKING STUDY

Variable	Units	US Sample Average	United Energy	United Energy/ Sample Average
Total Cost	Thousands of $(US)	377,782,714	171,158,503	0.45
Price of Capital Services	Index Number	1.00	1.07	1.07
Price of Labor Services	$1,000(US) per Employee	51.75	36.59	0.71
Price of Materials	Index Number	1.12	1.08	0.97
Total Customers	Customers	695,777	538,000	0.77
Retail Deliveries	MWh	17,358,000	6,448,605	0.36
Miles of Distribution System	Miles	20,480	3,387	0.36
% of Distribution System Electric	Percent	89%	100%	1.12

Source:  Pacific Economics Group, Kaufmann, L., Lowry, M.N., and Hovde, D., United Energy Performance, Results of International Benchmarking, November 1999, p. 39

However fully documenting the productivity performance of Australian distribution businesses is difficult.  This is not least because data in the ESAA annual publication Electricity Australia shows some inconsistencies, possibly because of the difficulties of unscrambling retail and distribution personnel in earlier years.

We can be reasonably confident of the 1999/2000 data from ESAA.  Measured in terms of customers per employee, this indicates labour productivity in NSW and Queensland respectively was only 62 and 61 per cent of that of Victoria.  South Australia, post its privatisation, appeared to have leapfrogged Victoria, while Western Australia (which covers only the South East interconnected system) was also well ahead.

Chart A1 illustrates this.

Chart A1

Source:  ESAA

The above yardstick measuring efficiency levels, labour productivity, excludes the important component of capital productivity.  Energy businesses themselves attempt to determine their relative efficiencies to set internal targets (and, in the regulated environment in which distribution operates, to deter regulators from seeking excessive price reductions).

Reliability Improvements

Reliability of distribution in Victoria has improved considerably since privatisation.  A steady improvement in reliability, as measured by minutes off supply, has been experienced in the years since 1995 as illustrated below.

Figure A1

Source:  ORG

The improvements have been seen in all five distribution businesses as illustrated in Chart A2 below.

Chart A2

Source:  ORG

A small increase (4 per cent) was recorded in minutes off supply in the first half of calender 2001.  This was ascribed to more normal storm situations following a very benign first half year in calender 2000.  The Office of the Regulator General noted that the distribution businesses remained on track to the target reductions in minutes off supply that had formed part of the 2001 rate re-set.

In respect of reliability, the Victorian outcome has shown relatively more improvement than that in other jurisdictions.  Chart A3 illustrates this.

Chart A3

Chart A3 shows that improved performances have been logged only by Victoria (outages down 32 per cent) and NSW (outages down 24 per cent).  Other states have shown increased outage times of between 41 per cent (Queensland) and 71 per cent (Tasmania)

Generator Performance

As with distribution, it is rarely possible to assemble simple benchmarks allowing state by state comparisons between generation businesses.  There are no measures of total factor productivity levels while partial measures like labour productivity can be misleading.  Thus, output per employee contains definitional problems following a greater use of contract labour.

In addition, different types of generator have different capital:labour ratios.  Gas generators and hydro-electric generators require fewer staff than coal fired generators, while Victoria's brown coal generators differ from other states' black coal generators since they mine their own coal.

Furthermore, as with distribution businesses, profit figures are now not readily available as a result of the privatised businesses normally consolidating profits into parent company accounts.

Nonetheless, there is sufficient data to be able to construct a reasonably accurate picture of the change in operational performance of the privatised Victorian generators and to compare this with the performances of other states' generators.

Chart A4 illustrates the comparative trends.

Chart A4

Source ESAA

The available data shows that productivity in all state systems has experienced marked improvements.  That of Victoria has, however, been the strongest.  Over the past decade, the Victorian generators' productivity has increased by 237 per cent.  The comparative performance of five states is shown in Chart A5 below.

Chart A5

Source ESAA

Part of the improved productivity of the generators is their greater availability.  Not only did the pre-1992 generation sector exhibit gross over-manning but the generators were available for less than 80 per cent of the time.  Having generators available to run at short notice enables them to meet unexpected changes in demand, and also brings about lower prices.  The improvement in Victoria's generators has been outstanding as Chart A6 illustrates (but recent breakdowns may have brought a deterioration).

Chart A6

Source:  ESAA

Prices to Customers

The ESAA publication Electricity Australia conducts its price surveys by dividing revenue by energy usage and subdividing this into different customer classes.  However for contestable customers, the fact that energy retailers now operate across states means, on these grounds alone, it is no longer possible to use such aggregate data to prepare such estimates.

As the Eastham Task Force found in South Australia, "The Task Force was not able to ascertain the number of business customers who have signed contracts with other retailers, nor the price of those contracts.  However information from AGL suggests that of the total contestable market in South Australia, around 40% of customer load will be supplied by other retailers from 1 July 2001.  This 40% figure has been confirmed by information available to the South Australian Independent Industry Regulator (SAIIR) which also indicates that a number of retailers are now active in South Australia." ⁽³¹⁾  A somewhat larger percentage of the larger (over 160MWh) contestable customer load has shifted in Victoria.  In noting that prices quoted to South Australian contestable customers had risen by 30-35 per cent, the State Premier also quoted evidence that similar price increases were evident in other markets.  The ESAA ⁽³²⁾ provides price surveys that offer useful information.

Business Customers

Business customers' prices, which are now largely deregulated, have seen quite considerable reductions across the different classes.  The ESAA estimates prices in constant dollars to have been as follows.

Figure A2

Large business customers in Victoria benefited from very low prices during the late 1990s.  The increase in wholesale prices since then brought a sharp increase from the year 2000.  New generation capacity that has been announced may bring a lowering of wholesale prices though they are unlikely to fall to the very low levels that prevailed in the 1997-1999 period.

Figure A3 shows that these charges for larger business customers with varying load factors

Figure A3

The different line configuration of the Victorian system tends to favour prices to larger customers in comparison with the NSW and Queensland systems (Victoria has few 11 kv lines).  Victoria's other business customers tend to have higher line charges due to the configuration of the system.  As with the larger business customers, the energy component within the total has tended to increase since the year 2000.

Network prices for small business customers in Sydney, Melbourne and Brisbane are shown in Figure A4 below.

Figure A4

Domestic Customers

Prices in Victoria to residential consumers have long been rather higher than those of NSW and Queensland.  In part this is due to lower levels of electricity consumption in Victoria (NSW households consume 33% and Queensland households 40% more than Victorian).  These lower consumption levels require higher amortisation costs.

It is also likely that Victorian prices had been higher as a result of the state's relatively high costs pre-corporatisation/privatisation.

Chart A7

Source ESAA Electricity Prices in Australia 2001/2002

Following increases in wholesale electricity prices, price increases to the formerly franchised customers were introduced in January 2002.

Retail competition means it is no longer easy to observe average price outcomes on a statewide basis.  What we can be sure about is that though governments can force down prices for some periods of time, competition will result in the lowest sustainable prices.

Appendix 2

ESSENTIAL FACILITIES REGULATION

There are two sets of arguments that can be advanced in favour of regulation of assets as essential facilities.  The first is based on the development of the common law as outlined by Professor Richard Epstein. ⁽³³⁾  The second is contained in the submission to the Productivity Commission's Review of the National Access Regime (n. 53) by Dr T Dwyer and R K H Lim and rests on the notion that the "essential facility" only obtains a right of way over others' properties by government action and owes a corresponding duty.

Epstein points out that resolving clashes of rights is the fundamental purpose of property law.  Sorting out the rights of different property owners where those rights are in conflict has been the task of courts throughout the ages.

There is a key distinction between a facility that has been developed without any protection or support from government and one that has been developed under some sort of franchise (or, like much Australian infrastructure, by the government itself).  Where the monopolist has seized his position by spotting an opportunity and offering value, the government regulation is pure coercion.  Where the monopoly is created by law, the monopolist is clearly bound by the terms of the original grant which include the quid pro quo for that grant.  Those undertaking a development of the former kind need not and should not face regulation regarding access or price.

Epstein, however does not consider the distinction between a franchise protected "essential facility" and one that developed without any privileges as being as crucial as this.  Much of his analysis (like the key English and American cases that established precedents) rests on the seventeenth century tract by Lord Matthew Hales de portabis mari ("concerning the gates of the sea").  In that tract, which was not published until the 1780s, Hales argued, that an asset (he was discussing cranes in ports) can be "affected with the public interest" either "because they are the only wharfs (sic) licensed by the queen" or "because there is no other wharf in that port".

Although not accepting a sharp dichotomy of approach between government supported and purely entrepreneurial infrastructure, Epstein argues "....regulation must be justified on the grounds that any monopolist charges too much and sells too little relative to the social -- that is the competitive -- optimum.  But even when true, the case for regulation is hardly ironclad.  The situational monopoly may confer only limited pricing power, and its durability could be cut short by new entry, or by technical innovation.  Regulation could easily cost more than it is worth, especially if the regulation entrenches present forms of production against the innovation needed to undermine its economic dominance." (p. 284)

2.3.2 Regulation as the price for government services

In their submission to the Productivity Commission, Dwyer and Lim (Submission 53) argue that it may be reasonable to allow the market to set the rates for infrastructure but that the market comprises more than the investor and the user.  They suggest it also comprises the Crown (as granter of the franchise) and the landholders giving or being forced to give access and other potential infrastructure providers.  This starts to resemble the dilution of control and subsequent fuzzy policy implications that is often seen when the firm is viewed as a series of "stakeholders".

The Dwyer and Lim submission focuses on property rights but assumes all things are owned by someone.  In fact the cardinal rule of property rights is that all things of value must be owned.  Things which have no value need not and usually should not be owned by anyone.  Their ownership becomes vested in those who discover the value.

This is the accepted procedure for patents and copyright.  The uninvented material is unowned until invented, after which the inventor obtains (limited) ownership rights.

This is also the principle behind mining law in most common law countries.  The crown is the theoretical owner of the minerals that are undiscovered and charges a "royalty" on them.  But that charge is reasonably well known in advance and is fixed.  The discoverer of the minerals obtains substantially all the value from them.  Were this not the case, the incentives would be wrongly placed:  the government and/or landowners would receive windfalls without expending any effort.  This misdirection of rewards for effort and risk taking would cause sub-optimal search and development activity.

Similarly, the mineral product needs to be transported over a landowner's property.  While it is reasonable that the landowner be fully compensated for any inconvenience thereby caused, to give the owner more than this would overcompensate him and, accordingly, undercompensate the explorer.  This would lead to a misallocation of resources.

It is possible for the state to seize rents from monopoly privileges the infrastructure owner is given.  Indeed, the very definition of economic rents might recommend this as the correct course since seizure could not have any adverse effect on economic activity.  But it is difficult to identify any such rents in advance.  There may, of course, as in the case of a mineral discovery, be very substantial rents ex post but taxing these will curtail search activity and their future availability.

Unless there are a number of infrastructure owners spotting an exceptionally profitable opportunity at the same time and only one development can proceed, the rents are not present in advance of a facility's development.  Attempts to anticipate them with a tax will constitute discriminatory investment policy, reduce investment and diminish economic welfare.

Governments are in competition one with the other to attract investment and to ensure they maintain the environment that allows their citizens to prosper.  If they purloin the value from their essential administrative role that prosperity will be attenuated.  In this respect, Dwyer and Lim maintain:

"Wood and others forget that the underlying property in question belonged to the Crown as landlord on behalf of the people in the first place. ...  If the Crown, on behalf of its subjects, says to an infrastructure developer ‘you may have these easements for your infrastructure on condition that, having been granted free access, you will not abuse your conferred monopoly, by charging more for access than your costs.' What is there to complain of?"

There is nothing to complain of when the ground rules are fully spelt out, but a nation that seeks at the outset to reduce entrepreneurs' opportunities to profit from spotting market opportunities will see less such activity.  If all infrastructure returns were to be capped at a rate of return that the government or its agents consider appropriate, there would be less of such infrastructure built.  There will certainly be less of the more risky infrastructure that has uncertain returns.  In terms of the infrastructure built, we would therefore see a concentration on serving existing known markets with known resources.  We would see far less activity on projects that entailed forecasts of demand growth that contain considerable up- and down-side uncertainty.  Not only does this deny the economy worthwhile ventures, but the ventures denied are those that improve its economic resiliency and ability to adapt to change.

As Thomas Friedman points out in The Lexus and the Olive Tree, government actions to reduce profitable opportunities will spark swift retribution in today's wired world.  Information concerning increased government intervention is quickly transmitted through such agencies as Dun and Bradstreet.  Capital, and perhaps scarce labour, will shun the country whose government acts so irresponsibly, forcing it back into line or resulting in the country facing a lower level of prosperity.  This discipline of globalisation does much to reduce the scope governments have to intervene within an economy.  It is a benefit in that it sharply constricts the ability of governments to tyrannise their own or foreign citizens.

However, it is not new.  The growth of the common law itself is due to the internationalisation of commerce in the Middle Ages.  The Law Merchant developed as a means of allowing trade to take place.  Governments that favoured some parties, either on their own behalf or on behalf of their citizens, found their lands were less patronised by traders and that some of their more productive citizens migrated.  Without anyone planning it, the law developed as a constraint on government action.  It remains so today.

Of course, it is true that Governments frequently play fast and loose with private property.  Even the US Supreme Court in Lucas v North Carolina refused to acknowledge a "taking" unless it was total.  However, the point is that a few grasshoppers do little damage to a crop but a plague of locusts destroys it.  Too much interventionary action shifts a nation to the political and economic periphery.  Very few politicians find it possible or palatable to totally refrain from overriding the established law but the difference between nations like Switzerland, the USA and Singapore are considerable when compared to countries like Sierra Leone, Malawi, Rumania, Myanmar and other unsuccessful economies.  The former group of countries is near the top and the latter near the bottom of the economic freedom league compiled by a group of "think tanks".  Countries are ranked according to criteria in which the degree to which their economies are characterised by considerable government intervention.  There is a very strong correlation between economic prosperity and economic freedom.

---

ENDNOTES

1.  Assessing:

• the potential for regions and small business to benefit from energy market development;
• the relative efficiency and cost effectiveness of options to reduce greenhouse gas emissions from the electricity and gas sectors;  and
• means of encouraging the wider penetration of natural gas.

2.  These included:  Natural Resources and Environment Committee of the Victorian Parliament, Electricity Supply ad Demand Beyond the Mid 1990s, Melbourne April 1988;  SECV/DITR, Demand Management Development Project, Melbourne June 1990.

3.  Industry Commission, Energy Generation and Distribution, Report No 11 AGPS, Canberra, 1991.

4.  Part of Queensland's gas retailing and distribution remains government owned.

5.  A fresh approach to public electricity assets, press release of 5 April 2002 by Liberal Leader John Brogden and Shadow Energy Minister Duncan Gay.

6.  Richard A. Epstein Principles for a Free Society, Perseus Books, Reading Mass, 1998

7.  NECG, International comparisons of rates of return, Comment on a NERA report, July 2001.

8.  Richard Dobbs and Matthew Elson, The McKinsey Quarterly, 1999 Number 1, pp. 133—144.

9.  Review of the National Access Regime:  Position Paper.  Productivity Commission, March 2001, p65.

10.  Productivity Commission, Review of the National Access Regime, March 2001

11.  see Moran, A.J. Scope Costs and Benefits of Business Regulation, in James M., Restraining Leviathan, CIS, Sydney 1987

12.  It should be noted that BHP's statement is no stronger than that its investment was "directly facilitated by the [Gas] Code".  It does not state that the investment would not have proceeded in the Code's absence, whereas the cases cited to the contrary have explicitly stated that certain investment proposals have been abandoned as a direct result of access regulation considerations.

13.  Australia Pacific Airports Corporation, Submission No.10, December 2000, p 5.

14.  Stigler, G.J. The Economic Theory of Regulation, Bell Journal of Economics, Spring 1971.

15.  Shuttleworth G, Updating Price Controls:  Rationale and Practicalities, a report to the ORG, June, 1998

16.  Banks G., Competition regulation of infrastructure:  getting the balance right, Presentation to IIR Conference, National Competition Policy Seven Years On, Eden on the Park, Melbourne, 14 March 2002.

17.  See Submission No. 19:  op cit., p 2.

18.  Economic Choices Associated with the Proposed Essential Services Commission.  Joshua Gans & Steven King, p21.  Submitted by the Australian Council for Infrastructure Development (Submission No.11).

19.  In this context, the Victorian Office of the Regulator-General's currently uses an "efficiency carryover" model, which allows regulated entities to obtain benefits from past efficiency gains over a five year time horizon.  It is however unclear why the ORG's 70/30 sharing between customers and companies is superior to a more "natural" 50/50 sharing.

20.  See Review of the National Access Regime:  Position Paper.  Productivity Commission, March 2001, p212.

21.  Arguably, for those new investments that are given a franchise or other effective subsidies, concurrent agreement on access issues would ensure that appropriate incentives could be maintained.  However, there may be difficulties under current access regime arrangements due to the difficulty in concluding such an ex ante set of access arrangements.

22.  This view is consistent with the Commission's own argument (p193) that "...the fact that a project may turn out to be highly profitable should not be of great concern. ...at the end of the day, if infrastructure facilities are not built, consumers will be worse off.

23.  "What is the Regulatory Policy Agenda for 2001 and Beyond?" Speech by Mr Rod Shogren, Commissioner ACCC, 30 April 2001.  See www.accc.gov.au

24.  Interconnector Development in the NEM:  A Report by the Interconnector Process Working Group June 2001.

25.  Black & Veatch and Siemens are proposing to build four power plants near coal mines in South Dakota and Wyoming.  This will transmit 6,000 MW of power along DC lines at a cost of $11 billion for the plants and $4 billion for the links.  Already approved is the Neptune Project with three cables, 3,600 MW in total, linking generation in Maine and Canada to New York and New England.

26.  The Productivity Commission has indicated a similar view via the inclusion of Proposal 6.1. in its Position Paper.  However, focus on ensuring a "substantial increase" in competition would derive from access regulation arguably would continue to fall short of the Hilmer formulation of access being provided where necessary to ensure "effective competition".

27.  Power by the Minute, February 2002

28.  Littlechild, S.C., Why we need electricity retailers:  A reply to Joskow on wholesale spot price passthrough, The Judge Institute of Management Studies, University of Cambridge, September 2000.

29.  ABARE's January paper, Competition in the Australian national electricity market, ABARE Current Issues, January 2002.

30.  See Richard Wood, Marginal Costs and Prices in the Electricity Industry, June 2000

31.  The state government electricity taskforce, final report, 29 June 2001

32.  ESAA, Electricity Prices in Australia, 2001/2002

33.  Richard A. Epstein Principles for a Free Society, Perseus Books, Reading Mass, 1998