The Economics of Essential Facilities Regulation

INTRODUCTORY OBSERVATIONS

This volume has sprung from concerns about the Access Provisions (Part IIIA) of the Trade Practices Act.  It comprises two pieces of research, which analyse these provisions from a legal and an economic perspective.

Part IIIA of the Trade Practices Act resulted from a perception in the 1990's that the Trade Practices Act was not capable of dealing effectively with competition where a single firm was in a dominant position.  It drew heavily upon the processes that the United States courts developed to deal with this issue and was introduced after a comprehensive review of competition policy published as the 1993 Hilmer Report.  Its aim is to prevent the owners of monopoly facilities from using them to obtain excessive profits or impose excessive costs either by charging too much for access or by restricting access to affiliated businesses.

Unfortunately the legislation has created greater intrusiveness than envisaged by the Hilmer Report, and the subsequent provisions of the Commonwealth/State/Territories Competitive Principles Agreement, which constituted the agreed terms that would be legislatively implemented.  In addition, in some cases the government institutions tasked with administering the legislation have interpreted their role in ways that add even greater intrusion.  The overall effect of this has been to produce far more government involvement into commercial matters than exists in the United States legal setting upon which the Access Regime was based.

Australia seems to be the only country in the world that has both a generic access regime and a general prohibition on the misuse of market power.  This fact, of itself, constitutes prima facie evidence of regulatory overkill.

Australia's access regime was conceived at a time when the misuse of market power provisions were seen as inadequate.  Since that time, High Court decisions, the most recent being NT Power, have added greater clarity to the notions of such misuse and made the Part IIIA provisions unnecessary and, indeed, in the light of the dual system they entail, somewhat confusing.

The legal framework under which businesses may be required to provide unrelated businesses access to their facilities impacts across the whole economy.  It is particularly important for those industries which are required to invest heavily in such facilities.  Innovative developments across many areas of economic activity have often brought considerable benefits to their customers and others making use of them.  Such innovations, almost by definition upstage their competition and have frequently commanded premium prices.  It is the prospect of high profits that has often been the key motivating factor in the pursuit of innovations.  Valuable innovations and wise investment, even where their outcome results in a degree of market power, generate benefits within the economy and for society at large.

Accordingly, pursuit of premium returns is something not to be discouraged.  Return on investment is a fundamental incentive to innovate.  The prospect of having to share facilities is a disincentive to innovation and any access regime should avoid dampening the dynamic processes which competition creates.  An access regime should not be a means whereby a party without the skill or drive to "blaze its own path" can appropriate, under the guise of "fair access to essential facilities" the capital investment and business acumen of others.

We believe that the access regime under Part IIIA of the Trade Practices Act does not implement the above principle.  Section 46 however carries it into effect.  Control of misuse of market power is considered appropriate in all other countries of the world without the necessity also to resort to a generic access regime.  Australia should be no different.

Furthermore, the regulatory system which has in fact been implemented is unnecessarily complex and entails a multiplicity of decision centres involving at least three evaluative tribunals and also a political decision maker.  All of this can be changed to make the whole system less cumbersome and more efficient.

This volume strongly argues that the Access Regime provisions of the Trade Practices Act are suppressing overall economic welfare.  In relation to infrastructure, the present legal setting fails to incorporate appropriate economic analysis or recognise the investment experiences in Australia and elsewhere.  In particular, it has not maintained currency with legal developments in the US.  These provided the rationale for Australia's legal settings but are more suitably structured and have been interpreted so as to avoid investment disincentives.

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ABSTRACT

Australia has benefited from competition reforms that have opened up previously closed sectors of the economy, especially those formerly reserved for government owned monopolies.  Fears that monopolies in many transport and communications services were natural and inevitable led Australian governments to opt for public ownership in those sectors.

1995 marked a new approach.  Owners of natural monopoly facilities were required, under provisions of the Trade Practices Act (TPA) particularly Part IIIA, to allow access to them on terms that are fair and cost-reflective.  Supporting and monitoring this provision is the National Competition Council (NCC) and the Australian Competition and Consumer Commission (ACCC).

Though inspired by US legal developments, Part IIIA's provisions provide greater scope for regulatory intervention because of the conditions under which a facility can be "declared" a natural monopoly.  US law bases such a declaration on a potential user being unable practically or reasonably to duplicate the essential facility.  Australia's "uneconomical to develop" test is more accommodating to the interest of potential users.

However, mindful of the dangers of regulatory interventions, the Government excluded production processes from the ambit of regulatory control.  This distinguishment of manufacturing from primary and services operations is becoming increasingly artificial as stages of production converge.

Whether or not fears of natural monopoly were originally justified, economic and technological developments have brought competition to many services of previous concern.  Yet, regulatory agencies have required owners of rail lines, gas pipelines, telecom lines and airports to give other businesses access to them at a specified price even where the facilities do not dominate their markets.  The consequent loss of flexibility and the lower prices inevitably discourage investment in new capacity.

With private rail lines that carry iron ore in the Pilbara, two Federal Court judgments covering substantially identical cases have delivered conflicting findings.  The first of these determined that the rail lines were essentially part of a production process and not therefore eligible for declaration.  The second took a more literalist view and, noting that Part IIIA specified that rail lines were likely to be essential facilities, required consideration of whether access should be given.

These rail facilities serve an area that will shortly have three differently owned lines.  Such alternative supply options remove any rationale for declaration.  If competing facility owners won't offer access to unrelated businesses, this must be because the conditions sought are too difficult operationally to arrange, owners require the capacity themselves or the price is likely to be too low.  There is no legitimate regulatory role in such circumstances.

Regulatory and bureaucratic controls like those embodied in Part IIIA have already led to reduced and distorted investment and wasted resources in the public sector, lobbying and legal services.  They are now threatening the creation of infrastructure vital to export industries like iron ore.

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1 LIMITING THE ROLE OF GOVERNMENT

Property rights in "long and thin" assets like networks should be respected, just as we recognise property rights in "short and fat" assets like houses, cars and television sets. ⁽¹⁾

PRIVATE OWNERSHIP AND COMPETITION

When twinned with open competition, private ownership gives firms considerable incentives to discover and meet demands at lowest cost.  Control and exclusivity rights are major benefits of ownership.  Assured property rights are crucial to promoting increased wealth, since their absence will discourage market suppliers from investing and encourage them to "free ride" on others' facilities.  Evidence in support of the potency of rigorously protected property rights can be found from economic examination of the outcomes for countries with differing legal frameworks.  Indeed, even civil law based systems, which are only slightly less protective than common law based systems of personal property, appear to deliver inferior economic outcomes. ⁽²⁾

Business deregulation and privatisation have been major factors behind the improved economic performance of Australia over the past 15 years.  Although the Productivity Commission ⁽³⁾ identified only 2.5 per cent of direct gains from the post 1995 National Competition Policy (NCP) reforms, it estimated that the indirect gains were much greater and have been the key factor in delivering 13 years of unbroken growth.  This lifted Australia's GDP per capita ranking within the OECD from 16th to 8th.

In specific industries, very impressive gains from deregulation and privatisation can be observed.  Labour productivity has more than doubled in the electricity generation industry since the mid-1990s, including a fivefold increase in Victoria.  Equally impressive gains are to be found in gas, the ports, and telecommunications. ⁽⁴⁾

THE NOTION OF ESSENTIAL FACILITIES

The justification for regulation of services is where they are provided by a facility that has characteristics of a natural monopoly.  Such conditions entail only one provider ever being likely to be viable, combined with a degree of essentiality in the services provided.  Unambiguously essential facilities were historically epitomized by a desert oasis or a ship passing survivors of a shipwreck.  In these sorts of cases, long traditions require assistance be given.

More modern requirements of access to essential facilities date back to sixteenth century ports and later to railway bridges that were choke points.  Access to a Missouri bridge at St. Louis was granted in the 1912 Terminal Railroads seminal case.  However, foreshadowing many subsequent cases where monopolies have proven to be ephemeral, within a few years that facility turned out to be far from essential as other bridges were built.

Even when accurately defined, natural monopolies are far from permanent.  In the first Australian edition of Samuelson's Economics, ⁽⁵⁾ examples cited were "water mains, gas pipes, electricity wires, telephone cables, train tracks and postal services".  Not all aspects of these would now be considered natural monopolies.

Australian network businesses prior to NCP were usually protected from competition and were either government-owned or, like AGL's NSW gas monopoly, franchised by government.  Governments sought to maintain control over these businesses' entire production chains, including those aspects that were highly vulnerable to competition, often to facilitate cross-subsidies or to influence general labour market policy.

At a time in Australia when monopolies had legal protection from competition, price gouging by monopolists was pervasive.  This was usually dissipated in operational inefficiencies such as over-manning and inappropriately selected or located investments.  The 1993 Hilmer Report was fundamentally concerned with removing monopoly powers of these mainly government owned firms.  In adopting its findings, Australian governments had come to accept that sheltering activities from competition had impaired productivity.  Because rival facilities can no longer be excluded, the risk of price gouging is much reduced.

ACCESS REGULATION'S DAMPENING EFFECT ON EFFICIENCY

Access regimes are departures from the standard rules about owners' use of their property.  The standard rules promote efficiency (and perhaps preserve liberty) by allowing owners to use their property as they please (as long as they do not harm others).  Inevitably, forcing firms to offer access to their facilities also entails the prospect of regulated price and service levels more advantageous to the non-owner than could be obtained in a voluntary contract.  If this were not the case the access seeker would have little reason to pursue a regulatory approach.

Normally, potential customers cannot be compelled to use and pay for a particular facility and price controls largely involve an upside limit on an investment's economic returns.  A limit on the upside returns with no limit on the downside creates an asymmetric (probability) distribution of potential economic returns.  This reduces the weighted average potential overall gain from a prospective investment and diminishes the incentives for further investment.

In the short term a price that is regulated below market levels means lower costs for users and higher demand for the services.  Over the longer term regulated prices are likely to undermine incentives to maintain facilities and to modernise them.  Important in this respect is modification or suspension of investment by firms seeking to avoid unwanted customers.

In addition, regulated prices reduce the "headroom" for alternative or competitive providers to enter the market.  In reducing the incentive for users to develop their own facilities, regulated prices are intended to allow a greater economy of facility use, but this also means less capacity is made available as some parties modify their business strategies to seek access while others defend their assets from unwanted encroachments.  This also brings wasteful litigation and paperburden costs where firms seek to recruit government assistance to obtain cheaper access to other firms' facilities.

Only under two circumstances can a mandatory access regime encourage investment.  The first is when customers are obligated to pay whether or not they use the facility.  This occurs with electricity lines and creates its own risks for efficiency because an institution, rather than an entrepreneur, is deciding the case for the investment.  The second set of circumstances arises if investors perceive that the alternative to the regulation is even more intrusive government behaviour.  In that case regulation may offer some reassurance but this merely demonstrates the degrees to which regulation can be onerous.

Forced sharing of facilities not only affects firms that have seized dominant market positions through innovations, but it may also have adverse effects even if the facilities were originally built under some form of protective regime.  Thierer and Crews disparagingly refer to this as "a reparations policy".  They argue that forced sharing is always counterproductive because it "breeds dependency on existing systems, resulting in numerous competitors haggling with network owners and regulators over the best terms of access to increasingly technologically obsolete networks of the past". ⁽⁶⁾  Because of this and because regulators will inevitably push rates too low they contend that the policy always backfires.

It is the "chilling" effect on investment that represents the major cost of access regulation.  It will encourage abandonment or deferral of new investment that is vulnerable to regulatory controls that allow firms cheap use of facilities owned by others.

Preventing handsome returns will prove especially deleterious to investment in the more risky infrastructure facing uncertain market and competitive environments.  In terms of the infrastructure built, we would therefore see a concentration on serving existing known markets with known resources and far less activity on projects that contain considerable up-and down-side uncertainty.

In this respect the Export and Infrastructure Taskforce concluded:

A quest for "first best" solutions, combined with a focus on removing monopoly rents, has distracted from what should be the regulatory task:  which is not to determine whether what has been proposed by way of access conditions is optimal, but whether it is reasonable.  The search for optimality and precision in regulatory decision making has not only made the regulatory process less predictable than it should be, but has also added greatly to regulatory delay, hindering investment in infrastructure used by export industries.

Australia's exporters operate in highly competitive global markets.  They are reliant on infrastructure investment that is undertaken in a timely way, not a time frame dictated by regulatory processes.  Waiting two or three years for regulatory decisions is as unacceptable as it is unnecessary. ⁽⁷⁾

Access policy also causes features of ownership rights to migrate to the incumbent users.  These may not provide the best signals for efficient capacity expansion and might see an interest in blocking expansions that increase competition for their own outputs.  If incumbent users have adequate capacity for their own needs, they would certainly resist price increases as a basis for expansions in capacity.  Attempting to negotiate capacity increases where the owner considers the regulated price is too low has proven difficult for a number of facilities, notably the Dampier to Bunbury Natural Gas Pipeline and the Dalrymple Bay coal loading facility in Queensland.

Price constraints, in bringing about inadequate capacity increases and surplus demand, also present problems of allocating the available capacity.  Preventing price flexibility entails inefficient rationing through queuing for capacity.  Anticipating this in the Gas Code, Australian regulatory authorities actually require facility owners to have a queuing policy as a condition for approval of their access proposals.  This recognises that policy is likely to create a market scarcity situation that requires blunt tools to allocate it between competing needs.

The different sorts of essential facilities and experiences of some other industries subject to access regulation are discussed in Attachment 1.  The adverse effects of regulating firms designated as natural monopolies can be summarised as:

• First, the regulated firm is not incentivised to innovate.  Indeed, unless given a guaranteed return, out of fear of regulatory expropriation the firm will avoid all but defensive capital investment.
• Secondly, the low price will leave access seekers with no incentive to build new facilities for themselves.  Competition, except in the form of re-sale of the regulated facility, will thereby be constrained.
• Thirdly, the availability of a recourse to government to fortify one side's commercial negotiations leads to strategic business approaches which deflect firms from a customer focus.  These include seeking to design facilities so that they are not readily useable by those underpaying.
• Related to this, the regulatory procedure for fixing prices is necessarily highly procedural and time-consuming and can paralyze commercial decision-making;  while the adverse impact of forced delays in a rival's decision-making may advantage the applicant, it is detrimental to the economy as a whole.
• Finally, the procedural nature of the regulation involves government and private legal and administrative resources that represent serious costs.

The world business landscape is littered with firms with strong market positions whose supply assets have atrophied as a result of government controls.  Hence, regulation of firms, even of monopolies, should be undertaken only with great reluctance.

Stigler ⁽⁸⁾ inspired a great deal of regulatory literature with his work featuring the notion of regulated firms capturing the regulator.  Yet, in more recent years at least, the risk has been in the opposite direction with the regulatory authorities engaging in what Shuttleworth ⁽⁹⁾ has called "regulatory opportunism" to please public opinion and government by reducing prices.  A self-interested regulator's time horizon will place a lower priority on the longer term.  By contrast, a business that is accountable to private shareholders has a combination of capital maintenance and current income as the focus of its self-interest.  The Productivity Commission Chairman, Gary Banks, has also recognised the phenomenon of regulatory opportunism, ⁽¹⁰⁾ which results in a bias in favour of insufficient rather than excessive supplier returns.

CONSTRAINTS ON GOVERNMENT REGULATORY EXCESSES

A powerful discipline on governments to avoid exploiting businesses is provided by the globalisation of markets.  This includes financial markets which increase capital costs to ventures where property rights are vulnerable to government regulation.

This facet of globalisation is not a new impediment to governments' arbitrary and unjust property seizures, onerous taxation, etc.  The internationalisation of commerce in the Middle Ages was a precursor to current conditions.  It led to the development of the Law Merchant 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 and has remained as a constraint on government action.

Even so, in a modern economy the mobilisation of these capital disciplines can be a lengthy process.  Much damage can be masked by other features of the economy before a "capital strike" becomes clearly apparent.  This is particularly the case in a resource abundant economy such as Australia.

General welfare is most vulnerable to intervention where the importance of new investment and innovation outweighs that of static efficiency.  Hence, only if the investment need is known and stable can we have confidence that an access regulation regime may be benign.  With the exception of roads, such situations are rare.  Accordingly, it is preferable to err on the side of failing to declare essential facilities, rather than on the side of declaring non-essential facilities.

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2 THE AUSTRALIAN LEGAL FRAMEWORK
FOR ESSENTIAL FACILITIES

TREATMENT OF REGULATORY SHARING REQUIREMENTS

Australia's provisions that the owner of essential facilities may be required to offer services to all comers, even competitors, follows developments in the US and the EU.  US courts recognise that in declaring a facility essential, they must then set business terms and conditions, something they are reluctant to do because they are ill-equipped for the task.  There has been less trepidation in these regards in Australia.  In the US, a threshold test for government involvement specifies that an asset would be "impractical to duplicate".  Australia however uses the term "uneconomical to develop", a phrase which opens many more vistas for regulatory intrusion.  Overseas developments in law are detailed in Section 2.

Recognising that economic disincentives flow from requiring firms to relinquish their property rights, Hilmer was keen to narrowly define an "essential facility".  The report set criteria which included the "significance of the industry to the national economy and the expected impact of effective competition in that industry on national competitiveness".  It argued, "Clearly, access to the facility should be essential, rather than merely convenient". ⁽¹¹⁾

In amplifying its reasons for limiting the requirement for access it said:

Any assessment of the public interest would need to place special emphasis on the need to ensure access rights did not undermine the viability of long term investment in important infrastructure projects.  Accordingly, wherever possible the likely obligations to provide access should be made clear before an investment is made ... where this is not possible, due account of the likely impact on incentives to invest should be made in determining whether or not to create a right of access, and if access is declared, through the declaration of appropriate pricing principles and other terms and conditions. ⁽¹²⁾

The Hilmer Report also recognised that the residue of public ownership meant that almost all areas where competition reforms should apply in opening essential facilities were in public or former public facilities.  Moreover it said, "At the same time, technological and other developments have eroded the extent of most genuine 'natural monopolies' and eliminated others altogether". ⁽¹³⁾

Though Part IIIA of the TPA was introduced in response to the Hilmer Report the two diverge in some important respects.  Thus, the provision in Hilmer paralleling the US terminology ("Clearly, access to the facility should be essential, rather than merely convenient") becomes in 44G(2)(b), "that it would be uneconomical for anyone to develop another facility to provide the service".

The increased scope that this provided for regulatory intrusion was welcomed by the NCC. ⁽¹⁴⁾  The NCC said:

Building and activating such (gas or electricity) networks is extremely expensive, but sending more gas or current around a network once it is operating is relatively cheap.  Clearly, rather than making a competitor build a second network to compete with the existing network, it would make more economic sense in such situations to give the competitor access to the existing network.

Hence, the NCC at the outset proclaimed a willingness to intervene to require access be given so that applicants would be able to gain advantage by using an owner's facility in a way that leverages off marginal costs that are frequently much lower than average costs.  That philosophy has been re-affirmed on a number of occasions.  Thus the then Chairman of the NCC, Mr Graeme Samuel, in an address to Utilicon 2000 Melbourne 7 August 2000 said,

... it is important to remember that not all investment is good investment.  Critics ignore the effects of NOT granting access -- what happens to investment in other markets if access is denied?  More broadly, investment is not desirable for its own sake, but rather for the benefits it brings in increasing living standards.  Does anyone want or need two electricity distribution networks running down their streets?  Does anyone argue in favour of such investment, regardless of whether it is public or private?  Society is best served by investment that involves the most productive use of its resources.

It is dangerous territory for a regulator to pre-judge when a duplication is wasteful.  Business firms, required to operate to maximise the wealth of their shareholders, are better evaluators.  A new rival is better placed than a regulator to decide whether to piggy-back on existing facilities or build its own.  The incumbent business may hold out for advantageous terms but is restrained in this respect by fears that if the new rival builds its own facilities, the excess capacity is likely to bring about a price war.

These issues aside, if an unrelated firm is required to be given access at a price below the market price, this represents a considerable redistribution of income and hence a modification of business incentives.  While taking advantage of lower marginal costs is standard business practice for a single entity to pursue internally (for example, firms normally take advantage of their existing sales team in launching a new product line), it is an extraordinary intervention to require a firm to extend such cost-saving to unrelated entities, especially competitors.

Awareness of these dangers led to a new and controversial branch of economic literature governing the appropriate regulatory pricing principles, the efficient components rule.  This specifies that the incumbent should be compensated in the mandatory access price for the monopoly profits attributable to the specific bottleneck component of an integrated facility. ⁽¹⁵⁾

Establishing terms of access to a facility that is not duplicable and is genuinely essential to the maintenance of a business or the life of an individual is one thing.  Even with pricing that fully compensates the incumbents' monopoly, extending access beyond such strict criteria is an action pregnant with investment disincentives and lobbying costs.

ACCESS TO PRODUCTION FACILITIES

In seeking to limit the scope of declarable essential facilities, the Hilmer report made a general caveat for "products, production processes or most commercial facilities (other than electricity transmission grids, major gas pipelines, major rail-beds and ports)".  This caveat was taken up in the TPA's Part IIIA amendments where section 44B limits declarable facilities to a service other than the use of a production process (except to the extent that it is an integral but subsidiary part of the service).

Heirs to Adam Smith's description of an eighteenth century pin-manufacturing facility, include car plants which bring together many subcomponents from other suppliers as well as in-house fabrications for final assembly.  Those plants essentially comprise conveyor belts along which specific assembly tasks take place.  Normally the facilities are capable of assembling a considerable variation of products, sometimes not even in batches.

Other production processes are found in industries like steel or oil refining.  In these cases a basic input is refined into a more useable product in the case of steel or into several such products in the case of crude oil.

Many other processes are less easily defined as production.  Thus sorting of product inputs is commonly referred to as a pre-manufacturing process, while simple beneficiation of raw materials is often not considered to be manufacturing.

The difficulty of defining industries is compounded when they metamorphose.  In previously integrated industries such as electricity production-transmission-distribution-retailing the original structural separation has changed.  Distribution and retail, originally joined under single firms, have separated from each other in recognition that totally different skills and business models were needed.  The retail arm manages volatile wholesale costs and a fixed retail price.  It is highly motivated to mitigate the generation supply risks involved.  Risk mitigation is best handled in part by ownership and, as a result, retail-generator combinations have emerged.

The odyssey of the creation of these electricity "gentailers" illustrates how defining where manufacturing or a production process starts and another commercial activity ends have no corporate governance significance.  Importantly from the perspective of Part IIIA's exclusion of production facilities from coverage, manufacturing, primary production and services are no longer meaningful terms for operational and hence for regulatory purposes.

Risk mitigation and price security are increasingly central to business strategies.  Judgements on these matters drive a great deal of the make or buy-in decision making frameworks of firms whose classifications as manufacturers, primary producers, transport contractors and so on are irrelevant.

THE DEVELOPMENT OF AUSTRALIAN ESSENTIAL FACILITY PROVISIONS

General Approach

Some areas of commerce were excluded from the reach of the general competition provisions of the Trade Practices Act from the outset.  Notable in this respect is international liner shipping.

Since the introduction of the Part IIIA provisions, other areas have been separated out in distinct parts of the legislation (telecommunications) or for special treatment (electricity transmission and distribution, and gas).  These are designed to allow greater industry specific expertise to be brought to bear and perhaps, inter alia, to facilitate prior approval "safe harbour" regulatory holidays for new proposals, although this has not been effective in the case of telecommunications.  In the case of the Gas Code the stated aims were to:

• facilitate the development and operation of a national market for gas;
• prevent abuse of monopoly power;
• promote a competitive market for gas in which customers may choose suppliers, including producers, retailers and traders;
• provide a right of access to gas pipelines on fair and reasonable terms for both pipeline owners and those seeking access;  and
• provide for resolution of access disputes

The aim was "to achieve the same sort of outcome in terms of access prices and quality of service that would occur in a competitive market." ⁽¹⁶⁾

Water and Sewerage

These aims in this sector have been rarely tested.  Sydney Water sewage transmission services were declared in 2004.  Sydney Water has a monopoly of sewage transportation and treatment and all parties agreed that it would be uneconomical for anyone to produce another such facility.  In 2005 the Australian Competition Tribunal found that competition would be promoted in the recycled water market if access was granted and declared the service for a period of 50 years.

The applicant, Services Sydney, has rejected an access offer from Sydney Water and has applied to the ACCC for a determination of the prices and conditions of access.  The NSW Government is to rescind Sydney Water's status as a legislative monopoly.

Gas

Regulators have frequently claimed (sometimes with the support of commissioned research) that the gas access regime has delivered considerable gains to the economy.  Indeed, citing industry developments, the Chairman of the ACCC said, "All of which I would have thought rather put the lie to the industry's claim that ACCC regulation has, in the words of one major player "had a chilling effect" on investment in the industry."  He went on to say, "While there are numerous plans mooted for the construction of new transmission pipelines in Australia, there does not appear to have been any significant shortfall in investment under the gas access regime". ⁽¹⁷⁾

ACCC Commissioner Ed Willett said (op. cit.), "The evidence supports a conclusion that the regime as applied is facilitating and could continue facilitating new pipeline development."  He argued that major new pipelines have been built under the regime including:

• Eastern Gas Pipeline ($450m, 795km)
• Tasmanian Gas Pipeline ($440m, 730km)
• SEA Gas Pipeline (estimated $500m, 680km)
• North Queensland Pipeline ($160m, 390km Coal Seam Methane from Moranbah to Townsville)
• Telfer Gas Pipeline (estimated $114m, 442.5 km from Port Hedland to Telfer).

Contrary to such assertions, no pipeline has been built as a result of the alleged greater certainty that Part IIIA and the Gas Code offer.  No new pipeline has been built in the expectation that it would be regulated. ⁽¹⁸⁾

Most gas pipelines were declared with the adoption of the Gas Code.  In the following period many declarations have been revoked by the NCC.  These have largely been cases where there was only one customer (e.g. Southern Cross Pipelines to Leinster power station) or where the pipelines were small, could not exercise market power and had regulation costs disproportionate to the returns (e.g. South West Slopes and Temora pipelines).

In 2001, coverage of the important Longford to Sydney Eastern Gas Pipeline (EGP) was revoked after appeal to the Australian Competition Tribunal (ACT), the NCC having rejected an application.  Once that line had been built, competition caused the price on the existing Moomba to Sydney line to fall from 71 cents to 66 cents per gigajoule.  However the NCC's consultants (Drs Ordover and Lehr) argued that under true competition the price should fall to around 50 cents per gigajoule (the authorities concluding that there was "implicit" collusion between the parties).  The consultants and the NCC considered regulation to be warranted as long as there were not parallel lines.  This notion of essentiality is capable of a very wide application across the economy and the ACT rejected it.

Revocation of the coverage over the EGP pipeline left a strong case for the competing Moomba-Sydney pipeline to be uncovered (leaving it under regulatory coverage would frustrate the rationale for removing coverage over the EGP since this would automatically fix both pipelines' prices).  Although the NCC rejected revocation, the Minister revoked coverage over the part of the pipeline that competed with the EGP, in effect, revoking coverage over the whole of the pipeline.

An earlier case involved a new pipeline in NSW, the Central West.  AGL and the users agreed prices for this (and the facility received a Commonwealth subsidy).  After its commitment the ACCC required its price be lowered, a decision heralding considerable risk to pursuing business opportunities without regulatory clearance.

Such outcomes doubtless influenced business strategies for the SEA Gas pipeline from Victoria to Adelaide.  This was built with the intention of avoiding the regulatory costs and distortions of coverage.  The partners designed the capacity inflexibly to prevent any availability for other users and therefore any case for declaration.  As building-in some provision for increased demand is relatively inexpensive, this represents regulation forcing sub-optimal investment. ⁽¹⁹⁾

SEA Gas competes with the established Epic pipeline from Moomba to Adelaide and once it commenced operation, the NCC in 2005 agreed to revoke coverage of the Epic pipeline.  However, the South Australian Minister has not concurred.

Some pipelines, though under coverage, have proceeded because the parties have agreed to contract with each other to circumvent regulatory intrusion.  This has been the case with the Roma to Brisbane pipeline expansion and the expansion of the Dampier to Bunbury Pipeline, where the customers and the owners (who overlap) all shared a common interest in expansion and agreed to pay a premium over the price for regulated capacity. ⁽²⁰⁾  The new Fairview to Wallumbilla and the Moranbah to Gladstone pipelines followed a similar approach and the PNG to Brisbane pipeline, if it eventually proceeds, is to be uncovered.

It is prudent for new facility investors to engage with prospective customers and, where possible, to tie down long term contracts prior to commitment.  The measures new pipeline developers feel obliged to follow are, however, of a different nature.  Detailed negotiations with customers prior to development are designed to circumvent regulatory oversight and are especially difficult since they require all parties' agreement.

Amendments to the gas law will also provide for access holidays for green field sites.  There is an irony, apparently lost on the proponents of the regulatory provisions, in formulating a code designed to regulate an essential facility that is yet to be brought into existence.  New pipelines have no franchise and, not having been built already, are clearly neither "essential" nor commercially certain.  Oxymoronic though such a green field provision is, it also relies upon agreement to the holiday by the ACCC, which has in the past suggested price conditions for such sites that are more suitable for established facilities facing little risk than for entrepreneurial facilities.

An additional pipeline brings new competition.  The regulatory arrangements are posited on natural monopoly, an inappropriate market depiction where new competition actually emerges.  Yet the regulatory agencies have too often contrived to regulate new ventures and to retain controls -- even with an outbreak of competition.  Regulation in those cases contains all the inevitable downside costs but no upside benefits.

Coal Terminals

Unsatisfactory outcomes are evident in the provision and expansion of coal port and rail facilities where users and owners are unrelated parties and the facilities are regulated.

Faced with an expansion of demand for coal in 2004, the BHP owned Hay Point facility saw an approval and commissioning of a 25 per cent increase in capacity in a little over three years.

By contrast, a comparable multiple-user regulated facility at Dalrymple Bay took an additional year, albeit with a larger planned capacity increase.  The owner of that facility sought a 35 per cent increase in the Terminal Infrastructure Charge in June 2003 but the regulator sought a 24.6 per cent reduction.  Agreement was reached in April 2005, with the delays causing $1 billion in forgone sales.  Though regulated under the Queensland Competition Authority Act rather than Part IIIA, the Dalrymple Bay coal loading facility demonstrates how the gestation time of approvals is often much greater with regulated facilities than with single user facilities.

Even greater delays are being experienced in expanding the facilities serving Port Waratah, the rail capacity to which has been increased following Commonwealth Government intervention.  However the coal exporters' different agendas have held up funding for expansion of the multi-user open access terminal by the coal exporting facilities but now face transport bottlenecks.

Airports

Price setting of airport charges was abandoned by the Commonwealth following a Productivity Commission (PC) report in 2002.  Price monitoring was put in place for most airside airport services.  Parties still have access to generic provisions under Part IIIA.  Sydney Airport Corporation Limited (SACL) and Virgin were engaged in a lengthy legal dispute over the applications of Part IIIA provisions.  Ironically, during the dispute, which concerned pricing, Virgin was able to rapidly increase its market share -- an indication that the market power SACL was claimed to be abusing was not impeding competition.

The PC in its 2007 review saw the positive outcomes of the current approach of price monitoring (with the option of Part IIIA declaration) as being:

• there is no evidence of systematic misuse of market power by airports in setting charges for aeronautical services;
• it has been much easier to undertake the investment necessary to sustain and enhance service provision in the face of growing demand for air travel;
• airports' productivity performance has been high by international standards, with service quality rated satisfactory to good;
• compliance costs have been lower than under the previous regime;  and
• some progress has been made in building commercial relations.

The declaration process for SACL has undergone several twists with the NCC first indicating that it would declare and then opting not to do so, the Tribunal then deciding to declare the services and the Full Federal Court upholding that but using a markedly different interpretation of Part IIIA.

Among the issues determined by the Full Federal Court are:

• Part IIIA is not a measure to remedy unacceptable conduct but is an instrument to allow more efficient working of essential facilities;
• the important aspect is whether "access or increased access" not "declaration" would promote competition;
• if "the service has been provided in a fair or even handed means and in a way to maximise vigorous competition in the downstream market, that may be a powerful and relevant consideration as to why no declaration should be made" (para 85);
• declaration is required because:
1. Sydney Airport is a natural monopoly and SACL exerts monopoly power;
2. the Airside Service is a necessary input for effective competition in the dependent market;
3. neither Bankstown (nor) Richmond Airport could provide the service;  and
4. the parent company of SACL had the first right of refusal to build and operate any second major airport within 100 kilometres of the Sydney CBD.

"Further, ... access to Sydney Airport is essential to compete in the domestic air passenger market."

These provisions may be of considerable importance in defining the future reach of essential facilities regulation.

Electricity Transmission

The electricity industry's highly meshed system based on alternating current has brought wide agreement for it to be accommodated by a variation of the generic Part IIIA provisions.  Electricity transmission has its own regulatory arrangements with principles outlined in the National Electricity Law (s.16(2)) that identify the industry as highly regulated with its own access scheme.

Present policy recognises generation and retailing as market driven contestable sub-industries, and transmission and distribution as natural monopolies that require regulatory control.  The interplay between regulated and deregulated parts of the industry poses considerable risks to efficiency and commercial viability.  Since transmission and new generation are alternative approaches to market supply, this has required a regulatory assessment of whether a transmission development may proceed.  The trade-off between nearby and remote generation (via transmission) is especially marked in Australia, where distances between load centres are vast and transmission costs can therefore be high.

There is no shortage of proposals for new regulated links since the revenue is from a compulsory charge on users and is widely considered to be guaranteed.

Two entrepreneurial links have been built to take advantage of price differentials where transmission shortages were evident.  These developments gave rise to issues concerning the circumstances under which a regulated augmentation of links should be permitted. ⁽²¹⁾  In this event, the merchant links in Australia could not compete against the links receiving a regulated return and have been given regulated status.

The case for regulated transmission rests on its indivisibility and the consequent externalities which are too great to allow profitable merchant transmission because the price benefits accrue to all and not only to those paying for the asset.  But a new generation facility will also tend to suppress the price of all delivered electricity in its interconnected region in a process similar to that of a transmission link introducing new power.  Few would argue that generation should therefore be government-owned or subsidised.  All forms of supply across the economy are accompanied by some externalities.

The present position in Australia regarding transmission is that regulated links will be permitted as long as a net market benefit is judged by the regulator to be the outcome and as long as the proposed link is the best of a range of feasible alternatives.  This, however, remains dissimilar from the decision making structure that is seen in the generation sector (or in markets more generally) since the value attributed to the transmission investment may incorporate network benefit externalities some of which a comparable investment in a new generator would not capture.

Cook ⁽²²⁾ has assembled estimates (see Table 1.1) of four proposals' regulatory benefits.  These are dominated by deferred investment.

Table 1.1:  The Calculation of the Regulatory Test Benefits

Benefit ($M)	Riverlink 1	QNI 2	Murraylink 3	SNI 4
Energy	4	90	82	25
Reliability	-	-	62	-
Deferred generation	158	571	54	154
Deferred network	15	-	24	18
TOTAL	177	661	222	197

1. Report on Technical Issues, Costs and Benefits Associated with the Riverlink Interconnection -- Between the Electricity Networks of South Australia and New South Wales, undated, Schedule 2
2. London Economics, 1997
3. Murraylink Transmission Company Application for Conversion and Maximum Allowed Revenue, Decision 1 October 2003, ACCC, page 75
4. Economic Evaluation of the Proposed SNI Interconnector, Roam Consulting Pty Ltd, October 2001, Results for Simulation 1-S-M

Note:  SNO VIC 400 Regulatory test benefits unavailable

In the case of the proposed regulated Riverlink line between NSW and South Australia, the estimated value of deferred investment was $158 million.  This was largely predicated on reserve capacity estimates being a relatively low 12.5 per cent.  However, in the three years following the proposal more than 1000 MW of new capacity was commissioned on top of the pre-existing South Australia capacity of 2980 MW bringing the reserve capacity margin to 32.8 per cent.

Similarly, the Queensland/New South Wales Interconnector (QNI) was estimated to bring $571 million of deferred generation benefits including $351 million for Queensland where supplies were tight at that time.  In the event, in the subsequent two years, Queensland's pre-existing capacity of 8,400 MW was augmented by 2,500 MW of additional capacity.

In these and other cases, the estimates of value of the proposal were based on a static situation in which other suppliers are assumed not to react to the same opportunities.  Yet the inclination at the time was to further facilitate the allowance of regulated links by incorporating into the estimates of their value the lower prices their "competition benefits" bring.  This is a departure from the outcome obtainable by a private entrepreneur, who would not be able to capture the consumer surplus value that stems from the price reductions forced on incumbent suppliers.  Hence a regulated investment justified on the basis of such benefits is overvalued vis-à-vis a private investment.

No jurisdiction anywhere in the world has developed a system for new transmission that does not rely on regulated prices and approvals.

A comprehensive assignment of property rights to the transmission system has been advocated previously by the present author as a means of allowing transmission to be efficiently provided without regulation. ⁽²³⁾  This would assign a share of the available transmission to incumbent generators.  Major new generation would then be required to finance any additional transmission capacity that its output required (or buy such capacity from a plant that was contemplating retirement).

Such an approach could avoid the tortuous public hearings and risks of inappropriate customer funding of new transmission.  That said, Australia's experiences, unsatisfactory though they are in bringing about regulatory neutrality between different facets of supply, are not dissimilar to those of other jurisdictions.

Private Railways

Significant Cases

Several cases for rail track services to be declared have been considered.  Rail services for the Gulf of Carpenteria, Sydney to Broken Hill, Hunter Valley, and Victoria intrastate were all decided by agreement of the parties.

Two Federal Court cases have been heard.  In Robe River (1998) Kenny J. determined that access was not justified because the rail facility was part of an integrated production process "by which a marketable commodity is created or manufactured" and was thereby excluded from coverage.  In BHP Billiton Iron Ore v NCC (2006), covering FMG's application for access to transport ore from its Mindy Mindy deposit, Middleton J. considered this to be incorrect.  He ruled that access to the railway is not "use of a production process", but rather it is a transport or conveyance service and cannot fall within the production process exception.  Attachment 2 outlines the two judgements and Section 2 (especially Part 6) addresses them in the wider context of legal development.

State Agreements Regarding the Pilbara Rail Lines

The rail lines in the Pilbara were developed through State Agreements which were seen as a package which would ensure that:

Through the resulting legal framework, major resources development would be recognised, encouraged, assisted and promoted.  (Department of Resources Development 1997, p. 6)

However, although the companies agreed to carry people and freight of third parties, this was highly conditional (Hamersley agreed to do so only if this was possible "without unduly prejudicing or interfering with its operations").

The State Government agreed to facilitate the removal of government barriers to the construction of the Pilbara railways but contributed no capital, land or other services.  It did allow "for nominal consideration -- townsite lots:  at peppercorn rental -- special leases of crown lands within the harbour area the townsites and the railway;  and rentals as prescribed by law or are otherwise reasonable -- lease rights mining tenements easements and licences in or under Crown lands." ⁽²⁴⁾

None of these constitutes things of value except in so far as the State has a monopoly of certain assets which assume a scarcity value once someone finds something which must be mixed with these assets to create wealth.  The support that Western Australian Governments extended to the iron ore developments was no more than would be offered to any new major investment.  It was rather less than State and Commonwealth governments have extended to new or updated motor vehicle plants, and few would maintain that such support confers some level of ownership or a case for special favours.  The rail lines were not built under some protective covenant or with the assistance of the government which therefore might be said to have acquired an implicit lien on them for the greater good of the State in general.  The State Agreements, in short, placed no unusual call on government funds or facilities that might require some quid pro quo in return.

Competitive Provision of Rail Lines in the Pilbara

BHP and Rio Tinto both have integrated iron ore production facilities in the Pilbara.  Each firm's rail lines are almost exclusively for their own use.  Hope Downs had announced it was to build a rail system to service its developments but has since reached an agreement with Rio Tinto to augment and make use of the latter's facility.  And FMG is to build a rail line (the Chichester Line) to service its extensive Christmas Creek and Cloud Break deposits.

This would mean three different lines serving the southern Pilbara area.

In its assessment of the analogous Duke Pipeline case the Tribunal firmly determined that, "there is no logic in excluding existing pipelines from consideration of whether criterion (b) (that it would be uneconomical for anyone to develop another facility to provide the service) is satisfied".  It went on to argue that it is "appropriate to enquire whether the Moomba to Sydney Pipeline or the interconnect provide or could be developed to provide the services provided by means of the Eastern Gas Pipeline." ⁽²⁵⁾

There is no monopoly over actual or potentially available services (one of which is for a rail spur to the Mindy Mindy deposit from FMG's own Chichester line).  Businesses will rarely reject profitable opportunities and the fact that there are three rail operators in the area means that none has market power.  If none of these rail systems are made available to a new deposit this indicates that:

• the sort of facility employed in this line of business must be totally controlled by the integrated firm and that an unrelated entity operating on the tracks would create too many managerial difficulties;
• there is no spare capacity or those presently having unused capacity envisage it being required in future;  or
• any apparently spare capacity may be needed for built-in redundancy purposes as and insurance against unplanned events.

In any event the track owners see the risk of contracting to transport for an unrelated entity as placing too great a risk on their integrated business.

It has already been observed that the language of the TPA's key section 44G2 in criterion (b), uneconomical ... to develop another facility, is more receptive to regulated access than the US formulation of Where facilities cannot practicably be duplicated by would-be competitors.  Even so the language is not totally open since it does not say, for example, that it would be less economical, and it does introduce the word anyone, both of which impose limits on the declaration.

The BHP/NCC process brought evidence from some very prominent economists.  Important in this respect is the position of Professor Ordover, who provided expert advice in the case of the Eastern Gas Pipeline to the degree that he endorsed the position of the regulatory authorities that a pipeline should be declared unless it is duplicated by a parallel line.  That position argues the case from the perspective of the production source as well as the point of consumption.  It seeks to reduce the bargaining power of a facility over a supplier as well as over the consumer.  Other authorities consider such measures would attract undue regulation.

Notably however, in the FMG/BHP case even Professor Ordover could find no reason to support declaration.  He said that, "the assessment whether it is or is not economic to build a parallel facility is "trumped" by the revealed behaviour of market participants".  He took to task the NCC in its view that "it is possible to envisage a case where criterion (b) is satisfied even though competing services exist.  Criterion (b) is a test of whether a facility can serve the range of foreseeable demand for the services provided by the facility at less cost than that of two or more facilities.  The status of a facility against this test does not change merely because another facility is inefficiently developed." ⁽²⁶⁾  He argued logically that whether or not something was thought to be economical is irrelevant if it is in place or will shortly be in place.

Professor Ordover's views on this matter are important because of his interventionist position on infrastructure sharing.  Thus, on the matter of whether or not a new facility would negate a natural monopoly he goes further than both the US guideline of cannot practically be duplicated, and the Australian uneconomical for anyone to develop another facility.  He endorsed the NCC guideline which proposes coverage as long as the overall cost to the economy -- the social cost -- of a single facility is lower than with two or more facilities.  In this respect he considered that the sunk cost should be disregarded in assessing whether an existing facility should be covered.  Most authorities would argue that such a position would cause excessive caution in new infrastructure investment as it would not only negate the rewards accruing to a successful innovatory entrepreneur but would provide the initial risk-bearer with a disadvantage over subsequent cheap riders on its assets.

Other economists passing judgment on the issue have not relied on the fact that the facility has already been duplicated to conclude that the NCC case is fatally flawed.

Professor Kalt of Harvard University had no doubt that the test of whether intervention is justified rests on whether for the applicant it is "infeasible or impractical to provide its own services".  He shows that the US policy of a feasible threat of entry is market based and the best means of ensuring that the social cost of inefficient duplication of facilities will be avoided.  The profit maximizing incumbent will readily grant access at a charge slightly below that which the entrant would bear in bypassing the facility.  Noting that such facilities had considerable sunk costs, he pointed out that this results in an incumbent being particularly concerned to avoid a new entrant building its own facilities since the excess capacity this would create would bring steep price discounts.  Professor Kalt pointed out that the lesser test outlined by the NCC would lead to excessive paperburden and strategic costs by applicants in evidence to persuade a tribunal to grant it access to a rival's facility.  This would apply even more if, as the NCC argues, sunk costs need not be included.

Professor Baumol endorsed this approach.  He added that intervention by the public sector, an excessive amount of which is invited by the NCC approach, would introduce additional costs generally.  Importantly this is likely to involve a firm that cannot succeed on its own merits recruiting the regulator to assist it.  In doing so it will be seeking access at a fee well below that which market forces would provide.

These views are also supported by Professor Willig of Princeton, who like Professor Ordover, could see no possible basis for applying a test to assess whether entry is possible.  He also maintained that the ex ante determination of costs that the NCC argues for is by no means as straightforwardly simple as the regulator imagines.  He drew upon the transaction cost literature developed by Coase and Williamson. ⁽²⁷⁾  This alerts one to the dangers of contracting where information is incomplete and contingencies may arise.  Hold-out problems can occur which often make integration through ownership a preferable option.

The more recent statements by economists on this matter reinforce concerns expressed in the earlier Hamersley case regarding North and Rio Tinto.  Unease was expressed about the possible far-reaching implications of Part IIIA in terms of government regulatory intrusion unless restrained in its interpretation. ⁽²⁸⁾

In Unlocking the Infrastructure, Stephen King and Rodney Maddock ⁽²⁹⁾ discussed their concerns about the risks that can arise if the test of "uneconomical to develop another facility" is not carefully applied.  They argued that if access were to apply to services provided by facilities that are other than natural monopolies, a great many facilities could be caught up in the regulatory net.

King and Maddock pointed to the situation where there are many facilities in competition but the market demand and prices may not be sufficiently high to make it possible for one more entrant to build a new facility and earn a positive return.  In those circumstances, they noted, the industry is already highly competitive and firms can freely enter or leave the industry.

Even with free entry, where an additional entrant cannot build a profitable new facility, it could seek access.  They argue, "But this means that any of the 50 facilities operating in the industry could be liable for declaration.  By applying the test only to 'another' facility, the Act opens the door to declaration of facilities even in those industries where competition is robust." ⁽³⁰⁾

Costs of Requiring Third Party Access to the Pilbara Rail Lines

Over the past ten years, Australia's iron ore exports have more than doubled.  With coal export growth not far behind, the two commodities have been responsible for virtually all of Australia's export growth over the past four or five years.  It is this export growth that has enabled a strong balance of payments, a firm Australian dollar and lowered the costs of imports of consumer goods, capital and business inputs.

While forecasts can readily be made, nobody can be certain about the future demand for Australian commodities that rely on infrastructure developments in the Pilbara and east coast coal production.  Iron ore annual market growth at some seven per cent over recent years may well continue and Australia's share could easily be maintained.  There are reasons to believe the share may increase (proximity to the fastest growing markets, abundance of supply, political stability, strong skills) but also reasons why it may fall (less supportive regulatory arrangements, excessive taxation etc.).  Australia has some 15 per cent of the world's iron ore market but faces strong competition from Brazil (where BHP and Rio Tinto are also active) as well as from India and South Africa.

In March 2007, BHP announced a major upgrade of its integrated facility to raise capacity from the current 109 million tonnes and the previously planned 129 million tonnes to 155 million tonnes by 2010.  In terms of the railway infrastructure, this entailed additional locomotives, ore wagons and sidings, rather than line duplication.

With a doubling of output, a doubling of infrastructure investment is necessary.  There may be some economies from sharing existing facilities but these are likely to be modest in such a magnitude of expansion.  Moreover, almost by definition, the most economic deposits have been located first and subsequent extractions are likely to be from deposits that are further afield, less easy to mine, lower grade and so on.  Somewhat offsetting this, technology and know-how is improved over time.

From a global perspective, the bottom line, of such considerations has been a slight downward trend in long term average prices of minerals.  This is in line with popular wisdom that the terms of trade between raw materials and manufactured goods show the former to be on a long term declining trend. ⁽³¹⁾  This trend has become far more difficult to measure over recent decades because, as previously discussed, the notion of goods (especially manufactured goods) has changed.  This aside, technology developments obscure comparisons over time -- how, for example, do we measure the value of a silicon chip when its power doubles every year and its price halves?

Real prices are however mightily important in establishing new contracts and infrastructure to support output increases.  Mining tends to be highly cyclical.  Real coal and iron ore prices are illustrated in Chart 1.1.

Chart 1.1:  Real long term contract prices (Japanese financial year)

Such trends tend to bring surges in investment followed by little such activity.  The industry in the major supply areas is highly dependent on infrastructure being put in place so that increased production can be available when the customers need it.

This in turn means early commitments to investment if the portended demand increase is to be met by one supply source rather than another.  Losing out at an early stage of planning means losing out on a whole cycle.  This is the nub of the present regulatory actions to declare access to private facilities.  Few firms would be willing to take the risk of major new capital investment if the investment were to be controlled or restricted by a government entity.

In the context of the Pilbara BHP access dispute, three respected economic consultancies have sought to investigate the implications of regulators' requiring access.  These are the Centre for International Economics (CIE), Charles River Associates (CRA) and Port Jackson Partners.  All three have used conservative assumptions in estimating outcomes but have still arrived at large costs.  All three see regulatory intrusion as bringing about delays in investment as a result of:

• the machinery of regulatory approvals,
• the diminished control of the investor over his investment expenditure and the need to engage in commercial negotiations outside the framework of an individual firm, and
• a higher risk premium required as a result of the increased uncertainty about when the investment can commence.

In addition, the uncertainty over future controls over the investment and the possibility that it might be opened up to parties that have not been engaged in the initial negotiations would add a further risk premium that is difficult to estimate.

CIE examined a deferment of six months in the commencement of an investment program which would eventually duplicate the estimated $35 billion in capital investment in the Pilbara mines and associated transport and port facilities.  The outcome involved a net loss over 20 years of $20 billion.

CRA estimated a one year investment delay in annual spending of $2 billion investment with a catch up in the following year would still mean a permanent loss of output of $400 million.

In both these cases the losses were borne by the economy as a whole -- that is by businesses and consumers that were not necessarily related to the iron ore miners.  The cost is transmitted through the economy largely by the effect of a reduction in exports and the associated effect of a lower value of the Australian dollar.

Port Jackson Partners used a different approach which arrived at similar outcomes.  They estimated the value of exports forgone from a one year delay at $21 billion over a 20 year period.

The actual delays would far exceed the assumptions that these models used.  Indeed, if the investments were to await the finalisation of a Part IIIA dispute they would, according to estimates made by the Queensland Mining Council, take a minimum of three years and more likely five years. ⁽³²⁾  But even the conservative assumptions used by the three consultancies indicate the huge penalty the economy pays for the sort of intrusive approach to property rights that key regulatory agencies are taking.  And although the agencies argue that the costs will be offset by lower prices from increased competition in the use of the facilities they want to control, this would not be a long term outcome.

Finally, in addition to the economic distortion costs that these studies examined, there is a resource cost in terms of government regulators and associated costs in the regulated businesses themselves.

---

3 ECONOMICS OF ACCESS

REGULATORY MEASURES THAT MODIFY MARKET OUTCOMES

Types of Regulatory Costs

The costs of the effects of the regulation comprise three parts:

• the economic costs (net of benefits) resulting from the deviation from unfettered competition;
• paperburden for the taxpayer;  and
• costs incurred by the regulated firm and those seeking the regulation.

Pioneering work on the costs of regulation by Murray Wiedenbaum, former Chairman of the US Council of Economic Advisers, estimated the costs of US regulations at over eight per cent of GDP.  This included the economic distortion costs and the administrative or paperburden costs.  It is the economic distortions to investment and operations that constitute the vast bulk of these costs.

Costs of Regulatory Distortion

In the US, the Office of Management and Budget undertook a considerable range of regulation impact statements as part of the regulatory review arrangements that successive US Administrations required from the mid 1970s.  Journals like the Cato Institute's Regulation and the Yale Journal on Regulation developed a stream of studies which costed different aspects of regulation.

In Australia, from the early 1970s, the Productivity Commission undertook several hundred reviews of particular industries or sets of regulatory arrangements the costs of most of which were estimated.  Recent economic management has required a dismantling of a great deal of those "economic" regulations over price and of entry barriers, to the great benefit of economic prosperity.

In previous eras, reasonable estimates of such costs could be made.  The distortions in the form of external tariffs, restraints on airline competition, on the dairy industry and on electricity supply could all be quantified.  Means of doing so comprised such measures as comparisons of prices on imported goods and domestically produced import substitutions;  or the observations of air travel costs or electricity prices in comparable markets to those of Australia.

The costs imposed by the regulations over "essential facilities" are costs that occur as a result of investment that is not made, that is delayed or that is modified from the optimal configuration that would occur without the regulatory distortion.  Estimating such costs has proven to be much more difficult and regulatory appraisals often confine judgments to general terms like "a chilling effect on investment".  Among the few rigorous quantifications of these effects that have been made are those previously discussed in the context of the Pilbara rail facilities.

There are no credible estimates of benefits from regulation over such facilities.  The ACCC commissioned ACiL Tasman to quantify the benefits of gas and electricity regulations.  These simply and unrealistically assumed permanent price reductions from the regulations.  Indeed, as modelled, had the prices been negative, even greater benefits would have been estimated. ⁽³³⁾

If they are not to impede the creation of general prosperity, governments should not use the monopoly they have over land use or land itself, which is otherwise of trivial value, to build hold-outs to the wealth-generation process.

Unfortunately this is often misunderstood by politicians.  Thus, influenced by the NCC's cast on the application of FMG to obtain access to BHP's rail lines for its Mindy Mindy deposit, Senator Andrew Murray, on 10 August 2006 said:

"I was disappointed to hear at Estimates that the fact that even though the Western Australian government facilitated the building of the BHP rail line which is now privately owned by BHP, the taxpayers contribution to this private asset was not a matter which the NCC took into account when making its decision.

In his own words Mr Feil said, 'The contribution the state made some time ago in facilitating the construction and planning of the railway line was reflected to a degree in the state access regime, so the quid pro quo was some conditions for third party access and a number of other things including royalties.  As it turns out, the state access regime does not appear to have provided the degree of access that perhaps at the time parties thought might have occurred but it is very hard to read exactly what the trade-offs were.  So we treat this as a fresh application for an asset that is essentially privately owned."  He went on to say, "I do not think it is necessary or appropriate to consider how much the state government or the people of WA might have contributed some time in the past.' "

The treatment of the Pilbara rail facilities has implications that go much wider than the iron ore industry.  The matters go to the heart of the scope of law, economics and policy on essential facilities.

This is illustrated in the evidence to the Senate Committee given by the NCC's CEO Mr Feil where he argued that the caveat of production process is used to escape coverage.  He said that the danger is that, "we run the risk that either the ore assets will be stranded and unable to be developed or they have the unpleasant choice of whether or not they sell to one or other of the incumbents".  He saw the process of declaration as "jogging the parties to a commercial solution" which he thought "would be a positive in terms of promoting competition".

There are four matters of considerable concern in this approach, aside from the issue of whether it is appropriate for an administrator of regulation to be championing an increased regulatory vista for his agency.

The first of these is the "unpleasant choice to sell to one or other of the incumbents".  This is an acknowledgement that the facility in question is not a monopoly.  The fortunate finder of the deposits has the option of parlaying his find to at least two parties (in addition to developing its own facility).  And it is abundantly clear that the two parties in this instance, Rio Tinto and BHP Billiton, are in intense competition one with the other.

The second matter of concern was the stated aim of the NCC of "jogging the parties to a commercial solution".  This smacks of bureaucratic hubris by suggesting that businesses are unable to reach commercial deals without the assistance of a prodding regulator.

Even bitter rivals will readily combine to pursue particular opportunities while remaining adversaries in other theatres.  Indeed, the management of any firm that avoided such opportunities would actually be behaving against the fundamental requirements of a public company -- that of acting to maximise the wealth of its shareholders.

Capital markets are formidable means of disciplining such management lapses.  Commercial opportunities are not so abundant that managements can ignore them to spite or victimise another party.  Foregoing commercial opportunities means lower profits and a lower share price, making the business vulnerable to takeover by a party that carries none of the personal baggage that might impede sensible decision making.

It might be said that capital market disciplines would seldom apply because most decisions to exclude profitable gains by major firms like BHP Billiton or Rio would be lost in the plethora of other decisions.  While no corporate theatre operates exactly as theorised, capital market disciplines are reinforced by the fact of business divisionalisation.  Each profit centre has management that is accountable, and in some degree is in competition with its peers for remuneration and promotion.  Non-commercial decisions would have a major impact on certain personnel within the firm and it would be difficult to compensate them for the loss of status, etc..

The "jogging" that Mr Feil referred to is designed to pressure the facility owner to sell access on terms that the regulator rather than the property owner himself sees as appropriate.

The third matter is that requiring facility sharing is only justifiable if spare capacity exists and the Trade Practices Act (44W(1)) rightly restricts the declaration possibilities where owners need the capacity themselves.  In the case of the Pilbara rail facilities, it is not difficult to envisage a doubling of demand in the next decade or so in the light of the booming Chinese economy.  Moreover, redundancy may be built in to ensure availability under unforeseen eventualities.  The SEA Gas pipeline from the Otways to Adelaide, as previously discussed, was deliberately and wastefully under-sized to reduce the scope for declaration under the Trade Practices Act.  Such outcomes amount to regulatory driven inefficiency.

A fourth matter refers back to the nature of the deposits.  Iron ore, like stone or bauxite, is not a rare mineral, though it is valuable in high concentrations as in the Pilbara region.  Although the producers only count a few years available resources, this is because proving up more reserves is not worthwhile and is unnecessary in view of the abundance of deposits.

A major part of the marketable worth of the iron ore is created not by the discovery of a particular concentration but by the measures that allow it to be transported cheaply to a port.  The core business of the producer is the transport, preparation, and marketing of the ore, not its discovery.  Requiring a firm with such facilities to share them with others is to take its core capabilities and redistribute them.  In effect, this socialises those features of production that the Hilmer Report and the Trade Practices Act (s.44 B) sought to reserve from such control.

Paperburden Costs

The paperburden costs of regulations comprise only a small share of the total.

Australian agencies do not report their costs and functions in categories that allow such analysis.  Regulatory agencies have however seen considerable growth in their overall resourcing.  Expenditure in real terms by the ACCC more than doubled between 1998/9 and 2006/7.  Chart 1.2 illustrates the growth of four major regulatory agencies.

It is however unlikely that Australia's costs would be any less than those in the US.

Chart 1.2:  Regulatory Agencies’ Resourcing

Telstra has estimated the regulatory resources devoted to itself as follows: ⁽³⁴⁾

Every year Telstra is required to submit paperwork to comply with regulation totalling more than 162,000 pages, this:

• equals approximately 163 editions of "War and Peace"
• stacks to a combined height of around 15 metres -- taller than a 3 storey apartment block
• weighs the equivalent of around 790kgs
• requires more than 75 full-time Telstra staff
• the compliance costs for Telstra staff alone are more than $10 million -- enough to upgrade 155 rural exchanges for broad band
• employs more than 500 full-time public servants to manage it

A survey of the gas and electricity supply industries undertaken by the writer in association with the industry associations estimated the paperburden costs of the businesses in the transmission and distribution sectors at $74 million. ⁽³⁵⁾  This is out of a turnover of about $9 billion per annum (with value-added comprising about 40 per cent of this).

Costs in terms of regulatory personnel, legal, engineering and economic expertise and consultancies, including the in-house resources of the firms themselves, are clearly considerable.  However, over and above these more readily allocatable costs are the far greater cost magnitudes brought about by diverting key managerial effort from customer and production focuses and by deterring new investment.

SETTING ACCESS PRICES

Requiring access to be given involves regulators in the difficult task of setting its price and other conditions of that access.  The market price has to take into consideration many factors, including the chance that the facility may fail (unanticipated competition, failure of demand, cost overruns etc).  Products and services exhibit considerable diversity in their features with complex consequences for the most appropriate approach to their pricing:

At one extreme are fashion goods with a premium price lasting only months or products within rapidly developing technology sectors, like computer chips which are worth a fraction of their previous price a year or so later on.

Pricing strategies for some other new products follow the opposite approach.  Often goods are given away or offered cheaply in an effort to persuade the consumer to try them and, if successful, the prices are then increased.

Other products are charged at very high prices because they have established a niche of excellence that alternatives are unable to breach.  Microsoft and Apple's products best describe this class.  The product breakthroughs they represent allow pricing that incorporates considerable monopoly rents in the sense that prices are far above what would be necessary to maintain output.

For major innovations, the "killer apps", regulatory intervention would have a dramatic effect in discouraging investment.  Microsoft, for example, with most of its products near or actual monopolies, gets an average 100 per cent annual return on its tangible capital assets.  Had it been controlled by a regulator, and compelled to charge "reasonable" rates, such returns would not have been allowed.  Hence the business is unlikely to have been so successful and the world's real income levels would be appreciably lower.  Because price setting is so difficult, assuming control over a facility is something that courts are reluctant to do.

Premium prices and high profits are the reward for successful innovatory activity.  The attraction of these prices has been the driving force behind information technologies and of transport innovations that have been at the heart of modern economic growth.  Each innovation has displaced something else and its owner has sought to maximise profits from it.  Many businesses -- Boeing or Airbus for example -- "bet the firm" on each new product.  And an interventionist interpretation of a successful project outcome would argue that it has become an "essential facility".  Business owners who anticipated the regulatory implications of such an interpretation would not undertake the risks involved.  Because they have allowed these developments to proceed on the basis of prices that are unregulated, market economies have prospered and socialist economies or economies without the impartial operations of the rule of law have failed.

US courts have been more articulate than those in Australia in explaining the reasons behind a reluctance to override market outcomes.  Thus the US Supreme Court in the Verizon case said, "Mere possession of monopoly power and ... charging of monopoly prices, is not only not unlawful;  it is an important element of the free market system".  The Supreme Court recognised the ability to command very high prices for a successful undertaking as encouraging innovation, risk-taking and economic growth.

Monopolies which would be welcome in such situations include an infrastructure developer who spots an opportunity for providing a service that is highly prized by the consumer and for which a premium price can be charged.

The infrastructure developer in Australia today, like the jet plane manufacturer, has no franchise protection and will always be vulnerable to competition.  The appropriate regulatory model is therefore not one of price or profit control.  This makes the sort of issues addressed in monopoly facility pricing facility largely redundant.  The two competing theories -- setting the price at the level of cost the owner incurs and the "Baumol-Willig" approach of compensating the owner for the revenue lost -- have a role only where a monopoly is stable and enduring.  This is not the case with landmark areas addressed in Australia including gas pipelines, rail links and, probably, telecom facilities.

Requiring an open access regime at a specified price provides a cheap ride on existing investments and discourages new investment.  These outcomes are exacerbated where rate regulation drives down revenues towards variable costs. ⁽³⁶⁾  For many facilities this means losses on the very large fixed and common costs such as those incurred by railroads in laying track or digging tunnels.  No firm will make investments unless it expects to recover its full costs including a premium for risk.

As addressed in the first Part of this Section, products themselves are not so readily defined as goods or services and are increasingly not a purchase at a given point of time but a stream of intermediate purchases that feed businesses which are heavily economising on inventories.  Hence the product's worth is deeply discounted if it is not produced at the right time, and at the place where it is needed.  Businesses that can guarantee delivery on time and that can quickly adjust supplies to the customers' needs receive a premium price.  This premium for reliability is intrinsic in commerce with the pervasive adoption of just-in-time management.  Buyers contract with suppliers to ensure components are there when needed, a contract which requires the supplier to set its investment, transport and employment strategies so that it retains the business.

THE ARBITRARY APPLICATION OF PART IIA

Part IIIA is set in the context of a monopoly facility.  Even so, businesses will normally willingly share their facilities with all parties, including competitors, as long as they can profit from the undertaking.

Many raw material producers effectively have only one plant as a customer.  This is the situation that confronts a great many small oil fields.  Indeed, in Western Australia there is only one oil refinery, (owned by BP).  There are 22 crude oil producing fields in the Perth Basin, 11 of which are operated by Arc Energy in the Dongara field.  The owners of these fields have the option of seeking refinery services from BP, developing their own refinery facility, or the very expensive solution of sending their crude to Singapore.

BP clearly and quite properly exploits its location to the full in terms of the charges it requires.  Anything else would be inefficient.  The wells close to its facility now account for around 15 per cent of the refinery throughput.

This is a variation of an "essential" facility in its wider definition employed by some regulators (and access seekers).  Certain choke points have been developed by businesses, whether in manufacturing facilities as traditionally defined or in transport and communications.  For many such facilities it would certainly be "uneconomical for anyone to provide another facility to provide the service".  Yet governments have correctly avoided intervention in the associated commercial conditions.

Similar sorts of issues about where one unregulated function (production) starts and a regulatable function (transport) begins have been confronted in gas.  Although the ACCC sought to bring gas producer pipelines (which transport gas from wells to the shore or processing plant) within the regulatable framework, this has not been allowed.  Producer pipelines from wells are not regulated under Part IIIA of the Trade Practice Act or the National Gas Code, as they are considered integral to the gas production system.

Decisions on which facilities are generically eligible for regulation are increasingly arbitrary.  The concept of manufacturing, if it ever was neatly segregated from transport and communications, is certainly not so today.  The continuous nature of the iron ore mining-transport-preparation system was prominent in Justice Kenny's insights in Robe v Hamersley.  Justice Kenny determined that Hamersley's rail lines take on a production process role akin to manufacturing in the course of conveying the product to the port since the sequencing of the shipments allows for ensuring the contracted mix on arrival at the port.

Arbitrary though the concept of a production processes is, those framing essential facility laws have excluded it from their reach conscious of the massive and debilitating scope such laws would have if they encompassed manufacturing facilities across the economy.  The US Supreme Court was similarly mindful in expressing concerns about restricting the reach -- and perhaps the very existence -- of such laws in the Verizon case.

VERTICAL INTEGRATION AND RISK MITIGATION

Inevitably, business firms have to take decisions about what products and services they produce in-house and which ones to buy-in.  And the buy-in decision itself contains variants, for example, is the product or component uniquely available or is it a standard item available generally?  Nor is the decision one that necessarily endures.  Often firms shift from internal supply to outsourcing and back again both in the light of experience and because of the changed nature of technology and customer needs.

Costs and risk management are the key features of the make or buy decision, particularly where, as with some manufacturing plant, firms have some form of final assembly into which the parts are brought together.

For products that are critically dependent on the various components being brought together precisely as required, the supply will often need premium service and frequently a built-in redundancy of availability.  With highly integrated production systems, product and transport is required to be available on demand.

This is a characteristic of rail lines transporting bulk products to ports or power stations.  The transport services being contracted often comprise more than a single trip, a series of journeys or the availability of track for such journeys.  The services are actually a guarantee that the journeys can be undertaken and not necessarily at times when they were planned.  This requires flexibility of the transport medium with the contract being a sort of insurance under which the services can be adapted to compensate for unexpected occurrences.  In this respect, the contract is for a form of chauffeur service dedicated to a single customer rather than for a scheduled bus service.

While it is often possible to arrange for this service to be bought-in, doing so may involve highly complex contracts where there are supply uncertainties.  Frequently it is preferable to retain the supply in-house, which is practical with rail, shipping and elements of telecommunications.

The advantage of internalising activities within the firm has long been recognised by management theorists.  Thus, Barnard ⁽³⁷⁾ stressed the importance of a coordinated administration with deep knowledge in a "conscious, deliberate and purposeful" way.  This allows adaptation without lengthy negotiation.  It may be too difficult to write contracts that cover every eventuality.

The firm is best thought of as a governance structure rather than a production function.  It provides greater certainty when long time periods are involved by allowing contractual decisions to be internalized.  In that way the contractual uncertainties that are ever-present with independent bodies become less relevant and subject to cost saving management short-cuts.  Important matters for governance are:

• asset specificity;
• likelihood and impact of disturbances to transactions;  and
• the frequency of disturbances

Coase, in The Theory of the Firm, ⁽³⁸⁾ saw transaction costs as the key to why most integration takes place.  Unlike with bilateral binding contracts, the firm becomes its own court -- it contracts within itself allocating overheads and determining accounting practices and changing conditions without recourse to a third party.  Vertical integration becomes a way of relieving bargaining where there is a bilateral monopoly and the correct division of profits is difficult to determine. ⁽³⁹⁾

Bargaining is not costless.  Where tasks are known with considerable certainty, and contracts are therefore easily transmitted and recorded vertically, integrated firms are not usually the best vehicle for production.  Contracts in the house building industry allow smooth production processes using independent contractors who have a very high degree of motivation.  Repeat contracts and the need to ensure a good name are important adjuncts to the efficiency of such arrangements.

Other types of production, especially those where a process is concerned, leave too many risks if they are based on independent contracting rather than under a management system.  As the Infrastructure Task Force expressed it, ⁽⁴⁰⁾

The difficulties associated with physical coordination of complementary investments are, however, greatly complicated by disputes over the division of the gains from those investments.  Historically, vertical integration between infrastructure providers and the activities that most rely on their services has been a way of avoiding these complications.  In some cases, this has taken the form of direct ownership of infrastructure assets by their sole or major user;  in others, ownership has been through what amounts to buyers' joint ventures.  But where vertical integration is impossible, or for wider policy reasons judged undesirable, coordination issues -- be it for complementary or for substitutive investments -- are likely to arise.  Difficulties in organising all the parties required for complementary investments to occur, and in securing agreement as to the sharing of the costs of needed capacity expansion, can paralyse the capacity expansion process -- perpetuating bottlenecks that all parties would be better off resolving.

UK Railtrack is an example of how things can go wrong where de-integration is made mandatory.  Gomez-Ibanez ⁽⁴¹⁾ addressed the difficulties in maintaining coordination in a vertically unbundled British Rail.  He found that co-ordination proved too complicated with rail track and trains being separately owned because it was difficult to reach agreement on network enhancements to improve safety in the light of expanding usage.  The lack of investment, because the formulae adopted by the regulator did not permit its recoupment, led to a deterioration in track quality and hence to disasters.

The Railtrack experience also illustrates the difficulties with contracting out aspects of supply where the capital assets are not easily compartmentalised.  The fact is that rail and the rolling stock are jointly provided and forcing the track to be independent creates an economic incentive problem.  Rolling stock owners have an incentive to economise on that asset even if this imposes excessive costs on the track owner.  Contracting to avoid such inefficiencies can often lead to prohibitive complexities.

Whether a supplier chooses to integrate or contract to ensure delivery precisely as required, it will, if the cost of missing a desired delivery time is high, ensure considerable redundancy in the delivery system.  That redundancy is not capacity "surplus to needs", but represents a supply buffer to meet unknown eventualities.  The supplier in that situation may also consider any form of sharing to provide risks too great for any level of compensation to mitigate.

This heightened importance of certainty of delivery is a familiar feature of modern commerce, where inventory reductions are a considerable source of cost saving.  Most vehicle assemblers, for example, have adopted just-in-time systems of component delivery whereby stock of some components is limited to a few hours production.

Thomas Friedman has proven to be a highly perceptive student of modern globalisation trends and their managerial implications.  In The World is Flat, ⁽⁴²⁾ he describes how the world's most successful retailer, Wal-Mart, has reached its current position by developing a distribution network that ensures timely delivery of goods from all over the world to all of its thousands of stores at the best prices.  The kernel of its success is the management of its distribution chain -- an unexpected form of asset specificity.

Doubtless Wal-Mart could offer the use of that supply chain to third parties.  However, the supply chain is integrated into its business.  Just like the assembly line of some manufacturers, it is at the heart of the firm's competitive advantage.  For this reason, very rarely will a major manufacturer agree to assemble a rival product on terms and with priorities that are the same as those of the in-house product.  To require a supply chain or assembly line to be opened to third parties would mean, in effect, government seizing the firm's key asset and determining at what price it would be made available to others.  Such action would send messages across the economy that no advantage a firm had developed is safe from confiscation.

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4 CONCLUDING COMMENTS

Requiring owners to allow unrelated parties to make use of their assets is a clear exception to the general rules of commerce.  It is one that must be used sparingly if ownership incentives are not to be blunted and excessive resources are not to be siphoned off into regulatory hearings rather than the management of businesses.

It should be generally accepted that regulation requiring a facility to be made available to third parties has no justification where a number of alternatives facilities are in place.

The Australian law has made an exception for production processes in the ambit available for regulatory coverage.  This recognizes the potentially debilitating effect of regulation that requires facilities be made available (essentially at a regulated price) where suppliers do not wish this to be the case.  Such a distinction of a production process, commonly associated with manufacturing, if it ever was a meaningful means of distinguishing commercial activities, no longer is.  Production functions are changing throughout industries and no clear demarcation of the different stages of these, particularly regarding manufacturing and services, is either consequential or appropriate.

Many businesses opt for vertical ownership for a variety of reasons, including to maintain control of a centrally important facet of production.  In some cases there may be built-in redundancy to ensure that the facility is available on demand to combat unforeseen eventualities.

Greater recognition is required about the legitimacy of these sorts of reasons which are often behind asset owners' reluctance to share their facilities, especially at some "normalised price".  Already there has been considerable economic damage in terms of delays to developments and costly legal challenges stemming from the considerable reach that Part IIIA brings to the regulatory framework of Australia.  The illumination of these costs in the case of the Pilbara rail lines highlights the problem the regulatory framework is bringing specifically to one key industry.  Its adverse effects however extend beyond this industry and its legal reach has been wound back by industry specific provisions for gas, electricity, airports, and communications.  A further wind back of the legal reach is necessary.

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ATTACHMENT 1
CONSIDERATIONS REGARDING ESSENTIAL FACILITIES

Historical Perspective

Professor Richard Epstein, ⁽⁴³⁾ one of the world's leading authorities on constitutional and property law, considers the case for controlling "essential facilities" is both sound and founded on the common law rules of reason.  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".

One important facet of the Hales dictum as adopted by Epstein is one of the two riders justifying the control, namely "they are the only wharfs licensed by the queen".  Hales, and hence Epstein, glosses over the important distinction of monopoly powers developed organically and those created by regulation.  But this is an important distinction in justifying overriding the property rights of the business concerned.

It would seem reasonable to argue that 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.  Such a monopoly must surely be different from and one achieved in the open market by the skills and foresight or luck of a firm or individual.  A business achieving dominance by its own commercial efforts would not unreasonably expect to be subject to less severe oversight.  Those undertaking a development of that kind would reasonably expect to have no obligation to face regulation regarding access or price.

Although not accepting a sharp dichotomy of approach between government supported and purely entrepreneurial infrastructure, Epstein does argue that:

"... 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)

Epstein's view is that an essential facility will inevitably be regulated.  Some credible support for this is offered by the progressive regulation of the railways in England and the US from the mid nineteenth century.  That point also underlines the hazards of regulation since the railways in the UK and in the US both faced such regulatory stringency that they were driven into parlous commercial positions, particularly once road systems undermined their monopolies.

The issues remain to define the facility, whether or when it is to be regulated, and how to ensure its owners have sufficient incentive to operate efficiently.

The different sorts of essential facilities

Essential facilities have been identified as covering a wide variety of services.  They tend to take two forms:  a network or a single vital node within a network.

The facilities themselves can be physical in the form of a constructed line or port.  And they can comprise non-physical resources like those using the electromagnetic spectrum.  They may have no lines on which their services travel -- postal services, for example (which at least at one time were monopolies) comprise sorting facilities and technologies but transport the materials themselves along public highways.  This is also the nature of other networks such as eBay, Google, and bank clearing systems.  Microsoft operating systems and Microsoft Explorer in particular are not networks but have assumed such predominance within their service class that European Union courts have treated them as essential facilities.

Ports, airports, and bridges are examples of single node based facilities which are sometimes thought of as being "essential facilities".  In many respects some of these network nodes are similar to a manufacturing plant.  A port comprises a series of services:  navigation control, tug operations, wharves, unloading and loading facilities, and so on.  All of these are amalgamated in some order, perhaps not as inflexibly as a manufacturing assembly plant, but no less so than many other manufacturing facilities that operate on a batch production process.

Falling under the rubric of networks are, at one extreme, telecommunication systems linking millions of different origin and destination points, and at the other, a pipeline or train line linking just two points.

Telecommunications are perhaps the purest form of network with origins and destinations both being highly diverse.  They also, in the main, have no predominant flow direction from particular origins to particular destinations.  In the case of telecommunications systems, there is built in redundancy and no single node is itself likely to be a bottleneck.

By contrast, another line based system, that of broadcasting and cable television, is exclusively in one direction.  Gas and electricity distribution lines, some rail systems and many gas transmission pipelines share this characteristic of transporting product exclusively in one direction.

Electricity transmission lines tend to operate as two way carriers.  In some cases electricity transmission lines link just one supply source with a few customers and occasionally only customer.  Local distribution lines are almost entirely one way.  Table 1.2 offers a classification schedule.

Table 1.2:  A Taxonomy of Essential Facilities

	Line-based facilities	Virtual facilities	Node-based facilities
Multiple   connections,   multi-directed	Telecommunications Electricity, gas,   water transmission Roads Mobile phones Wireless Intra-city rail lines	Bank clearing systems Postal systems Instant messaging   services	Google eBay Microsoft operating   systems Microsoft Explorer General ports Airports Bridges
Multiple   connections   predominantly   one directional	Electricity, gas,   water distribution Broadcasting Cable companies		Special cargo ports
Few   connections	Inter-regional rail   lines	Firms internal   messenger systems

In addition to being assigned into one of the seven relatively arbitrary categories, all of the facilities identified above have their own internal differentiations.  For example, most rail lines have flows that are preponderantly in one direction at a particular time (New York's subway system being a rare exception).  Many rail networks have several lines interconnected and operated in common with scheduled services and specific access and exit points.  Others serve only one exit point, sometimes with only one access point and with no backhaul.  In between are systems, often using a single track, that service several suppliers moving goods to an end point.  Among these are the rail lines conveying coal or wheat from the interior to ports like Melbourne and Port Waratah.

Priest ⁽⁴⁴⁾ considers the distinction between network industries and hard goods industries to be crucial.  The latter were the traditional targets of anti-trust agencies but the validity of their pursuit has been discredited.  With hard goods the consumer's use has little to do with the benefit obtained by other consumers.  The consumer obtains all the value for himself and there is no externality of a public goods nature.  With network industries "the value of the product or service to consumers increases as the size of the network over some range increases" (p.118).  There is no advantage in having a wide coverage for those users of a rail or gas line that do not interact with other users on the same network.

These access externalities are important for Windows or airlines or Visa card networks, though the advantage of regulating them is lost if there are resulting disincentives for upkeep and expansion.  The public goods case diminishes where the natural monopoly features are eroded as has been the case with most telecommunications and rail facilities.

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ATTACHMENT 2
LEGAL JUDGMENTS ON THE PILBARA RAIL LINES

There have been two legal cases on producer based rail networks -- the Hamersley case (Justice Kenny) and the BHPBILL case (Justice Middleton) and these are set out below in summary form followed by a discussion.

The types of infrastructure services that are declarable under the National regime are defined in Section 44B of the Trade Practices Act which states:

"services" means a service provided by means of a facility and includes:

1. the use of an infrastructure facility such as a road or railway line;
2. handling or transporting things such as goods or people;
3. a communications service or similar service;

but does not include:

1. the supply of goods;  or
2. the use of intellectual property;  or
3. the use of a production process;

except to the extent that it is an integral but subsidiary part of the service.

THE KENNY JUDGMENT

Justice Kenny found in favour of Hamersley, holding that the rail track was not a service within s 44B of the TPA, and as a result the NCC did not have power to make a recommendation regarding declaration of the rail track service.  She stated that the critical question was whether the use by Robe of the railway line (and associated infrastructure) that Hamersley owns and operates would involve the use of a production process.  She found that the term "production process" ordinarily means the creation or manufacture by a series of operations of some marketable commodity.

Justice Kenny found that Hamersley's use of its railway line was an integral and essential operation in its production process, as the railway line was used to make up the "recipe" formulated for a particular batch of Hamersley's product.

While the respondents submitted that only the use of an entire production process would bring the relevant service within the production process exemption, Justice Kenny disagreed, and found that it suffices if the use of the railway line is an integral and essential operation.  Her Honour found that it would defeat the purpose of the production process exemption in s.44B of the TPA if the exclusion were construed as not extending to the situation where the service involves the use of an operation integral and essential to the production process.  Use of the rail track was therefore not a "service", as it fell within the production process exemption.

THE MIDDLETON JUDGEMENT

Justice Middleton considered that Justice Kenny's construction of the "service" definition in Hamersley was "clearly wrong" or "plainly wrong", and made the following observations:

• Although Kenny J's consideration of the dictionary definitions of the terms in the composite phrase "production process" was appropriate, the meaning of the phrase should depend on its context and subject matter, not merely the combination of dictionary definitions.  The appropriate emphasis is on "a process of production", and the BHPBIO railway does not produce anything.
• Kenny J's "marketable commodity" was based on tax law cases, and was not helpful to understanding the "service" definition.
• Given that the "service" definition contemplates the use of a railway line as a service, Kenny J's interpretation could potentially exclude infrastructure that would normally be expected to be considered under Part IIIA, and does not assist in promoting the purposes of Part IIIA.
• Kenny J wrongly considered the phrase "involving the use of a production process" rather than simply "the use of a production process".
• The fact that the use of a railway might be essential to operations does not mean it is a production process.

Justice Middleton said that the question about whether the relevant service fell within the production process exemption could be resolved, putting aside Hamersley, was as follows:

• BHPBIO's mine and port facilities depend on BHPBIO's use of its railway;  FMG might interfere with BHPBIO's rail operations, but that matter could be addressed at a later stage (eg arbitration), and does not mean that access to the railway is "use of a production process".
• The natural and ordinary meaning of "production process" is "the creation or making of a product or the transforming of one thing into another."  The relevant enquiry must focus on the essential nature of the facility and the particular claimed production process.  The railway is integral and essential to BHPBIO's overall process, but it provides a transport or conveyance service (similarly to a gas pipeline), not "a process of transformation", and as such could not have been intended to fall within the production process exception.

Justice Middleton held that the relevant service was a "service" within s.44B of the TPA.

The argument by Justice Middleton appears to be that although the railway is essential to the operations of the mining plant, because it is a railway it can take other traffic due to the nature of rail network businesses providing there is excess capacity.  However, this view does not consider the issue of the benefit to competition test which needs to be considered in a cost benefit framework.  This would look at the benefits and costs to society from access compared with no access.

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ENDNOTES

1.  Adam Thierer and Clyde Wayne Crews, What's yours is mine, Cato Institute, Washington DC, 2003.

2.  See P.G. Mahoney, "The Common Law and Economic Growth", Journal of Legal Studies, Vol. 30, 2001, pages 503-525;  B. Heitger, "Property Rights and the Wealth of Nations", Cato Journal, Vol. 23 (3), 2004, pages 381-402.

3.  Productivity Commission, Review of National Competition Policy Reforms, 2005, available at:  http://www.pc.gov.au/inquiry/ncp/finalreport/ncp.pdf

4.  See Richard J. Wood, Impact and Outcome of Deregulation

5.  P. Samuelson, K. Hancock and R. Wallace, Economics, McGraw Hill, Sydney, 1970.  As well as writing a standard economics text book, Samuelson is generally credited with originating the theory of public goods in a paper published in 1954.

6.  Thierer and Crews, op. cit., page 33.

7.  B. Fisher, M. Moore-Wilton and H. Ergas, Australia's Export Infrastructure, Report to the Prime Minister, 2005, page 2.

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

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

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

11.  F. Hilmer, M. Rayner and G. Taperell, National Competition Policy, Report by the Independent Committee of Inquiry, 1993, page 251.

12.  Loc. cit

13.  Ibid., page 193.

14.  National Competition Council, The National Access Regime, A Draft Guide to Part IIIA of the Trade Practices Act, 26 August 1996

15.  see Australia and PNG Gas Conference, 6th December 2005, Ed Willett, Commissioner. http://www.accc.gov.au/content/item.phtml?itemId=716598&nodeId=ce692a205821b43f55b813e0433886f0&fn=Developing%20gas%20pipeline%20infrastructure.pdf

16.  A critical summary of the rule is at H. Ergas & E. Ralph "Pricing Network Interconnection:  Is the Baumol-Willig Rule the Answer?" 1966, http://www.ekonomicsllc.com.Ergas&Ralph1993Ix&ECPR.pdf

17.  Graeme Samuel, Chairman ACCC, Promoting Competition and Fair Trading, Australian Council for Infrastructure Development, The Case for Regulation, 22 July 2004. http://www.accc.gov.au/content/item.phtml?itemId=560097&nodeId=fc57d88c0cfd97e8b70cccaf82122a3b&fn=2004-07-22%20AusCID.pdf

18.  This should have been well known to the ACCC.  At the 2001 APIA Convention respected former CEO of APT, Jim McDonald, in an address titled "Gorillas in the Myths" examined all contemporary pipelines developments and showed that none were developed because of regulation.  The matter was later addressed at length in the PC's Gas Access Review (http://www.pc.gov.au/inquiry/gas/finalreport/gas2.pdf ) In the PC review, the ACCC argued that coverage risk is low for new pipelines but the Commission considered, "that the regime subjects most, if not all, new pipelines to coverage risk". (p.111)  Specific references in the Report included:

APIA maintained that "Of the seven pipelines completed since 1996, only the $30 million Central West Pipeline (that proceeded on the basis of direct government financial assistance) is regulated under the Gas Access Regime.  That is, less than 2 per cent by value of new investment in transmission pipelines since the introduction of the Gas Access Regime is actually regulated under the Gas Access Regime, and arguably the investment decision in relation to the covered pipeline was affected by government assistance.  Moreover, where investment faced the threat of regulation (as with the Goldfields pipeline), measures were taken to insure the pipeline owners against potential detriments.  APIA believes that this clearly indicates the reality that the investment that has occurred over the last eight years has occurred in spite of the Gas Access Regime rather than because of it.  (sub. 74, p. 14)"

Regarding the SEAgas pipeline a number of submissions provided evidence of deliberate undersizing purely to avoid regulatory coverage APT said, "From a pipeline owners' perspective, this reduces the potential for coverage under the [Gas] Code;  and even if a coverage application was successful, the absence of spare capacity would be expected to reduce regulatory uncertainty.  The adverse consequence of minimum pipeline sizing is that opportunities to induce investment in pipelines sized for future market growth have inevitably been lost.  (Australian Pipeline Trust, sub. 55, pp. 6-7)"

The PC's Finding 4.3 (p. 139) was, "The Gas Access Regime is likely to be distorting investment in favour of less risky projects, including altering the nature and timing of pipeline investments.  Pipeline construction might be delayed, for example, and there might be greater emphasis on building capacity that is essentially fully contracted prior to construction."

19.  The Australian Pipeline Industry Association's submission to the Productivity Commission's gas inquiry said, "In any proposed project, the developer must weigh up the probability and timing of future demand growth and whether it is best to build a smaller diameter pipeline with the thought of increasing capacity in the future via an option such as adding additional compression or simply building a larger diameter pipeline in the first instance which will be capable of satisfying future forecast demand.  A simple example of the impact of this trade off which reflects the relative costs of the different options is as follows:

	Scaled to Initial Demand (300 mm)	Scaled to Future Demand (400 mm)
Demand	100 TJ/Day	180 TJ/Day
Construction Cost $/KM	$225,000	$300,000
Compression Cost $/KM	$150,000	-
Total Cost $/KM for 180 TJ/Day	$375,000	$300,000

The presence of regulatory risk will reduce the willingness of developers to invest in initial uncontracted capacity and instead will result in only higher cost developable capacity being available.  Moreover, the development of partial spare capacity can only enhance a pipeline owner's incentive to increase throughput."  Submission available at:  http://www.pc.gov.au/inquiry/gas/subs/sub044.rtf

20.  In that case there remain commercial concerns because the regulatory coverage is presently envisaged to revert to the State regulatory authority in 2016.

21.  This brought about a voluminous level of studies.  Those in Australia include the sceptical like B. Mountain and G. Swier, "Entrepreneurial Interconnectors and Transmission Planning in Australia", The Electricity Journal March 2003.  In its work for the ACCC, London Economics (Review of Australian Transmission Pricing 1999) also concluded that entrepreneurial links could not cover their fixed costs.  This scepticism is also seen in the work of P. Joskow and J. Tirole (e.g. Merchant Transmission Investment, CMI Working Paper 24 The Cambridge-MIT Institute, 2003).  The Australian 2002 Parer Independent Review of Energy Market Directions (www.energymarket review.org) saw a possible role.  Littlechild has been more supportive both in studies in Australia and Argentina (e.g. S. Littlechild, (2004) "Regulated and merchant interconnectors in Australia:  SNI and Murraylink revisited." Applied Economics Department and The Cambridge-MIT Institute, Cambridge University, Cambridge Working Papers in Economics CWPE No.0410 and CMI Working Paper 37;  and S. Littlechild and C. Skerk Regulation of transmission expansion in Argentina CMI, Working Paper 61, University of Cambridge, Department of Applied Economics, 15 November 2004).

22.  A. Cook, "Maintaining the Security of Supply to South Australia through Interconnections", Address to South Australian Power Conference, 2004.

23.  R.J. Wood, "Firm access rights:  The key to efficient management of transmission", Submission to The NECA Transmission Pricing Review, Energy Issues Paper no. 12, 1999.

24.  Kenny J., Hamersley v NCC 164 ALR 203 p. 221.

25.  Para 57 of the Council's Guide to Part IIIA of the Trade Practices Act 1974, Part B Declarations, December 2002.

26.  The National Access Regime:  A Guide to Part IIIA of the Trade Practices Act 1974, Part B Declaration National Competition Council December 2002 para 4.35.

27.  The "transaction cost" theory of the firm and vertical integration is principally attributed to Coase and to Williamson.  See R.H. Coase, "The Nature of the Firm", Economica, 4, 1937, pages 386-405, and O.E. Williamson, "Transaction-Cost Economics:  The Governance of Contractual Relations", Journal of Law and Economics, 22, 1979, pages 233-261.

28.  National Competition Council, Application by Robe River Iron Associates for Declaration of a Rail Service Provided by Hamersley Iron Pty Limited, Discussion paper, March 1999.

29.  S. King and R. Maddock, Unlocking the Infrastructure:  The Reform of Public Utilities in Australia, Allen & Unwin, 1997.  At the time, King was Professor of Economics at the University of Melbourne, and is now an ACCC Commissioner.  Maddock was Professor of Economics at La Trobe University.

30.  King and Maddock, pages 79-80.  1997.

31.  A contrary and since discredited view was offered by the Club of Rome's Donella H. Meadows et al., Limits to Growth, Universe Books, New York, 1974.

32.  Productivity Commission, "Review of the National Access Regime.  Position Paper", 2001, p. 399.

33.  See http://www.accc.gov.au/content/item.phtml?itemId=506371&nodeId=e5ecb71be83de39f23e6bb0c879b3c6c&fn=Breakout%20Session%202:Gas%20-%20Paul%20Balfe%20presentation.pdf

34.  Available at http://www.nowwearetalking.com.au/Home/Page.aspx?mid=18#telcoInvest

35.  Paperburden Costs of Economic Regulation in the Gas and Electricity Supply Industry, Wood & Associates, November 2003.  Generation comprised a further $13 million.

36.  This was the case with rail regulation in the US for nearly a century until, in an early example of deregulation, stifling layer of price regulation were removed by the Staggers Act of 1980.  The outcome was an upsurge in investment and productivity.  In the past courts have sometimes attempted to set prices with farcical outcomes.  Thus in Pont Data v ASX in 1991, Justice Wilcox set the price as being the marginal cost of connecting to the ASX system at $100 per annum, compared to a price of $1.45 million set by the Full Federal Court.  Former ACCC Chairman Allan Fels had also called an approach that did not incorporate pricing principles (AFR, 7 April 1995).

37.  Chester I. Barnard, The Functions of the Executive, Cambridge University Press, 1938.

38.  R.H. Coase, The Firm, the Market, and the Law, University of Chicago Press 1991.

39.  F. Machlup and M. Tabor, "Bilateral Monopoly, Successive Monopoly and Vertical Integration", Economica, May 27 1960, pages 101-119.

40.  Australia's Export Infrastructure Taskforce, available at:  http://www.infrastructure.gov.au/pdf/Report.pdf, page 18.

41.  José A. Gómez-Ibáñez, "Regulating Coordination:  British Railroads" in Regulating Infrastructure:  Monopoly, Contracts, and Discretion, The Harvard University Press, 2003.

42.  Thomas Friedman, The World is Flat, Penguin 2006.

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

44.  George L Priest, "Flawed Efforts in Network Industries" in High Stakes Antitrust, ed. Robert Hahn, AEI Brookings.