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PHARMACEUTICALS AND LIFE SCIENCESInfrastructure regulation –

exploring the key models

Dr Martyn Taylor, Partner

February 2015

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INFRASTRUCTURE REGULATION

Exploring the key models

• Insights into different regulatory models used in Australia

• Relationship between Commonwealth and State regulation

• Current issues and regulatory trends

• Importance of the Regulatory Asset Base and WACC

• Impact of regulation on infrastructure cash flows Dr Martyn Taylor

Partner

Norton Rose Fulbright Australia

+61 2 9330 8056

martyn.taylor@nortonrose.com

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Insights into different regulatory models

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Why do we regulate infrastructure ?

Market failure remains the fundamental policy concern…

• Infrastructure may have natural monopoly

characteristics – declining costs with scale.

• Most efficient market structure is a monopoly.

• Excessive pricing (exploitative conduct):

– Monopoly has substantial market power and

can increase prices while reducing supply.

– Accordingly, markets may fail to allocate

scarce resources optimally – circumstances of

market failure from imperfect competition.

• Discrimination (exclusionary conduct):

– Where the owner of the infrastructure

competes in upstream or downstream markets,

an ‘essential facility’ problem also arises.

– Owner of an essential facility can impede

market entry by competitors, thereby giving its

own operations an unfair advantage.

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When is regulation of infrastructure appropriate?

Competition law may be inadequate to address market failures…

• Generic competition law is the minimum set of

conduct standards applying to all markets in the

economy to ensure competition is maintained.

• However, in certain circumstances, competition

law proves insufficient, eg:

– Market structure may tend to monopoly,

hence no competition may exist.

– Barriers to market entry may be so high that

entry may not occur absent intervention.

– Infrastructure owner may have the incentive

and ability to manipulate access for self gain.

• Sector-specific regulation therefore evolved

over time to address such ‘market failures’.

• Competition policy has subsequently promoted

the rationalisation and deregulation of such

sectoral regulation, so remaining sectoral

regulation is now principled and proportionate.

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A range of policy instruments exist

• Different countries adopt

different approaches, partly

influenced by their institutional

framework and political

preferences.

• Australia concentrates

significant regulatory power

within high quality and

independent regulatory

agencies, such as the ACCC

and State-based regulators.

• Australia has also been

increasing its use of regulation

by contract, including such

instruments as the Aurizon rail

access undertaking and the

NBN Co telecoms special

access undertaking

• Outsourcing of regulatory

functions to third parties in

Australia is less common.

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Independent regulation above political control

• As with most advanced

industrialised

economies, Australia’s

regulatory models

generally favour

independent regulation

above State ownership

and political control.

• Even where the State

has remained as a

shareholder, principles

of transparency and

competitive neutrality

have been applied.

• As a consequence,

Australia’s approach to

infrastructure regulation

is of a high quality by

global standards. We

have been a global

leader in competition

policy reform.

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Regulation of exclusionary conduct in Australia

• Australia gives primacy to commercial negotiations

for access.

• In those infrastructure sectors where commercial

negotiations are usually successful, light-handed

access regulation applies. The threat of regulation

may be regarded as sufficient (eg ports).

• In those infrastructure sectors where commercial

negotiations are often unsuccessful, heavier

regulation has evolved over time (eg telecoms).

• Greater regulation normally involves various

mechanisms to facilitate commercial negotiations,

including:

– Access undertakings (up-front offers to provide access)

– Industry codes, model terms, and access guidelines

• If negotiations fail, Australia favours a

‘negotiate/arbitrate’ regime with the regulator

permitted to arbitrate terms of access and pricing.

• However, the telecoms sector was subjected to a

heavier-handed approach in 2010, now involving ex

ante access determinations by the ACCC.

“You shall not pass”

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Regulation of exploitative conduct in Australia

• Australia does (or has) applied price controls to certain types

of infrastructure where there has been public concern about

excessive pricing and an absence of competition.

• Australia also maintains a national price control regime that

allows regulation to be applied in certain circumstances,

essentially creating a threat of greater regulation if excessive

pricing of infrastructure were to occur.

• Price regulation has been directed at both wholesale and

retail supply, the former intended partly to address potential

exclusionary behaviour by vertically-integrated businesses

(eg wholesale pricing in telecoms).

• A key infrastructure sector where price controls have been

applied at the retail level is electricity distribution. The

favoured approach has been to use the ‘building block

methodology’ (BBM), thereby providing certainty to

infrastructure owners that they can achieve a reasonable

return on their regulated asset base (RAB).

• Australia has moved away from forward looking asset

valuations that are ‘point-in-time’ specific, such as were used

in telecoms under the TSLRIC costing models. Such point-

in-time valuation approaches have been recognised as

potentially deterring long-term infrastructure investment.

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Australia’s regulation of infrastructure types

• INSERT TABLE • [ ].

Infrastructure Exclusionary conduct Exploitative conduct

Gas National Gas Law – negotiate / arbitrate

model for natural gas pipeline access

Distribution businesses must submit

reference tariffs for approval that are

derived using the BBM/RAB approach.

Water A range of state-based access regimes

exist, typically involving the use of a

negotiate-arbitrate model

A range of state-based regimes exist, but

they typically use either the BBM/RAB

approach or a retail minus methodology.

Electricity National Electricity Law – negotiate /

arbitrate model with some standard terms

Distribution businesses are subject to

revenue caps and retail price caps

derived using the BBM/RAB approach.

Telecoms Telecoms Access Regime – ex ante

access determinations

Telstra has been subject to CPI-X retail

price caps, but deregulation is occurring.

Wholesale pricing is determined by a

number of means, including BBM/RAB.

Airports Airports are potentially subject to access

regulation under the national access

regime.

ACCC undertakes price monitoring of the

top four leased federal airports against

various benchmark financial metrics

Ports Generally lightly regulated – reliant on

threat of regulation

Generally lightly regulated – reliant on

threat of regulation

Rail State-based access regimes – negotiate /

arbitrate model with some undertakings

Below-rail access pricing has generally

been based on the BBM/RAB approach.

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Relationship between Commonwealth & States

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Hilmer Reforms and National Competition Policy

• The relationship between the Commonwealth and

States in relation to infrastructure regulation has

been heavily influenced by the National Competition

Policy, dating from 1992.

• The ‘Hilmer Review’ of 1993 recommended a series

of reforms to harmonise infrastructure regulation

across Australia, leading to three key agreements

between the Commonwealth and States in 1995.

• Competition payments were made by the

Commonwealth to the States in consideration for the

implementation of various competition policy

reforms. The result has been the adoption of a

broadly consistent approach to infrastructure

regulation throughout Australia.

• Pursuant to these agreements, a co-operative

approach between the States lead to the adoption of

the National Electricity Law and the National Gas

Law by most States based on the simultaneous

enactment of identical State-based legislation.

• Infrastructure regulation harmonisation issues are

currently pursued through the Council of Australian

Governments (COAG).

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Managing the federal balance of power

States defer to Commonwealth

• Under the Constitution of Australia, certain

infrastructure services (namely post and telecoms)

are the subject of Commonwealth regulation rather

than State-based regulation.

• The Commonwealth also has power to regulate

certain significant national infrastructure on the basis

of its importance to inter-state trade or commerce or

to the national economy. The national access

regime has been enacted on this basis.

Commonwealth defers to States

• Otherwise, the power to regulate infrastructure lies

primarily with the States. The States have then

agreed with the Commonwealth and between

themselves to adopt various consistent regulatory

approaches (as mentioned in the previous slide).

• In relation to nationally significant infrastructure, the

States and the Commonwealth have agreed a

certification regime in which the State-based regime

has primacy if certain minimum criteria are met.

Overview of State-based regulation

• Ports are not heavily regulated in Australia.

• If regulation exists, it is generally directed at:

– channel access;

– vertically-integrated facilities (eg

wharves/berths);

– non-contestable services.

• Most regulation of Australian ports involves price

monitoring. In some cases access regimes apply.

• Some port access regimes have been certified as

effective under the national access regime:

– Dalrymple Bay Coal Terminal, QLD;

– South Australian Ports.

• Regulation may also apply to specific

infrastructure associated with ports, including:

– grain silos (a new Code is under review);

– railway systems (eg Aurizon QLD undertaking);

– gas pipelines (National Gas Law).

Approach of different States

• NSW – NSW removed Ministerial approval of port pricing in

the NSW port privatisations and implemented a price

monitoring regime by the Minister. If the Minister is

dissatisfied, an IPART investigation can be requested.

• VIC - The VIC regime is adjusted every 5 years on review

by ESC. The ESC review for 2014 favours continued

reference tariffs, price monitoring, increased transparency

and a credible threat of greater regulation.

• SA – SA currently has a price monitoring regime, although

ESCOSA has the power to make pricing determinations. SA

also has a port access regime that has been certified under

the national access regime.

• QLD – QLD has applied access regulation to DBCT. Other

ports are not currently subject to access regulation or

monitoring, although declaration by QCA could occur (or an

undertaking ‘voluntarily’ sought). Open access is a condition

of the WICET lease. Port Brisbane has given a voluntary

access undertaking.

• WA – Relies on Government ownership and policy to control

pricing, so will need to reform their regulatory regimes when

privatising ports. In WA, certain port services could become

regulated services subject to ERAWA oversight.

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Case study – ports primarily subject to State regulation

• CIRA was agreed by the Council of Australian

Governments (COAG) to achieve a simpler and

more consistent approach to the economic

regulation of significant ports.

• The States agreed to review the regulation of ports

to ensure they were consistent with the CIRA

agreed principles (see right).

• The various reviews resulted in a range of

conclusions. Generally, the conclusions of the

various reviews favoured:

– Commercial negotiations;

– Light-handed regulation and price monitoring;

– Threat of greater regulation if a light-handed

regulatory approach failed.

• KMPG undertook an audit for COAG in 2009 of the

various State-based ports reviews and confirmed

the veracity of the reviews – although WA failed to

make the deadline.

Agreed principles set out in CIRA

• Where possible, commercial negotiations and

outcomes should be promoted.

• States should create the structures and settings for

competitive markets, rather than regulating ad hoc.

• Regulation should only be applied only where

evidence of a market failure, such as:

– monopoly pricing / substantial market power;

– risk of upstream or downstream discrimination.

• Price monitoring to improve transparency is a first

step where price regulation is required.

• Any regulation should occur via an independent

State regulator acting within binding time limits.

• Third party access regimes should include

consistent regulatory principles (as listed in CIRA).

• Access regimes must be capable of national

certification under the national access regime.

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Ports - consistency between State-based regimes

Competition and Infrastructure Reform

Agreement 2006 (CIRA)

• The national access regime is set out in Part IIIA of

the Competition and Consumer Act 2010 (Cth).

• Any person can apply to the National Competition

Council (NCC) for the access regime to be applied

to any port service.

• The NCC will undertake public consultation and

make a recommendation to the relevant State

Treasurer whether statutory criteria are met.

• Once regulated, a port service would be subject to

a negotiate/arbitrate regime before the ACCC.

• To date, this regime has been applied to rail but

not yet to ports. Possible it could be applied.

• Ability to offer access undertakings.

• A State can seek a declaration that its existing

ports regulatory regime is “effective”. By doing so,

it can formally displace the Commonwealth Part

IIIA regime so that only the State’s access regime

will apply. South Australia has achieved this for its

State-based Ports regime.

Price surveillance (Part VIIA)

• Price surveillance can apply to supply of goods or

services in any industry, including ports.

• Price inquiries: Commonwealth Treasurer can

require ACCC to hold price inquiries. ACCC has

ability to prevent price increases during the inquiry.

• Price notifications: Commonwealth Treasurer or

ACCC (with approval) may notify goods or services

and hence restrict price increases.

• Price monitoring: Commonwealth Treasurer may

direct ACCC to monitor prices, costs and profits in

relation to the supply of goods or services.

• At present, no Australian port infrastructure is

subject to either Part IIIA or Part VIIA. However,

either regime could potentially be applied if

concerns arose from the public or port users.

• The Part VIIA regime has been applied to

stevedoring operations at various key ports. The

ACCC currently monitors prices, costs and profits

of stevedores at those ports.

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Ports - Commonwealth regulatory overlay

National Access Regime (Part IIIA)

Current issues and regulatory trends

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Harper Competition Policy Review

• The ACCC has no practical ability to block or

approve a particular privatisation structure, but its

view can be influential in some instances.

• Recent comments and submissions by the ACCC

regarding infrastructure privatisations:

– The ACCC is generally supportive of

privatisations on the basis that the private sector

can more efficiently operate assets.

– The ACCC’s primary concern is that the

privatisation structure needs to be set so as to

maximise competition and ensure any monopoly

assets are subject to effective regulation.

• The ACCC’s view has the potential to diverge from

the views of State Treasurers, who are seeking to

maximise the value of the privatised asset.

• The ACCC has raised concerns regarding some

historical privatisation structures:

– Privatisation of Telstra as a vertically-integrated

telecoms business.

– Privatisation of Sydney Airport inclusive of an

option for developing a second airport (rather than

having two competing airports).

Comments by the ACCC – October 2014

• “There have been very high multiples paid for

some of these ports and the worry is that the

buyers may only recoup their outlays if they push

up prices quite a bit more than otherwise would

have happened,” Mr Sims told The Australian

Financial Review.

• “Governments should avoid the temptation to

attempt to maximise sale revenue by privatising

without appropriate price and access regulation in

place”: ACCC’s Container Stevedoring Monitoring

Report No. 16, October 2014

• “The regulator warns that “restrictions on

competition” inserted into sale conditions “may be

unlawful and could be unenforceable”. Its points of

reference were the sale of Port Botany and Port of

Newcastle, which included conditions that prevent

the world’s biggest coal port from building a

container terminal. The problem for the regulator is

that there is significant doubt over whether the

behaviours of government are contained by the

competition law”: The Australian Financial Review.

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Views of the ACCC on privatisations

Views of ACCC on privatisations

Importance of the Regulatory Asset Base and WACC

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Case study - regulation of electricity distribution

Distribution networks

• Services are regulated under the

National Electricity Rules based

on the extent to which they are

contestable – in three baskets.

• Unregulated services are not

regulated.

• Negotiated services are subject to

a negotiate/arbitrate regime.

• Direct control services are subject

to price and access regulation.

• The AER may determine the type

of price regulation. The AER has

favoured establishing annual

revenue caps within a regulatory

control cycle.

• Annual tariffs must also be

approved by the AER within the

revenue caps.

Distribution services

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Application of price regulation - BBM

Building Block Model (BBM)

• In order to determine the revenue cap for distribution

and transmission networks, the AER makes revenue

determinations guided by various statutory criteria.

• The National Electricity Rules prescribe a cost-

based pricing methodology for those determinations,

known as the “building block model” or “BBM”.

• The BBM enables an “annual revenue requirement”

(or “maximum allowable revenue”) to be determined

for each network business in the form of a revenue

cap for each regulatory control period.

• Objective of BBM is to deliver an NPV=0 outcome so

that an operator only recovers its efficient costs plus

a risk-adjusted return equivalent to its weighted

average cost of capital (WACC).

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Application of price regulation – RAB

Regulated Asset Base (RAB)

• The first step in the initial application of the BBM

was to historically determine the ‘regulated asset

base’ (RAB) for each business.

• The RAB is a snapshot of the regulatory valuation of

the assets of an electricity network.

• The RAB is used to determine the return on capital

and the return of capital in the BBM.

• Initial RAB comprised the value of the sunk assets.

• Each year, that ‘locked in’ RAB has been ‘rolled

forward’ via annual adjustments that reflect the net

effect of depreciation and asset disposals (each as

a RAB reduction) and capital expenditure and

inflation (each as a RAB addition).

• The RAB is therefore a snapshot of the regulatory

valuation of the assets of an electricity network.

Impact of regulation on infrastructure cash flows

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Draft determinations in NSW electricity distribution

Impact of regulatory decisions on regulated revenues can be dramatic…

30%

difference

of opinion

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Why is there a 30% difference in opinion ?

Differences in calculation of WACC parameters

• The previous WACC had been set at the height of the GFC, so included a high debt risk premium. The AER

adjusted the WACC to reflect prevailing market views on the risk of debt. The AER also made a range of other

refinements to WACC parameters to reflect different views on the return on equity, return on debt and

appropriate treatment of imputation credits. Small changes in the WACC can have large impacts on revenues.

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Why is there a 30% difference in opinion ?

Reduction in CAPEX to reflect changes in demand

Greater efficiencies to be realised in OPEX

Conclusions

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Conclusions

• Australia’s approach to infrastructure regulation is of a high quality by international standards and has

involved the concentration of regulatory power within high quality, independent regulators.

• Australia has focussed on access regulation of infrastructure, applying a negotiate-arbitrate regime

where commercial negotiations have failed. Australia is making more use of regulatory contracts.

• Exploitative conduct in Australia is not heavily regulated, except in electricity transmission and

distribution. In circumstances where prices are controlled or regulated, the BBM/RAB framework is the

most common form of price regulation. ‘Point in time’ asset valuations are not favoured.

• Australia’s federal structure means that the Commonwealth and States must co-ordinate their

regulatory activities. Most infrastructure is subject to State-based regulation with a Commonwealth

overlay, subject to mechanisms to prevent double-regulation.

• The ACCC has strong views on privatisations, but its influence is limited. The ACCC’s public position

is that privatisation structures should be adopted that maximise post-privatisation competition.

• The current Harper Review is considering ways to strengthen Australia’s National Competition Policy

and to reinvigorate the historic Hilmer recommendations.

• While the BBM/RAB framework is widely used in infrastructure regulation in Australia, regulators and

access providers can have significantly different views on the input variables into the BBM/RAB,

including the WACC. This is illustrated, for example, by the 30% difference in revenue associated with

the current NSW electricity distribution draft determinations. Regulatory debate in Australia tends to

focus on these issues given their critical impact on asset valuation.

About Norton Rose Fulbright

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Contact us

Dr Martyn Taylor

Partner

Norton Rose Fulbright Australia

+61 2 9330 8056

martyn.taylor@nortonrosefulbright.com

nortonrosefulbright.com

2185357232

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