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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
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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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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)
• 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
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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.
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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
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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.
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Partner
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+61 2 9330 8056
nortonrosefulbright.com
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