Alice Springs Rail

Evaluation of the proposed

COMPETITIVE IMPUTATION RULE FOR THIRD PARTY ACCESS REGIME for the AUSTRALASIA RAILWAY PROJECT

Stephen King and Rodney Maddock 1 March 1999

AustralAsia Railway Project: Competitive imputation rule for third party access regime

1.

The objective of this paper

The AustralAsia Railway Corporation is working with the Governments of the Northern Territory and South Australia to put in place a third party access regime for the Tarcoola to Darwin railway. The services that will be included involve the provision of access to the existing rail infrastructure from Tarcoola to Alice Springs and a new facility to be constructed between Alice Springs and Darwin to allow for the carrying of freight and passengers over this track.

The railway is a greenfields, pioneering project in a developing region of the national economy. The region currently lacks key infrastructure and the Commonwealth, SA and NT governments believe that the development of this infrastructure is necessary for the region’s future growth.

The purpose of this paper is to form a view as to whether the basic access pricing principles proposed to govern third party access for the project conforms to the requirements of an “effective” access regime.

An access regime for a new infrastructure project needs to balance two sets of interests. For legal and public policy reasons, any significant new infrastructure project must consider developing an access regime which is not inconsistent with the guidelines contained in the national Competition Principles Agreement (CPA). At the same time, the regime must also meet the needs of the equity providers and financiers otherwise the project itself will not be undertaken. The SA and NT governments in conjunction with the AustralAsia Railway Corporation have developed a State or Territory based access regime that they believe meets the needs of financiers and equity providers. It is involved in discussions with the NCC as to whether the proposed access regime is consistent with the guidelines for a conforming State-based regime as set out in the CPA at Clause 6.

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2.

Legislative requirements

The 1995 national Competition Principles Agreement established principles to which a State or Territory access regime was required to incorporate in order to be considered an effective access regime. These were amended from 31 July 1998 to allow the NCC and the relevant Minister considerably greater flexibility. The new Section 44DA of the Trade Practices Act 1974 (as amended) requires that the underlying principles be treated as guidelines rather than as binding rules.

The guidelines for judging a conforming access regime are contained in two subclauses of Clause 6, that is 6(3) and 6(4).

Subclause 6(3) requires that the access regime (a) should apply to significant infrastructure, where (i) it would not be economically feasible to duplicate the facility, (ii) access is necessary to permit effective competition in a downstream or upstream market, (iii) the safe use of the facility can be ensured, and (b) should incorporate the guidelines in subclause 6(4).

Subclause 6(4) contains sixteen guidelines. With the exception of guideline 6(4)(i), these create an environment where access seekers can negotiate terms with some protection. We have not been asked to opine on whether the proposed access regime meets all of the guiding principles contained in the CPA. Our opinion has been sought on the narrow question of whether the proposed competitive imputation rule complies with the relevant guiding principles of the CPA, namely those set out in subclause 6(4)(i).

Subclause 6(4)(i) establishes guidelines that a dispute resolution body needs to take into account when determining the terms and conditions of access. The wording of the subclause is: In deciding on the terms and conditions for access, the dispute resolution body should take into account: -3-

(i)

the owner’s legitimate business interests and investment in the facility;

(ii)

the cost to the owner of providing access, including any costs from extending the facility but not costs associated with losses arising from increased competition in upstream or downstream markets;

(iii)

the economic value to the owner of any additional investment that the person seeking access or the owner has agreed to undertake;

(iv ) the interests of all persons holding contracts for use of the facility; (v)

firm and binding contractual obligations of the owner or other persons (or both) already using the facility;

(vi) the operational and technical requirements necessary for the safe and reliable operation of the facility; (vii) the economically efficient operation of the facility; and (viii) the benefit to the public from having competitive markets.

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3.

The competitive imputation approach

3.1

The basic philosophy

The proposed access regime for the AustralAsia railway project uses ‘competitive imputation’. The underlying concept behind the competitive imputation pricing rule (CIPR) is that access prices are capped by prices set by competing transport modes rather than by prices established by a regulator (such as rate of return). In this sense, the rule imitates the normal working of a competitive market where the price a firm can charge is limited by the prices charged by competitors.

The competitive imputation approach is economically desirable in certain circumstances. In particular, it is designed to establish access rules for a new facility:

- where the potential returns on that facility are subject to considerable uncertainty and

- where the investment in that facility might be rendered non-viable by any significant truncation of the distribution of potential returns from the investment.

We believe that these conditions are satisfied for the proposed AustralAsia railway and provide a discussion of the basis for this conclusion below.

Further, as the relevant access prices under the CIPR are based on competition in the services provided by the use of the facility, relevant competitive alternatives must exist. To judge the practicality of the competitive imputation pricing rule for the AustralAsia railway, we need to consider whether the projected railway line will be an unconstrained monopoly in the market for the services it provides or whether it will be subject to relevant competition. This is dealt with in section 3.2.

It should be noted that if the two criteria given above are both satisfied then the competitive imputation pricing rule is the only access pricing rule that both • does not distort the relevant investment decision and -5-

• is ex ante efficient. In particular, any standard alternative approach to access pricing based on ex post costs and revenues will be ex ante inefficient if the two criteria are satisfied. This means that approaches such as those considered in the Carpenteria and in the Sydney airport matters on which the NCC has expressed an opinion are not relevant to this project - they may be relevant for mature and profitable infrastructure but not for new, risky projects where a change to the regulatory environment could easily result in the project not going ahead. This is discussed in more detail in section 4.3.

3.2

Market definition

There are two potential approaches to market definition that are relevant for analysis of the AustralAsia railway project. First, the railway could be considered as operating in a market for transport of freight and passengers. In this case, access to the railway might promote competition in relevant downstream markets, such as a market for produce in Darwin. Alternatively, it might be viewed that there is a railway track services market that is separate from the freight market. Access in the market for railway track services might then promote competition in the freight market. In either case, in our opinion, railway freight operators will be subject to significant competition in the freight market. This market is currently highly competitive, and alternative modes of transport will continue to provide competitive constraint on rail after the project is completed.

If the freight market is highly competitive then the owners of the railway will not be able to abuse any market power, as they will not have any market power.

This is obvious under the first approach to market definition. The railway will only operate in the competitive market for the transport of freight and passengers and, due to competition, will have no market power.

The same conclusion applies under the second approach. If there is a separate market for railway track services that provides an input for some firms that compete in the freight market, then competition in the freight market will prevent the owners of -6-

the railway from gaining any market power. General freight competition will limit the profits that are obtainable from the use of rail to standard competitive levels and, because of this, the railway owners will be unable to seize any monopoly profits from the sale of access. Any attempt to do so will simply be thwarted by downstream intermodal competition.

Considering this second case more fully, it is sometimes stated that railways are ‘natural monopolies’. However, this may not be correct, particularly in the case of a greenfields development such as the Tarcoola to Darwin railway. A railway may have a natural monopoly technology, in the sense that it has high fixed costs and low variable costs that make it socially wasteful to duplicate the railway. However a natural monopoly technology does not necessarily translate into monopoly power. A monopoly is a characteristic of a market not a technology. If railway freight is in competition, for example, with road freight then the railway owner cannot seize monopoly profits. The owner of the railway cannot raise the access charge above the level imposed by road competition. To attempt to do so would simply drive railway freight companies out of business, as they could not compete against road freight. Rather, the owner of the railway can only seize profits that are created by rail freight being more efficient than the competitive alternative.

Under either approach, a central issue for analysis is the definition of the market in which the transport operators using the railway will be competing. In particular, do rail and other modes of transport (especially road but also possibly sea and air) operate in the same market? Secondly, if the relevant market includes modes of transport other than simply rail, are competing modes of transportation likely to impose a significant constraint on rail pricing?

In our view the proposed rail transport operation would operate in the same market as at least road transport and possibly the other transport modes. This conclusion follows from the Trade Practices Tribunal’s definition of a market for the application of Australian Trade Practices Law. According to the Tribunal, a market “is the field of actual or potential transactions between buyers and sellers amongst whom there can be strong substitution, at least in the long run, if given a sufficient price incentive” -7-

(Re Q.C.M.A. and Defiance Holdings, 1976, ATPR 40-012 at 17,247). This definition and the approach to market definition that it embodies has been upheld in numerous trade practices cases, including the recent cases of Queensland Wire Industries Pty Ltd v BHP (1989) 167 CLR 177, Regents Pty. Ltd. v Subaru Pty. Ltd. and News Ltd. v Australian Rugby Football League and Ors. (Australian Federal Court, 1998 and 1995 respectively).

Under this accepted approach to market definition, a market depends on the potential for substitution by both buyers and sellers. Also, it depends on potential competitors who may enter the market if a firm were to attempt to raise prices, as well as existing competitors. It can reasonably be expected that the existing transport companies that currently provide freight services over the same route as the proposed railway (or between the same destinations) will be in competition with rail freight after the railway is completed. On the route between Adelaide and Darwin each of air, sea and road compete at the current time. Rail would simply be a new entrant hoping to compete with them on that route. On the route between Alice Springs and Darwin, services are currently being provided by road. Again, the expectation is that rail might be able to compete with road. The road and sea carriers can be expected to provide competitive alternatives to rail once the project is complete and will provide a price constraint on the railway operators. Clearly the railway will not be able to charge more than the existing alternative carriers and service providers or else their potential customers will simply continue to use the alternatives. To the degree that the railway charges a lower price, this will benefit customers. The presence of alternative substitute carriers means that the relevant market should not be narrowly construed as a ‘rail market’but rather as a general transport market that is competitive. The AustralAsia railway project is aimed at allowing rail to enter this market.

3.3

The effectiveness of the inter-modal constraint

Rail will be part of a general transportation market. As such the prices that are charged for rail (and as a result, for access to the railway line) will be constrained by the prices set by competing modes of delivery. But this is not the same as saying -8-

that the owners of the railway will have no market power. Market power depends not only on the breadth of the market but also on the degree of competition in that market. Will inter-modal competition impose a significant constraint on the prices rail operators can charge? We base our views on published transport market data and supplementary information provided to us by Booz-Allen & Hamilton.

We understand that the split of freight between rail and road on long distance routes across Australia ranges from about 65:35 to 30:70 depending on the route. The Productivity Commission estimates that rail’s share of total freight carried in 1994-95 was 56 percent (Productivity Commission Performance of Government Trading Enterprises 1991-92 to 1996-97, Research Report, Ausinfo, Canberra, 1998 especially Chapter 6). The balance of freight on the current Tarcoola to Alice Springs route is approximately 30 percent rail, 70 percent road. Table 1 provides illustrative data.

Table 1: 1994/95 Estimates of Road and Rail Market Shares Selected Corridors

Corridor

Distance (km) Road

Brisbane-Sydney

Rail

Tonnage (000's) Road

Rail Share

Rail

972

999

2026

1494

42%

1,570

1,932

1326

351

21%

887

933

5472

1619

23%

3,423

3,947

176

359

67%

726

826

2352

1457

38%

Melbourne-Perth

3,467

3,487

298

698

70%

Adelaide-Perth

2,706

2,661

156

612

80%

Brisbane-Melbourne Sydney-Melbourne Sydney-Perth Melbourne-Adelaide

Source: NTPT, BTCE (1996)

The absolute volume of freight carried by rail has been flat over recent years with most of the growth being captured by road as a result (in part) of advantageous relative price movements. There appears to be a substantial substitution between the modes: “we [Booz-Allen & Hamilton] estimate that the cross-elasticity of demand

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between road and rail to be in the range of 1.5 to 2.0.1 This estimate is supported by the historic behaviour of demand volumes in response to increases in rail prices in the long distance general freight market. It is also consistent with empirical studies which have placed the rail-road cross-elasticities considerably in excess of one.” The inference is that there is likely to be intense inter-modal competition in the Tarcoola-Darwin freight market. It is important to remember that this project involves rail being launched into a mature existing freight market without some of the protections which have applied for earlier rail lines in other states (such as environmental2 or other requirements that coal or wheat be carried on rail. There were also legislative requirements in some states that certain products had to be carried on rail).

Since rail will be the new mode competing with incumbent road, sea and air operators, any first-mover or incumbency advantages that exists in the freight market will lie with these other mode. Rail will have to win custom from other modes so that competition should be vigorous.

We can also expect that the change to the taxation system expected this year will further improve the competitive position of road relative to rail. Some estimates suggest that this will improve the relative competitive position of road by 10 to 15 percent.

Table 2 – Simple Analysis of Impact of GST and Road and Rail Linehaul Costs

Road

Rail

Diesel Fuel Price

0.65

0.58

Current Excise

0.43

0.36

Excise under GST

0.18

0.18

% Cost Saving

38%

31%

1

Since in Australia road prices have historically fallen relative to rail this is a one sided elasticity estimate. However one author, Maddock, has undertaken confidential empirical work for the Victorian government using stated preference methodology which finds similarly high cross price elasticities for movements in either direction. 2 Environmental or other regulations can create a situation where some product can only be carried by rail.

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Fuel Costs as % of Total Costs

25%

20%

Source: Booz-Allen & Hamilton calculations

The existence of such intense inter-modal freight competition means that rail operators will have little chance to extract monopoly rents from users when they set their final prices. This, in turn, means that the railway owners will be unable to extract any rents from these operators through access prices. Competition will eliminate any anti-competitive rents in the vertical production chain of railway freight and the profits that accrue from the project can be expected to reflect the relative efficiency of the rail service relative to the competitive alternatives. Table 3 provides some evidence of the gradual loss of freight from rail over the last thirty years.

Table 3 – Sydney Melbourne Rail Market Share Year 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

Road 1,290 1,340 1,450 1,550 1,650 1,710 1,690 1,712 1,935 1,959 2,274 2,536 2,645 2,645 2,867 3,178 3,340 3,458 3,022 3,639 3,706 4,127

Net Tonnes 000's Rail Sea 1,690 1,720 1,730 1,750 1,620 1,630 1,690 1,614 1,725 1,764 1,488 1,458 1,494 1,408 1,444 1,599 1,565 1,641 1,231 1,401 1,405 1,420

340 310 270 260 390 310 430 438 463 821 895 697 714 701 918 917 952 961 769 754 694 659 -11-

Total 3,320 3,370 3,450 3,560 3,660 3,650 3,810 3,764 4,123 4,544 4,657 4,691 4,853 4,754 5,229 5,694 5,857 6,060 5,022 5,794 5,805 6,206

Rail Market Share (Road/Rail Split) 57% 56% 54% 53% 50% 49% 50% 49% 47% 47% 40% 37% 36% 35% 33% 33% 32% 32% 29% 28% 27% 26%

1987 1988 1989 1990 1991 1992 1993 1994

4,479 4,885 5,340 5,438 5,466 5,494 5,522 5,550

1,607 1,621 1,848 1,777 1,867 1,957 2,047 2,137

480 620 722 755 621 487 353 219

6,566 7,126 7,910 7,970 7,954 7,938 7,922 7,906

26% 25% 26% 25% 25% 26% 27% 28%

Source: BTCE Occasional Paper 98, Booz·Allen & Hamilton Data

The current phase of intense rivalry between transport modes is not a new phenomenon in Australia. N. Butlin, A. Barnard and J. Pincus Government and capitalism, Allen & Unwin, Sydney 1982 discuss the long term loss of market share by rail to alternative transport methods. Their long term estimates are that real rail prices rose by about 27 percent between 1950 and 1975 while the price of private vehicle operation fell by about 12 percent. During this period rail failed to pay for the capital employed. Butlin et al argue that the competitive situation for rail has been in decline since some time in the 1920s; that is a period of seventy-five years. The continuation of this historic trend of weak rail finances to the current day is captured in the views of the Productivity Commission. “Over the period monitored [the nineties], most rail GBEs have made significant operating losses and generated poor returns on equity” (op cit, p.224). Most States fund the operating deficits of their rail enterprises so that normal commercial returns on capital are not even considered.

The inference we draw from the evidence is that for the post-war period rail has demonstrated poor profitability. The main reason for poor profitability is that prices are constrained by inter-modal competition from road. Given that this state of affairs appears to have persisted for seventy-five years, we believe that it is likely that this will continue into the foreseeable future. It thus seems sensible to assume that the competitive pressure imposed on rail freight prices from road freight will continue for the next thirty years and probably for longer than that.

3.4

The competitive imputation price in practice

Competitive imputation pricing uses the existing inter-modal competition to establish access prices. It starts from the view that the final delivered prices for the carriage of some commodity from point A to point B is restricted by the price of providing the -12-

same service by some other means. Call this other price the competitive alternative delivered price (CRLP)3.

We arrive at the competitive imputation access price (CIAP) by subtracting some costs from the competitive alternative delivered price. The costs we net out are the incremental costs to the railway owner/operator of providing itself the above rail freight or passenger service. We do this because the owner/operator will avoid these costs if the access seeker runs its own freight or passenger trains.

Thus CIAP = CRLP - incremental above rail service costs.

In determining the price for which the service can be offered on a competing mode of transport, it would be appropriate to consider the price that the other mode would charge if it were to operate commercially on the transport corridor in the medium to long term. This means that the appropriate road price to be considered would be the price of running a commercial road operation that is with trucks running in both directions so that backhaul losses should be allowed for in the calculations.

3

This follows the nomenclature in the proposed legislation – Competitive Rail Linehaul Price.

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4.

Price floors, price ceilings and related issues

There are three additional points that need to be raised regarding the access pricing rule.

4.1

Access price should not fall below the incremental (below rail) operating costs

It would not be appropriate to have a pricing rule that forced the rail operator to provide access at a price below the incremental (below rail) cost of providing the service, as could result from the operation of the CIPR. This might arise for example where the alternative transport mode is very cheap. To require the operator to continue to provide services at prices below the incremental cost of using the tracks, signalling etc would violate the conditions in subclause 6(4)(i)(i) of the CPA which protects the owner’s legitimate business interests and subclause 6(4)(I)(vi), which deals with the safety and reliability of the facility which could be compromised if there is insufficient incentive for expenditure on maintenance etc.

To avoid this anomaly of CIPR, the pricing rule should incorporate a floor on the access price. This would be based on the incremental below rail costs plus an appropriate margin.

4.2

Pricing in the absence of a competing mode

The competitive imputation principle assumes that there is a competing mode of transport which can be used to establish the base-line from which the CIPR access price can be developed. This is clearly the case for existing freight. The current mode of transport is providing the competitive alternative. But it might be believed that such a competitive alternative may not exist for some new freight that could be transported using the new railway.4

4

We note that a price cap is now proposed to deal with this alternative.

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The most often discussed situation is where a new mine might be developed. There are however mining operations in many parts of the world that use road transport rather than rail even though rail is more common in Australia. Even iron ore is carried by road in the major Brazilian Samarco mine. Rigid plus 3 tri-tri truck configurations are currently used in the Northern Territory’s Woodcutters mine and the 3B combination (3 “B” doubles - six trailers - and a carriage of 205 tonnes) is in use to bring ore from the Macarthur River mine to the Bing Bong loading facility. There is no in principle reason why the 4 “B” double used in some parts of the US could not be used as well. The essential point is that road does currently provide carriage services for ore from a variety of mines in the Northern Territory so that it is difficult to envisage a situation where a road transport alternative to the rail does not exist.

Secondly, for a new mine, transport options will need to be considered as part of the feasibility study for that mine. Both the financiers of the mine and the government (concerned about environmental impact) require a formal analysis of transport alternatives. In the situation where the mine has not been developed, the potential mine operator and the rail operator would negotiate the prices which might be charged for rail transport before the mine goes ahead. The transport costs can thus be incorporated into the project analysis. We would normally expect that both sides would be interested in arriving at a long-term contract whereby the freight did travel on the rail. In this situation the rail operator is at a disadvantage in that the rail infrastructure would be in place and hence a sunk cost while the mine would involve a much lower level of sunk cost. Normal bargaining should produce an outcome that is beneficial to both sides. Clearly the rail operator loses if it insists on a high rail access price so that the mine does not proceed. In this case the railway makes zero revenue rather than having the new mine make some contribution to the railway costs.

A further possible concern with the use of the alternative mode to establish the competitive imputation price is that, if the rail project were highly successful, the current alternative carriers may exit from the market. In this sense, it might be felt that competitive pressures on the railway might diminish over time. However, even if -15-

existing carriers did exit the market, it is both actual and potential competition that is relevant. If alternative carriers could quickly re-enter the market in response to a rise in rail freight prices then these carriers would provide competitive restraint on the railway and are still in the relevant market. This is particularly relevant for road transport where the relevant capital (the trucks) can be quickly moved in from other freight routes. The road industry is one where entry and exit are relatively easy. Further, the figures cited above suggest that rail and road co-exist on all major rail transport routes so that we would expect them both to continue to operate between Tarcoola and Darwin.

4.3

Regulatory controls and the ex ante efficiency of the CIPR

As noted above the CIPR is particularly designed for new investment projects that face demand uncertainty. In these circumstances, most access rules will distort the return profile from the investment and may risk the viability of the project. The competitive imputation pricing rule, by contrast, does not distort the investment return profile.

The key difficulty with investments in new, greenfields projects is that the flow of revenues that might result is very difficult to estimate. Investors thus consider the range of possible returns that might result from the investment and attempt to attach a probability to each in order to ascertain the expected revenue stream. They then undertake the risky investment on the basis of comparing this expected revenue with the project costs. Once the project has been undertaken they then face considerable regulatory risk.

As an example, consider two alternative outcomes, one where the project revenues are high and one where they are low. If a priori the probabilities are equal then the expected revenue will be in the middle of these two values. If this expected revenue exceeds the project cost, then the investment will be undertaken. Once the facility is built, revenues will either turn out to be high or low. If they are low, the project will be unprofitable. If they are high, the investment will be very profitable.

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A regulator can distort these choices: • in the unprofitable case, there is likely to be no regulatory interference. • if the project is successful however, a regulator might try to take away the gains and force the project to earn no more than ‘normal’returns.

The consequence of this is to distort the investment choice. If a regulator insists on taking away profits if the project turns out to be successful and investors know this will occur before the investment is made, then the return profile is changed. The project will either earn low returns and be unprofitable or it will earn intermediate profits (because the high revenue outcome occurred but the benefits were regulated away). The average expected revenues (after regulation) are thus reduced. In this situation a project that was viable will not proceed. The regulatory stance has distorted the investment decision and has lowered Australian economic welfare. (This concern is treated in detail in Chapter 7 of S. King and R. Maddock Unlocking the infrastructure, Allen & Unwin, Sydney 1996 to which the interested reader is referred).

This suggests that it is important for investment efficiency, when considering a truly new and innovative project, that regulators do not attempt to penalise such projects when they are successful. However, most access rules do just that. For example, if a regulator sets an access rule that is based on the facility owner gaining a reasonable rate of return and this truncates the potential profits that the owner might make from its investment, then the return profile is distorted and regulation can inefficiently reduce investment. Note that the problem with such an access rule is that it prevents the investor from gaining profits if the project is highly successful but leaves the investor completely exposed to losses if the project fails. Because of this, it is not sufficient to simply adjust the relevant cost of capital used in the regulatory evaluation of reasonable access prices. Any access price rule based on ‘reasonable returns’will truncate the investors’return profile and may distort investment decisions unless it is identical in practice to the CIPR.

If a regulator believes that an extra price ceiling needs to be placed on the access provider in addition to the ceiling provided by the CIPR, then this ceiling should be -17-

set at the stand alone cost for the relevant access seeker. In essence, this is the equivalent of a competitive alternative if there is no actual practical alternative in the market. Such a rule still allows investors to obtain the benefits if a low probability, highly profitable outcome occurs. Note however, that going beyond this seeker-byseeker cap, for example by using a combinatorial stand alone cost price cap, will distort the investment choice and ultimately reduce the regulatory model to rate of return regulation. We do not believe that this is appropriate for an innovative, risky, greenfields project of the sort under consideration here.

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5.

Evaluation

5.1

The “benefit from competitive markets” guideline

The railway line under consideration does not currently exist. The construction of such a railway line has been under discussion for nearly 100 years. The project has been analysed many times and never undertaken. As we understand the current cost-benefit analysis, the project may now be feasible principally on the basis of revenues expected over the life of the 50 year project. That is, the stream of expected revenues from the investment only exceeds expected economic costs by a small margin over that long period.

An access rule that allowed entrants to compete with the facility owner in the rail transport business, and diverts any legitimate investment returns from the owner, is likely to have the effect of rendering the project non-viable. The consequence is to reduce competition on the route.

Subclause 6(4)(i)(viii) of the CPA creates a requirement that the access rule should take account of the desirability of having competitive markets. To the degree that rail provides an efficient alternative to current transport alternatives, the construction of the railway will promote competition in the transport markets which shift goods into or out of Darwin, as well as in a range of other upstream and downstream markets. The project may also improve the economics of some currently undeveloped mines and lower input costs in a range of other industries with flow-on effects into a number of other markets. It is thus important in terms of the Competition Principles Agreement to develop an access regime that does not impede the construction of the facility.

5.2

The “economically efficient operation of the facility” guideline

In the context of this project, economically efficient operation applies to a facility once constructed. The underlying assumption of the competitive imputation rule is that rail competes with road, sea and possibly air in the relevant transport market. -19-

Competition between the modes should lead to rail only being used where it is economically efficient to do so. The competitive imputation pricing rule that is proposed provides incentives for the facility owner to allow entrants to operate using the facility whenever they are able to do so at lower cost.

If rail provides a cheaper transport option on some route than road or sea transport, and the rail service is provided by a third party, the margin between the rail cost and the competitive price (a producer surplus) would be retained by the facility owner rather than by the third party. This does not violate economic efficiency for two reasons. It is precisely this surplus which makes the facility viable in the first place. Taking the surplus away from the facility owner is likely to mean that the facility is not developed at all. In this case, the surplus would not be generated and this loss of surplus would be an economic loss arising from inappropriate access pricing. The second reason is that ex post it makes no difference in terms of economic efficiency who captures the surplus: it involves the distribution of income but has no efficiency consequences in itself.

5.3

The “owner’s legitimate business investment in the facility” guideline

The proposed rule provides an access structure in two parts. In relation to the use of the rail it creates an environment where the owner is able to capture any economic returns arising from the use of the facility. The owner cannot seize monopoly rents because of the constraint of inter-modal competition. This structure exactly mimics the working of a normal competitive market. As such it protects the owner’s legitimate business investment in the facility.

From the discussion above it should be clear that the evaluation of risky investment projects assigns probabilities to the various revenue scenarios which might occur and contrasts the expected project revenue with the project costs. Any regulatory decision to truncate the distribution by regulating away the highly successful outcomes if they occur changes the return profile of the project. The project under consideration has been evaluated many times but has never been undertaken. Our understanding of the project economics is that the project is unlikely to be feasible -20-

even now if the low probability/high payoff revenue alternatives are regulated away. It is our view that the owner’s legitimate business investment in the facility is protected by allowing the owner access to the upside if the project is successful just as the owner would have to carry the losses should the project prove unsuccessful.

5.4

The “cost of providing access” guideline

This guideline has two elements; one concerned with railway infrastructure costs, and the other with compensation for possible losses in other markets.

The rules as proposed take account of the cost to the owner of providing access as required by guideline in subclause 6(4)(i)(ii) of the CPA. Most importantly the owner should never be required to sell access at a price below the avoidable cost of providing access.

In terms of the second element of the guideline, it might be believed that the CIPR would compensate the rail owner for “costs associated with losses arising from increased competition”. This is not the case. If inter-modal transport provides the relevant competitive constraint on rail freight, then the prices of inter-modal transport constrain the rail freight operators and neither the operators nor the owners of the railway have relevant market power. The CIPR in this case only compensates the rail owner for the legitimate costs of the investment including the ex ante risk of the investment. Further, to the degree that any operator seeking access is more efficient at providing freight services than the railway owner, the CIPR explicitly does not allow the railway owner to seize any of the benefits of this improved efficiency. However, as noted above, setting any access price below the CIPR does not adequately compensate for ex ante risk as it truncates the investment profile and may deter the investment in railway altogether.

A simple example may help to illustrate this point. Suppose that the railway has been constructed, is in operation, and that the current rail freight price of a commodity is $20 per kg. This price is set by road competition, which also has a price of $20 per kg. Of the rail price, suppose that $11 is above rail costs. Suppose further that a new -21-

operator is able to reduce above rail costs to $8 per kg. Using the CIPR, the operator can gain rail access at a price of $9 per kg. So the new operator’s costs are $17 per kg. The new operator can now price at $19.50 per kg, undercut the road and rail competition, and make a profit of $2.50 per kg. The existing rail operators will no longer find it economical to ship the product and the new rail operator may seize a significant amount of business from road. But note that the new operator retains all of the profits associated with their innovation. The rail owner only receives the revenues that they were previously receiving that are directly associated with their rail investment. These are the legitimate (but ex ante uncertain) returns that drove the investment decision in the first place. The same analysis might be carried out in relation to any downstream market, such as the impact on freight carried between Darwin and Singapore, with the same outcome: the rule does not allow the operator to gain compensation for losses in downstream markets.

In contrast, suppose that a change in government policy makes road freight more competitive. Competition drives the price of road freight down to $18 per kg and rail operators must drop their price to compete. But the whole cost of this extra competition is borne by the rail owner through the CIPR. As the competitive alternative falls by $2, so does the rail access price. Rather than compensating the railway owner for “costs associated with losses arising from increased competition”, the rail owner is completely exposed to the cost of increased inter-modal competition under the CIPR.

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6.

Conclusion

In our view, the competitive imputation access pricing rule is consistent with the guidelines incorporated within the Competition Principles Agreement. It thus complies with the requirements of Section 44DA of the Trade Practices Act.

The method proposed is akin philosophically to price-cap regulation although in this case the price cap is set by the competing modes of transport. Given the experience of rail in Australia, competition from road has been highly effective in preventing the extraction of monopoly rents on general purpose rail lines. In the light of the long term nature of the shift in competitiveness from rail to road, we see no reason to expect that road competition will not impose a strong competitive threat to rail into the foreseeable future. It is our expectation that alternative transport modes such as road would provide an effective discipline on the rail operator for at least the next thirty years.

The competitive imputation rule has three additional advantages: (i) it allows third parties to enter in situations where they can provide the service more cheaply than the incumbent. The market should thus be characterised by efficient operation, (ii) it allows all relevant producer surplus to be captured by the rail operator. This is important for this facility and is ex ante efficient. The project is marginal. The diversion of surplus from the owner to third parties may well render it non-viable. The proposed methodology thus creates appropriate incentives for risky, greenfields investments of the type under consideration here, and (iii) the methodology increases the likelihood that the project will actually go ahead. The public interest would be served better by the railway being constructed rather than the opposite.

On balance, the public interest is well served by the competitive imputation rule. This is because of the particular circumstances of this project and may not apply in other cases.

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