Gas

Draft Determination on the Proposed Access Undertaking of AGL Gas Companies

Submission

by London Economics, Joshua Gans & John Kay October 1996

Draft Determination on the Proposed Access Undertaking of AGL Gas Companies

Submission

by London Economics, Joshua Gans & John Kay October 1996

Contents

Page

1. Introduction

1

2. Terms of reference

2

3. Roles and objective of regulation

4

3.1 Regulation to facilitate bargaining 3.2 Regulation to facilitate competitive market outcomes 3.3 Regulatory threats 3.4 Minimising adverse incentives 3.5 Regulation in the NSW gas market 3.6 Summary

5 5 6 6 7 7

4. The design of the overall price control

8

4.1 Options for regulation 4.2 The length of the price review 4.3 Summary

8 11 12

5. Calculating allowable revenue - practical and theoretical considerations 13 5.1 5.2 5.3 5.4 5.5 5.6

Valuation of assets The cost of capital Operating expenditure Capital expenditure Depreciation Summary

14 16 17 18 18 19

6. Structure of access charges and the promotion of competition 20 6.1 Barriers to entry 6.2 The structure of prices 6.3 Administered charges versus price negotiations 6.4 The definition of the cross-subsidy 6.5 Summary

20 22 23 24 24

7. AGL’s incentives

26

7.1 Regulatory transparency 7.2 Potential for adverse incentives 7.3 Summary

27 28 30

London Economics October 1996

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Contents

Page

Notes

32

Annex 1: Asset valuation Annex 2: Calculation of allowable revenues

34 36

London Economics October 1996

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Executive summary

Executive summary 1. London Economics has been asked by BHP Petroleum to provide an independent review of the proposed gas access price regulation arrangements in NSW, as outlined in the Independent Pricing and Regulatory Tribunal’s (IPART’s) Draft Determination of September 1996. 2. This submission summarises London Economics’ findings in this respect. We comment on two central aspects of network regulation: §

imposing constraints on the tariffs that may be charged by a monopoly network owner to protect users and final customers; and

§

structuring tariffs to ensure that effective competition can take place in the presence of a vertically integrated network owner.

The role of regulation 3. Substantial parts of the gas industry - the transmission and the distribution network are essentially natural monopolies. The role of regulation is to set in place the conditions for maximising the value created by the industry. To theextent that the regulator is able to make credible threats, this may not require ongoing regulatory intervention. 4. The effectiveness of regulation is likely to be limited by a regulated utility’s incentive to exploit its informational advantage in relation to the regulator in order to increase revenues and profits.

Overall price control 5. The range of options for a regulatory framework range from rate of return regulation to price cap and average revenue regulation. All forms of regulation, including the regulatory approach that IPART is considering, suffer from adverse incentives by regulated utilities to exploit the informationasymmetry that is present between the regulator and the regulated company. 6. The length of time between reviews of the price control reflects a trade-off between providing efficiency incentives to the regulated company and transferring efficiency gains to customers. This balance is a key factor in determining the sustainability and legitimacy of the regulatory regime. IPART’s recommendation of a three-year review process is probably appropriate in this context.

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Executive summary

Allowable revenues 7. The calculation of allowable revenues derived from the overall price control relies on the appropriate definition and measurement of a number of key components. In practice, this has presented significant problems in the history of UK utility regulation. These issues are independent of the design of the overall price control. 8. IPART has not addressed a number of central issues that are critical in determining allowable revenues. 9. Where the valuation of assets is concerned, the proposed approach: §

is essentially circular;

§

fails to address the question ofan appropriate opening value for assets and associateddistributional issues between shareholders and customers; and

§

does not comment on how asset values will be rolled forward which is likely to affect AGL’s capital expenditure incentives.

10. The cost of capital discussion in the Draft Determinationappears to focus on AGL’s actual financial structure. This is likely to present AGL with adverse regulatory incentives to adjust its capital structure to increase its cost of capital. 11. IPART do not comment on how appropriate levels of operating expenditureshould be determined. Without further investigation, the Regulator has no means of determining appropriate levels of operating (and capital) expenditure, and what efficiencies AGL is capable of. AGL should be required to undertake independent yardstick competition analyses or detailedefficiency studies as a means of assessing potential cost improvements. 12. Determination and measurement of capital expenditureand depreciation play an important role in determining incentives by the regulated company to over- or underinvest: §

the circular approach to asset valuation could discourage investment that should optimally occur.

§

In the absence of clear regulatory guidelines for the depreciation approach, there are likely to be credibility problems and AGL will again have an incentive to distort its short and long-term decisions.

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Executive summary

The structure of access charges 13. AGL’s incentives to erect barriers to entry to undermine competition have only been addressed in passing. We are particularly concerned with AGL’s apparent ability to: §

undertake strategic price discrimination;

§

cross-subsidise different network activities; and

§

charge predatory prices.

14. These concerns are directly linked to AGL’s vertically integrated structure and its role as a competitor in the gas supply market. 15. It appears that AGL’s proposed Reference Tariffs are structured according to a standard ‘two-part tariff’approach. However, it is likely that a marginal cost pricing approach will over-recoverAGL’s allowed revenues. 16. We have concerns that the emphasis on negotiated as opposed to administered charges leaves AGL with the ability to price discriminate in order to undermine competition. Ultimately, the only feasible route to fair competition may be to unbundle charges for gas trading services from those for the gas transportation business. 17. While IPART’s definition of what constitutes a cross-subsidy based is on avoidable costs, their definition of these costs appears to deviate from common economic usage.

AGL’s incentive structure 18. The UK experience illustrates that the benefits from increased regulatory commitment and accountability may be limited if this undermines the exercise of informed judgement. However, uncertainty regarding the terms of access to AGL’s network may discourage investment by other industry participants. 19. More generally, we have some sympathy with IPART’s concerns about adverse incentives on the part of AGL to manipulate a single driving determinant of asset valuation and revenue requirements, such as the return on rate base. However, the proposedlack of certainty in the price regulation process does not imply that the incentives to AGL to manipulate future reviews are eliminated or even diminished.

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Executive summary

20. Revenue determination based on a basket of financial indicators does not remove adverse incentive effects. Indeed, it offers AGL insurance against any potential risk of losses from these actions. This is the opposite of good incentive creation in regulation which would reduce the firm’s insurance against uncertainty in order to ensure that it internalisesthe risk of poor decision-making. 21. AGL may take actions such that strong regulatory steps will harm its financial indicators without reducing its anticipated revenues in the absence of such steps. Such actions include signing take or pay contracts that are sensitive to redetermined revenues or undertaking risky investments. 22. More generally, the implications of the regulatory regime for remaining gas industry participants have not been considered. In effect, IPART has proposed to put in place a framework characterised by a substantial degree of uncertainty regarding the basis on which prices will be reviewed at the end of the next review period.

Conclusions 23. The issues raised in this submission are in many ways endemic to access price regulation. The concerns raised here outline the need for a careful review of the structure and particulars of the industry at hand, especially in any initial determination. Today, regulators play an important role in setting the agenda for other future determinations and thus, special attention must be paid to the signals sent by current determinations.

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Section 1

Introduction

1. Introduction The Independent Pricing and Regulatory Tribunal’s (IPART’s) Draft Determinationof September 19961 describes AGL’s proposed undertaking to provide access to third parties for the use of its infrastructureassets, and IPART’s preliminary findings in this regard. This submission by London Economics on behalf of BHP Petroleum reviews and comments on the approach proposed by IPART. The IPART Draft Determination covers a broad range of issues and concerns. In this paper, drawing onthe UK experience to date, we focus on those that we believe to be the most important: §

Section 3 of this paper reviews the roles and objectives of regulation.

§

The trade-offs associated with different forms of regulation and the length of the review period are discussed in Section 4.

§

Section 5 reviews essential considerations for determining an overall price cap. The manner in which each of these inputs derived is is likely to have profound implications for the operation of the proposed regulatory regime.

§

Section 6 addresses the structure of relative prices and key concerns for the development of competition in NSW.

§

Section 7, finally, considers how the specific form of regulation is likely to influence AGL’s incentives.

This document is supported by two Annexes: §

Annex 1 contains an illustrativecalculation linking together key items in the regulatory formula.

§

Annex 2 provides an overview of asset valuation techniques.

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Section 2

Terms of reference

2. Terms of reference IPART’s Draft Determination IPART’s Draft Determination comes in the context of a developing regulatory structure for gas in NSW. Prior to the introduction of a formal regulatory framework in 1990,Boards of Inquiry administered a system of ‘reasonable profit’ to determine gas tariff prices.2 After this time, the Gas Council of NSW placed AGL Gas’ five companies under separate CPI-X price control formulae. Following a request by AGL in 1993, the price control formula was replaced with a Combined Maximum Average Price (CMAP). The formula set the average tariff charge based on the costs of production, government fees, profit and CPI-X for the industry as a whole. IPART highlight the importance of competition: It needs to be stressed that the overridingobjectivein providingaccessto distribution networks is to facilitate competition in upstream and downstream markets. Access to these networks is a means to an end; it is not an end in itself. (Foreword, page i) The Draft Determination for access price regulation in NSW gas distribution is based on the following key features: §

a form of average revenue regulation where maximum prices are set with reference to the forecast ‘sustainable revenue’ stream of AGL;

§

‘sustainable’ revenue is determined with reference to a basket of financial indicators;

§

there are no limitations on contract negotiations;

§

periodic review of price caps; and

§

transitional provisions.

IPART reject strict reliance on the ‘return on rate base’ principle as a driving determinant of revenue requirement of the network. Rather, the determination of the level ofrevenue regarded as ‘sustainable’ is made with reference to a basket of financial indicators.

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Section 2

Terms of reference

These indicators include the rate of return on assets, but also: §

the nature of contracts signed;

§

the cash position of AGL;

§

risk measures based on debt and equity positions;

§

historical cost valuations of AGL assets; and

§

operating cost measures.

The Draft Determination also makes reference to a number of other important issues, including: §

the definition of cross-subsidies;

§

the appropriate rate of return, given AGL’s business risks and financial structure;

§

the role of past user contributions to network infrastructure;

§

the definition and structure of reference tariffs;

§

as well as non-price issues, including access principles, reference price services and key terms and conditions of supply.

London Economics’ terms of reference This submission comments on the two central aspects of network regulation: §

imposing constraints on the tariffs that may be charged bymonopoly a network owner to protect users and final customers; and

§

given the objective of achieving competition in the supply of gas, structuring tariffs to ensure that effective competition can take place in the presence of a vertically integrated network owner.

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Section 3

Roles and objective of regulation

3. Roles and objective of regulation Substantial parts of the gas industry - the transmission and distribution network - are essentially natural monopolies. Investment in infrastructureis substantial with material and sunk costs. The characteristics of the infrastructureare such that duplication is uneconomic, and competition in infrastructure provision only tends to occur where there are substantial volumes of trade or tariff distortions encouraging by-pass by customers. Regulation has a positiveeconomic role in industries such as gas because it can potentially ensure that the weighted sum of consumer and producer welfare is maximised. That is, regulators can take actions which ensure that value created in the industry is as large as possible. Without regulation, different parties have incentives to take actions which maximise their own value at the expense of others. Monopoly power is the archetypal such action, involving one firm choosing prices in order to maximise its own revenues. This notonly reduces the value captured by consumers, but also the total amount of value created - creating so-called dead-weight losses. In the case of access to gas distribution, we are concerned with the value created by the industry today, as well as in the future. This is determined by the decisions of: §

gas producers regarding what quantity of gas to supply and whether to invest in expanding their production facilities;

§

gas distributors as to how they operate pipelines, the technologies they choose, and the capacity they invest in; and

§

final consumers and users as to how much gas they choose to use.

Deciding the optimal combination of these decision is a difficult problem. It is certainly beyond the role of any regulator to monitor and ensure that these decisions are made appropriately. However, under two theoretical benchmarks, appropriate decision-making can be achieved even when the relevant parties behave in a unregulated and non-cooperative fashion: §

When the parties (producers, distributor and consumers) are identifiable and there are no significant transactionscosts, constructive bargaining can take place and they will reach agreements that maximise value created. Their relative bargaining strengths will then determine how this value is divided between them.

§

When markets involve a large number of participants who cannot efficiently engage inface-to-face negotiations, perfect competition can, theoretically,ensure that their individual, self-interesteddecisions will be based on price signals that accurately reflect the costs and benefits of particular arrangements.

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Section 3

Roles and objective of regulation

Thus, rather than intervene directly in decision-making, the role of regulation is to set in place the conditions for favourable decentralised outcomes. That is, the regulator can take actions that facilitate efficient bargaining, competitive outcomes or some combination of the two. We deal with each of these in turn.

3.1 Regulation to facilitate bargaining The efficient bargaining arrangement is an appropriate benchmark when there are a small number of parties negotiating. The relationship between gas producers and a distributor is one such example. However, efficient bargaining outcomes may be difficult to achieve. Two broad reasons involve information asymmetries and investment hold-up: §

Information asymmetries occur when one party does not know the value of the relationshipto the other. This can lead to inefficient bargaining breakdown as each party tries to negotiate better a deal for themselves at the risk of causing the other party to withdraw from further negotiations.3

§

Investment hold-up occurs when bargaining over price and other elements can take place after key investments have been made. In this environment, parties may distort their investment decisions to improve their later bargaining position, or because of a fear that they will not earn a sufficient rate of return after bargaining has taken place. This is sometimes termed ‘hold-up,’ referring to a situation where one party 4 delays trade in order to renegotiate contract terms.

When bargaining is not efficient, regulation can facilitate value creation by providing compulsory arbitration of disputes. This canreduce the incidence of bargaining breakdown and secure the returns to earlier investments.

3.2 Regulation to facilitate competitive market outcomes In markets with a large number of participants, face-to-face bargaining is not practical, nor is it likelyto be efficient under these circumstances. Here, competitive pressure can ensure that prices reflect the costs of production and hence can form an appropriate basis for value enhancing decisions. The retail market for gas is an example of an environment with too many participants to support face-to-face bargaining.

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Section 3

Roles and objective of regulation

However, when competitive pressures are imperfect (i.e., there are monopolistic tendencies), prices no longer send signals which result in efficient consumption. This, in turn,alters the decisions of participants in a way that reduces value created. The role of regulation in this circumstance is to provide mechanisms by which the correct prices will be generated and all market participants will be able to base their decisions on appropriate information.5

3.3 Regulatory threats The above discussion has implied that regulation takes an active role in facilitating value creation. However, it is possible that this positive role can be achieved without ongoing and explicit intervention. If the regulator can be seen as a potential player, this may constrain undesirable behaviour. For example, without regulation, a monopolist network owner will set transport charges too high, resulting in dead weight losses. If there is effective regulation, prices will be brought down, but regulation is a costly activity. If the regulator can make a credible commitment to intervene if prices are observed to be too high, a monopolist fearing this situation may limit price rises so as not to provoke a regulatory response. While not as effective as active regulation, this mechanism has the benefit that it avoids regulatory costs.6 However, the threat of regulatory action must be credible. If a regulator is perceived to have observed a breach in conduct and fails to take action, the threat of regulatory intervention and associated costs to the utility loses its significance. Beliefs about what a regulator might do can have a profound influence on the behaviour of market participants and this is the subject of our discussion of AGL’s incentives in Section 7. While this may lead to positive outcomes, it might also create adverse incentives (see below) to engage in behaviour designed to influence anticipatory regulatory actions.

3.4 Minimising adverse incentives There are limits on the ability of regulation to facilitate value creation. These limits are directlyrelated to the information asymmetry that exists between the regulator and the regulated utility. AGL has superior information to the regulator about existing and efficient cost structures and levels, investment programmes, technological choices and associated costs, and future trends 7 in demand for its services. This issue is also recognised by IPART.

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Section 3

Roles and objective of regulation

There is therefore a fundamental conflict of interest arising from the fact that the information needed for effective regulation comes from the regulated utility itself, which is interested in securing flexibility to raise prices. Moreover, different forms of regulation themselves generate adverse incentives. These incentives involve interested parties attempting to ‘game the system’.8 Thus, the role of regulation is to facilitate welfare enhancing outcomes subject to the constraint of minimising adverse incentives. In some cases, the costs of such adverse incentives or gaming can be so great as to render virtually impossible the facilitating role of regulation.

3.5 Regulation in the NSW gas market The NSW gas market iscurrently structured around AGL which acts as the sole, vertically integrated distributor/supplier of gas to all final customers. Thus, while the producer-distributor relationship might be characterised by face-to-face negotiations, the distributor-user relationship is more of a mass market. What is the role of regulation in such a mixed trading environment? To see the critical issue here, suppose that the regulator effectively facilitates efficient agreements among the producersand AGL. Those agreements will be based on their interests alone and are likely to be the same as if producers and distributor acted as a pure monopolist or group of oligopolists in the consumer/user market. This is clearlynot a desirable outcome. Therefore, regulation involves more than facilitating efficient agreements among producers and AGL. It must ensure that the final prices resulting from that agreement are reflective of costs so that users are able to make decisions based on appropriate information. Regulatory rules must balance the interestsof producers, AGL and consumers in facilitating agreements, and effective regulation involves limiting the set of agreements reached between upstream suppliers so that they reflect the interests of final users.

3.6 Summary As a vertically integrated gas distributor / supplier, AGL is in a strong position to exert market power and to reduce valuecreated by the NSW gas industry. The role of regulation is to put in place a framework that facilitates efficient industry outcomes by balancing the interests of upstream producers (existing and new), AGL and final customers by playing an active role and the use of regulatory threats. However, the effectiveness of regulation is limited by the degree to which a regulated utility can exploit its information advantage to undermine regulatory objectives.

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Section 4

The design of the overall price control

4. The design of the overall price control This Section considers alternative forms of utility regulation which set the context for the approach that IPART is contemplating. We consider the practical and informational requirementsfor implementation, the incentives for efficient operation and investment and then comment on the frequency of the regulatory review.

4.1 Options for regulation The tension between confiscating profits and inducing productive efficiency is at the heart of the regulation debate. It is encapsulated in the contrast between two types of regulatory contract or price rules: §

Cost plus regulation, or rate of return regulation comprises a profits confiscationrule that aims to achieve allocative efficiency by relating price to reported marginal or average cost.

§

Fixed price regulation comprises a rule that allows the public utility to be the residual claimant to the profits achieved by lowest cost productive efficiency.

The fact that we observe neither of these two regimes practised for very long is due to another consideration coming into play, which is that the regime must be sustainable. Public utilities supply essential services; moreover, they tend to be the sole supplier of that service in a particular region or nation. These characteristics mean that the public do not expect to be exploited, either through the inefficiency or bad management of the utility induced by one system of regulation, or through the accumulation of excessive profits by shareholders induced by the other system.

4.1.1 Rate of return regulation Rate of return regulation aims to give the regulated firm an incentive to keep prices low. Without regulation, the firm will choose prices so as to maximise profits. Therefore, by limiting its profits, it can indirectly be forced to keep prices low. In practice, regulation of this form sets the rate of return the firm can earn off its capital assets. So long as this rate of return is determined appropriately, it will give the firm the incentive to invest optimally in its capacity. This has several advantages: §

the firm is free to price to respond to changing cost and demand conditions; and

§

the nature of future investment is flexible.

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Section 4

The design of the overall price control

However, there are several (well-known) limitations to rate of return regulation: §

given that the rate of return is fixed (and profits will remain unchanged), the firm has little incentive to operate to minimise costs;

§

in an access environment, setting the rate of return for the monopolist removes its incentive to ensure that network users enter the market in a cost minimising way;9 and

§

the firm’s incentives to invest in capacity depend not only on economic conditions, but also on how the rate of return is measured.

There are means in which these incentive problems can be addressed, although each of these, in turn, require substantial information on the part of the regulator: §

if excess investment is a concern, a credible commitment to revalue assets and not consider assets that have been developed with excessive cost will mitigate against this;

§

if the optimal technological choice cannot be easily observed, the use of alternative measures including benchmarking with best practice elsewhere and a revaluation that takes best practice into account can provide countervailing incentives;10 and

§

if there is a possibility of by-pass, this might provide the firm with sufficient incentives to invest properly.

These measures may mitigate adverse incentive effects. However, the discussion in Section 5 highlights that a range of fundamental theoretical and measurement issues need to be addressed in the process. More generally, adverse incentives arelikely to be reduced if the regulator is able to issue credible threats to sanction inappropriate behaviour. However, such mechanisms will have a positive influence if they are explicit and the regulator is able to commit to carrying them out in the future. We return to this issue in Section 7.

4.1.2 Price caps Price cap regulation determines a maximum price that the network owner can charge in any given year.In practice this involves determining a rule by which an initial maximum price isset, and subsequently adjusting the price to grow at some rate below inflation (i.e. CPI-X). In theory at least, the X is set to reflect productivity growth in the industry and is reviewed periodically.

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Section 4

The design of the overall price control

Price cap regulation tends to providebetter incentives for the regulated firm to operate efficiently. This is because the firm can capture in profits the benefits of any productivity improvements until the next review period. However, in practice, afirm considering lowering costs might hesitate to do so prior to a regulatory review, in orderto ensure that the X is set low upon review. This ratchet effect undermines the incentive benefits of price caps. Another potential disadvantage of price caps on individual prices is that these can limit the utility’s ability to negotiate terms with other market participants. Subject to competition policy considerations (see Section 6), this can be addressed by allowing renegotiation to take place on the basis that other market participants are at least as well off under alternative arrangementsas they are if they purchase the service at the price cap level. Such negotiations are permitted under the IPART Draft Determination. The effectiveness of price cap regulation is limited as a result of the information asymmetry problem we have referred toabove and concerns the estimation of potential productivity improvements - this is discussed in more detail in Section 5. It should be noted that the methodology that has emerged in the UK, which identifies a strong role for the recovery of a fair rate of return, is quite different to the early expectations of how CPI-X regulation would work. In the 1980sit was envisaged that X would simply represent an estimate of future productivity growth - it is clear that in fact X captures far more than that simple statistic.

4.1.3 Average revenue regulation Average revenue regulation (sometimes called the revenue yield approach) is a form of average price regulation, where total revenue divided by total output is constrained to be no greater than a price cap and some adjustment factor.11 IPART is considering a form of total revenue regulation where AGL’s total revenue stream from the provision of network services is fixed, and this revenue must be raised from network users. Average revenue regulation allows the regulated firm price rebalancing within the confines of the overall restriction. Within a vertically integrated structure, this raises competition policy concerns (see Section 6). Average revenue regulation can only be applied when products are commensurable, for example, when the same output is delivered to different geographic areas. Under average revenue regulation, as it is carried out in the UK, TransCo’s allowed revenue depends on the total number of therms it transports. TransCo therefore has incentives to expand the volume of gas transported while underestimating future sales prospect. In order to address this, the UK regulator is currently considering linking allowed revenue to three different elements - a capacity element and different commodity elements for large and smaller loads.

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Section 4

The design of the overall price control

4.1.4 Sliding scale regulation Sliding scale regulation aims to create positive incentives for regulated firms to implement cost savings by sharing the resulting benefits with customers. Various forms of sliding scale regulation have been introduced in the US where state regulators have developed indices linked to either utility prices or revenues. Most plans specify ranges within which there is no sharing of risks (a so-called‘deadband’), broader ranges within which sharing in some proportion is to occur and limits beyond which automatic reviews and / or adjustments are required. The most substantial group of issues to be tackled in implementing sliding scale regulation is concerned with the measurement of profits (or profit equivalents). Theseproblems concern both the base level (however defined) and verifying reported figures. Given the measurement and accounting difficulties raised by this, it hasbeen suggested that the differences between operating cost & revenue projections and outturns are shared, because these are easily measurable, cashbased concepts. In the absence of unambiguous guidelines, sliding scale regulation may aggravate the problem of gaming between regulator and regulated company, and lead to a significant increase 12 in the intrusiveness of regulation.

4.2 The length of the price review The design of the price control has significant implications for the efficiency and sustainability of any regulatory regime. Even under the most meticulously conducted price review, it is inevitable that the outcomes for operating and capital expenditure will diverge from their expected values. Moreover, given the informational advantage of the firm, they are likely to differ in only one direction. Consequently, the important issue, for both the efficiency of the overall price control, and its sustainability, is how frequently unanticipated gains are shared with customers. Early proponents of price cap regulation would argue that price controls should only be reset infrequently, if at all. Advocates of this form of regulation such as Starkey and Van Pelt (1995) do, however, draw attention to the key premise underlying this form of regulation, namely, that increasedprofits for the firm will be viewed by regulators and their constituencyas somethingother than a failureof regulationitself. If this premise is false then the regulators will be under constant pressure to 13 recontract when the firm reports higher profits.

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Section 4

The design of the overall price control

It is the understanding that this premise is generally false that gives rise to regulatory mechanisms that depart from this very high powered incentive contract. At the other end ofthe scale, complete clawback of profits due to unanticipated operatingand capital expenditure efficiency gains is likely to have an unacceptably adverse impact on incentives. The important judgement to be made is where to settle between these two extremes. Having decided where to settle, the instruments should be agreed: §

Is the regime to be a fixedprice control with reviews every three years, or is a price formula adjustment mechanism to be adopted over a rather longer period?

§

Furthermore, once the transitional period is over and the regulator has gained experience, would it be possible to extend the regulatory lag?

The experience of the UK is that its regulatory system has been weakened by not appearing to include customers in the gains that were accruing to shareholders and managers of the regulated businesses in the first few years after privatisation. By the time the gains began to flow to customers following the first quinquennial reviews, the system had ceased to command broad public support and has become unsustainable. Thus, the recommendation inIPART’s Draft Determinationto review prices after three years isa welcome acknowledgment that all stakeholders should be included in the benefits of incentive regulation.

4.3 Summary It is clear that the design of the price control can have significant implications for the efficiency and sustainability of the regulatory regime. Even under the most meticulously conducted price review, it is inevitable that the outcomes for operating and capital expenditure will diverge from their expected values. Moreover, given the informational advantage of the firm, they are likely to differ in only one direction. Consequently, the important issue, forboth the efficiency of the regime, and its sustainability, is how frequently unanticipated gains are shared with customers.

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Section 5

Calculating allowable revenue practical and theoretical considerations

5. Calculating allowable revenue - practical and theoretical considerations Put at its simplest, the job of a regulator is to determine allowable revenue for a period of time, that is to determine the price of the regulated output for a period of time. The number of inputs into this process is small. They are: §

an opening asset valuation;

§

a cost of capital;

§

expected values for operating expenditure;

§

expected values for capital expenditure; and

§

expected values for depreciation.

The approaches by which allowablerevenue can be calculated is reported in Annex 2. Energy regulators in the UK have adopted the cash-flow approach to setting prices. While the derivation of allowed revenue is straightforward, the measurement of each variable raises quite different practical and theoretical considerations depending on which variable is being considered. It appears that these issues have not been considered by IPART in sufficient depth: §

The measurement of the asset value and the cost of capital raise distributional, commitment and credibility issues that are largely invariant to the design of the regulatory constraint.

§

The measurement of the operating and capital expenditure and depreciation highlight the problemof asymmetric information between the regulator and the regulated company. How each variable is calculated, especially operating expenditure, will have key implications for the incentive properties of the regulatory system.

Before considering each ‘building block’ in turn it is important to recognise that the approach to price setting which has evolved in the UK is quite different to what is being proposed for AGL. The proposed IPART approach is to calculate revenue requirements based on a range of indicators, and then to ensure that the present value of the net revenue stream is reasonable, that is, it lies between historic and replacement cost asset values. While we recognise the need for regulatory discretion, this approach to price setting is circular and potentially capricious, as we discuss in the next section.

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Section 5

Calculating allowable revenue practical and theoretical considerations

5.1 Valuation of assets The opening asset valuation should be the fixed point in any system of regulation. An asset valuation that is based purely on the present value of net revenues is circular and leaves the shareholder at risk of capital expropriation, which will require compensation through a higher rate of return. Moreover, such an approach sets no clear standard for judging the efficiency of tariffs, or its distributional implications. Different approaches for asset valuation are set out in Annex 2 to this document. The cost of a marginal investmentis based on the actual cost of purchasing the asset and the opportunity cost of capital. Applied to a network, an efficient set of prices would recover: §

the opportunity cost of capital on the replacement cost of the assets; and

§

the consumption of the assets (or full replacement cost depreciation).

There may be good distributional reasons why regulators may be unwilling to allow the firm to recover such costs in their entirety, but the Draft Determination does not touch on these. It appears that the only constraint on IPART’s discretion on setting allowable revenues is that the present value of those revenues should lie between historic and replacement cost values. An indication that this approach to price setting is circular is summarised by two quotes on two consecutive pages of the Draft Determination: The Tribunal wishes to emphasisethat the rate of return on the regulatory asset base is only one indicator used testto the reasonableness of the sustainable revenue stream and the resulting prices (page 19). Note that the sustainable revenue stream has been used to determine the asset value, not that the asset value has been used to determinethe revenue stream (page 20, emphasis added). These two remarks appear to be circular. The opening value of the assets, and the basis for rolling the asset base forward, should be immutable. IPART should reconsider the issue of asset valuation.

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Section 5

Calculating allowable revenue practical and theoretical considerations

5.1.1 Customers’ versus shareholders’ interests There are two obvious bases for deriving the opening value of assets: §

the flotation / market value of the company (or a variant thereof); or

§

the replacement costs of the assets.

If a company is valued for less than the replacement costs of the assets, then allowing shareholders to receive a return on the entire replacement costs of the assets will hand them a windfall gain. Thus, basing the opening asset value on the market value preserves the existing distributional settlement between shareholders and customers. A separate question is how the asset base is rolled forward over time. itIfis a regulatory objective that regulated prices should be efficient in the long run, then a regulator may start from the market valuation of the company and put in an automatic mechanism such that as assets are replaced the regulatory value of the company tends towards thereplacement costs of the assets - this is essentially the approach the Monopolies and Mergers Commission took in the case of British Gas. If, however, the market valuation of the assets is so far below the replacement cost then it may not be feasible to reduce the gap because it would involve an unacceptable redistributionof income from customers to shareholders. This is the viewtaken by the water regulator in the UK - new investment earns a full rate of return but even when all assets have been replaced there will bea wedge between the regulatory and replacement cost values.14 What is important is not necessarily the particular method chosen, but that a method is chosen so that all stakeholders understand the distributional settlement, and so that shareholders can be assured that their assets will not be expropriated. The reluctance of IPART to specify an asset value will not be emulated by commentators, customer groups and shareholders, eager to establish the size of the slices of the cake accruing to particular groups. The treatment of the opening asset value, and the manner in which it is rolled forward requires a rule. The treatmentof the other inputs into the process requires guidelines, as we now discuss.

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Section 5

Calculating allowable revenue practical and theoretical considerations

5.2 The cost of capital IPART’s cost of capital calculation applies a Capital Asset Pricing Model (CAPM) approach to what appears to be AGL’s future capital structure: In future years, the capitalstructurewill changeto reflectthe applicationof the Gas Customers Reserve Account (GCRA), and this will have a corresponding effect on AGL’s WACC. (page 19) We have not verified the precise nature of the AGL’s cost of capital calculations. However, we would emphasise the following principles: §

The calculation ofthe cost of capital should be open and transparent, revealing data sources, measurement techniques, sample sizes and other relevant information.

§

When establishing the cost of capital for a regulated company the following guidelines should be followed: 1.

Gearing (or leverage) of the company should be based on the optimal level, rather than the actual level adopted by the company. If the regulator permits the cost of capital to reflect actual gearing levels, then the company may have an incentive to choose a sub-optimal position at the price review which is then 15 adjusted post-review to allow the company to benefit.

2.

The cost of equity should be calculated on the basis of the CAPM with the correct adjustment for the equity beta to take into account the optimal, rather than actual gearing. A range of beta values, based on the standard error of the beta estimate, should be considered. Where no actual beta value can be found, comparative beta estimates should be considered - from other domestic utilities and international gas companies - with adjustments made to take into account: ⇒ differences in regulatory regimes; and ⇒ expected differences in non-diversifiable risk (arising from differences in customer base etc).

3.

Finally, the cost ofdebt should be measured as the risk-free rate from the cost of equity calculation, plus a premium. The premium should either be based on the observed premium for bonds from this company over and above the equivalent maturity government bond redemption yields, or a comparison of comparator premia - derived from the same sources as the comparator beta values.

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Section 5

Calculating allowable revenue practical and theoretical considerations

5.3 Operating expenditure In determining expectations of operating expenditure, capital expenditure and depreciation we begin to consider the problem of asymmetric information inherent in regulation. Quite simply, the regulator has no way of knowing what operating expenditure efficiencies the firm is capable of. The manner in which the regulator forms his or her expectations has important implications for the efficiency of the regulatory regime. IPART have not beenexplicit in how forecast efficiencies have been derived, although the Tribunal and AGL are considering a forward looking revenue path expressed as “CPI-13, 10, 7” (page 15). There are a number of ways in which a regulator can form expectations: 1.

extrapolation of past performance;

2.

productivity elsewhere in the economy;

3.

productivity elsewhere in the industry - yardstick competition; and

4.

conduct detailed efficiency studies of the firm’s activities.

Extrapolation of past performance can be expected to have poor incentive properties unless the firm is so myopicthat it does not realise that straining to achieve a productivity rate now will simply result in that rate forming the basis for future price reductions. Option 2. is likely to give unsustainable outcomes - depending on which sector of the economy is chosen the firm will receive an undemanding price regime, leading to protest from customers, or an excessively demanding regime leading to financial distress for the firm. In multi-firm industries, yardstick competition is likely to be an effective way of both encouraging productive efficiency and reducing prices to customers - essentially the regulator sets prices on the basis of average costs in the industry (oreven lowest cost in the industry) which encourages firms to reduce costs which will result in lower prices. The difficulty with this approach is that firms are not directly comparable, but there are a number of techniques available to estimate efficiency, after taking into account firm specific characteristics. If the firm is a single monopolist, and there are no obvious comparators, then in order to establish the scope for future efficiency gains the regulator may need to send engineers and management consultants into the firm to conduct efficiency studies of the firm’s processes and audit the forecasts of future operating expenditure. On the basis of this information, the regulator may be better equipped to understand what productivity gains can be achieved.

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Section 5

Calculating allowable revenue practical and theoretical considerations

Guidelines in this area should be minimal and should essentially relate to best regulatory practice. Revelation of the basis on which operating expenditure targets aremade may precipitate a strategic response from the firm resulting in a sub-optimal long run outcome.

5.4 Capital expenditure Capital expenditure allowances do not impact on allowable revenue by as much as operating expenditure and depreciation, because only the financing cost of capital expenditure (i.e. depreciation and the required rate of return) 16 is covered by allowable revenue. What is important is that the design of the regulatory regime itself should not impart perverse incentives to over- or underinvest.Underinvestmentcan occur when regulators cannot commit to remuneratingpast investment. In this context, a circular approach to asset valuation will tend to discourage investment that should optimally occur. This is because, under the proposed IPART methodology, the asset value derived bytaking an NPV of future revenues is only likely to be equal to the money shareholders have actually invested by chance. This reinforces the need to fix the opening asset value and the manner in which it is rolled forward. Overinvestment occurs if, given a consistent approach to asset values, the firm expects the regulator to allow a rate of return greater than the true cost of capital more often than he/she allows a rate of return that is lower than the true cost ofcapital over the entire life of the asset. Since the chances of this happening are not that great, whilst the downside is potentially quite large, the incentives to over-invest in the classic Averch-Johnson sense are not that serious. However, clawback of unspent capital expenditure, like clawback of extraordinary profits resulting from unanticipated efficiency gains, can be expected to be distortionary.In the UK, Ofgas have proposed to clawback the revenue associated with unspent capital expenditure from the previous period - this completely removes the incentive to economise on investment plans, and tilts the balance strongly in favour of sub-optimal over-investment.17

5.5 Depreciation The issue of depreciation is strongly linked with both the asymmetric information problem and the asset valuation problem discussed above. Depreciation can either be calculated on a replacement cost or renewals basis. In the former case the regulator must take a view on the extent to which the replacement cost value of the assets will change from year to year. If depreciation is calculated on a renewals basis, the regulator must take a longer term view of capital expenditure requirements and set the depreciation profile to ensurecash-flow neutrality over the period - this has

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Section 5

Calculating allowable revenue practical and theoretical considerations

the advantage of avoiding the large gaps that can develop between capital expenditure and depreciation. As for the asset valuequestion, guidelines should be established which give a clear indication of the methodology the regulator proposes to adopt otherwise credibility problems about the remuneration of past investment will emerge. For example, a regulator could choose replacement cost depreciation when capital expenditure is high relative to depreciation but then switch to a renewals approach when the major investment programme has finished. This would result in temporarily low prices but would deter any new investment.

5.6 Summary This Section has outlined how the calculation of each element of the allowable revenue calculation can affect behaviour. These issues have not been sufficiently addressed in the design of the proposed NSW access regime: §

IPART’s proposed treatment ofthe opening asset value appears to be circular and the manner in which it will be rolled forward has not been clarified.

§

The calculation of AGL’s proposed cost of capital appears to have been based on AGL’s current and forecast capital structure. Given that this approach is likely to present AGLwith adverse gaming incentives, the cost of capital should be calculated independently of AGL’s position.

§

It is not clear how IPART intends to form a view regarding appropriate levels of operating and capital expenditure.Yardstick and engineering comparisons represent one approach for overcoming the information asymmetry of the Regulator vis a vis AGL. At the same time, AGL should retain sufficient incentives to invest appropriately.

§

Where depreciation is concerned, IPART should establish guidelines which give a clear indication of the methodology the regulator proposes to adopt in order to address credibility problems about the remuneration of past investment.

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Section 6

Structure of access charges and the promotion of competition

6. Structure of access charges and the promotion of competition The NSW gas market is essentiallystructured around AGL which currently acts as the sole, vertically integrated distributor/supplier of gas to final customers. AGL has contracted with the upstream Cooper Basin producers for gas supplies to all customer classes. The previous discussion of the role of regulation has taken the structure of the NSW gas industry as given. However, there are numerous issues that arise because of the vertically integrated structure of the industry. Any serious reforms aimed at producing competitive outcomes in the gas industry have to address the question of the overall industry structure.

6.1 Barriers to entry Concerns with insufficient competitive entry in vertically related markets focus on the possibility of strategicbehaviour by firms to create barriersto entry. The implication of this threat for price regulation is that the ability of the network access provider to engage in the following should be limited: 1.

Strategicdiscrimination: placing itself at a cost advantage relative to its downstream competitors by implicitly charging access prices to itself lower than those charged to other firms.

2.

Cross-subsidy: subsidising unduly low margins downstream, for example, with unduly high network access prices.

3.

Predation:setting retail and network access prices at a level which will prevent other equally or more efficient firms from earning sufficient margins to enable them to remain competitive, thus deterring entry or inducing exit from upstream and downstream markets.

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Section 6

Structure of access charges and the promotion of competition

In order to achieve these aims there are two general principles of access pricing, frequently referred to as the Baumol-Willigconditions,which are designed to deal with economies of scale (where costs per unit fall as output increases) and scope (where total costs fall when activities are carried out together rather than separately). The conditions may be stated as follows: 1.

No price, or set of prices, shouldexceed the stand-alone costs (SAC) of providing the service or services, where stand-alone costs are determined as the costs an efficient competitor would incur in providing just that service or group of services.

2.

No price, or set of prices, should be less than the incremental (or avoidable) costs of providing the serviceor services, where incremental costs are the additional costs incurred by the monopolist in providing just that service or group of services.

These are designed to mimic the constraints of contestable marketsand should ensure that a network access monopolist is unable to earn more than a competitive rate of return, engage in predation or cross-subsidisation and that inefficient bypass is deterred. However these conditions do not select a singlepricing scheme and hence an analysis of individual schemes is still necessary. IPART has set out the following basic criteria which a network access pricing regime should satisfy: 1. charges should permit the infrastructureowner to recover its network costs and to earn a “reasonable level of profit”; 2. charges should not price off the network those customers who could cover the avoidable costs of their use of the network; 3. charges should preclude inefficient network by-pass; and 4. charges should facilitate the development of efficient upstream and downstream competition. How the first of the above objectives can be achieved has already been considered in Section 4. In this Section we consider the latter three goals. It is intended that the Regulator will determine Reference Tariffs for network access services which are compatible with these aims. However, these Reference Tariffs are not to preclude a customer and a network service provider from entering into individual negotiations to determine an alternative price which reflects cost and market conditions. Within the framework of access pricing principles, negotiation is viewed by IPART as a vital element.

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Section 6

Structure of access charges and the promotion of competition

6.2 The structure of prices First, however, what structure should prices take? The structure and derivation of the proposed Reference Tariffs has not been clarified in the Draft Determination. A standard discussion of network pricing begins from the premise that efficient marginal cost prices are insufficient to recover the costs of the business. In fact, the opposite is often the case. Utility regulators rarely allow the recovery of the full replacement cost depreciation or allow the firm to earn a full return on theentire replacementcost assetvaluation,in particular when assets are sunk. Indeed, IPART state that it will permit AGLearn to a return on assets somewhere between historical cost and replacement cost valuation. Joshua,can we put in a sentence here to say that it is not really appropriate to try and recover replacement costs on sunk assets, specially if they have been valued at historical cost in the past? The question of the basis on which existing network assets are valued then has wider implications for the optimalstructure of charges. Whether or not marginal cost charging will lead to cost over- or underrecovery in the specific case of AGL depends on three factors which work in opposite direction: §

In the presence ofeconomies of scale and scope, marginal cost pricing will lead to cost under-recovery.

§

In the presence of substantial excess capacity, marginal cost pricing may lead to cost under-recovery.

§

However, marginal costs are forwardlooking and are derived within a replacement cost framework. Marginal costpricing will then be greater than average costs andlead to cost over-recovery, if large parts of the network are valued on a historical cost basis, rather than at replacement cost.

The net effect of these three forces is an empirical matter and cannot be determined ex ante. Thus, average cost allowed to be recovered by the regulator may be less than marginal cost. This is also likely to be the case for AGL, since the regulatory asset base has been set at less than the replacement cost value. Thus, unless prices are hopelessly out of line with costs it is unlikely that points (2) and 18 (3) of IPART’s criteria will be violated.

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Section 6

Structure of access charges and the promotion of competition

6.3 Administered charges versus price negotiations As a vertically integrated player, AGL is in a position to exert significant market power on potential competitors in order to deter entry in downstream markets. In the absence of vertical integration,we would agree that a regime of negotiated charges (subject to an overall revenue constraint) 19 would be superior to the regulator administering network prices. It should be remembered, however, that bargaining and negotiation can be costly and can also result in inefficiencies. It is crucial, therefore, that the framework within which negotiations take place is one designed to maximise the likelihood that efficient agreements will be reached. In short, a general message of modern bargaining theory is that bargaining costs (i.e. delays, break-downs in negotiations, impasses, failure to reach efficient agreements etc.) increase with the amount of private information held by the parties. Efficient and effective outcomes are more likely to occur, the greater the amount of information shared between the parties. From the standpoint of encouraging economic efficiency, therefore, the regulator’s task should be to ensure that all information concerning the network service provider’s costs is made known to those entering into negotiations with it. These considerations are consistent with the recommendations in the Hilmer report relating to access to “Essential Facilities” and reflect our comments on the role of regulation in Section 3.1: To facilitate negotiation of appropriate access agreements once a facilityhas been declared,the owner of the facility should be required to provide relevantcost or other data to the party entitledto seek accessand, if need be, to the arbitrator. (Hilmer Report, page 256) However, if the network service provider is vertically integrated either upstream or downstream - and both are the case for AGL, the conclusion that negotiated charges are preferable to administered charges becomes far less obvious. Much depends on the protection afforded to actual and potential competitors in the verticallyrelated markets by competition policy and the regulatory regime. Weakcompetition rules or ineffectual regulation deters optimal entry, whereas pro-competitor regulation (as opposed to procompetition regulation) can result in a backlash from the incumbent - both Oftel and Ofgas have had a poorrelationship with, respectively BT and BG, as a result of their efforts to promote competition. Ultimately, unless competition rules are flexible and speedy dispute resolutions are possible, the only feasible route to fair competition may be to further unbundle the trading activity from the transportationbusiness - this has been the result in the gas and telecommunications markets in the UK. Only then, irrespective of the efficiency of actual prices charged, will all parties be assured that they are being charged on the same basis as all the players in the market.

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Section 6

Structure of access charges and the promotion of competition

6.4 The definition of the cross-subsidy While the IPART Draft Determination recognises that the existence of different rates to different market segments does not in itself amount to cross subsidisation, and that a subsidy exists if the rate does not cover avoidable costs, their definition of such costs appears to deviate from common economic usage. Avoidablecosts in the tariffmarketincludethe operating,maintenance and connection costs of supplying the tariff market and the opportunity cost of utilising assets to supply the marketwherethe assets and fundsemployedin those assets could be used more profitably elsewhere. (page 17, emphasis added) Most commonly, avoidable costs are defined as those costs that would not be incurred if a user or group of users did not receive the service.20 This definition excludes joint costs among users, and the inclusion in IPART’s Draft Determination of opportunity cost of funds aspart of avoidable costs is inconsistentwith standard definitions of avoidable costs. If an asset has been purchased and is effectively sunk,then if some users do not utilise the 21,22,23 asset, those costs remain unchanged and are therefore not avoidable.

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Section 6

Structure of access charges and the promotion of competition

6.5 Summary This Section isconcerned with the structure of Reference Tariffs which AGL is proposing to post for potential competitorsand focuses on three separate issues: §

the structure of these tariffs;

§

AGL’s ability and incentives to price discriminate in order to undermine competition; and

§

the definition of the cross subsidy.

The basis on which these Reference Tariffs are likely to be derived is unclear. Given the tension between an asset valuation approach below replacement costs and the forward looking nature of marginal costs, charges below marginal costs may be appropriate. More importantly, as a vertically integrated supplier, AGL has strong incentives to price discriminate against potential entrants. Finally, while IPART propose to define cross-subsidies on the basis of avoidable costs, the definition of thesecosts that has been used in the Draft Determination requires clarification.

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Section 7

AGL’s incentives

7. AGL’s incentives This Section comments in detail to the proposed approach for determining AGL’s revenues. IPARTproposes to regulate AGL’s maximum prices with reference to a forecast ‘sustainable revenue’ stream. Sustainablerevenue is determined with regard to a range of publicly available financial indicators. The basic rationale for using a range of financial indicators is to prevent AGL from taking actionsdesigned to manipulated any single indicator. In effect, IPART is proposing to play what game theorist’s term a “mixed strategy.” Such a strategy involves placing weights on each possible method of revenue determination in such a way that AGLcannot game any single method. The logic here is akin to a tennis player mixing up shots to an opponent’s left and right side. This approach prevents an opponent from becoming prepared for any particular shot. However, the success of a “mixed strategy” depends on just that: it mustbe completelymixed. Providing certainty on any particular 24 Below we show dimension can undermine the basis for the entire approach. that IPART’s proposed approach, while correct in spirit, falls short of its desired goal. IPART claim that: The use of indicatorsbasedon publiclyavailableor easily accessible information reduces the problemsof informationasymmetryprevalent in regulatoryregimesaroundthe world. The Tribunalhas taken the view that reliance on any singleindicatormay distortthe Regulatory framework by encouraging inappropriate behaviour. (page 10) However, it is difficult to agree with either of these claims: §

The majority of financial indicators used must come from AGL, and hence there is scope (and indeed an incentive for) misreporting.IPART do not explain how this information will be obtained.

§

As we shall discuss in more detail below, there are actions that AGL can take that can distort each of these indicators in a way that improves their average revenue over time and in subsequent reviews. Thus, even if these indicators can be measured accurately, there are no provisions in the proposal that prevents their manipulation.

The expectation that no such manipulation will occur appears to rest on the notion that inappropriate actions can only affect single indicators. Such an implicit assumption would support the rationale for a mixed strategy approach to regulation. Hence, it is argued that AGL would not have adverse incentives since such actions are costly and each single indicator receives a small weight in the basket. However, this does not imply that AGL will not take such actions. Since a number of the financial indicators listed are, in fact, closely linked, IPART has in effect reverted to the use of, perhaps not one, but a very limited range of indicators of AGL’s financial status.

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Section 7

AGL’s incentives

In addition, IPART’s intention to rely on a number of financial indicators has implications for remaining gas industry participants which have not been considered. In effect, IPART has put in place a regime characterised by a substantial degree of uncertainty regarding the basis on which prices will be reviewed at the end of the next review period. If this increased uncertainty gave AGL incentives to reduce access charges, this would not present a difficulty for other participants. But to the extent that it fails to achieve this end, IPART’s proposed approach leaves other market participants with little indication of what is likely to be an appropriate price path for transportation charges. This undermines their ability to take appropriate decisions.

7.1 Regulatory transparency The question of regulatory commitment and accountability is receiving increasing attention in the UK. One effect of increased judicial or public (MMC) review of the regulatory process has been that it has increased the reluctance of regulators to provide detailed rationale for their decisions. It is easier to mount legal challenges to the steps of an argument than to the simple exercise of a general discretion whichstatute undoubtedly confers on the regulator.25 However, in many instances the sought for clarity and transparency of regulatory procedures and formulae, is largely illusory. The UK experience has shown that many regulatory decisions can only be made with the exercise of informed judgement. It is certainly possible to construct formulae which would, in whole or in part, provide answers to these questions by arithmetic rules, rather than regulatory discretion. At the same time, there isa risk that the operation of these formulae would be arbitrary and unfair. More importantly, regulated companies would almost certainly attempt to manipulate the parameters of these formulae. The demand for greater precision and less discretion in regulation is therefore often a demand for a combination of the more extensive use of these formulae together with a much larger role for the Courts in interpreting such statutory requirements as “the proper financing of functions” and “the promotion of effective competition”. The practical issues is therefore, whether decisions on such issues as the market consequences of price discrimination or the reasonableness of efficiency targets, are better made by regulators, or by judges. However, there are good reasons for thinking that these considerations do not apply in AGL’s case. Our primary concern is that, far from removing AGL’s incentives to game, the proposed system of financial indicators aggravates the adverse incentives. We comment in greater depth on this issue below. Secondly, AGL acts as a key infrastructureprovider and link between upstream producers and final customers. The degree of uncertainty surrounding AGL’s overall price cap and hence the likely level of access

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Section 7

AGL’s incentives

charges over the medium-term planning horizon is unlikely to encourage investment by potential competitors and hence benefits to final customers.

7.2 Potential for adverse incentives IPART’s proposed approach provides AGL with significant adverse incentives. Thisbecomes apparent if regulatory decision-making is thought of in two stages. In the initial or regulatory determination stage, the regulator chooses a mechanism and approach for regulation. In the future or regulatory redetermination stage, the regulator reviews the price caps and other decisions in light of new information. Between these stages,the regulated utility chooses its own behaviour based on knowledge of the initial determination and its anticipation of the regulator’s future behaviour. The regulated firm seeks to maximise its profits over the entire time frame.As such, the regulated firm will consider very carefully how their actions at the end of stage one, affect the Regulator’s decisions in stage two. This essential model captures most of the concerns regarding adverse incentives. Consider these examples: §

Suppose the regulator announces a policy of rate of return regulation in Stage 1 with an intention to review prices in Stage 2, again based on rate of return using historic costs as a measure of the rate base. Anticipating the Stage 2 continuation of the policy, the firm knows that if it can expand its rate base it will make more profits. Hence, its anticipation of a continued policy of rate of return regulation adversely affects the firm’s investment behaviour.

§

Alternatively, suppose that the regulator intends to use rate of return regulation, but that this time the investment chosen by the firm in after Stage 1 is sunk for the entire life of the industry. In Stage 2, the regulator will maximise social welfare by using scrap value as its measure of the rate base as this is most likely to lead to optimal pricing. Anticipating this, the firmwill realise that it will be unable to cover the costs of its investment and hence, will choose to under-invest. Even if the regulatormakes a promise not to use scrap value in Stage 2, unless this promise is credible, the firm will fear a scrap value approach and curtail its investment.

The difference between these two conclusions rests on what the firm believes the regulator will do. IPART correctly point out that committing to any particular method of price redetermination can lead to adverse incentives. However, the question is: does not committing to a particular method of future redetermination reduce those incentives?

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Section 7

AGL’s incentives

7.2.1 Implications of IPART’s proposed regulatory approach IPART’s proposals can also be viewed as part of a two-stage process. In Stage 1, IPART set out an initial price determination and also the method for redetermination. The redeterminedmethod involves reviewing the price cap on the basis of a basket of financial indicators. What can AGL anticipate about how the Stage 2 redeterminationwill actually occur as oppose to the announced criterion. In other words, what has IPART committed to do in Stage 2? IPART claim to have committed to have a redetermination based on the indicators. All of those indicators have something in common: they reflect the financial viability of AGL. IPART is concerned for the continued viability of AGL and have stated their “responsibility not to jeopardise the financial integrity of the infrastructure owner.” This promise not to redetermine prices in such away as to raise the risk of bankruptcy of AGL is a credible one - it is not in the interest of producers or final users see to the distribution network cease operations. Thus, while AGL cannot anticipate the precise price redetermination, it can be assured that any redeterminationthat harms its financial integrity will not be carried out. This anticipation is likely to adversely affect AGL’s revenues. In its investment expenditures and otheractions, such as contractual negotiations and terms, AGL will often face a trade-off between: §

the expected revenues from these actions; and

§

the volatility of those revenues.

No profit maximising firm will choose a path that raises volatility without resulting in a higher expected revenue, as this imposes additional risks without greater return. In the normal operation of its business, AGL will then choose its actions to balance risk and return. However, IPART’s credible promise not to jeopardise the firm’s financial integrity alters this balance, adversely, in favour of greater return and greater risk. To see this, note that the costs of greater risks AGL to are losses in the event of lower than anticipated demand. However, given IPART’s promise, AGL knows that, if it is at risk of financial harm, IPART will favourably review revenues. Even if demand is high at the time of the redetermination, the basket of financial indicators will demonstrate that risk analysis for the firm is not conducive to price decreases and may favour anincrease. At Stage 2, IPART cannot refuse to take into account these risks as they are real by that time.

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Section 7

AGL’s incentives

7.2.2 Illustrative examples Consider some examples of actions which AGLmay take that unfavourably harm its risk assessment without reducing its anticipated revenues (in anticipation of IPART’s promise): §

Agreeing to price sensitive contracts. The terms and conditions of contracts are listed among the financial indicators that IPART will take into account in price redetermination.If AGL signs a series of take or pay contracts that are sensitive to redetermined revenues or reference tariffs, then it is forcedto reduce contracted prices accordingly. AGL, however, knows that no unfavourable redetermination will likely occur, because IPART will be concerned about the adverse affect this will have on financial viability.

§

Risky investments. If AGL invests in a pipeline to attract business from another state or location this is risky because it may simultaneously face new competition. Nonetheless, such investments can allow it to earn higher average revenues. Such investments alter the risk profile of the firm. Thus, on redetermination, revenues will have to be maintained so as not to risk AGL’s financial integrity. This is of particular concern if the gas distributor’s activities are not ring fenced.

§

Inefficientgrowth of the tariff market. AGL might decide to engage in inefficient growth of the residentialmarket (there is some evidence to suggest that thishas been AGL’s policy in the past). It could do this by setting low connection charges to consumers and offering initial discounts on usage. The effect of this would be similar to expanding the rate base of AGL. Inefficient expansion can affect AGL’s financial viability in the short-term with a view to raising future Reference Tariffs to already connected users (who face high switching costs).

§

Accounting difficulties. AGL’s method of accounting for profits and costs could be manipulated in such a way as to make them look at risk.26 Most accounting procedures are designed toeliminate reporting of too little risk.

7.3 Summary We have some sympathy with IPART’s concerns about adverse incentives on the part of AGL to manipulate a single driving determinant of asset valuation and revenue requirements,such as return on rate base. However, IPART’s basic approach of a lack of transparency in its price regulation process does not necessarily imply that the incentives to AGL to manipulate future reviews are eliminated or even diminished.

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Section 7

AGL’s incentives

Revenue determination based on a basket of financial indicators does not remove adverse incentive effects. Indeed, it offers AGL insurance against any potential risk of losses from these actions. This is precisely the opposite of good incentive creation in regulation which would reduce the firm’s insurance against uncertainty in order to ensure that it internalisesrisk the of poor decision-making.

8. Conclusions The issues raised in this submission are in many ways endemic to access price regulation. Standardforms of price regulation carry with them issues of sensible asset valuation and the risk of adverse incentives. Regulators are constrained in that they mustpay attention to the financial consequences of their determinations, buteven this might be the subject of gaming. Indeed, the problems regulators face in this regard are similar to concerns about “soft budget constraints” facing state owned firms in the former Communist 27 countries of Eastern Europe. This makes the task of regulation in the post-Hilmer environment quite difficult. In particular, it brings to the forefront the notion that general prescriptive approaches to regulation are unlikely to be optimal. The details of the access dispute at hand have to be considered and assessments must be made regarding whether ways of alleviating the problems of information asymmetry -- specific to the industry -- are available. In the case of gas, benchmarking and tough reviews of investment decisions have emerged as regulatory solutions in both the UK and the US. Finally, it should be emphasised that regulators today play an important role in setting the agenda, not only for future determinationsin the industry, but also determinations in future access disputes. Thus, it is critical that the economic objectives of regulation be adhered and referred to in access determinations. Such an approach sends a signal to others of the criteria for regulation and hence, can strengthen the actual effectiveness of regulation in creating value.

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Notes

Notes 1

Independent Pricing and Regulatory Tribunal of New South Wales, Draft Determination on the Proposed Access Undertaking of AGL Gas Companies (NSW) Limited, September 1996.

2

Gas Council of NSW, “Four Year Review of the Price Control Formula the in Tariff Gas Market,” November 1994.

3

John McMillan, Games, Strategiesand Managers,Oxford University Press: Oxford, 1992.

4

Oliver E. Williamson, The Economic Institutionsof Capitalism,Free Press: New York, 1985, Oliver Hart, Firms, Contracts and Financial Structure, Oxford University Press: Oxford, 1995.

5

Paul Milgrom and John Roberts, Economics,Organizationsand Management, Prentice-Hall: New York, 1992.

6

Another example of implied behaviour by regulators is the threat of compulsory arbitration. As Stephen P. King and Rodney Maddock, “A Strategic Analysis of Part IIIA of the Trade Practices Act,” mimeo., ANU, 1996, show in relation to the Competition Policy Reform Act in Australia, this threat may not only ensure that there is no bargaining breakdown, but that (under some conditions) the agreement reached will partly reflect the interests of consumers. The benefit of this is the avoidance legal of and court costs and the need for a dedicated regulatory institution in many industries.

7

The use of indicators based on publicly available or easily accessible information reduces the problems of information asymmetry prevalent in regulatory regimes around the world.

8

J-J. Laffont and Jean Tirole, A Theory of Incentives in Procurement and Regulation,MIT Press: Cambridge (MA), 1993; Mark Armstrong, Simon Cowan and John Vickers, RegulatoryReform,MIT Press: Cambridge (MA)., 1994.

9

Stephen P. King, “Who Took the Competition Out of National Competition Policy: Access Pricing Under Rate-of-Return Regulation,” mimeo., Australian National University, 1996.

10

Note that it is notnecessary that alternative systems be strictly comparable. If the regulator can, over time, observe productivity improvements elsewhere then this is evidence that there ought to be such improvements in the local industry as well.

11

Average revenue regulation is applied to British Gas (BG) in the UK.

12

Kay, J., “The Future of UK Utility Regulation,” The Institute of Economic Affairs lecture on regulation, delivered at the RSA in London on 31 October 1995.

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Notes

13

Starkey, M. and J Van Pelt (1995), “Productivity measurement and price cap regulation: Issues for local exchange carriers in the USA,” Telecommunications Policy, Vol. 19, No. 2 pp. 151-160.

14

To see this consider the steady state where depreciation equals new capital expenditure - the regulatory asset value on which shareholders receive a full return therefore remains constant over time and the replacement cost valuation will also be constant but at a higher level.

15

Although the Modigliani-Miller theorem holds that the company’s cost of capital is invariant to the structure of the balance sheet, it is well known that taxes and market imperfections allow the firm to manipulate its cost of capital. In a regulatory context, the firm may adjust its balance sheet in order to appear to have a higher cost of capital, only to reverse the financial engineering once the price review is over.

16

In our example in Annex 2, if capital expenditure was doubled, resulting in an increase in the present value ofcapital expenditure from 77 to 154 units, allowable revenue would only increase by 12 units.

17

An alternative, where the Regulator becomes more involved in the minutia of corporate information and seeks to establish how much of the underspend is due to efficiency savings and how much isdue to information asymmetry may be a preferable solution but raises further information questions

18

To the extent that marginal cost pricing would lead to overrecovery of costs, this may present an argument for an ‘inverse’ Ramsey price structure where inelastic customers are charged a lower price than elastic customers, given the same cost of serving each. Thus, if a regulatory decision is made to hold overall prices below marginal cost, then a charging structure which favoured households over businesses could in fact be optimal.

19

The value of negotiations to users depends on reference tariffs being determined independent of the outcomes of these. Otherwise, AGL could negotiate discounts to larger customers with an effective ability to rely on rises in reference tariffs to other users.

20

Zoltan Biro and John Kay, “Utility Cost Allocation in Principle and Practice,” in P. Burns (ed.), EffectiveUtility Regulation- The Accounting Requirements, CRI: London, 1994, Chapter 3.

21

However, this definition highlights the importance of the time horizon that is implicit behind this discussion. Costs which may be fixed in the short term, such as ongoing network maintenance and upgrading, may be avoidable over a medium- to longer-term time horizon.

22

The imprecision in the IPART proposal is also reflected in the following statement when they argue for lower connectioncharges for new customers: “These new customers will make a contribution greater than their avoidable costs, further reducing the cross subsidy.” (page 17)

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Notes

23

There is another issue here which reflects the above discussion regarding the tension betweena pricing rule (such as the Baumol-Willig definition of cross-subsidies referred to in IPART’s document) which is based on a replacement cost concept, and an asset valuation approach for determining aggregate revenues linked to historical costs (or, at any rate, a valuation less than full replacement costs). In this case, if aggregate revenues are capped below replacement costs, it will be impossible to put in place a charging structure that is consistent with the Baumol-Willig conditions (i.e. that prices are at least equal to incremental cost). IPART’s proposed framework for limiting AGL’s overall revenues is therefore appears to be inconsistent with the definition of cross-subsidies.

24

These concerns for gaming have arisen in the literature on incentives for workers within firms (see George Baker, Robert Gibbons and Kevin J. Murphy, “Subjective Performance Measures in Optimal Incentive Contracts,” Quarterly Journalof Economics,Vol. 109, No. 4, 1994, pp.11251156.

25

Kay, J., op.cit.

26

For a discussion of this issue see Stephen King and Rohan Pitchford, “A Theory of Privatisation and Corporatisation,” mimeo., Australian National University, 1996.

27

Janos Kornai, “The Soft Budget Constraint,” Kyklos, Vol. 39, No. 1, 1986, pp.3-30.

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