King-access-law

PRICING FOR INFRASTRUCTURE ACCESS Dr. Stephen P. King Competition and Regulatory Policy Program Center for Economic Policy Research Research School of Social Sciences Australian National University

I. THE ECONOMIC FOUNDATIONS OF ACCESS PRICING Before discussing appropriate methodologies for pricing access to essential infrastructure facilities, it is necessary to answer some preliminary questions. First, why do we care about infrastructure access? Secondly, even if we care about access, why should we care about the price charged for access services? Thirdly, what basis should be used to determine whether one set of access prices are better or worse than another set? A. ESSENTIAL FACILITY ACCESS Infrastructure access, through both the new Part IIIA of the Trade Practices Act 1974, and the Competition Principles Agreement, provides a solution to the 'essential facilities' problem.1 While much of National Competition Policy involves the removal of barriers to competition, there may be circumstances where competitive production is inefficient. If production involves increasing-returns-to-scale technology, or more generally a natural monopoly technology, then it is always more efficient to have only a single firm or facility involved in all relevant production. In such circumstances, competitive production will lead to excessively high costs and a waste of social resources.2 However, the existence of natural monopoly technology does not immediately imply that there is a problem with competition. While competitive production

of the relevant good or service (which may itself be an input into further production) is wasteful, the owner of an unregulated natural monopoly facility may be constrained by competition from other products. If the good or service produced by a natural monopoly facility is merely one of a number of products that are reasonably close substitutes then there may be little or no scope for monopoly abuse. As an example, consider residential gas distribution. It is reasonable to suggest that such distribution involves a natural monopoly technology. Production costs are likely to be minimised if each house is serviced by only a single low pressure pipeline controlled by one firm. Efficient production dictates that gas distribution is controlled by a monopoly service provider. If gas is simply one product in a larger market for "fuels and energy sources", then retaining an unregulated monopoly gas distributor may provide little concern. While gas distribution involves a natural monopoly, the owner of the gas distribution network will have little or no monopoly power if other fuel sources, such as electricity and oil, provide ready substitutes. In contrast, if there exists a separate gas market, where consumers have little ability to substitute between fuel sources, then the existence of natural monopoly technology in gas distribution may raise significant concerns.3 A firm with natural monopoly technology only creates regulatory problems if it either has substantial power in a final product market or if it provides an essential input to either upstream or downstream production processes. It is this latter case which leads to the 'essential facility' problem An essentiality facility involves two distinct characteristics. First, the relevant product involves a natural monopoly technology, so that it is always socially efficient to have a single producer. Secondly, the product is essential to final market production. The product must be essential to the manufacture of another good or service in that there does not exist an alternative input or production process that can enable a competitor to produce an equivalent final good or service at a comparable cost. In addition, the product is only essential if there does not exist an alternative final good or service that is able to be supplied at a competitive price without that input.4

Essential facilities provide a problem for policy makers. Allowing competition in the provision of the natural monopoly product may lead to socially wasteful facility duplication. At the same time, in the absence of any effective competition, a firm that controls an essential facility will be able to exercise considerable monopoly power, to the detriment of consumers and economic welfare. The Hilmer Report approached the essential facility problem by recommending a regulated access regime. If a facility produces a service which is both characterised by natural monopoly technology and is essential to competition in another market, then the owner of the facility must allow other firms access to that service. This recommendation formed the basis of the access regimes included in the Trade Practices Act and the Competition Principles Agreement.5 B. PRICING AND ESSENTIAL FACILITY ACCESS Requiring access, by itself, is insufficient to prevent the owner of an essential facility from abusing his market power to reap monopoly profits. While access will aid entry into relevant downstream or upstream markets, the facility owner will be able to seize all available monopoly profits by choosing appropriate pricing schemes for access.6 For example, consider the case of an infrastructure owner who controls an essential input for downstream competition. If the infrastructure owner is required to provide access to other firms, then he can no longer monopolise the downstream market. But this does not mean that the owner need forego any monopoly profits. Rather than reaping monopoly profits directly from the downstream market, the facility owner can simply seize those profits upstream by setting appropriate access prices. If he believes that there will be many firms seeking access, resulting in strong downstream competition, then the facility owner merely needs to charge a sufficiently high price for access to garner all available profits. If he believes that there will only be weak competition downstream, then the facility owner can lower the per unit price for access to encourage downstream price competition while seizing all available profits by charging each access seeker an appropriate upfront fee.

Requiring a facility owner to provide access is unlikely to substantially reduce his market power. Additional measures will be required to overcome the essential facility problem. For example, if regulators impose price controls on relevant downstream markets then the upstream facility owner will be indirectly constrained by these controls. Total profits will be constrained by final market prices. While the access provider can use a variety of schemes to seize all the available profits, he cannot seize profits that are unavailable due to the final market price controls. Alternatively, regulators could impose profit constraints directly on the infrastructure provider. The access regime recently proposed for electricity transmission infrastructure by the National Grid Management Council (NGMC) includes rate-of-return requirements that limit facility owners' profits.7 While there has been significant debate over the form of profit regulation chosen by the NGMC,8 to the degree that the rate-of-return constraints are binding, owners of transmission facilities will have less ability to abuse their market power. Constraining the prices that can be charged for access can also remove a facility owner's ability to abuse his market power. For example, restricting the type of pricing schemes that a facility owner can use will often limit his ability to seize profits from the downstream market.9 Using downstream price controls, constraining facility owners' profits or limiting allowed access prices will all help to restrict abuse of market power by an owner of an essential facility. To some degree, all these tools overlap. For example, if there are effective downstream price controls then it is unlikely to be necessary to directly restrict the upstream profits of an access provider. These profits will be indirectly constrained by the regulated downstream prices. Similarly, if an access provider is constrained by effective profit regulation, then the actual structure of access prices may be irrelevant.10 However, in general, even if an access provider's profits are directly or indirectly controlled, the access prices that he sets will have implications for economic efficiency. Returning, for example, to the access regime proposed

by the NGMC, even if a transmission company is constrained by profit regulation, there are many different pricing schemes that can be used for access to the transmission system. While all of these schemes may lead to identical profits for the transmission company, most of them will be inefficient in that they will not provide correct incentives for access users. An efficient access pricing scheme will not only prevent the transmission company from abusing its market power, it will also provide incentives for generators to choose an optimal location for their facilities, and provide consumers with incentives to choose when to operate electrical equipment. Access prices have two important roles. First, by restricting an access provider to set appropriate prices for his services, regulators can constrain the ability of an essential facility owner to abuse his market power and seize monopoly profits. Secondly, setting appropriate access prices will provide both access users and final good consumers with appropriate economic incentives. C. JUDGING ACCESS PRICES Pricing is arguably the most important element of an access regime. But how should appropriate access prices be judged? While economic efficiency provides one basis for comparison, there are at least three separate and distinct aspects of economic efficiency that need to be considered for access pricing. First, access pricing should promote productive efficiency. This requires that access prices give both the infrastructure owner and access seekers the correct incentives to produce their relevant outputs at least cost. For example, if the access provider is required to always price at average cost then he will have little incentive to operate his facility efficiently. Rather, the access provider will find it beneficial to raise his average production costs and take his profits as perquisites. Similarly, if the access prices are averaged over all buyers rather than reflecting individual costs of supply, then access seekers will have little incentive to choose their location or production process to minimise the costs of obtaining access . Secondly, access prices should promote allocative efficiency. Final product prices should reflect the social cost of production. If the production process is

not congested, then consumer prices should reflect the resources used for production. If production is constrained by congestion, then consumer prices should reflect this congestion with the constrained output going to those consumers who value it most highly. Thirdly, access prices should promote efficient investment in new facilities over time. If access prices are set so low that the facility owner cannot earn at least a market rate of return on his investment, then he will have no incentive to maintain his facility or invest in new facilities when appropriate. Alternatively, if the infrastructure owner is able to price access to reflect facility congestion then he will have an incentive to constrain capacity and increase his profits from congestion pricing. While access prices can be used to promote each of these elements of economic efficiency, it is unlikely that any single pricing scheme will be able to satisfy all of these requirements. A pricing scheme that allows for productive efficiency is unlikely to promote efficient investment. A scheme that ensures efficient investment over time will generally reduce allocative efficiency. Access pricing will either require a trade off between these different elements of economic efficiency or additional regulatory tools designed to overcome deficiencies in the pricing rules. Economic efficiency should be one goal of access pricing. However, it may not be the only goal. Section 44X.1.b of the Trade Practices Act 1974 requires the ACCC to consider "the public interest, including the public interest in having competition in markets" when making a determination of an access dispute. The Commission may also have regard to this matter in deciding whether to accept an access undertaking (s.44ZZA.3.b). These sections suggest that the public interest should be interpreted more broadly than economic efficiency. Such an interpretation would be in line with the discussion in the Hilmer report, which notes that notes the importance of "other social goals" such as "empowerment of consumers".11 The Industry Commission notes that "[c]onsistency in approach suggests that the NCC and the ACCC should be required to give priority to efficiency in resource allocation in their deliberations".12 While this conclusion is subject to

some debate, for the purpose of this paper, we will use the three forms of economic efficiency as a base to compare different access price regimes. II. ACCESS PRICING: EFFICIENCY AND COMPROMISE A. PRICING AND ALLOCATIVE EFFICIENCY A simple economic principle underlies access pricing that promotes allocative efficiency. In the absence of any offsetting effects, the optimal price is set equal to the short-run marginal cost (SRMC) of production for the last unit sold.13 The SRMC of production is the extra cost associated with a one unit increase in output. For example, if a firm needs to increase its use of labour by one hour at a wage of $50 per hour and needs to buy additional raw materials at a cost of $100 to produce an extra unit of output, then the SRMC of that extra unit is simply the total cost of the additional inputs, $150. If production occurs in a factory that is already rented by the firm on an annual contract then the SRMC would not include any part of that rent. The rent is a fixed cost for the firm in the short-run. The SRMC only includes those costs directly associated with the additional unit of output. SRMC is based on economic costs rather than accounting costs. For example, consider that in addition to an extra hour of labour and the additional raw materials, a one unit the increase in production requires the use of a machine which otherwise could be used to produce an alternative product. Then any (economic) profits that would have accrued from producing that alternative product represent an opportunity cost to the firm. Such opportunity costs need to be included in SRMC.14 Similarly, if the firm increases its production and this leads to a social loss that is not borne by the firm, this loss should be considered part of SRMC. An example is the social cost of pollution. If the relevant production facility is capacity constrained, so that no extra output can be produced in the short-run, then the SRMC is adjusted to allow for congestion. In this situation, efficient pricing involves rationing the infrastructure service on the basis of price.

SRMC pricing promotes allocative efficiency because it sends the correct economic signals to anyone wishing to obtain the relevant good or service. From an economic perspective, we would only want an extra unit to be produced and sold if the value to the person purchasing that unit is at least as great as the cost of providing that unit. If price was below SRMC there would be excessive demand for the product. If the producer were to meet this demand, then some consumers would purchase the good despite the marginal cost of production being greater than their personal value. Such consumption would be socially wasteful. It is also undesirable to set the price so that a potential purchaser who does value the output at more than the marginal cost of production is dissuaded from buying the product. Such a failure to purchase would lead to a social loss as the cost of providing the product is less than its value to the purchaser and yet the product has not been provided. The optimal regime involves price equal to SRMC. While SRMC pricing maximises allocative efficiency, it presents two practical problems which impinge on productive efficiency and incentives for efficient investment. First, if the regulator requires access to be offered at short run marginal cost, then the facility owner may have little incentive to reduce this cost. Any effort taken by the owner that improves productive efficiency by lowering SRMC is transferred into lower access prices. While time lags between the realisation of cost savings and the adjustment of access prices by the regulator may provide the facility owner with some temporary return from improved productive efficiency, the owner is unlikely to face the optimal incentives to engage in cost minimising activities.15 Secondly, access services that are produced using large infrastructure facilities such as transmission grids, rail systems or networks of pipelines, often involve significant returns to scale. Average production costs tend to fall for these facilities as output rises until the facility becomes congested, and short run marginal costs are generally less than average production costs. SRMC pricing does not allow the facility owner to cover his costs unless the facility is so congested that the congestion rents under SRMC pricing are able to

cover the owner's average costs. A facility owner who believes that he will be forced to price access at SRMC will either refuse to build a facility or will so restrict the capacity of the facility that the congestion rents will allow him to make at least an adequate return on his investment. Neither situation is likely to be economically optimal. B. IMPROVING ON SRMC PRICING 1. Non-linear pricing While SRMC pricing requires that the marginal price for access is set equal to SRMC, it does not require that the infra marginal price is also set equal to SRMC. By allowing a facility owner to use non-linear pricing schemes it is possible for him to generate a reasonable return on his investment without constraining capacity in an undesirable way. A two-part tariff, which involves an upfront fee and a per unit price, is the simplest form of non-linear pricing scheme. By setting the per unit price equal to SRMC, a two-part tariff retains allocative efficiency. At the same time, the upfront fee can be used to cover the costs of infrastructure development. Freebairn and Trace16 recommend a two-part tariff for pricing railway services to coal producers. "The first-part tariff ... would cover each mine's allocation of unattributable costs as well as the capital costs of dedicated infrastructure. ... The second-part tariff would be a per tonne of product charge based on marginal costs". When setting the upfront part of a two-part tariff, it may be desirable to allow the access provider to discriminate between access purchasers. Setting a uniform upfront fee, say, at a simple average of facility development costs, may exclude some low value users from purchasing access even though these consumers have a marginal willingness to pay that exceeds SRMC. Allowing the access provider to set a lower upfront fee for these users, but a larger fee for higher value access seekers will promote efficient facility use. Price discrimination will only be possible if resale between access seekers can be prevented. Also, both efficiency and equity considerations will require a

limit to be placed on the profits the access provider can make from the upfront fees. Without such a constraint, the access provider will have an incentive to raise upfront fees. This will provide him with two benefits. Raising the fee will limit the degree of downstream competition by creating a barrier to entry for new firms. The high fee will also enable the access provider to reap most of the profits that are created by restricting downstream competition. While two-part tariffs are the simplest form of non-linear prices, it is possible to design far more complex tariffs. Common examples include "block tariffs" and quantity discounts.17 2. Rate of return regulation The use of non-linear tariffs can allow the infrastructure owner to gain a reasonable return on his investment. However, it may be difficult for the regulator to judge whether the prices set by a facility owner represent a reasonable return or abuse of market power. To the degree that the facility owner is able to reap monopoly profits through a non-linear access pricing scheme, and in so doing distort final product competition and prices, the regulator will want to control those profits. A traditional approach to this problem involves valuing the infrastructure owner's capital stock to form a 'rate base' and allowing him to set access prices that generate no more than a regulated return on this base. This regulation, which has been used extensively in the United States for more than a century, is called rate-ofreturn (ROR) regulation. While ROR regulation is often linked with uniform pricing (above SRMC) this need not occur. Given the allowed return on his rate base, the facility owner should be encouraged to set prices that lead to optimal facility use. However, ROR regulation presents other problems. Like other regulations which limit the facility owner's profits, ROR regulation reduces the incentives for the owner to minimise production costs. In fact, ROR regulation creates incentives for the access provider to deliberately choose an inefficient mix of productive inputs. If the access provider expands his capital inputs then this will increase his rate base and raise allowed profits. Consequently, ROR

regulation tends to be associated with over capitalisation and over investment in infrastructure facilities.18 While solving the problem of allowing the owner to receive a reasonable return on his investment, ROR regulation can exacerbate productive distortions. 3. Price cap and incentive regulation Price cap regulation is a commonly used alternative to rate-of-return regulation. Unlike ROR regulation, price caps are designed to promote productive efficiency. The regulator sets a maximum price that the facility owner can charge for, say, the next five years. The facility owner can then retain all of the extra profits that he can make by reducing operating costs over that five year period until the price caps are reviewed by the regulator. The price caps can be adjusted for inflation and for expected future cost savings when they are reviewed. As a result, price cap regulation is often called RPIX regulation in the UK or CPI-X regulation in Australia. The caps are automatically adjusted for the inflation rate as measured by the retail price index (RPI) or the consumer price index (CPI) together with a reduction reflecting expected future cost savings (X). Price cap regulation has been widely used in telecommunications, to regulate BT in the UK, AT&T in the US, and Telstra in Australia.19 RPI-X and CPI-X regulation can be problematic. For a multi-product firm, such as a telecommunications company, the price cap will apply to baskets of goods. The firm will retain some ability to rebalance prices within a basket. Such rebalancing need not be economically efficient or politically desirable. For example, when initially regulated by an RPI-3 rule, BT quickly rebalanced its prices to raise local call charges and drop long distance rates. These price changes enabled BT to aggressively fight the entry of Mercury Communications Ltd in the long distance call market while raising profits through high prices in its monopoly areas.20 Reviewing the value of X has also led to a blurred distinction between price caps and ROR regulation. The resetting of X has depended on the realised profits of the regulated firm. Consequently, as the review process approaches, the firm has similar incentives to distort its costs as under other forms of

regulation. Further, even though price cap regulation is meant to involve fixed periods between reviews, in practice regulatory intervention has been forthcoming between reviews when observed profits appear too high. In practice, price cap regulation and ROR regulation appear to have similar consequences. However, this similarity is due to inappropriate reliance on historic costs and profits in reviewing the value of X. A review process based on comparisons between access providers in different markets or even different countries, which also uses other data that is not specific to the regulated firm, may offer significant advantages.21 Whether such a procedure can be practically implemented remains to be seen. 4. Efficient components pricing rule Efficient components pricing (ECPR) is a regulatory rule designed to promote productive efficiency among access seekers when there is a vertically integrated access provider. It involves a two-part regulatory process. First, final product prices are restrained by a price cap. Given this cap, the facility owner can sell access at a price that not only recoups his production costs, but also compensates him for any foregone profits from final product sales due to the additional competition from access seekers. ECPR has been strongly advocated by Baumol and Sidak for electricity and local telephone access in the US.22 The recent case between Clear Communications and Telecom New Zealand centred around ECPR (called the Baumol-Willig rule in this case). In particular, the case examined whether Telecom New Zealand's offer to provide local interconnection to Clear on the basis of ECPR was a violation of s36 of the New Zealand Commerce Act, when there were no final market price controls in place. The logic behind ECPR is both simple and, in the correct context, compelling. As an example,23 consider that the marginal cost of access is $3 per unit of the final good and the other marginal costs of providing a unit of the final good are $5. Let the price of the final good be constrained by a price cap at $10. A facility owner who is vertically integrated and operates as a final market monopolist would make variable profits of $2 per unit from final goods sales. Assume that if the facility owner provides a unit of access to a competitor in

the final market then the access provider's sales in this market decline by one for each extra unit sold by the competition. If the facility owner provides one unit of access to a competitor who uses this access to provide one unit of the final good, then the opportunity cost of providing this access is the marginal cost $3 plus the foregone profits $2. Under ECPR the access charge should be set, not at SRMC which is $3 but at opportunity cost which is $5. Why is such pricing desirable? Consider a downstream competitor who is not as efficient as the incumbent integrated facility owner. For example, the competitors cost of producing the downstream product given a unit of access might be $5.50. It would then be economically undesirable for the competitor to enter the downstream market. Such entry would result in inefficient production. However, the inefficient competitor could enter if access was priced at SRMC. If the competitor paid $3 for a unit of access and paid an additional $5.50 to produce the final product given the unit of access, then his total cost per unit will be $8.50. This is $0.50 more than the cost for the incumbent firm but is less than the market price of $10. The inefficient competitor can enter and make $1.50 profit per unit. In contrast, if access prices were set by ECPR then the total cost of production for the inefficient competitor would be $10.50; $5 for a unit of access and $5.50 to turn this unit into final product. The competitor could not make a profit at a final market price of $10. Only if the competitors costs of turning access into final product were at least as low as those of the incumbent facility owner, would the competitor be able to profitably enter when access is priced according to ECPR. ECPR can promote efficient entry and production in the final goods market.24 However, this is not the same as the productive efficiency discussed above. Rather, previous sections have discussed efficient production of access, not efficient production by the access seekers. This omission has been quite deliberate. If we are seeking to open final market production to competition by requiring the facility owner to provide access, then so long as all competitors (including the facility owner himself) can buy access at the same price then competition should drive inefficient downstream producers out of the market. If an access seeker is inefficient then an alternative producer

should be able to enter the final market, buy access and force out the inefficient producer. If the access provider himself is inefficient in downstream production then he will also be forced out of final market production and will have to retreat to simply providing access to his essential infrastructure services. Put simply, ECPR only does what we expect competition to do anyway. ECPR is a useful adjunct to downstream competition only when regulators believe that downstream competition will be either muted or distorted. For example, if regulators restrict final market entry to a single licensed firm, as has occurred in telephone carriage services in Australia, then there is unlikely to be effective final market competition. ECPR can be used in this situation to prevent the licensed firm entering markets where it is less efficient than the vertically integrated incumbent. However, a better solution to this problem may be to allow unrestricted entry downstream. Alternatively, a vertically integrated incumbent may be able to abuse its control over access to distort downstream competition and either provide its own subsidiary with access at a more favourable price than it offers to competitors, or engage in cross subsidisation in order to manipulate its regulatory regime.25 ECPR will limit these distortions. For example, it does not pay a vertically integrated producer to protect its own inefficient downstream subsidiary under ECPR as it is fully compensated for foregone profits. However, a better regulatory solution may involve tackling the distorted competition at its source by requiring the access producer to vertically divest its downstream subsidiary.26 A third situation where ECPR can aid efficient downstream entry is if regulated final product prices involve cross subsidies. For example, the vertically integrated incumbent producer may be required to cross subsidise rural consumers by charging a higher price to urban consumers. If the downstream market is opened to competition with access sold at SRMC, then new entrants will only sell to profitable market segments. New entrants will be able to undercut the incumbent in the urban market as they do not need to cross subsidise rural consumers. To protect the incumbent and maintain the

cross subsidy, access can be priced by ECPR so that new competitors in the urban market compensate the incumbent for any foregone profits through the access price. However, a better regulatory solution may involve either removing the cross subsidies from the final product prices or removing the facility owner’s burden to finance these subsidies. ECPR is most useful when political constraints prevent the introduction of fair competition in the downstream market. However, in the absence of such concerns, ECPR is equivalent to a final market price cap regime, with unregulated uniform access prices. The incentives for productive efficiency in the provision of access under a final market price cap will be similar to those that arise when access prices are directly capped. As discussed above, to the degree that future price caps are set according to current profits, price cap regulation will provide distorted productive incentives, similar to ROR regulation. Also, if the price caps are set too high, then there will be a loss of allocative efficiency. ECPR does not address either of these issues. If ECPR is used without final market price caps then the rule is the same as allowing unconstrained monopoly pricing of access. This has been recognised by the proponents of ECPR.27 However, the problem is not the access pricing rule but rather that ECPR is really a two-stage process. It is only designed to work with final market price controls in place. The access pricing rule under ECPR is not designed to promote either allocative efficiency, efficient access production or efficient investment decisions over time. Rather, these issues are handled by final market price constraints under ECPR. The access pricing rule is designed solely to promote efficient entry in the downstream market in circumstances when other distortions exist that would impede such entry and those distortions cannot be removed for either economic or political reasons. Because of its limited applicability, ECPR is unlikely to play a major role in Australian infrastructure access.

C. EFFICIENT INVESTMENT AND LONG-RUN MARGINAL COST PRICING Using non-linear tariffs, together with SRMC pricing, can promote allocative efficiency and least cost downstream production while allowing facility owners to earn a reasonable return on their investments. Utilising price caps may also promote efficient production decisions. Even so, such schemes are unlikely to promote efficient investment. Long run marginal cost (LRMC) is the cost of increasing output by one unit when both the variable costs of production and the costs of expanding the relevant facility are taken into account. Unlike SRMC, which ignores any input costs that cannot be adjusted in the short-term (for example, production capacity that is already rented on an annual contract), LRMC considers the cost of production when all inputs can be varied. Because it can allow for an optimal plant capacity, LRMC will be below SRMC whenever existing production facilities are operating above their optimal capacity. However, if existing facilities are operating below optimal capacity, LRMC will exceed SRMC.28 If demand for access grows steadily over time, then requiring a facility owner to price access at LRMC can induce efficient investment without any loss of allocative efficiency. Under LRMC pricing, capacity will adjust to the economically optimal level while simultaneously setting the access price equal to the congested adjusted SRMC. Unfortunately, if demand for access is more complicated; involving for example periods of peak and off-peak use, a variety of different peak periods say over a daily cycle, or varying around a trend rate of growth; then simple LRMC pricing will promote neither allocative efficiency nor optimal investment. If there are multiple peak periods using the same access facilities, then economically optimal investment requires expanding the facility until the total value of an extra unit of capacity to all peak users is equal to LRMC. Pricing to promote efficient investment would require that the sum of all peak period prices equals long run marginal cost. Setting price at LRMC to all users would substantially overprice access and lead to under

investment. If there are both peak and off-peak users, then LRMC pricing will lead to allocative inefficiency in off-peak periods. Peak period users will have too little incentive to substitute to off-peak and off-peak users will tend to purchase too little access. Finally, if there is a single (peak period) demand that is volatile, LRMC pricing will require non-price rationing when demand is unexpectedly high and will overprice access when demand is unexpectedly low. LRMC pricing is most likely to be useful where there is a single, well-defined peak period for access demand. In such a circumstance efficient investment is encouraged by requiring the access provider to sell reserved capacity during the peak period at long run marginal cost and to expand capacity whenever demand in the peak period cannot be met at this price. SRMC pricing can be used in off-peak periods, and upfront tariffs can recover any costs associated with initial construction that are not covered by LRMC pricing. These situations are likely to be rare in practice. In energy industries, peak use is often related to weather and cannot be predicted in advance. In water industries, new infrastructure involves lumpy investments so that LRMC is not well defined. In urban rail systems, there are usually multiple peaks in both the morning and the evening rush hours. While LRMC tariffs may provide a useful basis for access pricing in some industries, these cases will be the exception rather than the norm. D. ACCESS PRICING AND ASYMMETRIC INFORMATION Access pricing inevitably involves information asymmetry between the access provider, the access seekers and the relevant regulatory authorities. Regulators will be unable to perfectly value the assets used to provide access. Short run and long run cost information will not be easily available and the access providers who are most likely to know relevant cost figures will often have little incentive to correctly provide this information to regulators. Sensible access pricing procedures recognise this information asymmetry. For example, price cap regulation is based on the premise that the regulator will not be able to perfectly monitor cost reducing activities by the access provider.

By allowing the access provider to retain any benefits from such activities, price cap regulation compromises allocative efficiency in order to maintain a greater degree of productive efficiency. Economic theory provides a wide range of tools designed to overcome regulatory problems with information.29 The lessons from this literature are relatively simple. First, regulators need to recognise that they will often be at a disadvantage compared to access providers. There is little point requiring access providers to set capacity according to long run marginal cost when the only information the regulator has about those costs will be provided by the access provider themselves. Such a request simply invites the access provider to plead ignorance, manipulate accounting measures of cost, and pad out LRMC measures so that any reports will provide little indication of the true level of costs. Secondly, efficient access pricing schemes will try to overcome asymmetric information and recognise information constraints which are unavoidable and minimise their effect. For example, benchmarking access against comparable facilities in Australia or overseas can provide a powerful tool to overcome information problems and improve incentives. Benchmark comparisons can be used to structure price caps or revenue caps for the access provider. Because these caps depend less on the access provider's own costs and more on the costs of related businesses, the facility owner has greater incentives to operate efficiently and less incentive to distort reported costs. Similarly, where a number of participants in the market place may have relevant cost information, then the regulator can use competition between these participants to reveal information. Franchise auctions are a simple example of a regulatory scheme designed to elicit information from multiple providers.30 Regulators can also use information provided by access seekers to control access prices. This information can be indirectly used by requiring the access provider to separately price each access service and then allowing facility bypass. An example in local telephone access would require the access provider to separately price switching, switch-to-customer access, and switch-to-point-of-interconnection access, allowing long distance telephone

companies that purchase access to bypass any of these three components if they believe it is overpriced. Alternatively, regulators can directly use access seeker cost information, realising that access seekers may also have incentives to distort regulatory reports. Thirdly, practical access prices will involve compromise. It is usually impractical to try and design an access pricing scheme that satisfies all the requirements of economic efficiency. A desirable access pricing regime will trade off distortions, weighing each by its potential long term detriment to welfare. Thus, a regulator may be quite satisfied with a price cap scheme that leads to overpricing in the short term if this loss is more than outweighed by long term productivity improvements. Similarly, it may be desirable to allow an access provider significant profits through the upfront component of a nonlinear pricing scheme if this leads to improved investment incentives. An important trade off involves administrative simplicity and regulatory complexity. While such compromises are unlikely to satisfy access providers, access seekers or final product consumers, maintaining a balance of incentives, information requirements and simplicity is most likely to provide economic benefits. III. NEGOTIATED ACCESS While the ACCC will be able to influence access prices through its role in judging access undertakings and making determinations for access disputes, the main thrust of both the Hilmer report recommendations and Part IIIA of the Trade Practices Act 1974 is to provide negotiated access. The parties to access negotiations, however, will be more interested in profits than economic efficiency. This may lead to negotiated access prices that differ substantially from the principles outlined above. There will be circumstances where profit maximising access prices and efficiency coincide. This will occur for example if the access seekers use the services as an input to a product for which they have little market power or which is fully exported. A railway line, such as the Hunter Valley Railway Project, which is used to transport coal for export, illustrates this point. Given the world price for coal, the coal producers and the rail authorities both have

an incentive to operate the line efficiently. All parties will find a scheme of nonlinear prices based on congestion adjusted SRMC desirable compared to other alternatives. While the rail authority and the miners will dispute parts of the pricing scheme, such as any upfront fees, such disputes represent a "cake splitting" problem. Each party wants a bigger slice of the 'cake' but no-one benefits by choosing inefficient access prices that make the 'cake' smaller. However, this coincidence of economic efficiency and profit maximisation will be rare. If there are monopoly rents to be gained from the relevant final product markets, then the access seekers and access provider will want to construct access prices that prevent these rents from being diluted by competition. Negotiating parties will have an incentive to set access prices that sustain high final product prices while simultaneously sharing the monopoly profits. For example, if there are few access seekers and final market competition will be weak, then it will pay all parties to set a low marginal price for access (possibly even below SRMC) and use upfront fees to divide final market profits between the access seekers and access provider. Conversely, if final market competition is likely to be strong, it will pay all parties to establish a relatively high marginal access price and to use, say, rising block tariffs to divide any profits.31 The disappointing (but rather obvious) conclusion is that negotiating parties will have strong incentives to agree on access prices that promote monopoly profits rather than economic efficiency. It may not be possible for all parties to perfectly coordinate on profit maximising prices.32 Disagreement may be encouraged by the ACCC. For example, if the ACCC treats initial access complainants more favourably than other access seekers in any subsequent determination then this would undermine access price agreements that sustain and divide monopoly profits. Encouraging access undertakings may also prevent undesirable negotiated access prices. However, to the degree that access disputes are resolved through negotiation without regulatory intervention or oversight, there are strong incentives for both access seekers and facility owners to construct prices that protect profits. IV. CONCLUSION

Access pricing presents a complex regulatory problem. There are no simple rules for pricing access which maximise allocative and productive efficiency and provide desirable investment incentives except in fairly limited circumstances. Even when such rules could be applied in theory, problems of implementation will usually mean that they cannot be used perfectly in practice. A sensible approach to access pricing recognises these limitations and develops a set of rules which trade-off various theoretical and practical concerns. These rules will often be industry specific. Optimal access prices will depend on market circumstances, such as the volatility of demand and the ability to use competitive tools to overcome information constraints. There may be some industries where short run marginal costs are easily calculated and non-linear tariffs using SRMC pricing can be swiftly implemented. In other circumstances, creating spot markets for access together with regulatory oversight of infrastructure investment, may lead to desirable incentives. Access pricing will involve a variety of trade-offs. There are, however, some broad principles that will often apply. Non-linear pricing schemes will usually be preferred to uniform pricing schemes. Congestion adjusted SRMC pricing will promote allocative efficiency. Constraining any congestion rents under SRMC pricing to not exceed long run marginal costs may help improve investment incentives. Transforming relevant constraints into price or revenue caps may aid productive efficiency. Using relative performance comparisons and reducing either explicit or implicit reliance on rate-of-return type procedures will also aid incentives for efficient production. Where access prices are set by negotiation between access seekers and the facility owner, there will be strong incentives for the negotiating parties to agree on prices that maintain and divide downstream monopoly profits. In some limited cases this will provide few concerns. But in general, negotiated infrastructure access may lead to few if any gains compared with integrated monopoly. Access pricing will involve compromise. It is important for regulators to recognise their information constraints and to work to limit the problems

created by these constraints. It is also important to recognise the costs of regulation and the need for simple, workable solutions to access pricing problems. While there is not a 'one size fits all' solution, there is scope for innovative approaches which recognise the needs and incentives of all parties. See The Commonwealth of Australia (1993) National Competition Policy: Report of the Independent Committee of Inquiry, (The Hilmer Report), AGPS, Canberra, especially chapter 11. 1

For a general discussion on these type of production processes, see S. King and R. Maddock (1996) Unlocking the Infrastructure, Allen and Unwin, St Leonards, particularly chapter 5, or M. Waterson (1987) "Recent developments in the theory of natural monopoly", Journal of Economic Surveys, 1, 59-80.

2

For a discussion of the potential for a separate gas market within the context of s50 of the Trade Practices Act 1974, see R. Smith (1995) "The practical problem of market definition revisited", Australian Business Law Review, 23, 52-60. For a discussion of market definition for access purposes, see S. King and A. Marshall (1996) Market definition and competition policy: the case of access, Mimeo, ANU.

3

In the United States, these two separate elements are (weakly) reflected in the 'essential facilities doctrine'. The elements required to apply the doctrine include monopoly control of an essential facility, the inability of a competitor to practically or reasonably duplicate the facility, and the denial of use of the facility to a competitor. Essentiality has been interpreted by the courts as requiring that it is economically infeasible to duplicate the facility and that denial of access would severely handicap new market entrants. See P. Cook (1994) "Essential facilities - does it have a place in Australian competition law?", Australian and New Zealand Trade Practices Law Bulletin, 10, 36-37 at 36. 4

Essential facility problems have previously been dealt with in Australia through industry specific legislation or through s46 of the Trade Practices Act. Queensland Wire Industries Pty Ltd v BHP Co Ltd (1989), ATPR, 40-925 and Pont Data Australia Pty. Ltd. v ASX Operations Pty. Ltd. & Anor (1990), ATPR, 41-007 are two examples of s46 cases involving access issues. The Hilmer report did not consider either of these approaches to be adequate. In particular, the report considered that the requirement under s.46 to prove a "proscribed purpose" was problematic (supra n1., p.243). The Hilmer Report was also concerned with the desirability of requiring the courts to determine "the terms and conditions, particularly the price, at which access

5

should occur" (supra n1, p.243). The report recommended the establishment of an alternative administered regime. 6

For a general discussion on issues relating to vertical relationships between firms see J. Tirole (1988) The Theory of Industrial Organisation, MIT Press, Cambridge MA. For a discussion in the Australian context, see S. King and R. Maddock (1996) supra n.2. See chapter six of the National Grid Management Council (1996) National Electricity Market Code, Draft version 1.0.

7

For example see Australian Competition and Consumer Commission (1996) National Electricity market Code of Conduct: Comments and Issues Arising, mimeo, Canberra and S. King (1996) Infrastructure Access: the case of electricity in Australia, Paper presented to the 1996 Industry Economics Conference, ANU, July..

8

9

Of course, if the facility owner is vertically integrated into the downstream market, constraining prices by itself will not solve the access problem. The facility owner will have an incentive to deny or avoid providing access to its competitors. This raises a number of issues, such as the ability of a facility owner to reduce the quality of access it sells to its downstream competitors, which are beyond the scope of this paper. In our discussion of access pricing below, we will assume that the regulator can ensure that access is provided to potential downstream competitors. S. King (1996) Who took the competition out of national competition policy: access pricing under rate of return regulation, mimeo, ANU, presents an example where, once the upstream profit constraint is established, actual access prices have no further economic implications.

10

11

Supra n.1 at 5.

(1995) Implementing the National Competition Policy: Access and price regulation, Information Paper, Melbourne, at 64. 12

See C. Doyle and M. Maher (1992) "Common carriage and the pricing of electricity transmission", The Energy Journal, 13, 63-94, A. Kahn (1988) The economics of regulation, MIT Press, Cambridge MA, and M. Slater (1989) "The rationale of marginal cost pricing" in D. Helm, J. Kay and D. Thompson (eds) The market for energy, Clarendon, Oxford. For a list of 'offsetting effects', see S. King (1995) Access Pricing, Research paper number 3, Government Pricing Tribunal of New South Wales, Sydney. 13

14

While the opportunity cost of inputs is part of SRMC, the opportunity cost of the output is not part of SRMC. For example, consider that access can be used by the facility owner in his own downstream production or can be sold to a downstream competitor. Then the foregone profits from own downstream production when a unit of access is sold to a competitor are an opportunity cost of that sale but are not a cost of producing access. This failure to distinguish between an opportunity cost of production and an opportunity cost from alternative disposal is incorporated in to the standard definition of the efficient components pricing rule. See for example, W. Baumol and J. G. Sidak (1994) Towards competition in local telephony, MIT Press, Cambridge, MA at page 94.

This problem and potential regulatory solutions is examined in detail by J. Laffont and J. Tirole (1993) A theory of procurement and regulation, MIT Press, Cambridge, MA. 15

(1992) "Efficient railway freight rates: Australian coal", Economic analysis and policy, 22, 23-38 at 37. 16

B. Mitchell and I. Vogelsang (1991)Telecommunications pricing: theory and practice, CUP, Cambridge, especially chapter 5, provide a more detailed analysis of a variety of non-linear pricing schemes.

17

This is sometimes referred to as the Averch-Johnson effect. It was first shown formally in H. Averch and L. Johnson (1962) "Behavior of the firm under regulatory constraint", American Economic Review, 52, 1052-1069. For a discussion of rate-of-return regulation, see chapter 21 in D. Carlton and J. Perloff (1994) Modern Industrial Organization, Harper Collins, New York. 18

Price caps are used slightly differently in the US to Australia and the UK. See D. Sappington and D. Sibley (1992) "Strategic nonlinear pricing under price-cap regulation", RAND Journal of Economics, 23, 1-19 and P. Navarro (1995) "The ABCs of PBR", Public Utilities Fortnightly, July 15, 1620. 19

See J. Vickers and G. Yarrow (1988) Privatization, an economic analysis, MIT Press, Cambridge, MA, and M. Armstrong, S. Cowan and J. Vickers (1994) Regulatory reform; economic analysis of the British experience, MIT Press, Cambridge, MA.

20

See M. Beesley (1996) "RPI-X: principles and their application to gas", in M. Beesley (ed), Regulating Utilities: Time for a Change?, Institute of Economic Affairs, London. 21

See W. Baumol and J. G. Sidak (1994) supra n.14. Also W. Baumol and J. G. Sidak (1995) "Stranded costs", Harvard Journal of Law and Public Policy, Summer, 837-849. 22

This example is similar to one provided in Baumol and Sidak (1994) supra n14. 23

The example given above is very simple. In any actual market, ECPR needs to be adjusted to retain its desirable features. For example, a unit of competitor's product need not crowd out exactly a unit of the incumbent's product. See M. Armstrong, C Doyle and J. Vickers (1996) "The access pricing problem: a synthesis", Journal of Industrial Economics, 44, 131-150. The example also assumes that the final price stays constant at $10, even if inefficient entry occurs. In contrast, if the access price was set at $3 and the threat of inefficient entry forced the incumbent facility owner to reduce his final product price to $8.49 in order to prevent entry, then the threat of (inefficient) entry would not lead to any actual inefficient production but would benefit consumers by lowering the final product price. For a broader discussion of this issue see N. Economides and L. White (1995) "Access and interconnection pricing: how efficient is the efficient components pricing rule?", Antitrust Bulletin, 40, 557-579. 24

These possibilities are discussed in T. Brennan (1987) "Why regulated firms should be kept out of unregulated markets; understanding the divestiture in United States v AT&T", Antitrust Bulletin, 32, 741-793. 25

For a discussion of the arguments for and against vertical divestiture, see chapter 8 in S. King and R. Maddock (1996) supra n.2. 26

27

See Baumol and Sidak (1994) supra n14 at 108.

28

For a brief review of the difference between long run and short run costs, see H. Varian (1993) Intermediate Microeconomics (3rd. ed.), Norton, New York, especially chapter 20. See D. Baron (1989) "Design of regulatory mechanisms and institutions", chapter 24 in R. Schmalensee and R. Willig (eds) Handbook of Industrial Organization, v2, North Holland and Laffont and Tirole supra n.15. 29

See H. Demsetz (1968) "Why regulate public utilities?", Journal of Law and Economics, 11, 55-65 and M. Crew and M. Zapan (1991) "Franchise bidding for public utilities revisited", chapter 10 in M. Crew (ed) Competition and the regulation of utilities, Kluwer.

30

For a more detailed discussion of these issues see King and Maddock (1996) supra n2. 31

For example, sequential contracting may prevent negotiating parties from perfectly sustaining final market monopoly prices. See R. P. McAfee and M. Schwartz (1994) "Opportunism in multilateral vertical contracting: nondiscrimination, exclusivity and uniformity", American Economic Review, 84, 210-230. Even in the case of only a single access seeker, brinksmanship and the incentive for the access provider to stall negotiations may lead to less than perfect monopoly pricing. See S. King and R. Maddock (1996) Regulation by negotiation: a strategic analysis of Part IIIA of the Trade Practices Act, paper presented to the 14th economic theory conference, LaTrobe University, February. 32