Regulation and privatisation

Privatisation of regulated infrastructure is popular with most Australian governments but it won’t work out well without sound frameworks to regulate the private infrastructure providers and policy settings that allow prices to reflect costs.

Investors and governments must be confident about these regulatory and policy settings. Regulatory uncertainty reduces the amount investors will pay for existing assets, increases their required return on new investments and makes framing cost-benefit analysis of infrastructure proposals difficult.

For example, the revenue an investor earns from a toll road (or its public benefits) depends on road pricing generally, including the toll structure. Usage of the road is discouraged if alternative roads are not priced. This restricts the operator’s revenue and the public’s benefits. Brisbane’s Clem 7 and Airport Link tunnels illustrate this. Similarly, mandating a flat toll structure restricts the public benefit of the road. For example, it prevents free use in off-peak periods when use imposes no social costs. Melbourne’s City Link suffers this.

Selling market power

In selling assets, governments are conflicted - loose regulation increases sales proceeds but reduces consumer protection. Regulated infrastructure regularly attracts prices exceeding the regulatory value of the asset base. This could reflect opportunities for private owners to cut public-ownership fat.  Or it could be that regulated rates of return exceed the investor’s discount rate. In the latter case privatisation is akin to selling market power.

One way to sell market power is to integrate monopoly and contestable businesses. The Queensland government sold parts of Queensland Rail as an integrated track-access and coal-freight business. Although third-party competition in the freight market was retained, vertical integration allows the track provider opportunities to discriminate against third-party freight operators, effectively transferring monopoly power from the tracks to freight operations. That is one reason that privatised QR turned out to be worth much more than purchasers paid for it. It also explains why the miners offered more for the tracks than could be justified by their regulated return.

Public resentment

Allowing unreasonably high regulated returns can lead to public resentment about high charges levied by privatised business and to political pressure forcing changes in the regulatory rules to curb charges. As documented by Oxford Professor Helm, UK privatisation history is replete with this. Similarly, Australian governments face pressure about high electricity-network charges. Many think the Australian Energy Regulator has been too slow to change the rules to restrain them.

Because investors are aware that rules might change, they demand rates of return higher than appropriate for public investment – the government can change the rules on private investors but not on itself. Investors also face the risk that technological developments might strand investments. The National Broadband Network is a good example. Both risks make investors want their money back quickly – to minimise the time available for rule or technology changes.

Regulating privatised monopolies - distinctions

In regulating privatised monopolies, policy makers should distinguish between businesses that service only large customers and businesses that cater to 'mums and dads'. The latter may need strong regulation because customers can’t look after themselves and the transaction costs of attempting to do so are high. But in the former case, the infrastructure provider and its customers are mutually dependent. As Harvard Professor Gomez-Ibanez points out, they have strong incentives to reach private agreements and the transactions costs of doing so are relatively small. The regulator might just get in the way.

Third-party-access is limited to large-customer cases. The High Court decision in the Pilbara case interpreted the 'uneconomic to duplicate' criterion for access declaration as a private-profitability rather than a social-efficiency test. This makes new declaration more difficult and revocation of existing declarations more likely. Gomez-Ibanez’s views suggest this might not be bad.

He sees third party access as trading off operational efficiency for protection against market power. Freight-rail networks offer plenty of examples of efficiencies available from coordination of track and freight operations. Ballast fouling is an interesting example. Coal spilling from wagons fouls track ballast, increasing maintenance costs. Loading wagons more carefully is also costly. A single entity owning the wagons and the track will find the least-cost solution but stand-alone track and freight operators might not.

Infrastructure operational efficiencies

Gomez-Ibanez demonstrates that modest coordination efficiencies can outweigh the gains from restraining market power. Operational efficiencies apply to all users of the infrastructure, whereas the gains from restraining market power apply just to business discouraged if infrastructure charges are above marginal costs.

But regulators don’t like market power even if tolerating it would reduce costs. Similarly, competition regulators sometimes think they have to promote competition even if it brings no discernible benefits to consumers. Policy makers should view regulation and competition as means to securing economic efficiency not as ends in themselves.