Public Policy and Efficiency: Some Lessons from the Reform of the Australian Gas Industry

1. Public Policy and Efficiency:Some Lessons from the Reform of the Australian Gas Industry Kevin Davis Colonial Professor of Finance Department of Accounting and Finance The University of Melbourne

2. Objectives of the Paper • Outline reform process • rationale based in perceived efficiency gains • Illustrate critical importance of (unknown) cost of capital • Demonstrate how structure of reform process may lead to the use of a biased cost of capital estimate • May offset operating efficiency gains • Suggest that privatization sale prices for Victorian gas businesses are indicative of such an effect • Indicate need for care in structure of reform processes

3. Background • Historically, gas transmission, distribution, retailing undertaken by a public monopoly • Divided (1996) into transmission co., 3 distribution cos., 3 retailers • Access prices for transmission & distribution to be determined (for 5 year horizon) by regulatory bodies (1998) • Businesses privatized (1998-99) • transmission business sold separately • distribution businesses “stapled” to retailer with 50 per cent geographical overlap • Regulated prices for retailers (reflecting gas purchase cost, transmission and distribution costs) apply only to “franchise” (non contestable) customers for next few years

4. Background (continued) • Access prices should mimic a (hypothetical) competitive outcome • Market value of business should be close to replacement value of assets • Privatization sale prices were over twice the replacement value of assets • Cannot be explained by potential operating efficiency gains or synergy • Unlikely to be largely due to “winner’s curse” • Unlikely to be due to underestimation of asset replacement value • Indicative of use of excessively high cost of capital in regulatory determination

5. Hypothesis • Reform process adopted resembles a two stage game • Stage 1: Regulators attempt to determine (unknown) cost of capital for gas businesses, based on (potentially biased) information received from government (as seller), potential buyers, and customers. • Stage 2: Gas businesses are sold by tender to bidder with lowest cost of capital (cet par.) • Result: • seller and potential buyers have incentives to provide upwardly biased estimates of the cost of capital in stage 1. • customers lack “financial authority” • Regulatory determination may not fully offset those biases.

6. The Regulatory Model • Determine target revenue stream for 5 year horizon, based on • Projections of volume • Revenue to cover (efficient) operating costs, return on capital, return of capital (depreciation) • Initial price determined from year 1 target revenue and volume projections • Subsequent prices for 5 year horizon set using CPI – X rule, where X set to give Present Value of resulting revenue stream equal to that of target revenue stream • Note: approximately 50% of target revenue is return on capital

7. The Regulatory Model • A net revenue stream which equals the required rate of return on written down book value plus depreciation each period means that the initial investment is zero NPV • Initial book value of assets established as DORC value • Depreciated Optimised Replacement Cost

8. Target Revenue Model Total Revenue=Operating Costs+ Return of Capital + Return on Capital CapitalBase=InitialCapitalBase (indexed) – Depreciation (indexed) + new facilities investment(indexed)– redundant capital. Ignoring new investment we have TRt = OCt + Dt* + r Kt-1 (1+pt) TRt = target revenue in year t OCt = operating costs in year t Dt* = CCA depreciation in year t Kt-1 = capital at start of year t pt = forecast inflation rate in year t r = real pre tax WACC

9. Potential Efficiency Gains from Reform Process • Better incentive structure (including incentive regulation) following privatization • Lower operating costs • Better investment decisions • “Competitive pricing” (via regulatory determination) • Financing efficiencies

10. Possible Impediments to Efficiency • Incorrect cost of capital estimate used in access price determination • “incorrect” market prices • “incorrect” investment incentives • Outcome in Victoria • Sale price/asset value multiple difficult to explain other than by use of upwardly biased cost of capital estimate • Despite regulators lowering initially proposed (real pre tax WACC) figure from 10% to 7.75% • Use of an excessively high cost of capital • Increases revenue stream of business • Increases gas transportation prices

11. Misinformation Incentives • Seller (government) • short term gain via higher sale price • higher gas prices over longer term horizon • political incentives towards short term • Gas users • Prefer lower price, but are not authoritative providers of information about cost of capital for business. • Potential buyers • NPV of “prize”( from winning tender) increased • if cost of capital implied by winning bid above actual cost of capital (required rate of return).

12. The Regulatory Problem • Cost of capital “built up” from component parts • many “unknowns” • CAPM parameters, tax issues, leverage & debt costs • real, pre tax WACC figure required (not well understood) • “cherry picking” of parameter estimates by participants in process • bias towards overstatement of WACC by participants

13. The Regulatory Problem • Regulators need to determine appropriate “discount” to apply to cost of capital proposed by vested interests • absence of prior market in transmission and distribution facilities means no “price check” on validity of implications of proposed cost of capital possible • “Stapled” sales of distribution business and retailers, mean that “excessive cost” of distribution services can be fully passed on to customers when retailers fully deregulated • “stapling” prevents overpricing of distribution business leading to equivalent under-pricing of retailers • advantageous to seller

14. Some Tentative Lessons • Process should enable “price check” against prior market prices of validity of regulatory cost of capital • no prior market in distribution / transmission services • Process should ensure that incorrect pricing of one component of the activity being sold will have offsetting implications for the sale price of another component • Incentives for revelation of “true” cost of capital required • Regulatory models used should be based on commonly accepted concepts