Issue 44 June 2012

The Form of Regulation and Non-diversifiable Risk

Michael S. Blake and John Fallon*

The regulated firm functions in an environment in which its operations and investment are circumscribed by both the broader regulatory framework and the more specific form of regulation or regulatory control. In the former case, the regulatory framework can, in general, be defined to encompass the legislative and institutional arrangements that prescribe the relevant regulatory objectives and processes that apply to the regulated firm. In the latter case, forms of regulation can be thought of as the different types of mechanisms that apply directly to the regulated firm in the context of setting its allowable revenue and price. For example, forms of regulation (i.e. controls) include price caps, revenue caps, and complementary mechanisms such as cost pass-throughs and unders-and-overs accounts.

While both of these aspects are important, this article addresses the second aspect of the regulatory environment, the form of regulation, and its relationship to the regulated firm’s regulatory cash flows and cost of capital. Given that current regulatory practice in Australia, New Zealand, and the United Kingdom (UK) predominantly applies some version of the Capital Asset Pricing Model (CAPM) to estimate the regulated firm’s cost of equity, the key emphasis is necessarily on systematic, or ‘non-diversifiable’, risk.

In the specific context of applying the CAPM to regulation, there is theoretical and empirical research that the form of regulation plays an important role in determining the regulated firm’s risk-adjusted cost of capital. Marshall, Yawitz and Greenberg (1981) observe that non-diversifiable (i.e. systematic) risk is endogenous to the regulatory structure as non-diversifiable risk is affected by the decisions of regulators and the firm’s managers. Specifically, when demand is uncertain, they show that the regulated price chosen by regulators determines how uncertain demand impacts the firm’s profit and, therefore, its return.

The form of regulation can affect the level and variability of the firm’s returns. If upside and downside variability (risk) of returns is moderated by the form of regulation, this means that total risk (diversifiable and non-diversifiable) is reduced. The total variability of returns comprises a non-diversifiable component that represents covariability of returns of the firm with the returns of the market portfolio and residual, firm-specific risk that is diversifiable by shareholders. Formally, if the form of regulation reduces the covariability of returns with the returns on the market portfolio, then this affects the firm’s asset beta which is the only firm-specific risk parameter in the CAPM. In addition, different forms of regulation are likely to affect both diversifiable and non-diversifiable risk differently.

To date, regulators in Australia and elsewhere have paid limited attention to the potential impact of the form of regulation on risk and the allowed rate of return in regulatory decisions. The purpose of this paper is to explore these issues further and, in particular, how different forms of regulation can have different implications for estimating the firm’s beta.

Contents

Lead Article 1

From the Journals 9

Regulatory Decisions in Australia

and New Zealand 14

Notes on Interesting Decisions 24

Regulatory News 26

* Dr Michael S. Blake is a Principal Analyst and Dr John Fallon is a Director at the Queensland Competition Authority. The views of the

authors, expressed in this paper, do not necessarily represent the views of the Authority.

The CAPM and Systematic Risk

Standard versions of the CAPM specify a linear relationship between the expected return on a risky asset and a risk parameter known as ‘beta’.1 Beta is defined as the covariance of an asset’s return with the return on a market portfolio of risky assets, expressed as a proportion of the variance of the return on the market portfolio (i.e., non-diversifiable or systematic risk). In the CAPM, the expected return on equity for an individual investment = the risk-free rate + (beta x market risk premium). Informally, beta represents the quantity of risk and the market risk premium represents the price of risk. Thus, when the covariance of returns for the individual investment with respect to the market returns is low, beta is low and hence the expected return for the individual investment is relatively low.

As is well known, beta only compensates investors for risks that they cannot diversify by holding a sufficient number of assets in the market portfolio, the latter of which is typically benchmarked by a national equity index. It should also be recognised that a relatively small portfolio of stocks can achieve effective diversification of firm-specific risk.

Consistent with Markowitz (1952), a key assumption of the CAPM is that asset returns are distributed multivariate normal or alternatively, that the mean and variance of asset returns are the only parameters relevant to investors. The implication of this assumption is that the CAPM does not compensate investors for ‘asymmetric’ risk. This issue has arisen in regulatory submissions on the cost of capital as it is variously argued that regulatory constraints limit firms' earning potential (i.e. ‘upside’) while exposing them to losses (i.e. ‘downside’), resulting in an asymmetric distribution of expected returns.

However, a counterbalancing point is that various regulatory mechanisms (e.g., review triggers) are often implemented by regulators to reduce the scope for large losses. These mechanisms, in effect, restore some symmetry to the firm’s distribution of returns. For many regulated businesses that provide ‘essential services’ to the community, a reasonable proposition is that governments will ensure that there is sufficient revenue to avoid financial distress, either through the regulatory arrangements or more direct interventions. To the extent that this proposition holds, it in effect greatly limits the downside risk of regulated firms.

In applying the CAPM in a regulatory setting, standard practice typically does not rely on estimates of the regulated firm’s actual beta (assuming its

1 In an investment context, ‘risk’ can be defined as deviation from an expectation or dispersion around an expected value.

returns data are available), as doing so might not provide an ‘efficient’ benchmark.2 Rather, and consistent with ‘comparables analysis’ that is typically applied for estimating other WACC parameters, regulators utilise external benchmarks. Major steps in this process include: (i) identifying the primary, underlying drivers of the regulated firm’s business risk;3 (ii) identifying (preferably unregulated) firms with similar drivers of systematic risk to obtain a relevant set of ‘comparable’ firms; and (iii) estimating the betas of the identified comparators in order to infer an estimate of the underlying asset beta to apply to the regulated firm.

The second step in the above process is flawed if the form of regulation affects the firm’s systematic risk and no adjustment is made to reflect the implicit effect of the form of regulation on beta (Marshall, Yawitz and Greenberg, 1981, pp. 909-910). An alternative is to benchmark comparable regulated firms. This option, however, raises several important issues. First, it raises the possibility of ‘circularity’ if the reference firms’ betas have been estimated using the same approach, so caution is required in these circumstances. Second, the regulatory environment and form of regulation of the comparator almost certainly will not be the same and, as a result, comparability could be materially compromised, depending on the extent and nature of the differences. However, in Australia, New Zealand and the UK, there is minimal explicit recognition that the form of regulation affects the allowed beta in a regulatory context.

With this background, the next section discusses several major forms of regulation and potential implications for systematic risk.

The Form of Regulation and Implications for Risk

Basic Paradigms

Two key characteristics of the form of regulation that impact on risk are:

a) the extent of de-coupling of allowable revenues from actual costs; and

b) the length of regulatory lag.

The first characteristic reflects the extent to which regulatory discretion ‘covers’ different elements of the regulated firm’s profit: price, output, controllable costs, and uncontrollable (i.e., exogenous) costs (Alexander, Mayer and Weeds, 1996, p. 8). For

2 Also, such practice can provide the regulated firm with an

incentive to manipulate its returns in response. 3 The finance literature in this area is extensive, but Lally

(2000) provides an excellent summary of the most relevant

literature.

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example, pure cost-of-service regulation effectively covers all profit elements such that allowable revenues essentially reflect actual costs, including an allowed return on capital. In contrast, under a pure price cap, the regulator sets a price such that costs, in theory, are completely de-coupled from revenue in the regulatory structure. Second, regulatory lag reflects the frequency with which regulated prices adjust to reflect changes in costs. For example, if ex post adjustments to reflect actual costs are frequent, then the regulated firm bears less variance from realised costs deviating from their expected values in comparison to a situation in which the regulator adjusts the price less frequently.

With these two criteria in mind, it is useful to consider two basic forms of discretionary regulation that lie at relatively opposite ends of a stylised spectrum of regulatory forms, namely cost-of-service regulation and price-cap regulation. Building blocks regulation as applied in Australia is considered to be closer to pure cost of service regulation than pure price-cap regulation. The building blocks model, as applied in Australia, is discussed in a later section.

Under cost-of-service regulation, the regulator sets total revenue to cover all of the firm’s costs of providing the service (i.e. average revenue is set to average cost). The costs of service basically comprise a return on capital, a return of capital (i.e. depreciation), and operating costs. The regulator then sets the regulated price based on the ex ante (i.e. forecast) average total cost, and that price is fixed until the next scheduled regulatory review.

If cost-of-service regulation was perfect, the regulated price would instantaneously and continuously change so that the firm's allowable revenues always matched its realised costs at any point in time. As such a mechanism would eliminate all deviations from expected outcomes, the regulated firm would bear no meaningful risk - either non-diversifiable or diversifiable. The realised return would always equal investors’ expected return, and returns would effectively look like those from a risk-free bond. Such regulation theoretically implies no non-diversifiable risk and a zero asset beta for the regulated firm.

In practice, cost-of-service regulation is imperfect as prices cannot change continuously to match costs even if such a property was desirable. The firm’s realised costs will differ from its forecast costs during the interim period before the next review, for example, due to unanticipated input price changes. As the regulator’s price changes at the next review follow the realisation of actual costs (i.e. ‘regulatory lag’), the regulated firm bears some risk over the interim period prior to that review. However, cost-of-service regulated firms have considerable rights to seek reviews prior to the next scheduled review in the

event of adverse cost movements against them – Pint (1992) reports that for the US almost all unscheduled reviews were initiated by regulated firms seeking a price increase. This feature allows firms to effectively reduce the regulatory lag and consequently, their exposure to risk.

As a result, the risk that firms bear under a cost-of-service paradigm will be relatively low as this approach effectively tracks all elements of the firm’s profits, which in turn, insulates the firm’s returns. Damodaran (2012) reports that US electric utilities subject to rate-of-return regulation are among the lowest asset beta industries. Furthermore, a short regulatory lag insulates firms from protracted exposure to risk and the variability of their returns. Other mechanisms such as unders and overs accounts (discussed below) have similar effects on risk. In summary, these features will significantly reduce the firm’s non-diversifiable risk.

At the opposite end of the spectrum is price-cap regulation. Under this form of regulation, the regulator imposes a price limit on the firm’s product (or on a set of products). The firm is then free to charge any price at, or below, the ceiling. The price ceiling does not necessarily have to be product-specific. It can apply to a set of the firm’s products such that the price ceiling is a weighted average of the prices of the products in the set. The firm is free to set product-specific prices subject to the constraint that their weighted average does not exceed the pre-determined ceiling.

A basic price-cap formula is augmented by two factors: the first is the rate of price inflation, which allows prices to adjust upward for input price increases beyond the firm’s control, while the second is an ‘X’-factor, which adjusts prices downward to reflect the firm's efficiency improvements (i.e. the ‘X’ determines how much less than the rate of inflation the regulated prices can increase). Typically, an exogenous price inflation index is used to ensure the firm’s prices remain de-coupled from its actual costs as much as possible. The regulator sets the price cap ex ante for the review period, and if the firm achieves cost savings that are greater than the net effect of the inflation and productivity adjustments in the formula then it retains them until the next review (at which point the parameters are reset).

Under perfect price-cap regulation, the initial price ceiling is never reset (i.e., an infinite regulatory lag applies) such that the regulated firm bears any variance in its expected cash flows.4 In contrast to

4 This form is clearly unrealistic but it is useful for comparative purposes. It also implicitly assumes that the regulator’s knowledge is strong, as a price cap that is ‘too high’ leads to excessive profits, while one that is ‘too low’ makes the firm unviable.

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cost-of-service regulation, the regulator only sets the price, such that any effects of changes in either demand or costs are absorbed by the shareholders of the firm. For example, if the firm experiences unanticipated fluctuations in its expected demand, then any resulting revenue windfall gain or loss is borne by the firm’s shareholders. This idealised form implies a positive asset beta for the regulated firm under general conditions, the magnitude of which depends on other underlying factors that affect beta (e.g., the nature of the industry).

In reality, price-cap regulation is, of course, also imperfect. Under almost all forms of price caps, costs that are difficult for the firm to control can be subject to pass-through provisions (discussed in more detail later), which effectively transfer uncontrollable risk to customers. In addition, regulatory lag is not infinite as regular reviews are held to revisit the parameters estimates for the base price as well as for the inflation and productivity factors. However, as a general principle, there is likely to be less certainty of cost recovery under price-cap regulation in comparison to cost-of-service regulation, as under price-cap regulation prices are typically set with more limited links to costs and reviews of the price-cap parameters occur on a less frequent basis than under cost-of-service regulation.

As the majority of regulated firms have high fixed costs that are invariant to the level of output, this feature potentially exposes them to material demand (i.e., volume) risk. Such risk can be reduced by other non-regulatory mechanisms such as, for example, take-or-pay contracts. This raises the option of using an intermediate mechanism between these two forms, namely an absolute revenue cap, which acts to reduce this demand-side risk by guaranteeing a pre-determined ‘allowable’ revenue. The absolute revenue cap places a ceiling on revenues that changes over time with inflation. Other types of caps include revenue-per-customer caps, where revenue grows with growth in the customer base, and statistical revenue caps, where revenue changes on the basis of changes in a number of pre-determined variables. With this mechanism, the regulator controls price and also estimates expected quantity demanded to set a revenue limit or cap. Without complementary controls, absolute revenue caps are associated with significant problems, including that, if the revenue cap is set less than the unregulated monopoly revenue, it leads the regulated firm to price above the unregulated, profit-maximising monopoly price (Crew and Kleindorfer, 1996).

To illustrate the potential implications of a revenue cap, recall that beta is the parameter in the cost of capital model which measures the non-diversifiable risk and the market risk premium is the price of that risk. Since beta is a statistical measure of the sensitivity of the returns to equity relative to variations

in returns to the market as a whole it will be closely related to the sensitivity of revenues to returns to the market as a whole.

Brealey, Myers, Partington and Robinson (2000) in their widely used textbook on the theory and practice of corporate finance specify the relationship between an asset beta and its components as follows:

Equation 1

where βA is the asset beta, A is the present value of the forward-looking value of the asset, R, FC, and VC are the present values of the forward-looking revenues, fixed costs, and variable costs of the firm respectively. The ‘beta’ for each of the latter three streams reflects the sensitivity of that component to the returns on the market portfolio of risky assets (Brealey, Myers, Partington and Robinson, 2000, pp. 247-248).

The intuition of equation (1) is that, just as an asset beta is a weighted average of equity and debt betas with the weights being the shares of equity and debt in the total value of the asset, the asset beta can be expressed as a weighted average of its underlying revenue and cost components. Note that the weight for each of the betas for the latter components reflects the importance of that component in terms of its contribution to the present value of the underlying asset.

As noted by Brealey, Myers, Partington and Robinson (2000, p. 258), the fixed cost beta is zero as, if a part of the cost stream does not vary when market returns change, then that part has no sensitivity to the market (i.e., a zero beta). Using this definition, equation (1) becomes:

Equation 2

Thus, it is clear that an asset beta is fundamentally dependent on its revenue beta. Furthermore, in a situation where revenue variability is effectively zero, or near zero, the asset beta could in fact be negative for a positive variable cost beta.5 However, for

5 The variable cost beta could be positive or negative depending on the nature of shocks to the economy and the covariance of the variable cost variable with the market. In the case of a large energy price shock during a recession, variable costs are more likely to be counter-cyclical and, therefore, imply a negative variable cost beta. However, if input costs are pro-cyclical, which is typically the case in the absence of large price shocks (when one recognises the co-variability of both the quantity and price components of a variable input with

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regulated industries with large sunk costs the impact of the variable cost beta on the asset beta would be small reflecting the share of variable cost in total cost. These relationships highlight how a revenue guarantee has fundamental implications for an asset beta.

A variant on this form is a hybrid revenue-price cap where a revenue cap applies to the regulated firm's fixed costs, while a price cap applies to its variable costs. The revenue cap effectively insulates the firm from demand shocks, while a fixed price cap leaves the firm exposed to cost shocks.6 All else equal, it would be expected that a regulated firm under such a hybrid mechanism would have an asset beta that is less than the beta of a pure price-cap-regulated firm but above the beta of a pure revenue-cap-regulated firm.

A hybrid revenue-price cap highlights the distinction between the fixed costs of the existing assets that comprise the regulatory asset base (RAB) and the variable costs that are typically associated with the firm’s operating and maintenance costs that support the RAB, and some capital expenditure. Specifically, potential sources of cost risk arise predominantly in ‘non-RAB’ areas, perhaps the exception being the administrative or corporate overhead costs required to maintain the RAB.

This distinction has led UK economist, Dieter Helm, to advocate a ‘split cost of capital’ approach to assessing the cost of capital for regulated firms. Specifically, Helm argues that the RAB is likely to be associated with no, or very low, risk, given that the RAB is coupled with a revenue guarantee in many cases. Given a revenue guarantee, there is virtually no scope for active asset management and accordingly, this implies no or very little requirement for equity capital. As such, Helm considers that the RAB assets should earn a rate of return at, or just above, the regulatory cost of debt. In contrast, Helm considers that the maintenance, operating cost, and capital expenditure activities of the business typically involve active asset management. As such, there is material equity risk that warrants a cost of capital with a significant equity component. This observation has led to the development of a split cost of capital (Helm, 2010, pp. 8-27).

overall economic activity) a positive variable cost beta is more likely. 6 The revenue cap is analogous to the fixed element of a two-part tariff charged to consumers, in that both operate as mechanisms to allocate risk. For example, many water businesses mitigate demand risks through the use of two-part tariffs, with fixed costs recovered via an access charge and variable costs recovered via a volumetric charge.

Ancillary Mechanisms

Three mechanisms that often accompany revenue caps and price caps are cost pass-throughs, review ‘triggers’, and ‘unders-and-overs’ accounts. First, cost pass-throughs allow specifically identified costs beyond the firm’s control to be passed through to users through price changes prior to the next formal regulatory review. The basic mechanics of the pass-through allow the regulated firm to adjust the price charged to users whenever the cost of the input subject to the pass-through deviates from a fixed base price, the latter having been previously approved by the regulator.

An early example is the fuel adjustment clause (FAC), implemented in regulatory circles in the United States in the 1970s in response to unexpected increases in energy costs. At that time, increases in prices of oil, gas, and coal were increasing faster than regulators could adjust prices. As a consequence, the equity holders of energy utilities absorbed the shock between revenues and unexpected increases in energy costs. Clarke (1980) finds empirical support for a material reduction in the systematic risk of U.S. electric utilities during that period relative to the utilities’ ‘pre-FAC’ non-diversifiable risk levels, as a result of regulators approving the use of FACs.

Second, most regulatory undertakings contain provisions that allow the regulated firm to trigger a review prior to the next scheduled review. The triggers for a review differ across regulatory regimes, but they commonly arise due to an unexpected event (e.g., an unanticipated decrease in demand). To the extent that the outcome of such a review reduces any systematic deviation from expected cash flows, such a mechanism affects the firm’s systematic risk exposure and asset beta.

A third mechanism is an ‘unders-and-overs’ account, which can apply to part, or all, of a regulated firm’s allowable revenue. If the firm under- (over-) recovers revenue from customers, then it receives (repays) the difference between the actual and allowable revenue. It, therefore, operates as a compensatory cash-flow mechanism that provides a guarantee against risk. However, the CAPM specifies a return that compensates investors for systematic deviation from expected cash flows, with the risk-adjusted discount rate consistent with the risk of the cash flow. Clearly, an unders-and-overs account is inconsistent with the concept of providing a risk-adjusted return and inappropriate.

In general terms, a full compensatory mechanism in effect eliminates variability in returns, albeit with a lag depending on the mechanics of the compensatory mechanism (although finance charges can be used to ensure lagged effects are eliminated as well). Since the total variability of returns is eliminated there is no

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meaningful risk (as measured by variability in returns) either diversifiable or non-diversifiable and hence beta would in effect be zero.

These ancillary mechanisms have their place in the context of risk allocation. However, to the extent that such mechanisms affect the regulated firm’s non-diversifiable risk, the regulator should take this into account when setting the regulatory cost of capital.

Empirical Evidence

It is intuitively appealing that since regulation effectively bounds the firm’s gains and losses, it reduces the regulated firm’s systematic risk. Building on the work of Stigler (1971), Peltzman (1976) argues that, in the face of an exogenous shock to the firm’s cash flows, the regulator will act to maximise general support for its regulatory arrangements, which results in both producers and consumers sharing the gains or losses resulting from the shock.

An important implication of Peltzman’s model is that the regulator effectively acts to ‘buffer’ shocks to the regulatory cash flows of the firm (i.e., the Peltzman ‘buffering’ hypothesis), reducing both the regulated firm’s asset beta and the variance in the firm’s returns. After controlling for other factors that affect the firm’s systematic risk, Binder and Norton (1999) find evidence consistent with this hypothesis.

In addition, Norton (1985) finds that the firm’s asset beta decreases (increases) when the ‘intensity’, of the regulatory control increases (decreases). In this context, ‘intensity’ refers to the degree of regulatory control over the regulated firm’s activities, and Norton’s result holds whether regulatory intensity is measured in terms of conferred authority (e.g., statutes and judicial opinions), inputs devoted to regulation (e.g., regulatory staff), or outputs (e.g., the regulated price) (Norton, 1985, p. 682). Davidson III, Rangan and Rosenstein (1997) confirm this result in a later study (Davidson III, Rangan and Rosenstein, 1997, pp. 178-179).

There are several studies that attempt to assess the differential impact of the form of regulation on systematic risk. Alexander, Mayer and Weeds (1996) estimate and compare betas across a number of regulated utilities in different countries, with particular focus on the forms of regulation in the UK and the US7. Their results show that, in general, UK utilities

7 Cross-country beta comparisons introduce a number of

empirical hurdles that they attempt to address. In general, the

key empirical difficulty is ensuring that the identified difference

in betas across countries is strictly attributable to the difference

in the forms of regulation and not to other, unrelated factors

(e.g. differences in market-specific leverage and/or national

equity indices).

subject to price cap regulation for a five-year period have materially higher average asset betas than US utilities subject to rate-of-return regulation for a one-year period (at which point there is a review). They attribute this result to the fact that rate-of-return regulation in the US provides a relatively safe operating environment for utilities (Alexander, Mayer and Weeds, 1996, pp. 30-32).

In another international study, Gaggero (2010), using a sample of 170 regulated firms across a range of countries, empirically tests whether ‘high incentive’ forms of regulation such as price caps imply more risk for firms than ‘low incentive’ forms of regulation such as rate-of-return regulation. In contrast to Alexander, Mayer and Weeds (1996), Gaggero finds that different regulatory regimes do not result in significantly different levels of business risk for the regulated firms. In explaining this result, Gaggero hypothesises that, while regulatory regimes differ in theory, the behaviour of regulated firms and regulators results in convergence to a similar level of risk. For example, firms subject to high incentive regulation (e.g., a price cap) pressure the regulator to pass-through unexpected costs to customers (Gaggero, 2010, pp. 8-11).

In the context of UK regulation, Grout and Zalewska (2006) examine the effect on returns of changing the form of regulation for a set of utilities from a price cap to a profit-sharing mechanism between the firms and their customers. Their results show that this change in the form of regulation causes a material reduction in the firms’ betas, after controlling for other explanatory factors such as leverage. This result is consistent with the proposition that profit-sharing entails lower risk than a price cap, as any deviations from actual profit from expected profit are ‘shared’ between the firms and their customers through the profit-sharing mechanism.

While this study is in a different regulatory environment than Australia, it is important for two principal reasons. First, as it examines a case in which regulation was specifically introduced to change the risk between the regulated firm and customers (rather than to create a wealth transfer), it provides a ‘clean’ case that isolates the risk effect. Second, it is free from the empirical difficulties posed by cross-country comparisons confronted by Alexander, Mayer and Weeds (1996) and Gaggero (2010).

Recent Regulatory Practice

In Australia, a standard approach to regulation lies somewhere between cost-of-service and price-cap regulation, but is probably closer to cost-of-service regulation. Regulators employ what is commonly known as the ‘building blocks model’. The model basically derives the allowed revenue for the

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regulated firm as the sum of its underlying elements or ‘building blocks’, which include a return on capital, a return of capital (i.e., depreciation), operating costs, and a tax allowance. The model is similar to a cost-of-service model in structure given this cost build-up and to the extent that the recovery of the allowable revenue is relatively certain.

It can be argued that by effectively locking in the regulatory asset base (i.e., providing a de facto guarantee of a regulatory WACC applied to an indexed regulatory asset base), this approach is more in line with cost-of-service regulation. For example, it can be argued that the electricity transmission network service providers, in general, are subject to revenue caps, which involve such an effective guarantee.8

The main difference between the building blocks model and pure cost-of-service regulation is that an estimate of expected efficient costs is allowed for in the former. Specifically, the regulatory arrangements for the building blocks model in Australia effectively guarantee revenue to cover expected, efficient controllable costs and actual costs over which the firm has no control. In contrast, the pure cost–of-service regulated firm recovers its actual (i.e., realised) costs.

To date, there has been varying acknowledgement by regulators in both Australia and the UK that the form of regulation affects systematic risk. For example, in its draft decision on the 2008 Water Price Review, the Essential Service Commission (ESC, 2008, p. 220) states:

The form of price control adopted can assist businesses to offset the impacts of uncertainty. The various forms of price control have differing advantages and disadvantages in terms of risk sharing between businesses and their customers, price certainty for customers and business flexibility to adjust prices to reflect changes in circumstances.

In relation to revenue caps, the ESC (2008, p. 221) further states:

A revenue cap is often an effective mechanism for assisting businesses to deal with demand and supply uncertainty. This form of price control is more appropriate when most of a business’s costs are fixed and do not vary significantly with the level of demand or supply.

It is notable that the ESC specifically recognises that the form of price control and, in particular, the

8 For the electricity distribution network service providers, the

form of control is determined by the Australian Energy

Regulator (AER) as part of the periodic reset process and

there is a range of allowed control mechanisms (AER, 2009, p.

251).

existence of a revenue cap ‘can assist businesses to offset the impacts of uncertainty’ and that the various forms of price control have different implications for risk-sharing between businesses and their customers.

Similar, in principle, positions have been taken by regulators in the UK. For example, in its comprehensive review of the regulatory framework for UK electricity and gas networks (i.e., RPI-X@20 Review), OFGEM (2010, p. 36) observes that:

...the allowed rate of return embedded in the regulatory settlement would relate to the riskiness of the network company’s revenue and cost streams, assuming that it operates in an economic and efficient manner (i.e. its cost of capital). The allowed return could vary across a regulated sector, driven by factors such as the size of the investment programme and the incentive structure provided by the regulatory regime.

This statement clearly recognises that the cost of capital could, in principle, be adjusted to take account of a range of factors that affect risks and incentives. However, as with Australian regulators, well-developed proposals for specific adjustments have not been developed to date.

Conclusions

An important conclusion of this article is that the balance of evidence to date supports the proposition that the form of regulation, in general, serves to decrease the non-diversifiable risk of the firm as it limits both upside and downside risk. The implication of this proposition for cost of capital estimation in the context of the CAPM is that the regulated firm’s beta is affected by the form of regulation and by supplementary regulatory controls. In showing that the presence of regulation reduces a regulated firm’s systematic risk, Riddick (1992, p. 151) observes:

The implication of these results is that regulators should consider that their actions are reducing the risk of equity in the firm when they set the required, or allowed, rate of return for the firm. This will lower the required return, the revenue requirement, and ultimately lower the rates that the firm charges for its products. Further, any attempts to determine the cost of equity for a regulated firm by using the cost of capital of an unregulated firm as a benchmark are suspect.

Further, the empirical evidence available shows that this reduction in risk becomes more significant the greater the intensity, or degree of stringency, of the form of regulation itself.

While the literature has long recognised these possible implications, there has been relatively limited acknowledgement by regulators to date. Overall, regulators tend to estimate the regulated firm’s asset beta largely independent of the form of

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regulation or without explicit recognition of the likely impact of the form of regulation on risk.

There are several possible explanations for this reluctance. First, it is likely that one reason is the inherent difficulty in untangling the effects of the form of regulation on beta from other factors that affect beta and operationalising an appropriate adjustment. Second, the relatively high standard errors of beta estimates pose challenges in empirically distinguishing between beta estimates under alternative forms of regulation.

However, given the progress in theoretical and empirical studies in this area, and the importance of the form of regulation in determining the regulated firm’s returns, it is considered that this issue warrants further exploration.

References

Alexander, I., C. Mayer, and H. Weeds (1996), ‘Regulatory Structure and Risk and Infrastructure Firms: An International Comparison’, World Bank Policy Research Working Paper No. 1698, December.

Australian Energy Regulator (2009), Electricity and Distribution Network Service Providers Review of the Weighted Average Cost of Capital (WACC) Parameters: Final Decision, May.

Binder, J. and S. Norton (1999), ‘Regulation, Profit Variability and Beta,’ Journal of Regulatory Economics, 15, 3, pp. 249-265.

Brealey, R., S. Myers, G. Partington, and D. Robinson (2000) Principles of Corporate Finance, McGraw-Hill Book Company Australia Pty Ltd: Roseville, New South Wales, Australia.

Clarke, R (1980) ‘The Effect of Fuel Adjustment Clauses on the Systematic Risk and Market Values of Electric Utilities’, The Journal of Finance, 35, 2, pp. 347-358.

Crew, M. and P. Kleindorfer (1996) ‘Price Caps and Revenue Caps: Incentives and Disincentives for Efficiency’, in Pricing and Regulatory Innovations Under Increasing Competition, Michael Crew (ed.), Kluwer Academic Publishers: Boston, Massachusetts, United States.

Damodaran, A. (2012) ‘Levered and Unlevered Betas by Industry’, dataset downloaded from http://people.stern.nyu.edu/adamodar/.

Davidson III, W., N. Rangan, and S. Rosenstein (1997) ‘Regulation and Systematic Risk in the Electric Utility Industry: A Test of the Buffering Hypothesis’, The Financial Review, 32, 1, pp. 163-184.

Essential Services Commission (2008) Water Price Review: Regional and Rural Businesses’ Water Plans 2008-2013 and Melbourne Water’s Drainage and Waterways Water Plan 2008-2013, Draft Decision, March.

Gaggero, A. (2010) ‘Regulation and Risk: A Cross-Country Survey of Regulated Companies’, Bulletin of Economic Research, pp. 1-13.

Grout, P. and A. Zalewska (2006) ‘The Impact of Regulation on Market Risk’, Journal of Financial Economics, 80, 1, pp. 149-184.

Helm, D. (2010) ‘Infrastructure and Infrastructure Finance: The Role of Government and the Private Sector in the Current World’, in EIB Papers: Public and Private Financing of Infrastructure – Policy Challenges in Mobilizing Finance, Hubert Strauss (ed.), 15, 2, pp. 8-27.

Lally, M. (2000) The Cost of Equity Capital and Its Estimation, McGraw-Hill Series in Advanced Finance, v.3, edited by T. Brailsford and R. Faff (eds.). McGraw-Hill Book Company Australia Pty Limited: Roseville, NSW, Australia.

Markowitz, H. (1952) ‘Portfolio Selection’, Journal of Finance, 7, pp. 77-91.

Marshall, W., J. Yawitz, and E. Greenberg (1981) ‘Optimal Regulation Under Uncertainty’, The Journal of Finance, 36, 1, pp. 909-921.

Norton, S. (1985) ‘Regulation and Systematic Risk: The Case of Electric Utilities’, Journal of Law and Economics, 28, 3, pp. 671-686.

OFGEM (2010). Regulating Energy Networks for the Future: RPI-X@20 Emerging Thinking, January.

Peltzman, S. (1976) ‘Toward A More General Theory of Regulation’, Journal of Law and Economics, 19, 2, pp. 211-240.

Pint, E. (1992) ‘Price-Cap versus Rate-of-Return Regulation in a Stochastic-Cost Model’, The Rand Journal of Economics, 23, 4, pp. 564-578.

Riddick, L. (1992) ‘The Effects of Regulation on Stochastic Systematic Risk’, Journal of Regulatory Economics, 4, pp. 139-157.

Stigler, G. (1971) ‘The Theory of Economic Regulation’, The Bell Journal of Economics and Management Science, 2, 1, pp. 3-21.

Critical Issues in Regulation – From the Journals

‘Regulatory Economics and the Journal of Regulatory Economics: A 30-year Retrospective’, Michael Crew and Paul Kleindorfer, Journal of Regulatory Economics, 41, 2012, pp. 1-18.

The purpose of this paper is to review and analyse some of the major developments in regulated industries and in regulatory theory and practice over the past 30 years. The article also discusses the contribution, during this period, of the Journal of Regulatory Economics to the literature on regulatory economics. The paper is primarily written from a US/UK perspective and focuses particularly on regulatory developments in the Communication, Energy and Post sectors.

In Communications, there have been dramatic changes, including a move to minimal regulation. However, the changes are a result of the changes in technology, rather than changes in regulation. The US experience is that access lines are no longer the only effective technology in telecommunications. Wireless, broadband and cable are superseding the traditional landline except in remote areas. When wireless carriers solved the roaming problem and were able to provide nationwide roaming, competition between carriers drove prices closer to marginal cost. Long distance could no longer be priced significantly above marginal cost. As a consequence, the role for regulation was reduced, and the response of regulators was to relax regulations on the traditional basic service.

Over the past 30 years, the postal industry has come to have a higher profile in research into regulatory economics. The primary impetus for research is from policy reforms in the European Union, where all of the major Universal Service Providers (USP) faced full end-to-end competition at the beginning of 2011. The primary themes in regulatory economics for the postal industry have been on two interrelated issues at the centre of the survival of USPs: first, the funding of the universal service obligation and, second, tariff and price regulation. The key development in the postal industry has been a decline in volumes due to electronic competition. Increased usage of both telephone and email has reduced postal volumes significantly, and this reduction has only been partially offset by the growth in volumes due to e-retailing. The paper predicts an active role for regulators and regulatory economics in the postal industry in the years ahead.

In the energy sector, one of the main developments is the effort to open up electricity generation to competitive forces. In opening up markets to

competition, economists underestimated the extent of the externalities in the transmission grid. Before being opened up, markets were vertically integrated, effectively internalising the externalities. But opening up the markets provided opportunities to exploit significant market power. When the UK electric utility industry was privatised, Stephen Littlechild was able to create targeted incentives which reduced these problems. However his task was made easier as there is a single grid operator in the UK. In the US and continental Europe, there are multiple grid operators, which makes the problem of designing targeted incentives more difficult. The authors judge that, where there are multiple operators, the problem with designing appropriate incentives has not been solved, either in theory or in practice.

‘The Public and Private Economics of Renewable Electricity Generation’, Severin Borenstein, Journal of Economic Perspectives, 26(1), 2012, pp. 67-92.

Borenstein observes that: ‘policymakers often find pricing externalities to be nearly impossible politically. Thus, the second-best discussion is over which, if any, alternative policy interventions are likely to do the most good, or at least to do more good than harm’. This paper is a discussion of how to assess public policies designed to promote renewable electricity generation.

A unit of electricity can have a different value at different times of the day or at different locations on the network. The simplest comparisons of the costs of different generation technologies use ‘levelised cost’ – that is, a simple cost per unit of output over the life of the plant. But this measure has several flaws. First, since electricity demand is variable and electricity is not easily stored, there is a separate demand for baseload generation which runs in most hours of the day, and for peak generation that is called on relatively few hours per year. Second, levelised cost estimates tend to ignore the impact on the transmission or distribution network. A remote wind farm may require consequent upgrades to the transmission network which are not taken into account in the levelised costs. Third, plants differ in how fast the output can be increased, how long the plant must remain off once it has been shut down, and how frequently it must be shut down for planned or unplanned maintenance. A careful levelised cost comparison would take these factors into account. Fourth, power from ‘intermittent’ resources, such as wind or solar, must be evaluated according to the value of electricity at the time the output is produced. Solar power tends to peak in the middle of the day, close to coincident with the highest electricity

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demand. Borenstein reports that the power from solar PV in California is about 20 per cent more valuable than the average power sold in the state because it is disproportionately produced at high-priced times. He recognises that wholesale electricity markets in the US have not been set up to allow prices to vary to the full extent necessary to reflect true scarcity. Instead, separate markets for reserve capacity have permitted relatively low ceilings on wholesale prices, limiting the variability of wholesale price signals.

A unit of electricity will usually have a different value at different locations on the network, which should be signalled through locational marginal pricing and reflected in the cost-benefit analysis. This is particularly an issue for renewable generation located inside distribution networks. Retail prices for electricity typically provide a poor signal to the locational value of electricity – retail prices often do not vary with the wholesale spot price, and even where they do, retail prices never reflect congestion within the distribution network. Moreover, the level of retail prices reflects the substantial fixed costs of the transmission and distribution businesses, not the marginal cost of a unit of electricity. Borenstein argues that the problem is that retail electricity is mainly charged on a per-unit basis, while the distribution and transmission of electricity is largely a fixed-cost business.

‘Benchmarking Economies of Vertical Integration in U.S. Electricity Supply: An Application of DEA’, Roland Meyer, Competition and Regulation in Network Industries, 12(4), 2011, pp. 299-320.

Meyer examines the existence of economies of scope in vertical stages of the US electricity industry. Vertical scope economies occur when a business provides more than one stage of supply with greater efficiency than separate businesses providing different stages of supply.

Meyer employs data envelopment analysis (DEA) with panel data for the US from 2001 to 2008. Two unbundling options are examined. First, generation unbundling is examined, where the generation stage of electricity supply is separated from the distribution and retail stages. Second, transmission unbundling is examined, where transmission is separated from other supply stages. In short, the study suggests that generation unbundling increases costs by 19 per cent. Transmission unbundling increases costs by two per cent. DEA is a non-parametric, linear-programming approach, using businesses’ input and output data. The approach calculates relative efficiencies of different businesses and derives an efficiency frontier. DEA is not based on statistical methods and does not assume a particular underlying production technology. Meyer uses a

bootstrapping procedure in order to obtain statistical features of the estimated results.

According to Meyer, vertical economies of scope arise in the electricity industry from ‘coordination economies’ and ‘market risk economies’. First, Meyer suggests that coordination economies occur because demand and supply information may flow within a vertically integrated business with greater efficiency than between businesses. This is important in electricity because electricity cannot be stored, and therefore supply and demand must be balanced in real-time. In this context, transaction costs may arise between multiple market participants in an unbundled market that is not vertically integrated. Second, market risk economies arise because generation and network assets are highly specific and irreversible investments with a long construction and operating duration. Meyer argues that businesses in an unbundled industry may be exposed to additional risk because retailers must purchase electricity from independent generators. By relying on wholesale spot markets, suppliers face the risk of price volatility. In contrast, vertically integrated suppliers are less likely to enjoy the same economies of specialisation that may arise in an unbundled situation. Efficiency gains can occur from greater management focus on specific tasks in unbundled businesses.

Meyer notes that the study does not provide an overall assessment of unbundling. It identifies the costs of unbundling but does not measure its benefits. For example, it does not measure the benefits arising from competition in unbundled retail and generation sectors. Nor does it measure benefits when unbundling prevents discriminatory, anti-competitive behaviour of vertically-integrated network owners in favour of their own supply interests.

‘The Impact of Different Fibre Access Network Technologies on Cost, Competition and Welfare’, Steffan Hoernig, Stephan Jay, Karl-Heinz Neumann, Martin Peitz, Thomas Plückebaum and Ingo Vogelsang, Telecommunications Policy, 36(2), March 2012, pp. 96-112.

This paper is about the economic evaluation of alternative network technologies and architectures for fibre-to-the-home (FTTH) provision. This inquiry requires four main things: an understanding of the different possible architectures for FTTH provision; models of costs using a bottom-up engineering economics model; realistic assumptions about prices, demands, etc. for a generic moderately sized country called Euroland; and a ‘pyramid’ competition model of an FTTH oligopoly based on Hotelling’s ‘stability in competition’ approach and the concept of a Nash equilibrium.

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Different network architectures have different costs and different compatibilities with competition. Therefore, there are trade-offs between the cost of deployment and other aspects of economic welfare. In particular, ‘GPON bitstream access’ (explained later) is the least costly to deploy, but is incompatible with unbundling and, therefore, with the promotion of competition. Data speed and future proofing are also affected by the choice of network architecture.

Network architectures for FTTH can be categorised broadly into Ethernet ‘point-to-point’ (P2P) or Gigabit Passive Optical Network (GPON), where GPON has a number of variants. A ‘Metropolitan Point of Presence’ (MPoP) is the fibre equivalent of the main distribution frame (MDF) of copper network technology, but can be located further away from end users because of the superior qualities of fibre over copper. These MPoPs are points of substantial traffic aggregation or concentration. The authors also consider a ‘combined P2P/GPON architecture because it has the potential to combine advantages of both worlds’. Even more architectures are considered.

The authors examine the differences between network architectures in the context of an ‘FTTH oligopoly’. The main variables in the theoretical analysis are consumer surplus, producer surplus and end-user prices. Various models are drawn on, most centrally that of Harold Hotelling (although his ‘Stability in Competition’ paper in the 1929 Economic Journal is not referenced). Its core elements are that consumers are equally distributed and there is a ‘distance’ between consumers and potential suppliers. The Hotelling model is generalised to more than two firms, and services are differentiated (imperfect or monopolistic competition; with attribution to the work of Steven Salop). The ‘pyramid’ work of Thomas von Ungern-Sternberg is also referenced. Equilibria in the model are in the familiar Nash form. The theoretical model is described more generally in the body of the paper and is more formally set out in a technical appendix.

The quantitative modelling is based on the hypothetical ‘Euroland’, a moderately sized European country with 20 million households and 2 million ‘businesses’ (non-household entities). Costs are based on the authors’ bottom-up cost modelling applied to the assumed conditions of the fictional construct – there are eight clusters representing different geo-types. All non-cost variables are based on generic values drawn from observations in several countries. The authors claim that Euroland is a ‘generically representative country’. The authors’ cost modelling indicates that GPON has a cost advantage of only about ten per cent over P2P architecture; but has disadvantages because it does not allow unbundling which is associated with greater competition and greater economic welfare. The

authors argue that GPON is also less ‘future proof’. They conclude that the welfare and other advantages of P2P outweigh the cost advantage of GPON, suggesting that this should be a matter of ‘public policy and regulatory concern’ in Europe. ‘Access Regulation and Infrastructure Investment in the Mobile Telecommunications Industry’, Kim Jihwan, Kim Yunhee, Noel Gaston, Romain Lestage, Kim Yeonbae, and David Flacher, Telecommunications Policy, 35, 2011, pp. 907-919.

The regulation of and access to mobile telecommunications infrastructure continues to be an important telecommunications policy issue. The capital expenditure required for investment in mobile telecommunications infrastructure and the limited radio spectrum have presented considerable challenges to government policy in this area.

To facilitate competition in the market for mobile telecommunications, some national regulatory bodies have allowed mobile operators, who do not posssess their own frequency spectrum and infrastructure, to lease the network facilities from mobile network operators (MNOs). These entrant mobile operators are known as mobile virtual network operators (MVNOs). While such entry and increased competiion under a mandatory access regime may seem benign, the authors claim that an MVNO seeking access to mobile network infrastructure can undermine the ability of an investing firm to appropriate the benefits from investments. If investment in facilities is largely sunk, MNOs may bear heavy sunk costs due to the risks associated with changed or volatile markets. MVNOs will only seek mandatory access if conditions are favourable, so that the MVNO shares the upside benefits. If conditions are unfavourable, the MVNO can avoid the downside risks by abandoning access or deciding not to lease the network.

High sunk costs and the potential for such asymmetric returns under a mandatory access regime may reduce MNO investment intensity. To evaluate this contention empirically, the authors test the hypothesis that mandatory access provision is likely to lead to under-investment vis a vis the case where access provision is voluntary. The data, drawn from the Wireless Intelligence database, provides the financial and operational performance of network operators in mobile markets, which consists of 58 MNOs operating in 21 countries for 35 quarters, from 1/2000 to 3/2008. The authors regressed MNO-capital expenditure (investment intensity) against the type of access regime (mandatory or voluntary) and a number of control variables, including market concentration, population, the real GDP growth rate, the level of each MNO’s market penetration, the growth rate in the MNO’s market penetration, firm

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age in years, the number of connections and the growth rate in connections.

The authors find that the effect of mandatory access has a significant negative impact on investment intensity of MNOs. Non-mandatory provision such as voluntary agreements is not significantly related to investment intensity. The authors note that the majority of cases in the data sample involve voluntary access provision. This suggests that countries with a voluntary access regime are highly unlikely to experience a decline of investment intensity. While mandated access provision is not as widespread as voluntary access provision, the authors note that there are sufficient observations that give confidence in the statistical results.

The authors argue that mandated access provision may reduce investment intensity by MNOs, potentially harming dynamic efficiency, and that regulators need to consider the investment disincentives that arise under a mandatory access regime. That said, the authors also acknowledge that investment intensity is not a foolproof proxy for dynamic efficiency since lower investment may not be undesirable where duplication of, or over-investment in, existing networks matter.

‘Does Vertical Separation Reduce Cost? An Empirical Analysis of the Rail Industry in European and East Asian OECD Countries’, Fumitoshi Mizutani and Shuji Uranishi, Journal of Regulatory Economics, published online on 13 April 2012.

This paper examines whether or not structural separation in the rail industry can reduce costs. It analyses the cost performance of rail operations in 23 European and East Asian OECD countries during the period 1994 to 2007. In this international study, the country selection is partly based on data considerations, as comparable country data are not necessarily available from the International Union of Railways database.

Rail privatisation and regulatory reforms have taken place in many countries in recent years. In particular, many Western European countries have experienced various degrees of vertical separation between rail operation and infrastructure management, such as accounting separation and organisational separation. Horizontal separations of passenger services from freight services, as well as regional separation, have also been observed in some countries.

The authors develop a Translog total-cost function to examine the impact of structural separation. Two alternative output specifications – single output with hedonic specification capturing output characteristics versus two outputs for passenger services and freight services – are modelled. The specification of an interaction term between the vertical separation

dummy and the train density variable allows the authors to examine whether the cost effect of vertical separation changes with the degree of train density.

The two main conclusions of the paper are the following. First, horizontal passenger-freight separation reduces cost, demonstrating that diseconomies of scope in rail operation and/or cost inefficiencies arise from subsidising passenger services. Second, vertical separation tends to reduce cost for rail operation with lower train density. For rail operation with sufficiently high train density, vertical separation can be more costly than integration as a result of high coordination costs between train operation and infrastructure management. While they acknowledge that their study has limitations, the authors consider that it provides evidence against the European Commission’s policy of applying universal vertical separation policy to the rail industry.

‘Private Monitoring and Communication in Cartels: Explaining Recent Collusive Practices’, Joseph Harrington and Andrzej Skrzypacz, American Economic Review, 101, 2011, pp. 2425-49.

Recent examples of stable cartel behaviour have been characterised by the presence of assigned sales volumes or market shares, self-reporting of actual sales volumes which are largely non-verifiable, monitoring of sales volumes by the cartel, and enforcement through inter-firm sales which act as a financial transfer to correct for any ‘unders’ or ‘overs’ in sales. Based on these observations, the authors develop a mathematical model of a stable collusive agreement which, given a number of assumptions, demonstrates how and when cartels may be able to operate effectively.

The examples of stable cartels considered in the article include a global cartel of five lysine producers during the mid 1990s in which cartel members agreed on a certain allocation of output and coordinated on price. If a member sold more than its quota, it was required to buy output from members that were below quota. During the same period, the five largest citric acid producers agreed on a sales quota scheme whereby each member’s market share of output was based on historical sales. This collusive agreement also involved self-reporting of output sales, market-share monitoring, and a buy-back system (where members over quota one year bought output from members under quota in the next year). One key feature of the cartel is that the customers were industrial buyers whose purchases made up only a small fraction of the unit cost of production, and therefore demand was probably inelastic over a relatively wide range of prices. A second feature is that prices were typically set through bilateral negotiations, and therefore were not observable.

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The mathematical model aims to explain the sustainability of these collusive agreements when there is imperfect monitoring. It is assumed that both prices and quantities are private information and that market demand is unobservable and stochastic. The static Nash equilibrium is used to consider cartel members’ behaviour. The authors show that if market demand is not too volatile and cartel members are sufficiently patient, then a collusive agreement can be supported, and the probability of transiting into a non-collusive stage is low.

An incentive compatibility constraint is used to show that firms are incentivised to report sales truthfully. The incentive arises because under-reporting or over-reporting would increase the probability of the cartel breaking down. It is shown that the probability of a price war is a decreasing function of total reported sales. Moreover, the probability of a price war is higher when total sales exceed maximum market demand. In the model, collusion can be sustained if the transfer payment is high enough to offset incentives to underprice and the value of maintaining collusion is sufficiently high to offset incentives to mis-report sales. In conclusion, potential indicators of collusion that anti-trust agencies could look for are firms exchanging sales reports – possibly through a trade association, inter-firm sales, and periodic price wars.

‘The Equity Risk Premium’, Roger Ibbotson in Rethinking the Equity Risk Premium, Research Foundation of CFA Institute, 2011, pp. 18-26.

There are a variety of different definitions and applications of the Equity Risk Premium (ERP). The ERP can be presented as a long-run equilibrium measurement, or a personal estimate. It can be a forecast of future returns, or a backward-looking analysis of actualised returns. For investors, the ERP is the expected return on stocks in excess of bonds. But for corporations, the ERP is an element in the cost of capital. For valuation purposes, the ERP is an element of the discount rate applied to future cash flows. Moreover, there are a range of methods for calculating the ERP, depending on the selection of which bonds, indices, and time periods should be used in an ERP calculation. Ibbotson attempts to clarify and categorise some of the different approaches. He covers four broad methodologies for generating an ERP estimate.

First, the ‘historical’ approach compares past stock returns to relevant past bond returns. The obvious advantage of the historical approach is that it measures actual events. However, the approach to averaging (geometric or arithmetic) is not consistent across industry and can lead to different results. Similarly, the choice of data for analysis is subjective; a long period of data reduces estimation error, but a

smaller, more recent data sample may better reflect current and future trends.

Second, the ‘consensus’ approach surveys market participants and estimates a ‘consensus’ ERP. Ibbotson suggests that, while market participants should have a good prediction of the ERP (because they directly influence it), personal estimates rarely effectively filter out biases such as optimism and pessimism. Any survey of experts can also suffer from the general problems outlined earlier: what sort of ERP is being estimated? What indices are being used?

Third, the ‘demand’ approach analytically solves for the level of ERP that compensates investors for the additional risk associated with stocks compared to bonds. This approach begins with an estimate of the coefficient of risk aversion and a measure of risk in the economy, and asks the question: what premium is implied by this level of risk and risk aversion? The ‘demand’ approach has also been labelled the ‘consumption CAPM’. The principal concern with it is that it implies implausibly low estimates of the ERP.

Fourth, the ‘supply’ approach estimates the cash flows that companies in the economy are capable of supplying to the market. This approach is also referred to as the ‘discounted cash flow’ model. Ibbotson has used this methodology and suggests it may be a promising alternative to traditional ERP calculations.

In the second half of the paper, Ibbotson surveys other premiums relevant to investment decisions, such as long- and short-horizon ERPs, and small-stock premiums. This discussion is used to contextualise the importance of the ERP as one premium among many (though often the largest of those premiums). Ibbotson explains that dynamic and tactical ERP forecasts are usually short-term estimates designed to help investors ‘beat the market’. If the tactical ERP is below the market ERP then the market may be over-valued, so bonds should be purchased rather than stocks (and vice versa).

Regulatory Decisions in Australia and New Zealand

Australia

Australian Competition and Consumer Commission (ACCC)

ACCC Issues Final Access Determination for Regulated Transmission Services

On 22 June 2012 the ACCC issued a final access determination (FAD) for the declared domestic transmission capacity service (DTCS). Transmission, often referred to as backhaul, is a high capacity wholesale service that aggregates traffic (including data and voice) on other services and carries it between service providers’ points of inter-connection in different locations. ACCC Commissioner Ed Willett commented “The FAD includes prices for regulated transmission services and sends an important signal to the industry about the prices that would be expected in a competitive market”. Read more

Appointment of Adjudicator gives Telstra Wholesale Customers New Avenue for Dispute Resolution

On 22 June 2012 the ACCC approved the nomination of Dr Rob Nicholls for the role of Independent Telecommunications Adjudicator. The Adjudicator will be able to make binding rulings in respect of the processes that Telstra must follow in allowing access to its network. This includes rulings regarding the processes by which end users will be migrated from Telstra’s networks onto the National Broadband Network as it is built. Earlier, on 29 March 2012 the ACCC released a discussion paper in relation to Telstra’s establishment of an Independent Telecommunications Adjudicator (ITA). Telstra’s structural separation undertaking requires Telstra to implement dispute resolution processes, including an ITA scheme. The establishment of the scheme requires ACCC approval of a Constitution, a Charter of Independence and appointment of an individual to the role of ITA Adjudicator. The discussion paper invited comment on draft versions of the ITA Constitution and Charter of Independence. Read more

ACCC Telecommunications Reports: Consumers Benefit from 20 Years of Competition

On 21 June 2012 the ACCC reported that its Australian Telecommunications Reports 2010–11, tabled in Parliament, show that consumers have benefited greatly since competition began 20 years ago. Read more

ACCC Suspends Assessment of NBN Co Special Access Undertaking

On 20 June 2012 the ACCC announced suspension of its assessment of the Special Access Undertaking (SAU) lodged by NBN Co, in the expectation that NBN Co will soon lodge a revised undertaking. NBN Co lodged the SAU for assessment by the ACCC on 5 December 2011, setting out a proposed framework for access to NBN Co’s fibre, wireless and satellite networks. The ACCC has subsequently undertaken significant consultation with stakeholders regarding NBN Co’s proposals. NBN Co has recently indicated to the ACCC that it intends to submit an amended SAU. NBN Co has provided an outline of its proposed amendments to the ACCC, and is in the process of developing this into a detailed undertaking. This outline will be published on the ACCC website. Read more

ACCC Proposes to Authorise NBN Co / Optus HFC Subscriber Agreement

On 28 May 2012 the ACCC issued a draft determination proposing to grant authorisation for an agreement between NBN Co and SingTel Optus for the migration of Optus’ HFC subscribers to the NBN and the decommissioning of parts of Optus’s HFC network. Under the Competition and Consumer Act 2010, the ACCC may authorise arrangements where it is satisfied that public benefits outweigh any public detriment likely to result from the arrangements. Read more

ACCC Allows More Time to Develop Wheat Port Capacity Auction in South Australia

On 9 May 2012 the ACCC announced its agreement to Viterra’s proposal to vary its port terminal services access undertaking. The variation will allow Viterra more time to improve the proposed auction system for port terminal services in South Australia for the export of bulk wheat. The original timeframe of May 2012 to introduce an auction system will be extended to November 2012. Viterra, the port terminal operator, is required by the undertaking to introduce an auction system in South Australia. Read more

No Cross-subsidy in Australia Post: ACCC Report

On 4 May 2012 the ACCC issued its seventh report assessing cross-subsidy between the services provided by Australia Post, seeking to establish whether its competitive services were being cross-subsidised with revenue from its statutory monopoly services. Read more

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ACCC Releases 2010-11 Water Monitoring Report for the Murray Darling Basin

On 26 April 2012 the ACCC released its second annual Water Monitoring Report for the Murray Darling Basin under the Water Act 2007. ACCC Chairman Rod Sims commented: "The report shows that water market reforms in the Basin are providing irrigators with the flexibility to maximise the value of their water assets through water trading and farming.” Read more

The ACCC Issues Final Guidelines on Non-Discrimination for NBN and Superfast Telecommunications Networks

On 19 April 2012 the ACCC released final guidelines on the non-discrimination provisions contained in Part XIC of the Competition and Consumer Act 2010 (Cth) (CCA). NBN Co and other providers of wholesale superfast telecommunications services are prohibited from discriminating between customers. The ACCC has a role under the CCA to prepare explanatory material and enforce the non-discrimination provisions. Under the ACCC’s approach, and except in limited circumstances, if more favourable supply terms are offered to only some customers, the ACCC will consider this to be discriminatory. The ACCC will actively monitor compliance with the non-discrimination provisions. The final guidelines and the ACCC’s response to issues raised by submissions to the draft guidelines will be available on the ACCC’s website. Read more

ACCC Seeks Comment on Proposed Variation to Fixed Line Final Access Determinations

On 5 April 2012 the ACCC announced commencement of a public inquiry into varying fixed-line final access determinations. Telstra has requested that the ACCC vary the final access determinations for the declared wholesale line rental, local carriage service and a subset of the public switched telephone network originating access service (PSTN OA) called preselect and override services. The ACCC will not consider the long-term regulation of these services as part of the inquiry. The ACCC may consider the need for regulation of wholesale aggregation services provided over the NBN at a future time. Submissions were required by 11 May 2012. Read more

ACCC Issues Annual Report on Airport Performance

On 30 March 2012 the ACCC submitted its annual monitoring report on the performance of Adelaide, Brisbane, Melbourne, Perth and Sydney airports for 2010-11 to the Assistant Treasurer, the Hon David Bradbury MP. Airports in these cities are monopolies and have market power. In 2002 the Australian Government directed the ACCC to monitor the prices,

costs, profits and quality of certain services provided by Australia's five major airports. Read more

Australian Energy Regulator (AER)

AER Request for Submissions on Murraylink’s 2013–14 to 2022–23 Regulatory Proposal

On 25 June 2012 the AER published Murraylink’s regulatory proposal for the ten-year period ending 30 June 2023. The AER is required under Chapter 6A of the National Electricity Rules to make a transmission determination for Murraylink in relation to its electricity transmission network. On 31 May 2012, Murraylink submitted its regulatory proposal, proposed negotiating framework and proposed pricing methodology to the AER. Submissions on Murraylink’s regulatory proposal and the AER’s proposed Negotiated Transmission Service Criteria are required by 10 August 2012. Read more

Connection Charge Guideline Under the Forthcoming Chapter 5A of the National Electricity Rules (NER) for Retail Customers

On 21 June 2012 the AER released its connection charge guideline, Connection Charge Guidelines under chapter 5A of the National Electricity Rules, for retail customers accessing the electricity distribution network and the Final Decision document, which explain the AER’s reasons. This followed a consultation process, including the publication of a consultation paper (10 June 2011), and a draft connection charge guideline and explanatory statement (22 December 2011). Read more

AER Approval of 2012-13 Electricity Distribution Pricing Proposals (non-Victorian Distributors)

On 7 June 2012 the AER announced that it has determined that the pricing proposals it had received from non-Victorian distributors are compliant with the National Electricity Rules (NER) and the relevant distribution determination, and that all forecasts associated with the proposals are reasonable. The NER also requires the DNSPs to publish on their websites the 2012–13 tariff information and a statement of expected price trends including the reasons for these expected trends. Read more

AER Draft Decision on Roma to Brisbane Gas Pipeline

On 25 May 2012, APT Petroleum Pipelines Pty Ltd (APTPPL) submitted its revised access arrangement proposal for the Roma to Brisbane Pipeline (RBP) for the period 12 April 2012 to 30 June 2017. The revised access arrangement proposal was submitted in response to the AER’s draft decision on the access

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arrangement for the RBP issued on 30 April 2012. The pipeline is owned and operated by APTPPL. The AER’s draft decision was expected to increase a typical residential customer’s bill by around $2 in the first year of the access arrangement period. The AER’s draft decision would result in additional total revenue of $263.4 million over the access arrangement period. Differences between the AER’s draft decision and APTPPL’s access arrangement proposal are principally driven by the weighted average cost of capital, capital expenditure and operating expenditure. These are influenced by different approaches to pipeline coverage, forecast capacity utilisation, and extension and expansion requirements. Read more

Tribunal Decision on AER Smart Meter Determination

On 4 May 2012 the Australian Competition Tribunal released its decision on the appeal by SP AusNet against the AER’s determination on smart meter budget and forecast charges for the period 2012 to 2015. In its appeal, SP AusNet claimed the AER made several material errors of fact in determining that SP AusNet should have reconsidered its choice of smart meter technology. The Tribunal found that the AER had not erred in reaching this conclusion. However, the Tribunal set aside the AER's decision and requires the AER to amend its decision by considering the costs and delays if SP AusNet were to change to a different technology. The AER's amended decision must also include additional expenditure relating to foreign exchange contracts and project management costs. Read more

Final Decision on Powerlink's Electricity Transmission Network Proposal

On 30 April 2012 the AER issued its final decision in relation to Powerlink's proposal to operate the Queensland electricity transmission network for 1 July 2012 to 30 June 2017. The AER’s determination limits the revenues that Powerlink can receive from its transmission network to $4,679 million, or 6.3 per cent below Powerlink's revised revenue proposal. The AER did not accept Powerlink’s capital costs to construct a 500kV capable electricity network to transport electricity from Western Queensland into the Brisbane area. This is based upon the AER’s view that alternative electricity demand and generation scenarios between now and 2017 reduce the need for the project expenditure. Read more

Final Determination on Aurora's Electricity Distribution Network Proposal

On 30 April 2012 the AER issued its final determination in relation to Aurora Energy's revised regulatory proposal. The AER’s final determination limits the revenues that Aurora can earn from its electricity distribution network for 1 July 2012 to 30 June 2017 to $1.4 billion over five years, $200 million less than Aurora’s revised proposal. The key difference of opinion between Aurora and the AER is the rate of return. The AER also rejected Aurora’s proposed operating expenditure. Read more

Federal Court upholds AER's decision on Ergon Energy's street lighting services

On 19 April 2012, the Federal Court delivered its judgment dismissing Ergon Energy's application to review the Australian Energy Regulator's 2010 electricity distribution determination. Ergon Energy argued that the AER did not have power under the National Electricity Rules to regulate street lighting services, arguing that street lighting services were not a 'distribution service.' Read more

National Competition Council (NCC)

Applications for a 15 Year No-coverage Determination for Proposed APLNG Pipeline

On 19 June 2012 the NCC released a Draft Recommendation in response to the 2 May 2012 application it received under the National Gas Law (NGL) from Australia Pacific LNG Gladstone Pipeline Pty Limited (APLNG) for a 15 year no-coverage determination for APLNG's proposed pipeline in Queensland, running from the Surat Basin to Curtis Island. If granted, the effect of such a determination is to exempt the pipeline from coverage under the NGL for 15 years from its commissioning. Submissions on the Draft Recommendation are required by 11 July 2012. Read more

Applications for Declaration of Jet Fuel Supply Infrastructure Services at Sydney Airport

On 10 May 2012, the Hon David Bradbury MP, published his decisions that the service provided by the Caltex pipeline which transports jet fuel from interconnection points with off-site jet fuel storage facilities at Port Botany to the Sydney airport Joint User Hydrant Facility (JUHI); and the jet fuel storage and pipeline network / JUHI facility – the services provided by the jet fuel storage facility (including facilities for refuelling trucks) and jet fuel hydrant pipeline network facility provided by the JUHI at Sydney airport, are not declared. In reaching these

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decisions the Minister determined that sections 44H(4)(a) and 44H(4)(f) were not satisfied by either application. On 15 March 2012 the NCC provided its final recommendations to the Minister. Read more

Australian Energy Market Commission (AEMC)

Extension for making draft determination on Small Generation Aggregator Framework

On 21 June 2012 the AEMC announced its decision to extend by two weeks the period of time for making the draft rule determination on the Small Generation Aggregator Framework rule proposal. The draft rule determination will now be published on 5 July 2012. Read more

Transmission Frameworks Review Updates

On 21 June 2012, the AEMC published a supplementary submission to the Transmission Frameworks Review provided by Grid Australia. The AEMC also published a letter received from the Chair of the Standing Council on Energy and Resources specifying that the Final Report for the review must now be delivered by 31 March 2013. Read more

AEMC Publishes Issues Paper on NEM Financial Market Resilience Advice

On 8 June 2012 the AEMC published an issues paper commencing consultation on advice that it has been asked to provide to the Standing Council on Energy and Resources (SCER) in relation to the resilience of the financial relationships and markets that underpin the operation of the National Electricity Market (NEM). The AEMC aims to publish a first interim report on issues, including options to address any risks identified, by December 2012. Read more

Draft Advice for NSW Government on Reliability Options for Electricity Distribution

On 8 June 2012 the AEMC called for public submissions on the draft report published under the Review of electricity distribution reliability outcomes and standards. The review was carried out due to NSW Government concerns that the State’s reliability standards have been driving increased investment in electricity distribution networks and contributing to higher retail prices. A final report will be published in late August 2012. Read more

Issues Paper Published on Reliability Panel's Review of the Guidelines for Identifying Reviewable Operating Incidents

On 8 May 2012 the Reliability Panel announced a review of its guidelines for identifying reviewable operating incidents and published an issues paper. These guidelines assist the Australian Energy Market Operator (AEMO) in determining when a power system incident is considered a 'reviewable operating incident' under the National Electricity Rules. Feedback on the issues paper was required by 6 June 2012, with the completion of the review anticipated in December 2012. Read more

Australian Capital Territory

Independent Competition and Regulatory Commission (ICRC)

Inquiry into Secondary Water Use

On 19 June 2012 the ICRC published its most recent submission on its Draft Report – Secondary Water Use in the ACT (Report 3 of 2012) which was first released on 14 May 2012. A final report to the Treasurer was required by 30 June 2012. Read more

Discussion Paper – ICRC Position on the Implementation of the National Energy Customer Framework in the ACT

From 1 July 2012, the ACT Government intends to apply the National Energy Customer Framework (NECF) arrangements to the regulation of energy retail in the ACT. The NECF will apply to the relationships between energy customers, retailers and distributors. These matters are currently handled through ACT regulation, primarily through the Utilities Act 2000 (the Utilities Act) and the Consumer Protection Code made by the ICRC under the Utilities Act. The ICRC released a Discussion Paper on the proposed changes to Industry Codes and Guidelines that currently apply to the regulation of energy retail in the ACT. Feedback on the Discussion Paper was required by 12 June 2012. Read more

Retail Price for Franchise Electricity Customers 2012-2014 – Release of Final Report

On 8 June 2012 the ICRC released its Final Report for the supply of electricity to franchise customers for the period 1 July 2012 to 30 June 2014. Read more

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Newly-appointed CEO of the Independent Competition and Regulatory Commission

On 5 June 2012 Ms Ranjini Nayager was announced Chief Executive Officer of the ICRC. Read more

Price Direction for the Supply of Water and Sewerage Services – Release of Issues Paper

On 2 April 2012 the ICRC announced receipt of its seventh submission regarding the Issues Paper ‘Regulated Water and Sewerage Services 2013-18’, released on 22 February 2012. The Paper is the first step in conducting the inquiry to determine water and sewerage prices that will apply in the ACT from 1 July 2013. The ICRC must report to the Treasurer by 1 May 2013. Read more

New South Wales

Independent Pricing and Regulatory Tribunal (IPART) Sydney Water Prices from 1 July 2012

On 19 June 2012 the IPART released its final decisions on Sydney Water’s prices. As a result of IPART’s decisions the water and sewerage bills of the vast majority of Sydney Water’s customers will go up by less than the rate of inflation, falling in real terms from 1 July 2012. The annual water and sewerage bill of a typical residential house will rise by $72 by 2016. This is 2.4 per cent less that the increase that would have occurred had prices risen in line with inflation. The IPART decisions implement new pricing structures that remove inequitable cross-subsidies between different users. Prices have been restructured to ensure that all customers pay bills that represent the costs they impose on Sydney Water. This does not increase the total revenue received by Sydney Water for its services. All residential customers will now pay the same water service charge but bills will vary depending on the volume of water the customer consumes. All non-residential customers will now pay water and sewerage service charges based on the size of their water meter and a lower sewerage usage charge. The bills of non-residential customers will depend on the size of their water meter and on the level of their water consumption, some bills will rise and some will fall. The final determination allows Sydney Water slightly higher annual revenues that the draft determination ($145.2 million or 1.6 per cent higher). Read more

Sydney Catchment Authority Prices from 1 July 2013

See Notes on Interesting Decisions.

Electricity and Gas Prices to Rise in New South Wales, Due to Higher Network Costs and the Introduction of the Carbon Price

See Notes on Interesting Decisions.

Northern Territory

Utilities Commission

Electricity Standards of Service Code

On 15 May 2012 the Utilities Commission announced its intent to make a new Electricity Standards of Service Code, the main objective being to establish standards of service and performance measures in the Northern Territory electricity supply industry. Submissions were required by 8 June 2012. Read more

Power System Review

On 30 March 2012 the Utilities Commission announced the release of its 2010-11 Power System Review, reporting to the Minister on prospective trends in the capacity and reliability of the Northern Territory’s power system. The Review also incorporated reporting on performance against standards of service under the Electricity Standards of Service Code. Read more

Queensland

Queensland Competition Authority (QCA)

2012-13 Investigation of Bulk Water Grid Service Charges

On 30 June 2012 the QCA is due to issue a Final Report which would investigate and recommend bulk water Grid Service Charges (GSCs) for 2012-13. As directed by the Minister for Energy and Water Utilities, the report should focus on fixed and variable operating costs, including undertaking an appropriate benchmark review and providing advice on potential efficiency improvements and business savings based on good industry practice. Read more

Dalrymple Bay Coal Terminal (DBCT) Annual Revenue Requirement (ARR) Roll-forward

On 5 June 2012 the QCA announced that on 1 June 2012 it had approved DBCT Management’s 2012-13 ARR and non-expansion capital (NECAP) applications, effective from 1 July 2012. On 15 May 2012, DBCT Management formally requested the QCA to approve its ARR roll-forward calculation for 2012-13. Separately, on 29 May 2012, DBCT

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Management sought approval for NECAP expenditure of around $19.7 million. The DBCT access undertaking provides for the QCA to approve the Annual Revenue Requirement (ARR) annual roll-forward of the terminal's regulated revenues and tariffs. Where DBCT Management also submits NECAP expenditure for inclusion into its regulated asset base, the QCA assesses the NECAP proposal jointly with the ARR roll-forward proposal as both affect the regulated revenues that DBCT Management can recover via the terminal infrastructure charge (TIC) from 1 July of the following financial year. Read more

Notified Electricity Prices 2012-13 – Final Determination

On 31 May 2012 the QCA released its Final Price Determination on the 2012-13 regulated retail electricity prices (notified prices) for all regulated retail electricity tariffs in Queensland, except for the main residential tariff. This followed the 30 March 2012 release of its Draft Determination on regulated retail electricity prices for 2012-13. The QCA was directed to set notified prices based on an ‘N + R cost build-up approach’ where the N (network cost) component is treated as a pass-through and the R (energy and retail cost) component is determined by the QCA. Read more

Queensland Rail 2012 Draft Access Undertaking

On 30 April 2012, the QCA released an issues paper to assist stakeholders in preparing their comments on the 2012 DAU. On 3 April 2012 the QCA announced that Queensland Rail (QRail) submitted on 30 March 2012 a voluntary draft access undertaking (the 2012 DAU) to the QCA for its approval. The 2012 DAU sets out the terms and conditions under which QRail proposes to provide access to rail infrastructure covered by the undertaking once its current access undertaking expires on 30 June 2012. On 30 April 2012, the QCA published an issues paper to assist stakeholders in preparing their comments on the 2012 DAU. As part of its investigation of QRail’s 2012 DAU, the QCA sought submissions by 1 June 2012. Stakeholders have asked that the QCA extend that deadline to allow time to consider the effect of the new material on the proposed standard access agreements in the 2012 DAU. Submissions are now required by 13 July 2012. Read more

2012-13 Draft Report on Grid Service Charges (GSCs)

Following submissions due by 25 April 2012 the QCA published its Draft Report, following receipt of a Direction Notice under the SEQ Water Market Rules from the Minister for Energy and Water Utilities to investigate and recommend bulk water GSCs for

2012-13. As part of the investigation, the QCA was required to undertake a detailed review of fixed and variable operating costs, including undertaking an appropriate benchmark review and to provide advice on potential efficiency improvements and business savings based on good industry practice. A Final Report will be due by 30 June 2012. Read more

QR Network’s Proposed Alternative Access Charge

On 3 April 2012, the QCA released its final decision to approve QR Network’s proposed alternative access charge (tariff) for a new coal haulage train service to operate between the Colton mine (near Maryborough) and the Port of Gladstone, submitted on 27 October 2011. The QCA received and considered three submissions on the proposed Colton access charge from: the Queensland Resources Council (QRC), BHP Billiton Mitsubishi Alliance (BMA) and Asciano Limited. Read more

Interim Price Monitoring of SEQ Water and Wastewater Distribution and Retail Activities – 2011-12 Review

On 3 April 2012 the QCA released its Final Report (Part A, Part B) on SEQ Interim Price Monitoring for 2011-12. The Deputy Premier, Treasurer, and Minister for State Development and Trade and the Minister for Finance and The Arts have referred the monopoly distribution and retail water and wastewater activities of Queensland Urban Utilities, Allconnex Water and Unitywater to the QCA for price monitoring covering the period from 1 July 2011 to 30 June 2013. Read more

South Australia

Essential Services Commission of South Australia (ESCOSA) 2012-13 Annual Gas Retail Tariff Adjustment

On 15 June 2012 the ESCOSA approved Origin Energy's Statement of Approval for 2012–13 gas standing contract prices on the basis that it demonstrates compliance with the relevant provisions of the 2011-2014 Gas Standing Contract Price Determination. Read more

2012 Origin Energy Pass Through Application – Carbon Price – Final Decision

On 15 June 2012 the ESCOSA released its decision regarding Origin Energy's application for a carbon price cost pass-through amount to apply from 1 July 2012. Read more

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1 July 2012 Electricity Standing Contract Price Adjustment

On 15 June 2012 the ESCOSA released its decision in respect of the standing contract prices which AGL South Australia Pty Ltd (AGL SA) will be allowed to charge its South Australian electricity standing contract customers from 1 July 2012. Read more

2012 AGL Application for Special Circumstances Review – Final Decision

On 15 June 2012 the ESCOSA received an application from AGL SA to re-open the Price Determination to adjust the tolerance band to accommodate any impacts of the introduction of carbon pricing mechanism on market contract prices. Read more

Final Advice to the Treasurer on Economic Regulation of the South Australian Water Industry

On 12 June 2012 the ESCOSA released its Final Advice to the Treasurer on its consideration of an appropriate form of price and non-price regulatory regime to apply to the South Australian water industry. The Final Advice excludes consideration of its approach to price regulation of SA Water’s drinking water and sewerage. The ESCOSA intends to publicly release a Statement of Approach on the price regulation of SA Water in early July 2012. Read more

2012 Ports Pricing and Access Review

On 7 June 2012 the ESCOSA released a Draft Report on the 2012 Ports Pricing and Access Review. The ESCOSA's draft findings are that both the current ports price monitoring regime and third-party access regime should continue beyond 30 October 2012, for at least another five years. Submissions are required by 20 July 2012. A Final Report is expected in September 2012. Read more

Review of the Enforcement Policy

On 4 June 2012 the ESCOSA announced that it was reviewing the terms of its Enforcement Policy and would issue the revised policy after 1 July 2012. Read more

Tasmania

Office of the Tasmanian Economic Regulator (OTTER)

2012 Tasmanian Water and Sewerage Price Determination

On 28 May 2012 the OTTER published its Final Report and Final Price Determinations, the result of an investigation into prices and service standards for water and sewerage services. The determinations set maximum prices for water and sewerage services to apply from 1 July 2012. Read more

Impact of the Carbon Pricing Mechanism on the Wholesale Energy Allowance for 2012-13

On 12 April 2012 the OTTER released a consultancy report into the expected impact of the Australian Government’s carbon price on Aurora Energy’s electricity supply costs for non-contestable customers. Electricity prices for 2012-13 will be determined in June 2012 after the OTTER considers Aurora's retail tariff proposal for 2012-13, which was required to be submitted by 30 May 2012. Read more

Victoria

Essential Services Commission (ESC)

Review of Water Performance Report Indicators - Draft Recommendations Paper

On 19 June 2012 the ESC released draft recommendations on its paper - Review of Water Performance Report Indicators – Staff Discussion Paper (first released in April 2012). The paper’s aim is to review and refine the performance indicator framework. Feedback on the draft recommendations is required by 13 July 2012.

Rail Access Arrangements – VicTrack – Final Decision

On 31 May 2012 the ESC released its Final Decision to approve VicTrack’s revised proposed access arrangement. On 2 March 2012, the ESC announced that VicTrack had submitted a proposed access arrangement for renewal of its existing arrangement for the provision of access to its declared rail infrastructure, including the North Dynon Intermodal Terminal and Agents' Sidings. VicTrack is an access provider for the purposes of the Rail Management Act 1996 (RMA). Under the RMA, the ESC is responsible for deciding whether to approve or not

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approve access arrangements submitted to it by access providers. Also under the RMA, a new access arrangement comes into operation from the day of the ESC’s final decision. VicTrack’s new access arrangement will expire on 31 May 2015. Read more

Pacific National Access Arrangement Assessment 2012 – Draft Decision

On 31 May 2012 the ESC released its draft decision on Pacific National’s proposed access arrangement. On 30 March 2012, the ESC received Pacific National’s (a subsidiary of Asciano Ltd) proposed access arrangement renewal application. Pacific National’s access arrangement sets out the terms and conditions by which it will provide access to the South Dynon Terminal. Feedback on the draft decision was required by 14 June 2012. Read more

V/Line Access Arrangement Assessment 2012

On 31 May 2012 the ESC released its draft decision on V/Line’s proposed rail access renewal arrangement, received on 30 March 2012. Feedback was required by 14 June 2012. Read more

Barwon Water Application for Price Adjustment – Draft Decision

In April 2012 the ESC released its Draft Decision on Barwon Water’s Application for Price Adjustment. The ESC will approve an adjustment to Barwon Water’s prices in 2012-13 of an additional three per cent on top of the already approved seven per cent, covering water services only, to reflect costs associated with the Melbourne to Geelong Pipeline (MGP). Feedback was required by 21 May 2012 and a final decision was expected in June 2012. Read more

Victorian Water Price Review 2013-18

The ESC has announced it will be reviewing the prices to apply to water and sewerage services provided by Victoria's water businesses for the regulatory period 2013-18. Water businesses in Victoria are Government owned enterprises and are subject to pricing regulation from the ESC. Under a process set out by the state Government, the ESC periodically assesses prices put forward by water businesses in a three to five year Water Plan. The ESC approved prices for all metropolitan water businesses for the four years commencing 1 July 2009. The prices were set to recover the expenditure required to operate and extend the water and sewerage networks over the period. Read more

Western Australia

Economic Regulation Authority (ERA)

Draft Decision on Western Power’s Proposed Revisions to the Access Arrangement for the Western Power Network – Public Submissions Received

On 19 June 2012 the ERA published additional submissions from interested parties on its Draft Decision on Western Power’s proposed revised Access Arrangement for the Western Power Network. The ERA is responsible for reviewing and approving the access arrangement for the Western Power Network, an electricity network in the south-west of Western Australia. The access arrangement includes terms and conditions including prices for services typically sought by third parties seeking access to the network. Western Power has proposed that this period will operate between 1 July 2012 and 30 June 2017. The due date for submissions was 29 May 2012; and three were accepted after the intended closing deadline. The ERA’s final decision is due to be released by 11 July 2012. Read more

Mid-West and South-West Gas Distribution System Access Arrangement – Proposed Reference Tariff Variation for 2012/13

On 30 May 2012 the ERA announced approval of the proposed reference tariff variation submitted by ATCO Gas Australia Pty Ltd on 18 May 2012, to apply from 1 July 2012. Read more

Goldfields Gas Pipeline – Access Arrangement and Access Arrangement Information – Amendments by Order of the Western Australian Electricity Review Board

On 13 April 2012 the ERA published the Access Arrangement and Access Arrangement Information for the Goldfields Gas Pipeline (GGP). The documents are amended from the GGP Access Arrangement documents published by the ERA on 5 August 2010, and are pursuant to the Electricity Review Board review of the decision by the ERA to approve its own revised Access Arrangement for the GGP. Read more

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New Zealand

Commerce Commission (NZCC)

NZCC to Issue Further Discussion Paper on Pricing of Copper Services

On 21 June 2012 the NZCC announced it will be issuing a further discussion paper on the pricing of services over Chorus’s copper local loop network. The NZCC is also extending the timeframe for the final stages of re-benchmarking the unbundled copper local loop service (UCLL) price. A further discussion paper is expected to be released in July. It is anticipated that a final decision will be made before 30 November 2012. The new pricing will come into effect on 1 December 2012. Read more

NZCC Releases Draft Input Methodologies

On 15 June 2012 the NZCC released draft input methodologies for electricity distribution services and gas pipeline services. It was directed to determine these input methodologies by the High Court following an appeal by Vector Limited in September 2011. The draft input methodologies concern the valuation of assets, allocation of costs and treatment of taxation. The NZCC will finalise the draft input methodologies by 30 September 2012. Submissions are welcomed on the draft input methodologies by 6 July 2012, and cross-submissions by 17 July 2012. Read more

NZCC Identifies Factors Likely to Affect the Uptake of High Speed Broadband

On 21 May 2012 the NZCC released its draft report on factors that may affect the uptake of high speed broadband. Feedback was required by 7 June 2012 and a final report anticipated by 29 June 2012. Read more

NZCC Releases Draft Price for the Unbundled Copper Local Loop for Consultation

On 4 May 2012 the NZCC published its revised draft decision re-benchmarking the wholesale price for the unbundled copper local loop service (UCLL). The UCLL service allows Chorus’s competitors to use Chorus’s copper network between an exchange and an end-user’s premises to provide their own services to customers. The proposed changes will result in a reduction in the geographically averaged UCLL wholesale price from its current average of $24.46 to a new average of $19.75. The proposed UCLL prices will be phased in over two years from 1 December 2012. The new averaged price will apply to all lines from 1 December 2014. The current urban price will remain largely unchanged, while the non-urban price will fall over the next two and a half years. The Commission is also consulting on whether there are reasonable grounds to commence a Schedule 3

investigation into the pricing principles for the unbundled copper low frequency service (UCLFS). Currently the UCLFS price is the same as the UCLL price but the services are different. The UCLL loop length is 29 per cent shorter on average than the UCLFS. Read more

Release of Annual Monitoring Report

On 1 May 2012 the NZCC released its fifth annual telecommunications annual monitoring report for 2011 analysing the state of New Zealand’s telecommunications markets. It is part of its continuing monitoring of the evolution of competition in the telecommunications sector in New Zealand. Read more

NZCC Issues Draft Determinations for UFB Information Disclosure

On 23 April 2012 the NZCC issued draft determinations (and an accompanying consultation paper) for the information disclosure requirements for companies who are building fibre networks as part of the Government’s ultra-fast broadband (UFB) initiative. The NZCC is required to collect information on the costs and characteristics of the UFB fibre networks for regulatory purposes. The draft determination proposes that the fibre network companies must supply the NZCC with financial and network information annually. Feedback on the consultation paper was required by 15 May 2012. Read more

NZCC Defines Criteria for Persons Potentially Liable for Telco Development Levy

On 19 April 2012 the NZCC set out its preliminary views on the persons potentially liable for the Telecommunications Development Levy (TDL) for the 2011-12 year. The Crown will use the TDL to pay for the Telecommunications Service Obligations (TSO) and other telecommunications infrastructure development in New Zealand. The NZCC sought submissions commenting on its views by 9 May 2012. Cross-submissions were due by 23 May 2012. Read more

Customers Switching for Better Broadband and Cheaper Mobile

On 12 April 2012 the NZCC released the findings of a nationwide survey on consumer switching behaviour which found that the main reason consumers give for switching fixed-line telecommunications service providers is to obtain better broadband services. Cheaper rates is the main reason given for switching mobile telecommunications service providers. Read more

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Cross-net Mobile Traffic Continues to Increase

On 5 April 2012 the NZCC released its third mobile monitoring report which showed a continuation of the narrowing between the prices of on and off-net calls and texts indicated in early reports. This has resulted in an increase in calling and texting between mobile networks. The NZCC expects the positive trends to continue and will prepare a more comprehensive report in July, when it has 12 months’ data. As part of the NZCC’s determination on mobile termination access services (MTAS), it collects mobile data on a monthly basis which it reports on quarterly. Read more

Notes on Interesting Decisions

Sydney Catchment Authority Prices from 1 July 2013

On 19 June 2012 the IPART released its final decisions on prices that Sydney Catchment Authority (SCA) charges. The prices allow SCA to continue to carry out its important role of meeting the supply needs of Sydney Water and its other customers and protecting the quality of water in the catchment.

The revenue that SCA requires to meet its efficient costs will decrease by 7.5 per cent in the first year of the determination period, 2012/13. The decrease in 2012/13 reflects IPART’s move to a post-tax weighted average cost of capital. Prices will then increase by slightly more than inflation over the remainder of the determination period. SCA will have different volumetric charges to Sydney Water to account for different water sales when the Sydney Desalination Plant (SDP) is operating and when it is not. A lower volumetric charge will apply when SDP is not operating as SCA’s sales to Sydney Water will be higher. When SDP is operating, the volumetric charge will increase to offset SCA’s lower sales to Sydney Water. Both volumetric charges will allow SCA to recover its costs which do not change with the operation of SDP. Prices to Sydney Water will have a larger fixed cost component than in the past. 80 per cent of SCA’s revenue will be recovered through a fixed charge, rising from 40 per cent in previous determinations. This better reflects SCA’s large fixed costs of doing business and is justified due to SCA’s dependence on one customer. SCA’s prices include the expected costs of the Australian Government’s carbon price scheme which will commence on 1 July 2012. Carbon price costs represent about 1.9 per cent of SCA’s operating costs or about 0.9 per cent of SCA’s required revenue. Read more

Electricity and Gas Prices to Rise in New South Wales, Due to Higher Network Costs and the Introduction of the Carbon Price

On 13 June 2012 the IPART released its final determination on the average prices that regulated electricity retailers in New South Wales (NSW) can charge residential and small business customers from 1 July 2012. The final decision allows for an average price increase of 18 per cent across NSW (including inflation), primarily as a result of rising network (poles and wires) costs and the introduction of the carbon price. The final decision is higher than the 16 per cent price increases indicated in the draft decision in April reflecting updated estimates of costs of generating electricity. The average price increases

will vary for customers of the three regulated electricity retailers as follows:

20.6 per cent for EnergyAustralia customers, which translates to an extra $7.00 per week ($364 per annum) on an average residential customer bill, and $9.07 per week ($472 per annum) on average for its small business customers

11.8 per cent for Integral Energy customers, which translates to an extra $4.00 per week ($208 per annum) on an average residential customer bill, and $5.19 per week ($270 per annum) on average for its small business customers

19.7 per cent for Country Energy customers, which translates to an extra $8.21 per week ($427 per annum) on an average residential customer bill, and $10.67 per week ($555 per annum) on average for its small business customers.

The IPART expressed concern about ongoing cost increases and has outlined a number of recommendations aimed at improving the future affordability of electricity. The IPART would like to ensure that the electricity industry works for the long-term interests of customers. There are aspects of the National Electricity Rules and the National Electricity Law that could be changed to reduce pressure on prices and to make sure that expenditure on the electricity network is efficient. The IPART has also outlined some areas around reliability standards, green schemes, and subsidies that could be reviewed to limit future price increases. The IPART noted that around half of the increase in NSW electricity prices from 1 July is because of the continuing rise in costs faced by the retailers from the electricity network – or the poles and wires. The other half is due to increasing wholesale electricity costs faced by the retailers resulting from the introduction of a carbon price on emissions from electricity generators.

Twenty four responses were received to the draft report including submissions from individuals, the energy industry and social welfare groups. A public forum was held in Sydney in April 2012. Retailers argued that the financing costs for electricity businesses that were included in the draft report were too low. The IPART further considered this issue and decided to increase its allowance for financing for electricity generation, given the risk in the current unsettled market. This had led to higher price increases than in the draft report. The IPART is aware that the 16 per cent price increase forecast in

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April caused concern among customers, and knows that a further 2 per cent increase will be even more difficult for many customers. However, the IPART noted that the costs of providing electricity are increasing.

On 1 July 2012, the NSW Government will increase the Low Income Household Rebate to $215 and introduce a Family Energy Rebate of $75 for eligible households. Additionally, low and middle- income households will receive carbon price compensation from the Commonwealth Government. The IPART’s analysis indicates that the Commonwealth Government’s assistance package will adequately compensate the large majority of low-income households for the impact of the carbon price on their electricity bills. Regulated retail gas prices will also increase by nine per cent to 15 per cent across NSW from 1 July 2012, with the price increases for individual customers depending on their standard retailer and their annual consumption. For the majority of customers around half the increase is due to the introduction of the carbon price and the other half is due to increases in gas distribution network prices which are regulated by the Australian Energy Regulator. The carbon price increases retail gas prices by six per cent to nine per cent. Gas distribution network price increases for AGL and ActewAGL customers (in Jemena’s gas distribution network area) will add a further 6 per cent to customers’ bills. The average price increases will vary for customers of the four retailers as follows:

14.8 per cent for AGL customers, which translates to an extra $2.03 per week ($106 per annum) on a typical residential customer bill.

10.4 per cent for Origin Energy’s Murray Valley customers, which translates to an extra $2.25 per week ($117 per annum) on a typical residential customer bill.

11.6 per cent for Origin Energy’s Country Energy customers (the Wagga Wagga area), which translates to an extra $1.78 per week ($93 per annum) on a typical residential customer bill.

8.8 per cent to 14.5 per cent for ActewAGL’s ACT/NSW border and Shoalhaven customers, which translates to an extra $0.88 to $2.73 per week ($46 to $142 per annum) on a typical residential customer bill.

The IPART has made recommendations to address the uneven nature of the appeals mechanisms available to gas network businesses and the outcomes for gas customers.

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Regulatory News

Sixth ACCC/AER Working Paper

The sixth working paper has now been released by the ACCC titled ‘Benchmarking Opex and Capex in Energy Networks’:

http://www.accc.gov.au/content/index.phtml/itemId/1054590

This working paper reviews five alternative benchmarking methods – namely partial performance indicators, index-number-based total factor productivity analysis, econometric method, stochastic frontier analysis, and data envelopment analysis – with a particular focus on their use in the benchmarking and regulation of energy networks. The review covers published studies from the academic literature and also consultancy reports written for regulatory purposes, as well as regulatory applications of benchmarking methods from 15 OECD countries. This paper also identifies the major technical and implementation issues in benchmarking energy networks.

ACCC Regulatory Conference

Final details for the annual ACCC Regulatory Conference in Brisbane on 26 and 26 July 2012 are now being put in place. The updated program for the conference is available at:

http://www.accc.gov.au/content/index.phtml/itemId/1034271

The registration form is also available at this link for those who have not yet registered.

Network is a quarterly publication of the Australian Competition and Consumer Commission for the Utility Regulators Forum. For editorial enquiries please contact Rob Albon (Robert.Albon@accc.gov.au) and for mailing list enquiries please contact Genevieve Pound (Genevieve.Pound@accc.gov.au).