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1© Covec Ltd 2007 Regulatory Evolution: Lessons from New Zealand John Small ACCC Regulatory Conference July 2007

2© Covec Ltd 2007July 2007 Outline Generic Background Motivations for regulation New Zealand’s regulatory history 1.State Domination (1870….1984) 2.Hands Off(1984….1998) 3.First attempts(2000….2007) 4.Search for quality What is LHR, and can it work?

3© Covec Ltd 2007July 2007 Motivations for regulation Economic motivation: improve allocative efficiency This creates extra welfare because there is more trade, in this market But, there are offsetting costs Direct costs of regulation Mostly fixed, so scale matters Indirect costs May deter efficient investment PMPM PCPC Demand QMQM QCQC Welfare Gain

4© Covec Ltd 2007July 2007 How big are the allocative benefits? What if customers captive? Inelastic demand No welfare gain from price cut Network connection charges are generally price inelastic Implication? Value of regulation lower the more essential is the service. PMPM PCPC Demand QMQM QCQC Welfare Gain

5© Covec Ltd 2007July 2007 Political motivation for regulation Distributional goals are common Focus is on delivering a great deal to the average voter Price cuts Service upgrades (broadband) Economists are mainly agnostic about rent transfers Just dividing the pie; not growing it If pushed, one might say… Some rents are an entry lure Transfers may have GE effects Marginal value of income varies Democratic voting/policy markets are very inefficient PMPM PCPC Demand QMQM QCQC Transfer

6© Covec Ltd 2007July 2007 NZ RegHist1: State domination NZ utilities were publicly owned from the outset Government (central or local) built and ran the networks Railways (Vogel borrowed £10m starting in 1870) Postal Telephone Electricity Water Roads Ports (air & sea) Several contributing factors Small local economy Challenging geography This was our regulatory model until 1984

7© Covec Ltd 2007July 2007 Regulation via social ownership Strengths “Victims” of monopolist are also the beneficiaries Weaknesses But redistribution still exists unless everyone is the same Weak pressure for cost containment Costs did get out of hand in some areas (notably railways) First addressed by corporatisation into State Owned Enterprises (SOEs) Some SOEs were later sold, including Telecom But the SOE model is still prevalent in electricity (generation & transmission)

8© Covec Ltd 2007July 2007 3 pillars of light handed regulation Competition law Illegality of collusion, abuse of dominance No price restraint, except if competition would be lessened Information disclosure Wide ranging but  Not linked to any specific regulatory model; and  Allowed firms to choose how to define things Threat of direct regulation In competition terms, the regulator was a “potential entrant” But this kind of entry is fairly slow and costly So credibility of the threat was questionable If firms were guided, it really was by an invisible hand

9© Covec Ltd 2007July 2007 some outcomes: ECPR and ODV Clear entered to compete with Telecom Telecom offered ECPR interconnection prices Privy Council confirmed that this did not breach Commerce Act The dispute lasted 5 years Electricity lines businesses revalued their assets Added close to $3bn through write-ups (1994-2002) Cost to consumers around $200m p.a. But no real efficiency loss, at least not in this market Lines charges are fixed fees, and connections are essential Self-regulating wholesale market for electricity (1996) Only 2 generators No retail competition: distribution/retail integrated monopolists

10© Covec Ltd 2007July 2007 Why was LHR unsustainable? There was no public uprising It wasn’t a nuclear issue, or rugby Electricity & telecoms just became politically embarrassing Telecom made hay & played very hard High dividend rate, minimal investment Number portability black hole Street by street pricing against Saturn, 0867 Competitive electricity markets were AWOL The wholesale market was a farce There was no retail competition Also, the LHR fans wouldn’t bend LHR was a yes/no belief issue; compromise wasn’t contemplated

11© Covec Ltd 2007July 2007 Evolution… Electricity Structural splits (1998) vertical split of distribution & retail horizontal split of dominant generator into 3 (all SOEs) Ministerial inquiry (2000) Supported self-regulation of wholesale market Recommended targeted price control for lines companies Legislation (2001) Thresholds regime for lines companies, at ComCom discretion Provision for electricity market regulation if industry process fails Electricity Commission (2003) Prompted by industry voting down its own rulebook Governance of electricity market & transmission investment

12© Covec Ltd 2007July 2007 Electricity Lines Thresholds Regime Was intended to be light handed & targeted Lines company-specific price & quality thresholds Breach does not invoke any sanction, just investigation ComCom could take control of pricing though In practice, lots of breaches; mostly minor

13© Covec Ltd 2007July 2007 Views on thresholds vary Firms’ main gripe is uncertainty Consequences of breaching thresholds unclear MED discussion paper outlines 3 issues Uncertain breach consequences May lead to a Part 5 investigation; may not Inability to get ex-ante approval for major investments Thresholds are backward-looking, based on sector averages Possibility of poor target selection May be selecting firms whose threshold was too tight MED also speculate on whether logic is sound The more specific the regime becomes, the weaker the connection to a light- handed and targeted model Most respondents want some changes

14© Covec Ltd 2007July 2007 And in telecoms… 2001 Act was intended to be light-handed Negotiate/Arbitrate Pricing principles known in advance for regulated services 2 “weights” of regulation: specified + designated Initial lists passed in legislation Process for adding/deleting services from schedule UBS has been added; MTR has not Universal service cost estimation and sharing Net cost of serving commercially non-viable customers is shared Things were muddling along OK, but Broadband progress was far too slow for politicians Act was amended in 2006: operational separation of Telecom

15© Covec Ltd 2007July 2007 Currently reviewing Part 4 Fundamental issues are being addressed The regulatory purpose statement Promoting competition? What counts as a benefit? Regulatory tests: whether/how; may/should “Whether/how” decisions are separate; no “should” test, only a “may” What regulatory options should be available? Propose/respond; Negotiate/arbitrate Are weaker (eg non-quant) tests appropriate for less intrusive regulation? Should we ditch the thresholds regime? Or sharpen it up & keep it in the tool box Merits review, and if so, in what form?

16© Covec Ltd 2007July 2007 Reinventing LHR LHR is minimum cost effective regulation What is the easiest way of meeting regulatory objectives? Suppose price control is an objective Obviously, price monitoring is necessary Equally obviously, it is not sufficient  An essential services monopolist will just keep hiking the price The firm must also be able to see the constraint And clarity of vision is desirable  It limits uncertainty and thereby reduces costs So, some 3 rd party needs to [be able to] set the price Either the regulator, or an independent arbitrator  What guidance should be provided?

17© Covec Ltd 2007July 2007 Greasing the LHR wheels Clarity over the rules is essential Regulators can develop input methodologies in advance eg asset valuation; WACC method; depreciation PC saw lack of asset valuation guidance as systemic problem in airports Legislation should describe triggers for further investigation Another systemic problem in Australian airport sector (PC) Propose / respond MED paper suggests an interesting option for lines companies  Commission proposes constraints for the whole sector  Firms respond with counter-proposal if they have good reasons  Commission accepts unless counter is unreasonable vis-à-vis rules Negotiate / arbitrate Advocated by aviation interests as a way of constraining airports  Along with abolishing statutory right for airports to charge “as they see fit” Binding, final offer arbitration, based on pre-set rules/methods

18© Covec Ltd 2007July 2007 Conclusion NZ – Australia are on similar journeys We’re both seeking low cost ways of Mitigating serious market power on basic infrastructure Without  Imposing undue costs; or  compromising efficient investment incentives Regulation is a politically driven activity This can be frustrating, but TINA The NZ models are being refined Outcomes of current consultation round will be worth watching

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