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

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

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

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

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

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

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

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

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

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

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

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

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

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