By Alan Moran
Infrastructure will suffer if companies can't raise prices.
SETTING prices for "natural monopolies" such as electricity lines, water pipes and gas distribution networks has developed as a relatively mechanistic procedure.
In Australia, we have several such price-setting bodies, the most important of which is the Australian Energy Regulator (AER). Invariably the price reviews are conducted with wide hearings where the businesses seek as high a price as possible and user groups seek the opposite. Voluminous reports are produced, rehearsing all the arguments canvassed by different interests. In the main, over the past decade, this has required a lowering of the current price.
The regulator's decision invariably brings a cacophony of protests from the owners, who claim they'll be ruined by the new price. Usually the regulator pares back the price somewhat in its final decision, but this still leaves the businesses grumbling that their capital investment program will be jeopardised and that consumers as well as their shareholders will suffer.
But in almost every case, the businesses have remained profitable and the networks' performances have steadily improved. To some degree this is a result of interest rates progressively falling over recent years and allowing unanticipated cost savings. Nonetheless, regulators have been conditioned to regard earlier protests as cases of the businesses crying "wolf". They have therefore steadily reduced the prices that may be charged by critically scrutinising claims of necessary investment expenditures and paring back the capital costs the businesses claim they must incur.
In general, partly due to previously falling interest rates, scepticism about firms' intended capital expenditures has proven correct. There have, however, been exceptions. Thus, the disastrous blackouts in Queensland in 2004 were largely due to the regulator squeezing the revenue and spending of the two (government owned) electricity distribution businesses.
The relatively uncontroversial assessment of the prices that gas and electricity utilities should charge disappears when the economy experiences a radical change. Such is the situation at present. In the past the authorities would assess how much debt and how much equity each of the utilities required and apply well known premiums over the risk-free rates.
But those premiums over the risk-free rates have suddenly changed.
In its latest price reset, the AER is fixing rates for the period from 2010 to 2019. The proposed rate of return for the equity component is 8.1 per cent based on a premium cost at 4.8 per cent above the Commonwealth bond rate.
While such a risk premium was reasonable two years ago, it is clearly inappropriate at present. One energy infrastructure business, Envestra, is in the process of raising more equity at what it estimates to be a yield equivalent of 18 per cent.
The AER price setting is in accordance with the methodology specified by its legislation. But unless the regulator uses greater finance-setting flexibility the level of investment in the energy networks will fall dramatically.
Energy firms' difficulties in raising money without the benefit of a government guarantee are amplified by the various government financial market interventions. Each guarantee or preferential treatment of sectors in distress imposes additional costs on those not so favoured. The $30 billion government-backed borrowing facility to bail out shopping centres cannibalises the funding resources available to areas such as electricity lines and gas pipelines.
One benefit of reducing incentives for electricity transmission lines is that it may force some useful economies. Major candidate areas for outlay savings are the grid links to the inefficient and poorly located wind farms, which would be forced to incur their own network costs. Doubtless governments, which have nailed their colours to the wind industry mast, will see such an outcome differently.
Rather more significant for the economy as a whole is that the reduced incentive to invest, which for some businesses becomes a financial impossibility, will have an effect on the maintenance of the existing system. Especially around Melbourne, the gas and electricity system is 40 and 50 years old and in many areas nearing the end of its life. Replacement is necessary to prevent power outages.
As with other ventures that don't have the benefit of a government guarantee the cost of funds for electricity and gas networks has risen markedly. Where their prices are regulated either they must be added to the lengthening list of businesses that are supported by the Government's credit rating or they must be given approval to raise prices to cover their increased costs of funds.
Alan Moran writes about deregulation for the Institute of Public Affairs, a policy research group.