Regulation and the price of privatised infrastructure businesses

A leading commentator on electricity markets recently accused Josh Frydenberg, Minister for the Environment and Energy, of a Trump moment. Minister Frydenberg, it seems, did not agree with the Full Federal Court’s decision on the regulation of electricity distribution and said so. The Australian Competition Tribunal (‘ACT’) had overturned an original decision of the Australian Energy Regulator (‘AER’) that would have markedly reduced the revenues that NSW distributors could earn and the prices that they could charge. The AER appealed. The court rejected that appeal, correctly given the law.

Minister Frydenberg’s outburst was hardly Trumpian. After all, the end result of this tortuous process is that electricity bills will go up, surely a matter for Ministerial concern. But leaving aside the specifics and the legal niceties, maybe we are missing the big picture when it comes to regulated prices.

How do we regulate?

Regulation is, at its heart, simple. First, we identify businesses that need regulation. Mostly they are monopolies like electricity distributors who manage the wires that connect our homes. We regulate monopolies because, if we don’t, they will set prices that are too high and a quality of service that is too low. We call such bad behaviour monopoly pricing.

Recalling Hilmer, we temper our desire to regulate with a cost-benefit test. If the cost of regulation is higher than the benefits of regulation, don’t. It is hard to measure the costs and benefits so typically we don’t bother. We rely on less precise tests such as ‘national significance’ and ‘economic to duplicate’. But for services like electricity distribution, most of us agree that regulation is a must.

Having established the need, the regulator has to determine a regulated price. In Australia they do this by gauging what assets the regulated business needs, the return they need on their investment in those assets, and the operating costs they necessarily incur to operate those assets. Divide all that by delivered energy and you have a regulated price.

In practice it is not so simple. The regulator doesn’t run distribution businesses (or, indeed, any business) so does not know what assets are needed, nor the extent of operating costs, nor the required return on new investment. It cannot tell the difference between an efficient and an inefficient business, nor whether prices are in fact monopolistic. It suffers from what is called information asymmetry.

Because regulation is so difficult, it is quite likely to be costly. The costs can include the direct costs of rectifying information asymmetry and, more importantly, the indirect costs of failing to do so. Given the severe consequences of both monopoly pricing and regulatory failure, we surely need a way of testing whether the regulators we have in place have done their job.

One such test is a process test. Has the regulator conducted itself in accordance with the rules it has been given? In the case of the AER, you might characterise the limited merits review by the ACT and judicial review by the Federal Court as process tests. But are there other tests based on the more normative question, “has the regulator got it right?”

Can we tell if the regulator gets it right?

In order to tell whether regulator gets it right, we need a test. Is there one?

Trivially, if regulators ‘get it right’, they set the required return on investment (which regulators term ‘WACC’) at a level that an efficient firm would require, and operating costs at the level of an efficient firm. And they only allow businesses to make new investments that are efficient (or to use the vernacular of Australian regulation, that are in the long term interest of customers or ‘LTIC’). But this just poses a different set of tests —what is the right WACC? what are efficient costs? — which are no easier to answer.

Framed in terms of these subsidiary tests, the basic question of whether ‘the regulator got it right’ presents a challenge. The test of correctness that is proposed, say the WACC of an efficient firm, is precisely what the regulator is itself trying to determine. If we had such a test, we probably wouldn’t need regulation that amounted to much more than an instruction ‘to do it right.’

So once again, we commonly rely upon process rather than metrics. The regulator is charged with examining a range of different factors to determine WACC: different theoretical models; market data on firms that might have some similarities to the regulated firm; government bond rates as proxies for risk free rates of return; different empirical estimates of the investment premium for holding equities etc. The process is further bolstered by a requirement to consult with interested parties and to consider the resultant disputation. What we typically get is polar positions on these important regulatory parameters, and it is no surprise that regulators often find some middle ground.

We also have a process for encouraging efficiency, basically allowing the regulated firm to keep for a period of time (usually for 5 years but only 5 years) the extra profits from reducing their costs below the regulator’s target. We have the buildings-block approach for working out revenue needs. And the AER, in the decisions contested in the Federal Court, was trying to introduce a new process for working out when firms are efficient, namely benchmarking.

Acquisition prices

In competitive markets, we don’t need these tests. We rely on competition to deliver efficient outcomes. But even though we don’t need the tests, the market itself reveals efficient revenues, prices and values. Perhaps there is a related ‘market’ test of whether regulators get it right that derives from the many privatisations of regulated businesses we have seen, most of which involve competitive auctions.

We should be able to say something about the price that an acquirer of a regulated business would be willing to pay if regulation ‘gets it right’. If the regulator does what, ideally, we would like it to [costlessly] do, the value of the regulated business should be equal to the value of the assets that the firm needs to provide the services, that is, the value of the regulatory asset base (‘RAB). More precisely, if acquirers of regulated businesses expect regulators to get it right, acquisition prices should be equal to the RAB value. This we can measure.

TransGrid, the NSW electricity transmission company was privatised under a 99-year lease in 2015. At the time of the sale, the AER determined that the value of RAB was around $6.5bn. The acquisition price was $10.3bn, a 58% premium over the RAB value. The Port of Melbourne was recently sold for $9.7bn. While the story here is a bit more complex, because there are regulated and unregulated components, this still represents a huge premium over the RAB value.

This test seems to suggests that regulators don’t get it right, or that buyers of regulated infrastructure don’t believe that they do.

Are there other reasons for these acquisition premiums?

Perhaps these acquisition prices don’t signal regulatory failure, but the winner’s curse. The winner’s curse is a well understood problem in auctions. In simple term, the buyer that most over-estimates value wins the auction but, in so doing, over-pays. This is not a good explanation for the premiums we have seen; sophisticated buyers know about the winner’s curse and adjust for it. And there is no reason to believe that the buyers of TransGrid, the Port of Melbourne and other infrastructure assets in Australia are anything other than sophisticated.

There are also legitimate reasons why a new owner might want to pay more than RAB value. The best owner should get more value from a business (and be willing to pay a higher price to acquire it) than an average owner. Even if the regulator has accurately judged what is efficient today, the new owners might think they can do better through their own operational excellence and innovations. This would be a wonderful outcome, but it should not justify a large purchase price premium over RAB value. Under standard regulatory practice, the business would only keep gains from superior performance for 5 years; it would then itself become the yardstick for efficient operation that the regulator adopts.

Perhaps the new owners are paying for all the profits they could earn from unregulated opportunities that arise from ownership. For example, transmission companies can and do provide backbone broadband transmission. But this, too, is a suspect basis for the  premium. First, current regulatory practice places severe constraints on the ability of regulated firms to use RAB assets to generate unregulated revenue streams. Second, new adjunct business activities are presumptively competitive. If they are competitive, they should generate zero economic profit and should add little or nothing to the acquisition price. Even if there are profitable ancillary opportunities, they would need to be very attractive indeed to justify the premiums that we observe.

Back to the test

Leaving aside why buyers pay a premium, let us simply go back to the axiom. Breaking it down, if:

  • superior firms are only allowed to retain the benefits of their superior performance for a short time, 5 years;
  • regulated firms are not allowed to generate unregulated revenues from their regulated asset base;
  • regulated firms are not allowed to make inefficient new investments; and
  • regulated firms are not allowed to monopoly price, make excessive returns or provide inadequate services, then

the acquisition price should be equal to the value of the RAB. Since in practice they have not, acquirers presumably expect that one or more of these core principles will not be met.

Required returns on investment

One plausible reason for the acquisition price premium over RAB value is that the new owner has a cost of capital that is materially lower than the WACC they expect the regulator will allow. A number of factors might contribute to this, for example: adopting a capital structure different from that assumed by the regulator; differences between actual and assumed taxation; lower actual debt costs than assumed debt costs; lower target returns for equity investors (or a different risk appetite) than assumed.

There are some good reasons for thinking that the actual cost of capital required by investors in recently privatised infrastructure businesses is low at the moment. Some overseas sources of funds, for example China, are keen to find investment opportunities that offer low risk and positive real returns over a long horizon. Superannuation funds in Australia, which have large cash inflows and long term liabilities, are also looking for low risk and positive real returns over a long horizon. Both are likely to favour the acquisition of existing mature infrastructure business over prospective new infrastructure business to avoid the construction and demand risks attendant with new projects. Desirable investment opportunities of this type are in short supply, which will drive down the returns that investors are willing to accept in order to secure them.

While we need to be circumspect in driving down WACC lest we undermine incentives for owners to continue to invest (noting that, broadly speaking, we are better served by over- rather than under-investment in infrastructure), there is scant evidence that regulators have taken this into account in their WACC determinations.


The conclusion from all this is simple. If investors are willing to accept lower returns to acquire low risk long life assets, for which there is at least a case to answer, social efficiency demands that this is passed on to customers in lower prices. This is the express role of regulators. They should deliver lower prices to customers by lowering the WACC estimates they use in their revenue determinations to reflect these forces. Large privatisation premiums can provide some guidance on how much.

So back to Minister Frydenberg. I am sure that at an intellectual level he understands and accepts the decision of the court, based as it is on law. I am equally sure that he has a point; there is a compelling case for lower bills.

29 June 2017