Allens

Competition Law

Client Update: Regulated returns – arguments in the pipeline

20 July 2012

In brief: A recent decision by the Australian Competition Tribunal, relating to gas pipeline access arrangements, sheds light on aspects of the current regulatory approach to setting returns for infrastructure assets. Partner Jo Daniels (view CV) and Senior Associate John Hedge look at the implications of the decision.

Background

On 8 June 2012, in Application by WA Gas Network Pty Ltd (No.3)1 , the Australian Competition Tribunal set aside the decision of the Economic Regulation Authority of Western Australia (the ERA) refusing, under the National Gas Rules, to approve the WA Gas Networks Pty Ltd access arrangements for the Mid-West and South-West Gas Distribution Systems in Western Australia.

The distribution pipelines were 'covered' pipelines, which meant that the ERA was responsible for approving the applicable access arrangements.

The ERA had decided that the appropriate rate of return for the infrastructure owner was the weighted average cost of capital (WACC) of 7.40 per cent on a real pre-tax basis, or 9.51 per cent on a nominal post-tax basis. The tribunal's decision was principally concerned with whether the ERA had determined an unreasonably low rate of return for the infrastructure owner (in this case, ATCO) for a range of reasons. The tribunal ultimately concluded that the ERA had made a number of reviewable errors that needed to be corrected by remaking the decision.

Two important implications of the decision are that:

  • arguments by infrastructure owners that the global financial crisis and its aftermath justify higher rates of return will be viewed with scepticism by regulators and the tribunal; and
  • the tribunal tended towards the view that access arrangements should not be prescriptive regarding terms that are considered 'commercial' in nature.

Return to top

The tribunal's decision

Under the National Gas Law (as applied in Western Australia by the National Gas Access (WA) Act 2009 (WA)) the grounds for review of the ERA's decision were limited to particular reviewable errors. Reviewable errors are: an error of fact that, either individually or in concert with other errors of fact, was material to the decision; an incorrect exercise of discretion; or the decision being unreasonable. Those grounds of review fall short of a full merits review, but are wider than the grounds of review available under statutory judicial review regimes.

The tribunal determined the ERA had erred in five ways:

  • Use of franking credits: setting the 'gamma' too high (effectively overestimating the utilisation of franking credits by ATCO's shareholders and therefore providing for a lower rate of return), which the ERA itself conceded it should have set at 0.25 based on subsequent regulatory precedent.
  • Debt risk premium: setting the debt risk premium (the premium above the risk-free rate that ATCO should be permitted as an efficient cost of debt) by a process involving a simple unweighted average of four samples of yields on Australian bonds, when certain bonds were given disproportionately greater weight due to being included in multiple samples.
  • Bridging finance costs: not allowing bridging finance costs as operating expenditure, where the tribunal accepted obtaining such finance was prudent in the context of ATCO having sought the bridging financing over an interim period, and that doing so arose from a series of unanticipated delays in the National Gas Law being implemented in Western Australia; that it was based on independent advice that this was the most cost-effective course; and done with a view to obtaining finance on the basis of settled access terms.
  • Allowable operating costs: not permitting the tariff variation mechanism to apply to capital expenditure obligations imposed by subsequent actions of government agencies, which the tribunal considered an incorrect exercise of discretion and an unreasonable decision in the context of the ERA having accepted such a variation for additional operating costs imposed by government agencies, the result being that ATCO would get no deduction allowances or return on such capital until the next regulatory period when the capital expenditure would be included in the regulatory asset base.
  • Standard haulage terms: requiring an obligation of a pipeline user under the standard haulage terms to be expressed as 'the user acknowledges it must use reasonable endeavours', rather than the 'the user must use reasonable endeavours'.

The other allegations were rejected, as the tribunal found they did not constitute a reviewable error, and were, rather, just ATCO seeking to challenge the merits of the decision.

The decision was remitted to the ERA to make again, subject to directions from the tribunal regarding the points mentioned above. However, the tribunal took the view that it was not itself in a position to form an appropriate view on the correct debt risk premium (see point two above) and left that to be considered further by the ERA.

The ERA has subsequently made a revised decision, increasing the real pre-tax WACC from 7.40 per cent to 7.55 per cent (as a result of the gamma of 0.25 required by the tribunal and a reduction in the debt risk premium from that initially determined).

Return to top

Implications for other regulated infrastructure

While many of the issues considered in the decision were specific to ATCO's circumstances, certain aspects of the decision have wider implications for regulatory decisions in other contexts.

The analysis of setting the debt risk premium, and the tribunal's view that it was not in a position to form an appropriate view on the correct premium, demonstrates that a regulator's determination of an appropriate debt risk premium remains a contentious issue.

Given the tightness of equity and debt finance markets following the global financial crisis and residual concerns about financial markets, regulated infrastructure owners are increasingly concerned that regulators will adopt a long-term market risk premium and debt premium without sufficient regard to their exposure to the current higher costs of debt finance. ACTO specifically argued that 'market evidence' of the rates at which financiers had indicated they would be willing to lend to it should be used in place of the traditional methods of fair value curves or other estimates derived from bond yields. However, the tribunal accepted the ERA's assessment that single estimates based on a potential financing transaction at a particular point in time of this kind were not an appropriate estimation of the debt risk premium. The tribunal also accepted the finding of the ERA that market conditions had substantially improved and that concerns about the impact of the GFC on the market had lessened.

Having said that, the tribunal's rejection of the ERA's averaging process on the debt risk premium also makes it clear that regulators cannot uncritically adopt a methodology, even if it gives a debt risk premium that the regulator considers 'about right'. Such 'eyeballing' of the right figure by regulators will evidently continue, but the decision is a reminder of the care regulators need to take in justifying any figure determined to mitigate the risks of subsequent challenges. Where an infrastructure owner takes issue with the end result, but cannot find fault with the process of reasoning, it will always be difficult to overturn a regulator's decision.

The other issue of wider relevance is the tribunal's support for the ERA's refusal to approve many of the detailed terms of the template haulage terms that ATCO proposed. While that support was partly based on what the National Gas Laws actually required, the tribunal expressly noted that it may be desirable for standard access terms to be less prescriptive. The tribunal approved a previous statement of the Full Federal Court that while greater prescription may facilitate quicker access, that needs to be balanced against the risks of unforseen effects (like impeding competition and efficient investment) from a regulator, which might suffer under a comparative lack of information to the infrastructure owner and industry participants, prescribing too tightly detailed terms.

However, we anticipate that not all access regulators will be quick to move away from existing levels of prescription, and neither would it be appropriate to do so for all regulated services. In particular, the balance referred to by the tribunal may still favour prescriptive regulation in the context of regulated industries or services, where previous conduct, a history of access disputes, or structural issues like vertical integration, create concerns that justify a more prescriptive approach.

Footnotes
  1. [2012] A CompT 12.

For further information, please contact:

Return to top

Share or Save for later

What are these?
 

To save this publication on your smartphone or
tablet for off-line reading (eg on a plane flight),
we recommend Pocket.