CONGRUENT REGULATION: DESIGNING THE OPTIMAL UTILITY … · 2020. 7. 17. · defined in chapter 1....

CONGRUENT REGULATION:

DESIGNING THE OPTIMAL UTILITY REGIME

Harriet Gray

16 June 2020

Student number: 3151406

College of Law

Australian National University

A thesis submitted for the degree of Doctor of Philosophy of

The Australian National University

© Copyright by Harriet Gray 2020

All Rights Reserved

i

THESIS STATEMENT

This thesis comprises only my original work except where acknowledgment

has been made in the text of other material used.

This thesis is less than 100,000 words (excluding footnotes, tables, figures,

and appendices).

Harriet Gray

16 June 2020

ii

ACKNOWLEDGMENTS For their advice:

Stephen Bottomley, Peta Spender and Alex Bruce

For their guidance on the initial proposal: Anne Plympton and Philip Williams

For their participation: Geoff Andrews, Ron Ben-David, Warren Bennett, Paul Bilyk, Nick Brodribb, Brian Cassidy, Rob Chilov, Cristina Cifuentes, Drew Clarke, Teresa Corbin, Garth Crawford, Andrew Deitz, Rhondda Dickson, Joe Dimasi, Roman Domanski, Steve Edwell, John Feil, Ray Finkelstein, John Fullerton, Ian Greer, Eric Groom, Michelle Groves, Peter Harris, Chris Harvey, Matt Healy, Shanthi Herd, Greg Houston, Gordon Jardine, Sean Kelly, Stephen King, Tim Kuypers, David Marchant, Mick McCormack, Peter McIntyre, Justin Oliver, Cameron O’Reilly, Simon Ormsby, George Passmore, Mark Pearson, John Pierce, Anthony Pitt, Dave Poddar, Mark Pollock, Carmel Price, Tim Reardon, Andrew Reeves, Tim Rothwell, Graeme Samuel, Andrew Sheridan, Rod Shogren, Rod Sims, Tony Slatyer, Rajat Sood, David Stanford, Rick Stankiewicz, Geoff Swier, John Tamblyn, Sarah Udy, Simon Uthmeyer, Ivan Varughese, Tony Warren, Ed Willett, Don Woodrow, Luke Woodward and Richard York

The views expressed by the author in this thesis do not necessarily reflect those of the persons listed above. The views expressed by the persons listed above and cited in this thesis do not necessarily reflect those of the organisations with which they are engaged.

iii

ABSTRACT

Picture a policy maker tasked with designing a regime to

regulate a utility. What design principles will produce an

optimal regime? This thesis develops the concept of

congruent regulation where all the components of a regime

work together. The thesis does not adjudicate on whether

Australian governments were right to follow the international

trend away from government monopoly provision of utilities

towards private ownership, open competition and independent

regulation of the bottleneck infrastructure. Instead, this thesis

points out contradictions in the design of individual

components of utility regimes: If market power justifies

economic regulation of the bottleneck infrastructure, why are

the components that are usually designed by lawyers such as

the regulatory process, appeal mechanism and institutional

structure not also tailored to market power? Can a

government’s complex objectives really be achieved through

the economists’ approach of designing price signals to deliver

economic efficiency with non-economic objectives addressed

through external instruments? In asking whether it is possible

to develop principles for the design of a utility regime as a

whole, this thesis develops a deceptively simple proposition:

Regime objectives and market characteristics should drive the

design of all the regime components subject to legacy issues.

In practice, this principle can cause heated debates as lawyers

and economists are challenged to give up cherished beliefs on

regulatory design. And yet the alternative is perennial surprise

when an incongruent regime does not deliver the intended

results.

iv

CONTENTS

Page

Introduction .……………………………………………………………… 1

Part I Chapter 1 The research question: How to answer it? 15

Chapter 2 Australian case study regimes .………….. 37

Chapter 3 Designing a utility regime …….................. 84

Chapter 4 Economic regulation in practice ………… 110

Part II Chapter 5 Objectives: Price methodology …………... 158

Chapter 6 Market power: Regulatory process …....... 221

Chapter 7 Public and private ownership .….………… 262

Chapter 8 Cross-business ownership: Ring-fencing and coordination ………….………………..

280

Chapter 9 Buyer characteristics: Consumer choice .. 303

Chapter 10 Transitional issues …………... …………... 344

Part III Chapter 11 Congruent regulation ……………………... 373

Conclusion ………………………………………………………………. 399

Appendices

A Interview methodology .………..…………………………... 401

B Australian regimes: Overview ...…………....……...…….... 410

C Australian regimes: Cases ....……………....……...…….... 461

Shortened forms .………………………………………………………… 502

Bibliography .……………………………………………………….…..... 510

1

INTRODUCTION

Source: http://www.lhc.ac.uk

The picture above is of the Large Hadron Collider (LHC) – a machine that

runs for 27km in a circular tunnel beneath the Swiss/French border at

Geneva.1 As a result of collisions of particles, it is possible that the LHC

could create mini ‘wormholes’ and so allow a form of time travel.2 If time

travel is feasible, it is likely to revolutionise economies across the world. It

would be a ‘public utility’3 – at least, for those countries that could afford it (the

27km LHC cost AU$6.27 billion to build).4 Just like the Roman censor Appius

Claudius Caecus when faced with unmet demand for water and the need for

a road to defeat the Samnites5 or Lieutenant Menzies when tasked with

developing the New South Wales ‘Coal Harbour and Hunter’s River’,6 a

government would have to decide: What intervention (regulation) is needed to

achieve the desired outcomes for time travel? Time travel provides the

scenario for a Gedankenexperiment (thought experiment)7 to address the

question: Is there an optimal design for a utility regime?

1 http://www.lhc.ac.uk (accessed 18 August 2016). 2 Although only subatomic particles would be small enough to travel through the

mini ‘wormholes’: Roger Highfield, ‘Time Travellers from the Future ‘Could be Here in Weeks’’, The Telegraph (6 February 2008) www.telegraph.co.uk.

3 Public utility is defined in chapter 1. 4 Geneva Correspondents, ‘What is the Large Hadron Collider?’, The Australian

(4 July 2012) www.theaustralian.com.au. The LHC was completed in 2008. The cost was 6.03 billion Swiss francs (AU$6.27 billion dollars, using the conversion rate as at the date of the article).

5 Gregory S. Aldrete, Daily Life in the Roman City: Rome, Pompeii, and Ostia (Greenwood Press, 2004) digital loc 294; Mary Beard, SPQR: A History of Ancient Rome (Profile Books, 2015) digital loc 1796.

6 Governor King to Lieutenant Menzies, 14 March 1804, Historical Records of New South Wales Vol 5: King 1803-1805 (Southwood Press, 1979) 361.

7 James Robert Brown and Yiftach Fehige, ‘Thought Experiments’ in Edward N. Zalta (ed.), The Stanford Encyclopedia of Philosophy (Spring 2016 Edition)

Introduction

2

But perhaps the question asked by this thesis is too broad? The thesis limits

the scope of the question by defining ‘public utility’ and ‘optimal economic

regulatory regime’ (also referred to as a ‘utility regime’ in this thesis).

Adapting Sleeman’s work from 1953,8 the thesis stipulates four characteristics

of a ‘public utility’. First, a public utility is a supplier of a service

(e.g. telecommunications) rather than a good (e.g. bread or ale9) – or, at

least, a service is an integral component of the supply chain10 (e.g. delivery of

electricity or natural gas). Secondly, the public utility is regarded as

‘essential’ – end-users require a constant and reliable service (e.g. water).

Thirdly, the supply chain or, at least, the service component, is a natural

monopoly (e.g. a single airport can serve the market at lower cost than a

combination of two or more airports). Usually, this is due to a large part of the

cost being fixed (e.g. the cost of a rail track is not dependent on the level of

usage). However, the natural monopoly component could arise, not from

capital investment, but from other characteristics such as the need to provide

a ubiquitous service including in remote areas where volumes are low and

populations dispersed (e.g. postal delivery). The third characteristic

contributes to the fourth. From the point of view of the consumer, the service

component is non-transferable (e.g. if the coal port operator raises the price,

the user cannot easily store the service, postpone their demand to another

point in time, or transfer their demand to a substitutable service).

In contrast to ‘public utility’, the thesis expansively defines ‘regulation’ as

government action that is intended to influence the way people behave.11

http://plato.stanford.edu/cgi-bin/encyclopedia/archinfo.cgi?entry=thought-experiment (accessed 18 August 2016).

8 J.F. Sleeman, British Public Utilities (Sir Isaac Pitman & Sons, 1953). See chapter 1 of the thesis.

9 From the middle ages, England had long-standing legal provisions controlling the price of bread, wine and ale: Ian Mortimer, The Time Traveller’s Guide to Medieval England (Random House, 2009) digital loc 1877. In Australia, in 1985, float glass, beer, cigarettes, tea, instant coffee and concrete roof tiles were declared, along with telecommunications and postal services, under the Prices Surveillance Act 1983 (Cth): Prices Surveillance Authority, Annual Report of the Prices Surveillance Authority 1984–1985 (AGPS, 1985).

10 ‘Supply chain’, along with the interchangeable term, ‘production chain’, is defined in chapter 1.

11 As discussed in chapter 1, the thesis adopts Windholz and Hodge’s approach to defining regulation. Although regulation can be undertaken by any part of society, for the purpose of this thesis, the question is being asked from the perspective of government (although government may elect to reply upon

Introduction

3

Regulation can thus range from legal rules to moral persuasion or reliance

upon ‘self-regulation’. However, the focus of the thesis is limited to

‘economic’ regulation’ where the government intervenes in market decisions,

such as price, output, rate of return, market entry or exit, and competition.

This excludes broad areas of regulation applying to public utilities such as

corporate law, taxation, occupational health and safety and industrial relations

– although the thesis examines the design of economic regulatory regimes to

achieve objectives other than economic efficiency such as equity and

environmental protection. An ‘optimal’ regime for the economic regulation of

a utility is defined in this thesis as one which is effective in achieving the

stated objectives, and efficient in terms of maximising the benefits to the

community, taking into account the costs.

Is it necessary to narrow further the scope of the thesis? One person

interviewed for the thesis in fact commented, in respect of the proposed

research topic on designing an optimal utility regime:12 I actually think that it’s not answerable – although that doesn't mean that it's

not worthwhile, particularly for the qualitative elements.

One option would be to confine the thesis to a particular component of a utility

regime such as Ottow’s work on good agency principles for market and

competition authorities.13 In fact, the thesis could focus on one

subcomponent such as the Australian Productivity Commission report on

auditing a regulator’s performance.14 However, this would miss the

opportunity to explore one of the most interesting insights to come out of the

regimes studied in this thesis – the interaction between the components of a

utility regime.

The thesis could be limited to a particular country such as Australia.

However, varying geographic, economic and social characteristics do not

instruments such as self-regulation). Eric Windholz and Graeme A. Hodge, ‘Conceptualising Social and Economic Regulation: Implications for Modern Regulators and Regulatory Activity’ (2012) 38(2) Monash University Law Review 212.

12 Interview, 2012. The role of interviews as part of the research methodology is described later in this introduction and in chapter 1 and appendix A.

13 Annetje Ottow, Market & Competition Authorities: Good Agency Principles (Oxford University Press, 2015).

14 Productivity Commission, Regulator Audit Framework (2014).

Introduction

4

obviate the practical need to articulate common principles for designing utility

regimes. The question arises each time the World Bank provides guidance

on the development of infrastructure,15 the European Union (EU) issues a directive to member nations prescribing requirements for national utility

regimes,16 the Association of Southeast Asian Nations (ASEAN) Energy

Regulators’ Network discusses regional cooperation,17 or the Australian

Commonwealth, States and Territories negotiate an intergovernmental

agreement setting out agreed principles for utility regulation.18

Yet one possible complication is that each utility industry has unique market

characteristics. As an interviewee commented:19 Post is a very different business to a lot of the other utilities. I know every

utility probably says ‘oh we're very different’, but 95 per cent of our cost

base on reserved services is operations and maintenance and 5 per cent is

capital.

Do these unique characteristics make it impossible to develop cross-industry

principles for utility regime design?

In the 1990s, Gunningham and Grabosky addressed a similar challenge in

the context of environmental regulation. The types of policies that will work

for issues such as ozone depletion, greenhouse effect, toxic waste or land

clearing will vary. However, despite the context-specific nature of each issue,

Gunningham and Grabosky developed abstract principles to guide the choice

of regulatory instruments (which they describe as ‘smart regulation’).20

15 See, e.g., Ashley C. Brown, Jon Stern, Bernard Tenenbaum and Defne

Gencer, International Bank for Reconstruction and Development (World Bank), Handbook for Evaluating Infrastructure Regulatory Systems (2006).

16 E.g. Directive 2002/19/EC of the European Parliament and of the Council of 7 March 2002 on access to, and interconnection of, electronic communications networks and associated facilities (Access Directive).

17 E.g. Association of Southeast Asian Nations, Joint Ministerial Statement of the 29th ASEAN Ministers on Energy Meeting (AMEM) (Jerudong, Brunei Darussalam, 20 September 2011).

18 E.g. Competition Principles Agreement (11 April 1995, as amended to 13 April 2007). As discussed in chapter 2 of the thesis, revisions to the Agreement were canvassed in the Competition Policy Review (Ian Harper, Peter Anderson, Su McCluskey and Michael O’Bryan) that concluded in 2015: Competition Policy Review, Final Report (March 2015).

19 Interview, 2012. 20 Neil Gunningham and Peter Grabosky with Darren Sinclair, Smart Regulation:

Designing Environmental Policy (Oxford University Press, 1998).

Introduction

5

This thesis similarly asks whether it is possible to develop principles for the

design of utility regimes despite the unique characteristics of each country or

industry. However, in contrast to ‘smart regulation’, this thesis is not

restricted to the different instruments that may be used for utility regulation

(for example, the choice between competition for the market, competition law,

moral persuasion, price monitoring, negotiate-arbitrate, and upfront price

regulation). A narrow focus on the regulatory tool would miss the interaction

between the components. It also fails to address the reality faced by policy

makers – our time travel policy maker cannot simply determine the regulatory

instrument then turn off their office light and head home.

This thesis argues that, despite the unique characteristics of each country

and industry, it is possible to draw out twelve questions that a policy maker

(whether it be our time travel policy maker or Edward Cardwell, who

developed the United Kingdom’s (UK) Railway and Canal Traffic Regulation

of 1854)21 must ask themselves when designing a utility regime.22 In

summary, these regime components are:

1. Objectives: What are the government’s objectives for the industry?

2. Market structure: Should the service component and/or related markets

across the supply chain be open to competition? Will a business that

operates in one part of the supply chain be allowed to operate in other

parts of that chain (vertical integration) or to operate competing

businesses (horizontal integration)?

3. Ownership: What parts of the supply chain should be publicly or privately

owned?

4. Identifying what should be regulated: What part of the supply chain should

be subject to economic regulation?

5. Regulatory tool: What tool or instrument(s) should be used to regulate the

utility service? For example, competition for the market, competition law,

21 The Act imposed on the companies the obligation to provide reasonable

facilities and avoid undue preference: An Act for the better regulation of the Traffic on Railways and Canals (1854) 17 & 18 Vict. C.31. See Timothy Leunig and Nicholas Crafts, Did Early Utility Regulation Work? An Investigation of British Railway Regulation Prior to the First World War (The Public Services Program Discussion Paper Series No. 0804, August 2008).

22 See chapter 3.

Introduction

6

moral persuasion, price monitoring, negotiate-arbitrate, and/or upfront

price regulation?

6. Price methodology: What methodology should be used to regulate the

price for the utility service?

7. Non-price terms: How should the non-price terms (upon which the

regulated service is supplied) be regulated?

8. Non-economic objectives: How should non-economic objectives be

addressed?

9. Making new markets work: What other provisions are required to facilitate

the operation of the markets that are open to competition? For example,

facilitation of consumer engagement in the new markets; or enforcement

mechanisms to prevent people from exceeding the allocation that they

purchase on the market (such as water in the Murray-Darling Basin).

10. Regulatory process: What process and approach should the economic

regulator follow when making decisions? Should there be an appeal

mechanism for the economic regulator’s decisions? How should the

regime be kept up-to-date?

11. Institutional structure: What policy making and regulatory institutions are

required?

12. Legacy and transitional issues: Are there any legacy and transitional

issues that will constrain the design of the preceding components?

These regime components were developed by reviewing eight Australian

case study regimes:23

1. telecommunications (1997)

2. postal services (1994)

3. airports (1996)

4. electricity (1996)

5. natural gas (1997)

6. interstate rail (2002)

7. Hunter Valley coal supply chain (2011)

8. irrigation services in the Murray-Darling Basin (2007).

23 See chapter 2.

Introduction

7

The strength of the case studies is that they cross multiple industries. The

weakness is that the case study regimes are not necessarily a

comprehensive guide to the components that should be contained in a utility

regime. To understand the effectiveness (or otherwise) of the case study

regimes in practice, 61 interviews were conducted with participants across the

regimes, and all of the appeal decisions and government-initiated policy

reviews that occurred in respect of the regimes, were analysed.24

Having identified twelve components of a utility regime, have we given our

time travel policy maker sufficient assistance to fill out that blank sheet of

paper titled ‘Time Travel White Paper’ or ‘Government media release:

Mapping the time travel industry of the future’? Unfortunately, our policy

maker is unlikely to be particularly appreciative. Assuming that there are

twelve regime components, and that for each component, there are (at least)

two options, this would produce 4,096 different regime designs. An analogy

is a children’s ‘flip the pages’ book which combines different parts of animals,

and which produces 4,096 different pictures to analyse. How is our time

travel policy maker to consider all of the pictures, and conclude that the

design on page 3,604 is optimal?

The thesis argues that, conceptually, these twelve regime components

provide a formula (an optimisation equation) for what should be contained in a

utility regime.25 An ‘optimisation’ problem is commonly expressed as a

mathematical equation.26 For example, the operator of the Australian national

electricity market uses a highly complex algorithm to determine the optimal

dispatch of electrical power given physical and economic constraints.27 A

policy maker, in designing a regime for the regulation of a public utility, faces

an analogous task: How should regime components 2 to 11 be designed

(given the legacy constraints in component 12) to deliver the objectives in

component 1?

24 See appendices B & C. 25 See chapters 1 and 3. 26 Gordon Mills, Optimisation in Economic Analysis (Allen & Unwin, 1984). 27 Australian Energy Market Operator, An Introduction to Australia’s National

Energy Market (July 2010); Australian Energy Market Operator, Dispatch Constraint Violation Penalty Factors (Document No. 140-0011, 1 July 2010).

Introduction

8

This thesis develops the concept of ‘congruent regulation’, drawing upon

Grabosky’s concept of ‘counterproductive regulation’28 and Feaver and

Sheehy’s concept of ‘coherent regulation’.29 The components of a utility

regime are interrelated. One interviewee likened utility regulation to a Rubik’s

Cube – if you change one square then you have to change the other

squares.30 A ‘congruent’ or ‘harmonious’ utility regime is one where all the

components work together to deliver the regime objectives.

This raises the question: Can we find an existing theory that informs the

design of each utility regime component to reduce the risk of regulatory

failure?31 The theory that appears to come closest to performing this function

was developed by Biggar in 2012. Biggar argues that utility regulation should

seek to protect the sunk investment of the customers of the monopoly firm.32

To extend this theory to time travel, a firm may be reluctant to invest in a

factory that relies on a time travel service because of the risk that, after the

sunk investment has been made in the factory, the time travel natural

monopoly service provider will increase the price. This theory shapes, not

only the price methodology, but also other regime components such as the

dispute resolution mechanism and the regulatory institutions. If the

underlying theory is correct, then it should deliver what this thesis calls a

‘congruent regime’ where the components work together.

The limitation of this approach is that it does not necessarily reflect the

circumstances faced by the policy maker.33 As one interviewee put it:34 It all stems from the natural monopoly, efficiency and encouraging

competition. But I think the argument about protecting the sunk investment

of consumers is a bit simplistic. There’s an example of buying a house

28 P.N. Grabosky, ‘Counterproductive Regulation’ (1995) 23 International Journal

of the Sociology of Law 347. 29 Benedict Sheehy and Donald Feaver, ‘Designing Effective Regulation: A

Normative Theory’ (2015) 38(1) University of New South Wales Law Journal 392.

30 Interview, 2012. 31 The concept of ‘regulatory failure’ and values assumed in this thesis are

discussed in chapter 1. 32 Darryl Biggar, The Economics of Public Utility Regulation: A New Approach

(LuLu, 2012). 33 See chapter 5 of the thesis. 34 Interview, 2012.

Introduction

9

alongside a train track. But it’s really the notion of protecting 23 million

consumers who need electricity, telecommunications, transport and so on.

Instead, this thesis asks whether it is possible to identify factors that impact

on the operation of each regime component. If the design of each component

is then tailored to this factor, could this produce a ‘congruent regime’ where

the components work together?

This thesis argues that a ‘harmonious’ or ‘congruent’ regime can be

developed by tailoring the design of each regime component to two key

factors: the regime objectives and market characteristics. Regime objectives

may encompass both economic efficiency and other objectives such as

fairness and environmental protection. Market characteristics cover supply-

side (e.g. whether the market is open to competition, whether the supplier is

vertically or horizontally integrated, and whether the supplier is publicly or

privately owned) and demand-side (e.g. whether the customer is a firm or

household; and whether the customer has countervailing bargaining power).

Part I of the thesis (chapters 1 to 4) provides the foundation for the thesis.

Chapter 1 begins by introducing the time travel scenario which is used,

throughout the thesis, to test the abstract principles for utility regime design

which are drawn from the case study regimes. Chapter 1 then defines the

research question, and explores alternative methodologies that could be used

to answer the question. Chapter 2 provides an overview of the case study

regimes. The chapter examines the evolution of the regimes since

Federation from government owned monopolies towards ‘regulatory

capitalism’.35

From the case study regimes in chapter 2, chapter 3 draws out the twelve

components of a utility regime. The contribution by economists to the design

of an ‘optimal’ utility regime is discussed in chapter 3. From the 1990s, the

dominant economic model has been to reflect the economic objective of

efficient price/output and market characteristics by: opening the market to

competition (component 2); at least, considering the options of vertically

35 John Braithwaite, Regulatory Capitalism: How it Works, Ideas for Making it

Work Better (Edward Elgar, 2008).

Introduction

10

separating the uncontestable bottleneck component of the utility supply chain

(component 2) and transferring government owned utilities to private

ownership (component 3); limiting price regulation to the natural monopoly

service (component 4); tailoring the regulatory instrument to the extent of

market power (component 5); designing the price methodology to provide

incentives for the regulated firm to act efficiently (component 6); and

achieving equity objectives through instruments other than the economic

regulatory regime (component 8). This in turn should be supported through

the model of an independent regulator (components 10 and 11). Chapter 4

uses the electricity case study to introduce the problems that can arise when

applying this approach in practice.

Part II (chapters 5 to 10) of the thesis draws on the Australian case study

regimes to explore six problems with the economic model of utility regulation

outlined in chapter 3:

1. Can a government’s objectives be achieved through price signals

combined with external instruments governing non-economic objectives?

Is the perfect price methodology really just around the corner?

2. One appeal mechanism, two different outcomes: Why is a standard

regulatory process used regardless of whether the regulated entity is a

utility with a multi-billion market capitalisation or a refugee applicant?

3. Why is the identical regulatory regime applied to government owned and

privately owned utilities?

4. Supplier characteristics: How should the cross-business ownership model

impact on the design of non-price access terms (ring-fencing in the case

of a vertically integrated utility, and coordination mechanisms in the case

of vertical separation)?

5. Buyer characteristics: How do buyer characteristics impact on new

markets, and what is required to make newly liberalised markets work?

6. How do legacy and transitional issues impact on the design of other

regime components?

To explain these six examples in more detail: Chapter 5 discusses how

objectives should impact on the design of the price methodology used to

regulate the bottleneck component of the utility supply chain. Despite the

economic theory that the number of instruments should equal the number of

Introduction

11

desired values, chapter 5 argues that, where essential services are supplied

to Australian households, the regulatory methodology should be tailored to

deliver outcomes that are regarded as fair as well as economically efficient.

Chapters 6 to 8 examine how the characteristics of the seller (market power,

private or public ownership and cross-business ownership) should impact on

utility regime design. As outlined in chapter 3, there is broad consensus that

the regulatory instrument (the extent of government intervention) should be

tailored to reflect market power. Chapter 6 examines whether this approach

also needs to be extended to the components that are usually left to lawyers

to design: the regulatory process, appeal mechanism and institutional

structure. In summary, chapter 6 argues that the standard administrative

decision making and review model produces different results depending on

market power. The same legislative provision can result in an open,

facilitative process (where the access provider has relatively low market

power) or a highly adversarial process (where the access provider has

relatively high market power with no strong natural contradictor). Chapter 6

explores options on how the economists’ approach could be extended to the

design of regime components 10 (regulatory process) and 11 (institutional

structure).

Whilst the question of privatisation is already covered by extensive research,

chapter 7 asks whether ownership should change the design of other regime

components (in particular, the price methodology, regulatory process and

institutions). The chapter challenges the current Australian ‘one size fits all’

model for publicly and privately owned utilities.

Chapter 8 focuses on how the cross-business ownership model should

impact on other regime components. As with public ownership, the question

of whether utilities should be vertically integrated or separated has already

been the subject of extensive prior literature with the debate focusing on the

impact on economic efficiency of supply chain coordination versus promoting

competition. However, once the policy maker has made the call on cross-

business ownership, what does this mean for the remainder of the regime?

For example, if the policy maker decides that the telecommunications

incumbent should remain vertically integrated, is it incongruent to introduce

ring-fencing provisions to prevent cross-subsidisation and transfer of

Introduction

12

information? Would it be a mistake to design the regime to promote access

regulation as opposed to interconnectivity by other vertically integrated

providers? Similarly, if vertical separation is the chosen model, should

provisions also be included to facilitate coordination, and what lessons can be

drawn from the Hunter Valley coal chain on how to achieve this?

Chapter 9 focuses on how buyer characteristics should impact on utility

regime design. Where services are provided to households and small

businesses, utility regimes commonly include provisions to protect

disadvantaged consumers. However, chapter 9 argues that utility regimes

need to go further in tailoring regime components to buyer characteristics.

The outcomes achieved in liberalised utility markets depend on the

willingness of customers to compare what is on offer and switch providers.

While the utility regimes developed in Australia in the 1990s focused on

disadvantaged consumers, the regimes generally did not address the

increased complexity and risk faced by all consumers. Chapter 9 discusses

the design of provisions to facilitate consumer engagement in utility markets.

Chapter 10 examines how legacy and transitional issues (component 12)

should impact on the design of other regime components. Chapter 10

discusses three problems that arose in practice under the Australian case

study regimes: path dependency, and its impact on Murray-Darling Basin

reforms; the failure to anticipate in the price methodology that the utility may

cease to be a utility for some but not all consumers; and the failure to ensure

that the costs and benefits of reform were shared equitably across society.

While the concepts of path dependency and disruption due to new technology

are well established, legacy and transitional issues continue to remain at the

back of legislative reform packages for utilities, drafted in the dying moments

of the policy process. Chapter 10 draws on the case study regimes to

examine how legacy and transitional issues should be reflected in the regime

as a whole.

From Part II (chapters 5 to 10) of the thesis, Part III (chapter 11) asks whether

it is possible to develop principles for designing the optimal utility regime. The

chapter discusses the concept of ‘congruent regulation’ where the regime

components must work in harmony to achieve the government’s objectives.

The chapter argues that regime objectives and market characteristics should

Introduction

13

drive the design of all the regime components subject to legacy issues. This

requires lawyers to accept that the standard consultation and appeal model

benefits only the regulated entity and the advisory sector where there is

relatively high market power and no natural contradictor. It requires

economists to accept that the standard price methodology is unwieldy and

politically unstainable where the methodology loses sight of the government’s

multiple objectives. It requires: policy makers to fully think through the

implications of cross-business ownership and legacy and transitional issues;

regulators to recognise the real differences in the way public and private

utilities operate; and economic consultants to think about whether the person

who manages their household finances really wants to spend their weekend

shopping around for the best electricity deal.

However, there are limitations to the extent to which this research question

can be answered. First, it is not possible, within one thesis, to examine in full

the impact of objectives and market characteristics on every regime

component. However, chapter 11 argues that the detailed analysis of the six

issues covered in chapters 5 to 10 shows how the operation of one

component of a utility regime can be undermined by the design of another

component within the regime unless each component is tailored to the regime

objectives and market characteristics.

Second, the thesis does not determinatively conclude what a government’s

objectives should be (regime component 1) or how a government should

design supplier or buyer characteristics (market structure and ownership

(regime components 2 & 3)) for a specific industry. As discussed in

chapters 2 and 3, there is an international trend towards the use of

competition (by removing statutory barriers) to promote economic efficiency

and thus social welfare, and privatisation of previously government owned

utilities. However, the point of chapter 11 is to examine how a government’s

choices over objectives and market characteristics should flow through to the

design of components 4 to 11 (subject to the usual transitional headache

provided by the legacy and transitional issues raised by component 12).

Many of the issues discussed in this thesis will be familiar to those who

followed the debate in Australia in 2012 over rising energy prices. The

genesis for commencing this thesis was a series of decisions made by the

Introduction

14

Australian Competition Tribunal in which regulated entities generally

succeeded in appealing energy but not telecommunications decisions. As

Australian household electricity prices increased by 35 per cent in real terms

between 2007 and 2011,36 the Australian populace started to query the

regulation of electricity networks (which account for up to 50 per cent of a

typical customer’s electricity bill) along with rising wholesale electricity prices

and retailer margins.37 A series of policy reviews conducted in 2012

recognised the interaction between energy regime components, and the need

for a holistic approach with the interests of Australian consumers as the

touchstone.38

The approach taken in this thesis is comparable to Train (an economist)

examining, in 1991, how to regulate natural monopolies so as to induce them

to produce and price optimally.39 The difference is that this thesis argues that

the objectives are broader than economically efficient price/output. A utility

regime can thus be defeated by Train’s narrow focus on economic efficiency.

A utility regime is also more than just the price methodology. A utility regime

can fail if the economist’s market analysis is not extended to all regime

components including those that are usually left to the domain of lawyers

such as the regulatory process and culture, appeal mechanisms and

institutional structures. In essence, this thesis argues that a policy maker, in

designing a time travel utility regime, is guaranteed to mess up the Rubik’s

Cube if they rely only on the economic model that has dominated since the

1990s.

36 Australian Energy Regulator, Economic Regulation of Transmission and

Distribution Network Service Providers: AER’s Proposed changes to the National Electricity Rules (September 2011) 4.

37 Australian Energy Regulator, Economic Regulation of Transmission and Distribution Network Service Providers: AER’s Proposed changes to the National Electricity Rules (September 2011) 6.

38 George Yarrow, Michael Egan and John Tamblyn, Review of the Limited Merits Review Regime: Stage Two Report (30 September 2012); Australian Government, Department of Resources, Energy and Tourism, Energy White Paper 2012: Australia’s Energy Transformation (October 2012); and Australian Energy Market Commission, Rule Determination: National Electricity Amendment (Economic Regulation of Network Service Providers) Rule 2012 and National Gas Amendment (Price and Revenue Regulation of Gas Services) Rule 2012 (29 November 2012).

39 Kenneth E. Train, Optimal Regulation: The Economic Theory of Natural Monopoly (MIT Press, 1991).

15

PART I

CHAPTER 1

THE RESEARCH QUESTION: HOW TO ANSWER IT?

1.1 Introduction

Top left – London Time Travel Station Top right – LHC machine Bottom left – Time travel capsule Bottom right – Protest against time travel, Sydney – Georgia Glen, 2016

Circular time travel tunnels have now been constructed underground by Firm

Incumbent in the centres of New York, Berlin, London and Beijing. A

customer (after purchasing a ticket) enters a capsule (similar in concept to a

one-person railway carriage) which is then propelled, at an extraordinarily

Chapter 1: Research question

16

high speed (11,000 circuits per second) in beams of hadrons guided by

massive superconducting magnets.1 When the beams are made to cross

paths, the capsule arrives at the same starting location but at a different point

in time nominated by the customer (the physical constraint being that the LHC

must have existed at that point in time). A time travel station has also been

proposed for Sydney, Australia – although many people are calling for a

moratorium as occurred for coal seam gas fracking.2 Concerns include: the

hazardous impact on human health; the unknown impact on the universe of

changing the past in a way that alters the present (the butterfly effect and

grandfather paradox);3 gaps in the criminal law;4 the challenges posed to

industries such as gambling and insurance; and equity (universal access to

the service). Despite these concerns, there have been many spin-off

innovations ranging from time travel souvenirs to the new Apple Iphone TT

which uses the beams of hadrons in the LHC to transmit signals to cell towers

back in time. In addition, a new supplier, Firm New Entrant, has developed

an improved version of the capsule which reduces the health risks. Firm New

Entrant is seeking to use Firm Incumbent’s existing LHC machines rather

than roll out duplicate tunnels – although Firm Incumbent has embarked on

copyright proceedings against Firm New Entrant. While you (the time travel

policy maker) are still trying to figure out how to use your electricity smart

meter and to switch your lights on by clapping your hands, the younger

generation is fully conversant with terms such as ATLAS, ALICE, CMS, LHCb

and WLCG.5 What is your government going to do about this new industry?

1 The time travel scenario is fictional but draws upon material from the LHC

(Large Hadron Collider) Resource Portal: http://www.stfc.ac.uk/research/particle-physics-and-particle-astrophysics/large-hadron-collider/lhc-large-hadron-collider-resource-portal/.

2 Australia, Parliament, Senate Select Committee on Unconventional Gas Mining, Interim Report (May 2016).

3 Nicholas J.J. Smith, ‘Time Travel’ in Edward N. Zalta (ed.), The Stanford Encyclopedia of Philosophy (Spring 2016 Edition) http://plato.stanford.edu/archives/spr2016/entries/time-travel (accessed 26 August 2016).

4 In one notorious case in New York, a person went back in time with the intent of killing their self.

5 The beams inside the LHC are made to collide at four locations around the accelerator ring, corresponding to the positions of four particle detectors –ATLAS,CMS, ALICE and LHCb. WLCG refers to the Worldwide LHC Computing Grid which provides computing resources for the storage, distribution and analysis of the data generated by the LHC. See https://home.cern/science/accelerators/large-hadron-collider (accessed 3 June 2019).

https://home.cern/about/how-detector-workshttps://home.cern/about/experiments/atlashttps://home.cern/about/experiments/cmshttps://home.cern/about/experiments/alicehttps://home.cern/about/experiments/lhcb


17

This thesis focuses on one particular aspect confronting the time travel policy

maker: the optimal design of an economic regulatory regime for the public

utility. Two preliminary questions are addressed in this chapter: the meaning

of the terms ‘public utility’ and ‘optimal utility regime’ which determine the

scope of the research question (section 1.2); and the methodology used to

answer the question (section 1.3).

1.2 Research question: Scope

What is a ‘public utility’?

The concept of ‘public utility’ (also shortened to ‘utility’) derives from the

‘common carrier’ doctrine developed in English common law from 1300.6 The

doctrine imposes a duty on a common carrier to serve all at a reasonable

rate, and strict liability for the care of goods entrusted to it.7 The common

carrier doctrine was subsequently used by the United States (US) Supreme

Court in 1876 in Munn v Illinois as a basis for distinguishing between a bare

private interest, and private property ‘affected with a public interest’.8 The

Court concluded that, where private property is devoted to a public use, a

State law regulating prices (in this case, the rates charged by grain elevators)

did not contravene the prohibition in the US Constitution on States depriving a

person of property without due process.9 By the early 1900s, such

6 The terms ‘public utility’ and ‘common carrier’ are treated synonymously in

Richard A. Posner, Economic Analysis of Law (Wolters Kluwer, 8th ed., 2011) 459.

7 William A. Mogel and John P. Gregg, ‘Appropriateness of Imposing Common Carrier Status on Interstate Natural Gas Pipelines’ (2004) 25 Energy Law Journal 21 at 32. For example, the Supreme Court of California has held that a Disney roller coaster is a common carrier: see Mark A. Franklin, ‘California’s Extension of Common Carrier Liability to Roller Coasters and Similar Devices: An Examination of Gomez v. Superior Court of Los Angeles’ (Fall 2006) 34(1) Western State University Law Review 29.

8 Munn v Illinois 94 US 113 (1876) at 126. 9 See Walter Clark, ‘The Right of the Public to Regulate the Charges of Common

Carriers and of All Others Discharging Public, or Quasi-Public Duties’ (1897) 31 American Law Review 685. The basis for identifying businesses ‘clothed with a public interest’ was further discussed by the US Supreme Court in a 1923 decision (Chas. Wolff Packing Co v Court of Industrial Relations of State 262 US 522 (1923), 534). The Court identified three categories of businesses including businesses which had become public due to their ‘peculiarly close relation’ to the public (such as in Munn v Illinois). This was due to the ‘indispensable nature of the service’ and the ‘exorbitant charges’ to which the public might be subjected without regulation (in particular, the Court referred to


18

businesses were commonly described as ‘public service corporations’10 or

‘public utilities’.11

The US Supreme Court’s use of the ‘due process’ clause to invalidate

legislation regulating business was eventually overturned in the 1930s.12

However, the term ‘public utility’ was adopted by other countries and has

remained in use.13 In Australia, for example, in the 1890s constitutional

debates, the South Australian delegate, in comparing Australian with US

colony investment in railways, referred to ‘those great state utilities’.14 The

term continues to be used across the world e.g. Australia’s ‘Utility Regulators

Forum’;15 the US National Association of Regulatory Utility Commissioners;16

Egypt’s Electric Utility and Consumer Protection Regulatory Agency;17 Latvia’s

the regulation of rates ‘to avoid monopoly’). The other two categories were: businesses carried on under a public grant of privileges which imposes a duty to provide a service to a member of the public; and certain ‘exceptional’ occupations where the public interest has been ‘recognized from earliest times’ (such as keepers of inns).

10 See, for example, N. Matthews Jr. and W.G. Thompson, ‘Public Service Company Rates and the Fourteenth Amendment’ (1901-1902) 15 Harvard Law Review 249. In 1907, the US State of New York created a ‘Public Service Commission’ to regulate businesses ‘engaged in serving the public’ (including rail, electricity, gas and telephone services): State of New York, Public Service Commission, Second District, First Annual Report (1908) and Fourth Annual Report (1911) 7-9 at http://www.archive.org (accessed 26 October 2011).

11 See, for example, Christopher G. Tiedeman, ‘Government Ownership of Public Utilities’ (1902-1903) 16 Harvard Law Review 476; and William H. Baily, ‘The Control of Public Utilities’ (1904) 12 The American Lawyer 444. The State of New Jersey established a ‘Board of Public Utilities’ in 1911: Institute of Public Utilities Regulatory Research and Education, Michigan State University, Public Service Commission Origins and Evolution (August 2011) at http://ipu.msu.edu (accessed 26 October 2011).

12 In the 1930s, the US Supreme Court reinterpreted the ‘due process’ clause so that the validity of a price control no longer depended on whether the business was ‘affected with a public interest’. See Keith M. Howe and Eugene F. Rasmussen, Public Utility Economics and Finance (Prentice-Hall, 1982) chapter 3.

13 By the 1930s, the term ‘public utility’ was also in common usage in Britain: Marshall E. Dimock, British Public Utilities and National Development (George Allen & Unwin, 1933) 22.

14 J.H. Gordon, Australasian Federal Convention (Third Session, Melbourne, 22 February 1898).

15 The Forum was established in 1997 by Commonwealth, State and Territory regulators with responsibility for utility regulation: http://www.accc.gov.au/content/index.phtml/itemId/3894 (accessed 22 January 2013).

16 https://www.naruc.org/ (accessed 3 June 2019). 17 http://www.egyptera.org/en/ (accessed 26 August 2016).


19

Public Utilities Commission;18 Jamaica’s Office of Utilities Regulation;19

Singapore’s Public Utilities Board;20 and Ghana’s Public Utilities Regulatory

Commission.21

While the term ‘public utility’ is legal in origin, it applies to a combination of

economic and social facts.22 For the purpose of this thesis, the most relevant

definition of ‘public utility’ was developed by Sleeman, a British economist, in

1953.23 Sleeman commences by defining a public utility as a supplier of a

service rather than a good. Although water and gas (and, as the Australian

Competition and Consumer Commission (ACCC) has also contended,

electricity)24 are physical commodities, the service component is integral to

the end-user25 – consumers require a ‘constant and reliable service’ laid on to

their ‘house or factory’.26 Sleeman also defines the service as a basic service

‘on which the life of the country depends’.27

18 http://erranet.org/AboutUs/Members/Profiles/Latvia (accessed 26 August

2016). 19 http://www.our.org.jm/ourweb/ (accessed 26 August 2016). 20 https://www.pub.gov.sg/ (accessed 26 August 2016). 21 http://www.purc.com.gh/ (accessed 26 August 2016). 22 Irston R. Barnes, The Economics of Public Utility Regulation (F.S. Crofts & Co,

1942) 1. 23 J.F. Sleeman, British Public Utilities (Sir Isaac Pitman & Sons, 1953) 3-4 and

chapter II. 24 Electricity Supply Assoc of Australia Ltd v Australian Competition and

Consumer Commission [2001] FCA 1296 (12 September 2001). The applicant contended that a supplier under an electricity supply contract was not liable for damage resulting from a power surge or power brown-out caused by acts beyond the reasonable control of the supplier. In contrast, the ACCC argued that electricity supply contracts with consumers were subject to the implied conditions under the former Trade Practices Act 1974 which required goods to be of merchantable quality and reasonably fit for the purpose for which they are known to be acquired.

25 An end-user is the ultimate consumer of the good or service. The concept is explained in the Explanatory Memorandum for the Trade Practices Amendment (Telecommunications) Bill 1996 (Cth) (under the heading ‘Proposed section 152AB - Object of this Part'):

The term ‘end-users' recognises that telecommunications networks and services are used both by customers with a direct contractual relationship with a carrier or service provider and other end-users of carriage or content services (such as the members of a customer's household).

The Australian Competition Tribunal, in relation to pay television, considered that ‘end-users’ included (or potentially included): subscribers and other viewers in their households; and businesses where people congregate (such as hotels): Re Seven Network Limited (No 4) [2004] ACompT 11 (23 December 2004) at [120].

26 J.F. Sleeman, British Public Utilities (Sir Isaac Pitman & Sons, 1953) 8. 27 J.F. Sleeman, British Public Utilities (Sir Isaac Pitman & Sons, 1953) 9.


20

This leads to Sleeman’s second characteristic of a public utility.28 A large

capital investment is required to supply a regular and reliable service. The

first and second characteristics lead to the third.29 From the point of view of

the consumer, the service is non-transferable. If the service supplier raises

the price, a consumer cannot easily store the service, postpone their demand

to another point in time, or transfer their demand to another supplier.

From these three characteristics (nature of the service, the importance of

fixed capital and non-transferability of demand), Sleeman identified a fourth

characteristic, natural monopoly.30 The market31 for time travel would be a

natural monopoly if a single firm can serve that market at lower cost than a

combination of two or more firms (that is, the long run average cost curve falls

continuously over a large range of output).32 Since there is this element of

natural monopoly, a fifth characteristic is that public utilities must be subject to

government regulation to prevent monopoly exploitation.33

However, these five characteristics require qualification. Sleeman’s first

characteristic (nature of the service) in fact incorporates two tests. First, a

public utility is a supplier of a service – or, at least, a service is an integral

component of the supply chain. Secondly, the public utility is considered to

be ‘essential’. For example, time travel could not be declared under

Australia’s national access regime in Part IIIA of the Competition and

Consumer Act 2010 (Cth) (CC Act) unless, among other things, it is a

‘service’ and it is provided by means of a facility that is ‘of national

28 J.F. Sleeman, British Public Utilities (Sir Isaac Pitman & Sons, 1953) 3-4 and 9-

11. Where the public utility involves the delivery of a good, the production of the good may also have high fixed costs (e.g. electricity power stations or natural gas exploration and production).

29 J.F. Sleeman, British Public Utilities (Sir Isaac Pitman & Sons, 1953) 4 and 11-13.

30 J.F. Sleeman, British Public Utilities (Sir Isaac Pitman & Sons, 1953) 4 and 13-14.

31 Economists use the term ‘natural monopoly’ to describe the characteristics of a firm in contrast to ‘perfect competition’ which describes the characteristics of a market. In the real world, policy makers just roll their eyes when economists make this pedantic distinction.

32 Joshua Gans, Stephen King, Robin Stonecash and N. Gregory Mankiw, Principles of Economics (Cengage Learning, 4th ed., 2009) 318-319.

33 J.F. Sleeman, British Public Utilities (Sir Isaac Pitman & Sons, 1953) 4.


21

significance’.34 The notion of an ‘essential service’ is discussed in more detail

in chapter 5.

The concept of a service being part of a supply chain also requires

elaboration. As outlined in chapter 2, since the 1990s, Australian

governments have, in respect of markets traditionally served by statutory

monopolies, generally sought to introduce competition where possible, and to

regulate access to the ‘bottlenecks’ (services supplied by facilities that exhibit

natural monopoly characteristics and to which businesses require access in

order to compete in upstream or downstream markets).35 For example,

vertically integrated36 government owned electricity utilities were separated

into network businesses (the poles and wires) and generation and retail.37 In

certain Australian States and Territories, the electricity retail market is

regarded as effectively competitive – an end-user can transfer to another

electricity retailer.38 However, does this mean that electricity retail has ceased

to be regarded as a public utility? Chapter 5 argues that the whole of the

chain is still regarded as something ‘on which the life of the country

depends’.39 For the purpose of this thesis, the term ‘public utilities’ includes

businesses that operate in a competitive market but which form part of a

supply chain that incorporates Sleeman’s natural monopoly service provider.40

34 CC Act s 44CA(1)(c). The history and operation of Part IIIA of the CC Act is

described in chapter 2 of this thesis. 35 Independent Committee of Inquiry, National Competition Policy (AGPS, 1993)

239. 36 A service provider is ‘vertically integrated’ where it also competes in a market

in which the service is a production input. Another relevant concept used in this thesis is ‘horizontal integration’ (where a firm takes over a competitor in the same market): see the Explanatory Memorandum to the Telecommunications Legislation Amendment (Competition and Consumer Safeguards) Bill 2010 (Cth).

37 An overview of electricity regulation in Australia is set out in chapter 2 of this thesis.

38 In 2016, the Australian Energy Market Commission found that retail competition remains effective for electricity markets in South East Queensland, New South Wales, Victoria, and South Australia. Electricity retail competition is less effective in the Australian Capital Territory and effective competition is yet to emerge in Tasmania and regional Queensland. Australian Energy Market Commission, Retail Competition Review (Final report, 30 June 2016).

39 This is evidenced by the obligations imposed by Australian governments on energy retailers to protect disadvantaged consumers: National Energy Retail Law set out in the schedule to the National Energy Retail Law (South Australia) Act 2011 (SA).

40 A supply chain is the set of business functions involved in fulfilling a customer’s request. See Sunil Chopra and Peter Meindl, Supply Chain Management: Strategy, Planning, and Operation (Prentice Hall, 4th ed., 2010) 2.


22

Two additional terms also need to be explained: ‘infrastructure’ and ‘supply

chain’. In response to the changing role of government, public policy dialogue

in Australia has shifted from ‘public utilities’ to ‘economic infrastructure’.41

‘Infrastructure’ has been defined as the structural elements of the economy

that provide basic services to industry and households.42 Such facilities are

often categorised as either economic or social.43 ‘Economic infrastructure’

usually forms part of a network,44 and is an input to production processes

(such as roads, ports, railways, airports, electricity and gas supply, water and

sewerage services and telecommunications services – and possibly also time

travel).45 ‘Social infrastructure’ (such as schools, hospitals, prisons and public

housing) is directed at providing community services.46 (In practice,47

quantitative studies of Australia’s ‘economic infrastructure’ often include both

the physical service delivery network and the related businesses.)48 The shift

41 E.g. Infrastructure Australia was created in 2008. 42 Alison Smith, Economic Infrastructure in Australia (Research Paper No. 4, The

Treasury, 1992) 3. 43 Productivity Commission, Annual Review of Regulatory Burdens on Business:

Social and Economic Infrastructure Services (Research Report, August 2009). The distinction between economic and social infrastructure is blurred. Social infrastructure (such as education) can affect economic efficiency whilst economic infrastructure (such as universal access to a telecommunications service) may deliver social objectives: Economic Planning Advisory Council, Economic Infrastructure in Australia (June 1988) 7. In Australia, as at 1995, about 70 per cent of infrastructure was classified as economic and the remaining 30 per cent as social: Private Infrastructure Task Force, Economic Planning Advisory Commission, Interim Report (May 1995) 27.

44 Michael Klein, Competition in Network Industries (Policy Research Working Paper No 1591, The World Bank, Private Sector Development Department, 1996).

45 Private Infrastructure Task Force, Economic Planning Advisory Commission, Final Report (September 1995) 5.

46 Alison Smith, Economic Infrastructure in Australia (Research Paper No. 4, The Treasury, 1992) 3.

47 See, for example, Productivity Commission, Trends in Australian Infrastructure Prices 1990-91 to 2000-01 (Performance Monitoring, May 2002). In these cases, the terms ‘economic infrastructure’ and ‘public utility’ appear to be synonymous. However, in this thesis (unless otherwise indicated) the term ‘infrastructure’ is used to refer only to the service delivery network (Sleeman’s natural monopoly service provider).

48 The definition of ‘related business’ depends on an understanding of the terms ‘competition’, ‘market’ and ‘market power’: • ‘Competition’ is a state of ongoing rivalry between firms – rivalry in terms

of price, service, technology and quality. • A ‘market’ is the space in which rivalry takes place. The key to market

definition is substitution. The two main dimensions of substitution are product and geographic. Market definition usually begins by selecting a product supplied by a firm in a particular geographic area and incrementally broadening the market to include the next closest substitute


23

away from vertically integrated government owned utilities has in turn

increased focus on the ‘supply (or production) chain’ – the series of stages

involved in producing a product or service that is delivered to the end

customer.49

A final comment on Sleeman’s first characteristic of a public utility is that, at

some point in the future, there may no longer even be a requirement for a

service to be an integral component of the supply chain. For example,

developing technologies such as photovoltaics, batteries and cogen may lead

to stand-alone distributed electricity generation systems in place of grids such

as the interconnected Australian national electricity market.50 A country’s

Energy Utility could become responsible for installing, and maintaining, such

systems rather than operating large-scale power stations (e.g. coal-fired, gas

and nuclear powered plants) and transmitting electricity over long distances.

The second qualification to Sleeman’s definition of a ‘public utility’ concerns

the requirement that there be a large capital investment for the delivery of the

service or good. In the case of time travel, a large component of the cost of

providing a time travel service would be fixed (that is, not dependent on the

until all close substitutes for the initial product are included. There are two types of substitution: demand-side substitution (customer-switching) and supply-side substitution (supplier-switching).

• The greater the degree of competition in a market, the less ‘market power’ each market participant will possess. A ‘competitive market’ is one in which a single economic actor cannot have a substantial influence on market prices.

• If the product produced in one market is a production input for a second market, then that second market is called a ‘related market’ (also an ‘upstream or downstream market’ or ‘dependent market’).

See Australian Competition and Consumer Commission, Merger Guidelines (November 2008) 10 & 15-16; and Joshua Gans, Stephen King, Robin Stonecash and N. Gregory Mankiw, Principles of Economics (Cengage Learning, 4th ed., 2009) 865. For an example of the terms ‘dependent market’ and ‘related market’, see In the matter of Fortescue Metals Group Limited [2010] ACompT 2 (30 June 2010).

49 Michael Klein, Competition in Network Industries (Policy Research Working Paper No 1591, The World Bank, Private Sector Development Department, 1996). For example, in 1997, in the context of proposed amendments to the national access regime, the Commonwealth Assistant Treasurer distinguished between monopoly services and services used by household consumers at the end of the ‘production chain’ (such as electricity): Second reading debate on the Trade Practices Amendment (Industry Access Codes) Bill 1996: Australia, Parliamentary Debates, Senate, 13 February 1997, 681 (Senator Kemp, Assistant Treasurer).

50 Rajab Khalilpour and Anthony Vassallo, ‘Leaving the Grid: An Ambition or a Real Choice?’ (2015) 82(C) Energy Policy 207.

https://en.wikipedia.org/wiki/Photovoltaicshttps://en.wikipedia.org/wiki/Battery_(electricity)https://en.wikipedia.org/wiki/Cogenhttps://en.wikipedia.org/wiki/Power_stationhttps://en.wikipedia.org/wiki/Coalhttps://en.wikipedia.org/wiki/Combined_cyclehttps://en.wikipedia.org/wiki/Nuclear_power


24

level of usage or output).51 However, in the case of Australia Post, even

though operating costs comprise the major part of the total cost of providing

letter services,52 Australia Post is still regarded as a ‘utility’.53 The natural

monopoly component arises, not from capital investment, but the provision of

a ubiquitous service including in remote areas where volumes are low and

populations dispersed.54 Sleeman’s second requirement of a large capital

investment is therefore, for the purpose of this thesis, not essential to the

definition of a utility. Rather, this thesis treats Sleeman’s fourth characteristic

(that the production chain or, at least, the service component, be a natural

monopoly) as the third requirement.

Sleeman’s third characteristic (the service is non-transferable) should in fact

be the fourth, and final, requirement. A service provider could be a natural

monopoly but not have market power due to substitutable services (e.g. the

choice between road or rail transport). Sleeman’s fifth characteristic (the

application of regulation) is treated, in this thesis, as a regime component

rather than part of the definition of a ‘public utility’.

Adapting Sleeman’s approach, this thesis thus stipulates four characteristics

of a ‘public utility’:

• a public utility is a supplier of a service – or, at least (for the present time),

a service is an integral component of the supply chain;

• the public utility is regarded as ‘essential’;

• the supply chain or, at least, the service component, is a natural

monopoly; and

• the natural monopoly component of the supply chain has market power.

51 Joshua Gans, Stephen King, Robin Stonecash and N. Gregory Mankiw,

Principles of Economics (Cengage Learning, 4th ed., 2009) 864. Another relevant concept used in this thesis is ‘sunk costs’ (costs that have been incurred, and cannot be recovered): John B. Taylor & Lionel Frost, Microeconomics (John Wiley & Sons, 4th ed., 2009) 406.

52 Australian Competition and Consumer Commission, Australian Postal Corporation 2010 Price Notification: Decision (May 2010) 96.

53 E.g. Second reading debate on the Postal and Telecommunications Amendment Bill 1983: Australia, Parliamentary Debates, House of Representatives, 9 November 1983, 2471 (Mr Duffy, Minister for Communications).

54 National Competition Council, Review of the Australian Postal Corporation Act: Final Report, Volume Two (February 1998) 263 & 271.


25

These characteristics provide the foundation for the discussion in chapter 3

on government objectives and market characteristics.

What is an ‘optimal utility regime’?

This thesis applies Windholz and Hodge’s approach to defining regulation.55

Windholz and Hodge commence with Black’s definition of regulation as a

process involving:56 the sustained and focused attempt to alter the behaviour of others

according to defined standards or purposes with the intention of producing a

broadly identified outcome or outcomes.

However, they add the qualifier that the process is one undertaken by or

under the auspices or authority of government. Similarly, the research

question in this thesis is being asked from the perspective of government

(whether a public servant, elected representative, monarch or dictator): How

can a government achieve its desired social outcomes for public utilities?

The significance of Black’s definition is that government action can

encompass a variety of forms including: primary and subordinate legislation;

administrative decisions and instruments pursuant to legislation; direct

government expenditure including grants and subsidies; taxation including the

imposition of taxes and the use of tax incentives; public ownership;

information campaigns, negotiation and moral persuasion; and reliance on

industry self-regulation.57 This thesis thus refers to ‘regulation’ as government

action that is intended to influence the way people behave58 but recognises

55 Eric Windholz and Graeme A. Hodge, ‘Conceptualising Social and Economic

Regulation: Implications for Modern Regulators and Regulatory Activity’ (2012) 38(2) Monash University Law Review 212. See also Bronwen Morgan and Karen Yeung, An Introduction to Law and Regulation: Text and Materials (Cambridge University Press, 2007) 3-4.

56 Julia Black, ‘Critical Reflections on Regulation’ (2002) 27 Australian Journal of Legal Philosophy 1, 26. See also Arie Freiberg, The Tools of Regulation (Federation Press, 2010) 2-5.

57 In the ‘regulatory space’, there may be an existing system of ordering which exists separately from government (although that private system may be constituted by, amongst other things, laws of property or contract): Colin Scott, ‘Analysing Regulatory Space: Fragmented Resources and Institutional Design’ (Summer 2001) Public Law 329; Julia Black, ‘Decentring Regulation: Understanding the Role of Regulation and Self-Regulation in a ‘Post-Regulatory’ World’ (2001) 54 Current Legal Problems 103, 122.

58 This definition is adapted from Office of Regulation Review, A Guide to Regulation (2nd ed., 1998) A1 and E. (The Guide has been superseded by the Australian Government, Guide to Regulation (2014)).


26

that a government’s chosen form of action may be to rely on industry self-

regulation.

In the scenario outlined at the start of this chapter, our time travel policy

maker is faced with a myriad of public policy issues. This thesis focusses

only on one category of regulation, ‘economic regulation’, defined as

government intervention in market decisions such as price, rate of return,

output, market entry or exit, and competition.59 However, there is no bright

dividing line. Economic regulation interacts with other forms of regulation

(such as technical operating standards) and economic regulation may have

both economic and non-economic objectives (including environmental

objectives and community service obligations which are a form of ‘social

regulation’).60 This reflects Windholz and Hodge’s argument that both social

and economic regulation is underpinned by a mix of interconnected and

interdependent social and economic values.61 Nevertheless, there remain

broad areas of regulation that apply to public utilities which are not covered by

this thesis such as corporate law, taxation and industrial relations.62

This thesis adopts the Organisation for Economic Co-operation and

Development’s (OECD) approach for evaluating regulatory policy.63 A regime

for the economic regulation of time travel would be optimal if it satisfies two

criteria – it is effective in achieving the stated objectives, and it is efficient in

terms of maximising the benefits to the community, taking into account the

costs.64

59 R.A. Posner, ‘Theories of Economic Regulation’ (1974) 5(2, Autumn) Bell

Journal of Economics and Management Science 335; W. Kip Viscusi, Joseph E. Harrington, Jr. and John M. Vernon, Economics of Regulation and Antitrust (MIT Press, 4th ed., 2005) 358.

60 See chapter 5 of this thesis. 61 Eric Windholz and Graeme A. Hodge, ‘Conceptualising Social and Economic

Regulation: Implications for Modern Regulators and Regulatory Activity’ (2012) 38(2) Monash University Law Review 212.

62 Although this thesis recognises that there are links across these areas of regulation. For example, chapter 8 discusses corporate law as a form of ring-fencing.

63 Organisation for Economic Co-operation and Development, OECD Framework for Regulatory Policy Evaluation (18 June 2014) DOI:10.1787/9789264214453-en.

64 Council of Australian Governments, Best Practice Regulation: A Guide for Ministerial Councils and National Standard Setting Bodies (2014) 4; Australian Government, Guide to Regulation (2014) 19. Gunningham and Grabosky add equity as an additional criterion. However, if equity is seen as part of the

http://dx.doi.org/10.1787/9789264214453-enhttp://dx.doi.org/10.1787/9789264214453-en


27

A possible concern is that the principles set out in this thesis will produce a

regime that is optimal in theory but unlikely to be applied in practice. In fact,

this thesis does take account of the ‘plurality of aspects’ in which regulation

enters our life65 by recognising the potentially broad nature of government

objectives and the impact of legacy constraints (e.g. on privatisation of a

government owned utility).66 However, this thesis is predicated on a particular

value system – that regulation occurs mainly for public, rather than private,

interest reasons – or, at least, that private interests drive a policy maker to a

public interest outcome.67 This issue is discussed further in chapter 2 but, in

essence, our time travel policy maker does not define an ‘optimal’ utility

regime as the one that most enriches their pocket. The time travel policy

objectives (as argued in chapter 5), then an effective regime is one that achieves that objective. See Neil Gunningham and Peter Grabosky with Darren Sinclair, Smart Regulation: Designing Environmental Policy (Oxford University Press, 1998) 25.

65 See David Levi-Faur, ‘Regulation and Regulatory Governance’ in David Levi-Faur (ed.), Handbook on the Politics of Regulation (Edward Elgar, 2011) 17.

66 See Barry M. Mitnick, ‘Capturing ‘Capture’: Definition and Mechanisms’ in David Levi-Faur (ed.), Handbook on the Politics of Regulation (Edward Elgar, 2011) 34.

67 The foundation to the public interest model is the belief that a competitive market (in which no individual firm or consumer has the power to control price) will maximise social welfare as each firm tries to make as much profit as possible and each consumer maximises their own utility. A government should regulate only where the market (Smith’s invisible hand) will not achieve the socially desired objective. Market failures may be categorised as: market imperfections (where a market is not competitive due to an unequal distribution of market power or information asymmetry); externalities (where the production or consumption of a good or service has an external effect that is not reflected in the price); public goods (where the good is a public good or common property); or equity (where a market will not meet social goals). The theory was later called the ‘normative analysis as a positive theory’: see Paul L. Joskow and Roger G. Noll, ‘Regulation in Theory and Practice: An Overview’ in Gary Fromm (ed.), Studies in Public Regulation (MIT Press, 1981). For surveys of the regulation literature, see Robert Horwitz, The Irony of Regulatory Reform: The Deregulation of American Telecommunications (Oxford University Press, 1989) 22-45; and Barry Mitnick, The Political Economy of Regulation: Creating, Designing and Removing Regulatory Forms (Columbia University Press, 1980).


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maker is concerned about the risk of ‘regulatory failure’68 and

‘counterproductive regulation’.69

1.3 How to answer the research question?

What methodology should be used to identify the optimal design for a utility

regime? A useful starting point is to consider how others have approached

similarly broad topics: How does the World Bank (in its guidance on

infrastructure development); economists (in texts on utility regulation); and

regulatory theorists (in texts on other broad categories of regulation) set about

identifying principles for regime design?

In 2006, the World Bank published fifteen ‘best-practice’ standards for

regulatory governance against which a utility regime should be evaluated.70

‘Regulatory governance’ refers to the institutional and legal design of the

regulatory system and the framework within which decisions are made, in

contrast to ‘regulatory substance’ which refers to the content of regulation

(e.g. the actual decisions made by the regulator about tariffs or quality of

service standards). The standards are summarised as:71

• legal framework;

• legal powers;

• property and contract rights;

• clarity of roles in regulation and policy;

68 See Coase’s concept of ‘government failure’ where economic policy is based

on an abstract of a market situation rather than what will actually work in practice: Ronald H. Coase, ‘The Regulated Industries – Discussion’ (1964) 54(3) American Economic Review 192. See also Joseph E. Stiglitz, ‘Regulation and Failure’ in David Moss and John Cisternino (eds.), New Perspectives on Regulation (The Tobin Project, 2009) 11.

69 Grabosky argues for the need to create structures and situations which enable policy makers to pre-empt the risk of regulatory initiatives that defeat themselves or inflict collateral damage (counterproductive regulation): P.N. Grabosky, ‘Counterproductive Regulation’ (1995) 23 International Journal of the Sociology of Law 347.

70 Ashley C. Brown, Jon Stern, Bernard Tenenbaum and Defne Gencer, International Bank for Reconstruction and Development (World Bank), Handbook for Evaluating Infrastructure Regulatory Systems (2006) 5 & 43.

71 Ashley C. Brown, Jon Stern, Bernard Tenenbaum and Defne Gencer, International Bank for Reconstruction and Development (World Bank), Handbook for Evaluating Infrastructure Regulatory Systems (2006) chapter 3. The report does not set out standards for regulatory substance as this ‘tends to be more context-specific and, consequently, is less amendable to general principles’: 49-50.


29

• clarity and comprehensiveness of regulatory decisions;

• predictability and flexibility;

• consumer rights and obligations;

• proportionality;72

• regulatory independence;

• financing of regulatory agencies;

• regulatory accountability;

• regulatory processes and transparency;

• public participation;

• appellate review of regulatory decisions; and

• ethics.

These standards were intended to facilitate private investment. The World

Bank has been criticised for seeing privatisation of state enterprises as an

end in itself and an automatic contributor to development, poverty alleviation

and environmental protection.73 However, the pertinent point, for the purpose

of this section 1.3, is to examine how the World Bank derived these

standards. In summary, the benchmarks used in the questionnaires

developed by the World Bank were derived from the ‘independent regulator

model’.74 The World Bank concluded, after reviewing the literature and what

occurs in practice, that this is, and should be, the de facto governance model

across most countries.

The economic literature on utility regulation also starts with a model, being the

welfare theorem where economic efficiency is maximised under conditions of

perfect competition.75 As outlined in chapter 3 of the thesis, this model has

been used to develop highly influential principles on the objective of utility

regulation, market structure, ownership, when to regulate, the regulatory tool,

72 Proportionality requires that regulation be kept to the minimum needed: at 67. 73 See, for example, Brettonwoods Project, The World Bank and the Private

Sector (Briefings, 14 June 2000). 74 The ‘independent regulator model’ is defined by the World Bank (at p. 50) as

‘decision making independence’ – the regulator’s decisions are made without the prior approval of any other government entity, and no entity other than a court or a pre-established appellate panel can overrule the regulator’s decisions. The institutional building blocks for decision making independence are organisational independence, financial independence and management independence.

75 This is further discussed in chapter 3.


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the price methodology, and how to achieve equity objectives in the most

efficient way possible.

Outside of utility regulation, regulatory theorists have developed principles for

other broad categories of regulation. As mentioned in the introduction, an

insightful model is Gunningham and Grabosky’s work on how environmental

regulation could be redesigned to perform optimally. The authors used

industry-specific case studies across the US, Australia and, to a lesser extent,

Western Europe and Canada, to derive lessons, of much broader application,

on the use of multiple, rather than single, regulatory instruments (command

and control, self-regulation, voluntarism, education and information,

economic, and free market environmentalism).

Case study methodology

To develop principles for utility regulation design, this thesis follows

Gunningham and Grabosky’s approach of using a case study methodology

(where a specific case with clear boundaries is studied, a context is set and

an in-depth picture of the case is given).76 A case study investigates

contemporary phenomenon within its real life context, particularly where many

more variables of interest exist than data points. As Yin notes, this makes a

case study methodology particularly suited to answering ‘how’ or ‘why’

questions.77 A good case study relies on multiple sources of evidence with

data needing to converge in a triangulating fashion.78 It also benefits from the

prior development of a theoretical position to guide data collection and

analys

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