Evaluation of the proposed

COMPETITIVE IMPUTATION RULE

FOR THIRD PARTY ACCESS REGIME

for the
AUSTRALASIA RAILWAY PROJECT

Stephen King and Rodney Maddock

1 March 1999
AustralAsia Railway Project:
Competitive imputation rule for third party access regime

1. The objective of this paper

The AustralAsia Railway Corporation is working with the Governments of the

Northern Territory and South Australia to put in place a third party access regime for
the Tarcoola to Darwin railway. The services that will be included involve the
provision of access to the existing rail infrastructure from Tarcoola to Alice Springs
and a new facility to be constructed between Alice Springs and Darwin to allow for
the carrying of freight and passengers over this track.

The railway is a greenfields, pioneering project in a developing region of the national

economy. The region currently lacks key infrastructure and the Commonwealth, SA
and NT governments believe that the development of this infrastructure is necessary
for the region’s future growth.

The purpose of this paper is to form a view as to whether the basic access pricing
principles proposed to govern third party access for the project conforms to the
requirements of an “effective” access regime.

An access regime for a new infrastructure project needs to balance two sets of
interests. For legal and public policy reasons, any significant new infrastructure
project must consider developing an access regime which is not inconsistent with the
guidelines contained in the national Competition Principles Agreement (CPA). At the
same time, the regime must also meet the needs of the equity providers and
financiers otherwise the project itself will not be undertaken. The SA and NT
governments in conjunction with the AustralAsia Railway Corporation have
developed a State or Territory based access regime that they believe meets the
needs of financiers and equity providers. It is involved in discussions with the NCC
as to whether the proposed access regime is consistent with the guidelines for a
conforming State-based regime as set out in the CPA at Clause 6.

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2. Legislative requirements

The 1995 national Competition Principles Agreement established principles to which

a State or Territory access regime was required to incorporate in order to be
considered an effective access regime. These were amended from 31 July 1998 to
allow the NCC and the relevant Minister considerably greater flexibility. The new
Section 44DA of the Trade Practices Act 1974 (as amended) requires that the
underlying principles be treated as guidelines rather than as binding rules.

The guidelines for judging a conforming access regime are contained in two
subclauses of Clause 6, that is 6(3) and 6(4).

Subclause 6(3) requires that the access regime

(a) should apply to significant infrastructure, where
(i) it would not be economically feasible to duplicate the facility,
(ii) access is necessary to permit effective competition in a downstream or
upstream market,
(iii) the safe use of the facility can be ensured, and
(b) should incorporate the guidelines in subclause 6(4).

Subclause 6(4) contains sixteen guidelines. With the exception of guideline 6(4)(i),
these create an environment where access seekers can negotiate terms with some
protection. We have not been asked to opine on whether the proposed access
regime meets all of the guiding principles contained in the CPA. Our opinion has
been sought on the narrow question of whether the proposed competitive imputation
rule complies with the relevant guiding principles of the CPA, namely those set out in
subclause 6(4)(i).

Subclause 6(4)(i) establishes guidelines that a dispute resolution body needs to take
into account when determining the terms and conditions of access. The wording of
the subclause is:
In deciding on the terms and conditions for access, the dispute resolution body
should take into account:

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(i) the owner’s legitimate business interests and investment in the facility;
(ii) the cost to the owner of providing access, including any costs from extending
the facility but not costs associated with losses arising from increased
competition in upstream or downstream markets;
(iii) the economic value to the owner of any additional investment that the person
seeking access or the owner has agreed to undertake;
(iv ) the interests of all persons holding contracts for use of the facility;
(v) firm and binding contractual obligations of the owner or other persons (or both)
already using the facility;
(vi) the operational and technical requirements necessary for the safe and reliable
operation of the facility;
(vii) the economically efficient operation of the facility; and
(viii) the benefit to the public from having competitive markets.

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3. The competitive imputation approach

3.1 The basic philosophy

The proposed access regime for the AustralAsia railway project uses ‘competitive
imputation’. The underlying concept behind the competitive imputation pricing rule
(CIPR) is that access prices are capped by prices set by competing transport modes
rather than by prices established by a regulator (such as rate of return). In this
sense, the rule imitates the normal working of a competitive market where the price a
firm can charge is limited by the prices charged by competitors.

The competitive imputation approach is economically desirable in certain

circumstances. In particular, it is designed to establish access rules for a new
facility: - where the potential returns on that facility are subject to considerable
uncertainty and
- where the investment in that facility might be rendered non-viable by any
significant truncation of the distribution of potential returns from the
investment.

We believe that these conditions are satisfied for the proposed AustralAsia railway
and provide a discussion of the basis for this conclusion below.

Further, as the relevant access prices under the CIPR are based on competition in
the services provided by the use of the facility, relevant competitive alternatives must
exist. To judge the practicality of the competitive imputation pricing rule for the
AustralAsia railway, we need to consider whether the projected railway line will be an
unconstrained monopoly in the market for the services it provides or whether it will
be subject to relevant competition. This is dealt with in section 3.2.

It should be noted that if the two criteria given above are both satisfied then the
competitive imputation pricing rule is the only access pricing rule that both

• does not distort the relevant investment decision and

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 • is ex ante efficient.
In particular, any standard alternative approach to access pricing based on ex post
costs and revenues will be ex ante inefficient if the two criteria are satisfied. This
means that approaches such as those considered in the Carpenteria and in the
Sydney airport matters on which the NCC has expressed an opinion are not relevant
to this project - they may be relevant for mature and profitable infrastructure but not
for new, risky projects where a change to the regulatory environment could easily
result in the project not going ahead. This is discussed in more detail in section 4.3.

3.2 Market definition

There are two potential approaches to market definition that are relevant for analysis
of the AustralAsia railway project. First, the railway could be considered as operating
in a market for transport of freight and passengers. In this case, access to the
railway might promote competition in relevant downstream markets, such as a
market for produce in Darwin. Alternatively, it might be viewed that there is a railway
track services market that is separate from the freight market. Access in the market
for railway track services might then promote competition in the freight market. In
either case, in our opinion, railway freight operators will be subject to significant
competition in the freight market. This market is currently highly competitive, and
alternative modes of transport will continue to provide competitive constraint on rail
after the project is completed.

If the freight market is highly competitive then the owners of the railway will not be
able to abuse any market power, as they will not have any market power.

This is obvious under the first approach to market definition. The railway will only
operate in the competitive market for the transport of freight and passengers and,
due to competition, will have no market power.

The same conclusion applies under the second approach. If there is a separate
market for railway track services that provides an input for some firms that compete
in the freight market, then competition in the freight market will prevent the owners of

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the railway from gaining any market power. General freight competition will limit the
profits that are obtainable from the use of rail to standard competitive levels and,
because of this, the railway owners will be unable to seize any monopoly profits from
the sale of access. Any attempt to do so will simply be thwarted by downstream inter-
modal competition.

Considering this second case more fully, it is sometimes stated that railways are
‘natural monopolies’. However, this may not be correct, particularly in the case of a
greenfields development such as the Tarcoola to Darwin railway. A railway may have
a natural monopoly technology, in the sense that it has high fixed costs and low
variable costs that make it socially wasteful to duplicate the railway. However a
natural monopoly technology does not necessarily translate into monopoly power. A
monopoly is a characteristic of a market not a technology. If railway freight is in
competition, for example, with road freight then the railway owner cannot seize
monopoly profits. The owner of the railway cannot raise the access charge above
the level imposed by road competition. To attempt to do so would simply drive
railway freight companies out of business, as they could not compete against road
freight. Rather, the owner of the railway can only seize profits that are created by rail
freight being more efficient than the competitive alternative.

Under either approach, a central issue for analysis is the definition of the market in
which the transport operators using the railway will be competing. In particular, do
rail and other modes of transport (especially road but also possibly sea and air)
operate in the same market? Secondly, if the relevant market includes modes of
transport other than simply rail, are competing modes of transportation likely to
impose a significant constraint on rail pricing?

In our view the proposed rail transport operation would operate in the same market
as at least road transport and possibly the other transport modes. This conclusion
follows from the Trade Practices Tribunal’s definition of a market for the application
of Australian Trade Practices Law. According to the Tribunal, a market “is the field of
actual or potential transactions between buyers and sellers amongst whom there can
be strong substitution, at least in the long run, if given a sufficient price incentive”

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(Re Q.C.M.A. and Defiance Holdings, 1976, ATPR 40-012 at 17,247). This definition
and the approach to market definition that it embodies has been upheld in numerous
trade practices cases, including the recent cases of Queensland Wire Industries Pty
Ltd v BHP (1989) 167 CLR 177, Regents Pty. Ltd. v Subaru Pty. Ltd. and News Ltd.
v Australian Rugby Football League and Ors. (Australian Federal Court, 1998 and
1995 respectively).

Under this accepted approach to market definition, a market depends on the

potential for substitution by both buyers and sellers. Also, it depends on potential
competitors who may enter the market if a firm were to attempt to raise prices, as
well as existing competitors. It can reasonably be expected that the existing
transport companies that currently provide freight services over the same route as
the proposed railway (or between the same destinations) will be in competition with
rail freight after the railway is completed. On the route between Adelaide and Darwin
each of air, sea and road compete at the current time. Rail would simply be a new
entrant hoping to compete with them on that route. On the route between Alice
Springs and Darwin, services are currently being provided by road. Again, the
expectation is that rail might be able to compete with road. The road and sea carriers
can be expected to provide competitive alternatives to rail once the project is
complete and will provide a price constraint on the railway operators. Clearly the
railway will not be able to charge more than the existing alternative carriers and
service providers or else their potential customers will simply continue to use the
alternatives. To the degree that the railway charges a lower price, this will benefit
customers. The presence of alternative substitute carriers means that the relevant
market should not be narrowly construed as a ‘rail market’but rather as a general
transport market that is competitive. The AustralAsia railway project is aimed at
allowing rail to enter this market.

3.3 The effectiveness of the inter-modal constraint

Rail will be part of a general transportation market. As such the prices that are
charged for rail (and as a result, for access to the railway line) will be constrained by
the prices set by competing modes of delivery. But this is not the same as saying

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that the owners of the railway will have no market power. Market power depends not
only on the breadth of the market but also on the degree of competition in that
market. Will inter-modal competition impose a significant constraint on the prices rail
operators can charge? We base our views on published transport market data and
supplementary information provided to us by Booz-Allen & Hamilton.

We understand that the split of freight between rail and road on long distance routes
across Australia ranges from about 65:35 to 30:70 depending on the route. The
Productivity Commission estimates that rail’s share of total freight carried in 1994-95
was 56 percent (Productivity Commission Performance of Government Trading
Enterprises 1991-92 to 1996-97, Research Report, Ausinfo, Canberra, 1998
especially Chapter 6). The balance of freight on the current Tarcoola to Alice
Springs route is approximately 30 percent rail, 70 percent road. Table 1 provides
illustrative data.

Table 1: 1994/95 Estimates of Road and Rail Market Shares Selected Corridors

Corridor Distance (km) Tonnage (000's) Rail Share

Road Rail Road Rail
Brisbane-Sydney 972 999 2026 1494 42%
Brisbane-Melbourne 1,570 1,932 1326 351 21%
Sydney-Melbourne 887 933 5472 1619 23%
Sydney-Perth 3,423 3,947 176 359 67%
Melbourne-Adelaide 726 826 2352 1457 38%
Melbourne-Perth 3,467 3,487 298 698 70%
Adelaide-Perth 2,706 2,661 156 612 80%

Source: NTPT, BTCE (1996)

The absolute volume of freight carried by rail has been flat over recent years with
most of the growth being captured by road as a result (in part) of advantageous
relative price movements. There appears to be a substantial substitution between
the modes: “we [Booz-Allen & Hamilton] estimate that the cross-elasticity of demand

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between road and rail to be in the range of 1.5 to 2.0.1 This estimate is supported by
the historic behaviour of demand volumes in response to increases in rail prices in
the long distance general freight market. It is also consistent with empirical studies
which have placed the rail-road cross-elasticities considerably in excess of one.”
The inference is that there is likely to be intense inter-modal competition in the
Tarcoola-Darwin freight market. It is important to remember that this project involves
rail being launched into a mature existing freight market without some of the
protections which have applied for earlier rail lines in other states (such as
environmental2 or other requirements that coal or wheat be carried on rail. There
were also legislative requirements in some states that certain products had to be
carried on rail).

Since rail will be the new mode competing with incumbent road, sea and air
operators, any first-mover or incumbency advantages that exists in the freight market
will lie with these other mode. Rail will have to win custom from other modes so that
competition should be vigorous.

We can also expect that the change to the taxation system expected this year will
further improve the competitive position of road relative to rail. Some estimates
suggest that this will improve the relative competitive position of road by 10 to 15
percent.

Table 2 – Simple Analysis of Impact of GST and Road and Rail Linehaul Costs

Road Rail
Diesel Fuel Price 0.65 0.58
Current Excise 0.43 0.36
Excise under GST 0.18 0.18
% Cost Saving 38% 31%

1
Since in Australia road prices have historically fallen relative to rail this is a one sided elasticity
estimate. However one author, Maddock, has undertaken confidential empirical work for the Victorian
government using stated preference methodology which finds similarly high cross price elasticities for
movements in either direction.
2
Environmental or other regulations can create a situation where some product can only be carried
by rail.

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 Fuel Costs as % of Total Costs 25% 20%

Source: Booz-Allen & Hamilton calculations

The existence of such intense inter-modal freight competition means that rail
operators will have little chance to extract monopoly rents from users when they set
their final prices. This, in turn, means that the railway owners will be unable to
extract any rents from these operators through access prices. Competition will
eliminate any anti-competitive rents in the vertical production chain of railway freight
and the profits that accrue from the project can be expected to reflect the relative
efficiency of the rail service relative to the competitive alternatives. Table 3 provides
some evidence of the gradual loss of freight from rail over the last thirty years.

Table 3 – Sydney Melbourne Rail Market Share

Net Tonnes 000's
Year Road Rail Sea Total Rail Market Share
(Road/Rail Split)
1965 1,290 1,690 340 3,320 57%
1966 1,340 1,720 310 3,370 56%
1967 1,450 1,730 270 3,450 54%
1968 1,550 1,750 260 3,560 53%
1969 1,650 1,620 390 3,660 50%
1970 1,710 1,630 310 3,650 49%
1971 1,690 1,690 430 3,810 50%
1972 1,712 1,614 438 3,764 49%
1973 1,935 1,725 463 4,123 47%
1974 1,959 1,764 821 4,544 47%
1975 2,274 1,488 895 4,657 40%
1976 2,536 1,458 697 4,691 37%
1977 2,645 1,494 714 4,853 36%
1978 2,645 1,408 701 4,754 35%
1979 2,867 1,444 918 5,229 33%
1980 3,178 1,599 917 5,694 33%
1981 3,340 1,565 952 5,857 32%
1982 3,458 1,641 961 6,060 32%
1983 3,022 1,231 769 5,022 29%
1984 3,639 1,401 754 5,794 28%
1985 3,706 1,405 694 5,805 27%
1986 4,127 1,420 659 6,206 26%
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 1987 4,479 1,607 480 6,566 26%
1988 4,885 1,621 620 7,126 25%
1989 5,340 1,848 722 7,910 26%
1990 5,438 1,777 755 7,970 25%
1991 5,466 1,867 621 7,954 25%
1992 5,494 1,957 487 7,938 26%
1993 5,522 2,047 353 7,922 27%
1994 5,550 2,137 219 7,906 28%
Source: BTCE Occasional Paper 98, Booz·Allen & Hamilton Data
The current phase of intense rivalry between transport modes is not a new
phenomenon in Australia. N. Butlin, A. Barnard and J. Pincus Government and
capitalism, Allen & Unwin, Sydney 1982 discuss the long term loss of market share
by rail to alternative transport methods. Their long term estimates are that real rail
prices rose by about 27 percent between 1950 and 1975 while the price of private
vehicle operation fell by about 12 percent. During this period rail failed to pay for the
capital employed. Butlin et al argue that the competitive situation for rail has been in
decline since some time in the 1920s; that is a period of seventy-five years. The
continuation of this historic trend of weak rail finances to the current day is captured
in the views of the Productivity Commission. “Over the period monitored [the
nineties], most rail GBEs have made significant operating losses and generated poor
returns on equity” (op cit, p.224). Most States fund the operating deficits of their rail
enterprises so that normal commercial returns on capital are not even considered.

The inference we draw from the evidence is that for the post-war period rail has
demonstrated poor profitability. The main reason for poor profitability is that prices
are constrained by inter-modal competition from road. Given that this state of affairs
appears to have persisted for seventy-five years, we believe that it is likely that this
will continue into the foreseeable future. It thus seems sensible to assume that the
competitive pressure imposed on rail freight prices from road freight will continue for
the next thirty years and probably for longer than that.

3.4 The competitive imputation price in practice

Competitive imputation pricing uses the existing inter-modal competition to establish

access prices. It starts from the view that the final delivered prices for the carriage of
some commodity from point A to point B is restricted by the price of providing the

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same service by some other means. Call this other price the competitive alternative
delivered price (CRLP)3.

We arrive at the competitive imputation access price (CIAP) by subtracting some

costs from the competitive alternative delivered price. The costs we net out are the
incremental costs to the railway owner/operator of providing itself the above rail
freight or passenger service. We do this because the owner/operator will avoid these
costs if the access seeker runs its own freight or passenger trains.

Thus
CIAP = CRLP - incremental above rail service costs.

In determining the price for which the service can be offered on a competing mode of
transport, it would be appropriate to consider the price that the other mode would
charge if it were to operate commercially on the transport corridor in the medium to
long term. This means that the appropriate road price to be considered would be the
price of running a commercial road operation that is with trucks running in both
directions so that backhaul losses should be allowed for in the calculations.

3
This follows the nomenclature in the proposed legislation – Competitive Rail Linehaul Price.

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4. Price floors, price ceilings and related issues

There are three additional points that need to be raised regarding the access pricing
rule.

4.1 Access price should not fall below the incremental (below rail) operating
costs

It would not be appropriate to have a pricing rule that forced the rail operator to
provide access at a price below the incremental (below rail) cost of providing the
service, as could result from the operation of the CIPR. This might arise for example
where the alternative transport mode is very cheap. To require the operator to
continue to provide services at prices below the incremental cost of using the tracks,
signalling etc would violate the conditions in subclause 6(4)(i)(i) of the CPA which
protects the owner’s legitimate business interests and subclause 6(4)(I)(vi), which
deals with the safety and reliability of the facility which could be compromised if
there is insufficient incentive for expenditure on maintenance etc.

To avoid this anomaly of CIPR, the pricing rule should incorporate a floor on the
access price. This would be based on the incremental below rail costs plus an
appropriate margin.

4.2 Pricing in the absence of a competing mode

The competitive imputation principle assumes that there is a competing mode of

transport which can be used to establish the base-line from which the CIPR access
price can be developed. This is clearly the case for existing freight. The current
mode of transport is providing the competitive alternative. But it might be believed
that such a competitive alternative may not exist for some new freight that could be
transported using the new railway.4

4
We note that a price cap is now proposed to deal with this alternative.

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The most often discussed situation is where a new mine might be developed. There
are however mining operations in many parts of the world that use road transport
rather than rail even though rail is more common in Australia. Even iron ore is
carried by road in the major Brazilian Samarco mine. Rigid plus 3 tri-tri truck
configurations are currently used in the Northern Territory’s Woodcutters mine and
the 3B combination (3 “B” doubles - six trailers - and a carriage of 205 tonnes) is in
use to bring ore from the Macarthur River mine to the Bing Bong loading facility.
There is no in principle reason why the 4 “B” double used in some parts of the US
could not be used as well. The essential point is that road does currently provide
carriage services for ore from a variety of mines in the Northern Territory so that it is
difficult to envisage a situation where a road transport alternative to the rail does not
exist.

Secondly, for a new mine, transport options will need to be considered as part of the
feasibility study for that mine. Both the financiers of the mine and the government
(concerned about environmental impact) require a formal analysis of transport
alternatives. In the situation where the mine has not been developed, the potential
mine operator and the rail operator would negotiate the prices which might be
charged for rail transport before the mine goes ahead. The transport costs can thus
be incorporated into the project analysis. We would normally expect that both sides
would be interested in arriving at a long-term contract whereby the freight did travel
on the rail. In this situation the rail operator is at a disadvantage in that the rail
infrastructure would be in place and hence a sunk cost while the mine would involve
a much lower level of sunk cost. Normal bargaining should produce an outcome that
is beneficial to both sides. Clearly the rail operator loses if it insists on a high rail
access price so that the mine does not proceed. In this case the railway makes zero
revenue rather than having the new mine make some contribution to the railway
costs.

A further possible concern with the use of the alternative mode to establish the
competitive imputation price is that, if the rail project were highly successful, the
current alternative carriers may exit from the market. In this sense, it might be felt
that competitive pressures on the railway might diminish over time. However, even if

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existing carriers did exit the market, it is both actual and potential competition that is
relevant. If alternative carriers could quickly re-enter the market in response to a rise
in rail freight prices then these carriers would provide competitive restraint on the
railway and are still in the relevant market. This is particularly relevant for road
transport where the relevant capital (the trucks) can be quickly moved in from other
freight routes. The road industry is one where entry and exit are relatively easy.
Further, the figures cited above suggest that rail and road co-exist on all major rail
transport routes so that we would expect them both to continue to operate between
Tarcoola and Darwin.

4.3 Regulatory controls and the ex ante efficiency of the CIPR

As noted above the CIPR is particularly designed for new investment projects that
face demand uncertainty. In these circumstances, most access rules will distort the
return profile from the investment and may risk the viability of the project. The
competitive imputation pricing rule, by contrast, does not distort the investment
return profile.

The key difficulty with investments in new, greenfields projects is that the flow of
revenues that might result is very difficult to estimate. Investors thus consider the
range of possible returns that might result from the investment and attempt to attach
a probability to each in order to ascertain the expected revenue stream. They then
undertake the risky investment on the basis of comparing this expected revenue with
the project costs. Once the project has been undertaken they then face considerable
regulatory risk.

As an example, consider two alternative outcomes, one where the project revenues
are high and one where they are low. If a priori the probabilities are equal then the
expected revenue will be in the middle of these two values. If this expected revenue
exceeds the project cost, then the investment will be undertaken. Once the facility is
built, revenues will either turn out to be high or low. If they are low, the project will be
unprofitable. If they are high, the investment will be very profitable.

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A regulator can distort these choices:
• in the unprofitable case, there is likely to be no regulatory interference.
• if the project is successful however, a regulator might try to take away the gains
and force the project to earn no more than ‘normal’returns.

The consequence of this is to distort the investment choice. If a regulator insists on

taking away profits if the project turns out to be successful and investors know this
will occur before the investment is made, then the return profile is changed. The
project will either earn low returns and be unprofitable or it will earn intermediate
profits (because the high revenue outcome occurred but the benefits were regulated
away). The average expected revenues (after regulation) are thus reduced. In this
situation a project that was viable will not proceed. The regulatory stance has
distorted the investment decision and has lowered Australian economic welfare.
(This concern is treated in detail in Chapter 7 of S. King and R. Maddock Unlocking
the infrastructure, Allen & Unwin, Sydney 1996 to which the interested reader is
referred).

This suggests that it is important for investment efficiency, when considering a truly
new and innovative project, that regulators do not attempt to penalise such projects
when they are successful. However, most access rules do just that. For example, if a
regulator sets an access rule that is based on the facility owner gaining a reasonable
rate of return and this truncates the potential profits that the owner might make from
its investment, then the return profile is distorted and regulation can inefficiently
reduce investment. Note that the problem with such an access rule is that it prevents
the investor from gaining profits if the project is highly successful but leaves the
investor completely exposed to losses if the project fails. Because of this, it is not
sufficient to simply adjust the relevant cost of capital used in the regulatory
evaluation of reasonable access prices. Any access price rule based on ‘reasonable
returns’will truncate the investors’return profile and may distort investment
decisions unless it is identical in practice to the CIPR.

If a regulator believes that an extra price ceiling needs to be placed on the access
provider in addition to the ceiling provided by the CIPR, then this ceiling should be

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set at the stand alone cost for the relevant access seeker. In essence, this is the
equivalent of a competitive alternative if there is no actual practical alternative in the
market. Such a rule still allows investors to obtain the benefits if a low probability,
highly profitable outcome occurs. Note however, that going beyond this seeker-by-
seeker cap, for example by using a combinatorial stand alone cost price cap, will
distort the investment choice and ultimately reduce the regulatory model to rate of
return regulation. We do not believe that this is appropriate for an innovative, risky,
greenfields project of the sort under consideration here.

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5. Evaluation

5.1 The “benefit from competitive markets” guideline

The railway line under consideration does not currently exist. The construction of
such a railway line has been under discussion for nearly 100 years. The project has
been analysed many times and never undertaken. As we understand the current
cost-benefit analysis, the project may now be feasible principally on the basis of
revenues expected over the life of the 50 year project. That is, the stream of
expected revenues from the investment only exceeds expected economic costs by a
small margin over that long period.

An access rule that allowed entrants to compete with the facility owner in the rail
transport business, and diverts any legitimate investment returns from the owner, is
likely to have the effect of rendering the project non-viable. The consequence is to
reduce competition on the route.

Subclause 6(4)(i)(viii) of the CPA creates a requirement that the access rule should
take account of the desirability of having competitive markets. To the degree that rail
provides an efficient alternative to current transport alternatives, the construction of
the railway will promote competition in the transport markets which shift goods into
or out of Darwin, as well as in a range of other upstream and downstream markets.
The project may also improve the economics of some currently undeveloped mines
and lower input costs in a range of other industries with flow-on effects into a number
of other markets. It is thus important in terms of the Competition Principles
Agreement to develop an access regime that does not impede the construction of
the facility.

5.2 The “economically efficient operation of the facility” guideline

In the context of this project, economically efficient operation applies to a facility

once constructed. The underlying assumption of the competitive imputation rule is
that rail competes with road, sea and possibly air in the relevant transport market.

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Competition between the modes should lead to rail only being used where it is
economically efficient to do so. The competitive imputation pricing rule that is
proposed provides incentives for the facility owner to allow entrants to operate using
the facility whenever they are able to do so at lower cost.

If rail provides a cheaper transport option on some route than road or sea transport,
and the rail service is provided by a third party, the margin between the rail cost and
the competitive price (a producer surplus) would be retained by the facility owner
rather than by the third party. This does not violate economic efficiency for two
reasons. It is precisely this surplus which makes the facility viable in the first place.
Taking the surplus away from the facility owner is likely to mean that the facility is
not developed at all. In this case, the surplus would not be generated and this loss of
surplus would be an economic loss arising from inappropriate access pricing. The
second reason is that ex post it makes no difference in terms of economic efficiency
who captures the surplus: it involves the distribution of income but has no efficiency
consequences in itself.

5.3 The “owner’s legitimate business investment in the facility” guideline

The proposed rule provides an access structure in two parts. In relation to the use of
the rail it creates an environment where the owner is able to capture any economic
returns arising from the use of the facility. The owner cannot seize monopoly rents
because of the constraint of inter-modal competition. This structure exactly mimics
the working of a normal competitive market. As such it protects the owner’s
legitimate business investment in the facility.

From the discussion above it should be clear that the evaluation of risky investment
projects assigns probabilities to the various revenue scenarios which might occur
and contrasts the expected project revenue with the project costs. Any regulatory
decision to truncate the distribution by regulating away the highly successful
outcomes if they occur changes the return profile of the project. The project under
consideration has been evaluated many times but has never been undertaken. Our
understanding of the project economics is that the project is unlikely to be feasible

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even now if the low probability/high payoff revenue alternatives are regulated away.
It is our view that the owner’s legitimate business investment in the facility is
protected by allowing the owner access to the upside if the project is successful just
as the owner would have to carry the losses should the project prove unsuccessful.

5.4 The “cost of providing access” guideline

This guideline has two elements; one concerned with railway infrastructure costs,
and the other with compensation for possible losses in other markets.

The rules as proposed take account of the cost to the owner of providing access as
required by guideline in subclause 6(4)(i)(ii) of the CPA. Most importantly the owner
should never be required to sell access at a price below the avoidable cost of
providing access.

In terms of the second element of the guideline, it might be believed that the CIPR
would compensate the rail owner for “costs associated with losses arising from
increased competition”. This is not the case. If inter-modal transport provides the
relevant competitive constraint on rail freight, then the prices of inter-modal transport
constrain the rail freight operators and neither the operators nor the owners of the
railway have relevant market power. The CIPR in this case only compensates the rail
owner for the legitimate costs of the investment including the ex ante risk of the
investment. Further, to the degree that any operator seeking access is more efficient
at providing freight services than the railway owner, the CIPR explicitly does not
allow the railway owner to seize any of the benefits of this improved efficiency.
However, as noted above, setting any access price below the CIPR does not
adequately compensate for ex ante risk as it truncates the investment profile and
may deter the investment in railway altogether.

A simple example may help to illustrate this point. Suppose that the railway has been
constructed, is in operation, and that the current rail freight price of a commodity is
$20 per kg. This price is set by road competition, which also has a price of $20 per
kg. Of the rail price, suppose that $11 is above rail costs. Suppose further that a new

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operator is able to reduce above rail costs to $8 per kg. Using the CIPR, the
operator can gain rail access at a price of $9 per kg. So the new operator’s costs are
$17 per kg. The new operator can now price at $19.50 per kg, undercut the road and
rail competition, and make a profit of $2.50 per kg. The existing rail operators will no
longer find it economical to ship the product and the new rail operator may seize a
significant amount of business from road. But note that the new operator retains all
of the profits associated with their innovation. The rail owner only receives the
revenues that they were previously receiving that are directly associated with their
rail investment. These are the legitimate (but ex ante uncertain) returns that drove
the investment decision in the first place. The same analysis might be carried out in
relation to any downstream market, such as the impact on freight carried between
Darwin and Singapore, with the same outcome: the rule does not allow the operator
to gain compensation for losses in downstream markets.

In contrast, suppose that a change in government policy makes road freight more
competitive. Competition drives the price of road freight down to $18 per kg and rail
operators must drop their price to compete. But the whole cost of this extra
competition is borne by the rail owner through the CIPR. As the competitive
alternative falls by $2, so does the rail access price. Rather than compensating the
railway owner for “costs associated with losses arising from increased competition”,
the rail owner is completely exposed to the cost of increased inter-modal competition
under the CIPR.

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6. Conclusion

In our view, the competitive imputation access pricing rule is consistent with the
guidelines incorporated within the Competition Principles Agreement. It thus
complies with the requirements of Section 44DA of the Trade Practices Act.

The method proposed is akin philosophically to price-cap regulation although in this

case the price cap is set by the competing modes of transport. Given the experience
of rail in Australia, competition from road has been highly effective in preventing the
extraction of monopoly rents on general purpose rail lines. In the light of the long
term nature of the shift in competitiveness from rail to road, we see no reason to
expect that road competition will not impose a strong competitive threat to rail into
the foreseeable future. It is our expectation that alternative transport modes such as
road would provide an effective discipline on the rail operator for at least the next
thirty years.

The competitive imputation rule has three additional advantages:

(i) it allows third parties to enter in situations where they can provide the service
more cheaply than the incumbent. The market should thus be characterised by
efficient operation,
(ii) it allows all relevant producer surplus to be captured by the rail operator. This is
important for this facility and is ex ante efficient. The project is marginal. The
diversion of surplus from the owner to third parties may well render it non-viable. The
proposed methodology thus creates appropriate incentives for risky, greenfields
investments of the type under consideration here, and
(iii) the methodology increases the likelihood that the project will actually go ahead.
The public interest would be served better by the railway being constructed rather
than the opposite.

On balance, the public interest is well served by the competitive imputation rule. This
is because of the particular circumstances of this project and may not apply in other
cases.

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