Multinet operating expenditure forecast
A REPORT PREPARED FOR JOHNSON WINTER SLATTERY
February 2016
© Frontier Economics Pty. Ltd., Australia.
February 2016 | Frontier Economics
i
Multinet operating expenditure forecast
Executive Summary
iii
1
Introduction
7
1.1
Background
7
1.2
The task
8
1.3
Structure
9
2
AER’s approach in its Draft Decision
11
2.1
Multinet adopted a bottom-up approach
11
2.2
AER’s Draft Decision rejects bottom-up forecasts in principle
12
2.3
Is this a debate between models?
14
3
Adjusting historical costs to forecast future efficient
expenditure
16
3.1
Adjusting for under-recovery of JAM’s costs
3.2
Adjusting for the ‘gaps’ in risk management and strategic planning 20
3.3
Adjusting for the cost-reducing efficiencies
21
4
Incentives created by AER approach
23
5
Conclusions
25
6
Declaration
26
7
Annexure A: CV
27
18
Contents
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Contents
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iii
Executive Summary
1
Johnson Winter & Slattery (JWS) has requested an expert opinion from Frontier
Economics on the approach adopted by the Australian Energy Regulator (AER)
towards Multinet Gas’s operating expenditure forecasts in the AER’s Draft
Decision for the 2013-2017 Gas Access Arrangement period. In its Draft
Decision, the AER rejected Multinet’s operating expenditure forecast on the
basis that it did not satisfy the requirements of sections 91(1) and 74(2) of the
National Gas Rules (NGR).
2
Multinet’s operating expenditure forecast was developed in the context of its
move away from a single outsourcing contract model with Jemena Asset
Management (JAM) to a new business model involving multiple competitivelytendered contracts and the decision to bring corporate and strategic functions
back in-house. Because of this shift to its new business model, Multinet decided
to forecast its operating expenditure using a bottom-up approach. In my opinion,
this approach was understandable and appropriate given the requirements of the
NGR.
3
The AER’s Draft Decision rejected the bottom-up methodology utilised by
Multinet in favour of the AER’s ‘revealed cost approach’. This approach takes
actual historical costs in a particular base year as a reliable starting point from
which to forecast efficient operating expenditures for the next access
arrangement period.
4
Despite acknowledging that JAM had made a loss on its contract with Multinet,
the AER refused to accept Multinet’s contention that its historical operating
expenditures (based on the contract with JAM) represented an inappropriate
basis for forecasting Multinet’s future efficient operating expenditures.
5
The two reasons the AER gave for rejecting Multinet’s forecasts were that:
a. any restructure could only have been undertaken to reduce Multinet’s
costs, which must have fallen by as much or more than the increase
needed to cover the shortfall suffered by JAM under the previous
business model; and
Executive Summary
iv
Frontier Economics | February 2016
b. allowing others to claim that their past costs were not sustainable would
create perverse incentives for businesses across the regulated energy
sector.
6
In my opinion, the AER should not have rejected the bottom-up approach
adopted by Multinet. There are good reasons why forecast efficient costs may be
higher than costs incurred in the past and the NGR does not dictate any
particular method for forecasting an efficient level of operating expenditure.
7
In any case, it should be possible to reconcile a bottom-up approach with a
revealed cost approach. These are merely methods by which a forecast is derived.
8
If it wished to rely on a revealed cost approach, the AER should have made the
following adjustments to Multinet’s historical expenditures (denoted as ‘a’):
a. an upward adjustment (denoted as ‘b’) to account for the historical
under-recovery of JAM’s costs (and absence of a reasonable profit
margin) under the previous fixed price contract;
b. an upward adjustment (denoted as ‘c’) to account for the expenditure
associated with addressing ‘gaps’ in risk management and strategic
planning that have come about due to the current contractual
arrangements; and
c. a downward adjustment (denoted as ‘d’) reflecting the cost-reducing
efficiencies of the new business model.
9
It appears the AER implicitly assumed that the cost-reducing efficiencies of the
new business model (d) would offset the upward cost adjustments that would be
required under the existing business model (b and c). However, the AER did not
provide any justification for why it believed this would be the case.
10
I disagree with the AER’s Draft Decision statement that setting forecast
operating expenditures in excess of historical revealed costs would create
perverse incentives for network service providers. The AER should allow a
reasonable estimate of the efficient sustainable costs. They should not impose on
businesses costs that are below the minimum that it would be efficient to sustain.
If adopted, the AER’s approach would give rise to incentives that are likely to be
Introduction
February 2016 | Frontier Economics
v
contrary to the long term interests of consumers and in turn contrary to the
National Gas Objective.
Executive Summary
February 2016 | Frontier Economics
1
Introduction
1.1
Background
11
I was a full-time academic economist at the University of Melbourne from 1978
7
until February 2002 when I resigned my full-time position as Professor of Law
and Economics in the Melbourne Business School. I continue to teach at the
University on a part-time basis; my principal teaching commitment is the delivery
each year of the subject Economics for Competition Lawyers in the LL M
Program of the University.
12
Since February 2002 I have been the full-time Executive Chairman of Frontier
Economics Pty Ltd. I founded the company in May 1999 with Danny Price; but I
worked in the company only one day a week until February 2002. Annexure A to
this Report is my current curriculum vitae.
13
In addition to my responsibilities as Chairman, I am responsible for Frontier’s
work in the legal/competition area. This involves giving advice on the economics
of legal and regulatory disputes, giving advice to the Australian Competition and
Consumer Commission (ACCC) and the New Zealand Commerce Commission
(NZCC), and giving advice to persons about submissions to the ACCC and the
NZCC.
14
By reason of the above, I have a wide expertise in industrial economics. I have
particular expertise in analysing competition and regulation within markets where
issues of market power arise.
15
I have been assisted in preparing this report by Rajat Sood. Rajat is a founding
member of Frontier Economics and is a qualified solicitor, as well as a trained
economist. He has a broad range of experience in advising state and national
governments, regulatory bodies and private entities on regulatory, cost-benefit
and trade practices economics, especially in relation to policy towards, and the
reform of, utilities. In recent years, Mr Sood has been a key advisor to institutions
such as the Australian Energy Market Commission (AEMC), the Australian
Energy Regulator (AER), the New Zealand Electricity Commission, the New
Introduction
8
Frontier Economics | February 2016
Zealand Ministry of Economic Development, the New Zealand Commerce
Commission, the Singapore Energy Market Authority and the Singapore
Economic Development Board. He holds an LL B (Hons) and a B Comm
(Hons) from the University of Melbourne.
16
I confirm that all the opinions expressed in this report are my own and that each
of the opinions is based on my specialised knowledge.
17
I have read, understood and complied with Practice Note CM7 dated 1 August
2011 concerning expert witnesses.
1.2
The task
18
Johnson Winter & Slattery (JWS) has requested an expert opinion from Frontier
Economics on the approach adopted by the Australian Energy Regulator (AER)
towards Multinet Gas’s operating expenditure forecasts in the AER’s Draft
Decision for the 2013-2017 Gas Access Arrangement period.
19
In its Draft Decision, the AER rejected Multinet’s operating expenditure forecast
on the basis that it did not satisfy the requirements of sections 91(1) and 74(2) of
the National Gas Rules (NGR).1 Accordingly, the AER substituted Multinet’s
forecast of $362.7 million (in 2012 dollars) with a forecast of $270.3 million (also
in 2012 dollars).2
20
The relevant provisions of the NGR are as follows:
91
Criteria governing operating expenditure
(1)
Operating expenditure must be such as would be incurred by a
prudent service provider acting efficiently, in accordance with
accepted good industry practice, to achieve the lowest sustainable
cost of delivering pipeline services.
(2)
The AER's discretion under this rule is limited.
1
AER, Access Arrangement Draft Decision, Multinet Gas, Part 2 Attachments, chapter 6, p.194 (AER
Draft Decision – Part 2 Attachments).
2
AER Draft Decision – Part 2 Attachments, p.225.
Introduction
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74
21
9
Forecasts and estimates
(1)
Information in the nature of a forecast or estimate must be
supported by a statement of the basis of the forecast or estimate.
(2)
A forecast or estimate:
(a)
must be arrived at on a reasonable basis; and
(b)
must represent the best forecast or estimate possible in the
circumstances.
Essentially, these provisions state that forecast operating expenditures must be:
a. efficient;
b. least-cost;
c. sustainable; and
d. developed on a reasonable basis.
22
The AER’s discretion under Rule 91 is limited. This means that the AER may
not withhold its approval to an element of an access arrangement proposal
governed by the relevant provisions if the AER is satisfied that it:
a. complies with applicable requirements of the Law; and
b. is consistent with applicable criteria (if any) prescribed by the Law.3
1.3
Structure
23
This report is structured as follows:
a. Section 2 outlines the AER’s approach to Multinet’s operating
expenditure forecast in its Draft Decision;
b. Section 3 discusses how Multinet’s historical operating expenditures
ought to be adjusted to generate an appropriate operating expenditure
forecast;
3
NGR sub-section 40(2).
Introduction
10
Frontier Economics | February 2016
c. Section 0 examines the incentives that the AER’s Draft Decision
approach to setting Multinet’s operating expenditure forecast would
create for gas distribution businesses; and
d. Section 0 sets out my conclusions.
Introduction
February 2016 | Frontier Economics
2
AER’s approach in its Draft Decision
2.1
Multinet adopted a bottom-up approach
25
Multinet’s operating expenditure forecast was developed in the context of its
11
move away from a single outsourcing contract model with Jemena Asset
Management (JAM) to a new business model involving multiple competitivelytendered contracts and the decision to bring corporate and strategic functions
back in-house. As explained in its Access Arrangement Information (AAI)
document:
a. The previous business model did not provide Multinet with sufficient
control and capability to make strategic decisions to drive long-term
sustainable cost efficiencies and service improvements.
b. A single service provider model precluded Multinet from contracting
directly with ‘best of breed’ contractors for specialist services. It also
creates a culture of dependency between Multinet and the service
provider, which ultimately led to inefficiency and greater risk exposure
for Multinet.
c. The fixed fee structure for operations and maintenance created an
incentive for JAM to reduce costs to unsustainably low levels. As the
current agreement expires on 30 June 2013, changes to existing terms and
conditions are unavoidable.4
26
The new business model was designed to overcome these issues by:
a. allowing Multinet to manage its risks more effectively by reducing its
reliance on a single provider of operations services and undertaking more
long term focussed activities in-house; and
b. creating a more competitive procurement model that places continuous
pressure on contractors to provide good value for money in the context
4
Multinet, Access Arrangement Information, 30 March 2012, p.19.
AER’s approach in its Draft Decision
12
Frontier Economics | February 2016
of changes in costs or service requirements, as well as reducing barriers to
the involvement of new service providers.5
27
Because Multinet decided to shift to its new business model, it decided to
forecast its operating expenditure using a bottom-up approach. In my opinion,
this approach was understandable and appropriate. Furthermore, it enabled
Multinet to satisfy the requirements of Rule 74(2)(b), which requires that
forecasts must represent the best forecast or estimate possible in the
circumstances.
2.2
AER’s Draft Decision rejects bottom-up forecasts
in principle
28
The AER’s Draft Decision rejected the bottom-up methodology utilised by
Multinet in favour of the AER’s ‘revealed cost approach’. This approach takes
actual historical costs in a particular base year as a reliable starting point from
which to forecast efficient operating expenditures for the next access
arrangement period.6
29
In adopting a revealed cost approach, it is necessary to assess the extent to which
past expenditures can provide a reliable starting point to forecast efficient future
expenditure. The AER claims to have undertaken such an assessment. It noted,
correctly, that the bulk of Multinet’s historical operating costs consisted of the
fee it paid to its contractor, JAM.
30
The AER acknowledged that JAM had made a loss on its contract with Multinet:
Therefore if JAM were to continue to provide these services after 30 June 2013
the AER agrees, all other things being equal, it is reasonable to assume that
JAM would seek to increase the fee it charges and this would lead to Multinet’s
costs being higher in the 2013-17 access arrangement period.7
31
Despite the AER’s acceptance of this point, the AER refused to accept
Multinet’s contention that its historical operating expenditures (based on the
5
Multinet, Access Arrangement Information, 30 March 2012, p.20.
6
AER Draft Decision – Part 2 Attachments, p 226.
7
AER Draft Decision – Part 2 Attachments, p.213.
AER’s approach in its Draft Decision
February 2016 | Frontier Economics
13
contract with JAM) represented an inappropriate basis for forecasting Multinet’s
future efficient operating expenditures.
32
The AER’s refusal to accept Multinet’s bottom-up approach seems to have been
driven by Multinet forecasting higher costs in the future than in the past.
However, an efficient level of operating expenditure can only be specified on the
assumption that a particular set of activities is undertaken by an enterprise. If it is
efficient for an enterprise to change the set of activities that it undertakes, the
new efficient level of operating expenditure must be defined with reference to
the new set of activities. The Draft Decision’s refusal to accept that operating
expenditure might increase from one period to the next must be based on an
implicit assumption that it would be inefficient for any regulated business to
change its set of activities from one period to the next.
33
The Draft Decision’s refusal to countenance any increase in operating
expenditure from one period to the next is clear from the two reasons it gives for
rejecting Multinet’s bottom-up forecasts. The first reason given is that any
restructure (of the kind that Multinet has undertaken) could only have been
undertaken to reduce its costs – and the reduction in costs associated with the
restructure must have been greater than the increase in Multinet’s costs that
would have been needed to cover the shortfall suffered by JAM under the
previous business model. The AER said:
By restructuring and removing JAM as its main outsourced provider, it is
reasonable to expect a forecast of Multinet's efficient costs for equivalent
services to be lower relative to the costs incurred by JAM under Multinet’s
current business model. This would be consistent with Multinet's claims about
the efficiency of its new business model. If Multinet did not expect its new
business model to be a more efficient model than its current business model
then the AER considers Multinet would not have restructured in the way it has.
While it is not possible to quantify the expected efficiencies from Multinet’s new
business model relative to its current business model, the information provided
by Multinet about the expected efficiencies indicates Multinet’s current
business model is not the most efficient model available. For this reason, the
AER cannot conclude JAM's costs are reflective of an efficient level of opex.
Moreover, the AER cannot conclude that a forecast of efficient opex in
the 2013–17 access arrangement period would be materially higher than
AER’s approach in its Draft Decision
14
Frontier Economics | February 2016
Multinet’s historical opex because the fee it paid to JAM was not enough
to cover JAM's costs.8 (Emphasis added)
34
The second reason given by the AER in its Draft Decision for rejecting a
bottom-up approach to forecasting was that allowing others to claim that their
past costs were not sustainable would:
...promote perverse incentives across the regulated energy sector. That is, if
the AER used an opex forecast higher than a base year estimate, the AER
would provide a signal to all regulated energy businesses that the AER is
willing to increase regulated opex above historical opex under certain
circumstances. It would provide an incentive to all regulated business
contemplating a restructure to achieve losses at the end of a regulatory period,
claim its current model is not sustainable in the event of such losses and then
restructure to a higher cost business model. If the AER increased regulated
opex each time a business incurred a loss in the base year, a regulated
business could repeat the cycle each time its current business model had
outlived its usefulness. This is not consistent with promoting economic
efficiency across the regulated energy sector.9
2.3
Is this a debate between models?
35
In my opinion, the AER should not have rejected the bottom-up approach
adopted by Multinet. Contrary to the views expressed by the AER in its Draft
Decision:
a. forecast efficient costs may be higher than costs incurred in the past if the
costs incurred in the past were not sustainable; and
b. forecast efficient costs may be higher than costs incurred in the past if the
past business model created incentives for too little expenditure in certain
functions.
36
In my opinion, the NGR does not dictate any particular method for forecasting
an efficient level of operating expenditure. If the conditions confronting the
business are unlikely to change significantly in the future compared with the past,
costs incurred in the past may be a good guide to those that are likely to be
incurred in the future. If conditions are likely to change significantly, it may be
difficult to predict future expenditure on the basis of past expenditure.
8
AER Draft Decision – Part 2 Attachments, p.214.
9
AER Draft Decision – Part 2 Attachments, pp.227-228.
AER’s approach in its Draft Decision
February 2016 | Frontier Economics
37
15
However, even if conditions are changing substantially, it should be possible to
reconcile a bottom-up approach with a revealed cost approach. These are merely
methods by which a forecast is derived. If the AER wishes to rely on a revealed
cost approach, it should check the extent to which the individual categories of
expenditure incurred in the past have changed between the past and the future. It
should not simply reject forecasts because they have been constructed from the
bottom up.
38
In the following section of this report, I show how (in my opinion) the AER
should have proceeded if it wished to rely on a revealed cost approach. It would
need to take Multinet’s past operating expenditure and make adjustments for the
categories of expenditure that Multinet stated had changed. In this way, the AER
could have continued with its revealed cost approach and verified the costs
claimed by Multinet. This would have enabled the AER to deal with the real
issues raised by the claim.
AER’s approach in its Draft Decision
16
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3
Adjusting historical costs to forecast future
efficient expenditure
39
The provisions of the NGR cited in section 1.2 above make it clear that the use
of historical costs to forecast future costs is not to be undertaken naively. The
relevant provisions of the NGR require that forecast costs “must be such as
would be incurred by a prudent service provider acting efficiently, in accordance
with accepted good industry practice, to achieve the lowest sustainable cost of
delivering pipeline services.” Further, forecasts “must be arrived at on a
reasonable basis” and “must represent the best forecast or estimate possible in
the circumstances.” There may be good reasons why future operating costs
should be higher than costs incurred historically.
40
For historically-incurred costs to be useful in forecasting future operating costs,
they need to be representative of the level of efficient future costs. Historical
costs are the best indicator of future costs where businesses are operating in a
steady-state. However, where historical costs are not representative of future
costs, forecasts based on historical costs will need to be adjusted to ensure that
they meet the requirements of the NGR.
41
Multinet’s submissions to the AER reveal three principal reasons why its
historical costs were not representative of future costs and subsequently why
forecasts needed to be adjusted away from historical costs to provide a reliable
guide to efficient expenditures for the next access arrangement period. These
reasons were:
a. Multinet’s historical costs were based on a fixed price contract with JAM
that, as the AER acknowledged, did not cover JAM’s actual costs of
service or a reasonable profit margin and, as such, are not sustainable;
b. The nature of Multinet’s fixed-price contract with JAM created incentives
for inefficient (excessively risky) conduct on the part of JAM; and
c. Multinet’s proposed business model introduces changes in contracting
arrangements to introduce cost-reducing efficiencies and additional
Adjusting historical costs to forecast future efficient
expenditure
February 2016 | Frontier Economics
17
management resources, internal systems and governance arrangements to
manage a more complex business model.
42
In my opinion, the AER’s Draft Decision confounds the effects of these three
factors. Taking Multinet’s historical costs (denoted as $a) as a starting point,
operating expenditure forecasts should be adjusted to reflect:
a. the historical under-recovery of JAM’s costs (and absence of a reasonable
profit margin) under the previous fixed price contract (reason (a)) – this
would lead to higher forecast future expenditure (denoted as $a + $b)
than not adjusting for this factor;
b. adjusting forecasts to account for the expenditure associated with
addressing ‘gaps’ in risk management (such as training) and strategic
planning (as well as other areas) that have come about due to the current
contractual arrangements (reason (b)) – this would also lead to higher
forecast future expenditure (denoted as $a + $b + $c) than not adjusting
for this factor; and
c. adjusting forecasts for the cost-reducing efficiencies of the new business
model (reason iii) – this would lead to lower forecast expenditure
(denoted as $a+$b+$c-$d) than not adjusting for this factor, at least in
the longer term.
43
Based on the passage reproduced in paragraph 33 above, it appears that in using
Multinet’s historical costs as the basis for setting Multinet’s operating expenditure
forecast, the AER’s Draft Decision implicitly assumed that the cost-reducing
efficiencies of the new business model (d) would offset the upward cost
adjustments that would be required under the existing business model (b and c).
Therefore, the AER implicitly assumed d = b + c even though the magnitude of
b and c are entirely unrelated to the magnitude of d. The AER did not provide
any justification for why it believed this would be the case and Frontier cannot
readily identify an economic rationale that would justify such an assumption.
44
The following sub-sections explain the nature of the required adjustments in
more detail.
Adjusting historical costs to forecast future efficient
expenditure
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3.1
Adjusting for under-recovery of JAM’s costs
45
This section discusses the extent to which Multinet’s historical operating
expenditures under its fixed price contract with JAM need to be adjusted to
account for JAM’s under-recovery of its costs and absence of a reasonable profit
margin under that contract.
46
As noted above, the AER considered that Multinet’s adoption of its new business
model was a key reason why its forecast operating expenditure exceeded its
historical expenditure. However, the AER also acknowledged that even if
Multinet were to continue with its current business model beyond the period of
the current contract (which expires on 30 June 2013), it would not be able to
contract with JAM at the same price that Multinet has enjoyed for the past
several years.
47
In my view, the AER’s acceptance of this basic fact has two implications:
a. First, it means that the new business model is not the only – or even a
primary – reason why Multinet’s forecast operating expenditures exceed
its historical expenditures. Multinet’s costs would rise even (and perhaps
more so) if it continued with the same business model it employed over
the 2008-12 period.
b. Second, it means that Multinet’s historical expenditures need to be
adjusted to reflect what would be an efficient and sustainable level of
operating expenditures for Multinet in the 2013-17 access arrangement
period, ignoring other cost drivers and scope changes.
48
This means that the AER’s revised starting point for setting Multinet’s efficient
operating expenditures should be the price that Multinet would need to pay JAM
if negotiating an otherwise identical contract today for future operating services. The
price that Multinet would need to pay JAM under a contract negotiated today
would be based on JAM’s expected actual cost of service, plus a reasonable profit
margin. As noted by the AER:
Therefore, if JAM were to continue to provide these services after 30 June
2013, the AER agrees, all other factors being equal, it is reasonable to assume
Adjusting historical costs to forecast future efficient
expenditure
February 2016 | Frontier Economics
19
that JAM would seek to increase the fee it charged, and this would lead to
Multinet’s costs being higher in the 2013-17 access arrangement period.10
49
Multinet’s historical expenditures reflect a historical contract price that is neither
repeatable nor reflective of any party’s actual costs of service. As such – and
contrary to the sentence of the AER’s Draft Decision bolded in paragraph 33
above – these historical prices cannot be used to indicate what would be an
efficient and sustainable level of operating expenditures for Multinet going
forward.
50
Indeed, the AER has previously accepted the need to adopt cost forecast that
reflect adjustments to historical expenditures for losses made under past service
contracts. For example, in its Final Decision for the Victorian electricity
distribution pricing review, the AER stated (in relation to United Energy’s
operating expenditure forecast):
Frontier Economics' view that the AER should place greater weight on
benchmarking rather than historical costs in assessing United Energy's opex
forecast is based on a view that the OSA [operating services agreement]
arrangements are unsustainable. Based on the arguments put forward to
support this contention, the AER has not found this to be the case, with the
exception of the loss currently being earned by JAM in servicing the contract.
As noted above and confirmed by Frontier Economics, the AER's approach
has adequately addressed this issue by adopting JAM's current actual costs
rather than the current contract charges. 11
51
Further, the AER has concurrently adopted an approach elsewhere in which it
makes operating expenditure forecasts based on the third party contractor’s
actual costs plus a margin. In the Envestra Draft Decision, the AER set an
operating expenditure forecast that reflected Envestra’s contractor’s (APA’s)
reasonable likely actual costs of service plus a network management fee of 3% of
Envestra’s network revenue.12 The NERA report prepared for Envestra found
that the implied EBIT margin paid by Envestra was about 6.4% over 2002-
10
AER Draft Decision – Part 2 Attachments, p.213.
11
AER, Victorian electricity distribution network service providers, Distribution determination 2011-2015, Final
decision - appendices, October 2010, p.159.
12
AER, Access Arrangement draft decision, Envestra Ltd, 2013-17, Part 2 – Attachments, September 2012,
section 6.5.6, p.287.
Adjusting historical costs to forecast future efficient
expenditure
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Frontier Economics | February 2016
2011.13 The AER’s Draft Decision on Envestra found that while NERA’s report
had limitations, it suggested that the margins paid by Envestra were “not
inconsistent
with
industry
practice.”14
Further,
the
AER
undertook
benchmarking of Envestra’s performance and found that its performance “while
it has not improved substantially since the mid 2000s, appears reasonable when
compared to other gas distribution service providers.”15 On these grounds, the
AER accepted Envestra’s proposed network management fee.
52
I note that the AER’s benchmarking analysis also showed that Multinet’s
performance was comparable to Envestra’s performance.16 Adjusting for JAM’s
under-recovery of costs and absence of profit margin to arrive at a price that
could be negotiated today for operating services going forward would require an
upward adjustment. An appropriate estimate of such an adjustment would be
JAM’s loss in 2011 (the relevant base year) plus an EBIT margin in line with the
average of implied EBIT margins found by NERA in its benchmark study for
Envestra over the period 2007-2011.17
3.2
Adjusting for the ‘gaps’ in risk management and
strategic planning
53
This section explains the extent to which Multinet’s historical costs should be
increased to reflect the incremental cost of addressing gaps in risk management
and strategic planning (as well as other areas) that have come about due to the
previous business model. These adjustments should apply in addition to the
13
NERA Economic Consulting, Benchmark Study of Contractor Profit Margins (2002-2011), Envestra,
March 2012, Table 4.2, p.20.
14
AER, Access Arrangement draft decision, Envestra Ltd, 2013-17, Part 3 – Appendices, September 2012,
section E5.1, p.166.
15
AER, Access Arrangement draft decision, Envestra Ltd, 2013-17, Part 3 – Appendices, September 2012,
section E5.1, p.166.
16
AER, Access Arrangement draft decision, Envestra Ltd, 2013-17, Part 3 – Appendices, September 2012,
section E5.1, pp.164-5.
Adjusting historical costs to forecast future efficient
expenditure
February 2016 | Frontier Economics
21
adjustments necessary to address JAM’s under-recovery of its costs under the
previous contract.
54
In Multinet’s view, the previous business model led to insufficient resources
being devoted to network planning, due to a combination of:
a. the fixed-price nature of the contract with JAM (with a very low fixed
price), which created strong incentives for JAM to inappropriately and
unsustainably cut costs in areas (such as planning) where the impact of
under-provision was only discernible in the longer term; and
b. Multinet’s use of too few resources to manage the risks associated with
the contract with JAM, which could have compensated (at least in part)
for the lack of attention JAM was paying to planning.
55
On this basis, Multinet’s forecast costs should be increased by an amount
(denoted as ‘c’) to reflect the cost of addressing gaps in its risk management and
strategic planning activities arising under the previous business model.
3.3
Adjusting for the cost-reducing efficiencies
56
The third adjustment that ought to be made to forecasts based on Multinet’s
historical costs concern the cost changes attributable to the adoption of the new
business model. As noted above, I expect that these cost changes (denoted by ‘d’)
are likely – in net terms – to result in an operating cost reduction to Multinet
relative to not taking account of these measures.
57
As explained in Multinet’s submissions, the new business model is expected to
have led to increased competitive tension for the provision of operating services
and hence a reduction in expected operating costs over the long term compared
to the costs that would arise under the previous business model (appropriately
adjusted to address previous cost under-recovery and inefficient planning
incentives). I consider that Multinet’s customers should enjoy the benefits of
these efficiencies (denoted as ‘d1’).
58
At the same time, the introduction of the new business model has also resulted in
Multinet incurring a number of one-off implementation costs. These costs
Adjusting historical costs to forecast future efficient
expenditure
22
Frontier Economics | February 2016
needed to be incurred to enable the cost-reducing efficiencies to be achieved. As
noted by Multinet, most of these costs were incurred in the current access
arrangement period (2008-12) and were thus borne by Multinet’s shareholders
rather than its customers.18 However, in principle, any remaining implementation
costs incurred over the 2013-2017 access arrangement period (denoted as ‘d2’)
should be recoverable from customers through Multinet’s operating expenditure
forecast.
59
Over the longer term, it would be reasonable to expect that Multinet would only
introduce a new business model if it generated cost savings in excess of the oneoff implementation costs (ie was ‘self-funding’ – such that d1 = or > d2).
Therefore, the overall long term impact of the new business model ought to be
to reduce costs (by d1-d2). That is why my suggested adjustment (d) for costreducing efficiencies is subtracted from Multinet’s adjusted historical costs (a + b
+ c). The key point to note is that this adjustment is a net adjustment – net of
one-off implementation costs (i.e. d1-d2) – not merely a gross adjustment
reflecting the ongoing cost savings resulting from the new business model.
60
I have noted above in paragraph 52 that a reasonable estimate of a + b can be
obtained by taking Multinet’s historical costs and adjusting for JAM’s loss in 2011
plus an appropriate EBIT margin. Multinet should be able to provide an estimate
of c. Multinet’s estimate of d can be calculated simply by calculating the
difference between (a + b + c) and its bottom-up forecast that it provided to the
AER. The AER may well wish to verify this estimate of d. However, it should
undertake this verification by verifying the individual components of Multinet’s
bottom-up forecasts – not by relying on broad in-principle judgments.
18
Multinet, Gas Access Arrangement Review January 2013 – December 2017, Response to AER question 10, 20
June 2012, pp.3, 19-20.
Adjusting historical costs to forecast future efficient
expenditure
February 2016 | Frontier Economics
4
Incentives created by AER approach
61
I disagree with the AER’s Draft Decision statement that setting forecast
23
operating expenditures in excess of historical revealed costs would create
perverse incentives for network service providers.
62
To recap, the AER said that such an approach:
...would provide an incentive to all regulated business contemplating a
restructure to achieve losses at the end of a regulatory period, claim its current
model is not sustainable in the event of such losses and then restructure to a
higher cost business model.19
63
On the contrary, I believe that the AER should allow a reasonable estimate of the
efficient sustainable costs. They should not impose on businesses costs that are
below the minimum that it would be efficient to sustain.
64
Multinet adopted a bottom-up approach to forecasting because it chose to
restructure its business to produce substantial improvements in efficiency –
where efficiency is to be understood more broadly than the mere reduction of
expenditure compared with the preceding period. The AER’s Draft Decision
denied the recovery of the costs Multinet has claimed – not on the grounds that
they are inefficient – but on the grounds that they are higher than in the
preceding period.
65
The problem with such an approach is that it gives rise to incentives that are
likely to be contrary to the long term interests of consumers and in turn contrary
to the National Gas Objective.20 Consider that in the present case, if Multinet
simply had renegotiated its outsourcing contract with JAM, Multinet’s regulatory
risks would have likely been reduced even though its forecast operating
expenditures would have been higher than what it has proposed. To provide
incentives for businesses to identify efficiencies, they should not be penalised
simply because their proposed changes to their operations reveal that their
19
AER Draft Decision – Part 2 Attachments, p.227.
20
The National Gas Objective is to promote efficient investment in, and efficient operation and use
of, natural gas services for the long term interests of consumers of natural gas with respect to price,
quality, safety, reliability and security of supply of natural gas (see section 23 of the National Gas
Law).
Incentives created by AER approach
24
Frontier Economics | February 2016
previous practices were imperfect. Frontier Economics made a very similar point
in our advice to the AER regarding the AER’s assessment of the Roma to
Brisbane Pipeline revised access arrangement. We said that:
Having regard to the National Gas Objective, we consider that it would be
unfortunate if service providers were deterred from pursuing cost savings
because to do so would reveal that their original processes were sub-optimal
and hence that their efforts to reduce costs were not worthy of reward.21
66
For these reasons I believe that the AER’s approach in its Draft Decision is
inappropriate and contrary to the National Gas Objective.
21
Frontier Economics, Review of capital expenditure on the Roma to Brisbane Pipeline access arrangement, A
report prepared for the Australian Energy Regulator, April 2012, p.13, available at the AER website here.
Incentives created by AER approach
February 2016 | Frontier Economics
5
Conclusions
67
In rejecting Multinet’s operating expenditure forecast, and basing its revised
25
forecast on Multinet’s historical expenditures under its contract with service
provider, JAM, the AER implicitly assumed that the cost-reducing efficiencies of
the new business model would offset the upward cost adjustments that would be
required if the existing business model were maintained. However, the AER did
not provide any justification for why they believed this would be the case.
68
The AER’s approach is flawed and inconsistent with the requirements of the
NGR. The AER could have used a revealed cost approach. However, this should
have clearly separated:
a. the upward adjustment to Multinet’s historical expenditures required due
to the historical under-recovery of JAM’s costs (and absence of a
reasonable profit margin) under the previous fixed price contract;
b. the upward adjustment required due to the need to account for the
expenditure associated with addressing ‘gaps’ in risk management and
strategic planning; and
c. the downward adjustment required due to the (net) cost-reducing
efficiencies of the new business model.
69
Further, I reject the AER’s contention in its Draft Decision that setting forecast
operating expenditures in excess of historical revealed costs would create
perverse incentives for network service providers. On the contrary, I believe that
the AER’s Draft Decision approach would eliminate incentives for regulated gas
network businesses to institute more efficient arrangements, in conflict with the
National Gas Objective.
Conclusions
26
Frontier Economics | February 2016
6
Declaration
70
I have made all the enquiries that I believe are desirable and appropriate and no
matters of significance that I regard as relevant have, to my knowledge, been
withheld from the Court.
Declaration
February 2016 | Frontier Economics
7
27
Annexure A: CV
Philip Williams is the Chairman of Frontier Economics (Australia). His key area
of expertise is the relationship between economics and the law, and he provides
economic advice to clients in the areas of trade practices, valuing damages,
intellectual property and contractual disputes. He also consults on access and
regulatory issues.
Philip has advised the Australian Competition and Consumer Commission
(ACCC), the National Competition Council (NCC) and the New Zealand
Commerce Commission. He has been retained by all of the leading law firms in
Australia and New Zealand to give advice on disputes relating to access and
regulatory issues, as well as competition and general commercial litigation.
Prior to joining Frontier, he taught full-time at the University of Melbourne from
1978 to February 2002, when he resigned as Professor of Law and Economics in
the Melbourne Business School at the University.
In addition to his role at Frontier, he is a member of the Trade Practices
Committee of the Law Council of Australia, a member of the Australian Energy
Regulator Dispute Resolution Panel and is a member of the Board of the
Epworth HealthCare.
KEY EXPERIENCE
Regulatory Disputes and Arbitrations

Interstate Wagering: Victoria passed legislation forbidding interstate
wagering operators from using information published by Harness Racing
Victoria (HRV) unless they negotiated to pay HRV a fee. Sportsbet (a
wagering operator based in the Northern Territory) alleged that this
legislation was ultra vires s92 (free trade between the States) of the Australian
Constitution. Frontier was retained by solicitors for Sportsbet to give
evidence concerning the effects of the legislation on free trade between the
States (2011).
 Air New Zealand input Methodologies: Retained by Air New Zealand to
assist them in submissions to the Commerce Commission on their input
methodologies (2011).
 TCL Air Conditioners and Castel Electronics: Retained by solicitors for
TCL to give evidence in arbitration of contractual dispute (2010).
 VISA New Zealand: Gave advice to VISA New Zealand in proceedings
issued by the Commerce Commission alleging that the interchange
arrangements constituted illegal price fixing. (2008)
Annexure A: CV
28
Frontier Economics | February 2016
 RBA Review of credit and debit regulation: Retained by solicitors of
MasterCard to help them prepare their submissions to the RBA’s review of
their regulation of credit and debit card systems. Participated in the
consultations conducted by the RBA. (2007-08)
 Transfer Pricing: Retained by lawyers advising a client challenging a
decision by the Australian Taxation Office. Frontier staff undertook detailed
analysis of prices paid by a range of international distributors to obtain armslength comparable unencumbered prices for goods imported by the client
into Australia (2008).
 VISA New Zealand: Gave advice to VISA New Zealand over their plans to
restructure. (2005)
 Challenge to designation of EFTPOS: Retained by solicitors for the
merchants to give advice and testimony for their challenge to the RBA’s
designation of EFTPOS. (2004)
 EFTPOS Interchange: Retained by solicitors for the merchants to give
advice and testimony for their appeal to the Australian Competition Tribunal
against the decision by the ACCC to authorise proposed arrangements
among the banks for the collective fixing of EFTPOS interchange fees.
(2004)
 Designation of credit cards: Retained by solicitors for the banks to give
advice concerning the implications of the Joint Study by the ACCC and the
RBA into the use of credit and debit cards. (2000-01)
 Auckland International Airport Landing Charges: Provided independent
assessment for AIR of the pricing proposals it put to airlines. Presented to
Board and to MED. (2007)
 Transfer Pricing: A listed Australian company required advice about the
international transfer pricing of goods that had no close comparators. A law
firm retained Frontier to use bargaining models to estimate what the transfer
price would be in the case of an arm’s length transaction. (2006)
 Mobile Termination charges of Vodafone New Zealand: Advice to
Vodafone New Zealand and gave written and oral submissions to NZCC
concerning mobile termination rates. (2005-07)
 Mobile Termination charges of Vodafone Australia: Advice to Vodafone
Australia and gave written and oral submissions to ACCC concerning mobile
termination rates. (2004-06)
 Epic: Advice and testimony at the trial before the Court of Appeal in
Western Australia in Epic’s claim that the decision of the Independent Gas
Pipelines Access Regulator concerning access to the Dampier to Bunbury
pipeline was inconsistent with the provisions of the Gas Code. (2002)
Annexure A: CV
February 2016 | Frontier Economics
29
 Integral Energy and Sithe Australia Power: Member of the NEC Dispute
Panel that arbitrated this dispute. Other panel members were Sir Anthony
Mason and Tony Fitzgerald. (2002).
CAREER
2002 - present
Executive Chairman, Frontier Economics
1988 - 2002
Melbourne Business School, University of Melbourne
1978 - 1988
Economics Department, University of Melbourne
1973 - 1977
Ph D Student, London School of Economics
1970– 1973
Non-tenured tutor, Department of Economics, Monash
University
EDUCATION
1977
Ph D London University (LSE)
1973
M Ec Monash University
PUBLICATIONS
Books
(With John Alford and Royston Gustavson) The Governance of Australia’s Courts: A
Managerial Perspective (Australian Institute of Judicial Administration, 2004).
(Edited with Frances Hanks) The Twenty-Fifth Anniversary of the Trade
Practices Act: A Celebration and a Stocktake (Federation Press, 2001).
(With Megan Richardson, Joshua Gans & Frances Hanks) The Benefits and Costs of
Copyright, an Economic Perspective (Centre for Copyright Studies, 2000).
(With Tim Fry, Charles Hyde and Richard Scheelings) Review of Scales of Legal
Professional Fees in Federal Jurisdictions (Canberra, Attorney-General’s
Department, 1998).
Annexure A: CV
30
Frontier Economics | February 2016
(Edited with Megan Richardson) The Law and the Market: Essays in Honour of
Maureen Brunt (Melbourne, The Federation Press, 1995).
(With Ross A Williams, Andrew J Goldsmith, & Patricia A Browne) The Cost of
Civil Litigation before Intermediate Courts in Australia (Melbourne, Australian
Institute of Judicial Administration, 1992).
(With R E Caves, I D S Ward, & J C G Wright) Australian Industry: Structure,
Conduct, Performance (Melbourne, Prentice-Hall, 2nd ed., 1987).
What is the Problem of Small Business? CEDA Monograph (Melbourne, Committee
for Economic Development of Australia, 1983).
(With R E Caves, I D S Ward, & J C G Wright) Australian Industry: Structure,
Conduct, Performance (Melbourne, Prentice-Hall, 1981).
The Emergence of the Theory of the Firm (London, MacMillan, 1978).
Journal Articles
“Investment and returns: Public policy and intellectual property”, Media and Arts
Law Review, Vol 17, 2012, pp 226-231.
“Survey evidence in valuing copyright: recent decisions of the Copyright
Tribunal”, Australian Intellectual Property Law Bulletin, Vol 23, No 2, 2010, pp
27-29.
(With Warwick Davis), “Structural separation in Australia, economic and policy
issues”, Telecommunications Journal of Australia, Vol 58, May 2008, 11.1-11.13.
(With Andrew Harpham and Donald Robertson), “The Competition Law
Analysis of Collaborative Structures”, Australian Business Law Review, Vol 34,
December 2006, 399-427.
(With Joshua S Gans and David Briggs), “Intellectual Property Rights: A Grant
of Monopoly or an Aid to Competition?”, Australian Economic Review, Vol 37,
No 4, December 2004, 383-90.
(With Chander Shekhar), “Should the pre-notification of mergers be compulsory
in Australia?” Australian Economic Review, Vol 37, No 4, December 2004, 1-8.
(With Joshua S Gans and Rajat Sood), “The Decision of the High Court in Rural
Press: How the literature on credible threats may have materially facilitated a
better decision,” Australian Business Law Review, Vol 32, No 5, October 2004,
337-44.
(With Graeme Woodbridge), “The Relation of Efficiencies to the Substantial
Lessening of Competition Test for Mergers: Substitutes or Complements?”
Australian Business Law Review, Vol 30, No 6, December 2002, 435-44.
Annexure A: CV
February 2016 | Frontier Economics
31
(With Charles E. Hyde), “Necessary costs and expenditure incentives under the
English rule”, International Review of Law and Economics, Vol 22, 2002, 133-52.
(With Joshua Gans and Frances Hanks), “The Treatment of Natural Monopolies
under the Trade Practices Act: Four Recent Decisions”, Australian Business
Law Review, Vol 29, No 6, December 2001, 492-507.
“The Decision of the High Court in Melway Publishing v Robert Hicks”,
Melbourne University Law Review, Vol 25, No 3, December 2001, 831-42.
(With Megan Richardson, Joshua Gans and Frances Hanks), “Benefits and costs
of copyright: an economic perspective”, Australian Intellectual Property Law
Bulletin, Vol 13, 2000, Part 1, Number 5, pp 62-65; Part 2, Number 6, pp 7992.
(With Joshua S Gans), “Efficient Investment Pricing Rules and Access
Regulation”, Australian Business Law Review, Vol 27, 1999, pp 267 – 79.
(With Joshua S Gans), “Access Regulation and the Timing of Infrastructure
Investment”, Economic Record, Vol 75, No 229, 1999, pp 127 – 137.
“Entry Deterrence and the Efficient Component Pricing Rule”, Australian
Economic Review, Vol. 30, No. 2, 1997, pp. 185-6.
“The Trade Practices Act and the Conditions of Entry”, Australian Economic
Review, No. 108, 1994, pp. 108-11.
“The Exercise of Market Power: Its Treatment under the Australian and New
Zealand Statutes”, Review of Industrial Organization, Vol. 9, 1994, pp. 607-26.
(With Ross A Williams), “The Cost of Litigation: An Empirical Study”,
International Review of Law and Economics, Vol. 14, 1994, pp. 73-86.
“Mabo and Inalienable Rights to Property”, Australian Economic Review, No. 103,
1993, pp. 35-8.
(With Jeff Borland), “An Economic Analysis of the Division of Copyright
between Newspaper Publishers and Journalists”, University of New South Wales
Law Journal, vol. 16, 1993, pp. 351-62.
(With Ross A Williams), “Competition and the Cost of Justice”, Policy, vol. 8,
Spring 1992, pp. 22-24.
“Marshallian Applied Welfare Economics:
Appliquee, vol. 43, 1990, pp. 231-245.
The Decline and Fall”, Economie
(With Frances Hanks), “Implications of the decision of the High Court in
Queensland Wire”, Melbourne University Law Review, vol. 17, June 1990, pp.
437-461.
(With Frances Hanks), “Queensland Wire Industries v. BHP, Judgment of the
High Court of Australia, Common Market Law Review, vol. 27, 1990, pp. 151-61
Annexure A: CV
32
Frontier Economics | February 2016
“Competitive Aspects of Electronic Funds Transfer Systems: The Emerging
Pattern of Point-of-Sale Networks”, Australian Economic Review, 1st Quarter,
1987, pp. 31-8
(With Frances Hanks), “The Treatment of Vertical Restraints Under the
Australian Trade Practices Act”, Australian Business Law Review, vol. 15, April
1987, pp. 147-168. Reprinted in John Duns and Mark Davison, Trade Practices
and Consumer Protection: Cases and Materials (Sydney, Butterworths, 1994).
“A Reconstruction of Marshall’s Temporary Equilibrium Pricing Model”, History
of Political Economy, vol. 18, Winter 1986, pp. 639-53.
(With Neville R Norman), “The Analysis of Market and Competition under the
Trade Practices Act: Towards the Resolution of Some Hitherto Unresolved
Issues”, Australian Business Law Review, vol. 11, December 1983, pp. 396-420
“Monopoly and Centralisation in Marx”, History of Political Economy, vol. 14,
Summer 1982, pp. 228-41
“Welfare and Collusion: Comment”, American Economic Review, vol. 72, March
1982, pp. 272-5.
“The ABG Decision: Competition or Fair Shares?”, European Law Review, vol.2,
August 1977, pp. 294-301.
Chapters in books
“Industry and Trade”, in Tiziano Raffaelli, Giacomo Becattini and Marco Dardi
(eds), The Elgar Companion to Alfred Marshall (Edward Elgar, 2006).
(With Graeme Woodbridge), “Antitrust Merger Policy: Lessons from the
Australian Experience”, in Takatoshi Ito and Anne O. Kruger (eds),
Governance, Regulation, and Privatization in the Asia-Pacific Region, NBER - East
Asia Seminar on Economics Volume 12, (University of Chicago Press, 2004).
(With Maureen Tehan), “Mabo and Inalienable Rights to Property: The
Efficiency and Justice of the New Legal Norm”, in Megan Richardson and
Gillian Hadfield (eds) The Second Wave of Law and Economics (The Federation
Press, 2001).
“The Role of the Expert Witness in Tru-Tone v Festival Records: Further
Progress to the Recognition of Cluster Markets Down Under”, in Daniel J
Slottje (ed) The Role of the Academic Economist in Litigation Support (Elsevier,
1999).
(With Joshua S. Gans) “A Primer of Access Regulation and Investment” in M.
Arblaster and M. Jamison (eds) Infrastructure Regulation and Market Reform:
Principles and Practice (ACCC/PURC, 1998).
Annexure A: CV
February 2016 | Frontier Economics
33
“The Bottleneck Problem and Access Pricing” in Megan Richardson (ed)
Deregulation of Public Utilities: Current Issues and Perspectives (Centre for
Corporate Law and Securities Regulation, 1996).
“What Prices Should Public Utilities Charge? The Case of Victoria’s Electricity
Reforms”, in Megan Richardson (ed) Deregulation of Public Utilities: Current
Issues and Perspectives (Centre for Corporate Law and Securities Regulation,
1996).
“Interconnection Prices in Local Telephony: The Implications of Symmetry”, in
Bureau of Industry Economics, 1995 Industry Economics Conference, Papers and
Proceedings (AGPS, 1995).
(With David Lindsay) “The Trade-Off Between Competition and Efficiency in
Telecommunications: The Australian Experience”, in Megan Richardson and
Philip Williams (eds.), The Law and the Market: Essays in Honour of Maureen
Brunt, (The Federation Press, 1995).
(With Robert Officer) “The Public Benefit Test in an Authorisation Decision”, in
Megan Richardson and Philip Williams (eds.), The Law and the Market: Essays
in Honour of Maureen Brunt, (The Federation Press, 1995).
“Corporate Groups: the Management Dilemma”, in Michael Gillooly (ed.), The
Law Relating to Corporate Groups (The Federation Press, 1993).
(With Andrew J Goldsmith, Ross A Williams, & Patricia A Browne), “The AIJA
Project on the Cost Benefit Efficiency of the Practice and Procedure of Civil
Litigation in Australia”, in Papers Presented at the Ninth Annual AIJA Conference,
Melbourne August 1990 (Australian Institute of Judicial Administration,
1991).
“The Attitudes of the Economics Professions in Britain and the United States to
the Trust Movement, 1890 - 1914”, in John D Hey and Donald Winch (eds.),
A Century of Economics: 100 years of the Royal Economic Society and the Economic
Journal (Basil Blackwell, 1990).
“Why Regulate for Competition?”, in Michael James (ed.), Regulating for
Competition? (Centre for Independent Studies, 1990). Reprinted in John Duns
and Mark Davison, Trade Practices and Consumer Protection: Cases and Materials
(Butterworths, 1994).
“The Place of Industry and Trade in the Analysis of Alfred Marshall”, in Ken
Tucker and C Baden Fuller (eds.), Firms and Markets: Essays in Honour of Basil
Yamey (Croom Helm, 1986).
“The Problem of Proving `Arrangement or Understanding’ under Section 45A of
the Trade Practices Act”, in Ross Cranston & Anne Schick (eds.), Law and
Economics (Australian National University, 1982).
Annexure A: CV
Frontier Economics Pty Ltd in Australia is a member of the Frontier Economics network, which
consists of separate companies based in Australia (Melbourne & Sydney) and Europe (Brussels,
Cologne, London & Madrid). The companies are independently owned, and legal commitments
entered into by any one company do not impose any obligations on other companies in the network.
All views expressed in this document are the views of Frontier Economics Pty Ltd.
Disclaimer
None of Frontier Economics Pty Ltd (including the directors and employees) make any
representation or warranty as to the accuracy or completeness of this report. Nor shall they have
any liability (whether arising from negligence or otherwise) for any representations (express or
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communications transmitted in the course of the project.
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