PPPs and economic regulation: substitute or complement? Prepared for the ACCC regulatory conference Warwick Davis, July 2018 Frontier Economics 1
Overview PPPs v economic regulation – substitutes or complements? 1 How PPPs and regulation could/should work together 2 Case study 1: Thames Tideway Tunnel 3 Case study 2: Desalination projects in NSW and Victoria Frontier Economics 2
PPPs and economic regulation ● Both are “contracts” that facilitate investment and ongoing Substitutable… service provision PPPs Economic regulation ● Large, well defined ● Direct user charging means investment incentive to invest is strong A good fit ● Produces a flow of services ● Ongoing investment creates where complexity that are readily monitored ● Large benefits from ● Primary concern to avoid competition for the market monopoly pricing or other uses of market power ● No direct user charging ● But the two can be combined (complementary) in some …but also circumstances. complementary ● Most obviously, where difficult to write a complete contract Frontier Economics 3
PPPs used instead of regulation Hospitals Courts Bioscience Prisons Major building developments Schools Desalination plant ● Sometimes, PPPs used where Roads (toll and other) economic regulation of the Rail (intermediate or ultimate) service supplier could have substituted – Why? User charges Frontier Economics 4
PPPs – two key economic issues resolved Information asymmetry Opportunism and commitment • Only I know whether I am efficient • What guarantee do I have that you will • Why should I give effort to keep costs keep your promise to me to recover my costs? down? (Moral hazard) • Time inconsistency + investment in • When costs are low, is it because firm is specific assets = opportunism efficient, or was the contractor not demanding enough? PPP contract • Bundle construction with operation • Price and quality controls (not costs) • Define risks in contracts Frontier Economics 5
These familiar issues are managed differently in regulation… Regulatory contract Opportunism / commitment Information asymmetry • Regulator uses ex ante allowance • A RAB (incentive regulation) to get firms to • Allow for contractual incompleteness reveal efficient costs through regulatory discretion • Then shares savings with consumers • With legislative direction on objectives, • Regulates quality as well as price and requirements for transparency …the regulatory contract allows for more flexibility for managing uncertainty and unforeseen events Frontier Economics 6
Example of cost overruns ● Regulation has discretionary, transparent Suppose an processes to deal with cost overruns investment is made ● For example, can recover costs if: □ in the “long term interests of users” The asset is damaged by an □ Can demonstrate that costs incurred are efficient (unforeseen) event □ Cost not reasonably foreseeable (e.g. was insurance an option?) Whose job is it to ● In a PPP the responsibility and cost oversight fix it, and how (usually) entirely depends on the contract much does it cost? □ This may be fine if there is minimal complexity □ Risk allocation clear in contract • Long term nature of private finance contracts created a problem When do problems for public bodies related to loss of expertise (UK National Audit Office 2018) occur? • Risks taken by private sector are too large - Carillion failure (2018) Frontier Economics 7
Overview PPPs v economic regulation – substitutes or complements? 1 How PPPs and regulation could/should work together 2 Case study 1: Thames Tideway Tunnel 3 Case study 2: Desalination projects in NSW and Victoria Frontier Economics 8
The two approaches can work together PPP contracts cover construction and operation • Can still realise benefits of bundling construction with operation (Hart 2003) • But payments treated differently in the construction and operation phases PPP locks in construction cost Regulation during operational phase Independent Appropriate incentive regulators better at Difficult for regulators to balance (setting cost Private firms better avoiding capture than set cost allowances and allowances and PPP ‘contract at management of a commercial rate of incentive enforcers’ – construction risk return mechanisms) requires transparency a key predictability element Frontier Economics 9
Case studies PPPs v economic regulation – substitutes or complements? 1 How PPPs and regulation could/should work together 2 Case study 1: Thames Tideway Tunnel 3 Case study 2: Desalination projects in NSW and Victoria Frontier Economics 10
Case study 1: Thames Tideway ● A major infrastructure project developed by Thames Water ● The Thames Purpose: update aging infrastructure Tideway to capture, store Tunnel and convey wastewater that may otherwise discharge into the River Thames. ● Capital cost £4.2 billion - the largest privately funded infrastructure project in Europe. Well suited to ● It was urgent. PPP for ● There are massive tunnelling risks involved, as much of the tunnelling will be carried out under central London. construction ● The construction time, estimated at 10 years, is much longer than most other projects. Frontier Economics 11
Case study 1: Thames Tideway Ofwat and licensing Regulatory features ● Ofwat has a special ● Cost of capital regulatory framework □ Bid on the basis of the lowest WACC in for large or complex the ‘construction phase’ (up to 2030) infrastructure □ PPP had From 2030, WACC will be set by Ofwat projects special ● Pre-determined construction cost ● Incumbent supplier regulatory threshold (apply to Ofwat if want more) competitively features… ● Ofwat issued economic guidance to tendered placate potential bidders (“we will treat ● Winner (Bazelgette) you fairly”) is regulated via a ● Rights to appeal to Competition and licence Markets Authority ● The tricky task of achieving an efficient risk allocation, and determining a commercial return, was left more in bidders’ hands. Complementarity ● Once the project is operational, it reverts to a standard incentive-based regulatory approach. ● Achieved real, post tax bid WACC of 2.5%. Frontier Economics 12
Case study 2: NSW and Vic desalination plants ● Victoria built desalination plant as a PPP ● NSW built as a government project, then privatised the lease ● NSW allowed for the state regulator to have a role in A comparison approving the costs of the (operational) plant ● Victoria did not of two approaches ● Can we evaluate which is better? ● Depends on your view of 1. uncertainty and the nature of the project 2. regulation and regulators Frontier Economics 13
Victoria ● Desalination built ● Private operator to finance, on the back of a design, build, operate, and bad drought maintain the project for 30 PPP years ● High capex / low motivation ● Capital cost = opex project $3.5 bn NPC = $5.7 bn ● Build it fast Total $nom = $23.9 bn ● Obligations on Melbourne Water to buy water ● Contract managed by Department ● Essential Services Commission (ESC) regulates MW retail PPP prices, but not desal input charges management ● The ESC can affect the pass through of those charges in and retail water determinations regulation ● For example, can spread the costs over the full asset life, rather than the lease life Frontier Economics 14
Structure of payments Usage charge Does not depend on demand, costs, WACC Fixed charge Longer term issues with credibility? Source: Ben-David (2013) Frontier Economics 15
NSW ● Desal built on the back of a bad drought (as per Victoria) Project motivation ● Costly project, build it fast ● Sydney Water Corporation (SWC) directed to construct (2007- 10) and operate Public, then ● NSW Government sold a 50 year lease on the plant in June private 2012 backed by a 50 year water supply contract with SWC. Sold for $2.3 bn. ● IPART sets the maximum prices SDP can charge for its water supply services to SWC Plant ● Can apply standard incentive regulation techniques management ● Efficiency adjustments and regulation ● Energy costs pass throughs Frontier Economics 16
NSW process ● IPART conducts transparent, rolling reviews of SDP’s costs Regulatory term Consideration of cost pass throughs 200+ Revenue requirement pages Expenditure review on… Energy costs WACC What are the benefits of this compared to the Victorian approach? Frontier Economics 17
Summing up 1 PPP contracts and regulation can be substitutes or complements 2 The long-lived nature of most assets built using PPPs can be a problem But these problems may take some time to emerge 3 Not all PPPs would benefit from ‘regulation’ For more complex PPPs, a PPP that incorporates regulation in the operational phase can address commitment (RAB) while allowing for contractual incompleteness Such a regime may have better long term credibility Frontier Economics 18
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