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Analysis: The SA Government has set the high price we pay for water

Analysis

Economist and former Essential Services Commissioner Richard Blandy dissects Lew Owens’ bombshell interim report – concluding that a robust democracy needs more rigorous independent oversight of government monopoly business investments.

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Lew Owens’ inquiry was established to “advise the SA Government if the revenue SA Water is permitted to raise from its drinking water retail services reflects the cost of providing these services, with particular reference to the reasonableness of the initial value of the regulated asset base”.

Owens has come to the correct conclusion in his interim report, “A Cautious Conclusion”: the initial value placed by the SA Government on SA Water’s regulated asset base (RAB) for providing its drinking water services is unreasonable.

The large increase in the price of water in South Australia is essentially because of a large revaluation of SA Water by its owner – the SA Government.

Over four years from 30 June 2008, the price of water in SA increased by 170 per cent!

The concluding two paragraphs of the Report say it all.

Those paragraphs conclude that the SA Government has unfairly benefitted over many years from an inflated valuation of the asset value of SA Water undertaken by itself – instead of by an independent third party.

A reduction in SA Water’s regulated asset base is required to address this.

Instead of water-pricing decisions based on independent reviews, the Government has repeatedly made (unwarranted) valuation and (hidden) water-pricing decisions relating to SA Water (a monopoly owned by the SA Government), which has enabled large profits to be earned to fund some of its political initiatives.

Over four years from 30 June 2008, as the Report notes, the price of water in SA increased by 170 per cent!

Such an increase came about because the capital value of SA Water’s assets was nearly doubled.

This is an extraordinary change, and must imply that SA Water’s capital value (and hence, the price of its water) had been substantially undervalued for a long period of time.

This change goes to the heart of an issue that bedevils the valuation of capital assets. A capital asset is worth the discounted cash flow (DCF) of its current and expected future earnings. Opinions differ about what an asset’s current and expected future earnings might be and what discount rate to apply. Hence, there are legitimately a range of possible valuations.

The Australian Stock Exchange exists as a place where people who place a high valuation on an asset’s future earnings at a low discount rate (and, therefore, value it highly) can buy it – for a price – from people who own it, and who place a lower valuation on the asset’s future earnings and/or have a higher discount rate (who, therefore, value it less).

These asset prices, or capital values, change all the time as people’s earnings expectations and discount rates change.

In the case of SA Water, though, this normal valuation process was put in reverse.

Over the four years from June 2008, a capital value increase drove a required increase in profits (and, therefore, of prices relative to costs).

SA Water’s capital value was unilaterally increased substantially – by its owner.

The SA Government increased the value of SA Water’s assets to support an increase in profit flow to itself from SA Water…  the corollary was the huge increase in SA’s price of water

A competitive rate of return was then applied to this increased capital value, resulting in a necessary increase in water prices (relative to recurrent costs) to produce the required increase in profit stream consistent with the increase in capital value.

There was no market that validated this increase in profits, prices and capital value. The increase derived purely from SA Water’s monopoly position and ownership by the SA Government, which approved the resulting water price (and monopoly profits) increase.

Everywhere-else in Australia, except Tasmania, Governments used the discounted cash flow of current earnings to value their water assets. The SA Treasury though, over the relevant period, chose to shift away from the DCF approach, to a replacement cost asset valuation approach (DORC – Depreciated Optimised Replacement Cost). This enabled them to increase the value of SA Water’s assets to support an increase in profit flow to itself from SA Water.

The corollary was the huge increase in SA’s price of water.

Under the approach used by the SA Government, the value of assets given to SA Water by developers was included in the value of SA Water, and earned a return for SA Water – and the SA Government.

That’s notwithstanding that, as the Report states, “the Pricing Principles of the National Water Initiative, the COAG principles and regulatory practice all agree that contributed assets should be removed from the RAB for pricing purposes”. But, to the contrary, former Treasurer Kevin Foley in 2004 “supported the estimate being based on all contributed assets provided to SA Water”.

Even unused assets – such as the unused country reservoirs unearthed by Lew Owens’ Inquiry – were valued in SA Water’s regulated asset base at $49 million and formed part of the capital base that earned a return for SA Water – and the SA Government!

Contrary to COAG and National Competition Policy

The actions of the SA Government were contrary to National Competition Policy, which cites the recommendation of the Competition Policy Review Committee that regulators be created with powers preventing businesses controlling “essential facilities”, with natural monopoly aspects, from using market power to set high prices.

The actions of the SA Government were also contrary to the COAG Guidelines which note “the two core principles of avoiding monopoly rents and maintaining the commercial viability of the business.”

Discussing the valuation of legacy (i.e. existing) assets, Owens’ Report says that, in SA, these “were valued at DORC (Depreciated Optimised Replacement Cost) as was allowed, but this was unlike other jurisdictions across Australia who elected at the time they established their opening RAB to write-down the value of their legacy assets to avoid upward pressure on prices.”

Owens’ latest interim report concludes its discussion of the valuation of SA Water’s legacy assets by the SA Government by saying:

“It appears to the Inquiry… that the application of the ‘line in the sand’ methodology by the government in 2006 and 2013 was very different from its use in other jurisdictions and resulted in a significantly higher RAB [value of the regulated asset base] than would have occurred if the government had followed the practices of the other jurisdictions. While the treatment of legacy assets might comply with a strict interpretation of the National Water Initiative Principles, it seems to the Inquiry it was hardly moderate or fair when compared to how other jurisdictions treated the value of their legacy assets.”

Notwithstanding his critical view of the revaluation of SA Water’s assets by the SA Government, Owens’ summation correctly allows the whole of the state’s cost for the Adelaide Desalination Plant capital expenditure to be added to the RAB – because this was a properly-made political decision intended to impact the availability and cost of water should the availability of River Murray water be curtailed.

The Government would appear to have unfairly benefitted from these decisions over many years

In the final section of his Report, Owens summarises his views of the process followed by the SA Government. Parts of his conclusions are worth repeating here:

“Compared to the independent inquiries and price reviews undertaken elsewhere… the process in SA was secretive and limited in its engagement. It was not conducive to a good outcome for consumers of water services…

“It can be conjectured that if the pricing process during the period 2004/05 to 2012/13 had been undertaken by an independent price regulator [it] would be expected to have resulted in further downward pressure on prices…

“Nevertheless, the lack of independent regulation during the period is a factor to be taken into account when considering the circumstances surrounding the decisions that were taken (as to whether there was an abuse of monopoly power and a conflict of interest for the Government as decision maker and owner).”

Owens’ interim report models various reasonable changes to what actually transpired. This modelling results – every time – in a reduction in the RAB (by between $421 million and $1071 million).

Owens eventually decides to put the unreasonable/not reasonable amount of the reduction at $1.012 billion.

Business SA’s submission (prepared by Cambridge Economic Policy Associates) puts the warranted reduction at $1.5 billion.

Owens correctly concludes from his inquiry’s analysis that:

“It is obvious from the preceding discussion that the Inquiry believes the Treasurer should review the RAB in order to correct decisions… which have resulted… in a RAB value which is higher than it would have been under an independent price regulatory regime.

“First, the Government would appear to have unfairly benefitted from these decisions over many years, and a reduction in RAB would remove this ongoing benefit. Secondly, this was a case of conflicted interests, where the Government was making decisions which benefitted itself, and without any independent review. Thirdly, because the Government elected to put in place a regime whereby it could arbitrarily set the RAB by a decision of the Treasurer through a Pricing Order… the Government left it open to changing the RAB whenever it decided to do so.”

In summary, Lew Owens’ report, “A Cautious Conclusion”, correctly emphasises that a democracy needs to have independent assessments of government monopoly business investments.

Otherwise, notwithstanding their public ownership, they will be just additional monopoly businesses with an incentive to charge excessively high prices and to make excessive profits instead of providing products and services to meet consumers’ needs appropriately at least cost.

Richard Blandy is a former chair of the Essential Services Commission of SA, an Emeritus Professor of Economics at Flinders University and a former Adjunct Professor of Economics at the University of South Australia.

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