Can anyone in the market profitably duplicate the essential facility?

Articles Written by Austin Bell (Partner), Andrew Moore

On 14 September 2012, the High Court delivered its much anticipated landmark decision in relation to the Pilbara iron ore railways access matters.

In doing so, it upheld the Full Federal Court's decision to overturn 15 years of regulatory and judicial precedent relating to declaration criterion (b) of Part IIIA of the Competition and Consumer Act 2010 (and analogous regimes such as the National Gas Code). The High Court also endorsed the current legislative position that any review of the Minster's decision on declaration under Part IIIA by the Australian Competition Tribunal must effectively be "on the papers".

A private profitability test under criterion (b)

The High Court (by 6:1 majority) held that the test under criterion (b) is a "private profitability" test. That is, the question of whether it would be uneconomical for anyone to develop another facility to provide the service sought to be declared is answered by asking whether it would be profitable or economically feasible for any actual or potential market participant to do so.

Prior to the High Court's decision, the National Competition Council (Council) and the Tribunal had variously adopted a net social benefit test and a natural monopoly test in interpreting and applying criterion (b).

The net social benefit test asks whether it would be more efficient in terms of costs and benefits to society as a whole for the relevant facility to meet the reasonably foreseeable demand for the services sought to be declared rather than more than one facility. The natural monopoly test asks whether the relevant facility can meet the reasonably foreseeable demand for the services sought to be declared at a lower total cost than if demand for the services were to be met by two or more facilities. Both were rejected.

The privateprofitability test adopted by the High Court requires an assessment of what is an acceptable rate of return on the capital invested to construct alternative facilities. While this will depend upon a number of factors including the projected long term market price of any downstream product, long term demand projections for the product, the nature of the facility and the relevant market, the views of banks, investors and financiers will become all important. This is because if an investor or financier is unwilling to lend money for the construction of an alternative facility on the basis that it would not receive a sufficient return on capital, it would be uneconomical for anyone to develop another facility to provide the service and criterion (b) would be met.

In this respect, it is important to note that higher rates of return are usually required by investors for large investments in long term infrastructure projects particularly where there is increased uncertainty. Further, since the global financial crisis, investors are more likely to be risk averse with significant investments further increasing what the acceptable rate of return may be.

What does this mean for access seekers and infrastructure owners?

Firstly, the test provides increased certainty as to whether criterion (b) is met or not.

Access seekers and infrastructure owners will more readily be able to assess whether there are any actual or potential market participants that could profitably construct alternative facilities by reference to market conditions, costs, prices, project demand and applicable rates of return. This information may be easier to collate and analyse than what was required under the net social benefit test and the natural monopoly test. The former required an assessment of all costs and benefits from society's perspective while the latter required an assessment of the maximum capacity of the relevant facility (which, given information asymmetry, was a difficult task for an access seeker). Both required theoretical and uncertain estimates of reasonably foreseeable demand for the services provided by the facility.

On the other hand, the privateprofitability test will be determined, using the words of ACCC Chairman Rod Sims in the context of merger review, by "commercial assessments based on real-world activity and evidence rather than theory."

Secondly, the applicable rate of return will be a sticking point.

Given that a higher rate of return will mean that it is less likely that it will be profitable or economically feasible for an actual or potential market participant to construct alternative facilities to provide the service, the level of the rate of return becomes critical to satisfying criterion (b). While access seekers (and their investors) will argue that higher rates of return are required to justify an investment (thus making it unprofitable to construct alternative facilities), infrastructure owners will argue that a sufficient rate of return can be achieved and access seekers are merely seeking a financially preferable and more profitable outcome via access.

Thirdly, in light of the High Court's effective endorsement of recent amendments to Part IIIA to limit the role of the Tribunal with respect to reviews of the Minister's decision about declaration, the content of applications for declaration and subsequent submissions will be critical.

While there is currently no requirement for the information in such documents to be supported by evidence, the more comprehensive the information, the more likely it will carry increased weight. Indeed, before declaring a service provided by means of a facility under Part IIIA, the Council must be positively satisfied that all of the declaration criteria have been meet. In light of the Metcash decision, there may be a question as to whether this means that the Council need only be satisfied that there is a "real chance" of each of the criterion being met or whether it is "more probable than not" that each criterion is met. The latter standard of proof is likely to apply.

Given that submissions will not be tested in an evidentiary sense, the Council may request parties to support propositions with evidence and/or produce internal strategic and board papers. In respect of criterion (b), this may include financial modelling undertaken by an access seeker to determine the economic feasibility of constructing alternative facilities. Such an approach would bring the Council declaration process into alignment with the ACCC's merger review process. While the Council has recently stated that it proposes to update its guidelines in light of the High Court's decision and other recent legislative changes and developments, it remains to be seen whether an increased onus will be placed upon parties to support their submissions with evidence including internal documents.

What access seekers should do now

In light of recent amendments to Part IIIA and the High Court's endorsement of the limited role of the Tribunal in reviewing declaration decisions, the declaration process has become relatively quick and cheap. Unlike the Pilbara rail access matters which have been running for many years, have cost many tens of millions of dollars and are still not resolved, new declaration applications should be determined within 15 months of lodging the initial application (where a review by the Tribunal is undertaken). This will significantly reduce cost.

In order to maximise the prospects of satisfying criterion (b), where applicable access seekers should remain independent and not enter consortia or alliances with one another. This will increase the likelihood of successfully arguing that there is no actual or potential participant in the market for which it would be profitable or economically feasible to construct alternative facilities. Ultimately however, this issue will depend upon a range of factors relating to current and likely market conditions and participants. Further, remaining independent may be contrary to other commercial objectives especially where scale is necessary to achieve those objectives.

Access seekers should also seek independent third party advice on the investment risk of constructing alternative facilities. If investors are not prepared to provide funds for alternative facilities on the basis that they will not achieve a sufficient rate of return (and there are no other participants in the market in more favourable positions), this will strongly assist in demonstrating that criterion (b) is met. At the same time, access seekers should ensure that there are no internal documents that indicate that it is economically feasible to construct alternative facilities (even though not preferable). Such documents will need to be appropriately qualified in any declaration application.

Finally, to the extent that an access seeker proposes to seek declaration of services provided by the infrastructure owner's facility, the access seeker should ensure that it has undertaken a comprehensive analysis (and has engaged relevant experts) prior to submitting its application.

What infrastructure owners should do now

Given that infrastructure owners will ordinarily be better resourced and more knowledgeable about current and future market conditions, they should - if faced with the threat of declaration - undertake a comprehensive analysis of the economic feasibility of their facility being duplicated by any actual or potential market participant. They will also be able to draw upon their expert knowledge about the costs of developing similar facilities which may enable them to show that it would be profitable for another player to develop such facilities.

Where applicable, infrastructure owners should argue that consortia and alliances are likely to occur in the market and would make it economically feasible for alternative facilities to be constructed. They may also be able to argue that investment may come from downstream customers rather than arms length investors which may lower the required rate of return.

Infrastructure owners should request that the Council obtain the board papers of access seekers. This is because it may, in fact, be economically feasible for the access seeker to construct an alternative facility but because such an approach may be less profitable than access, the access seeker maintains (publicly and in submissions) that it would not be profitable to construct alternative facilities.

Important Disclaimer: The material contained in this article is comment of a general nature only and is not and nor is it intended to be advice on any specific professional matter. In that the effectiveness or accuracy of any professional advice depends upon the particular circumstances of each case, neither the firm nor any individual author accepts any responsibility whatsoever for any acts or omissions resulting from reliance upon the content of any articles. Before acting on the basis of any material contained in this publication, we recommend that you consult your professional adviser. Liability limited by a scheme approved under Professional Standards Legislation (Australia-wide except in Tasmania).

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