the game has changed, but not yet the rules

1Juturna P/L The game has changed, but not yet the rules

The game has changed, but not

yet the rules:

Government & market briefing paper

The hard competition and public sector reforms needed to drive more

sustainable and profitable private sector investment in Australia’s

freight infrastructure assets

April, 2013


Overview

The April 2013 sale of the government-owned Port Botany in Sydney – Australia’s second largest container port – and the nearby Port Kembla to a superannuation fund for a combined price of $5.07 billion represents a step change in the scale of private capital invested in Australia’s freight infrastructure. That the price represented 25 times annual earnings for the current owners suggests that the asset was heavily undervalued and underperformingI. The new owners now have the task of turning that around. But do they stand a fair chance of doing so?

How difficult does Australia intend to make the ongoing operational conditions for private investors in freight infrastructure assets? These are key areas of investment that are in most need of capital, as scarce public funds experience ever stronger calls from health and education, amongst other things. As a rule, governments have ignored dedicated freight investments in Australia as the siren song of public transport and private commuter roads has sung loudest at ballot boxes. Botany-Kembla is one freight sale – a big one indeed, but only one. Only success will bring more.

This briefing argues that sweetening investment prospects for potential new investors and filling the treasuries on an ongoing basis relies on Australian governments tending to unfinished competition restructures of the freight infrastructure sector to promote greater capital access and investment.

Anything less than genuine reform will almost certainly result in a false dawn for global investors in Australian freight infrastructure assets. This matters for the investors, of course, and for cash-poor Australian treasuries. But it matters to the public too, because the ongoing failure to reinvest in freight infrastructure is a slow form of asphyxiation to the nation’s standard of living. So there is a lot on the line in the Botany-Kembla sale, in reputational terms. Success lies in hard-edged government reforms. The good news is Australia has a pedigree for this sort of reform. The real question is whether governments will bother to do the hard structural reforms, once the sale cheques have been banked.

What determines whether private capital investments in roads, rail and ports are ‘hard’ or ‘easy’?

Once the dust settles on the Botany-Kembla sale, work will begin on improving asset performance. Beyond simple corporatisation, the most important place for this work to start is in addressing the quality of ‘third party access’ arrangements to freight infrastructure: in simple terms, this relates to the market investor’s ability to operate and upgrade freight-intensive roads, rail, ports and sea channels to be more efficient, accommodating more freight and bigger, better vehicles at less cost - all under the legal protection of the Competition and Consumer Act (2010) (formerly the Trade Practices Act).

The problem for new private freight asset owners is that there is a significant amount of unfinished business in the macroeconomic restructuring of freight infrastructure. This work was begun in the late 1980s – indeed, those efforts led the world at the time - but genuine efforts stalled in the decade after, and have been replaced since by an overly bureaucratic successor process – one which trades on the legacy of genuine achievements past, but – at least for freight infrastructure - does very little of substance to improve on them.

There are better solutions. This is a worthwhile reform path to travel to unlock better private capital spend in these asset classes.

About this paper

This briefing is the first in an intended series of occasional papers to industry and government offering fresh thinking in areas of importance for Australian freight infrastructure planning, operational performance and new investment. To discuss aspects of this paper or Juturna’s practice more generally, contact the principal:

Luke Fraser m: 61 437 146 274 w: www.juturna.com.au e: [email protected] s: lukeatjuturna

4 The game has changed, but not yet the rules Juturna P/L

Australian pedigree: market-driven reforms that led the world and energised an economy

In the late 1980s, spurred by dwindling economic performance over the preceding two decades, Australia embarked on an ambitious – and indeed, for its time, truly world-leading – series of competition reforms to its economy – parts of freight infrastructure were among the areas of economic infrastructure to be addressed.

In the words of the OECD, two first-order objectives of Australia’s competition reforms were ‘to correct the government business relationship’II and ‘lower barriers to entry and reduce public ownership in the network sectors’. Competition reform of the Australian economy was embarked upon in earnest in the late 1980s and early 1990s. Government monopoly infrastructure such as railways was subjected to market access, operation and improvement regimes under the then Trade Practice Act.

In 2003, an independent committee of review ‘endorsed the structural change and increasing competitiveness of Australian markets brought about by the (competition) reforms

as being responsible for the increased rate of productivity and strong growth in the economy since the 1990s’III. Australia’s Productivity Commission itself has since estimated that the surge in general productivity and efficiency ‘especially in capital productivity’ that occurred via competition reform displayed significant benefits:

‘the observed productivity and price changes in key infrastructure sectors in the 1990s — to which National Competition Policy and related reforms have directly contributed — have increased Australia’s GDP by 2.5 per cent, or $20 billion’IV.

Likewise, the OECD Review of Regulatory Reforms in Australia (2010) suggests, as did the Productivity Commission, that this period of reforms in the 1990s drove the nation forward:

‘In terms of ranking, GDP per capita in Australia increased from 16th place among OECD countries in 1992 to 8th highest in 2007. This impressive growth performance was accompanied by sustained falls in unemployment and consumer price inflation from the high levels seen in the 1980s’.


Jurassic Park? Freight infrastructure was not sufficiently reformed during the 1990s

The defining feature of a successful wave of restructuring was the Report of the Independent Commission of Inquiry into Competition Policy in 1993 – chaired by Professor Fred Hilmer, and commonly known as ‘the Hilmer Report’. In a speech in 2002 – a whole decade after the restructuring began, the then-chairman of Australia’s Productivity Commission used this report as shorthand to describe part of the intent and impact of those early efforts:

‘Twenty years ago, Australia’s key infrastructure services – such as energy, water, transport and telecommunications – were delivered by a few publicly-owned corporate behemoths. They were unassailable by competition because their position was statutorily entrenched and many were natural monopolies. Their governance structures were antiquated, their orientation was often technical rather than customer-focused and their costs often inflated by inefficiency. These were the industrial dinosaurs waiting for the Hilmer meteorite’V.

On reflection, perhaps this sense of achievement was a little premature: for freight outcomes in particular, a lot of ‘dinosaurs’ survived the market reform meteorite: the freight sector and its supply chains in particular were never fully restructured to attract private capital and improve scale and scope efficiencies across different freight modes. Twenty years later, this remains perhaps the greatest barrier to creating better deal pipelines and structures for private investment in these asset classes (although there is also the important lingering problem that much of Australia’s third party access reforms remain in thrall to litigation as the only effective remedy for dispute resolution. In the case of the Fortesque/Rio Tinto mine rail access dispute in the Pilbara, this approach is reputed to have cost the commercial proponents hundreds of millions of dollars and over a decade in various courts and competition tribunals).

Train your dinosaur: bureaucratic resistance to reforms is real

Another challenge appears to be whether government agencies are really willing to take up the baton of further meaningful restructure on competition lines – even when it is expressly recommended by independent statutory advisers: in 2005, the Productivity Commission called for ‘national coordination of further competition reforms’ and expressly identified further effort in freight as a priority in this respect:

‘…these areas — many of which have been encompassed by National Competition Policy, should be brought together in a new reform program with common governance and monitoring arrangements. Priorities for the program include…developing coordinated strategies to deliver an efficient and integrated freight transport system…’VI

Following Hilmer, rail, ports and airports in particular underwent significant changes: assets were sold, railways were opened to private sector access. But in practice, ‘Hilmer era’ restructuring efforts of the late 1980s and 1990s amounted to reforms sector by sector, asset class by asset class. If a more holistic treatment of competition reform in the freight sector had occurred, there might have been more effort spent in examining how competition reform and market access could be applied to roads, sea channels and across whole freight supply chains: in other words, a solution might have been found to delivering the competition-reformed, ‘integrated freight transport system’ that the Productivity Commission alluded to.


Barrier 1: Investment scale and scope barrier - ‘whole of supply chain’ infrastructure access and investment is not yet permitted

Botany-Kembla sale purportedly offers the new leaseholder some involvement in roads, but the extent to which this market actor will be able to manipulate the public sector road monopoly is yet to be tested.

Big reforms but costs of inaction are steep

Pan-supply chain investments by their nature would need to be subject to careful independent regulation, but the monopoly risks that such investments pose if regulation is not effective must surely be balanced against the productivity gains on offer from greater potential capital investment, which are intuitively large, and the opportunity cost of not making these investments, which is that significant status quo inefficiencies remain: Australia’s ports, whether public or private, still suffer from significant productivity barriers beyond their gates which they have no ability (outside base political lobbying) to access or improve; road freight arteries are often out-dated, leading to poor truck turnarounds and increased urban congestion; the depth of many Australian seaport channels and berths is shallower than the latest emerging container and bulk fleet designs would require, putting these ports’ futures as destinations of choice for global trade at risk.

Taken together, these ubiquitous barriers to efficiency are not insignificant, but they are almost certain to be left unaddressed given the scale of capital investment required to fix the problems, combined with the fact that public funds are in short supply.

The importance of supply chain-wide access reforms – including third party road access and improvement for the road freight sector - lies in understanding what drives freight efficiency in the first place: goods moved on a commercial basis often employ more than one transport mode on their journey from the consignor to the end customer. If individual assets like ports, their sea channels, freight highways and railways generally rely on their interaction with other parts of the network for their overall efficiency, then the lowest point of efficiency across a complex freight network becomes the upper limit of efficiency for the whole network: for example, a major freight railway can have many millions invested in it, but if the main port it services does not maintain competitive channel depths, the most modern and efficient large ships might no longer visit that port - rendering the rail investment wasteful; if an airport spends millions attracting global carriers to become a major regional airfreight hub, restrictions to truck access imposed by road agencies put the entire time-sensitive logistics chain at risk.

Private investors are not yet permitted to invest across a whole Australian freight supply chain where public infrastructure is involved. They cannot at present make a single investment – even oversighted, for argument’s sake, by a single independent regulator - across a freight supply chain that, for instance, includes a sea channel, a port and its hinterland rail and road freight connections. For the most part, private freight investments are made for individual pieces of infrastructure, such as a port, or a railway. The


Case study: Australia’s ‘ring-fenced’ ports – locked out of supply chain investment and better performance prospects

Australian ports versus the world – could preventing whole of freight supply chain investment be harming individual port asset performance in Australia?

Average Average global Average all ports Australian ports (1) comparator ports (2)

Total debt/shareholder’s equity 58.9% 166.4% 109.1%

Total debt/total assets 21.2% 25.6% 23.3%

Return on assets 2.1% 5.2% 3.5%

EBIT return on assets 5.0% 7.5% 6.2%

Return on equity 3.6% 9.2% 6.2%

Interest coverage ratio 7.30 7.31 7.30

Debt coverage 0.60 1.45 1.00

Revenue/total assets 0.20 0.23 0.21

Current ratio 2.59 2.00 2.32

Quick ratio 2.19 1.53 1.88

The lesson of Australia’s ports shows the dangers of assuming that simply selling off or otherwise corporatizing isolated freight assets is a way to bring about optimal freight productivity and returns to investors: while ports have been the subject of some reforms, the Industry Commission review of ports in the early 1990s did not tackle upstream and downstream access challenges.

Instead, it saw the primary issue for these assets as being whether port services should be overall ‘narrow’ in service provision or ‘expansive’VII. Even the matter of port ownership was a second order issue to the initial review. Since this time, in regulatory and access terms, little has changed since for Australia’s ports: some have been privatised, all have been subject to levels of corporatisation. But almost all remain disconnected from their upstream hinterlands and downstream

channels in terms of having a legal right of access and improvement on these critical enabling pieces of freight infrastructure. That this has stymied the overall profitability of ports is a contention that might find support in Infrastructure Australia’s recent Review of Port Balance Sheet Capacity (2012) which revealed that 8 of Australia’s major ports were offering an average return on equity of 3.6% compared with a figure of 9.2% for a group of major international comparator portsVIII.

The report also suggested that significant additional gearing was available to some Australian ports, but the persistence of significant upstream and downstream inefficiencies over which these ports (through lack of whole of supply chain access reforms) have no influence might render further gearing and investment within the port confines a wasted exercise.

Notes: (1) Australian ports analysed were: Melbourne, Port Kembla, Newcastle, Townsville, Fremantle, Bunbury, Tasports, Port Hedland (2) International ports analysed for comparative purposes were: Singapore, DP World ports, Lyttelton, Auckland, Sydney, Toronto, Vancouver

Source: Infrastructure Australia/Deloitte Review of Port Balance Sheet Capacity Draft Report (2012) p. 11


Barrier 2: Roads –the neglected lynchpin of private freight infrastructure operations

Roads were the glaring omission in Australia’s early competition restructuring efforts as they related to freight. Whether commonly recognised or not, roads in Australia (excepting some private urban toll concessions and remote mine haul roads) are all unreformed government monopolies, where government agency, not the market for freight, is the sole legal power for planning, funding and deciding on the relative efficiency of the road network.

These same agencies are generally acknowledged to be short of required funds. Roads remain the biggest ‘dinosaur’ in Australia’s economic infrastructure, and while the dinosaur remains, almost all of the putative investments in ports, rail and airports remain compromised from achieving optimal intermodal freight efficiencies.

Commercial freight investors and operators have no legal rights to access or improve the road network (as they do in rail, energy, telecommunications,

or water, for example) to accommodate more productive new vehicles and road upgrade that would support them, despite the fact that Australia leads the world in its skill and innovation in trucking efficiency. Instead, larger, more productive and environmentally efficient vehicles can be blocked from more productive access to key freight locations because road agencies lack the capital for the facilitating the road upgrade that would enable the better vehicles to run on that road.

Under this arrangement, the community too suffers alongside investors. Inadequate freight infrastructure and mismatching of obsolete vehicles to outdated, underfunded and politically unattractive freight arteries breeds congestion in capital cities, higher freight prices, less opportunities for road freight aggregations to railheads (making railfreight more viable) and more trucks on these roads than there really needs to be; almost imperceptibly, cities and their trading economies become asphyxiated.

PHOTO By TIM GILES


No road investment reform, no portfolio growth?

Australia’s unreformed road sector is not a sideline issue for greater freight investment – it is a core problem: this was reinforced by Infrastructure Australia’s 2011 National Ports Strategy, which

pointed out that for the 5 major container ports in Australia, road transport interface costs have risen at crippling levels, even as all other charges have fallen overallIX:

This research also gestures towards the difficulties that lack of road reform is presenting to an ailing Australian manufacturing sector: road and intermodal efficiencies could assist manufacturing, lowering its overall cost structure. Instead, the opposite is happening, as the above table shows: if

foreign exchange and competitive labour market advantage from other countries is not enough of a burden, road freight inefficiencies that come from a lack of market-driven road freight infrastructure investment seem to be finishing the job, instead of rescuing the situation.

Competition reform of the road sector is not even squarely on the ‘reform’ agendum as yet

Port interface costs % changes in road and total charges per teu, and manufactoring cost index, 1996-2009

120%60%0% 100%40%-20% 80%20%-40%

Brisbane

Sydney

Melbourne

Adelaide

Fremantle

Road transport charges All other charges Manufacturing cost index

Manufacturing cost index

To date, serious competition reform of this sector has not occurred. In its place stand ‘false’ competition reforms –pale successors to original National Competition Policy efforts: National Heavy Vehicle Legislative and Regulatory Harmonisation - a process for ensuring that all state and territory trucking laws are consistent for trucking operators nationwide - and National Heavy Vehicle Charging and Investment Reform - a road funding reform project begun in 2007, which has yet to deliver any practical outcomes, but which coordinated national third party road freight access and improvement trials in 2009 which were almost a complete

failureX. These reforms, although important for the road freight sector, are not competition reforms.

Genuine road reform is indeed taking a tortuous path, to say the least, and at least some parts of the bureaucracy appear not to appreciate the core challenges to this infrastructure: most recently, the Federal Infrastructure and Transport Department advised the Productivity Commission’s Review of the National Access Regime that ‘…roads…have been a major part (of the microeconomic reforms begun in the 1980s’XI and that competition reform of roads would not be necessary as:


‘…in some cases, heavy vehicle operators may claim that they are unable to ‘access’ the Australian road network in particular locations, and may suggest to the Commission that this is the type of issue that Part IIIA might be used to address. However, the Department’s experience is that decisions about the level of road access available to Higher Productivity Vehicles are generally made for safety, technical or engineering reasons, rather than competition reasons’XII.

So, all is well, apparently. Except it isn’t: road freight experiences access challenges to bigger and better vehicles every day, but the source of this problem is a lack of capital. Usually, ‘safety, technical and engineering barriers’ to more productive freight can be solved with more capital. Such wrong-headed public sector understandings of the core problem – rarely advanced for public scrutiny – show just what unseen risks like in wait for investors relying on whole-of-chain access and investment in freight investment. The challenge is both cultural and structural.

Way ahead: a changed role for the public sector, a clearer pipeline for private sector asset investorsIf a future government is to undertake meaningful further reforms of the freight sector, it might profit from a dual focus: first, the role of the myriad government transport agencies will need to alter to reflect new arrangements. Second, the potential global market for investment in freight infrastructure needs a better sense of a pipeline of investments that will prove robust. This should not be a wish list of assets that governments think they can dust off and sell: they should be assets that are underwritten by clear and consistent access and improvement arrangements across all freight modes.

Make the gold, make the rules: the future for bureaucracies must change to reflect greater private capital investments in freight

In recent years it has become apparent that the public purse has not been able to fund the full scale of efficient expenditure in the nation’s freight infrastructure. yet despite this fact, and despite the general recognition that sustainable private investment in these asset classes is desirable, public sector agencies remain heavily structured along 20th century lines: in most cases they act

as lead freight infrastructure planner, funder and access arbiter. If private sector investment is to find Australia a more attractive destination for freight asset investments – if Botany-Kembla is to work as well as it could - this arrangement must change, and the public sector must adapt itself to play more of a governance and facilitation role over private capital.

This emerging challenge has already been noted by the OECD, which foreshadows a move away from a traditional agency role to perhaps that of more predominantly ‘facilitator of market access and investments’ and ‘scrutineer of such investments with sustainability and the public interest in mind’:

‘…there is a growing need for effective regulatory oversight, no matter how services are provided, and a need for central government to continue to play a strategic role, especially with respect to social, environmental and fiscal policy direction. The potential challenges for regulation are likely to increase as new technology is adopted and organisational forms respond to its deployment. It could well be that responsibilities in the area of service delivery become blurred, requiring a greater level of governance to protect the public. The interrelationship of different spheres of regulation, safety, economic, quality, environment, consumer protection and perhaps others will become more challenging and complex’XIII. (Author’s emboldening)

Clearing the pathway for capital remains a challenge

Right now, notwithstanding the one-off sale of Botany-Kembla, there is no obvious ‘pipeline’ of Australian freight investments discernible to the market. Governments have traditionally made little effort to publish information in a market-friendly format that would tell investors where such investments are being considered: where are the places where freight patronage is highest? Where are the ports of greatest value and activity? Which shipping channels most need dredging or other upgrades? Where can rail freight into ports be enhanced, and to what extent does the market have any certainty that these potential investments will be backed by the security of efficient third party access and improvement arrangements? Government agencies are not oriented to producing such data. It is largely irrelevant to the inherited structure and culture.


Recent cause for optimism – a national freight investor map

The recent development of Australia’s first National Freight Network is a good start towards a freight investment pipeline. This document – agreed by all Australian jurisdictions – in effect encompass the key high-volume freight networks and places across the country. In producing this map, Infrastructure Australia has foreshadowed that these nationally significant ‘places for freight’ – the places where the greatest volumes of freight activity take place, or are expected to in the future - should all be opened to third-party access and operation in preference to having to be funded and improved through scarce taxpayer dollars. Australia therefore has at least a fledgling pipeline for major productive private freight infrastructure investments.

Work will need to occur to develop structures for how the market can make unsolicited bids for these parts of the network without risking their intellectual property, but this is an important breakthrough for would-.be freight asset investors in Australia. In time, those looking back might see this as a pivot point, when Australia regained critical momentum for ongoing competition restructuring of its economy. But there is much yet to achieve, particularly in competition reform of roads as well as whole of supply chain access and improvement and the restructuring of transport agencies, before such first steps can deliver their full potential for national productivity and productive global capital inflows to Australian freight infrastructure. The final note of challenge might be left to the OECD:

‘Australia has been one of the most successful OECD countries in weathering the Global Financial Crisis. Mature regulatory settings and a strong fiscal position have worked in Australia’s favour…however, Australia still has a challenge to lift productivity to return to a higher long-run growth path and continued future prosperity’XIV.

Meeting the challenge relies on investors in projects like Botany-Kembla realising good returns and few surprises over long investment timeframes. For governments, the key to securing such outcomes lies in realising that there is major reform work ahead after the sale cheque is banked.

More ambitious and comprehensive competition reform of the freight sector, combined with accordingly reshaped public sector transport agencies are big parts of that work.

Luke Fraser is the principal of Juturna PL, an Australian-based freight infrastructure advisor to the public and private sectors specialising in whole of supply chain freight infrastructure planning and investment reform. Juturna is a retained advisor on market-based freight infrastructure reforms to Infrastructure Australia and a global leader in the development of productive private sector road freight infrastructure investment. Mr Fraser was recently appointed by Australian transport ministers as industry representative to the national road reform project board. The views expressed here are Juturna’s own, and are not intended to reflect those of its clients or of its principal’s board affiliations.

End notes:I. Australian Financial Review ‘Port Sale Reaps

‘Historic $5b Price for NSW’ 12 April 2013

II. OECD Review of Regulatory Reform: Competition Reform in Australia (2010) p.6

III. OECD Op Cit p.13, quoting the findings of the Review of the Competition Provisions of the Trade Practices Act (‘The Dawson Review’) (2003)

IV. Productivity Commission Review of National Competition Policy Reforms Inquiry No 33 (2005) p. xvii

V. Banks, Gary, Regulating Australia’s infrastructure: looking forward Presentation to the Financial Review and AusCID National Infrastructure Summit, Melbourne August 2002.

VI. Productivity Commission Op Cit p.xii

VII. Australian Industry Commission Inquiry into Port Authority Services and Activities Report 31, (1993)

VIII. Infrastructure Australia Review of Port Balance Sheet Capacity Deloitte (2012) p. 11

IX. Infrastructure Australia National Ports Strategy Discussion Paper (2010) p.24

X. Cf: Juturna Consulting COAG Road Freight Incremental Pricing Trials Report for Infrastructure Australia (2011)

XI. Department of Infrastructure and Transport Submission to the Productivity Commission’s Review of the National Access Regime (2012) p.2

XII. Ibid p. 5

XIII. OECD Infrastructure to 2030: Telecom, Land Transport, Water and Electricity (2006) Volume 1 p. 47

XIV. OECD Review of Regulatory Reform: Australia - Towards a Seamless National Economy (2010) p.13

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