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Infrastructure: what is needed and how do we pay for it? Paper presented to the New Agenda for Prosperity: 2008 Economic and Social Outlook conference, Melbourne.

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Infrastructure: What is needed and How do we pay for it?

Michael Keating AC

Chairman, Independent Pricing and Regulatory Tribunal, NSW

In 1880 Australia had the highest living standard in the world. For much

of the following hundred years our rate of public investment was also just

about the highest in the world. But despite this high investment in

infrastructure, Australia dropped down the international league table of

living standards. No doubt there were multiple causes for Australia’s

relative decline in GDP per capita, and part of our high investment was

an inevitable response to the tyranny of distance. Nevertheless, this

historical experience strongly suggests that too much of our

infrastructure investment has been wasted in the past. And it is not

difficult to think of examples - railways and irrigation schemes that never

did nor could have even hoped to make a return, of which the Ord River

scheme and Darwin to Alice Springs railway are only the most recent

glaring reminders of our tendency to suspend our collective critical

faculties when it comes to infrastructure investment.

So now we are being warned that once again we are facing yet another

infrastructure crisis - I have even seen it referred to as our “infrastructure

nightmare”! But should we believe these prophets of doom? There are

after all a number of vested interests:

• The finance industry is experiencing very rapid growth in

superannuation funds available for investment, and infrastructure is

an especially attractive investment for these funds - offering a

steady stream of returns with often low risks because of various

forms of government risk sharing or guarantees


• The construction industry is particularly dependent on public

investment, and

• There are political pressures - some of us will always remember

that modest member of Parliament, Bert Kelly, who smelt another

dam coming on every time a new election was announced

It is, of course, possible to point to particular instances where additional

infrastructure investment would seem to be warranted, but do these

instances add up to a general conclusion that we are significantly under-investing in total or just that there is some misallocation of the present

investment? Certainly our ranking according to the World Economic

Forum puts us not far from the top in terms of the quality of our

infrastructure (see Chart).

So before we spend taxpayers’ money on yet another infrastructure crisis

I suggest that we need to start by answering some critical questions.

How do we define a shortage of infrastructure and why does government

need to intervene? How much infrastructure is appropriate, and how

should the total of infrastructure investment be determined?

How should infrastructure investment be determined?

In a free market where price reflects the cost of production we can be

reasonably confident that demand will equal supply, at least over time.

When there is excess demand and a shortage, the price will rise and

investment will fairly rapidly respond to the increased returns, so that the

shortage disappears.

So what makes so-called infrastructure different? First, there are often

externalities associated with infrastructure investment, so that the full


cost of the investment is not normally recovered only from the direct

users. For example, the rest of society can benefit from investment in

railways which leads to lower congestion, and accordingly the optimal

amount of rail investment is likely to be more than the amount that

passengers should be asked to pay for. The second problem is that

public infrastructure is often associated with considerable economies of

scale. These economies provide the conditions for natural monopolies

that in private hands may provide some incentive to under-invest and

thus achieve monopoly profits.

It is this combination of externalities and economies of scale that gave

rise to our history of government provision of infrastructure and an

absence of market tests. Instead infrastructure has often been

subsidised or even provided for free and financed out of consolidated

revenue. But when something is provided for free, we should not be

surprised if there is apparently excess demand for its services. Instead

we should be asking would there be a shortage of infrastructure if there

were appropriate cost recovery through charges? Furthermore, proper

pricing signals can often lead to more efficient use of infrastructure so

that there is no need to build additional capacity. In other words do we

face an infrastructure crisis or a pricing crisis?

The provision of economic infrastructure

I now want to explore these possibilities for using pricing more

effectively, particularly to determine the investment in economic

infrastructure. Indeed, a major thrust of public sector reforms since the

mid-1980s, and especially under the Hawke and Keating governments,

has been the development of a more market-oriented framework through

corporatisation and sometimes the privatisation of public utilities, and the


introduction of competition wherever possible. My purpose is now to

briefly discuss how these reforms have affected the provision of

infrastructure in each of the energy, water supply, urban transport and

communication sectors.


A national energy market has now been established and the wholesale

price of energy is now set competitively. Although the retail price of

energy is still controlled in most states, I believe that electricity and gas

prices are being set high enough to ensure that the necessary

investment will be forthcoming to maintain the supply of gas and

electricity to those markets. Indeed, because the regulator is targeting a

specific rate of return on investment when setting prices, this will remove

some of the riskiness in that investment, so in theory this type of

regulation can encourage a tendency to over-investment. On the other

hand others would argue that regulation creates its own types of

“regulatory risk”.

In actual fact in NSW, which is the market that I know best, I think the

evidence shows that the rate of return incorporated in the retail electricity

price, and the conservative approach to forecasting the future wholesale

electricity price, will be sufficient to provide the necessary incentive for

future investment, including in new generation capacity. Indeed, that is


Urban Water

Possibly even more interesting have been the changes in the provision

and pricing of urban water; although some jurisdictions are still seeking

Commonwealth funding and have not accepted that urban water can and


should be fully cost recovered. In any event, with the exception of Hobart

all our capital cities are presently embarking on major investments in the

provision of urban water in an attempt to drought proof these cities.

In Sydney the desalination plant and other re-cycling schemes that are

presently being built will be fully cost-recovered and should be sufficient

to ensure that Sydney will not experience water scarcity for at least ten

years. The regulator, IPART, has just determined that this cost recovery

will involve an increase in the price of water from its present $1.34 kl to

$1.83 kl over the next four years in real terms. The water and sewerage

bill for a typical household will then increase by $203 pa or at an annual

average rate of 6.3 per cent. While this may sound a high rate of

increase, the price of $1.83 for a thousand litres of tap water compares

with a similar price for a single litre bottle of water at the super market.

Most importantly, this price of $1.83 kl equates to the long run marginal

cost of future additions to the water supply. It should thus provide an

adequate incentive for future investment in Sydney’s water supply,

including by the private sector. I suggest therefore that this investment

and associated pricing in Sydney’s water is an example of infrastructure

investment where a market test can be applied, and as a result we can

be reasonably confident that the investment will be forthcoming in the

future without the need for any subsidy.

As you know the choice of desalination has been contested by some, but

in some Australian cities desalination is the most viable strategy to

increase urban water supply, as its cost is equal to or lower than the

costs of transporting traditional rain/river water supplies from further

away. However, there are some other cities, such as Melbourne and


possibly Adelaide, where if trading of rural water were encouraged, then

it may well be cheaper to purchase rural water than to invest in new

sources of urban water.

Rural Water

The much more difficult case is the appropriate provision of infrastructure

for rural water. In recent times drought has put rural water at the top of

the policy agenda with the announcement of a National Water Plan

which provides for expenditure of $10 billion on irrigation in the Murray-Darling basin. This plan has been warmly welcomed and has bi-partisan

support. Approximately $6 billion will be spent on improving the supply of

water to irrigators by efficiency improvements. So far there has been no

suggestion that the cost of this extra water will be recovered from the

irrigators, despite the requirement in the National Water guidelines,

agreed by COAG, that there will be full cost recovery. But is this

investment justified if we apply these cost recovery guidelines?

For example, in NSW - and I don’t think the situation differs materially in

other states - because of the write-downs of past poor investments, in

2006-07 the regulatory asset base for NSW State Water was only $340

million of which the irrigator’s notional share was a mere $84 million.

Assuming that NSW maintains its share and that roughly half of the

proposed $6 billion under the NWP is eventually spent in NSW, and that

most of this expenditure benefits irrigators, then under that national water

guidelines the regulatory asset base for the return on and of capital to be

recovered from NSW irrigators could increase from $84 million to as

much as $3000 million plus - that is up to thirty times. Even if most of the

extra NWP funding were attributed to the environment - which seems

unlikely - the capital base attributed to NSW irrigators would still rise


approximately tenfold. Furthermore, water supply is very capital

intensive, so unless this latest investment produces a lot more extra

water than all previous irrigation schemes then prices could also be

expected to increase by not much less than the increase in capital.

Obviously these numbers would need to be refined, but they are

sufficient to prompt the question how many irrigators would support this

proposed $6 billion expenditure on irrigation infrastructure if they had to

pay for it? My strong suspicion is that this is a major infrastructure

investment that would be better avoided or at least massively scaled

down. The money saved could be better used buying back water

licences which would then cost less if their value were not inflated, as

they will be, by the provision of more free water.

Urban Transport

As I indicated earlier there are good reasons for not seeking full cost

recovery for most forms of transport. Economies of scale mean that the

marginal cost of roads, for example, is typically well below the average

cost. Indeed, where there is excess capacity, the marginal cost from an

extra user of an existing road is typically close to zero. Full cost recovery

where prices equate to average cost would then result in less than

optimal road use, and users failing to take up that spare capacity. But

that is not a reason for failing to evaluate the benefits relative to the

average costs of any new road investment.

In the case of rail investment, I have already referred to the external

benefits from public transport in reducing congestion, pollution, and

improved safety. Consequently we cannot rely on a pure market test

when it comes to determining the adequacy of much of rail investment.


Again it does behove us, however, to undertake proper cost-benefit

analysis on a project by project basis, and not rush to accept that every

squeaky wheel needs oiling with new investment.

But notwithstanding the need for that detailed analysis, I think we can

also attempt a broad assessment of the returns from more investment in

urban transport. In particular, a commonly touted figure used to justify

increasing transport investment is that the costs of congestion in

Australia now amount to more than $9 billion1. But that begs the

question of how much difference the various investment proposals would

make to the amount of congestion, and whether there are other more

cost-effective alternatives. For example, investment in urban arterial

roads too often just shifts the point of congestion rather making much

difference to the overall rate of congestion.

In response the advocates of public transport argue that instead of road

investment, congestion requires more investment in urban rail systems.

While I personally have no doubts that there are useful investments that

could be made in urban rail projects in Australia, we need to be highly

selective. The hay-day of rail was before the arrival of the motor car and

rail transit works best in those cities whose basic form and structure was

determined before the arrival of car transport. Thus a critical problem

facing rail investment in new lines in urban Australia is that rail is not well

suited to serving the highly dispersed patterns of housing and

employment characteristic of Australian cities. Indeed if experience in

the US is any guide to our future, it is worth noting that by 2006 fewer

than 1 million US workers commuted to work by rail compared with more

1 Bureau of Transport and Regional Economics, 2007, Estimating urban traffic and cost trends for Australian cities, Working Paper 71


than 2 million in 1980, and this fall was despite substantial investment,

including in new systems, and a 150 per cent increase in the real cost of

government aid to cover rail transit operating deficits2. The problem is

that urban rail systems are directed to bringing commuters into the CBD,

but over the years our cities have re-structured so that the proportion of

jobs in the CBD is steadily declining.

To further illustrate my point I want to explore the returns on investment

in City Rail in Sydney. As you will know, Sydney is our most densely

populated city, and the number of rail passengers carried in Sydney is

about 50 per cent and 470 per cent more than in Melbourne and

Brisbane respectively, while the extent of their suburban rail networks is

only a little less than Sydney’s. So Sydney is probably more suited to rail

transit than other Australian cities.

The return on investment in Sydney’s urban rail system can be

characterised as the external benefits less the operating losses

sustained. The external benefits include not only the reduction of

congestion, but also environmental benefits - such as less pollution -

and the increased safety of rail travel. In addition, some analysts would

also add to these external benefits, the consumer surplus captured by

users who experience a welfare gain when they pay prices that are less

than their willingness to pay.

Work commissioned by the NSW Railcorp suggests that the external

benefits from Sydney’s CityRail were of the order of $984 million in 2006-

2 Winston, C and Maheshri, V, 2006, “On the social desirability of urban rail transit systems”, Journal of Urban Economics, pp.362-382


073. This compares with a reported government subsidy to cover the

operating loss of $1650 million - clearly much more than the estimate of

external benefits, even after including rail’s impact on the reduction of

congestion in Sydney. Furthermore, this reported operating loss of

$1650 million only allows for a relatively small amount of depreciation, so

there is no recovery of much of the past investment, and there is no

provision for any return on capital.

The NSW Railcorp work also estimates that the consumers’ surplus

amounted to just over $2 billion, which is then deemed sufficient to

generate an overall net benefit to the Sydney community. However,

even if that judgement were accepted, the vast bulk of that net benefit

clearly is captured by the minority of the community who are rail users.

Interestingly the extent of this net benefit is shown to be rapidly declining,

mainly because of the cost of recovering the rapid build up in new

investment by the NSW Government to improve and upgrade the rail

network. The problem is that this rate of investment build-up is so far not

being matched by the rate of increase in patronage.

In addition, although I think it is legitimate to write off much past

investment in rail systems because of past poor investment decisions,

this work does underline the caution that should accompany proposals to

expand the network. Instead new investment will usually be more

successful if it carefully targets those projects which are frequently not

very expensive but which can make a dramatic difference to the capacity

of the existing system.

3 Karpouzis, G, Rahman, A, Tandy, K and Taylor, C, 2007, “The value of CityRail to the NSW community 1997-98 to 2006-07”, paper delivered to the 30th Australasian Transport Research Forum


In these circumstances governments should develop a regulatory

framework for setting transport prices that encourages a proper

consideration of investment proposals. I am pleased to say that in this

respect I believe the NSW Government is now providing a lead with the

reference that it has given to the Independent Pricing and Regulatory

Tribunal for the future regulation of rail fares. But I also think that instead

of being constantly held to account for alleged under-investment in

transport infrastructure, if governments are seriously concerned about

congestion problems then they will need to consider how they introduce

various forms of congestion pricing.

In this regard, I think that in future we will need to pay much more

attention to the structure of pricing, as well as to the rate of cost

recovery. Especially in the case of transport there is a strong case for

peak pricing to encourage demand to shift to times of the day when

capacity is less strained. This peak pricing is, of course, already

common in much of public transport, but it needs to be extended. For

example, stevedores work 24/7 when loading and unloading containers

from ships, but the road transport industry would prefer to work mainly in

business hours when their customers are open to take delivery. The net

result is much under-used infrastructure in some hours, and excess

demand in peak hours. The solution according to some road carriers is

more investment by the stevedores in cranes, but a better solution would

be to auction loading slots so that their price reflected their scarcity

value. In that case demand would probably shift to be spaced more

evenly over the whole 24/7 period. In addition, rail would then become

more competitive with road, thus also easing congestion.



The communications industry is now largely privatised and prices are set

competitively to reflect market conditions. In most respects that should

not lead to any shortage of infrastructure, but it would seem that

governments are still tempted to intervene, although the nature of the

market failure that governments wish to address is not clear. The risk is

that governments will seek to extend the use of the most advanced

technologies to areas where that is quite uneconomic, and where other

much cheaper technologies will give almost the same benefits.

Third Party Access

An alternative justification for government intervention in the provision of

communications infrastructure, as well as in rail, water, energy, is that

investments in trunk systems and associated networks, such as broad

band, do give rise to enormous economies of scale. Accordingly

governments have tried to promote third party access to these networks.

This third party access has, for example, been successful in allowing

access to the rail and energy networks, and has promoted competition.

Recently the NSW Government has legislated to similarly allow third

party access to the water and sewerage pipeline systems. In addition, to

promoting efficiency through competition it is hoped that this will

encourage new entrants to the water industry who will propose more new

innovative solutions, leading to overall savings.

However, experience also suggests, particularly in telecommunications,

that there can be considerable difficulty in achieving a price that will

encourage both third party access to the network while providing an

adequate return to the original investor. Thus in the long run the best

solution may be some form of structural separation which separates that


part of any supply chain where there is a natural monopoly. The different

producers and retailers can then access that monopoly distribution

system on equal terms.


The micro-economic reforms of the past two decades or more were

particularly focussed on building more competitive markets for the

provision of infrastructure services. Where elements of natural monopoly

unavoidably remain, regulatory regimes have been introduced that are

intended for the most part to replicate the results that would have been

obtained through competitive markets. In these circumstances prices

and the return on assets should determine the optimal amount of

infrastructure investment. This market oriented approach will certainly

provide a far better guide to future infrastructure investment than relying

on the unproven and unprovable claims of an infrastructure crisis. Claims

that are most likely to lead to a perpetuation of the white elephants of the

past and the poor returns on investment that have undermined our

economic performance and productivity of capital.