Toll road in Australia

Toll Review Public Hearing Presentation

6 November 2023
From our ‘Thinking outside the box’ series
This is the presentation given to the NSW Toll Review Public Hearing on 11 July 2023 by Professor Martin Locke. In preparation the discussion paper, summary of work completed and the submissions from TfNSW, Transurban and IPA to last year’s inquiry, were reviewed.

The need for toll reform is widely accepted and the current structure of tolls and toll road contracts is not sustainable. Toll relief is a short-term band-aid solution. This review has the potential to come up with a meaningful and long-lasting reform plan.

A lot of useful discussion has already taken place on the arguments for introducing simpler standard motorway network pricing across the entire motorway network to fix our current patchwork approach. This also needs to address escalation and bi-directional tolling on all roads.

My presentation only covers one aspect of the debate, namely whether tolls should be subject to regulation by IPART. I believe the logical solution to fixing our toll road contracts is to adopt the regulated utility model.

Changes in tolls and escalation will require discussion with concessionaires and we are told by IPA that concessionaires are willing to consider reform including a single network policy.

Transurban has stated that it welcomes the opportunity to consider changes to tolling regimes including the shift to network wide tolling and road user charges.

Transurban has highlighted the risk of social licence to its investors and that negative public sentiment may result in political measures that adversely impact its operations.

So the time is right to move to a regulated model with mutual interest and support from concessionaires.

So what needs to happen? The history of our toll road contracts is anchored in the project finance model. When a toll road contract is negotiated, a base case financial model becomes the foundation of the agreement. In simple terms, the financial model projects costs and revenues over the term of the concession with return on equity as the key output.

The concessionaire forecasts revenue based on patronage assumptions and the prescribed toll and escalation provisions. If the government changes the toll provisions, the concessionaire would normally be entitled to compensation for any net adverse financial impact determined by the financial model; the test is the level of the equity return.

So if for example, the government is assessing the reasonableness of the unsolicited proposal to widen the M7, the concessionaire will prepare an updated financial model with updated cost and revenue assumptions. Government will assess the reasonableness of the cost and revenue assumptions and the financing assumptions, particularly the equity return. This is regulation by contract.

The problem with this model is the rigidity introduced by the base case financial model, the costly process of agreeing changes and the absence of competitive tension in negotiating with an incumbent. There are also concerns around lack of transparency and loss of social legitimacy.

Interestingly, the UK provides a precedent with a shift away from the traditional economic infrastructure PPP to the regulated enterprise model used on the Thames Tideway project.

The regulator would undertake a periodic review of the contract, review the reasonableness of the cost assumptions and the Regulated Asset Base and the reasonableness of the equity return using the Capital Asset Pricing Model. The regulator can then assess the toll price and revenue assumptions.

In all honesty this sounds not too dissimilar than the current ad hoc arrangements. But there are four key differences; (i) the equity return is determined by the regulator rather than being anchored in the base case equity return, (ii) there is a periodic regulatory reset, (iii) the regulatory determination is binding and (iv) everything is made public.

I found the comments last year from TfNSW somewhat dismissive about the potential benefits of a regulator.

TfNSW said that IPART regulation of toll roads was not consistent with its core function and area of expertise.

TfNSW said introducing regulation could change the risk profile for private finance and make it more difficult to secure funding with decreased competition in the market; regulation would have extremely negative impacts on existing concession agreements, risk ongoing viability, insufficient revenues to repay financiers and trigger claims for compensation.

I disagree with this gloomy interpretation. Regulation done properly could avoid all of these concerns. Indeed, regulation can provide greater certainty to financiers and improve competition.

Infrastructure financiers generally regard regulated utilities as having a lower risk/return profile than natural monopolies like toll roads and airports. Moreover, the regulated model provides greater flexibility for changing tolls over time and supporting social legitimacy; infrastructure financiers reportedly prioritise sustainability and doing something worthwhile over myopic financial returns; here is the opportunity to put that into practice.

How could regulation happen and what are the key issues?

We would need to agree on the period of the regulatory reset. A shorter period would help deal with the changing pricing dimensions.

The regulator can then determine what is base level of permitted toll revenue over that period considering the capital base and the return. Any excess revenue could be shared on a 50:50 basis like the treatment of refinancing gains. Note this is much more balanced than the lop-sided upside sharing provisions in standard toll contracts.

The proposed regulatory principles could be set out by the regulator and agreed with the concessionaires.

If we consider the WCX concession, for example, was it sensible to fix tolls for 40 years with tolls escalating at the higher of CPI and 4% for the first 20 years. Isn't that inflexible? And why was it necessary to opt for a 40 year term?

Changes can be negotiated but only in the context of the contracted terms and the base case financial model; compensation claims protect the equity investors for loss. A shift to a regulated utility model sounds much more pragmatic.

Moreover, it is highly likely that further changes to tolling beyond the shift to standard network pricing will be required. Future changes could include wider use of time-of-day tolling and more widespread adoption of road user pricing; such changes could be easily accommodated under a regulated utility model.

Have a look at the reasons why the Victorian Government adopted a State Tolling Company model rather than outsourcing toll revenues under a typical concession contract. Its review noted that network pricing and development and road user charging was more within the control of government and competition was limited because of existing toll road operator incumbency.

And whilst the ACCC has required Transurban to publish quarterly traffic data, Transurban will be in a unique position to leverage its existing network to support future expansions; NCX is a good example as no other party could provide a competing proposal due to Transurban's ownership of the adjoining M7/M2 tollroads.

Moreover, TfNSW noted that operators with investments in multiple roads can realise synergistic benefits and economies of scale; this implies that it will be increasingly difficult to compete with Transurban. Regulation is the most appropriate tool to manage natural monopolies.

The question was asked how it can be ensured that the benefit from toll relief obtained by operators is passed back to the community. Interlink Roads has benefitted from M5 Cashback boosting patronage. The regulated model would have passed this back to the community.

Finally the Western Harbour Tunnel provides a unique opportunity to both reform tolls and strengthen the State's fiscal position.

We need to be imaginative about exploring potential securitisation of the aggregated toll revenue of the three harbour crossings. Bi-directional tolling makes sense. The aggregated revenue provides a low-risk investment opportunity. Adopting the regulated model would safeguard community interest and broaden competition.

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