As I mentioned in the first post in this series, Babcock & Brown is not a bank. That means it’s not regulated by APRA and doesn’t need to worry about capital adequacy and the like. But regulation plays a large part in its business, because many of the assets it owns and manages – power stations, ports, wind farms and the like – are either natural monopolies or former government businesses, and the government therefore likes to moderate how much money they can make.
Regulation comes in as many different forms as there are assets. Airports in Australia are subject to ‘light-handed regulation’ – don’t abuse your power and you’ll be left to your own devices. But at the other end of the scale are monopolies where the government (or its representative) has complete control over the price you can charge.
For example, the price the Dalrymple Bay Coal Terminal can charge users is set by the Queensland Competition Authority with reference to the amount of capital invested. It’s know as a WACC (weighted average cost of capital) model, where the regulator sets a price that’s supposed to provide a particular return on the owner’s investment.
At Dalrymple Bay, the regulator’s most recent determination was that – based on assets of $850m, a WACC of 9.02%, annual capital expenditure of $30m and corporate overheads of $6m – the owner of the terminal (B&B Infrastructure) should collect $86.8m a year in revenue.
You might think this type of arrangement would make for a boring and straightforward business, but for the MBAs working at places like Babcock it simply represents a challenge. Convince the regulator that Dalrymple Bay’s overheads are $10m not $6m, and you’ll collect an extra $4m a year in revenue. Convince it that your cost of capital is 10% and not 9%, and another $8m a year will land in your pot.
For Babcock, regulation is not so much a risk as an opportunity to put its skills to the test. With increasing private investment in public infrastructure and new frameworks on the slate for carbon trading and renewable energy, it’s a set of skills that might well come in handy.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.