Hon Max Bradford MP
Minister of Energy
2 October 1997

Introduction

I welcome the opportunity to share with you this morning some thoughts on electricity reforms.

In recent speeches, Ministers with responsibility for energy and state owned assets in the electricity sector have been talking about the next stage of reform in the electricity sector.

That there will be further reform is certain.

The reform will have a number of key objectives.

First, we have to reduce the costs of producing and distributing energy in general, and electricity in particular, to enhance the competitiveness of New Zealand exporters and business.

Secondly, consumers deserve a better break in terms of choice and control over their power bills. Only effective competition will achieve that, and we do not have effective competition as yet.

Thirdly, we have only one more opportunity to get the structures and the incentives right to ensure the legacy of 10 years of reform is a truly competitive electricity market. This round of reform by the Government is it.

The challenge now is to find solutions that are effective, lasting, and create the right incentives to stakeholders in the sector: consumers, investors, and management.

Today, I want to fill in more of the background to the issues as I see them, and to traverse the options likely to be considered by the Government. I intend to direct most of my comments at the retail end of the market.

Achievements to date
It is easy to overlook, or undervalue, the achievements so far.

I want to acknowledge and pay tribute to some of the very good things your industry has achieved since deregulation and corporatisation nearly five years ago.

These include:

·-efficiency gains with corporatisation and a much clearer business focus
·-improved customer service
·-the development of competition for larger consumers, with sharper prices and more responsive service

·-more accurate pricing for many customer groups. This has involved the removal of cross subsidies to smaller consumer groups. Not popular, but necessary. While prices have risen for domestic consumers, they have fallen for industrial and commercial users. There is a question of whether this rebalancing has now gone too far however

·-the establishment last year of the wholesale electricity market. This was a major achievement by the industry as a whole, and a demonstration of what can be done with focus and motivation

Equally, some impressive achievements have been made in the upstream sectors, transmission and generation. I'm reminded repeatedly how significant these sectors are, usually when a retail company is justifying to customers why it is putting up it's own prices. About 70 percent of total electricity costs derive from generation and transmission, most of it Government owned.

It is for this reason the major benefit, in terms of reducing costs, have come from the
reforms in the generation and transmission sectors:

·-an 18 percent reduction in wholesale prices since corporatisation and then the split of ECNZ, with a substantial reduction in staff numbers and a 10 percent boost in capacity from more efficient use of plant. Contact Energy has made impressive gains

·-an 18 percent reduction in per unit transmission costs since the establishment of Trans Power.

If nothing else had happened, we should have expected a drop in average energy prices in the last 10 years.

In fact we do not seem to have achieved this.

So what seems have been happening is that many of the gains of reform and
deregulation at the generation and transmission end of the market have been soaked
up by shareholders in retail power companies and by some consumers(eg large
industrial consumers and those consumers able to enjoy rebates).

I note, as a point of interest that comparative price reductions over the last five[?] years are ? for generation, ? for transmission and ? for distribution including retailing. [Gary Eng to provide].

Further reform in generation and transmission

The Government is determined to press for more efficiency gains in generation and transmission however. Further breakup in generation is being actively considered. This will lead to lower wholesale prices, provided it is accompanied by other reforms elsewhere in the electricity market.

One important part is to remove the present constraints on ECNZ, which comprises about 70 percent of the generation market. If it is to be further split, and the generation companies are of similar size, they should be allowed to compete in generation and in the sale of energy.

Without strong energy traders in the marketplace, there is little chance of consumers getting real choice and control.

The Government is prepared to take a hit on the value of its SOE assets but only if the benefits flow to the economy as a whole. A key part will be to ensure lower wholesale prices are passed on to consumers, and consumers gain choice and control over their power bills.

On transmission, we recently introduced a new SCI for Trans Power emphasising the priority of efficiency and lowest costs over commercial objectives. It also required Trans Power to ensure its customers set the grid security standards they are prepared to pay for, and to make its services contestable wherever possible. We will also revisit the adequacy of the ODV valuation methodology for monopoly lines businesses.

Retail Distribution Sector

Let me turn now to the distribution sector. When the Government said it was going to look at further reform in generation, the distribution sector applauded. This seems to have turned to dismay when we said we also intended to review the distribution sector.

Many power companies have become very defensive and are arguing vigorously that things are just fine without much further change.

Indeed, in recent days I have had drawn to my attention a campaign being run by one of your large members against the Government's intention to undertake further reforms.

Under the guise of wanting a "robust intellectual debate on the role of government in a modern economy", the campaign argues that "disaggregation and privatisation" is the answer, despite the fact that the company pursuing the campaign shelters behind an ownership structure that is neither privatised nor disaggregated.

Furthermore, the Government's options are described as "an ad hoc populist response to a perceived problem" and raises the spectre that the Minister of Energy "will be turning his mind to other industries… and… force separation of... facilities in the oil industry… then extrapolate this logic to other network industries, for example telecommunications and gas."

This campaign is nothing more than a scurrilous scare campaign, designed to put the frighteners on a number of companies who own and operate near-natural monopolies, presumably to encourage them to lobby the Government in secret.

My message to your industry is simple: if you want a robust "intellectual" debate on the issues you can have it. For its part the Government has done this , and will continue to do it through an open, public process of consultation where we have asked for written submissions from all participants in the sector.

I spend much of my time talking in open public forums like this about what the problems are, and what the Government's thinking is. None of it is in secret.

The final proposals from the Government will be made public and be subject to the normal open, Parliamentary processes.

That is the way we work, rather than an underground campaign by one or two of the big players in your industry.

The simple fact is there are weaknesses in our regulatory regime for electricity, and, understandably, many power companies have sought to exploit them.

These weaknesses were highlighted a couple of years ago by BZW.

It is worth just recalling some of the rather prophetic things said at the time.

The basic thesis of BZW was to advise retail power companies(ESCs) how they could increase their returns in the following manner.

"Overstate the value of assets employed".

The text said in relation to the Information Disclosure Regulations, that "the valuation guidelines are broad and can be exploited… and…we believe upward revaluation of distribution assets is the easiest way for ESCs to increase their earnings potential".

What has happened? Over the last couple of years we have seen a jump in ODV values. Some noteworthy examples are Mercury by 20 percent in ? , Power New Zealand by? [etc]. and Southpower by 25 percent in 1997.

Southpower's revaluation gave it a 30 percent accounting rate of profit in 1996/7. It then turned round recently and raised its prices, substantially blaming the Government because it removed the South Island power subsidy!

"Overstate distribution costs".

Secondly, BZW advised retail power companies to "overstate distribution costs".

"Profit maximising ESCs will use the opportunity to allocate as many costs [as possible] away from generation and energy trading, and into the distribution network".

This advice seems to have been followed in some instances. One mid sized company, for example, shows a total asset value in its retail network of $126,000, including one motor vehicle.

"Exploit the non-interventionist attitude of the regulator".

Thirdly, BZW encouraged companies to "exploit the non-interventionist attitude of the regulator".

"The Government is unlikely to impose price restraint without extensive warning and negotiation".

There is some realism in this view. Centre-right Governments don't like to price control or to directly regulate industry.

I am certainly in that category, but having said that neither I nor this Government will stand idly by and see consumers gouged by one or two companies using their market power or dominance to extract monopoly profits.

That goes for Government owned SOEs as well, and that is why we have changed direction through, for example, the new Trans Power SCI.

The answer is not control, but competition - effective, lasting competition where no one market participant dominates or controls competition in the marketplace.

We have recently completed our 1996/97 price statistics. [Slide]. This shows some interesting results. Wholesale and transmission prices continue to fall. At the same time average delivered energy prices have risen, for the second year in a row.

Domestic prices continue to rise. In the past this appeared to be driven by rebalancing as prices for commercial and industrial consumers fell. Since 1995 however, all categories of prices have risen.

Moreover, some companies' prices appear to be well out of line. For example, the median price for an 8000kWh/year consumer is ? c/kWh.

The Ministry of Commerce has experienced some difficulties in compiling 1996/97 statistics. Interestingly, the greatest difficulties, in terms of late or plain wrong returns have been experienced with three of the four largest power companies. One very large company was unable to separate its line and energy statistics, which is a real worry and doesn't inspire much confidence in a timely information disclosure regulatory framework.

Long run returns

Finally, BZW believed that retail power companies could get above competitive market rates of return out of the present regulatory framework. That is another way of saying monopoly profits, where consumers pay for them.

"We estimate that ESCs will achieve long run rates of return on average 2 to 3 percent higher than an objectively determined WACC".

The point here is that companies cannot do this in a competitive market. Only companies with natural monopolies or considerable market power can sustain returns like this.

It is noteworthy that the capital markets seem to share BZW's conclusions. Several takeovers and mergers have occurred at substantially above ODV values, including adding in retail, generation and other non-line assets.

Moreover, analysts tell me that a substantial premium is being paid over asset values for shares which are subject to trading.

This indicates to me that capital markets do not think the regulatory regime, or competition, will prevent companies taking monopoly rents.

I don't buy the argument uncritically that these share and takeover prices simply reflect the efficiency gains the new owners expect to achieve. The main assets are lines, and correctly measured ODVs require optimisation of the lines: in other words efficiency is already built in to the ODV.

I'm not apportioning blame here. BZW rightly drew attention to weaknesses in our regime, and businesses have moved to take advantage of them. The drive of businesses is to exploit opportunities.

Equally however, the Government has a responsibility to address market power where it seems it is being misused, or competition is shrinking or is controlled by one or two players.

Disappointed Expectations

For those people who believed that continued public ownership of their retail power companies would protect them from such behaviour, the BZW advice and conclusions will come as a shock.

If anything, community ownership of about two-thirds of the retail industry has done little to give consumers, and particularly household consumers, the break they deserve from 10 years of reform.

One statistic of concern to the Government is the apparent shrinking of competition within and between, retail power company regional areas.

The latest information is that in the last two years, sales of energy by other electricity companies or traders has fallen rather than increased - from an already totally inadequate 7 percent to under 5.

This development is hardly a sign of healthy and developing competition.

The Government will play its part in establishing an effective competitive market with what it brings to the forthcoming round of reform.

Your industry has to play its part as well, not only by saying you believe in and welcome, competition, but most importantly by getting the structure right to allow consumers to have real choice and control over their energy supplier and to allow competition to flower.

Access to lines

Moving beyond the BZW analysis, there are other concerns about lines, and in particular lines combined in a vertically integrated business with contestable activities like retailing and generation.

One is access to lines and network facilities for competing retailers. On the positive side, it is evident that many access agreements have been negotiated. Complaints to the Commerce Commission are declining.

At the same time, I still hear many reports of difficulties with access. These range from extra charges for new retailers to continual delays and other niggles, to over-charging of new developers and consumers by lines businesses.

Surprisingly, it appears that many power companies will still only offer conveyancing agreements to new retailers, whereby the customer ends up receiving two bills, one from the lines business and one from the new retailer. Not surprisingly, this is unattractive to most customers.

Cross subsidies and capital market pressures

Another concern is cross subsidies and inadequate capital market pressures.

The current regulatory regime, including the proposed new information disclosure regime, leaves considerable scope for creative transfer pricing.

Cross subsidies from the lines business or captive retail customers to large retail customers and generation is very difficult to prove or disprove.

However, there are some grounds for concern. The gross energy margin - the difference between energy only prices and wholesale energy prices - is 15 percent for domestic and commercial consumers. This seems rather high given that retailing is relatively low cost. In contrast, the margin for industrial consumers is minus 7 percent.

There is also widespread awareness that we are going into a period of excess supply of generation. Some 1350 MW of new plant has been built or committed at a time when increased demand only requires the addition of around 100MW a year.

So much for all the gloom and doom-saying over recent years, much of it emanating from this Association, that no-one would build new plants unless the price went up and that we were heading into a supply crisis.

In a normal market, when oversupply looms, prices tumble, and investors and shareholders take a hit for investing when they should not have. This is the critical discipline on investment decisions in a competitive market.

It is not at all clear to me that these disciplines will apply to generation investments made by vertically integrated power companies. They have the ability to recover from poor investment decisions on the backs of their captive customers.

Ask yourself honestly: who will ultimately pay for poor generation investments: shareholders and management or consumers? If it's the latter then we do not have a truly competitive market. It's as simple as that.

I know there are those who will say we would not be facing an oversupply situation if Contact, a state owned generator, had not committed to build Otahuhu.

This is as may be, but the key point is that Contact does not have any captive customers. It is operating in the competitive spot market, unlike vertically integrated companies with imbedded generation and captive regional customers.

On the other hand if Contact gets it wrong, the Crown as shareholder will take a hit, and I can assure you that Contact's board and management will be held accountable.

Consumers will not be the sacrificial innocents in Contact's case, management and the Board will.

Can the same be said of retail power companies with imbedded generation and little competitive energy trading within its supply area?

Amalgamations

The final area of concern is the painful slowness of amalgamations since the
Reforms began. In five years the number of power companies with lines has only reduced from 44 to 36. [Check]

The balance is badly skewed as well.

One company has 48 percent of the New Zealand market, and the rest is shared amongst 34 retail power companies.

There is clear scope for efficiency gains in distribution businesses. The Ministry of Commerce has recently calculated that if all distribution companies were as efficient as the fifth most efficient company, which is Mercury, the potential gains to consumers and the economy are conservatively estimated at $40 to $100m a year. A good part of these efficiencies are available from economies of scale.

So what is restricting the amalgamation of power companies? Amongst the answers are parochialism, ownership structures which prevent normal capital market pressures, and the bundled nature of power company operations.

It is an ongoing irony that the companies, which recognised the benefits of capital market pressures, are now vulnerable to takeover from companies which are not themselves subject to takeover.

While I favour ongoing rationalisation in the industry, I am at the same time concerned about undue dominance, particularly by vertically integrated companies based around lines and where they are not subject to capital market disciplines because of their ownership structures.

Options for reform

All of this says it is timely for the Government to be considering the options for further reform in distribution.

This is especially the case when we are also considering further reform in generation. This is likely to reduce wholesale prices and we want to be sure consumers see the benefits.

There is a range of options available to the Government, and the costs and benefits of each will need to be considered carefully. No one option addresses all the issues I have identified today. This means a menu of options will have to be implemented. Nor are the options necessarily mutually exclusive.

What are the options?

1. Enhanced information disclosure

The options start with an enhanced information disclosure regime, which has been worked on extensively by officials and interested parties. It could be beefed up further by providing for more user friendly information to consumers, greater analysis of disclosed information including more benchmarking of prices and efficiency measures.

You will be aware of my scepticism about the robustness of information disclosure however, given its after-the-event nature and the incentives on parties to find creative ways around accounting rules. I fear consumers and officials will be always behind the play.

2. Structural reform

Other options include structural reform, to try to ensure that the right incentives are in place on a day to day basis. The key option here is separation of the lines business from contestable businesses, notably the sale of energy and generation. The sub-options are full ownership separation or corporate separation.

This is consistent with the current regime. We already require full accounting separation of lines and energy as if they were separate businesses. Corporate or ownership separation goes a step further in putting in governance arrangements to make this more of a reality.

There are plenty of precedents for corporate or ownership separation of contestable and non-contestable businesses. The Government, to the applause of your industry, separated Trans Power from ECNZ to deal with conflict of interest problems, but your industry seems reluctant to implement this for yourselves.

I understand that Queensland and California, after looking at the experiences of those who deregulated before them, are proposing to require separation.

3. Price control

Further options for reform include price control to remove monopoly rents which are the source of overpricing and cross subsidies. Interestingly, every country or state which has deregulated its electricity industry, including those in advance of us, have retained price control on parts of the industry where there is market power.

As Minister of Energy, I have the statutory authority under the Commerce Act (as amended by the Ministry of Energy (Abolition) Act) to initiate price control in the energy sector, which would be managed by the Commerce Commission.

Such price control need not be imposed across-the-board, but could be targeted at particular companies.

As most of you know, the threat of price control has always been an explicit part of our regulatory regime here. Threats lose their value if they lack credibility through never being used, but that is a risky strategy to build a business on given governments can change.

4. Profiling

Another option under consideration is deemed profiling to encourage competition for smaller consumers. This would be a temporary option until the costs of time-of-use metering and related data processing are no longer a barrier.

As you know, I am very keen to see New Zealand become a world leader in metering technology for business and households. To achieve this, the industry needs to ensure there are open, transparent, and common pricing access arrangements across the electricity network; easy and inexpensive "clearing house" rules for settlements; and seamless choice for consumers.

The industry, through EMCO, needs to make rapid progress in this area, and I will be following developments closely over the next few months.

I welcome and commend the trial on profiling being carried out by Southpower and United Electricity. I would like to see much more pro-competitive activity by other power companies too.

In the absence of this, consideration will need to be given to the role of the Government in facilitating the emergence of competition for smaller consumers, not just domestic consumers, but also smaller commercial customers.

5. Amending the Commerce Act

A final option is the generic one of strengthening the ability of the Commerce Act to deal with regulatory issues relating to access to networks. This may include such things as increasing penalties for breaches, incorporating access principles and, if possible, speeding up processes.

Work is ongoing in several of these areas, and the generic option will require careful consideration. However, amendment to generic legislation is not a speedy or easy process, given the wider implications for other sectors.

Conclusion

To recap, our first round of reforms in the electricity industry have resulted in tangible and very worthwhile improvements. However, there is little doubt in my mind that we are not there yet, that we are not yet enjoying the full benefits of vigorous competition, and that the time has come for a serious look at a further round of reform. I hope that we will have decisions, at least in principle, on a further reform package by Christmas.

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