Rebstock: New Zealand Energy Summit
8th Annual New Zealand Energy Summit 17 July 2006
Chair, Commerce Commission
1. Good morning and thank you for the opportunity to provide an update of Commerce Commission activity in the energy sector.
2. Today I will focus on the Commission’s current enforcement and regulatory activities relating to energy.
3. In the enforcement area I will briefly touch on the Commission’s investigation into the electricity industry under Part II of the Commerce Act.
4. Then I will comment on the joint marketing of gas and the Commission’s recent revocation of its authorisation for joint marketing of gas from the Pohokura field.
5. Finally I will touch on the Commission’s two recent decisions under the Electricity Industry Reform Act.
6. On the regulatory front I will begin with an overview of electricity regulation under Part 4a, and consider how the regime is working, and where the biggest gains have been made.
7. Then I will look in more detail at some aspects of the electricity regime including administrative settlements, information disclosure, pricing issues and incentives for investment.
8. Finally I will provide a brief update on the Commission’s work in the gas control area.
9. I will be happy to answer any questions at the end of the presentation.
10. The Commerce Act is one of the key pieces of legislation enforced by the Commission. Part II of the Act prohibits understandings that substantially lessen competition; price fixing, and taking advantage of market power to deter entry to a market.
11. At present, we are investigating whether breaches of Part II of the Commerce Act have occurred in New Zealand’s wholesale and retail electricity markets.
12. In theory, effective competition in a market subjects prices to downward pressure. In an industry with multiple suppliers, high prices may be due to numerous factors, one of which may be industry participants acting collectively to increase prices. Alternatively, firms that enjoy a substantial degree of power in the market may have used that power to prevent competition to keep prices high.
13. There is public debate about whether New Zealand electricity prices have been at workably competitive levels. The Commission has received complaints from residential and business consumers, not only about prices, but also in relation to other behaviour in the marketplace. On this basis the Commission opened its investigation.
14. To complete its investigation the Commission requires substantial amounts of complex data. This data has taken considerable time and effort to obtain, and the quality and availability of industry data (particularly going back four or five years) has, in many cases, been less than satisfactory.
15. Obtaining robust historic information has been a challenging task and despite the use of its information gathering powers the Commission is finding that its timeframes are continually being pushed out.
16. While some may consider our requests for information are excessive, it is worth noting that, in many jurisdictions around the world, much of the data we have gathered for this investigation would have to be disclosed either publicly or to a regulator as a matter of course.
17. To assist with the analysis of the information the Commission has gathered from industry participants, we have engaged the economist Professor Frank A. Wolak of Stanford University. Professor Wolak is also Chairman of the Market Surveillance Committee of the California Independent System Operator for the electricity supply industry in California, a visiting scholar at the University of California’s Energy Institute and a Research Associate of the US National Bureau of Economic Research.
18. A major focus of Professor Wolak’s work over the past twenty years has been the empirical analysis of market power. He will be constructing a measure of the ability of participants in both the retail and wholesale markets to raise prices above competitive levels. Clearly, factors such as electricity demand, water availability and network constraints, amongst others, will feed into this analysis.
19. By the end of the investigation, the Commission will have been able to analyse more information about the workings of the electricity market than any other person or organisation in the past, and will hopefully be in a sound position to draw robust conclusions about the operation of the market, the competitiveness of observed prices, and the behaviours of the participants in the market.
20. The Commission is very clear that this investigation is not an inquiry to determine whether policy decisions need to be made about the structure or design of the market. It is inevitable, however, that information relating to the structure and design of the market will be thrown up during the investigation.
21. In deciding what information will be made public at the conclusion of its investigation, the Commission will strive to strike a reasonable and legal balance between protecting the rights of the industry participants under investigation and the rights of New Zealand electricity consumers and interested parties to transparent, fair and reasoned answers to their concerns.
22. Critical to the outcome of this balancing exercise will be whether the Commission identifies any anti-competitive behaviour which should be brought before the Courts. Should there be no basis for legal proceedings, the Commission will need to consider what information should be publicly provided in the closing investigation report.
23. The Commission is seeking to finish its investigation as quickly as it can, without compromising the integrity of its processes or the robustness of its analysis.
Joint Marketing of Gas
24. The Commission last month revoked an authorisation it had given to the Pohokura joint venture partners to jointly market gas from the Pohokura field. For those not familiar with the case, in 2003 the Commission concluded that if the parties in the joint venture (Shell, Todd and OMV) marketed and sold the gas in the field jointly, the gas production market would be less competitive than it would be if each had sold their equity share of the gas separately. However, the Commission authorised joint marketing because it was persuaded that joint marketing was necessary to achieve early production from the field.
25. Things turned out somewhat differently from what had been anticipated. The joint venture parties who had previously been adamant that separate marketing was extremely difficult and would cause delays in field development of perhaps seven years, discovered that it was easier than joint marketing and proceeded to sell separately rights to perhaps half the reserves of the field without it causing any obvious delay in field development. In other words the predominant benefit claimed for joint marketing (and the one on which the Commission based its authorisation) was lost.
26. As a result the Commission considered it appropriate to revoke the authorisation. Any future variation from separate marketing of Pohokura gas will put the parties at risk of breaching the Commerce Act.
27. One point to note from this case is that the Commission will have no compunction about revoking authorisations it issues under the Commerce Act if it is demonstrated that they were based on false or misleading information, or if there has been a material change in circumstance since the authorisation was granted.
28. The other comment I would make is that the Commission does not have a general objection to the joint development of gas fields, or the joint marketing of gas from those fields. Each case is considered on its merits. The important relevant feature of Pohokura is the significance of the field (accounting for something like 39% of New Zealand’s total reserves) and of the significance of the joint venture parties (which between them have a substantial interest in fields together accounting for around 77% of total reserves). Other parties with other fields are very unlikely to raise the same competition concerns.
29. In addition to our work under the Commerce Act, the Commission also has responsibility for enforcing the Electricity Industry Reform Act. In 2001 the Act was amended to allow for lines companies to invest in unlimited new renewable generation activities. However, these investments must still be made in accordance with the corporate separation and arms-length provisions of the EIR Act.
30. Recently, the Commission considered the first two applications for exemption from these provisions: one from Unison Networks and the other from Eastland Networks.
Unison exemption granted
31. Unison sought an exemption in respect of its proposed investment in a wind farm by way of a joint venture with Hydro Tasmania. Unison sought exemption from the Arms Length Rules in the EIR Act and permission to enter into electricity hedges. Unison did not propose to retail the electricity to customers connected to its own network.
32. The Commission granted a limited exemption to Unison in respect of certain Arms Length Rules relating to the appointment of managers to the board of the joint venture company. The exemption required the other Arms Length Rules to be observed. The exemption is also conditional on Unison not retailing the electricity to customers located on its own network, and on the generation asset not being connected to Unison’s electricity lines networks.
Eastland exemption declined
33. The second wind farm application was from Eastland. Eastland also sought an exemption from the obligation to comply with the Arms Length Rules and from the prohibition against trading in electricity hedges. Eastland, as part of its proposal, intended to retail the electricity generated directly to customers on its own network.
34. Following an extensive investigation, the Commission determined that the granting of an exemption would be likely to give Eastland the incentive and opportunity to inhibit competition in the electricity industry, particularly in those areas where the distribution network is operated by Eastland.
35. The Commission considered that such incentives and opportunities would include the potential for the lines business delaying or inhibiting access to its lines by its retail competitors and the lines business having information advantages regarding customers on its network, to the disadvantage of other retail competitors.
Conclusion on EIRA
36. The Eastland and Unison applications had features in common, including that they were both proposing to build new renewable generation.
37. While the amendments to the Act allow a lines company to retail electricity from renewable generation, it requires those companies meet the Arm’s Length Provisions in the Act to limit the extent to which they can favour their own retail business over others.
38. In its case Eastland was proposing to retail the electricity it generated to users connected to its network, and this meant that it may be able to inhibit other electricity retailers from competing with its retail business.
39. The important distinction with Unison was that Unison was not proposing to retail its renewable generation on its network Therefore, Unison would not have an incentive to inhibit retail competition. Accordingly the Commission decided to give a partial exemption from the arms-length rule to Unison, but found it was unable to give a similar exemption to Eastland.
Part 4A introduction
40. I will now move on to our regulatory activities for electricity and gas lines businesses.
41. Part 4A of the Commerce Act, relating to electricity lines businesses, came into effect on 8 August 2001.
42. Part 4A encompasses a targeted control regime, and also an information disclosure regime, for the 28 distribution businesses plus Transpower.
None of the electricity lines businesses are automatically
subject to control of their prices, revenues, and/or quality
of service. The Commission cannot make a declaration of
control, and then authorise prices, revenues or quality,
unless a lines business has breached one or more performance
thresholds set by the Commission.
44. The Commission has established two such performance thresholds to assess the lines businesses:
a price path threshold; and
a quality threshold.
45. These two thresholds are in effect until March 2009, at which time they will be reset following consultation with interested parties. I will comment more on the 2009 threshold reset later.
46. First, I would like to make a few observations about the impact to date of the targeted control regime, which has now been in place since June 2003.
What the regime has achieved
47. The price path threshold provides incentives for lines businesses to improve efficiency, share efficiency gains with consumers, and limit their ability to extract excessive profits.
48. The quality threshold encourages lines business to supply electricity transmission and distribution services at a quality that reflects consumer demands, and to not let that quality reduce in pursuit of lower costs and higher profits.
49. To comply with the current CPI minus X price path threshold, around two-thirds of lines businesses have had to reduce their average prices in real terms over the last three years and they face further reductions over the next two years. Given current inflation rates, all businesses have been able to increase prices in nominal terms. However, limiting price increases to be less than inflation provides incentives for businesses to make efficiency gains and, over time, to share those gains with consumers.
50. A small number of businesses can increase their average prices at a greater rate than inflation without the prospect of further scrutiny from the Commission. This is because the Commission has found that some companies, while they appear to be relatively efficient, have been setting prices at a level that is not sufficient for re-investment in their networks over the longer term. The price path threshold is flexible enough to allow for companies in very different situations.
51. So while the perception may be that New Zealand is moving closer to other jurisdictions’ approaches to regulating electricity sector monopolies, the targeted control regime is still light handed by international standards. It allows companies to make their own business decisions about price, quality and investment within broad boundaries of behaviour and is flexible enough to allow workable solutions to be developed without necessarily moving to control.
What happens when companies breach?
52. A breach of a threshold is not necessarily a breach of the law. A threshold breach simply alerts the Commission to take a look at the circumstances and, if necessary, investigate in more depth the current and future performance of the business.
53. The Commission must strike a balance. On one hand, we must assure New Zealand consumers that these companies, which are natural monopolies, are not exploiting their market power.
54. On the other hand we must ensure that the companies are able to run their businesses efficiently and have incentives to make appropriate investments.
55. To allow us to balance those imperatives, there are a number of options available to the Commission in responding to a breach of the thresholds.
56. First, the Commission may decide that, following a breach, there is no need to take further action, because the business may be performing in a manner consistent with the long-term benefits of consumers.
57. Secondly, the Commission may consider it possible to resolve the breach through an administrative settlement between the Commission and the business concerned.
58. Finally, should the Commission be concerned about the performance of the business, but be unable to reach an agreement with that business, it cannot automatically impose control. The Commission must first publish its intention to declare control and then consult with interested parties. It is worth noting that the Commission can enter into an administrative settlement at any stage of this process.
59. To date, the Commission has published an intention to declare control for only two lines businesses: Transpower and Unison Networks. In response, both companies have sought to settle with the Commission. We are also considering administrative settlement offers from a number of other businesses.
60. The Commission considers that administrative settlements may, in principle and in certain circumstances, produce better outcomes for consumers. They may allow for greater flexibility, should involve lower administrative and compliance costs, and are likely to be less intrusive.
61. Each individual settlement would, however, need to result in long-term net benefits to consumers than are demonstrably equal to or greater than the net benefits of control. This suggests that settlements may need to last for a number of years, and address as many of the Commission’s concerns as is appropriate at that time.
62. If the Commission decides that an administrative settlement is acceptable in principle, then it will consult publicly on the terms of that settlement, and whether a settlement is appropriate. Apart from permitting feedback on the specific settlement terms, any public consultation process would also allow interested parties to provide their views on the Commission’s proposed broader framework and processes relating to the evaluation of settlements.
63. It is important to make the point that that what might be acceptable to the Commission as part of a settlement cannot be seen as a proxy for the terms on which control might subsequently be imposed, if a settlement is not able to be reached.
64. If the Commission is unable to reach an agreement, and it decides that a declaration of control is appropriate, then further consultation may also take place. This may be the case where there is a sufficient amount of new or updated information to warrant feedback prior to a final decision on control.
65. One area of concern however, is that the settlement process has in some circumstances been used to relitigate industry-wide matters, for instance, the Commission’s ODV Handbook. The settlement process should be used to discuss business-specific matters, and relitigation of past decisions is not an appropriate use of the administrative settlement process.
66. I should also stress that resolution of significant breaches is not intended to be a lengthy process. While it is good that some businesses have deferred or reversed price increases in order to work through a settlement, the Commission will become concerned if the settlement process is too drawn out.
67. If the settlement process does take a long time, it suggests that there are complex issues involved that require a full “bottom up” analysis of the company to come to an informed view. In those circumstances control may be a more suitable option than a settlement.
68. Furthermore, the Commission may consider moving much more quickly to announce whether it intends publishing a declaration of control on the basis of information before it, rather than waiting to see whether a settlement offer emerges.
69. Let me now turn to the information disclosure regime.
70. Information disclosure is intended to ensure that businesses make information about their operation and behaviour publicly available. Timely and reliable public disclosure is a vital part of the regulatory regime.
71. The information disclosure regime promotes a greater understanding of the relative performance of lines businesses over time, provides information for assessing threshold compliance, and aids in the resetting of thresholds.
72. The Commission is currently undertaking a far-reaching review of the Electricity Information Disclosure Requirements. This considers the fundamental question of what regulatory performance accounts should look like in the context of Part 4A, while at the same time assessing the compliance costs to lines businesses of producing disclosure information.
Asset management plans
73. A key priority for the Commission in this review has been to improve the disclosure of asset management plans, and the new requirements for these plans were released in March this year.
74. In the Commission’s view, sound asset management planning is an integral part of ensuring that distribution businesses improve efficiency and provide quality services. The new requirements will see businesses reporting back on actual versus planned investment and maintenance expenditure, and explaining any differences.
Pricing methodologies and line charges
75. The Commission is currently consulting on revisions to the disclosure requirements for lines business pricing methodologies and line charges. Past compliance against the existing requirements has been a particular concern with all businesses having been required to re-disclose their 2004 and 2005 pricing methodology information.
76. In the Commission’s view, the disclosure of pricing methodology and line charges is essential for helping different consumer groups understand the costs and share of profits to which they are contributing when they pay their electricity bill. Such disclosures also keep industry players informed about pricing and cost allocation policies, thereby encouraging lines businesses to evaluate the factors which drive their costs and therefore the extent to which their line charges are cost-reflective.
Financial performance measures
77. The Commission is preparing new financial information disclosure requirements including key performance measure such as the return on investment. The release of these has been delayed and the Commission will be updating businesses further on the likely release date. The due date provisions will be amended to allow businesses five months from the release date in order to complete and audit their disclosures.
78. The Commission will be requiring disclosure under the new financial requirements for the year ended March 2006 to enable at least two years’ worth of information to be used as an input into the 2009 threshold reset. Lines businesses will need to cooperate with the Commission on information disclosure if they wish key factors to be taken into account in the 2009 reset.
79. The Commission is intending to hold a workshop with businesses and auditors to assist with understanding the new information disclosure requirements once they have been released. The new requirements, together with the targeted control regime, will constitute the twin pillars of a coordinated and effective regulatory framework.
Key issues going forward
80. I would now like to share with you a number of key issues for the Commission in respect of both the targeted control and information disclosure regimes going forward.
81. The Commission has yet to resolve a number of threshold breaches, particularly where the quality thresholds have been breached due to increases in network outages. Clearance of these breaches has been delayed while the Commission finalises its criteria for determining whether weather or other events that impact system reliability can be considered “extreme”.
82. Clearance of price path breaches occurring during the same assessment period has also been held up, as the Commission considers these breaches together. We intend resolving these over the next few months, as well as those post-breach inquiries into businesses that have not approached the Commission with a settlement offer.
83. On the subject of threshold compliance, I do also need to express the Commission’s disappointment concerning the quality of the certifications of threshold compliance statements by some auditors. Should this continue, we may need to consider introducing a process for certifying the auditors themselves, as is the case in many international jurisdictions.
84. The Commission is beginning to gear up for initial rounds of consultation on key issues relating to the 2009 reset. We will be canvassing the views of interested parties as to what extent a number of issues that have arisen in implementing the regime to date should and could be taken into account in the revised thresholds from April 2009.
85. Possible incentives or disincentives provided by the regime will be a key area of focus, with possible topics including any impact of the regime on increased distributed generation and changes in the transmission/distribution boundary.
86. More generally, however, the Commission is particularly interested in views on investment incentives. Much anecdotal evidence exists regarding the burgeoning capital expenditure needs of the electricity lines sector—the so-called “wall of wire”.
87. As I mentioned earlier, the recent changes to the disclosure requirements for Asset Management Plans will help the Commission monitor the need for increased investment on a business-specific and industry-wide basis.
88. These changes, particularly the requirement for businesses to explain discrepancies between planned and actual investment, will also allow the Commission to monitor whether planned investments actually proceed. Recent experience from overseas jurisdictions suggests that utilities do not always deliver on their forecast capital expenditures. The Commission intends exploring the application of possible investment incentive and accountability mechanisms in either the thresholds, or in other regulatory instruments under the targeted control regime.
89. The Commission is also interested whether the governance arrangements of trust-owned lines businesses might result in too great a focus on providing short-term rebates to consumers rather than on meeting long-term investment needs. The Commission would also be concerned if it found that trust-owned lines businesses weighted their investment or pricing decisions in favour of their consumer owners.
90. More generally, the Commission has concerns about the level of cross-subsidies between different customer groups. This has now become a major point of focus for us given evidence that we have uncovered during some post-breach inquiries to date, as well as through the pricing methodology disclosures. The Commission is very clear that businesses must not have economically unjustifiable differentials between customers, either by region or by customer class.
91. Companies that do not meet this requirement for any reason need to fix that problem now, as the Commission will take action to ensure that one group of consumers is not subsidising another. Certainly such imbalances must be corrected before the 2009 reset, subject of course to relevant constraints that government policy places on pricing.
92. If such businesses breach in the meantime, then this is an issue we may look at closely. If a lack of cost-reflective pricing appears to remain an industry-wide concern by the time of the reset then we may need to consider whether the reset thresholds are specifically re-designed to address this issue.
93. On a more positive note, as experience with the regime is gained over the next few years, it may be possible for the Commission to exercise its discretion not to assess all businesses every year where it is clear that businesses are achieving efficiencies and quality improvements, and cost savings are being passed on to consumers. This may help to further reduce compliance costs across the industry.
94. I would like to finish the regulatory update with an overview of the Commission’s progress on implementing gas control.
95. Since the Commission issued the provisional authorisation, we have been working towards issuing a final authorisation for Powerco’s and Vector’s gas distribution businesses. A Discussion Paper on the form of control was released last week. It sets out the range of options for form of control and the Commission's initial proposals as to the appropriate form of control for the controlled services.
96. The Commission proposes using a hybrid form of control with different forms of price control for three separate groups. For standard consumers the form of control proposed is a weighted average price cap. For non-standard consumers and for metering consumers a total revenue cap is proposed.
97. For the regulation of quality, the Commission is proposing a form of control that provides financial incentives for the businesses to maintain quality at the standards that are set by the Commission.
98. Details of the proposed form of control can be found in the Commission’s Discussion Paper on forms of control, and submissions on this Paper are due by the 7 August. Following this the Commission will hold a conference on the form of control on 5 and 6 September.
99. The Commission plans to issue the final authorisation in May 2007. It is expected that the pricing impact of the final authorisation will be felt by consumers through the annual price changes which occur each 1 October.
100. The Commission recognises the importance of giving both the businesses and retailers sufficient time to implement the final authorisation. However, it is important that there are not unacceptable delays to the process. All parties, including the retailers, are expected to fully pass the effect of the final authorisation through to consumers in a timely manner. The Commission will closely monitor the market to ensure that the intention of the Authorisation is carried through.
101. While the Commission is working towards issuing the Final Authorisation, the 9% and 9.5% price cuts required by the Provisional Authorisation will remain in effect.
102. The Commission has decided not to amend the provisional authorisation, but if any further price reductions are found to be necessary when the final authorisation is reached, these can be backdated.
103. In closing, the energy sector continues to be a priority for the Commission, as the effective operation of the electricity and gas markets are essential to New Zealand’s economic performance.
104. The most important issue for the Commission in the energy sector is investment. Regulatory regimes must facilitate investment, and consumers must be confident that investment is being planned and carried out efficiently, is priced fairly, and is subject to public scrutiny.
105. Regulation is often criticised as a barrier to investment, but it is important to note that unregulated businesses will not always choose to make necessary investments. In New Zealand’s electricity sector we now have a pent up need for investment, because necessary investment did not occur in the past.
106. An effective regulator will not be swayed by unsubstantiated claims about barriers to investment. Any claims that regulation is discouraging investment must be substantiated. The Commission is planning substantial work in this area to consider what the investment needs in the sector are, before the threshold reset in 2009.
107. The Commission is very aware that as a regulator it is our role to ensure that investment does occur, and that it is efficient, transparent, and meets the long term needs of consumers. We will continue to work with industry to refine the regime so that the best outcomes can be achieved. And we will continue to maintain our independence, and require that submissions on investment incentives be substantiated with robust analysis.
108. Of course there is more to the Commission’s role than industry-specific regulation. As I noted at the beginning of this presentation, we have other tools at our disposal to address market issues that are not covered by regulation, and where there are competition or market structure issues, the Commission will undertake Commerce Act investigations.
109. And if consumers are not receiving accurate or reliable information to make informed choices, the Commission will investigate under the Fair Trading Act.
110. Through applying the appropriate tools the Commission can help ensure that New Zealand energy markets are dynamic, competitive and deliver the energy that is so vital to the welfare of New Zealand’s industrial, commercial and residential consumers.
111. Thank you for your time today.