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Bradford Speech: Free Choice in Electricity Market

Embargoed until delivery (about 4pm)
how difficult is it to achieve?

Thank you for inviting me to address this second meeting of the APEC Energy Business Network.

APEC economies will be spending billions of dollars on energy projects in the years ahead and I am grateful for this opportunity to share with you the benefits of New Zealand’s model for market reform.

The topic given to me today: Consumer choice in energy markets; is particularly apt.

Our objective in New Zealand has been a simple one – to achieve an efficient industry that gives the best deal to consumers, primarily through competition.

Regulation should be used sparingly, when it is clear that competition can’t provide the answer.

Key characteristics of the New Zealand electricity sector

Before I begin,I need to give you some background to the key characteristics and unique features of the New Zealand electricity sector.

New Zealand’s 7,500MW capacity and consumption of 35,000 GW hours per year is very small on the world scale.

Seventy per cent of our generation is from hydro, 20 per cent from gas, 5 percent from geothermal, 3 percent from coal and 2 percent from other sources.

Two thirds of our electricity is generated in the South Island, all of it hydro, yet two thirds of consumer demand is in the North Island.

We also have a special problem, a vulnerability to dry years because of the small size of our storage lakes.

The electricity generation sector at present consists of 3 competing State-owned companies comprising 60 percent of the market, and one major and a number of small private sector generators comprising the remaining 40 percent.

No licences are required to generate, distribute or retail electricity. Anyone can build capacity.

There are no restrictions on building new generation, other than a requirement to meet environment regulations and the electricity standards in the market.

The supply and demand signals, which any efficient market needs, are provided through a private company, Mco (The Marketplace Company Limited) which operates the New Zealand electricity market. Seventy five percent – 85 percent of the volume of electricity is traded through the market.

Our regulatory framework is provided by general cross-sector law.

Competition law is set by the Commerce Act.

Environmental law is set by the Resource Management Act.

And consumer law is provided by the Fair Trading Act.

We do not have any industry regulators except for the Commerce Commission, which is our competition and trade practices regulator.

With no restrictions on foreign ownership, and a predictable, transparent regulatory framework to provide investor confidence, New Zealand offers excellent investment opportunities.

Above all, we have no formalised “energy plan”.

An efficient competitive market is much more effective than bureaucrats in arranging risk management strategies to deal with hydro shortages or determining when new generation plant is required.

Background summary of electricity reforms

Until the late 1980’s the industry was characterised by vertical integration and public control.

Natural monopoly line businesses were combined with potentially competitive generation and retail activities.

Generation and transmission were amongst the responsibilities of a government department, while local distribution and retail was conducted by locally elected power boards or municipalities.

Extensive political involvement occurred in generation investment decisions which were not always economically rational.

Project management was not accorded the attention that meets best practice standards, and wholesale pricing was in part determined by political factors.

In the mid-1980’s a review of the Government’s role in the electricity industry took place.

The aim was to separate operational from other functions in order to introduce commercial disciplines.

In 1987 the Electricity Corporation of New Zealand, known as ECNZ, was set up as a State-owned enterprise, separating generation and transmission assets from the Ministry of Energy.

In 1992 the Electricity Act was passed removing statutory exclusive retailing franchise areas and opening the way for competition.

Also in 1992 the Energy Companies Act required corporatisation of the local distribution and supply authorities.

Diverse ownership structures resulted, with many companies owned by local trusts or local government, sometimes in combination with private interests.

A few companies were, or have since become, owned by private interests, and a degree of overseas ownership has occurred.

Comprehensive information disclosure regulations were introduced in 1994, requiring financial separation of the natural monopoly lines and competitive retailing and generation activities within common ownership.

Transmission was separated from generation in 1994, with a new State-owned enterprise, Transpower, established.

Ownership of the transmission network by the dominant generator was seen as incompatible with encouraging new entry to the generation market.

Separation was considered an essential part of the move to establish a robust wholesale electricity market.

In 1995 the generator, ECNZ was split into two competing State-owned enterprises.

ECNZ, with 70% of the market and Contact Energy with 25% (the remaining 5% was owned by distributors and retailers).

In 1996 a fully competitive wholesale market was established, run by all industry players without government involvement.

Remaining policy concerns - 1997

These major reforms of the late 1980’s and early 1990’s made some progress towards an efficient consumer driven market, but by 1997 significant policy concerns remained.

Competition in generation meant that ECNZ had to be broken up further. Barriers to retail competition had to be removed. Barely 3-5% of electricity consumption was subject to competition.

Some regulation was required on natural monopoly lines businesses to ensure the gains from competition in the wholesale market were passed onto consumers.

 So, in July 1998 The Electricity Industry Reform Act was passed. It required total ownership separation of electricity lines from electricity retail and generation, a pattern which is becoming increasingly common in other countries;

 ECNZ was split into three competing State-owned generators in April 1999;

 Contact Energy was sold in 1999, with a 40% cornerstone shareholding sold to a US–based company, Edison Mission Energy with the remaining sixty percent floated;

 tougher information disclosure regulations were introduced in 1999;

 the electricity industry, at the Government’s request, introduced in April 1999 a nation-wide system (based on customer profiles) which enables small consumers to switch retailer without installing time of use meters;

 the Government part-funded an Internet based information system to assist consumers in working out which of the new electricity retailers are offering the best deal; and,

 finally, midway through 1999, a Bill was introduced which would place monopoly line companies under price control. It is yet to pass through Parliament.

Electricity retail competition is flourishing

When you look at the electricity industry in New Zealand today, it’s hard to believe how far we’ve come in such a short time.

The Electricity Industry Reform Act came into force just 14 months ago, prompting a period of unprecedented change for the industry.

Ownership separation has unleashed forces of competition that had been kept in check even after power companies were put on a more commercial footing and deregulated in the early 1990s.

Now, 14 months on, competition is flourishing.

In Auckland, our largest city, domestic consumers supplied via the network now have a choice of 5 retailers.

And if you have a time-of-use meter, you may find one or two more knocking on your door.

In smaller centres, similar levels of competition have yet to develop.

As you’d expect in the early stages of development of a competitive market, the greatest competitive activity begins around large users and large concentrations of users.

At the most recent count there were about 10 retailers selling electricity in various parts of the country.

I can’t be more precise than that because new retailers and new retail initiatives keep emerging.

So far, over 60% of New Zealanders have more than one retailer supplying electricity in their area.

What’s more most of those can now buy electricity, if they choose to switch, at prices lower than before the reforms.

Competition will spread rapidly throughout the country over the next 12-18 months. Already we are headed towards 5-6% of consumers switching suppliers annually.

One of the reasons for my optimism is the dynamic state of the electricity retail industry.

We are seeing innovative marketing strategies like the retailer which links with a pay television company to offer discounted television subscriptions.

Something that’s particularly pleasing for me is that the development of competition is not just about retailer push.

There are examples of consumer pull as well.

I’m talking about the trend for businesses with operations in many parts of the country to buy electricity from one supplier.

A dairy farming group in one of our major dairy farming areas, for example, has cut a deal with an electricity retailer that is earning up to 15% savings for over 9000 dairy farmers.

The best-known of the consumer groups is a joint venture between a retailer and Federated Farmers, our national farmer’s organisation to earn savings of up to 10 percent.

Competition in the wholesale electricity market is also vigorous

The decision to split the major State generator ECNZ into three further companies has balanced the market much better.

And the sale of State generator, Contact Energy, to the private sector allows the State-owned generators to have their performance benchmarked against an investor-owned generator.

The Electricity Reform Transition Unit, which advised the Government on the split of ECNZ, said it expected average wholesale prices would be between 14 and 20 percent lower on average as a result of the introduction of vigorous wholesale competition.

Wholesale prices have, in fact, halved on average since the beginning of April 1999.

Having said that, these prices are probably too low to be sustainable.

But it does seem that the Transition Unit’s prediction will be achieved, and may even prove to be conservative.

Security of electricity supply

But what about security of supply?

Without direct Government control of generation, how can we be sure that the lights will stay on and that price won’t rise dramatically because of shortages in dry years?

These are concerns I still hear.

The concerns are particularly relevant given New Zealand’s very extensive use of hydro for generation, and the very small size of our storage lakes.

The establishment of competition between generators means that security of supply risks will be better managed.

There will be stronger incentives for all the generators to actively manage their risks, and for hydro-only companies to maximise the value of their water resources.

Both sellers and buyers on the wholesale market have access to the most reliable information available, and take that into account in making their investment decisions.

This could mean upgrading existing plant, improving efficiency, building new generation capacity or improving demand-side management.

Medium-term security is substantially provided by bilateral contracts, which sets medium-term energy prices between generators, retailers and some end users.

Again, information is critical to support soundly based decision making.

Rising electricity prices will act as an early warning mechanism of an impending shortage.

Under the previous arrangement, dominated by ECNZ, the impact of changing rainfall was managed internally.

Public warning systems were under-developed, and significant shortages sometimes occurred.

Under the new arrangements better price-shortage signals will assist generators, retailers and consumers to manage any future supply risks.

Put simply, generators that cannot supply during shortages or because of systems failure will not make any money.

Indeed, depending on their long-term contracts, they could lose very heavily.
What better incentive is there to ensure electricity supply?

Distribution line businesses – unfinished business

While it is easy to reflect positively on developments in generation, wholesale and retail electricity markets, I still have concerns about line businesses.

Line businesses are natural monopolies, and it is here that regulation has a role.

New Zealand consumers are almost certainly paying too much for the conveyance of their electricity.

Line prices should be falling, not rising.

Some of my concern stems from high line business valuations that allow line businesses to increase prices, without raising profits to levels that might attract regulatory attention.

Another cause of concern is the slow progress toward amalgamations.

There are currently only 4 lines companies with over 100,000 customers and 27 with fewer than 100,000 customers.

This suggests there is significant room for efficiency gains, lower cost operation, and therefore lower lines charges to consumers.

A defining event came in the course of ownership separation earlier this year, when power companies sold functions such as meters, meter reading, customer billing and call centres to retail companies without reducing line charges accordingly.

At that point, the Government reluctantly concluded that price control must be imposed.

It must be clear from this Government’s track record in promoting competition over our years in office that price control is not our weapon of choice.

However, we are prepared to use price control to make sure that consumers – at home and in business – reap the full benefits that the electricity reforms have to offer.

But the Government does not have the majority to pass the legislation that would allow us to take action.

I have no doubt though, that one way or another, we will see price control imposed on line businesses in the not-too-distant future.

How difficult is it to achieve free consumer choice?

In conclusion, I want to come back to the subheading of my topic; “how difficult is it to achieve (free consumer choice)?”

There are two messages you should take from my comments.

One is that it doesn’t need to take a long time to introduce retail competition once the legislative and commercial frameworks are in place, and if the Government gives a clear lead.

The other message is that it doesn’t require a lot of Government involvement – it’s better for the industry to undertake the detailed work, within a conducive over-arching legal framework.

For example, the introduction of low-cost arrangements for switching consumers between competing retailers, including profiling, does not require extensive regulation.

Industry participants are far better placed than Government to come up with a workable and cost effective scheme for switching supplier.

After all, it is the industry that has to work with the scheme.

A partnership of industry and Government ensures that the interests of both are met.

Fourteen months on I am in no doubt about the appropriateness and effectiveness of the systems the Government put in place.

Consumers are benefiting from choice, and they will benefit further once price control on lines is in place.

Thank you

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