Michael Clark, Director Networks Branch, 5 August 2006
Introduction
Today I would like to discuss the range of regulatory tools available to the Commission under the Commerce Act.
I am grateful for the opportunity to put forward the Commission's view on its regulatory work.
I will start with an overview of New Zealand's regulatory environment, and then focus on the Commission's work under Parts 4 and 4A of the Act, in relation to recommending or determining whether control should be imposed on goods or services.
I will then discuss the regime in Part 5 of the Act for controlling goods and services (sections 70 to 74 of the Act), and provide an update on the Commission's work in relation to developing control terms for gas pipeline services.
Regulatory environment
One of the Commission's main regulatory objectives is to ensure that markets operate efficiently and businesses are prevented from misusing market power. A competitive market environment allows efficient and innovative firms to flourish, consumers to get the best quality and prices, and New Zealand to make best use of its resources.
New Zealand's regulatory approach starts from the premise that general competition law should constrain the accumulation of market power through consolidation, and prevent the abuse of monopoly power where it exists. But competition law has limitations where markets are incapable of sustaining competition. In these circumstances, sound regulation may be the next best alternative. This is often appropriate for infrastructure industries where economies of scale mean that a single supplier is the most efficient form of provision, and that supplier has a natural monopoly. In many western economies such as the US, UK and Australia, these industries are subject to direct control from the start. New Zealand is unique with its more light-handed approach. In New Zealand we need to be persuaded that regulation is required.
There are a couple of features of the regulatory environment in New Zealand that differ from many jurisdictions overseas and that require us to exercise particular care in developing our regulatory frameworks.
First, regulation is effected through the Commerce Act and by the competition regulator, rather than through industry-specific legislation and regulatory bodies. (The exceptions is the telecommunications sector.)
There are both advantages and challenges to regulating in this way. For example, Part 5 leaves the Commission with considerable discretion over the form of regulation. This gives us the flexibility to tailor our approach to the circumstances of the industry in question. However, it also means that key elements of the regulatory framework are not enshrined in primary legislation, which entails a level of uncertainty for regulated firms. Recognising this, the Commission emphasises the importance of involving the industry in the development of our regulatory frameworks through consultation - we aim to limit regulatory uncertainty through openness and to reduce the risk of regulatory error through industry engagement on technical issues.
Industry-specific regulation restricts the exercise of market power by attempting to simulate the outcomes that might be expected in competitive markets. Regulation should not deter innovation or efficiency. Rather, sound regulatory regimes ensure that there are incentives for incumbent players to be innovative and efficient, and to share any resulting benefits with consumers.
Industry-specific regulation can take a number of forms, from the more generic provisions provided for in Part 4 and 5 of the Act to the targeted threshold regime used in Part 4A for the electricity line companies and the industry-specific access legislation applied to telecommunications.
The general regime for implementing control is set out in Part 4 of the Act. These provisions are intended to be a regulatory backstop. The control provisions should deter monopolies from earning excess profits, but deterrent provisions are only effective if there is credible evidence that they will be enforced.
The possibility of control became a reality in the gas industry when the Minister of Energy decided to impose control over the gas distribution services of Powerco and Vector.
In making its regulatory decisions, the Commission needs to achieve a balance between constraining market power and providing the right incentives to encourage efficient investment, innovation and production. The Commission is mindful of ensuring that companies have the ability to achieve a reasonable return on their assets and investments. The Commission does this not only through an assessment of WACC (Weighted Average Cost of Capital) but also by considering the impact of other regulatory settings on risks and expected returns.
However, I do wish to note that adequate returns are necessary for investment to occur, but they do not guarantee that it will occur. Even in the absence of regulation, infrastructure companies may choose to take profits in the short term rather than make replacement or new capital expenditure to deliver continued or improving quality of service over the long term. A history of this behaviour has led to a pent up need for investment, the so-called "wall of wire" currently facing the electricity lines businesses.
The Commission must, therefore, ensure that where consumers are required to pay for new investment, that investment is delivered. Businesses will not be allowed to raise prices on the basis that investment is required, and then fail to make that investment.
The Commission is also aware of the importance to investors of a stable and transparent regulatory environment. An important part of this is a coherent regulatory framework and consistent application of regulatory principles. The Commission recognises the importance of its decisions at this critical stage in the development of the regulatory regimes for gas and electricity, and seeks to make decisions that will enhance regulatory certainty and predictability going forward.
1 will now turn to the specific interrelationships between Parts 4A, 4 and 5 of the Act. In doing so I will draw on current examples, including the gas control inquiry and aspects of the electricity targeted control regime to provide insight into how these parts of the Act work.
disclosure regimes share a common overall purpose - that is to promote the efficient operation of markets directly related to electricity distribution and transmission services.
The principal feature of the targeted control regime, which distinguishes it from regulatory regimes for similar companies overseas, is that none of the electricity lines businesses are automatically subject to control of their prices, revenues, or quality of service.
The Commission can make a declaration of control, and then authorize prices, revenues or quality, only if lines business has breached one or more performance thresholds set by the Commission, and followed a number of subsequent steps outlined in the legislation.
The Commission has established two performance thresholds to assess the lines businesses:
a price path threshold of CPI-X; and
a quality threshold based on the frequency and duration of interruptions to customers, supplemented by a requirement to consult periodically with customers about the trade-off between price and quality.
These two thresholds are in effect until March 2009 (for the 28 electricity lines businesses), at which time they will be reset by the Commission following consultation with interested parties.
When a breach occurs the Commission examines the circumstances and, if necessary, investigate in more depth the current and future performance of the business. Some breaches may be due to events that are not fully controllable by the lines businesses, such as severe storms causing supply interruptions. In some cases, having examined the relevant information, the Commission may be satisfied that the breach does not warrant further investigation. The Commission may prioritise its duties under Part 4A.
The thresholds have been designed to encourage efficiency in the industry without automatically imposing control. Even where businesses have breached the thresholds, the Commission has found that desired outcomes can be largely achieved without resorting to the more intrusive control instruments available under Part 5.
For instance, some previous price increases have been reversed and planned price increases suspended, with obvious benefits to consumers, as a result of the Commission taking decisive action in respect of breaches. Also, those businesses that are in breach have an opportunity to resolve matters through a voluntary agreement with the Commission, which is termed an "administrative settlement". The Commission is currently considering administrative settlement offers from Transpower, Unison, and most recently, Vector, as well as a number of other businesses.
The Commission considers that administrative settlements can, in principle, produce better outcomes for consumers because they can allow for greater flexibility, should involve lower administrative and compliance costs, and are likely to be less intrusive than full control. However each individual settlement would need to result in net benefits to consumers over the long term that are demonstrably equal to or greater than the benefits of control.
Hence, while the perception may be that New Zealand is moving closer to other jurisdictions' approaches to regulating electricity sector monopolies, the targeted control regime still allows companies to make their own business decisions about price, quality and investment and minimises the cost of regulatory intervention.
If the Commission is concerned about the performance of the business following a breach, it cannot automatically impose control. The Commission must first publish its intention to declare control and then consult with interested parties. 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 proposed administrative settlements, and suspended price increases while those settlements are negotiated. However if an appropriate settlement cannot be reached within a timely manner, the Commission will have no choice but to proceed to determine whether to declare control over the lines business.
The concept of 'control' is often misunderstood. Control does not mean that a team of Commission staff will take part in the day-to-day management of the business.
If the Commission makes a declaration of control it can then set rules termed an "authorisation" governing the prices, revenue and / or quality of those controlled services for up to five years. While the company may face penalties if it does not comply with those rules, the operation of the company will continue to be undertaken by its management and Board of Directors as normal.
consider the merits of other approaches to constrain the airport's market power that might be less interventionist than control by the Commission. As you will be aware, the Minister did not accept the Commission's recommendation in the airports inquiry.
In the Gas Control Inquiry, the Commission considered markets directly related to gas transmission and distribution.
In considering whether competition was limited or was likely to be lessened in those markets the Commission assessed both structural and behavioural considerations in the markets in which gas services were supplied.
The Commission found that outside the limited bypass areas there was little potential for pipeline-on-pipeline competition in the distribution and transmission markets. The constraint provided by energy users to switch to alternative forms of energy fell short of the constraint which suppliers face in competitive markets.
In considering whether control was necessary or desirable in the interests of acquirers, the Commission analysed what would happen if the status quo were to continue, contrasted with the potential benefits and detriments to acquirers if control were to be imposed. In doing so, the Commission conducted an analysis of productive, aNocative and dynamic effiencies. The Commission assessed and quantified the net benefits to acquirers of control.
The Commission decided that the requirements of section 52 were met for all gas pipeline services except for Nova Gas and various small Taranaki pipelines.
The Commission found that Powerco and Vector each had substantial market power and estimated that over the assessment period, Powerco would earn an average rate of return of 12.7%, and Vector would earn 13.5%. Based on the calculation of the net benefits to acquirers, and taking into account the efficiency cost of control, the Commission was satisfied that it should recommend direct control. For other pipeline companies, the Commission considered that the benefits to acquirers from control were not sufficient to justify the resulting reduction in efficiency. Accordingly, the Commission recommended that the other gas pipelines not be controlled, but advised that a thresholds regime be put in place for ail gas pipelines.
The Minister accepted the Commission's recommendation and declared control over the gas pipeline services of Powerco and Vector, effective from 25 August 2005. The Commission's Provisional Authorisation took effect on the same date. Since then, the Commission has been busy determining the appropriate form of control under Part 5 of the Act. The Commission will ensure that the most appropriate form of control is applied, which maximises the benefits and minimises the costs (including the cost of regulatory error), having regard to the considerations in section 70A.
To enable the continued lawful supply of gas by Powerco and Vector, the Commission issued a Provisional Authorisation under section 71 of the Act to coincide with the date of commencement of the Order in Council. The Controlled Services must, for the time being, be supplied pursuant to this Provisional Authorisation.
The Provisional Authorisation reduces Powerco and Vector's allowed revenue by 9% and 9.5%, respectively. It will be revoked once the Commission has made an authorisation pursuant to section 70, or if an undertaking were proposed by Powerco or Vector and accepted by the Commission.
The Commission is now determining an Authorisation pursuant to section 70.
The Commission is given a broad discretion under Part 5 as to the form of control. The Commission may make an authorisation in respect of all or any component of the prices, revenues, or quality standards that apply in respect of the supply of controlled goods or services, using whatever approach it considers appropriate.
The Commission's framework for issuing the Final Authorisation involves two key work streams.
The first is the identification of the input data such as the demand forecasts, efficient costs, and quality standards to be fed into the form of control framework. This work stream involves establishing the value of the Regulatory Asset Base, determining the appropriate WACC, and determining efficient costs. Through this work stream the Commission will arrive at the total allowed revenue requirement for the businesses.
The second work stream determines the appropriate form of control to be imposed on the businesses. The form of control will determine how the business can set their prices within the overall constraint on price or revenue levels.
The Commission released a Discussion Paper on the form of control in July. This Paper sets out the range of options for the form of control and the Commission's initial proposals as to the appropriate form of control for the controlled services, and requests submissions on a number of questions.
The Commission would particularly welcome views on the proposal to implement separate forms of control for standard and non-standard customers, and on the proposal to rebalance the split of fixed and variable charges to better reflect the underlying cost split.
Submissions on this Paper are due by 7 August. The Commission will hold a conference on the form of control on 5 and 6 September.
In making its final decision the Commission will have regard to the scheme and purpose of the Act and the considerations of section 70A. This means the form of control should maximise the efficient operation of the controlled services. It should capture the maximum benefits for acquirers, net the cost of the form of control. The decision should also reflect proper consideration of the current situation in the markets for the controlled services.
At this stage we anticipate that the Commission will issue the Final Authorisation in May 2007, and that the pricing impact of the Final Authorisation will be felt by consumers through the annual price changes, which occur each 1 October. The Commission recognizes 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.
Under section 70C the Commission can impose, as part of the Final Authorisation, provisions providing for remedies and penalties that apply if, for example, the prices determined by the Commission in the Final Authorisation are lower than any prices charged to any person under the Provisional Authorisation. This allows the Commission to 'claw-back' revenue it allowed Powerco and Vector to collect under the Provisional Authorisation, if the Final Authorisation sets lower prices.
The Commission has a lot of work to get through before it can make its Final Authorisation. Each issue will be thoroughly deliberated on and consulted on to ensure that the Commission achieves the right balance between constraining market power and ensuring that the controlled businesses face incentives to invest appropriately and share efficiency gains with consumers.
encourage businesses that have market power to examine the Commission's current regulatory activities to understand how they can minimise the need for intervention.
Thank you for the opportunity to speak to you today.
