Good morning and thank you for the opportunity to address you today.
Introduction
The Commission has achieved some important milestones in the energy sector in the twelve months since it last addressed this forum.
In September 2005 the Commission published its first Intention to Declare Control - in respect of Unison Networks' electricity distribution business. This was followed in December by the publication of an Intention to Declare Control in respect of Transpower's transmission services.
Subsequently both Unison and Transpower have announced they will reverse or defer price increases in order to seek administrative settlements with the Commission. An administrative settlement is an alternative to the Commission declaring control, when a company has breached price or quality thresholds set under the Commerce Act, and is less intrusive and less costly than imposing control. I will describe how this works in more detail later.
The Commission has also published the first substantial amendments arising from its first-principles review of the electricity information disclosure requirements. The revised requirements will introduce much greater transparency to the disclosure of pricing methodologies and financial performance information, and will assist in the promotion of best practice asset management planning, all of which have important ramifications for the reset of the thresholds in 2009.
Finally, the Commission has issued a process paper describing its proposed approach for issuing the final authorisation for the supply of gas distribution services by Vector Ltd and Powerco Ltd. This is the first time the Commission has had to implement control under Part 5 of the Commerce Act, and its experience here is obviously relevant to the targeted control regime for electricity lines businesses.
In carrying out these activities in energy regulation the Commission must take into account the purpose of Parts 4A and 5 of the Commerce Act both which focus on the promotion of efficiency. Trust owners of energy businesses also have an important role to play in ensuring these businesses are operating consistently with the purpose of the legislation and this is a key theme that I will return to in the course of this presentation.
Overview of the presentation
Today, I will provide you with a brief recap of the regulatory regime, and an explanation of the Commission's processes arising from breaches of the price path and quality thresholds by lines businesses, including an update of where the Commission is with its major post-breach inquiry work-streams.
I would also like to highlight a number of strategic issues the Commission will be directing its attention to as we approach the 2009 thresholds reset. These include:
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the need for some businesses to move towards cost-reflective pricing at a customer class level;
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how the Commission plans to consider future uplifts in the investment requirements of lines businesses and maintain incentives to invest; and
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the need for some companies to strive towards a more sustainable footing to deliver long term benefits for consumers.
I will conclude by sharing with you some observations on the impact of the regulatory regime to date and the reasons why we consider it continues to be light-handed both in its design and its implementation.
I am also happy to answer some questions at the end of the presentation.
Part 4A of the Commerce Act
Part 4A of the Commerce Act encompasses the targeted control regime and also an information disclosure regime.
Both regimes share a common overall purpose to promote the efficient operation of markets directly related to electricity distribution and transmission services and they work together as the two pillars of an effective light-handed regime. The performance measures provided by information disclosure, properly specified, are an important indicator of the success in delivering against the common purpose and will also produce important information for the reset of the thresholds in 2009. Of course it also governs the disclosure of information in compliance statements, which determine compliance with the thresholds.
The targeted control regime itself seeks specific outcomes for the long-term benefit of consumers - by ensuring that electricity lines businesses:
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are limited in their ability to extract excessive profits;
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face strong incentives to improve efficiency and provide services at a quality that reflects consumer demands; and
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share the benefits of efficiency gains with consumers, including through lower prices.
In the Commission's view, consumers will only benefit in the long-term if electricity lines businesses retain sufficient incentives to make efficient investments in their networks.
Options for responding to a breach of the thresholds
It is important to recognise that there are a number of options available to the Commission in responding to a breach of the thresholds. Control of prices, revenues or quality standards are only one option.
First, the targeted control regime gives the Commission wide decision making powers. These powers include the ability for the Commission to take no further action following a breach, where the Commission considers there are reasons to justify that decision. The Commission must, however, publish its reasons for not declaring control.
The Commission considers the materiality of a breach to be an important prioritisation factor in deciding whether to take further action, rather than being a part of the thresholds themselves. Having said this, the Commission takes all factors surrounding the breach into account when making its decision whether to investigate further. The fact that a breach is not material does not automatically imply no further action.
Secondly, the Commission has indicated that it may be possible for the breach to be resolved by an "administrative settlement" between the Commission and the business concerned. An administrative settlement involves the business voluntarily reaching an agreement with the Commission on an appropriate course of action, and may achieve a better outcome than would be the case through control. Settlements are already a well-established enforcement tool used by the Commission in relation to its other responsibilities under the Commerce Act and the Fair Trading Act.
Should the Commission be unable to reach an agreement with the business, and decide that control would be in the long-term interests of consumers, it cannot automatically impose control.
The Commission must first:
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publish its intention to declare control;
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invite interested parties to give their views on the matter;
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give those parties a reasonable opportunity to give those views; and
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have regard to those views.
In considering these various options, and deciding whether or not to declare control, the Commission must take into account the purpose of the targeted control regime. It is important to understand that control does not mean managing the business as has been suggested by some media reports. It just means authorising prices, revenues, and/or, in the case of distribution businesses, service quality.
In respect of its Unison and Transpower post-breach inquiries the Commission has published an intention to declare control for public consultation and has been in the process of deciding whether to make a declaration of control. Both of these businesses are now seeking to negotiate an administrative settlement with the Commission and have reversed or deferred price increases as a measure of their commitment to this alternative arrangement. Should the negotiations break down then the Commission will resume making its decision on whether to declare control.
If, as we hope, agreement on preliminary administrative settlements can be reached, then the Commission would consult publicly on the terms of each settlement, before formalising its agreement. The terms of an administrative settlement would continue to be monitored by the Commission.
Part 5 Control
In the last year the Commission has implemented regulatory control over the gas pipeline businesses of Powerco and Vector after the decision to declare control was announced by the Minister of Energy in July 2005.
Where businesses are subject to control it is illegal for them to trade without an authorised price undertaking in place. The Commission has therefore implemented a provisional authorisation requiring reductions in prices of 9.5% for Vector and 9% for Powerco while it continues to work towards a final authorisation. This final authorisation may be an authorisation of prices, revenue and/or quality.
The Commission will soon be consulting on the appropriate form of control for Powerco and Vector, whether this be a price cap, a revenue cap, or some other incentive-based form of control that will encourage businesses to achieve various forms of efficiency.
After significant information gathering and analysis the Commission will then consult upon its draft decision, which would include all of the relevant inputs such as the asset base, WACC, and allowable capital and operating expenditure values. Once the Commission has had regard to submissions it will issue its final authorisation. Control may only be for up to a period of five years under Part 4A whereas the control of Powerco's and Vector's gas distribution services has been imposed by the Minister for a period of up to eleven years. In all other respects, whether control arises from a decision of the Commission pursuant to Part 4A or the Minister pursuant to Part 4 does not affect the manner of its implementation.
Changes to Information disclosure regime
Let me turn now to the information disclosure regime.
Information disclosure is intended to contribute to achieving the overall purpose of the regulatory regime by ensuring businesses make publicly available reliable and timely information about their operation and behaviour.
The Commission is required to summarise and analyse the disclosed information to promote greater understanding of the relative performance of lines businesses over time.
Disclosed information may include, without limitation, financial and non-financial performance measures, financial statements, asset values and valuation reports, prices and pricing methodologies, plans and forecasts, contracts, transactions with related parties, as well as policies and methodologies in these or other areas.
The Commission's current information disclosure requirements largely replicate and replace the previous information disclosure regime provided under the Electricity (Information Disclosure) Regulations 1999, administered by the Ministry of Economic Development. While these were considered to be an appropriate interim measure, the Commission has been undertaking a full review of its information disclosure requirements, beginning from first principles.
Cost-reflective pricing
As we move towards the Threshold reset we are beginning to have serious concerns about unjustifiable cross subsidisation between regional networks and the imbalance between networks managed by individual lines businesses. We are equally becoming increasingly concerned that there are levels of cross subsidisation between customer classes that cannot be justified. The businesses concerned have little time to resolve these issues of balance before the threshold resets and the Commission will be saying more on these issues in the future.
Companies should be clear that these issues will be addressed in post-breach inquiries. Customer class and regional pricing should be rebalanced to reflect the underlying economic costs of operating services to that class or region.
The Commission will shortly issue its revised requirements for pricing methodology disclosures. The existing requirements are intended to make transparent the link between costs, returns and tariffs for each customer class but due to some misinterpretation, compliance with the existing requirements has been uniformly poor. The Commission will be looking to strongly enforce its revised requirements to ensure that consumers are able to see clearly how their prices reflect the costs of supplying distribution services.
Asset management planning
Let me turn now to a very important aspect of the information disclosure regime - the disclosure of asset management plans.
In the Commission's view, sound asset management planning is an integral part of ensuring that, over the long term, distribution businesses improve efficiency and provide services at a quality that reflects consumer demands.
Therefore, as part of our review of the information disclosure regime, one of the Commission's first steps has been to consider possible improvements to the current disclosure requirements for asset management plans. Accordingly, on 31 March this year the Commission published its Asset Management Plans: Revised Information Disclosure Requirements and Handbook Decision Paper.
The Decision Paper outlines the Commission's final decisions on revisions to the Information Disclosure Requirements and Handbook to implement best practice for Asset Management Plans and discusses other issues relating to AMP disclosures. The revisions will apply for disclosures for the 2006/7 year. In brief the key final decisions made by the Commission were that:
- the Commission requires each AMP disclosure to be approved by the Board of the disclosing entity;
- AMP disclosures now coincide with the financial information disclosure timing requirement; and
- the Commission has clarified the requirements to improve interpretation and consistency of disclosures.
The Commission also indicated that it will continue its annual review of AMPs and that it intends to require forecast capital expenditures and variances explanations as part of AMP disclosures. Undertaking asset management plan reviews will, over time, assist the Commission to assess how significant any step changes in investment are for each business and for the industry as a whole.
One of the issues that the Commission is now dealing with is the issue of how to account for uplift in investment requirements, particularly in the area of renewals. This issue has surfaced in both the Unison and Transpower post-breach inquiries and the Commission will look to consider the issue in the threshold reset. One key area of improvement that we expect from the lines businesses is the adoption of robust Asset Management Plans and the systems supporting these plans to ensuring best practice asset management planning and the early identification of investment need within the networks.
We expect all businesses to have the asset management planning in very good shape in advance of the threshold reset and it is in the best interests of shareholders to ensure that this happens.
As a matter of governance the businesses should be held accountable for delivering against approved AMPs and the Trusts must understand on behalf of beneficiaries the nature of the AMP commitments and whether or not individual companies have delivered the investment forecast in the plans. The disclosure of investment variance explanations should assist with this process.
The Commission for its part will definitely hold the businesses accountable in order to be assured that these businesses are operating within the purpose statements of the legislation.
In addition to the changes already made the Commission intends introducing guidelines for consumer engagement to reflect its conviction that two-way communication with consumers on service levels and line charges should be a key element of the asset management planning process, as well as more generally important.
It is the Commission's intention that most of the current Revisions will apply to disclosures for the 2005/06 year and hence on 31 March the Commission also notified changes to the timing requirements for particular disclosures to temporarily postpone them until the Revisions are implemented.
Sustainable long-term businesses
At the time the thresholds were set there were a number of businesses that the Commission was concerned about in that the rates of return they were earning did not appear to provide a likely sustainable long-term return sufficient for them to achieve the purposes of the legislation.
We are still concerned that this may be the case for some businesses and hence warn about the expectations of beneficiaries and the need for some companies to strive towards a more sustainable footing in order to meet expectations on what they will deliver for the long-term benefit of consumers. In order for Trust owners to ensure that the Companies they have the investment in work within the purposes of the legislative regime, they should reconsider policies that require consistent explicit or implicit rebating of a significant share of distribution business revenue back to consumer owners.
Similarly any price caps must also be examined, in the light of the cost-reflective pricing discussion earlier.
Some observations on the regime so far
Now I would like to make a few observations to address concerns expressed in some quarters regarding the impact of economic regulation on continuing investment. In particular, the concern that gas and electricity lines businesses will be limited to a return of no more than their Weighted Average Cost of Capital. It can be demonstrated very simply that this is not the case.
The CPI-X form of the thresholds has been designed to ensure that by making efficiency gains businesses can earn above normal returns. They will, of course, have to eventually share these higher returns with consumers and the appropriate mechanism for such sharing will be considered as part of consultation on the threshold reset. But for a period of time they will be able to pocket the gains.
It is also worth noting that, in the five years that the targeted control regime has been in place, not one business has actually been controlled. In fact on only five occasions has a breach led to a more detailed investigation of a business. The Commission can hardly be accused of rushing in to exercise the full extent of its powers.
On the contrary, our approach to regulation of electricity lines businesses has been relatively light handed. I note that all businesses can increase prices in nominal terms, and outcomes of post-breach inquiries could sanction further nominal price increases. The processes that are under way with regards to administrative settlement negotiations with Transpower and Unison show that desired outcomes can be achieved without resorting to more intrusive control.
Should the Commission move to a declaration of control for any lines business, we would consult on setting the specific parameters for control. We would seek to preserve incentives for investment and for improved efficiencies, while ensuring that the controlled business shares the benefits of efficiency gains with consumers.
As I mentioned earlier it is important to understand that control does not mean managing the business. It just means authorising prices, revenues, and/or, in the case of distribution businesses, service quality. Such control is typical for network businesses in most regulatory jurisdictions overseas. New Zealand's regime clearly differs, with no business subject to control at the outset. The perception may be that New Zealand is moving closer to other jurisdictions' approaches to regulating electricity sector monopolies. But by design, the targeted control regime is light handed in that it allows companies to make their own business decisions about price, quality and investment. In practice it is also light-handed in that the Commission to date has shown its willingness to explore solutions that will continue to preserve this relative autonomy.
