Good morning and thank you for the opportunity to provide a brief update on the Commission's work in the energy sector over the last twelve months.
A diverse audience like this will have a diverse range of opinions about the Commission's work in the energy field. One thing I think we can all agree on, however, is that the last twelve months have seen some important, and in some instances ground-breaking, activity in this area.
2005 saw a number of firsts. In July the Minister of Energy declared control of Vector's and Powerco's gas pipeline businesses and announced the Government's intention to introduce a new thresholds regime for gas distribution and transmission.
In September the Commission announced for the first time its intention to declare control of an electricity lines business (Unison Networks), and in December an intention to declare control of Transpower was also a first.
While some of the Commission's work in the energy sector has been unusually high profile in the last twelve months, other important achievements have not attracted so much attention. The release of our draft guidelines on the Weighted Average Cost of Capital, for example was unlikely to hit the headlines. But those in the industry understand that the release of WACC guidelines or an ODV Handbook is just as important for the long term functioning of the regulatory regime.
It is also important to remember that, in addition to the regulatory regimes it administers, the Commission is able to promote competition in energy sector through its enforcement work. Like participants in any other industry, energy companies are subject to the Commerce Act and Fair Trading Act, and I will discuss later some of the Commission's activities in the energy sector in relation to these acts.
I would like to start with the Commission's work on electricity regulation.
Part 4A of the Commerce Act encompasses a targeted control regime and 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.
One of the Commission's key ongoing work-streams has been its review from first principles of the existing Electricity Information Disclosure Requirements. We assumed responsibility for these in March 2004.
The Commission has been conducting workshops with electricity lines representatives to assist it in developing robust and useful performance measures for the electricity information disclosure regime.
The work is being done in four broad work-streams
- Asset Management Plans;
- Financial Information (which includes regulatory accounts and asset values);
- Technical Information (about service levels, also engineering statistics);
- Pricing methodology/Line charges.
New requirements for Asset Management Plans, Financial Information and Pricing Methodology disclosures will be implemented in the first half of this calendar year for application to the disclosure year ended 31 March 2006. It is likely that an extension to the reporting dates will be necessary to allow businesses sufficient time to prepare the required information.
For Asset Management Plans the Commission will be issuing its new requirements based on the best practice recommendations that it consulted on prior to Christmas. Its continuing review of Asset Management Plans will identify those businesses that are slow to comply with the new best practice requirements.
Compliance with the current requirements for Pricing Methodology disclosures has been universally poor. The Commission has required the re-disclosure of the past two years' information for all lines businesses and will be providing clear guidance for what is expected in the new requirements.
Our analysis of the targeted returns by customer class has raised concerns about sub-network pricing and the markedly preferential treatment of some customer classes. This is something the Commission expects that lines businesses will attend to by rebalancing tariffs where there are large unjustifiable differences, and the Commission will monitor the pricing methodology disclosures for signs of pricing movement.
If these concerns are not addressed by the businesses themselves, the Commission may have to consider whether they need to be directly addressed by the design of the thresholds at the next reset in 2009. In any case the Commission can look closely into relative pricing across sub-networks in a post-breach inquiry. In its published analysis of the disclosures the Commission is likely to comment on comparative pricing and trends.
In September 2005 the Commission published an Intention to Declare Control of Unison Networks' electricity distribution business. This was the first such decision under the targeted control regime. The Commission is now processing cross-submissions from the conferences held to test the views of interested parties and will make its final decision in due course.
In December we published an Intention to Declare Control over Transpower's transmission business. The reasons were published separately in January 2006. The move followed an inquiry opened by the Commission after Transpower reported breaches of the price path threshold in the pricing year 2003/2004, 2004/2005 and 2005/6. The breach in 2005/6 was $43.2m.
In April 2004 Transpower implemented a major price increase (13% for HVAC customers and 16% for HVDC customers). In November 2004, the company announced further price increases, including an increase of 19% from April 2006, to be followed by a 13% increase in each of the subsequent five years.
The Commerce Commission commissioned analysis of the breaches by the New Zealand Institute of Economic Research. This analysis showed that even after allowing for volume and other adjustments in favour of Transpower, the company still significantly breached its thresholds in 2004/05 and 2005/06($35.8 million).
Following rigorous analysis the Commission was not satisfied that Transpower's past breaches could be justified. Therefore, the Commission's preliminary view was that Transpower's April 2004 price increase was not justified and the company is likely to have been earning excess profits from the 2004/05 year onward.
When deciding whether to impose control, the Commission not only considers past threshold breaches, but must also be satisfied that control of Transpower can be justified in terms of ensuring the efficient operation of markets related to electricity distribution and transmission services, as required by the Commerce Act.
The Commerce Commission considers there to be evidence that:
- Transpower's approach to the Electricity Commission investment approval processes is likely to result in investment outcomes inconsistent with the objectives of the regulatory regime;
- Transpower's planned price increases would allow it to recover the cost of investments that have not yet been approved or made; and
- The planned timing of Transpower's price increases is not consistent with the company's forecast capital expenditure, and its planned April 2006 price increase is not justified.
When the regulatory regime was put in place, it seems clear that Parliament and Government intended that the Electricity Commission would scrutinise Transpower's investments to ensure they are efficient and in the long-term interest of consumers. This process also allows alternatives to be scrutinised and debated by the public. Yet of Transpower's planned investments, totaling $3.4 billion, only a small proportion has been approved by the Electricity Commission so far.
The Commerce Commission considers Transpower is effectively seeking to pre-fund substantial investments that have not yet been approved by the Electricity Commission. This could result in today's consumers paying disproportionately for investments that will benefit consumers well into the future. It could also limit the scope for alternative investments.
Even more significantly, the additional revenue Transpower will gain means that there is less incentive for the company to minimise costs, and this may inappropriately transfer risk associated with the investments from the company to consumers.
Transpower's planned investments may ultimately be found to be prudent and be approved by the Electricity Commission, but even if the investments were approved, the Commerce Commission would continue to have concerns about the timing of price rises to cover the cost of those investments.
In estimating the net benefits to consumers of control, the Commission has considered Transpower's planned price increases; the extent of any excess returns Transpower is likely to earn in the future; and the likely efficiency of Transpower's future investment plans, including the timing of the investments and the timing of price increases.
Taking these factors into account the Commerce Commission has reached the preliminary view that imposing control would result in benefits, which could include:
- Transpower being limited from earning excess profits in the future;
- significant savings due to investment efficiency gains through ensuring that the full application of the Grid Investment Test impacts on Transpower's investment decisions;
- more efficient timing of investments;
- more appropriate timing of price increases; and
- lower cost implementation of investments.
The Commission estimates the incremental direct and indirect costs of control to be small, so our analysis to date suggests the benefits of control would far outweigh these costs.
Transpower is required to operate in a manner consistent with the Government Policy Statement, the Electricity Governance Rules and Part 4A of the Commerce Act. The Commerce Commission considers that Transpower is not currently operating in such a manner, and the Commission's preliminary view is that control would result in significant long-term benefits for consumers.
Submissions from interested persons, including Transpower, were posted on our website on the due date of Monday this week. Cross submissions are due on Monday 13 March, and so it is inappropriate for the Commission to comment at this stage on any of the comments made publicly by Transpower on its own submission. The Commission intends to make a final decision and publish its decision paper by March 31st.
Now I would like to discuss recent 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. But for a period of time they will be able to pocket the gains. The incentives for continuing investment are therefore built in.
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. The Commission can hardly be accused of rushing in to exercise the full extent of its powers. In fact, our approach to regulation of electricity lines businesses has been relatively light handed.
Around two-thirds of the businesses are able to increase their prices in nominal terms under their thresholds. And even where breaches of the thresholds occur, the desired outcomes may be able to be achieved without resorting to the more intrusive Part V control. On only five occasions has a breach led to a more detailed investigation of a business.
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.
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 the norm for electricity transmission and distribution businesses overseas. New Zealand's regime differs because it is light-handed, with no business subject to control at the outset.
The light handed approach to regulation is appropriate, particularly given the relatively high number of businesses for the size of the economy.and we can see it has been effective. Since the regime was introduced, electricity prices coming down in real terms where they need to, but at the same time, prices have risen where they need to rise to provide for investment. This demonstrates that the Commission's approach to electricity regulation is preserving incentives for investment.
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.
The indicative timeline published by the Commission would see a final authorisation being issued in September this year. The timing may, however, be affected by delays in gathering information. If delay occurs then the Commission may decide to issue an amended provisional authorisation to ensure the timely removal of unreasonable excess profits.
In August 2005 the Commission confirmed it was opening an investigation into the electricity retail and generation markets to identify if there are restrictive trade practices occurring in breach of the Commerce Act. The investigation was opened due to complaints about a perceived low level of competitive activity. The Commission indicated that it expects substantial progress on the investigation to be made by the middle of 2006.
This investigation is a top priority for the Commission for 2006 and I can advise that progress is being made, and a full range of information gathering and expert analysis is being undertaken.
Knowledge of the investigation has raised expectations with industry and the public, and I would like to briefly discuss the nature of the investigation, and the likely result.
This is not an industry-wide review, as the Commission has undertaken in the past with its reviews of gas distribution and airports. Hence it will not result in a report on the industry, as these reviews did.
Rather, if the investigation discovers anti-competitive behaviour, the Commission may exercise its discretion to prosecute companies and individuals as appropriate. Should prosecutions occur they will follow the Commission's normal enforcement processes and information related to such prosecutions will be subject to the usual constraints for cases being pursued through the Courts.
In short, the Commission's investigation into the generation and retail electricity markets may result in further investigations and/or prosecutions. It will not result in a "state of the market" type report, and industry, media and the public need to be aware of that fact.
As well as regulatory and Commerce Act interventions in the electricity market, the Commission has also dealt with competition issues in electricity Commission through consumer interventions under the Fair Trading Act.
Vertical separation resulted in much greater potential for competition in the electricity retail market and the Commission saw a corresponding rise in breaches of the Fair Trading Act by electricity companies. The main issues related to competitive offers that were not delivered, customer switching issues, and false representations about the reason for price rises, or the quality of the service offered.
The Commission continues to receive complaints in relation to electricity companies and the representations they make about their prices and services. There are currently seven open Fair Trading investigations in relation to energy retailers; most relate to alleged misrepresentations about the reasons for price rises.
A deregulated energy market will only work if consumers have the accurate information they need to effectively exercise choice. Misleading information has the potential to reduce the likelihood of customers switching providers and can undermine consumer confidence. The Commission views misrepresentations about price advertising in the energy sector as a very real threat to competition. The misleading behaviour addressed under the Fair Trading Act can undermine competition just as certainly as breaches of the Commerce Act or regulatory thresholds.
The Commission will continue to use all the tools available to it to ensure effective competition in the electricity market.
Looking ahead to next 12 months the Commission's priorities include:
- resolving the intentions to declare control of Unison Networks and Transpower;
- completing other post-breach inquiries currently underway;
- concluding the investigation of the electricity retail and generation markets;
- finalising and implementing the information disclosure regime for lines businesses; and
- deciding on a method of control for Vector and Powerco, and implementing a control regime for the gas distribution industry.
Considering the activities of the last twelve months and the busy year ahead, we can see that the New Zealand energy markets are dynamic by anyone's standard.
Unlike many utility markets, where concentrated market power sees little change in the big picture from year to year, New Zealand's energy landscape continues to evolve. The Commission will continue to influence that evolution through using the full range of the tools available to it, be they regulatory regimes or the Commerce and Fair Trading Acts. A dynamic, competitive market will ensure that the fittest companies survive, and thrive, bringing long term benefits to consumers.
