Good morning and thank you for the opportunity to address you today.
The Commission has been given the statutory responsibility to view the electricity lines industry as a whole and to compare the relative performance of all distribution businesses over time, irrespective of ownership.
The Commission is uniquely placed to objectively assess benefits to all electricity consumers over the longer term, as perhaps opposed to only some consumers in just the short or medium term.
I am aware that many of you here today may feel that the Commission plays an unnecessary role in regulating trust-owned distribution businesses. I have heard the argument that trust members have a strong incentive to act in the best interests of consumers, given that you are directly accountable to them.
This may well be the case. However, as you are well aware, the nature of the industry is changing. As trust-owned distribution businesses acquire or invest in other lines businesses, the relationship between consumer owners and the overall consumer base is becoming less direct.
For instance, the Commission observes that many trust-owned distribution businesses consistently rebate a significant share of their revenue back to consumer owners. In some instances, rebates have amounted to almost 60% of line charge revenue.
On the other hand, the Commission often hears claims about the so-called "wall-of-wire" that the lines industry is facing.
The Commission has the tools available to investigate such claims in light of actual business behaviour, not only in individual businesses, but in the sector as a whole, while maintaining a focus on long-term benefits to consumers.
This is a theme I will return to a number of times throughout this presentation.
Overview of the presentation
Today, I will provide you with a general overview of the regulatory regime, and also give you an update on the Commission's current work. I will also talk about some of the progress we have made, and will highlight some of the issues and areas where we have concerns. I am also happy to answer some questions at the end of the presentation.
In explaining the regime I would like to highlight a number of strategic priorities for the Commission. Those priorities are:
- the way in which we respond to breaches of the "performance thresholds" set under the regime;
- disaggregation of disclosed performance information;
- asset management planning; and
- engagement with consumers concerning price/quality trade-offs.
I would also like to discuss the significance of a recent High Court decision relating to the Commission's role in establishing and enforcing the thresholds.
I will conclude by sharing with you some observations on the impact of the regime to date and by the time I have finished, you should have a good understanding of what our objectives are in carrying out our statutory responsibilities and how we intend going about it.
Part 4A of the Commerce Act
I will start first by explaining the Commission's responsibilities under Part 4A of the Commerce Act.
Part 4A, relates to electricity lines businesses, and came into effect nearly four years ago, on 8 August 2001. Currently, electricity lines businesses provide the only goods or services subject to a special industry-specific regulatory regime under the Commerce Act.
Among other things, 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.
Targeted control regime
The targeted control regime seeks specific outcomes for the long-term benefit of consumers – by ensuring that electricity lines businesses:
- are limited in their ability to extract excessive profits;
- face strong incentives to improve efficiency and provide services at a quality that reflects consumer demands; and
- 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.
The principal feature of this control regime, which distinguishes it from regimes in other countries, is that it is "targeted". That means none of the 29 lines businesses in New Zealand will be controlled by default. A business may only be controlled by the Commission if it has crossed some threshold of performance.
The Commission has set two thresholds which apply to distribution businesses for a five year period from 1 April 2004. The first threshold is a "CPI minus X" price path threshold, representing the expected annual change in businesses' average prices. These are prices net of certain "pass-through costs". For distribution businesses, the most significant pass-through costs are the transmission charges they are required to pay Transpower.
The price path threshold
Going forward, any distribution business whose average price changes at an annual rate exceeding the change in the consumer price index, less the annual rate of X percent set by the Commission for that business, will breach the price path threshold. Different X values, termed "X factors", have been assigned to four groups of distribution businesses on the basis of their relative productivity and relative profitability, and these range between negative one percent, and positive two percent.
Of the 28 distribution businesses:
- nine have been assigned an X factor of two percent. Assuming that the consumer price index is around two and a half percent, these businesses would be able to increase their average prices by around half a percent per annum, and still comply with the price path threshold;
- nine distribution businesses have been assigned an X factor of one percent;
- seven businesses have been assigned an X of zero; and
- the remaining three have been assigned an X of negative one percent.
These business-specific parameters differ from the initial price path threshold set in June 2003, in which all businesses were effectively set a constant price path in nominal terms.
It is interesting to note that the Commission's relative productivity analysis found that trust-owned distribution businesses exhibited a range of performance – from above average to below average.
This suggests that trust-owned businesses are neither consistent under- nor over- performers.
The quality threshold
The second threshold is a quality threshold, comprising reliability criteria and consumer engagement criteria. The reliability criteria require that, each year, a distribution business must demonstrate that there has been no material deterioration in the reliability of its line services.
The consumer engagement criteria require that, at least every two years, the business must demonstrate that it has meaningfully engaged with consumers to determine their demand for service quality. In particular, businesses are expected to properly advise their customers about the price/quality trade-offs available to them.
The price path and quality thresholds are simply a "trigger" for the Commission to identify distribution businesses whose performance may warrant further examination, and if necessary, control.
The Commission considers that, if a distribution business stays within the Commission's thresholds, it should be left to run its business without further intervention from the Commission, other than continued regular disclosure of information concerning its performance.
If a distribution business breaches a threshold, the Commission is prepared to declare control, where this is in the long-term interests of consumers.
However, I stress that the thresholds are just that – thresholds which may trigger further Commission consideration.
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 is only one option.
Firstly, 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.
A number of distribution businesses have proposed including materiality margins in the thresholds to reduce the number of "false" or "technical" breaches. However, Part 4A specifically provides for the extent of a breach to be taken into account. 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.
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 would involve 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.
I should stress that resolution of significant breaches is not intended to be a lengthy process. If businesses wish to seek to reach an administrative settlement with the Commission – and there have been a number of instances where businesses have said this is the case – then it is in their interests for them to table an offer promptly.
In future, the Commission may consider moving much more quickly to announce whether it intends publishing an intention to declare control on the basis of information already before it, rather than waiting to see whether an offer of administrative settlement emerges. However, this would not preclude a settlement from being considered by the Commission at a later stage of the process.
Finally, 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:
- publish its intention to declare control;
- invite interested parties to give their views on the matter;
- give those parties a reasonable opportunity to give those views; and
- 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.
Assessments against the thresholds
The third assessment date against the thresholds was 31 March this year, and all distribution business are due to publicly release their threshold compliance statements shortly.
At the first or second assessment dates a significant number of lines businesses were found to have breached the thresholds. However, to date, the Commission has only found that five businesses have warranted any significant level of further investigation. One of those businesses is Transpower.
Many of the price path threshold breaches identified to date were "technical" in nature. Some breaches were caused by timing differences between movements in pass-through costs and movements in average prices.
A number of the breaches of the reliability criteria of the quality threshold were clearly caused by rare, high impact events outside the range of events for which distribution businesses typically plan. In such cases, no further action was warranted.
However, the Commission plans to establish more robust criteria for distinguishing extreme events in future, and we intend consulting on our preliminary views shortly.
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.
The Commission considered replication to be an appropriate interim measure because the scope of information disclosure provided for under Part 4A is similar to that under the previous disclosure regulations. The Part 4A information disclosure regime differs from the regulations in that there is a different statutory authority and purpose, and is complemented by the targeted control regime.
The Commission is currently undertaking a full review of its information disclosure requirements, beginning from first principles.
The disclosure regime plays an important role in providing the information needed for assessing compliance with the thresholds and for resetting the thresholds at the end of the current five-year regulatory period.
Disaggregation of information
But the role of information disclosure is broader than simply serving the targeted control regime. Notably, the information provided in threshold compliance statements is highly aggregated – relating to average prices and the reliability of each business as a whole.
The Commission is mindful that expanded disclosure requirements may come with increased compliance costs. However, consumers are understandably interested in information that more closely affects them directly – such as local service quality levels.
A particular issue of interest to some consumers is likely to arise where the consumer owners of a trust-owned business are in only a sub-network of the overall network. In such cases, "distributions" – through rebates or dividends – will only accrue to the consumer owners and not the total customer base.
The Commission's preliminary view is that, at a minimum, disclosed information should be sufficiently disaggregated to identify whether business pricing and investment decisions are weighted in favour of consumer owners.
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.
Public disclosure of asset management plans contributes to the transparency of distribution business decisions and performance. For instance, much of the investment in existing network assets took place 20 to 40 years ago, and those assets will one day need to be replaced – some sooner rather than later. Undertaking asset management plan reviews will, over time, assist the Commission to assess how significant the "wall-of-wire" is for each business and for the industry as a whole.
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.
The Commission recently released a report that presents best practice recommendations for the future preparation of such plans by distribution businesses. The report also provides an overall review of the 2004 asset management plans prepared by each business against the current disclosure requirements.
Many businesses appear to experience problems interpreting the current requirements. Therefore, the Commission did not consider it appropriate to specifically name businesses whose asset management plans appear to fall short of complying with the requirements.
Each business has been sent the Commission's individual review of its own plan. There were a number of very competent asset management plans. However, it is fair to say that there were serious shortcomings in some businesses' plans. In particular, a number appear to have been prepared simply to meet the disclosure obligations, rather than to play a central role in the company's asset management process.
In future, without action, the Commission considers it likely that these shortcomings will appear even greater when measured against best practice.
Let me provide some feedback on the 2004 asset management plans.
- Interaction with corporate goals. Few plans contained a description of corporate goals with regard to asset management, or described the interaction of the plan with other business planning processes. It was therefore not possible to assess how the plan assists in meeting those goals.
- Consumer demands for service quality. Few plans provided a description of how (and whether) stakeholder interests have been determined and how (and whether) those interests have been taken into account in setting service level targets. Also, the service level targets themselves were often poorly defined. As I'll come to again in a moment, one of the reasons the Commission places a strong emphasis on meaningful consumer engagement is because of the link this has to effective asset management. In the Commission's view, asset management planning should be demand driven rather than supply driven.
- Description of asset condition. Given the importance of asset condition to asset management, descriptions of the condition of existing assets were in many plans surprisingly weak. We expect to see the industry as a whole rise to the standard of those plans which already present a clear link between asset condition, and planning for asset renewal or refurbishment.
- Network development planning criteria. In some cases, no network development planning criteria were defined. Where criteria were defined, and the process for identifying the need for development projects to meet those criteria was described, the process for then prioritising the projects was not discussed sufficiently (if at all).
- Risk management. Most businesses appear to be well-experienced in managing day-to-day risk. However, only a few businesses demonstrated that they have sufficiently assessed low-probability, high-impact risks to their asset base and have measures in place to mitigate such risks.
On a positive note, maintenance planning was generally the most thorough and complete section of the 2004 asset management plans. In some plans the presentations in this area were excellent.
Also, the Commission acknowledges that shortcomings in the plans may not necessarily be indicative of any inadequacy in asset management planning. In some cases the problem may lie with the way asset management processes are disclosed rather than the way they are actually performed.
The Commission's recent report on asset management plans also recommends best practice ways for distribution businesses to engage with electricity consumers concerning the trade-offs between distribution prices and service quality. While this exercise related more to the consumer engagement criteria of the quality threshold than to information disclosure, there is a strong link between consumer engagement and asset management planning.
The Commission considers that two-way communication with consumers on service levels and line charges should be a key element of the asset management planning process. But we certainly acknowledge that many businesses struggle with the concept of meaningful price/quality trade-offs, particularly in respect of residential and other low use consumers.
Partly this is because retailers typically have more direct contact than distribution businesses with lower use consumers. Also, such consumers share network assets, and it may be difficult to differentiate between users on a common network.
However, while meaningful engagement with residential and smaller consumers may be more of a challenge, the Commission does not see this as an excuse for inaction.
The Commission's report recommends a number of best practice principles for communicating with consumers.
- Relevant information should be targeted, as appropriate, to specific market segments;
- information should be provided in a manner that is able to be generally understood by that segment; and
- channels of communication should be designed to reach a significant proportion of that target segment.
A key pre-requisite of effective consumer engagement is being able to define the service levels offered in various network areas, and to report actual performance against service level targets. This brings us back to the link with asset management planning. As I mentioned earlier, many current asset management plans do not present issues concerning service levels particularly well.
Furthermore, whereas many larger consumers are able to understand and interpret asset management plans, or can engage parties to assist them with this, the situation for small consumers is different. Relevant information needs to be made accessible and meaningful for the small consumer market segment.
The Commission's report recommends a range of ways that information about price/quality trade-offs can be provided to and obtained from small consumers.
For instance, it appears that few distribution businesses seek access to retailer call centre data. The Commission recommends that distribution businesses should report and develop frameworks for reporting actual results and trends from this data. Such call centre analysis and history can complement information obtained from well-designed consumer surveys.
Based on the report's best practice recommendations, the Commission proposes introducing guidelines for consumer engagement next year. This will be coupled with enhancements to the requirements for preparing asset management plans.
In the future, distribution businesses identified as falling short of best practice will be expected to develop more effective processes for understanding and responding to consumer preferences.
Judicial review proceedings
Since setting the thresholds, two judicial review proceedings have been issued against the Commission.
In the first - Electra, Centralines, Counties Power, and The Lines Company - claimed that the Commission's consultation process for setting the thresholds was flawed and the threshold decisions were unreasonable.
In her High Court judgment, Justice France observed that the Commission's consultation process was open and wide-ranging, and that at some point "the Commission has to be able to say, 'enough', and move on and make a decision." She also noted that it is relevant that the thresholds are a screening mechanism to trigger further inquiry, and do not necessarily lead to control.
The four distribution businesses that issued the proceedings all provide significant rebates to consumers. They argued that in comparing their performance with other distribution businesses that do not provide rebates, the Commission's approach to the treatment of tax – in the context of setting the price path threshold – was unreasonable.
Justice France acknowledged the Commission's view that, in assessing the performance of rebating distribution businesses, some attention has to be paid to the overall efficiency of the business, not just to the tax efficiencies. She also highlighted that the Commission is an expert body with a broad discretion and mandate.
The Commission was particularly pleased that the High Court recognised the relationship between the Commission's approach to setting the price path threshold and the statutory purpose – to promote the efficient operation of markets for distribution and transmission services.
The Commission remains concerned about the wider efficiency effects that arise from the lack of transparency associated with rebates, compared with keeping prices lower in the first place.
Clearly, the Commission does not have a problem with businesses earning reasonable returns on behalf of their shareholders. However, the Commission would have a concern were we to find that consumer owners are being over-charged in the first instance simply to provide higher distributions at a later date.
I have heard the argument that such practices may allow distribution businesses to increase their borrowing ability. However, this simply transfers risk from the business to consumers, and it is not clear that consumers are better placed to manage that risk.
Such behaviour is only possible because distribution businesses are monopolies and are not exposed to the same disciplines as firms operating in a competitive market.
We have noted that a number of trust-owned businesses have moved away from providing discretionary rebates. Instead, these businesses are committing to a specified level of discounts in their published line charge schedules.
This is clearly a step in the right direction, as it means that consumers will be able to make more informed consumption decisions.
The second proceedings against the Commission were issued by Unison Networks, and the hearing is set for October.
Impact of the targeted control regime
In closing, I would like to make a few observations about the impact of the regime, which has now been operating since June 2003.
Experience to date indicates that desired outcomes can be largely achieved without resorting to the more intrusive control.
Around two-thirds of distribution businesses have had to reduce their prices in real terms over two consecutive years and face further reductions over the next three years.
However, while only three distribution businesses will be able to increase prices in real terms over the five year price path threshold, given the current CPI, most businesses can increase prices in nominal terms.
Furthermore, outcomes of post-breach inquiries could sanction further nominal price increases.
As a consequence, there is also a growing need to improve public awareness of the regime and mitigate pejorative perception of some "breaches".
Analyses of smaller businesses could raise questions about efficient scale.
For trust-owned businesses, any evaluation of broader efficiency implications of providing rebates may continue to draw attention.
Finally, differential sub-network returns are likely to draw regulatory focus if lines businesses do not move to restructure prices, where this is appropriate. The Commission would be concerned to find significant uneconomic cross-subsidisation across sub-networks within a particular lines business, especially if the beneficiaries of such cross-subsidisation are solely the consumer owners of the business.
This is one of the issues the Commission may look into if a distribution business breaches the thresholds for any reason. Investigations to date have uncovered situations where line charges to the consumer owners of a distribution business result in associated rates of return that are less than one-third the returns received from all other consumers supplied by that business. Remember, the Commission potentially has the ability to control any subset of prices and revenues, and not just the overall average.
On a more positive note, as experience with the regime is gained over the next few years, the Commission may find that more targeted thresholds, involving lower compliance costs across the industry, might be able to meet the purpose of the legislation at the time the thresholds are reset.
For example, 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.
The perception may be that New Zealand is moving closer to other jurisdictions' approaches to regulating electricity sector monopolies, but the targeted control regime is demonstrably a light-handed regime that allows companies to make their own business decisions about price, quality and investment. The direct control of prices, revenues and/or service quality will likely continue to be the exception rather than the rule.
Thank you again for the opportunity to address you today, and I'd be pleased to answer any questions.