Michael Clark, Director Networks Branch, 26 September 2006
Part V of the Commerce Act and the Gas Control project: challenges and developments
Good morning and thank you for the opportunity to provide an update on the Commerce Commission's work regarding setting the control terms for gas distribution services.
The Commission has been working on the authorisation since the government's decision to impose control on the gas pipeline distribution services of Powerco Limited and Vector Limited.
Today I will start by:
- Describing the Commission's inquiry into gas control under Part 4 of the Commerce Act which led to the Government's decision to declare control.
- I will then discuss the Legislation framework of Part 5 of the Act which sets out the regime for control.
- Next, I will compare the Part 5 regime with the current Part 4A regulatory regime that encompasses the targeted control regime for electricity lines businesses; also referred to as the "Thresholds Regime" and cover the possibility of a similar regime being introduced for those other gas pipeline services.
- I will then provide an update on the Commission's work in relation to developing control terms for gas distribution services
- Finally, I will discuss some of the key issues relating to the setting of control terms for Vector and Powerco.
I am happy to answer any questions at the end of the presentation. However, if they do get too technical in their detail I may have to undertake to get back to you.
COMMISSION'S GAS CONTROL INQUIRY
Under Part 4 of the Act, the Minister of Commerce may request the Commission to prepare a report on whether certain goods or services should be controlled. (The Commission may also conduct an inquiry on its own motion and prepare a report to the Minister). In 20 April 2003, the Minister requested the Commission to report on whether gas pipeline services should be subject to control.
In considering whether goods or services may be controlled, the Commission must establish the following factors in accordance with section 52 of the Act:
- the goods or services are, or will be, supplied or acquired in a market in which competition is limited or is likely to be lessened; and
- control is necessary or desirable in the interests of persons who acquire or supply the goods or services in the affected market.
Having determined whether control may be imposed, the Commission reports to the Minister on whether control should be imposed.
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, allocative and dynamic efficiencies. The Commission assessed and quantified the benefits to acquirers of control net of the costs of control.
For the Gas Control Inquiry the Commission estimated the possible direct and indirect costs of control. For future inquiries under Part 4 the Commission is considering whether it would be more transparent to factor into the point-range of the rate of return (used in the net benefits assessment) the impacts of regulation.
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. The Commission estimated that the average rate of return of these companies range from 11.8% for Wanganui Gas, 10.5% for NGC Distribution and 9.1% for NGC Transmission. Accordingly, the Commission recommended that the other gas pipelines not be controlled, but advised that a targeted control regime, similar to that regime in place for electricity lines businesses, be put in place for all gas pipelines.
I will discuss the merits of such a regime for gas when I cover Part 4A of the Act later.
The Minister accepted the Commission's recommendations and declared control over the gas pipeline services of Powerco and Vector, effective from 25 August 2005. Once control has been imposed, the controlled services can only lawfully be supplied pursuant to and in accordance with an undertaking, an authorisation or a provisional authorisation under Part 5 of the Act.
I will now discuss the legislative framework of Part 5 of the Commerce Act.
PART 5 OF THE COMMERCE ACT
To enable the continued lawful supply of gas by Powerco and Vector, the Commission was required to issue and so issued a Provisional Authorisation under section 71 of the Act to coincide with the commencement date (25 August 2005) of the Order in Council. The Controlled Services must, for the time being, be supplied pursuant to this Provisional Authorisation.
The Provisional Authorisation reduced Powerco and Vector's allowed revenue by 9% and 9.5%, respectively as at 1 October 2005. The businesses average price from 1 October 2005 must equal the average price charged during the previous year. Also the Provisional Authorisation requires the businesses to demonstrate that there has been no material deterioration in the quality of services since 25 August 2005.
The Commission estimated significant excess returns by these businesses in the gas control inquiry. The Provisional Authorisation only removed a share of these excess returns. The Commission did this for two reasons:
- Removal of the full amount may have been too big a one-off hit for the business - A glide path approach in such circumstances is a more acceptable approach to move the businesses to normal returns over time.
- The Passage of Time - Also there may have been events since the conclusion of the gas control inquiry that may have affected the extent of the excess returns. There was limited time between the Government's decision and the commencement date for the Commission to fully investigate such issues. Similarly, there are quality requirements (reporting requirements) associated with the provisional authorisations that really could not be developed or refined in any way given the short period within which the provisional authorisation was required to be made. Therefore "standard" reporting of Public Reported Escapes; System Average Interruption Duration Index (SAIDI) and System Average Interruption Frequency Index (SAIFI) seemed the most effective measures to have reported during the provisional period.
The provisional authorisation is a temporary control authorisation, the design of which was driven by the need to impose a simple and practical control regime in a very limited time and the need for some of the benefits of control to be transferred to consumers. It will be revoked once the Commission has made an authorisation pursuant to section 70 ("final authorisation"). It may also be revoked or amended should the Commission consider, following consultation that there is a need to do so. Finally, the Act contemplates the ability of either party to propose undertakings to the Commission that must then be considered by the Commission as to whether such undertakings would be acceptable alternatives to controlling one or other of the businesses. If such a proposal was put to the Commission then the Commission must consider this and it is likely that a consultative process would follow before any final acceptance of such a proposal would be made. Should acceptance be forthcoming, then the provisional authorisation would be revoked and the terms of the undertaking would be activated; whatever those might be.
Part 5 governs the procedure for the making of authorisations and leaves the Commission with considerable discretion over the form of regulation. It states that: "the Commission can make an authorisation in respect of all or any component of the prices, revenues and/or quality of the controlled services, using whatever approach it considers appropriate."
Further that: "the approach may include the use of formula or other methods from which prices and revenues, or any part of a price or revenue, may be determined."
This gives the Commission the flexibility to tailor its approach to the circumstances of the industry in question.
Part 5 also states those factors that the Commission must give due consideration to in making any authorisation. The Commission will exercise its powers under Part 5 (section 70) having regard to the scheme and purpose of the Act and the considerations set out in section 70A. Section 1A sets out the scheme and purpose of the Act. Section 1A provides that: "[t]he purpose of this Act is to promote competition in markets for the long-term benefit of consumers within New Zealand."
Pursuant to section 70A the Commission is required to have regard to the following mandatory considerations:
- the extent to which competition is limited or likely to be lessened in respect of the controlled services;
- the necessity or desirability of safeguarding the interests of persons who acquire (whether directly or indirectly) or supply the controlled services; and
- the promotion of efficiency in the production and supply or acquisition of the controlled services.
The Commission also has other relevant factors to consider. In addition, the Commission is required to have regard to:
- The Government's Government Policy Statement on Gas Governance, provided to the Commission in October 2004 pursuant to section 26 of the Act;
- The Government's recent Policy Statement on Incentives of regulated businesses to invest in infrastructure provided to the Commission in August 2006 pursuant to section 26 of the Act; and
- submissions by the supplier, and by any acquirer of the controlled services (s70B(3))2.
I would like now to briefly discuss the most recent Government's Policy Statement on investment incentives produced on 7 August 2006.
The Government Policy Statement sets out the government's current economic policy on infrastructure investment for those businesses subject to Parts 4; 4A; and Part 5 of the Commerce Act. This Commission must have regard to such a statement, as is set out at section 26 of the Act.
The first point to be clear about is that such a statement must be considered in the context of the purpose statement of a statute. The statute sets out the purposes that the Commission must work to achieve and it is the purpose statement that expresses the principles upon which the Commission has jurisdiction to make such decisions; whichever part of the Act is being applied.
The second point is, as is expressed clearly in the Act, backed by clear legal jurisprudence, any Government Policy Statement of this kind cannot be a direction to the Commission. Rather such statements are statements that the Commission must have regard to. Such regard must be a careful and genuine consideration as noted in the High Court. In other words; the substance of the GPS is another factor that the Commission must consider and balance in its decision-making. This latter point is important as without it, the Commission could not continue to be an independent regulatory body removed from executive decision-making. This has important implications for transparency and certainty over time.
The Government Policy Statement states that the regulated businesses have incentives to invest and that this is best achieved through certainty; commercially realistic rates of returns; and by giving the businesses confidence that they will not be disadvantaged if they invest in other infrastructures and services. The Statement also requires the Commission to equally consider and balance the factors set out in paragraph 8 of the GPS, which are that:
- The consumers of regulated businesses are not disadvantaged by the investments of regulated businesses in other infrastructure and services;
- Regulated businesses are held accountable for making investments in that business where those investments have been provided for in regulated revenues and prices; and
- Regulated businesses provide infrastructure at the quality required by consumers at an efficient price.
The Commission agrees with and supports the policy statement and will have due consideration to the statement when implementing the control terms for Powerco and Vector. It is important that businesses have the confidence and face proper incentives to make appropriate investments that are affordable and accountable. However, such considerations must be balanced with the key objectives of economic regulation, as outlined a paragraph 8.
A key aspect of Part 5, compared to overseas regimes, is that the 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.
I want to note another important aspect of the Part 5 regime. Section 70 C of the Act states the Commission may impose, as part of the authorisation, remedies and penalties if the prices determined by the Commission in the authorisation are lower than any price charged under the provisional authorisation.
Following consultation in June, the Commission decided not to amend the provisional authorisation, for either company, but this provision under Part 5 means if any further price reductions are found to be necessary when the final authorisation is reached, these can be backdated.
I noted above that when making regulatory decisions under Part 5, 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 will do 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 while adequate returns are necessary for investment to occur, 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.
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. This may entail clear reporting of proposed investment; periodic prudency reviews; and clear compliance reporting by the controlled companies.
I now wish to briefly explain Part 4A of the Commerce Act which sets the regulatory regime for electricity lines business. I want to contrast this regime with the control regime under Part 5. I will also explain what the Part 4A regime has achieved to date and why the Commission recommended such a regime for the other gas pipeline businesses.
PART 4A OF THE COMMERCE ACT
Part 4A of the Act encompasses a targeted control regime ("Thresholds"), and also an information disclosure regime, for the 28 electricity distribution businesses plus Transpower. The targeted control and the information disclosure regimes share a common overall purpose, namely, 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 only make a declaration of control, and then authorise prices, revenues or quality, if a lines business has breached one or more of the performance thresholds set by the Commission. Such a declaration can only occur if a number of subsequent steps outlined in the legislation have been followed.
The regime is predicated on two performance thresholds established by the Commission. These thresholds are used as a screening device to assess each lines business performance each year. The performance thresholds are:
- a price path threshold of CPI-X; and
- a quality threshold based on the frequency and duration of interruptions to customers (SAIFI and SAIDI), 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 of a threshold occurs the Commission examines the circumstances and, if necessary, will investigate the current and future performance of the business in more depth. Some breaches may be due to events that are not fully controllable by the lines businesses, such as severe storms causing supply interruptions. Such extreme events, for example, will be investigated and information sought from the specific company. In cases where, having examined the relevant information, the Commission may be satisfied that the breach does not warrant further investigation. No further action will be taken. The Commission has statutory flexibility under the regime to prioritise its duties also.
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 awaiting administrative settlement offers from Transpower and Unison. It expects offers from other businesses also.
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.
A key aim of the regime is to retain the certainty of the thresholds. These were set for a five-year period in 2004. The next reset will be in March 2009. We will be working hard therefore to ensure that any administrative settlement has the objective, where possible, of retaining the existing threshold set in 2004. By doing so this will align with the five-year investment plans of the lines businesses.
The price path threshold provides incentives for lines businesses to improve efficiency; share efficiency gains with consumers; and limit their ability to extract excessive profits.
The quality threshold encourages lines businesses to supply electricity transmission and distribution services at a quality reflecting consumer demands, and to not let that quality reduce in pursuit of lower costs and higher profits.
The other aspect of the Part 4A regime - information disclosure - is intended to ensure that businesses make information about their operation and behaviour publicly available. Timely and reliable public disclosure is a vital part of any regulatory regime. The information disclosure regime promotes a greater understanding of the relative performance of lines businesses over time; provides information for assessing threshold compliance; and aids in the resetting of thresholds.
So while the perception may be that New Zealand is moving closer to other jurisdictions' approaches to regulating electricity sector monopolies, the targeted control regime is still light-handed by international standards. It allows companies to make their own business decisions about price, quality and investment within broad boundaries of behaviour and is flexible enough to allow workable solutions to be developed without necessarily moving to control.
It is the Commission's desire that this remain so. It is the belief of the Commission that the two pillars of information disclosure and the targeted control regime - "Thresholds" will over time provide a great deal of regulatory certainty for businesses without the nation having resorted to more intrusive regulatory tools as a matter of policy. The Commission intends to only resort to such tools where the performance and behaviour of the particular company in question leave no other options open to the Commission.
Control under Part 5 differs from the Part 4A regime because it involves considerable additional steps in investigating the requisite businesses' activities and costs either by way of a Part 4 inquiry or as a result of the performance or behaviour of the business under Part 4A resulting in a declaration of an intention to control and a further decision, following consultation, that the business should be controlled.
Under Part 5 therefore, the decision to control has already been taken. What is then required is a considerably more intrusive, detailed investigation into the activities and costs of the relevant business. It was due to the intrusive nature of control that the Commission recommended to the Government in the Gas Control Inquiry that a similar targeted control regime be established for gas pipeline businesses. It remains the Commission's view that such a regime has the potential to offer a more favourable trade off between costs and benefits of regulatory intervention for those companies that were identified as not earning significant excessive returns.
The Government has yet to introduce a similar regime for gas pipelines. If it did, further consultation would be required on the implementation and operation of such a regime. There is also the possibility that the businesses currently subject to control could be moved from Part 5 control to the introduced targeted control regime. Therefore the regime should be designed to ease such movement between the regimes. I do note however that the Government recently announced a review of Parts 4, 4A and 5 of the Commerce Act. In so doing they stated that the implementation of any targeted control regime for gas pipeline businesses would be delayed until completion of the review, which I understand to be currently scheduled for October 2007.
I would like to finish this regulatory update with an overview of the Commission's progress towards implementing gas control for the pipeline businesses of Powerco and Vector.
Since the Commission issued the provisional authorisation, we have been working towards issuing a final authorisation for the two businesses. 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.
An important aspect of this work stream will be determination of the appropriate allowance for tax costs. The Commission has outlined its proposed approach to calculating tax allowance in its Intention to Declare Control of Unison Paper.
The Commission's approach to tax seeks to model the actual tax obligations of the ring-fenced lines business, were it acting efficiently. To model this approach, the Commission considers it necessary to use a measure of tax that is intended to estimate the actual tax payable to the Inland Revenue Department. Commission calculates the tax payable derived from the regulatory accounts of the regulated part of the lines business by applying tax rules with adjustments for differences between the regulatory and tax accounts.
I note that the use of this tax approach is the subject of judicial review. However, I do wish to iterate that in the buildings block approach, for the reasons outlined above, the Commission considers the tax payable model outlined above is a legitimate approach. The Commission therefore proposes to apply a similar approach to the gas authorisation. The input parameters will be consulted on fully as part of the Commission's Draft Decisions Process.
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. A Discussion Paper on the form of control was released on 7 July. It sets out the range of options for form of control and the Commission's initial proposals as to the appropriate form of control for the controlled services.
In the paper, the Commission evaluates the possible form of control models, ranging from total revenue caps to disaggregated price caps. It assessed each model's implications for efficiency, volume risk and pricing flexibility plus required information needs for the model to operate. The Commission proposed using a hybrid form of control with different forms of price control for three separate groups. For standard consumers the form of control proposed is a weighted average price cap. For non-standard consumers and for controlled metering services a total revenue cap is proposed. For the regulation of quality, the Commission has proposed a form of control that provides financial incentives for the businesses to maintain quality at the standards that are set by the Commission.
The Commission considered that these proposals best fulfilled the objectives of the Part 5 regime. Consumers' interests are safeguarded through the businesses charging efficient prices and providing the appropriate standard of quality.
Submissions were received on 7 August and again on 4 September following a second round of consultation on the consideration of the recent Government policy statement regarding investment incentives. The Commission also convened a conference on 5 & 6 September. Unfortunately during that week Powerco senior management were unable to attend the conference following the operational problems experienced in Central Wellington. It was therefore agreed that the Conference would be adjourned until a convenient time could be set for Powerco to be able to present at the conference and to answer questions of the Commission; experts and staff.
The Commission is reviewing the issues raised by the submissions and aims to set out its proposed decisions on form of control as soon as possible. I wish to note some of the key issues raised by the parties:
Parties, especially Powerco and Vector argued against the hybrid approach of separate controls for standard and non-standard customers. They argued that separate controls would lead to unnecessary complexity and additional costs and would create issues regarding the possibility of customers changing from standard to non-standard contracts.
Vector raised concerns that a total revenue cap for non-standard customers could create a strong disincentive on them seeking new connections.
Parties raised a concern that any move from the current fixed and variable proportions to the charges towards a proportion based upon the businesses fixed and variable costs would lead to loss of residential connections and would drive away potential connections in an easily substitutable sector.
Another key point raised in submissions was that the Commission proposed an end date of 1 October 2010 for the first period where the control terms are set. This would mean an effective three-year control period. The businesses argued this would diminish the efficiency incentives on the businesses. Both Powerco and Vector have argued for minimum five-year control periods.
The Commission will be mindful of the points made in the submissions to reach draft decisions on the form of control.
One of the difficulties we have confronted has been that of obtaining useful suggestions on meaningful quality measures by the businesses. Vector submitted that for the first five-years there should be no more than an information disclosure regime in place that will establish consistent trend data. Vector argues that there is limited quality data available. On the other hand, the Commission is aware of the role GANZ has been playing in developing meaningful data for the industry and that this is something they have been working hard on particularly over the past five-to-eight years. Moreover, the Commission is also mindful of the Energy Safety Review Bill and the work to develop a safety management system for all gas businesses. The Commission considers that quality measures, which can be transparently measured and reported on will be an important part of the final authorisation from the first period onwards. Mechanisms that provide incentives for businesses to maintain and improve quality and potentially to compensate consumers that are subject to poor quality will be explored.
The Commission still has a lot of work to get through before it can make its Final Authorisation under Part 5. 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. It is for those reasons that the original intention of completing the final authorisation this year has been extended into 2007. Should there be further delays such that the Commission is unlikely to complete its final authorisation in time for pricing changes to be implemented in October 2007, it would have to reconsider amending the provisional authorisation.
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 regime for the gas pipeline businesses, and seeks to make decisions that will enhance regulatory certainty and predictability going forward.