43. The aim of this proposal is to give lines companies access to a wide range of trading arrangements to manage risks and to capture the benefits of owning generation. For example, enabling them to offer continuous supply contracts and manage the associated risks of doing so.

44. The Ministry has already consulted on this proposal⁵. Industry submissions regarding potential merits and ramifications of this proposal have been analysed, and the main benefits and costs/risks of this proposal are as follows:

Benefits

45. Allowing lines companies limited access to hedge market trading may encourage investment by lines companies in new generation up to the permitted limits by enabling lines companies to better manage revenue flows from their output.

46. An ability to trade in financial hedges will allow lines companies to better manage any supply of electricity they can offer into the market, which may provide them with the ability to sell electricity to retail customers. An increased level of retail competition in local areas is another possible benefit of this proposal, although this increase will be limited to the relatively small output of the generation owned by the lines companies.

Costs/Risks

47. Electricity generation/retail companies have argued that if lines companies decide to sell their electricity to retail customers as a result of being able to trade in financial hedges, then they may have incentives to favour their own retail supply against competing retailers, or create difficulties for other retailers.

48. This risk is much lower than before ownership separation was introduced because lines companies no longer own the incumbent retailer and use-of-system agreements for competing retailers are in place. This risk will also be reduced by continuing to require lines companies to be subject to appropriate corporate separation and arms length rules, as well as the thresholds (price) control regime. In addition, lines companies' generation and retail activities will be capped at the amount of their own generation.

Conclusion

49. The Ministry has already consulted on this proposal. On balance, the Ministry considers that the risks of this proposal are low and there is a good case for allowing lines companies to trade in hedges and related financial instruments to better manage their trading risks for the output from the generation stations they own.

4.2 Changes to the Arms Length Rules

4.2.1 Proposed Option - Increase the ALR Threshold/Align the ALR Thresholds with the Ownership Thresholds

50. The proposal is to raise the threshold for arms-length separation above the current minimum level (5 MW or 2% of lines peak load) or up to the current cross-ownership limits (50 MW or 20%).

51. It should be noted that raising the threshold to 50 MW or 20% would align the arms length threshold with the current cross-ownership limits, effectively removing all statutory constraints on cross-involvement up to the specified capacity limit.

52. By its very nature, a threshold will always be a particular number, and there will be some examples that can be argued should be allowed or disallowed on either side of it. The question is whether a higher threshold would encourage additional investment in generation while ensuring lines companies do not have opportunities to reduce competition. In particular, are there some smaller generation investments that are not viable because of arms-length rules applying? Is there a threshold at which the percentage of costs due to the arms length rules will discourage investment? At what threshold or percentage of the lines company load are competitive concerns in the generation market are likely to become an issue?

53. The proposal to raise the arms-length threshold has been analysed in the context of its impact on lines companies' ability to cross subsidise its generation and retail activities and to lessen competition in generation and retail markets. The likely benefits and costs/risks of this proposal, as seen by the Ministry, are outlined below.

Benefits

54. It is likely that some additional competition or at least threat of competition in generation would take place if the current arms length rules were relaxed. Lines companies have expressed an interest in investing in generation and claimed to have some comparative advantage in doing so, including:

Involvement in the electricity sector (investment in generation, as argued by lines companies, is a natural extension of their current business activities);
Strong balance sheets; and
Local presence and knowledge of generation opportunities.

55. While it seems likely that there will be some increase in investment in generation resulting from this proposal, it is unclear how much additional generation is likely to eventuate. By and large, there is no apparent shortage of project proposals or capital for investment in generation. Rather, the main barriers to generation investment are uncertainty regarding the availability of gas, climate change policies and RMA difficulties. None of these would be affected by the relaxation of the arms length rules.

56. Additional competition in retailing, or the threat of competition, also appears a likely consequence of raising the arms length threshold to 50 MW.

Costs/Risks

57. There are several short and long term risks associated with a proposed change in the threshold where arms length rules apply. These are listed below.

58. There is a risk of cross-subsidy from captive lines customers to retailing activities. While this risk has been considerably reduced by the Commerce Commission's threshold regimes, the requirement for stand-alone companies and arms-length rules provides a useful buffer for a regime that has not yet been fully tested.

59. There is a risk that lines companies would favour their own retailer against competing retailers. While this risk is much lower than before ownership separation was introduced, without the requirement for an arms length relationship, the more retailing a lines company undertakes, the more opportunity it has to create difficulties for competing retailers.

60. Similarly there is a risk that lines companies may have opportunities to create difficulties for competing local distributed generation. Potential new entrant generators would be required to reveal commercially confidential plans to the lines company which could also be a competitor.

61. There is also a risk that too much reliance on behavioural regulations (e.g. information disclosure under part 4A of the Commerce Act) would be much less effective than a form of structural separation, such as the current corporate separation accompanied by the arms length governance requirements. While impacting on the underlying incentives, behavioural regulations do not remove the ability of companies to act anticompetitively, are difficult and costly to police and involve a constant "uphill battle" for the regulator.

62. The proposed relaxation of the arms length rules is inconsistent with the internationally accepted argument that other regulatory measures that could be put in place of corporate separation are unlikely to be sufficiently robust to address the implications of vertical integration and information asymmetry. Examples of international approaches from the UK and Australia showing several forms of corporate/legal separation are included as Appendix 3.

Conclusion

63. The Ministry considers that the risk of anticompetitive behaviour by lines companies if the threshold was raised to 50 MW may be significantly greater than any potential long term benefit to electricity consumers. It is, therefore, considered that implementation of this proposal, at this stage, is not desirable. However, the Ministry is still evaluating the merits of raising the threshold where arms length rules apply to a level above 5 MW or 2%, and will consider submissions addressing this issue.

4.2.2 Proposed Option - Apply Less Onerous Requirements for Small (Up to 50 MW) Generation Projects

64. If the threshold for arms-length separation was not raised, another option to consider would be introducing less onerous requirements for arms length rules between the two current thresholds. For example, accounting and information separation could be required, but staff, managers and/or directors may be able to provide services for both the lines and generation parts of the distribution company.

65. There are similar benefits and costs for this proposal as for the proposal to raise the arms-length threshold outlined above. The key question here is whether cross-involvement by individual directors or staff would provide material opportunity for anti-competitive behaviour, for example, misusing information acquired in the lines business.

Benefits

66. Less onerous arms length rules may reduce compliance costs for lines companies, as they would not need to meet as many requirements of arms length separation.

Costs/Risks

67. Any scheme would need to be carefully designed to avoid possible risks of lines companies favouring their own generation or retail, by misusing the information or knowledge that individual staff or directors may acquire through their involvement in the lines business.

68. As noted above, there is a risk that relying on a greater degree of behavioural regulation would be less effective than having a stronger form of structural separation, such as the current corporate separation and arms length rules. A greater degree of behavioural regulation would not remove the ability of companies to act anticompetitively, would be difficult and costly to police and would involve a constant "uphill battle" for the regulator.

69. In particular, it is likely that additional monitoring would be necessary. In addition to the price thresholds regime monitoring, it may be necessary to have more active monitoring under EIRA to ensure the purpose of parts 1-5 is met, i.e. that companies are not able to inhibit competition in the electricity industry or cross-subsidise generation activities from electricity lines businesses.

Conclusion

70. On balance, the Ministry considers that the risk of anticompetitive behaviour by lines companies from making the arms length rules less onerous may be greater than any potential long term benefit to electricity consumers. It is therefore considered that implementation of this proposal is not desirable.

4.2.3 Proposed Option - Provide Increased Flexibility to Lines Companies to Meet Their Arms Length Obligations

71. Provide lines companies with more flexibility to decide how they are going to meet the arms-length requirements. For example, in the UK electricity distributors develop their own proposals outlining how they will comply with conditions and submit these to the regulator for approval. In Australia, the regulator provides an option where if a distributor considers that they have a better method of ring-fencing that meets the high level objectives, they can seek the regulator's permission to implement it.

Benefits

72. Administrative costs for lines companies could be reduced if greater flexibility were provided for lines companies to implement arms length requirements in a way that is lowest cost for them while still meeting the intent of the rules. Greater flexibility may also lead to more efficient and innovative solutions to reduce costs for lines companies.

73. If arms length costs were reduced, this may also lead to an increased level of investment in generation.

Costs/Risks

74. Decisions on whether arms length requirements have been met may take more time and effort, and have a higher degree of uncertainty. The overall process for implementing arms length requirements would be less clear than if it were specifically defined in legislation. Default arms length provisions would need to be retained in legislation.

75. With a higher degree of flexibility in the application of arms length rules, there may need to be additional monitoring to ensure the intent of the arms length rules was still being complied with. This would lead to greater regulatory costs.

76. There is also a question of how different a process of applying for flexible application of arms length rules would be from seeking an exemption under current legislation. The current exemptions process considers applications on a number of criteria including whether an exemption would create a relationship between an electricity lines business and an electricity supplier which is not at arms length. I.e. it considers whether the arms length rules are being met without meeting the specific provisions of the legislation.

Conclusion

77. On balance, the Ministry considers that the current exemptions regime would take into account cases where lines companies sought additional flexibility in applying arms length rules and does not consider there is a necessity for a separate process, as any process for assessment would be sufficiently similar to the current exemptions process.

4.2.4 Proposed Option - Remove Arms Length Requirements for Generation Connected Not to the Lines Company's Own Network

78. Remove the requirement for lines companies to comply with arms length rules when generation owned by a lines company is connected to a different distribution network or the transmission grid, and retail customers (if any) are outside the lines company's network. In this situation, it is suggested the lines company has no conflict of interest with other generation proposals on the local network, and no insider information about customers' energy usage, and therefore that there is no need to impose constraints on lines company involvement in energy supply.

79. Recent decisions by the Commerce Commission on exemption applications from Unison and Eastland Networks are consistent with this proposal. Unison Networks was granted an exemption for a wind farm connected to the transmission grid provided they did not retail the output from this wind farm to customers on their own network. On the other hand, Eastland Networks application for exemption from the provisions of EIRA was declined as Eastland Networks proposed to retail electricity on their own network and the Commerce Commission considered that this would create incentives and opportunities to inhibit competition in the electricity industry.

Benefits

80. Generation not connected to local networks will capture the benefits of any comparative advantage that lines companies have in investing in generation, including involvement in the electricity sector, while not providing incentives for companies to use their knowledge to behave anti-competitively or favour their own generation and retail on their network.

81. The incentive and ability for lines companies to create difficulties for local distributed generation connecting to their network would be removed. Lines companies would be connecting to other distribution networks, so would not be competing on their own networks.

82. Overall there would be less need for arms length requirements as lines companies will not have information they can share with their generation part of the company about the best places to connect generation or information about customers' energy usage. This would lead to reduced compliance costs for lines companies.

Costs/Risks

83. There would still be some risk of lines businesses using the monopoly part of their business to subsidise the competitive parts of their business (generation and retail). Lines companies may still require some sort of accounting/financial separation between competitive generation and monopoly lines businesses to avoid cross subsidisation risks. However this risk is substantially reduced by the Commerce Commission monitoring of the price threshold regime and information disclosure requirements set out in part 4A of the Commerce Act.

Conclusion

84. On balance, we conclude that there is a case for removing the arms length rules when generation is connected to an unrelated network.

4.3 Reducing Legislative Uncertainty

4.3.1 Proposed Option - Criteria to Guide the Commerce Commission in Exemption Applications

85. The proposal is to provide specific criteria to guide Commerce Commission and distribution companies in applications for exemptions from the provisions of EIRA.

86. Some lines companies argue that in order to be in a position to satisfy Commerce Commission questions, a project needs to be a long way into its development plan, and that guidelines would enable the Commerce Commission to obtain relevant information for decision-making and provide clarity earlier in the exemptions process.

87. Currently, the Commerce Commission can make exemptions under section 81 of EIRA. The Commission's Practice Note 3 outlines the criteria that the Commerce Commission uses to decide applications. The Commission will have regard to the particular purpose of parts 1-5 of the Act as defined in section 2(2) of the Act, and the overall purpose of the Act as set out in section 2(1) of the Act, and will not grant exemptions if they believe these will be contrary to this purpose. In particular, the Commerce Commission will evaluate whether an exemption would:

create incentives or opportunities to inhibit competition in the electricity industry;
create incentives or opportunities to cross-subsidise generation activities from electricity lines businesses; or
permit a relationship between an electricity lines business and an electricity supply business which is not at arms length.

88. Factors the Commerce Commission considers include the relevant market(s) within the electricity industry, the nature and temporal nature of any incentives or opportunities created, and the nature and temporal nature of any relationship which is not at arms length.

89. The question is whether it would be possible to improve the current process for deciding exemptions by improving clarity and reducing time taken and information required for decision-making. To answer this question requires more information from stakeholders on what they consider to be the issues with the current situation, including time taken for exemption applications to be processed, costs incurred in making an application whether successful or unsuccessful, and any other issues experienced with the process of applying for exemptions. This information would clarify whether providing criteria in legislation would create more certainty around the process of applying for exemptions.

90. At present, it is not clear, given the criteria for decision-making from Practice Note 3, whether additional legislative requirements would help solve process issues, bearing in mind that any legislative guidelines for exemptions also need to ensure exemption applications are consistent with the purpose of the EIRA.

91. Whether legislative criteria would make a difference to the exemptions process will also depend on what those criteria are. One possibility would be to emulate the criteria used in Australia by the Australian Competition and Consumer Commission (ACCC) for testing exemptions from the ring-fencing guidelines for transmission companies. This test requires the ACCC to assess the public benefits of compliance with the obligations in the guidelines and the administrative costs of compliance with the obligations in the guidelines. If the ACCC is satisfied that the administrative cost outweighs the public benefit, the waiver will be granted. In addition, as part of the process of granting a waiver from the ring-fencing guidelines, the ACCC may consider imposing any additional obligations.

92. Before considering whether this legislative test would be useful in the New Zealand context, we would need more information from stakeholders on whether it would simplify exemption applications, including information on how stakeholders could define and estimate both the administrative costs of applying current arms length rules and what the public benefits of compliance with the rules are.

93. Whether criteria should be added in legislation will depend on whether doing so would improve the process of applying for exemptions and create more certainty. There is a need to also consider whether making criteria compulsory would assist the exemptions process more than including non-compulsory criteria that may be taken into account. The advantages and disadvantages of being more prescriptive in legislation and therefore more certain about the procedure for exemptions are discussed briefly below.

Benefits

94. If specific criteria for deciding exemptions were outlined in legislation it may be easier for lines companies to put together an application for an exemption saying how these criteria will be met, and provide more transparency for applicants. In addition, specific guidelines in legislation might speed up decision-making by the Commerce Commission.

Costs/Risks

95. If the suggested criteria are too detailed and prescriptive, or are compulsory, rather than simply criteria which may be taken into consideration, this may lead to a lack of flexibility around exemptions, which may make it harder to give some generation projects appropriate consideration and slow down the process of consideration of exemptions. Whether this is the case will depend strongly on what proposed criteria are, so there is a need to ensure any particular criteria proposed would in fact facilitate the exemptions process.

96. If guidelines are not outlined in legislation, then any decision on an exemption may have the effect of creating a precedent which the Commerce Commission and the industry will look to for guidance in future applications.

97. There have only been two applications relating to exemptions from arms length rules for major lines companies to build new generation decided under the Act. These are Eastland Networks' application for an exemption to build and operate a wind farm located at Mokairau, and retail the electricity produced on its own network, and Unison Networks' application for an exemption to develop and operate a wind farm in the Hawkes Bay, which would be connected to the transmission grid and sold on the wholesale electricity market.

98. Unison Networks was granted an exemption from the arms length rule forbidding appointment of managers from the lines business to the board of the joint venture company and allowed to enter into electricity hedges, but required to comply with all the other arms length provisions and may not retail the output from the wind farm to customers on its own network. Eastland Networks' exemption was declined as the Commerce Commission considered that granting it would create incentives and opportunities to inhibit competition, in particular, that Eastland Networks could favour its own retailer over others using its network.

99. The decisions from these exemption applications may provide guidance for future exemptions, decreasing decision-making time. However, in New Zealand, which is a small jurisdiction, it may take a long time for a sufficient number of cases to be decided to provide a body of case law. This is particularly because we are yet to be convinced that exemptions are likely to be widespread, rather than limited to a few specific cases. However, once a body of cases exist, guidance from these may be more useful than creating an additional set of legislative guidelines.

Conclusion

100. It is unclear the extent to which the exemptions process needs changing. Not many cases requesting exemption for investment in new generation have yet been considered. On balance, the Ministry's recommendation is that any additional criteria would be included as something that may be taken into account, rather than as requirements.

4.3.2 Proposed Option - Redraft Arms Length Rules to Make These More Specific

101. Redraft the provisions of "arms length" rules in Schedule 1 of EIRA to include more information spelling out what is and is not permitted and description of activity/functions rather than the titles of individuals performing functions.

Benefits

102. Some lines companies suggest that more specific wording of the arms length rules in Schedule 1 of EIRA would make it easier for them to know how to meet the requirements of the act and to reduce uncertainty, which would encourage additional investment in generation.

103. This proposal would be consistent with international approaches to this issue. As noted in Appendix 3, both Australian and UK rules are much more specific on detail of what is required in order to ensure separation between monopoly and competitive parts of an electricity business. For example, in New South Wales, businesses are required to have physical separation of offices, information separation, and staff separation between lines and supply businesses.

Costs/Risks

104. There is a need to consider the balance between being flexible and being specific. If the arms length rules were made more specific, they would also become more prescriptive. This may then also discourage investment in generation if lines companies find difficulties in meeting particular requirements.

105. The questions stakeholders need to consider are firstly whether they consider the costs of uncertainty under the current provisions in schedule one are greater than the costs of complying with more detailed arms length requirements, and secondly which specific areas do lines companies require more certainty in?

Conclusion

106. On balance, the Ministry does not recommend reviewing the provisions of the arms length rules at this stage.

⁵Facilitating in Investment in Generation by Lines Companies: a discussion note

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Printed: 09/11/2009