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Reasons for economic regulation (price-quality control)

15. The key reason for economic regulation is to counter the ability of firms which are not faced with competition or the threat of competition to charge excessive prices and/or cut back on quality. Potentially, such firms may also have weak incentives to improve efficiency and to make investments in a timely manner.

16. There are relatively few sectors which are not faced with competition or the threat of competition and where there is substantial scope for the exercise of market power. These sectors tend to be basic infrastructure such as electricity lines, gas pipelines, water, some airport services, telecommunications lines (last mile), and, in some countries, rail and ports. All OECD countries regulate such sectors where they are privately owned.

Issues identified with Parts 4 and 4A

17. The review of Parts 4 and 4A was prompted by a number of perceived problems. Submitters generally (but not unanimously) agreed that the issues include:

• Absence of a specific purpose statement for Part 4. This has led to dispute and uncertainty³
• The test for whether to regulate is controversial,⁴ and the practice of the Commission is to undertake a comprehensive quantitative cost-benefit analysis when undertaking inquiries⁵
• Separate inquiries are required on "whether to regulate" and "how to regulate"
• There are no powers to implement alternative forms of regulation
• The Part 4A thresholds regime is generally regarded (except by the Commission and two other submitters) as unsatisfactory, in terms of certainty for businesses and incentives to invest (covered more fully later)
• The accountability regime for the Commission is limited (only judicial review is available).

18. Additionally, several submitters argued that the current Act had a negative backward-looking focus on control as punishment for bad behaviour and "breaches", rather than a forward-looking incentive-based approach where the regulator and the firm seek to mimic the outcomes of competitive markets.

Overall objectives of the review

19. The objectives of the review have been to seek ways of addressing these issues, and in particular to:

• Provide an efficient and credible regime to address the potential to exercise market power in markets where competition is not possible
• Improve clarity, certainty, timeliness and predictability for businesses
• Tailor the regime to New Zealand's small size (with small firms and limited resources)
• Provide specifically for incentives to invest in infrastructure. Certainty is considered a pre-requisite for this.

Purpose statement

20. As noted, there is currently no purpose statement for Part 4. Part 4A does have a purpose statement however.⁶

21. All submitters agreed that a purpose statement was required for Part 4, but there was no consensus on suitable wording. A key point of contention was whether the purpose should be about improving overall efficiency in the economy or should also explicitly provide for protection of consumers from excessive prices (although these two objectives are not necessarily in conflict).

22. We consider that both issues need to be explicitly provided for, and propose wording along the following lines (subject to PCO drafting) which builds on existing wording in Part 4A:

"The purpose of this Part is to provide for regulation of prices and quality of goods and services to promote the long term benefit of consumers in markets where there is little or no competition and prospect of competition. Any regulation provided for under this Part should promote outcomes such that suppliers:

1. have incentives to innovate and to invest, including in replacement, upgraded and new assets and in related businesses;
2. face strong incentives to improve efficiency and provide services at a quality that reflects consumer demands;
3. share the benefits of efficiency gains with consumers, including through lower prices;
4. are limited in their ability to extract excessive profits."

Forms of regulation

23. At present, the Act only provides powers to implement full price control where an inquiry concludes that economic regulation is justified. Submitters generally agreed with the proposals in the discussion paper that a wider range of regulatory instruments should be available. (There were differences in views on the design detail of some of these forms: these are discussed later in this paper).

24. The following forms of regulation are proposed:

• Information disclosure
• A negotiate/arbitrate regime
• A "default / customised price-quality path" regime for sectors to replace Part 4A
• Price-quality control for individual firms.

25. These models are specified later in the paper and in more detail in Appendix B.

Tests and processes for imposing regulation

26. The current test for whether control may be imposed on goods and services is that competition is limited and control is necessary or desirable in the interests of acquirers. There is no test for whether control should be imposed. Separate inquiries are required on whether to control and, if so, how to control.

27. Decisions on whether to regulate are currently made by the Minister of Commerce, or, in the case of energy sectors, the Minister of Energy. The Commission may initiate inquiries or it may be requested to undertake an inquiry by the Minister.

28. As noted, the Commission's practice, when undertaking inquiries, is to undertake full quantitative cost-benefit analysis on "net acquirers benefit" in assessing whether regulation may be imposed. For the gas pipelines inquiry, the Minister also asked the Commission to assess "net public benefits" to assist in the judgement about whether regulation should be imposed. These inquiries are very time and resource intensive, and open up wide scope for dispute.

29. Following consideration of submissions, the following revised criteria and processes are recommended:

1. Goods or services in a market may be subject to regulation where:
   1. There is little or no competition and prospect of competition and there is substantial scope for the exercise of market power, taking into account the effectiveness of existing regulation or arrangements (including ownership arrangements), and
   2. The benefits of regulation in meeting the objectives of the purpose statement clearly exceed the costs and risks of regulation.
2. In providing recommendations to the Minister, the Commission should undertake a qualitative analysis of all material long-term efficiency and distributional considerations. As part of this analysis, the Commission should, as far as possible and practicable:
   1. quantify material effects on market efficiency
   2. quantify material distributional and welfare consequences on suppliers and consumers
   3. assess the direct and indirect costs and risks of the forms of regulation considered, including administrative and compliance costs, transaction costs, and spill-over effects
3. Any regulation should be the least intrusive necessary to meet the objectives of the purpose statement
4. Where competition develops in a market so that the test for whether regulation may be imposed is no longer met, regulation should be removed
5. "Whether to regulate" and "how to regulate" should, to the extent practicable, be determined at the same time.

30. Most submitters favoured retaining current decision-making processes, whereby decisions on whether to regulate are made by the Minister, given the need to weigh up a range of factors including efficiency and distributional considerations. It is proposed however that:

• The current powers for Ministers to make decisions without an inquiry by the Commerce Commission be repealed
• That decisions be taken by the Minister of Commerce in consultation with the sector Minister (such as the Minister of Energy or the Minister of Transport)
• An inquiry be required both on whether regulation should be introduced (and the form of regulation) and on proposals to change the form of regulation.

Input methodologies

31. "Input methodologies" refers to the methodologies for how to calculate the weighted average cost of capital (WACC), value assets, allocate common costs, prepare regulatory accounts and so forth.⁷ They are a critical input for any inquiry and for implementing all forms of regulation, including information disclosure, negotiate/arbitrate and setting price paths.

32. The discussion document proposed that "input methodologies" be set in an up-front stand-alone process at the start of inquiries and any set or re-set of price/quality paths. The purpose is to give greater certainty, transparency and predictability to businesses (including businesses not subject to regulation) and their customers. Virtually all submitters, including the Commission, endorsed the proposal.

33. The Commission has already developed (and continues to develop) high-level principles, guidelines and specifications on many of the input methodologies as part of its current duties (including administering Part 4A, developing information disclosure for electricity lines, setting price control terms for the gas pipelines of Vector and Powerco and undertaking inquiries on airports and gas pipelines). However, the Commission advises that finalising the methodologies and frameworks at an early date constitutes a major additional workload.

34. Most submitters were strongly of the view that the methodologies should be subject to some form of merits review given the importance of the issues, the need to correct any errors and to provide confidence to businesses about the integrity of the regulatory regime.

35. There are two main options for review, one is an independent expert panel appointed by the Minister and the other is appeal to the High Court (with specialist lay members). The pros and cons are noted below:

36. On balance, we prefer, and recommend, consideration of appeals by the High Court. In particular we think this is a more conventional approach, minimises the risk of further appeals and reviews (because processes are likely to be better) and minimises the difficulties of managing conflict of interest problems.

37. The Commission estimates its costs for preparing input methodologies (at a high generic level, and for electricity lines, gas pipelines and airports) at $1m in 2007/08, $2m in 2008/09 and $1m in 2009/10. These costs would be funded by levy. The costs exclude defending any appeals (estimated at $1.6m in 2009/10 and $1.6m in 2010/11).

Ministry of Justice's views

38. The Ministry of Justice agrees that the input methodologies should be subject to independent review, however, it disagrees with the proposal that appeals be to the High Court. The Ministry considers that review decisions about input methodologies are not suited for judicial decision-making since they relate to fact, rather than interpretation and application of the law. There may also be difficulties in assigning judges with specialist knowledge in this area. While many judges have particular areas of interest and particular specialist knowledge, their role is to interpret and apply the law to a particular factual situation, rather than be the principal decision-maker in matters which require highly specialised knowledge about input methodologies.

39. Although the proposal allows for the High Court to appoint lay members with specialist knowledge, the Ministry considers that an independent body made up of specialists is more appropriate. An independent panel will enable the appointment of people with the appropriate technical knowledge and skills. Furthermore, an appeal to the High Court is likely to take more time than an independent panel which could dedicate resource to such reviews. This could impact on the timeliness of inquiries under the Commerce Act as well as implementing regulation.

Criteria for appeals

40. It is proposed that the criteria for appeals be based on the draft Australian National Gas Law, as follows:

1. The original decision maker made an error of fact in its findings of facts, and that error of fact was material to the making of the decision;
2. The original decision maker made more than one error fact in its findings of facts, and those errors of fact, in combination, were material to the making of the decisions;
3. The exercise of the original decision maker's discretion was incorrect, having regard to all the circumstances.
4. The original decision maker's decision was unreasonable, having regard to all the circumstances.⁸

41. It is also proposed that:

• The Commission may adopt, with modifications where required, methodologies used by regulatory bodies in similar overseas jurisdictions
• Appeal processes should be limited to a re-consideration of material submitted to the Commission.⁹

Information disclosure

42. We propose that powers to recommend and implement information disclosure be provided in the Act. Information disclosure is a relatively light-handed form of regulation, although it can be quite powerful in setting standards on what is acceptable and for early identification of trends which may raise concerns.

43. It is recommended that the power includes the ability to require forward-looking information (such as asset management plans, investment intentions, regulatory accounts, prices and quality standards) and that the Commission be empowered to monitor compliance and outcomes. Clear and explicit "input methodologies", including pricing principles, are a key component of effective information disclosure.

Negotiate/arbitrate regime

44. The discussion paper proposed that the Commerce Act include powers to put in place a "negotiate/arbitrate" regime, as follows:

1. Parties (suppliers and their customers) would be encouraged to negotiate a settlement on matters such as investments, quality of service and prices
2. If they fail to agree within a specified timeframe, they may agree on an arbitrator, or the Commission may appoint an arbitrator (including itself as arbitrator)
3. The Commission would have powers to set processes and timeframes for negotiation, and specify the scope of negotiation, the form of arbitration (including final offer arbitration) and the input methodologies to be used.

45. The Australian Trade Practices Act Part III provides for a negotiate/arbitrate regime for terms and conditions for access to essential facilities and negotiate/arbitrate-determine also underpins New Zealand's Telecommunications Act. A number of overseas jurisdictions (including Canada and Florida on electricity and the UK with some airports) are said to have experienced success with "negotiated settlements", with suppliers and customers able to customise a settlement to meet their own requirements.

46. Submitters were divided on whether negotiate/arbitrate was a useful option.¹⁰ The option was strongly supported by airlines (which want it applied to airports), and was strongly opposed by airports (which see it as not much different to full regulation).

47. On balance, we propose to include this form of regulation as an option, recognising that it will only be likely to be used in fairly specialised circumstances.

Default/customised price-quality path

48. This approach is designed to build on and replace the Part 4A thresholds regime for electricity lines businesses (except trust-owned businesses: see later). It is also proposed for gas pipelines (see later comment) and to be available as a potential form of regulation for other sectors.

49. The design details are specified in Appendix B. Its key features are as follows:

1. The Commission should set a default price-quality path for a regulatory period (normally 5 years) for all businesses in a regulated sector based on factors such as productivity trends and comparative benchmarking. In this respect it would be very similar to the current Part 4A thresholds regime
2. A firm would have a choice of either accepting this default path or making a (public) proposal to the Commission for a customised path. The Commission would specify the scope and quality of information required from the firm for a proposal, including use of specified input methodologies (for WACC etc),¹¹ consultation requirements with customers, independent audit and so forth.
3. The Commission would make a determination on the firm's proposal within 9 months (plus two months if additional information is required from the firm for a complete proposal, plus a further 6 weeks if the firm and the Commission agree). Timeframes are shown in Appendix C. The Commission may set a tougher price-quality path than the default.
4. Conventional penalties and remedies would apply to any breaches of default or customised price-quality paths.
5. Other design specifications:
   1. The firm may submit a proposal in any year of the regulatory period, but may only submit a proposal once during the regulatory period
   2. The Commission would only be obliged to make determinations on four proposals per sector a year, and to prioritise its work as it saw fit. Other proposals would be deferred until the following year
   3. The default path would apply from the start of the regulatory period. Provision would be available for reasonable revenue-recovery where the Commission subsequently set a higher price path
   4. Any customised path would apply for 3 to 5 years and firms coming off a customised path would revert to the then applicable default path
   5. If the Commission does not make a determination on a proposal for a customised price-quality path within the specified timeframe:
      1. The default path would apply if, in the Commission's view, the firm had not adequately met the Commission's (reasonable) requests for additional information within specified timeframes
      2. The firm's proposed path would apply if the firm had met such requests.

50. This regime is designed to build on the strengths of the Part 4A thresholds (namely setting sector-wide price paths based on comparative information) while addressing its main weaknesses. These weaknesses include:

• Lack of certainty for businesses. (There is uncertainty for firms over what happens in the event of a breach and the outcomes of administrative settlement processes. Over 100 breaches dating back to 2003 remain outstanding, and 27 of 28 lines businesses have breached. One effect of uncertainty is that the incentives built into CPI-X thresholds do not work properly).¹²
• Absence of a mechanism for ex-ante approval of abnormal investment. (A firm must breach thresholds in order to engage with the Commission on future investment. This tends to be an adversarial and time-consuming process)
• Lack of timeliness in decision-making
• Potentially disproportionate penalties for breaches. (Breaches may be minor, technical and historic, while the consequences can relate to any aspect of a firm's activities).

51. The proposed regime overcomes these deficiencies by providing an ex-ante, time-bound opportunity for firms to seek Commission approval of a customised path. Any breaches of a price-quality path would be subject to a conventional "reasonable" penalty/remedy regime (already provided for in the Act).

52. Virtually all submitters¹³ favoured some sort of replacement to the Part 4A regime. The Electricity Networks Association (ENA) favoured a "propose-respond" regime whereby firms which breach thresholds could make proposals at any time to which the Commission would respond. (ENA proposed that arbitration or merits review would be available where the firm and the Commission could not agree).

53. The Commerce Commission favours retaining the Part 4A regime. It considers it is working well, that criticisms are over-stated, that future thresholds could have an ex-ante element, that administrative settlements are effective, and that as precedents are set firms would be provided with more certainty. The Commission notes that regulation is a learned process, is developed over time with experience, and that the thresholds regime is still relatively new and has not yet completed its first cycle. It also argued that the regime provides it with flexibility to address problems and issues which arise and that it is premature to replace it.

54. Careful consideration has been given to the views of submitters and the Commission, and the proposed regime reflects detailed discussion with the Commission on practicalities. On balance, we consider that the proposed regime retains the most useful aspect of the Part 4A regime (setting price-quality paths based on sectoral information) while improving certainty and incentives for investment.

Merits review

55. The discussion paper raised the possibility of limited merits review of Commission decisions relating to specific matters (as well as input methodologies), for example on customised price-quality paths.¹⁴ It suggested that merits review might be by way of appeal to the High Court for a re-rehearing.¹⁵

56. The main arguments for and against merits review can be summarised as follows:

57. Businesses submitters generally supported the introduction of merits review, noting the importance and far-reaching effects of regulatory decisions. They argued that merits review is desirable to minimise the risk of regulatory error and improve the quality of regulatory decisions over time. Experience in overseas jurisdictions was cited (such as the UK) where relatively few decisions have gone to appeal.

58. The Commission argued that the case for introducing merits review had not been made. It questioned whether, given the highly technical nature of arguments, courts are well placed to make better judgements than the Commission.

59. Officials recommend that merits review be provided for. However, on balance, we (Ministers) consider that the arguments against introducing merits review of Commission decisions (other than on input methodologies) outweigh the benefits. Accordingly, we consider that appeals should be permitted only on points of law. Commission decisions would also be subject to judicial review.

Electricity lines businesses

Consumer trust-owned electricity lines businesses

60. The discussion paper raised the possibility that 100 percent consumer trust-owned electricity lines businesses should be subject to lighter-handed regulation (such as information disclosure) on the grounds that (a) their consumers were also their owners and (b) their relatively small size may mean that the costs of heavier regulation outweigh the benefits.

61. The arguments in submissions covered the following:

62. The Electricity Networks Association (ENA) and trust-owned companies in particular supported a lighter-handed regime where there is a high overlap (over 90 percent) between customers and beneficial (voting) owners of the business. The Commerce Commission, some generators and some non-trust ELBs recommended against a special regime for trust-owned ELBs for the reasons noted above.¹⁶

63. On balance, we recommend that 100 percent consumer trust-owned ELBs be subject to information disclosure only. Qualifying criteria are:

• There is an overlap of at least 90 percent between consumer owners and customers of the ELB
• All of the ELB's consumers (including, for example, businesses) benefit from any distribution of profits made by the ELB or the trust, and
• The ELB is "small" (under 100,000 consumers).

64. Information disclosure would cover both historic and forward looking information, including prices, investments, asset management plans, and quality. It is also proposed that input methodologies specify principles for pricing and cost allocation, to ensure that prices to particular classes of customer are cost-reflective and do not involve cross-subsidies. Information disclosure will reveal compliance with these principles.

65. To manage risks, it is proposed that the Commission may make a recommendation to the Minister that the "default / customised price-quality path" regime be imposed on a trust-owned ELBs where:

• it no longer qualifies for the lighter regime, or
• where a substantial proportion of its consumers have petitioned the Commission and the Commission concludes that a change in the form of regulation would better meet the purpose statement.¹⁷

66. The main reason for the lighter-handed approach is that the case for economic regulation is relatively weak where the customers are also the owners of a firm. The incentive of trusts to charge excessive prices is relatively low where excess profits are returned to the customers. With regard to quality, the power of consumers to replace trustees and the right to petition the Commission constitute sufficient safeguards against quality which is unacceptable to the affected community. In addition, we propose that the Commission be empowered to require trust-owned ELBs to disclose their performance against quality and price standards set for other ELBs, and to analyse and comment on that performance.

67. This approach would cover 17 of 28 ELBs. A list of affected ELBs is provided in Appendix D.

Transitional arrangements for other ELBs

68. As noted earlier, it is proposed that the "default/customised price-quality path" be applied to other electricity lines businesses.

69. The existing thresholds under Part 4A expire on 31 March 2009. The Commission is currently working on a re-set for 2009 to 2014. ELBs have argued for a roll-over of thresholds at the rate of CPI-0% until a replacement regime (including input methodologies) is in place. However, it is not evident that CPI-0% (or roll-over of existing thresholds) is appropriate, and the proposal raises legislative and timing issues. Accordingly the following transitional arrangement is proposed:

• The Commission should continue its current work programme to re-set thresholds from 1 April 2009 (this includes updating its non-statutory Guidelines, which can be regarded as a pre-cursor to statutory "input methodologies")
• the "default/customised price-quality path" regime should apply from 1 April 2009 with the thresholds becoming the default path
• Until the input methodologies are ready, any proposals by firms for a customised path should be based on the Commission's Guidelines. Conventional penalties/remedies apply to breaches.
• Any administrative settlements in place at 31 March 2009 would continue for their term
• Breaches older than six months should expire when the legislation comes into force (except where the Commission has notified the company of its intention to undertake an inquiry or has given notice of an intention to declare control).

Transpower

70. Transpower is currently subject to the Part 4A regime administered by the Commerce Commission. Transpower breached its thresholds in 2003 and every subsequent year. The Commission and Transpower are currently finalising an administrative settlement to apply until 2010/11.

71. The Commerce Act currently provides for transferring responsibility for administering Part 4A for Transpower (and other lines businesses) from the Commerce Commission to the Electricity Commission by Order in Council. The Minister of Energy consulted on whether to transfer responsibility for Part 4A to the Electricity Commission in 2006. At that time, the Minister decided not to make the transfer because of concerns about the capability of the Electricity Commission to undertake the additional workload. Both Commissions also recommended against the transfer at that time.

72. Transpower's submission favoured transferring responsibility for the Part 4/4A regime to the Electricity Commission as part of the amendments to the Commerce Act. It considered this would improve certainty, reduce administration and compliance costs, and ensure integrated decision-making.¹⁸

73. However, the Electricity Commission considers the case for transferring responsibility at this stage is not strong. It considers that the tasks of the two Commissions are different, and that an updated Memorandum of Understanding between them ensures that decisions are taken in an integrated manner. It also notes that it would need to replicate expertise currently held by the Commerce Commission and that a decision to transfer can be made in future, if necessary, under the current provisions of the Act.

74. After considering the various views, we propose to retain the status quo.

Energy efficiency

75. The way price/revenue paths are set has an important influence on incentives for electricity lines businesses to invest in energy efficiency and demand-side management. Arguably, the way thresholds are currently set (based on price irrespective of volume) incentivises firms to encourage consumption (or at least not discourage consumption) because this improves their rates of return.¹⁹ (An exception to this occurs where lines/facilities are near capacity and where investing in demand reduction would be cheaper than constructing new lines/facilities).

76. In order to avoid this effect, we recommended that the Commission be required to provide for incentives to improve energy efficiency/demand-side management and to reduce energy losses when administering the regime for electricity lines businesses.

Gas pipelines

77. In 2005 the Government accepted the recommendations of the Commission, following an inquiry, that price control (under Part 5) be imposed on the gas pipelines of Vector and Powerco. The Commission is expected to set a 5 year price path early next year.

78. The Commission also recommended that the Government legislate for a Part 4A regime for all gas pipelines (except Nova Gas and the Taranaki pipelines). The Government also accepted this recommendation.

79. On the basis of these decisions, it is recommended that all gas pipelines (except Nova Gas and the Taranaki pipelines) be subject to the "default / customised price-quality path" regime and that Powerco and Vector transfer to this regime at end of their current regulatory period.

Other sectors

80. A companion paper makes recommendations concerning the regulatory regime for airports. No changes are proposed for other sectors. The amended Commerce Act would be available for application if an apparent need arise.