Wholesale and retail electricity prices should signal the full cost of producing each extra unit of electricity;
So that investors and consumers can make decisions which seek to get the most value from each extra unit of electricity

Electricity costs and prices should be subject to strong and sustained downward pressure;
So that electricity producers are forced to innovate and find least-cost solutions over time.

D. In generation, these outcomes are best achieved by a process of effective competition among buyers and sellers, in particular:

Competition in generation: multiple generators should compete vigorously against each other in producing electricity and investing in any necessary further capacity;
Demand-side alternatives: energy efficiency options should compete actively as an alternative to buying additional more expensive power;
Competition in contracts: buyers should be offered a diversity of prices and other terms and conditions for purchasing electricity contracts;
Competition in spot market: prices for electricity in the spot market should be disciplined by effective competition among buyers and sellers.

E. In distribution, the desired outcomes are best achieved by:

Cost minimisation: distribution companies seeking to minimise costs while providing the level of services demanded by customers. An effective price control threat, along with information disclosure, should encourage distribution companies to cost minimisation; and
Customer trade-offs: customers making trade-offs between price and alternative levels of service, and distribution companies providing the level of services demanded by customers through a process of contractual negotiations.

F. In retail, the desired outcomes are best achieved by

Competition in retail: multiple retailers competing vigorously to supply customers; and
Demand-side alternatives: competing retailers and other market participants providing information to consumers on energy efficiency alternatives and consumers evaluating the costs and benefits of those options compared to buying more electricity.

Industry Reforms to Date

G. Over recent years, the industry has evolved through various stages:

In 1987, ECNZ was established as an SOE;
In 1991, Transpower was formed as a separate subsidiary within ECNZ;
In 1993, the former electricity supply authorities were established as energy companies;
In 1994, Transpower was established as a separate SOE.

H. In June 1995, the Government announced an initial package of reforms, mainly focused on the generation sector. Among other things, it provided for:

The formation of Contact Energy Limited, with around 25% of ECNZ's assets;
The sale of eight small hydro stations;
Various restraints on ECNZ expanding and exercising its dominance;
A framework for buying and selling electricity through a wholesale pool; and
Policy statements on security of supply, electricity distribution and electricity pricing.

I. The 1995 reform package was a significant step in the direction of effective competition in generation.

Gains in Wholesale Market

J. The 1995 reforms have delivered a range of benefits, including:

Lower wholesale prices than were expected without the split;
Worthwhile reductions in controllable generation costs;
A fully operational wholesale electricity market (the New Zealand Electricity Market); and
Significantly improved information flows in the market, and the associated benefits of greater transparency and contestability of views.

Problems in Wholesale Market

K. However, the current generation structure also has a range of problems and limitations, in particular:

ECNZ is still dominant in the spot and contracts markets, and is likely to remain so for many years unless there is further break up. The result is that:
- Prices are not competitive: Spot and contract prices are significantly higher than they would be in a fully competitive market;
- Weak future price signals: Market signals of medium to long term prices are not readily available due to limited trading of contracts. This is caused by several factors, in particular ECNZ's incentives to manage its business risks internally;
- Over-capacity: New stations have been committed prematurely, resulting in over-capacity and harm to the environment which could have been deferred or avoided;
- Insufficient pressure on costs: The level of pressure on generation costs is not as strong as it could or should be; and
- Waste of fuel: Less efficient generation plant (New Plymouth) is running ahead of more efficient plant (Huntly), which wastes gas and increases CO2 emissions. The risk of spilling scarce water is also higher.
In addition, the 1995 restraints on ECNZ expanding or exercising its dominance are likely to be ineffective over time. There is significant scope for differences of interpretation and problems in monitoring and enforcement.

L. These problems are not unexpected. The 1995 reform package was a step in a direction, not an end-point. It expressly contemplated that further reforms may be necessary to more fully achieve effective competition in generation.

Problems in Distribution and Retail

M. There are three main outstanding policy problems in the distribution and retail sector which have yet to be effectively addressed:

Monopoly rents: Pressure on costs and profits in distribution, which is a natural monopoly, are relatively weak. While competition in electricity retailing is limited, monopoly rents may also arise in retailing.
Barriers to retail competition: Owners of local electricity companies have the incentives to deter competition in retailing by:
- failing to provide low cost systems to enable customers to switch retailers;
- unreasonably restricting access by competing retailers to their distribution network; and/or
- using monopoly rents to cross-subsidise retail customers at risk to competitors, thereby decreasing the risk that these customers will be competed away.
Uneconomic generation: Local electricity companies have incentives to cross-subsidise generation investments from distribution and retail customers not subject to competition.

No Privatisation

N. The Coalition Agreement rules out the privatisation of Contact Energy, ECNZ and Transpower.

1998 Reforms

O. The reforms as summarised in the following section below are designed to address the problems in paragraphs K and M above.

Summary

Generation Reforms

Split ECNZ into Three SOEs

ECNZ is to be split into three SOEs comprising:

Huntly + Tongariro
Waikato hydros
Waitaki + Manapouri

Remove Restraints on ECNZ's Dominance

Existing restraints on ECNZ exercising its dominance imposed by shareholder directions under section 13 of the SOE Act are to be removed when the split is completed.

Develop a Detailed Implementation Plan

A Transition Team is to prepare a detailed implementation plan over the next two months. SOE Development Groups will then be formed to negotiate detailed contracts for the split within the framework of the Transition Team's implementation plan.

Key Factors to Address Before Final Decision

Government decisions so far are 'in principle' and subject to:

Appropriate consultation with Maori on Treaty issues;
Certification by Transition Team and SOE Development Groups on financial viability;
Certifications by SOE Development Groups that each new SOE is structured to compete vigorously;
Obtaining positive affirmation from market participants, especially wholesale buyers, that they accept full responsibility for security of supply risks; and
Advice from the SOE Development Groups and officials where appropriate, that they have identified any likely changes to station usage and made suitable arrangements to address any environmental issues. Existing protections and penalties under the Resource Management Act are to remain in force.

Distribution and Retail Reforms

Strengthened Disclosure Requirements

Information disclosure requirements, including ODV rules, are to be substantially strengthened. In addition, the disclosure regulations will be amended to provide for a greater level of information which is more readily understandable to ordinary consumers.

Improved Public Analysis

Government will fund better analysis of disclosed information, including publishing regular comparative performance tables and graphs.

Need for Low Cost System to Enable Consumers to Switch Supplier

The industry is required to deliver, within 12 months, a low cost option to enable small consumers to switch electricity supplier if they wish. If this is not delivered, the Government will regulate for a mandatory default switching system (likely to be a form of 'deemed profiling').

Ownership Separation of Lines and Competitive Businesses

Lines businesses are to be owned separately from retail or generation businesses. In particular, power companies can either:

By 1 April 1999, set up a separate trust-owned company for their distribution or electricity retailing/generation activities; or
By 31 December 2003, sell their distribution or electricity retail/generation services and, between 1 April 1999 and the time of sale, operate these activities as separate companies on an arms-length basis.

Increased Threat of Price Control

The threat of price control on the monopoly lines business is to be strengthened by:

Empowering the Commerce Commission to apply price control within Government set criteria or thresholds, subject to Ministerial override; and
Enabling the Government to seek advice from the Commerce Commission on the thresholds and criteria which, if breached, could trigger selective price control.

These mechanisms for strengthening the threat of price control are subject to further work on design and implementation.

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Printed: 24/11/2009