Light-Handed Regulation of New Zealand's Electricity and Gas Industries

Energy Policy Group
Ministry of Commerce
Wellington
October 1995

1. This note:

• describes the main features of the light-handed regime of economic regulation being adopted in New Zealand's electricity and gas sectors;
• describes the key elements of the information disclosure arrangements which are part of the light-handed regulatory regime; and
• summarises the advantages and disadvantages of light-handed regulation.

The note does not deal with regulations covering safety, measurement, and work standards.

Description of Light-Handed Regulation

2. Light-handed regulation consists of three components:

• use of the existing competition policy regime, i.e. the Commerce Act 1986, to deal with anti-competitive behaviour, including the possibility of court action by private parties or the Commerce Commission;
• extensive information disclosure, to make transparent the performance of electricity and gas businesses with market power; this will facilitate both negotiations with these businesses and recourse to the provisions of the Commerce Act; and
• the threat of further regulation, such as introduction of price control, if market dominance is abused.

3. Light-handed regulation is being used in New Zealand to stem abuses of market power in network industries (specifically, light-handed regulation has been implemented for telecommunications and electricity, and is being implemented in the natural gas markets). Possible abuses include anti-competitive behaviour (e.g. unreasonable denial of access to lines or pipelines to exclude a competitor from a market), and monopoly pricing (i.e. instances of excessive profits or recovery of excessive costs). In energy, light-handed regulation focuses particularly on the natural monopoly components of the two industries (i.e. the wire and pipeline components of transmission and local distribution) where concerns relating to dominance are greatest. Requirements on components where competition is possible (energy retailing, electricity generation and gas wholesaling) are much less stringent.

4. Two provisions of the Commerce Act 1986 are particularly relevant to the regulation of electricity and gas industries:

• section 36, which prohibits businesses which are dominant in a market from using that dominance to restrict entry of any person into a market, or from deterring competition in a market; and
• Part IV, which allows the government to introduce price control in markets where competition is limited and where price control is considered to be in the interests of a market participant or participants.

In addition, a temporary provision in the Electricity Act 1992 permits price control to be imposed on electricity supplied to domestic consumers.

5. The information disclosure requirements in energy are considerably more wide ranging than in telecommunications. This reflects the much more competitive market faced by Telecom New Zealand Limited, the dominant player in that market, given the range of alternative communications possibilities and relatively rapid technological change vis-a-vis the energy sector. Within energy, information disclosure requirements for electricity are greater than proposed for gas, again reflecting relative competitive conditions (electricity is an essential requirement for almost all premises, and technological change is relatively slow in most situations, while gas faces much stronger inter-fuel competition, including from electricity).

6. Information disclosure regulations for electricity took effect from 11 August 1994. The disclosure regulations for gas are currently under development.

Content and Purpose of Information Disclosure Regulations

7. Collectively, information disclosure is designed to help:

• discourage monopoly pricing (i.e. excessive profits and/or costs);
• promote competition in electricity retailing and generation, and in gas retailing and wholesaling (e.g. by clearly "ring-fencing" natural monopoly and potentially competitive sectors). Information disclosure does this by:
• promoting open access to natural monopoly lines
• revealing predatory pricing
• revealing cross-subsidies between natural monopoly and competitive activities
• discourage uneconomic electricity generation; and
• discourage excessive cross subsidies between consumer classes.

8. The information that will be required to be disclosed is listed below.

Potentially Competitive Sectors - Electricity Retailing and Generation, and Gas Retailing and Wholesaling

1. Dominant firms, which possess market power compared to consumers and potential competitors, will be required to disclose prices, terms and conditions of supply (i.e. the main provisions of both standard and non-standard contracts). Contracts pre-dating 1 August 1990 are excluded (1 August 1990 corresponds to the date that the new regime was announced, and it is considered that contracts prior to that date would be unlikely to contain anti-competitive conditions).
   • This will help facilitate new entry, e.g. by facilitating detection of any instances of anti-competitive pricing including predatory pricing (predatory pricing is charging particular customers artificially low prices in order to eliminate a competitor). It will also improve the negotiating position of consumers, e.g. by facilitating comparisons between contracts offered by the dominant company.
   • The requirement for disclosure of prices, terms and conditions of supply will not apply to gas retailing. This recognises the competition faced in this part of the energy market.
   • The requirements for disclosure of prices, terms and conditions for electricity retailing and generation, and gas wholesaling will be dropped once effective competition emerges.
2. Electricity generators having assets with a rated electricity generating capacity equal to or greater than 10 MW, within the same business group as a line business, will be required to disclose prices, terms and conditions of supply of generated electricity to other parties within the same business group. Contracts pre-dating 1 August 1990 are excluded. Where no specific contracts exist, imputed prices must be disclosed, together with the methodology used for determining those imputed prices.
   • While competition in the retail sector will, over time, discourage uneconomic investment in generation, this disclosure will help detect any instances where the costs of uneconomic generation are passed on to the (captive) customers of line businesses.

Natural Monopoly Sectors - Electricity and Gas Transmission, and Local Electricity Line and Gas Pipeline Distribution

1. Where a business group undertakes both activities which have natural monopoly characteristics and activities which are potentially competitive, separate audited financial statements will be required. In electricity, separate statements will also be required for generation equal to or greater than 10 MW (i.e. separate statements will be required for generation and retailing, where both are conducted within the same entity).
   • This will help promote competition in the potentially competitive sectors, by revealing any instances in which potentially competitive activity is leveraged off natural monopoly line or pipeline businesses.

   Methodologies for the allocation of assets, liabilities, costs and revenues as between potentially competitive and natural monopoly line or pipeline activity will also need to be disclosed.

   • This will help ensure transparency in the allocations between line or pipeline businesses and potentially competitive businesses, thus supporting scrutiny of the financial statements.

   Costs transferred between potentially competitive and natural monopoly activities within the same business group will also need to be disclosed.

   • This will help detect any instances where the costs of potentially competitive activity are passed on to the (captive) customers of line or pipeline businesses, or where line or pipeline businesses undercut independent businesses in supplying services to potentially competitive activities.
2. Prices, terms and conditions of supply of line services (i.e. the main provisions of both standard and non-standard contracts) will need to be disclosed. Contracts pre-dating 1 August 1990 are excluded.
   • This will allow consumers and competitors to detect anti-competitive behaviour, e.g. questions would be raised if price discrimination occurs. It will also improve the negotiating position of consumers (e.g. by facilitating comparisons of contracts offered). In limited cases where bypass of networks is possible, this disclosure will also assist new entrants.
3. Performance measures, including financial, efficiency, energy efficiency, and reliability performance measures will need to be disclosed.

   Financial and efficiency performance measures will identify any instances of monopoly pricing (i.e. excessive profits, or the recovery of excessive costs).

   In the case of electricity, the financial performance measures and the financial components of the efficiency performance measures will be required to be derived from financial statements in which:

   • assets are valued using the optimised deprival value (ODV) methodology; and in which
   • any double counting of depreciation and maintenance on network assets is eliminated.

   Yardstick comparisons of performance of different line and pipeline businesses will be possible, covering performance as measured by each of the performance measures.

4. Charges for line and pipeline services to individual consumers, together with the methodologies for determining those charges, will need to be disclosed.
   • This will promote competition in electricity and gas retailing, by enabling consumers to distinguish between the line/pipeline and energy components of their bills. It is thus tantamount to unbundling consumer bills. Line and pipeline charge disclosure will enable consumers to assess the appropriateness of the line charges they face, by enabling scrutiny of the methodology used, and by revealing whether the line or pipeline charge is common to other consumers or is confined to a small group. Disclosure will also facilitate identification of any cases in which electricity or gas supply companies are protecting competitive markets for energy supply, by introducing prices involving a cross-subsidy from consumers of small amounts, who may be last to enjoy the benefits of competition (because metering technology is not yet sufficiently advanced to permit cost-effective competition at this level, at least in electricity).
   • As noted above, disclosure of line and pipeline charges incorporated within bills faced by final consumers is tantamount to unbundling consumers' bills. Similar requirements are not proposed at the wholesale levels, for either electricity or gas. This reflects the development of separate contracts for transmission and energy in the electricity sector, and the Natural Gas Corporation's (NGC's) moves to develop separate contracts for transmission and energy in gas wholesaling.
5. Costs and revenues by final consumer tariff category, together with the methodology for allocation of costs and revenues by tariff category.
   • This will help reveal any excessive cross subsidies between consumer groups.
   • Gas distribution pipeline owners will be subject to disclosure of certain information concerning unaccounted for gas (UFG). This is to help reveal the extent of any cross-subsidisation from the method of charging for gas lost from distribution pipeline networks.
6. Specifically for gas, a wide range of information concerning capacity of high-pressure transmission and distribution pipelines, and the methodology (in effect, simulation models) used to measure that capacity.
   • This will enable gas producers, wholesalers or retailers (and those wishing to enter those markets), who wish to obtain access to transmission or distribution pipelines to supply particular customers, to have an informative level of public information available on pipeline capacity without the need to approach the pipeline owner (which may be a competitor for supply to those customers).
   • It will also discourage any pipeline owners which are also suppliers of gas, from managing capacity to disadvantage competing suppliers of gas, or to favour certain customers.
   • Similar requirements are not included in the electricity regulations. The competition policy issues addressed by disclosure in this area reflect the extent of vertical integration in gas markets. In particular, NGC is involved in gas transmission, distribution and retailing, and has ownership linkages with gas production. By contrast, Trans Power, responsible for electricity transmission, is a stand-alone company.

Advantages of Light-Handed Regulation Compared with Heavy-Handed Regulation

9. The advantages of light-handed regulation include that it places responsibility for access and pricing of line and pipeline facilities with market participants. These participants have the best incentives to deal effectively with the issues. Negotiations and agreements can take place without government involvement.

10. Disclosure of financial and non-financial performance measures will promote comparisons by customers and market commentators of the financial and non-financial performance of line and pipeline businesses. In this and other ways, light-handed regulation encourages self-regulation by businesses with natural monopoly characteristics or market dominance, aimed at restraining profits, minimising costs and improving reliability and efficiency.

11. Parties affected by any abuse of dominance have the appropriate incentives and ability to monitor market performance. They can then decide what level of prices and performance they are prepared to accept. The costs of constraining market behaviour are met directly by market participants. Competitors and consumers are encouraged to use a wide range of dispute resolution procedures, such as arbitration and mediation. Interested parties may use direct negotiations, or the courts, backed up by information disclosure and the independent authority of the Commerce Commission to seek redress should that be required. The parties are encouraged to adopt these dispute resolution procedures, because there is no specific regulator to intervene and resolve the issues arising.

12. Copies of disclosed information are provided to the Ministry of Commerce. This is primarily to enable the Ministry to monitor compliance with the requirements of the disclosure regulations. However, the Ministry will also be drawing on the information in order to inform its advice to the government on the effectiveness of light-handed regulation.

13. By contrast, heavy-handed regulation usually consists of:

• industry specific price control; and
• an industry specific regulator to monitor and enforce the price control regulation (and often other non-price issues as well).

14. Under heavy-handed regulation, businesses often focus effort on dealing with the regulator rather than competing with each other. Firms expend monetary and human resources to comply with, to attempt to avoid, or to change the application of the regulations. The time of senior staff is spent on regulatory issues and in lobbying the regulators and/or government. This ties up resources, both within the industry and within the government.

15. Light-handed regulation avoids a number of drawbacks with heavy-handed regulation that can arise from the involvement of regulators. These include:

• reduced incentives on parties to resolve disputes;
• tendency of the regulatory body to take over business decision making;
• inflexibility in developing efficient market responses to changing market circumstances;
• regulations which in effect guarantee firms a cost plus rate of return do not provide strong incentives for firms to minimise costs, and can foster uneconomic new entry;
• regulators tend to be captured by interest groups, usually the industry, as close working relationships are developed;
• regulations not tailored precisely often fail to achieve their intended purpose (indeed, they can have undesirable unpredicted consequences) - regulators often face information and administrative/legislative lags in keeping the regulations in line with changing market developments; and
• the administrative costs of the regulator, which can be substantial, are often borne by the taxpayers rather than those affected by the industry.

16. As noted in paragraphs 2 and 4, the possibility of further regulation cannot be excluded if market dominance is abused. Price control provisions in both the Commerce Act 1986 and Electricity Act 1992 would permit restrictions to be imposed across-the-board or on individual companies. In addition, the Government has stated (with respect to electricity), that if there is a clear and consistent pattern of abuse by natural monopoly line businesses, the government would seriously consider requiring the ownership of line businesses to be separated from ownership of competitive activities, such as generation and energy retailing.

Disadvantages of Light-Handed Regulation Compared with Heavy-Handed Regulation

17. An extra degree of uncertainty can arise under light-handed regulation, from the possibility that the regulations may turn out to be insufficient to meet the objectives mentioned in paragraphs 3 and 7, thus requiring extension in the direction of a heavier approach. It is often said that this uncertainty increases costs, by increasing the cost of raising capital on financial markets.

18. Some commentators consider that the Commerce Commission may not always be regarded as a strong back up. The Chairman of the Commission has commented that the Commission has no formal power to impose conduct in the positive sense. It can only act in the negative sense of preventing prohibited conduct.

19. Furthermore, the time, cost and outcome of court action (which may be taken by the Commerce Commission or any affected party) are uncertain. There is the potential for drawn out court battles, which may advantage the party with market power. The person who would obtain the benefits from an action may not be able to afford the expense involved. The resources of the Commerce Commission, recently increased, may need to be further expanded to deal with all significant cases referred to it.

20. Some of the arguments that reliance on the courts under light-handed regulation is very costly are overstated. Heavy-handed regulation (i.e. an industry specific regulator and price control) are also very costly. Nor is court action precluded under heavy-handed regulation. Representations before the regulator, which must act "fairly" and hear all parties, are expensive. The possibility of judicial reviews and court appeals arises.

21. The Government is currently reviewing the effectiveness of section 36 of the Commerce Act in relation to inter-connection (or access) charges (as noted in paragraph 4). Consideration is being given to introduction of arbitration arrangements, guided by principles appropriate to efficient inter-connection (access). The Ministry of Commerce and the Treasury have issued a discussion paper (dated August 1995), addressing concerns in this area, which have been primarily focused on issues in the telecommunications sector.

Conclusion

22. The light-handed regulatory approach has been adopted on the grounds that general competition law (the Commerce Act), on which it relies, should be sufficient to deal with potential problems from abuse of natural monopoly power. It has also been recognised that more heavy-handed regulation, for instance involving explicit price control, can be complex, costly to administer, and may not always produce the desired result. In addition, once regulations are in place, it is common for loopholes to appear, giving rise to a need for additional regulation. The regulatory framework can therefore become ever more complex.

23. There are advantages in keeping new regulations as simple as possible from the start. In this context, the government has agreed that light-handed regulation be introduced and given the opportunity to demonstrate its worth. If weaknesses in light-handed regulation are identified, then carefully targeted additional measures can be introduced to overcome them.

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