Electricity Reform Package: Questions and Answers
[ Last Updated 22 November 2005 ]
Generation Reforms
1. Will the split increase overheads, finance costs and hydro co-ordination costs without offsetting benefits?
No. The split will increase some costs but these are likely to be more than offset by savings in controllable costs as a result of increased competition. This is demonstrated by the Contact Energy split.
2. Will the split reduce prices? By how much?
Yes, prices will drop. How much depends on a range of factors, including the competitive strategies adopted by the new SOEs and other generators.
3. ECNZ has claimed that the loss in Crown value could reach $2.1b. Does the Government agree? If not, what is the expected loss in Crown value?
The value of the Crown’s investment will be reduced by lower (more competitive) prices. We do not agree with ECNZ’s estimated range of $900-2,100m. The Government’s estimated range of the total loss in Crown value is between $200-1,200m. (For ECNZ, the loss is estimated at $350-450m; for Contact Energy, $300-400m). The actual value loss will depend on future market conditions and the commercial strategies of the generators.
The Crown can only avoid these losses if ECNZ remains dominant and prices stay high. The Crown couldn’t retain this value from higher profits (often called 'rents’) if we had real competition. The split will simply leave those rents with consumers.
4. Will the Crown have to inject more capital into the new SOEs to make them viable?
Preliminary advice received by the Crown indicates that each of the proposed SOEs should be viable without requiring fresh injections of capital from the Crown. If further equity is required, it should be relatively small in size and able to be provided by various means such as shareholders drawing lower dividends for a period.
5. Why split ECNZ when it is making efficiency gains and reducing prices?
ECNZ is still dominant in the electricity market. It controls around 70% of total generation capacity. It has performed well within the current structure. However, compared with effective competition, ECNZ dominance results in:
- higher prices;
- higher costs;
- over building of new capacity, which wastes resources and causes unnecessary harm to the environment; and
- poor signals for future investment.
These problems impose real costs on the economy. Reducing ECNZ’s dominance will address each of them.
6. Will the split of ECNZ increase the risk of an electricity shortage?
No. New Zealand is vulnerable to water shortages no matter how ECNZ is structured. The objective is to manage that risk in a way which is least cost to the economy as a whole. This means that each buyer and seller must work out how best to manage their exposure. The days of a few people in Wellington deciding what is right for everyone are long gone.
In a fully competitive electricity market:
- Changing spot and contract prices are expected to send early and strong signals to all buyers and sellers about changing hydro conditions - in other words, more people will be assessing more information and developing their own risk management strategies;
- Hydro generators will want to get the maximum possible value from their scarce water resources. This means not wasting it and selling it when it has the most value - which is when water is most scarce;
- Hydro generators are likely to be committed to long term contracts. If they can’t supply in a shortage, they will incur severe financial losses. Their incentives are therefore to manage their water very prudently and to have back-up contracts with other generators.
It is also worth noting that the surplus capacity over the next five years or so will provide a greater security margin which gives the market (particularly in the North Island) time to develop risk management strategies.
7. Doesn’t Contact’s management of Lake Hawea last winter show that hydro companies may not be prudent?
No. Lake Hawea holds a fraction (about 8%) of New Zealand's total hydro storage. (Most of New Zealand's hydro storage is in Lake Pukaki, which ECNZ has controlled). It is therefore not correct to argue that Hawea water should be managed in the same manner as Pukaki water.
8. What impact will the split have on the environment?
The Government has considered this issue carefully. Government officials analysed the likely environmental impacts and obtained independent review advice from a consultant, Chris Collins of Eden Resources Limited. (A copy is available on request from the Ministry for the Environment).
The main environmental impacts are expected to be as follows:
- New power stations: Over the next 10-20 years, a significant deferral (or reduction) in the requirement for new capacity, resulting in significantly less harm to the environment. Why is this? Several factors, in particular having prices resulting from vigorous competition that signal the full costs of producing an extra unit of power in the future;
- CO2 emissions: Same or less than the status quo. With real competition, less efficient stations such as New Plymouth are likely to stop running as more efficient stations such as the new combined-cycle plants at Stratford and Otahuhu come on-stream;
- Lake and river levels: The rate of change of river and lake levels is likely to increase. Some resource management consents may be need to be adjusted over time to allow for this;
- Water spill: Same or better use of scarce water, as a result of the new hydro companies seeking to extract more value from their water inflows - water is will be their source of revenue;
- Demand-side management: Real gains in the medium to long term, especially with the retail/distribution reforms. As prices reflect the full cost of supplying extra power, competition and the need to manage risk will force consumers and retailers to look for cheaper alternatives to buying more power.
Overall, the environmental impacts in the short term are likely to be the same or slightly positive compared to the status quo. In the longer term, the impacts are likely to be strongly positive.
9. Is the real reason for splitting ECNZ to allow privatisation?
No. Government policy is to retain ownership of strategic assets such as ECNZ and Contact Energy. The reason for breaking up ECNZ is to unlock efficiency gains by increasing competition.
If we wanted to privatise ECNZ, we would do it now with ECNZ intact to get the highest possible return for the taxpayers’ investment. Breaking up ECNZ will reduce its value significantly.
10. Aren’t the current restraints on ECNZ supposed to deal with its dominance?
The current restraints - which relate to building new generation, ring-fencing new capacity and long term contracts - are difficult to monitor and enforce. In the end, they can be easily avoided. Under the new structure, these special restraints on ECNZ will be lifted.
11. Lower prices will not get passed on to consumers but will be captured by the distribution sector. Does this mean that there will be no economic gains from the Crown’s lost value?
The Government’s reforms in the distribution and retail sector are designed to ensure that the benefits of generation reform are passed on to consumers.
12. Will the new SOEs be too small to be efficient? Is the New Zealand market too small to have so many competing generators?
The new SOEs will be similar in size to Contact Energy, which is a profitable business. New Zealand is not too small to have multiple generators. Norway and Victoria, with similar populations, have many competing generators.
13. Will there be separate shareholding Ministers for each SOE?
It has not yet been decided whether to have separate shareholding Ministers.
14. Will there be genuine competition when all the four major generation companies are government-owned?
If anything, the risks of the Crown 'managing’ competition between the SOEs is greatly reduced with this split compared to having only two SOEs (where coordination by common owners may, in theory, be easier). In addition, collusion would be difficult in a highly transparent market with at least four major competitors and with a growing number of new entrants.
15. The split doesn’t provide any more competition in the South Island, so won’t South Island consumers miss out?
South Island consumers will benefit to the same extent as North Island consumers from lower prices while power can be transferred between the North and South Islands on the HVDC link.
16. Will generators be able to retail electricity direct to consumers?
Yes. This will significantly increase competition in retailing to the benefit of consumers.
17. Doesn’t Huntly’s need for access to cooling water make it dependent on the competing Waikato company?
The Waikato SOE cannot prevent the flow of water down the Waikato, although it can affect the timing of peak flows. At most times of the year the river flows are sufficient for Huntly to operate as it wishes. However, there can be a constraint imposed on Huntly during a dry summer period.
It is efficient for Waikato and Huntly to negotiate a contract for how water flow will be managed during a dry period. Such a contract may involve Waikato guaranteeing minimum river flow levels in exchange for a fixed fee. If Waikato faces competitive pressure it would welcome the opportunity to earn a fixed fee from Huntly, particularly as Waikato would often (in non-dry periods) earn the fee without incurring any costs or losses.
The contractual approach allows Huntly to face an explicit cost for seeking to constrain the usage of the Waikato hydro stations. Such a cost is economically efficient.
Distribution and Retail Reforms
18. What are "distribution" and "retail"?
Electricity supply companies typically provide a mix of:
- distribution or "lines" services (which is a natural regional monopoly); and
- retail and generation services (which is contestable).
"Electricity distribution services" is the conveyance of electricity from generators and the national grid to consumers’ premises. "Electricity retailing services" is the sale of electricity to consumers.
19. What practical difference will the reforms make for small consumers? How much will prices fall, and when?
Prices of wholesale electricity are expected to fall with increased competition in generation and retail.
Together, this will ensure that consumers get the best possible prices for the electricity they consume.
How much prices fall will depend on how vigorous the competition is. The main point is that the new structure will enable much stronger competition than at present.
20. Have the reforms over the last decade worked? If not, why does the Government think that these reforms will be any different?
There is no doubt that the economy has benefited from the reforms to date. Costs have been reduced, generation prices are lower in real terms, and prices to consumers are more closely in line with the costs of supply to them.
However, competition will not work if monopoly lines are integrated with generation and retail. By dealing with the problem at its roots, much more rapid improvements in pricing and service quality are likely.
21. Doesn’t ownership separation require privatisation of community or council owned assets?
No. Ownership separation does not require privatisation. Companies have been given the choice of how they wish to separate their lines and retail/generation activities. One of the options is to set up a separate trust.
22. Why doesn’t the Government introduce price control, like other countries?
The Government is prepared to introduce price control in electricity distribution (which is a natural monopoly and therefore not subject to competition) if there is clear evidence of excessive costs or profits. This would most likely be targeted at individual companies and operate for a defined period.
The Government has agreed in principle to beef up the price control regime by empowering the Commerce Commission to decide to apply price control (subject to Ministerial override) within Government set criteria or thresholds. (At present, price control can only be introduced by Ministerial decision). This proposal is subject to further work on design and implementation issues, which will be addressed over the next six months.
23. What benefits are expected from ownership separation? What problems is the Government seeking to address?
It will eliminate the ability and incentives of a monopoly lines business to:
- restrict access to its network by competing retailers; and
- use monopoly rents from lines to cross-subsidise retail customers; and/or
- use monopoly rents from lines to cross-subsidise investments in generation.
It will eliminate the risks of vertically integrated electricity companies failing to distinguish adequately between the business risks and requirements of:
- The monopoly lines business (on the one hand), where the focus should be on efficient asset management (including security of supply) and cost minimisation; and
- The competitive electricity selling businesses (on the other hand), where the focus should be on managing entrepreneurial risk.
It will help to better expose the monopoly lines business to closer scrutiny by users and other market participants. The lines businesses will become stand-alone entities which will be more easily targeted for consumer comment - in the same way that Transpower has become more transparent since it was separated from ECNZ in 1994.
It will encourage the amalgamation of retail businesses to achieve greater efficiencies and stronger competitive choice for consumers.
It will encourage the amalgamation of lines businesses to achieve lower costs and better service to users.
24. Does the Government intend to introduce ownership separation in other network industries, like gas and telecommunications?
The Government has no plans to introduce ownership separation in other network industries.
Competition policy concerns in gas and telecommunications are less significant than electricity - gas is faced with competition from other fuels, and in telecommunications, technology is developing more rapidly to enable consumers to have real choices.
However, the threat of price control under Part IV of the Commerce Act remains.
25. What does the Government expect will happen to costs under ownership separation? Won’t ownership separation result in higher costs, and therefore higher prices?
Some higher costs are likely, however, these should be more than offset by efficiency gains.
Cost savings are also very likely from amalgamations between retail businesses and between lines businesses. New Zealand has 37 electricity supply companies for its population of 3.5 million. By contrast, the United Kingdom’s 60 million people are served by just 12 companies.
The Government will closely monitor electricity supply companies’ prices to ensure that they do not use ownership separation as an excuse to increase unnecessarily their prices and profits. The Government will also closely monitor whether electricity supply companies are effectively minimising their costs.
26. Will the Government compensate electricity supply companies for any losses in value arising from ownership separation?
No. The separation is required to achieve the regulatory objectives of enhancing competition to increase consumer welfare. Assets can be sold at market prices and an extended period (five years) has been provided to achieve this.
For the avoidance of doubt, the government intends to legislate to exclude compensation.
27. If a company chooses to set up a separate trust, it has to do it within one year. But if a company chooses to divest on the open market, it gets five years. Why the difference?
Because in most cases selling to a trust is not likely to result in a change of the underlying beneficiaries.
28. The industry says that information disclosure and the Commerce Act are sufficient to achieve the Government’s objectives. Why does the Government disagree?
On their own, information disclosure and the Commerce Act are not sufficient for dealing with access, cross-subsidy and monopoly rent problems.
Setting up electricity supply companies in a way that removes incentives to act anti-competitively is a cleaner and more reliable way of dealing with access and cross-subsidy problems.
29. Why doesn’t the Government simply require corporate separation, with common ownership, rather than ownership separation. Wouldn’t corporate separation be sufficient?
Corporate separation would go some way to dealing with the Government’s concerns. However, so long as distribution and retail/generation businesses have common owners, distribution businesses will continue to have both the incentives and the ability to act anti-competitively. Corporate separation rules would have to be just as intrusive as ownership separation rules to achieve the same policy results.
Ownership separation (in which the separate companies need to be under separate ownership) is a cleaner and more reliable way of dealing with these concerns.
30. Will separately owned electricity retail companies be viable?
Considerable cost savings and efficiency improvements are likely to be achieved by amalgamating small retail companies, enabling them to complete effectively. Strategic alliances with other businesses are also likely.
31. Who will build new generation if it isn’t funded by lines?
Only lines businesses will be precluded from investing in generation. There are many companies, both domestic and overseas, likely to be interested in building new generation plants. Consortia are also likely to invest in generation. Large facilities are built in other markets (like pulp and paper, commercial offices and so on) without relying on access to monopoly revenues. Investment in generation plant should be no different.
32. Why are these reforms being introduced before the investigation into Mercury Energy’s management of its lines has been completed? Will ownership separation adversely affect security of supply?
Ownership separation is expected to strengthen, not weaken, security of lines.
Following g ownership separation, distribution businesses can be expected to concentrate to a greater extent on their core business of asset management (including security of supply) and cost minimisation. They will not be diverted by the entrepreneurial and competitive issues which arise in the retail/generation parts of the electricity industry.
33. When will the legislation for ownership separation be passed?
The legislation will be introduced this year.
34. When will domestic consumers be able to choose supplier?
As part of the reforms, the industry is required within 12 months to establish low cost mechanisms to enable small consumers to switch retailer if they wish.
35. What protection is there for smaller consumers before competition emerges?
An enhanced information disclosure regime is being put in place requiring electricity supply companies to disclose their prices, costs, profits and performance.
The Government has made it clear that if an electricity supply company charges excessive prices, it will consider introducing price control for that company.
7 April 1998
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