Creation of a New Electricity Market Operation Service Provider and Minor Levy Regulation Amendments

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1 DRAFT File No: C/004/ME/004 OFFICE OF THE MINISTER OF ENERGY AND RESOURCES The Chair Cabinet Economic Growth and Infrastructure Committee Creation of a New Electricity Market Operation Service Provider and Minor Levy Regulation Amendments Proposal 1 I seek agreement to: a. create a new market operation service provider through regulation, called the extended reserve manager; b. amend the Electricity Industry (Enforcement) Regulations 2010 to set a liability limit for the new extended reserve manager; c. two unrelated amendments the Electricity Industry (Levy of Industry Participants) Regulations 2010 to: (i) include in the definition of market operations reference to a new Part 14A of the Electricity Industry Participation Code 2010; and (ii) enable the Electricity Authority to levy electricity retailers for the costs of its activities relating to facilitating consumer participation in the electricity market. Executive Summary 2 The Electricity Authority (the Authority), as the electricity market regulator, has introduced new extended reserve arrangements for managing rare and extreme events that threaten electricity supply security. 3 A new electricity market operation service provider is required for the extended reserve arrangements to operate efficiently, and that can only be done by regulation. Regulations can also limit the liability of that service provider, which is considered appropriate for this type of role. 4 In addition, the proposed amendments to the Electricity Industry (Levy of Industry Participants) Regulations 2010 (the levy regulations) will enable the Authority to continue to recover costs from the appropriate levy payers for its prudential security arrangements, and for its work to facilitate consumer participation in the electricity market. 5 There are no immediate financial implications resulting from the creation of a new service provider, and no financial implications resulting from the proposed amendments to the levy regulations. Background 6 The Authority has made amendments to the Electricity Industry Participation Code 2010 (the Code) to create a new mechanism to manage rare and extreme events that threaten the stability of the electricity system. 7 The new extended reserve arrangements build on the existing approach under which customers are obliged to shed large blocks of electricity load by providing greater

2 2 flexibility as to when, which and how much load can be shed. The new arrangements include the creation of a manager responsible for selecting providers of extended reserve. A fuller explanation of the new arrangements is in Appendix 1. 8 The Authority has begun implementing the new arrangements and has selected NZX as the supplier for the extended reserve manager role via an open tender process. NZX is expected to take up the position in mid To provide legal certainty, and to limit the liability of the manager, it is desirable that the extended reserve manager be made a market operation service provider (MOSP). MOSPs are used by the Authority to manage and operate the electricity market. 10 The other two proposals seek to ensure that the levy regulations recover the Authority s costs from the industry participants who most benefit from the Authority s activities. 11 The proposal to levy electricity retailers for the costs of the Authority s work to facilitate consumer participation in the electricity market stems from a decision in Budget 2014 to appropriate an additional $7.5 million over three years for this activity. 12 The proposal to levy electricity generators and purchasers for the Authority s prudential security arrangements stems from Code amendments made by the Authority. Comment Creating the extended reserve market operation service provider and setting a liability limit 13 While the Authority is able to amend the Code to create the extended reserve arrangements, it does not have the ability to define a new MOSP in law. The Electricity Industry Act 2010 (the Act) specifies MOSPs, but also provides that additional roles can be created by regulation 1. It is, therefore, proposed that regulations are made to create the MOSP role of extended reserve manager. 14 It is considered appropriate to designate the extended reserve manager as a MOSP because: a. the role and its relationship with the Authority are akin to those of existing MOSPs with similar regulatory and contractual issues; and b. it provides legal certainty as to the status of the extended reserve manager and allows its liability to be limited, conditions that are necessary to ensure that the extended reserve manager can operate efficiently and effectively. 15 Making the extended reserve manager a MOSP by regulation will mean it is an industry participant that is subject to the regulation pertaining to MOSPs, which includes a requirement to comply with the Code and makes the participant subject to the electricity Rulings Panel 2. An MOSP is also protected from action in law from other industry participants. 1 In 2012 a Financial Transmission Rights market operation service provider was created under the Electricity Industry (Participants and Roles) Regulation The Rulings Panel is the statutory body established under the Electricity Industry 2010 that assists in the enforcement of the Code.

3 3 16 The majority of MOSPs have limited liability under regulation from orders of the Rulings Panel for compensation 3. The objective is to balance incentives for compliance with MOSP s performance obligations and to avoid risky behaviour with the risk that participants either choose not to enter the market or be overly conservative in their approach. 17 A limit on the liability of the extended reserve manager is proposed to ensure that it can operate efficiently. Without a limit on liability, the extended reserve manager would be exposed to potentially high penalties and compensation payments if its action, or inaction, adversely affected other industry participants. The likely consequences of this include the manager being unduly conservative in its role and/or seeking to manage its liability by charging higher costs for its service. 18 Situations when the extended reserve manager may incur a liability include making an error when selecting participants who will shed electricity load that leads to the failure of the system to cope with a rare or extreme event. The risk of this occurring is low (due to the numerous checks and balances in place in the Code), but the impact would be high as it would mean that many electricity consumers would experience power outages. 19 The proposed liability limit is $550,000 in respect of any one event or series of closely related events arising from the same cause or circumstance, or $550,000 in respect of all events occurring in any financial year. 20 The proposed level was arrived at having regard to the level of risk associated with the extended reserve manager s actions, the likely size of damages if the extended reserve manager performed poorly, as well as the fees recovered by the extended reserve manager. Because the extended reserve manager is expected to cause harm to others very infrequently, it is proposed that the per event and annual liability limits be the same. Amendments to Electricity Industry (Levy of Industry Participants) Regulations This paper also seeks agreement for two amendments to the levy regulations, which enable the Crown to be reimbursed for the costs of the Authority. The Act requires that all the costs of the Authority in performing its functions and exercising its powers and duties under the Act are fully met by the levy 4. The Authority collects the levy from electricity industry participants on behalf of the Crown. 22 The proposed amendments will have no impact on the overall amount collected from levy payers, but there would be a negative impact on some industry participants if the amendments were not made. Prudential security in the wholesale electricity market 23 The Authority has created new Parts 14 and 14A in the Code (effective from 24 March 2015) to set out (in Part 14A) revised prudential security arrangements for purchasers of electricity from the wholesale market 5. There is currently no ability in the levy regulations to levy the appropriate industry participants for any activity related to the new Part 14A. 3 The Electricity Industry (Enforcement) Regulations 2010, which are made under section 112(1)(I) of the Act, provides for regulations that restrict or limit the amount of liability of, or the amount of any penalty that may be imposed upon, an industry participant, such as MOSPs, or class of industry participant. 4 Section 128 (3) 5 The old Part 14 was revoked in its entirely in this amendment to the Code

4 4 24 Previously, prudential security arrangements were included in Part 14 of the Code and recovered from generators and purchasers through the levy as market operations costs. The definition of market operations in regulation 4 of the levy regulations needs to be amended to include a reference to the new Part 14A. 25 The proposed amendment is merely an administrative consequence of the introduction of the new part number in the Code. Without it, Part 14A activity will have to be treated as an other activity which means that electricity distributors (as well as generators and purchasers) would be levied for a portion of the costs even though they are not beneficiaries of this activity. 26 It is proposed that this amendment take effect prior to 30 June 2015, so that the Authority can collect the costs for the 2014/15 period from 24 March in accordance with the amended regulations. The Authority s estimate of the annual costs that will now be allocated to Part 14A (instead of Part 14) is $1.15m per annum (based on 2013/14 actual costs). Facilitating consumer participation 27 The Authority undertakes a range of activities in relation to encouraging and assisting consumers to participate in the electricity market in accordance with its functions under section 16 of the Act 6. For example, it promotes customer switching through the What s My Number advertising campaign and website. 28 Previously, these costs were covered by the Customer Switching Fund, which was established under section 128(3)(d) of the Act, but expired on 30 April 2014 in accordance with that section. However, a further $7.5 million (over three years) was appropriated in Budget 2014 to enable the Authority to continue this work. The levy regulations provide for the costs of the (now expired) Customer Switching Fund to be recovered from electricity retailers, but now the only activity this work can be levied under is registry and consumer operations, which is recovered from both retailers and distributors. 29 These activities fall within the statutory functions of the Authority. Therefore the costs must be recovered from electricity industry participants via the levy. An amendment is sought to enable this work to continue to be recovered from electricity retailers only, because it does not relate to the activities of distributors. It is also proposed to replace the activity with a more enduring title and description Facilitating Consumer Participation, which encompasses programmes focussing on addressing consumer awareness, understanding, motivation and action to assist them to participate in electricity markets. 30 It is proposed that this amendment take effect from 1 July This is because the Commerce Commission has made provision for distributors that are subject to pricequality regulation to recover from retailers the additional Authority levy for 2014/15. Consultation 31 The Ministry has consulted with The Treasury and the Electricity Authority on this paper. The Department of Prime Minister and Cabinet has been informed. 6 Specific functions in section 16 of the Act that this work encompasses include: Making and amending the Code [s16(1)(b)] Undertaking market facilitation measures, such as education, guidelines, information and model arrangements [s16(1)(f) Promoting to consumers the benefits of comparing and switching retailers [s16(1)(i)]

5 5 Creating the extended reserve manager through regulation and setting a liability limit 32 The Authority consulted on options for extended reserve procurement and the associated Code amendments, including the proposal to create the role of extended reserve manager and to set a liability limit. 33 Twelve submissions (mostly from industry participants) were received on the proposal for the extended reserve manager to be a MOSP 7. All but one supported the proposal and the alternative view was that the role could be attached to that of the system operator. 34 The Authority separately consulted on what liability limits should apply to the extended reserve manager as a MOSP 8. The proposed limits were calculated using a methodology that included economic liability theory and the likely size of damages if the extended reserve manager performed poorly. The proposed limit was $550,000 for any one event or series of closely related events arising from the same cause or circumstance, or $550,000 in respect of all events occurring in any financial year. 35 Five submissions were received, three of which agreed that the per event and per financial year limit should be the same amount, and the other two submitters preferred a per financial year much larger than the per event limit. A larger figure was not supported by the methodology. Amendments to Electricity Industry (Levy of Industry Participants) Regulations Consultation on these proposed amendments was not necessary as they substantially re-enact the current regulatory provisions and will have no impact on levy payers. 37 However, the Authority did consult on the amendments resulting from the creation of Part 14A of the Code 9. The five submitters unanimously supported the allocation of Parts 14A costs on the same basis as they are currently allocated. Four submitters were either purchasers or generators who would be affected by the decision. Fiscal Implications Creating the extended reserve manager through regulation and setting a liability limit 38 There are no immediate financial implications resulting from the proposals in this paper. The Authority intends to fund the implementation costs in 2015/16 from existing appropriations. 39 The Authority is in the early stages of negotiating with NZX to determine the specific details of work required, including changes to existing market systems. A finalised estimate of the ongoing cost to the Authority is not available at this time. Early indications are that the new arrangements for managing extended reserve, including the new MOSP role, may cost in the vicinity of $1.5 million per year. 40 The Authority is currently re-tendering for four of its MOSPs, which are estimated to cost $6.5 million in 2015/16. The existing contracts for these roles have been in place for over eight years and expire on 30 April The extent to which the Authority may seek an appropriation increase in Budget 2016 to cover service provider costs, including 7 Efficient procurement of extended reserve - draft Code amendment, April Limiting the Liability of the extended reserve manager, November Settlement and Prudential Code Amendments and Changes to Levy Regulations, July 2014

6 6 the new arrangements for managing extended reserve, is dependent upon the outcome of the tender process and its ability to reprioritise expenditure within existing appropriations. Amendments to Electricity Industry (Levy of Industry Participants) Regulations There are no financial implications resulting from the proposed amendments to the levy regulations as they relate to how the costs are allocated not the amount collected. Human Rights 42 There are no human rights implications from this paper. Legislative Implications 43 New regulations and amendments to existing regulations are required to implement this policy. Regulatory Impact Analysis 44 A regulatory impact statement (RIS) has been prepared on the proposed regulations to support the extended reserve arrangements and is attached as Appendix A RIS is not required for the proposed amendments to the Electricity Industry (Levy of Industry Participants) Regulations 2010 because they are technical (clarifying the existing intent) and have no or minor impact. Quality of the Impact Analysis 46 The General Manager, Strategic Policy branch and the Regulatory Impact Analysis Review Panel have reviewed the attached Regulatory Impact Statement (RIS) prepared by the Ministry of Business, Innovation and Employment. They consider that the information and analysis summarised in the RIS meets the criteria necessary for ministers to fairly compare the available policy options and take informed decisions on the proposals in this paper. Consistency with Government Statement on Regulation 47 I have considered the analysis and advice of my officials, as summarised in the attached RIS and I am satisfied that, aside from the risks, uncertainties and caveats already noted in this Cabinet paper, the regulatory proposals recommended in this paper: a. are required in the public interest b. will deliver the highest net benefits of the practical options available, and c. are consistent with our commitments in the Government Statement on Regulation. Publicity 48 The Authority will publicise any decision on the proposed regulations to electricity industry participants through its website and weekly Market Brief . This paper and the RIS will be published on the Ministry of Business, Innovation and Employment s website.

7 Recommendations 49 It is recommended that the Committee: Creating the extended reserve market operation service provider and setting a liability limit 7 a. note that the Electricity Authority has introduced new extended reserve arrangements for managing situations where an unplanned event causes the frequency of New Zealand s electrical system to fall well below normal; b. note that the Electricity Authority has created a new extended reserve manager role, to develop and run the process to select participants who will provide extended reserve, and it is considered appropriate that this role be made a market operation service provider so that it is subject to the appropriate regulation; c. agree that regulations under section 109(b) of the Electricity Act 2010 be made to designate the role of extended reserve manager as a market operation service provider role; d. note that caps on the liability of market operation service providers are needed for the market to operate efficiently, and a similar cap on liability is considered appropriate for the extended reserve manager; e. agree that regulations be made under section 112(1)(i) of the Electricity Industry Act 2010 limiting the liability of the extended reserve manager to $550,000 in respect of any one event or $550,000 in respect of all events occurring in any financial year; Amendments to the Electricity Industry (Levy of Industry Participants) Regulations 2010 f. note that this paper proposes two minor technical amendments to the Electricity Industry (Levy of Industry Participants) Regulations 2010 which will have no, or only minor, impact on industry participants; g. note that the Electricity Authority has created a new Part 14A of the Electricity Industry Participation Code 2010, which sets out new prudential security arrangements for purchasers of electricity from the wholesale market, replacing provisions that were previously contained in Part 14 of the Code; h. agree to amend the Electricity Industry (Levy of Industry Participants) Regulations 2010 to enable the Authority to collect levies to recover the costs of Part 14A of the Code from the same industry participants (generators and purchasers) that were levied for these costs under Part 14; i. agree that the amendment should take effect prior to 30 June 2015 so that the Authority can collect the costs for 2014/15 from 24 March in accordance with the proposed amended regulations; j. note that the Electricity Authority undertakes a range of activities to encourage and assist consumers to participate in the electricity market, but that the costs can no longer be recovered from retailers only because the enabling provision in the Electricity Industry Act 2010 has expired; k. note that these activities fall within the statutory functions of the Electricity Authority and as such the costs related to carrying out this work must be recovered through the Electricity (Levy of Industry Participants) Regulations 2010;

8 Other 8 l. agree to create a new levy category in the Electricity Industry (Levy of Industry Participants) Regulations 2010 called Facilitating Consumer Participation and allocate the costs of that activity to electricity retailers; m. note that Facilitating Consumer Participation encompasses programmes focussing on addressing consumer awareness, understanding, motivation and action to assist them to participate in electricity markets; n. note that costs in 2014/15 have been allocated to distributors and retailers, but that the Commerce Commission has made provision in its electricity price-quality regulation for distributors to pass the costs on to retailers; o. agree to amend the Electricity Industry (Levy of Industry Participants) Regulations 2010 to enable the Electricity Authority to collect the costs relating to Facilitating Consumer Participation from electricity retailers with effect from 1 July 2015; p. invite the Minister of Energy and Resources to issue drafting instructions to the Parliamentary Counsel Office to give effect to the above decisions; q. agree that this paper be publicly released on the website of the Ministry of Business, Innovation and Employment, subject to any appropriate withholdings that may be required in accordance with the Official Information Act 1982; r. note that the Regulatory Impact Statement will be published on the internet in the normal manner. Hon Simon Bridges Minister of Energy and Resources / /

9 9 Appendix 1: Extended Reserve Arrangements 1 Electrical systems around the world are subject to the risk of rare and extreme events that, if not appropriately planned for, could lead to catastrophic power failure. In New Zealand, the principal means of addressing such risks is through dropping large blocks of load called Automatic Under-Frequency Load Shedding (AUFLS). 2 Several events have occurred that put these last resort systems to the test. While the system stayed on for these events, Transpower identified that the AUFLS scheme could be improved to reduce the risk of non-performance for a wider range of events than considered when the AUFLS scheme was first designed. 3 In parallel, the Authority identified significant inefficiencies in the mechanisms for determining which loads should provide AUFLS to meet the overall system requirement. As well as economic costs arising from inappropriate load being assigned to provide AUFLS, the poor procurement approach was also exacerbating system reliability risks. 4 The new extended reserve arrangements aim to correct these inefficiencies. Specifically, the new provisions: a. take account of the possibility of new technology being developed for addressing under-frequency events, including by introducing the wider term extended reserve to replace AUFLS ; b. enable a new technical approach to extended reserve to be implemented, which will involve (among other features) providers being selected based on the suitability of their load; c. implement a new method for procuring extended reserve, including introducing a new market operation service provider (the extended reserve manager) to oversee the process; and d. enable extended reserve providers to be compensated from charges to distributors (including direct consumers). 5 Under the new arrangements, an extended reserve manager will select providers of extended reserve. If selected, providers will make detailed arrangements with the system operator to provide extended reserve in a manner that meets system security requirements