Electricity Industry Bill

Electricity Industry Bill Request for additional information by Finance and Expenditure Committee The additional information sought by the committee on 17 February 2010 is set out in the following tables. The following documents are included in this package: o Chronology of New Zealand Electricity Reform o Discussion Paper Improving Electricity Market Performance, August 2009, Volume I o Discussion Paper, August 2009, Vol. II o Summary Note on Recommendations, taking account of submissions, October 2009 o Cabinet Paper Ministerial Review of the Electricity Market, 13 November 2009 o * Officials paper to ETAG Meeting 3, 12 May 2009, Market Governance and Regulation: Key Considerations Assessing Options o Frank Wolak, An assessment of the performance of the New Zealand wholesale electricity market, 2009 ( the Wolak Report ), 19 May 2009 o * MED advice to Minister on the Wolak Report (with two reports from consultants as separate attachments, from Concept Consulting and from Concept Economics) All documents except the two marked with an * are available on the internet and hyperlinks are provided in the tables. Ministry of Economic Development February 2010 982068 1

History of electricity reforms A history of reform in the electricity industry A comprehensive chronology electricity reform is available on the Ministry of Economic Development website. Key dates are: o 1987 ECNZ established (an SOE) o 1988 Transpower set up as a subsidiary of ECNZ o 1992 Corporatisation of Electricity Supply Authorities o 1993 Electricity Act 1992 come into effect (deregulation - removal of statutory monopolies) o 1994 Transpower separated from ECNZ; Information Disclosure Regulations promulgated (for lines and retail) o 1996 Contact Energy separated from ECNZ; competitive wholesale electricity market commenced operation o 1998 ECNZ split into three SOEs; ownership separation of line and energy businesses in the Electricity Industry Reform Act o 1999 Contact Energy privatised. o 2000/2001 Further electricity sector reforms. Framework for new electricity governance self-regulation put in place with provision for Crown entity if industry self regulation failed. Commerce Act amended to enable Commission to control businesses which breach thresholds set by Commission. EIRA amended to relax rules on ownership of generation by lines. o 2003 Electricity Commission established o 2004 New electricity market arrangements established under new Electricity Governance Regulations and Rules 2003 o 2004 Further reforms. Electricity Act amended to reflect establishment of Electricity Commission. EIRA amended. o 2008 Electricity Industry Reform Amendment Act o 2008 Commerce Amendment Act puts in place an improved regulatory regime for electricity lines businesses o 2009 Ministerial review of electricity market and Electricity Industry Bill introduced Chronology of New Zealand Electricity Reform 982068 2

Electricity Spot Market An explanation of how the electricity spot market works All electricity flowing through the national grid goes through the spot market (or pool ). Generators compete in an auction (every half-hour 24/7) to have their plant despatched by the System Operator (SO). If they are successful in the auction (ie get despatched to generate) they get paid the auction clearing price for that half-hour. The clearing price or spot price is the price offered by the most expensive generating plant that the SO needs to despatch in order to match supply and demand (ie keep the lights on). Generators receive no spot market revenues for plant which is not despatched. Buyers of wholesale electricity (retailers, traders and major users) pay the spot price for the electricity they use. A key assumption of this auction is that competitive pressures (to be despatched and receive spot market revenue) will force generators to offer their generation plant at close to their marginal costs of production. While all electricity (on the grid) goes through the spot market, around 90 percent is covered by (fixed price) hedge contracts, which removes exposure to the spot price. The way hedge contracts work is explained in A short primer on the electricity market (see Further Information ). Note that vertically integrated generator-retailers have an internal hedge since they both receive and pay the spot price. Discussion Document Vol. II, Appendix 3, A short primer on the electricity market. See in particular paras 37-51 (pp 28-32) 982068 3

Wolak report A copy of Professor Wolak s report to the Commerce Commission, and officials response to this report. Wolak report The Wolak report was released by the Commerce Commission in May 2009. It concluded that generators had exercised market power in the spot market in dry years and over-charged by $4.3 billion in the period 2001-7. Wolak used a competitive benchmark of short-run marginal costs (SRMC: essentially operating costs) to calculate the level of overcharging (market power rents). The Ministerial Review identified a number of serious reservations about the report, including: o Underestimation of the opportunity cost of hydro, that is, the value of water preserved for later use. This is crucial, since it is efficient for spot prices to rise to reflect the increasing risk or probability of water shortages, given the very serious and prolonged economic and social consequences of actually running out of water o Underestimation of the opportunity cost of gas, and overestimating its availability, particularly in the light of the decline of the Maui gas field o SRMC price levels are not sufficient to cover the costs of building new capacity and ensuring security of supply. (The Commerce Commission appears to accept this crucial point) o The analysis was done in hindsight, and assumes perfect foresight on the part of decision-makers, with no apparent allowance for the uncertainties that parties face in the real world, such as future demand, plant reliability and hydro inflows. A more useful benchmark of wholesale market performance is to compare average hedge contract prices over time with the cost of MED s response to the Wolak report (not available on the internet) Discussion Document Vol. I, para. 100-105 (p38) Discussion Document Vol. II, Appendix 13 (pp 90-95) 982068 4

building new capacity, or long run marginal cost (LRMC). ETAG concluded that, using the LRMC benchmark, there is no clear evidence of the sustained or prolonged exercise of market power. Nonetheless, there are concerns about the potential to exercise market power in the wholesale market (spot and hedge), and about insufficient competition in the retail market. Accordingly, the Bill seeks to improve competition (which Wolak recommended) through: o Asset swaps between SOEs (Wolak also recommended further breakup of generation) o Developing a more liquid hedge market (to facilitate competition and new entry in both generation and retail) o Allowing lines companies to retail electricity o Providing a transmission hedging mechanism o Facilitating demand-side participation in the wholesale market o Promoting smart meters and tariffs o Encouraging consumers to shop around. 982068 5

Objectives of the Electricity Authority Explanation as to why environmental sustainability was removed from the objective of the Electricity Authority The aim is to narrow the objectives (and functions) of the Electricity Authority. This is intended to ensure the EA focuses on its key role of rule-making and enforcement to achieve an efficient, reliable and competitive market. In addition, environmental (and social) objectives are best delivered through generic policies (such as the RMA and climate change policies) rather than on a sector-specific basis. This minimises distortions in resource allocation across the economy. It is not considered best practice to give regulators multiple objectives requiring complex trade-offs. This greatly complicates their work, can involve them in making trade-offs that are best taken by Ministers (eg between social objectives and efficiency), and makes it difficult to hold them accountable for performance. Discussion Document Vol. I, para 201-202 (p67) Official s paper to ETAG meeting 3 (not available on the internet) 982068 6

New matters to be included in the Electricity Industry Participation Code Why does the Bill not provide more detail on the specification of the new matters that must be included in the Code (clause 45)? The Bill does not go into prescriptive detail regarding these new matters because the issues are technically very complicated. There is a high risk of perverse outcomes or unintended consequences if measures are not very carefully designed. This means that hard-wiring details into the Bill runs a high risk of poor outcomes, or requiring legislative amendments further down the track. Why does the Bill allow so much time for completion of the new matters? The detailed specifications need to be carefully designed, subject to cost-benefit analysis, and carefully consulted on. Much of this work is well underway with the Electricity Commission s Market Development Programme. The Bill gives the EA a year (following its establishment) to put in place the new matters. This is considered quite challenging given the technical complexity of the work (and the long-term consequences of getting it wrong). For the same reason, the Minister needs a three year window to regulate if the EA does not succeed in putting in place satisfactory measures (or provide satisfactory reasons why not). Complex regulations of this nature are highly likely to need fine-tuning. 982068 7

Electricity Industry Reform Act 1998 Further information on the roll-back of EIRA (letting lines companies back into retailing) and on whether this is likely to lead to competition problems. The objective of allowing lines back into retailing is to increase the level of competition in retailing: o The Ministerial Review identified weak retail competition as a significant problem in the electricity market especially outside the main centres. Discussion Document Vol. II, Appendix 18 (pp141-142) o This weak competition has resulted in high and increasing retail margins, especially for residential consumers. Retail margins are high compared to overseas (Australia and the UK) and compared to estimated costs. The electricity market has changed substantially since 1998 (when the Electricity Industry Reform Act, or EIRA, was passed), making it unnecessary to retain all of the prohibitions on lines businesses retailing electricity (and building generation). o Lines businesses are now subject to effective price control provisions (or information disclosure in the case of trusts), which prevent them cross-subsidising contestable businesses like retailing and generation. This was not the case in 1998. o We now have an electricity regulator with strong powers to regulate to require open access to lines. This was not the case in 1998, when industry self-governance and ineffective general competition law applied. o Arms-length use of system agreements between lines and retailers are now well-established in the industry (as a result of the 1998 982068 8

reforms). This was not the case in 1998, when new entrant retailers found it very difficult to negotiate use-of-system agreements with vertically integrated lines and retail businesses. That is, the 1998 reforms succeeded in getting independent retailers into the market, and this means that ownership separation is no longer needed. However, some rules are still needed to prevent lines companies from trying to (re-)introduce discriminatory elements into use-of system arrangements. The main rules are: corporate separation and compliance with arms-length rules; and requirements for transparent and non-discriminatory useof-system agreements. Also, ownership separation has been retained between lines and large generator-retailers (with more than 100MW of grid-connected generation). o Note that the original 1998 legislation has been progressively relaxed by successive governments as a result of the factors noted earlier. As a consequence, lines businesses can already retail as much electricity as they wish, provided only that they build enough (renewables) generation first. In effect, it is this latter restriction which is being removed. 982068 9

Asset swaps More information on the Tekapo A & B asset swaps Cabinet Paper, para 27-45 (pp7-15) and on the impact on the Discussion Document Vol. II, efficiency of the whole Appendix 15 (pp113-135) Waitaki scheme. Also, information on the costs and benefits of alternative options considered. The Ministerial Review considered a range of asset re-configuration options. These included: o Setting up a new SOE comprising the Huntly station and Manapouri and transferring Tekapo A and B to Genesis o Transferring Huntly to Solid Energy and Manapouri to Genesis o Transferring the Lower Waitaki hydro stations (Benmore, Aviemore and Waitaki) to Genesis and e3p and p40 to Meridian o Transferring Manapouri to Genesis and e3p and p40 to Meridian o Transferring Tekapo A and B to Genesis. The costs (including contingency costs) for these options are set out in the discussion paper and the appendices to the Summary Note on Recommendations (see Further Information ). The discussion paper also assessed the level of benefits that would need to be achieved in order to cover these costs. With regard to Tekapo A and B, the benefits of transferring the stations to Genesis are expected to be: o Allowing and encouraging Genesis to enter the retail market in the South Island. Note that this has already occurred in anticipation of the transfer: Genesis has made a vigorous entry into the Dunedin market, offering prices on average $200/year less than Contact o Providing a diversity of views on the value of stored water, and improving competition in the wholesale market. (At present Meridian has 70 percent of New Zealand s hydro storage: this will reduce to 50 percent after the transfer) o Encouraging Genesis to consider itself a South Island generator, likely leading to more competition in new generation build. Summary Note on Recommendations, pp67-108 982068 10

Some concerns have been raised about the potential loss of efficiency of water use on the Waitaki river chain. The Ministerial Review allowed a contingency of up to 1 percent loss of efficiency as a result of increased water spill. This level of loss has an NPV (net present value) of $21m. Meridian has argued that the efficiency loss could be up to 3 percent. It says it will need to operate Lake Pukaki at a higher average level in order to be sure it can meet minimum river flow requirements at Waitaki in dry years (and higher average lake levels increases the risk of hydro spills during high inflows). The Government considers this unlikely, because Meridian and Genesis will be required to enter into a water management agreement. The agreement is intended to ensure that Meridian can meet minimum river flow conditions (as well as flood control). Some commentators have also argued that Genesis is likely to run Lake Tekapo at a higher average level than Meridian, increasing the risk of hydro spill from Tekapo. Again this is considered unlikely. Spilled water amounts to wasting valuable fuel: it makes no commercial sense to do this. Note that the level of spill generally appears to have declined since the split of ECNZ (as per the following chart). This is to be expected: competition increases incentives to use fuel efficiently. However, at the time of the split, some commentators (as now) argued that competition would result in more hydro spill and a less efficient electricity system. 982068 11

4,500 NZ Hydro Storage (GWh) ECNZ split into 3 SOEs 3,000 1,500 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 200 Weekly Spill (GWh) 150 100 50 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 5,000 Annual Spill (GWh) 4,000 3,000 2,000 1,000 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 982068 12

Competition in the electricity market Information about current competition that exists and how effective it is has been in constraining prices, and what the Bill is expected to do to competition The review concluded that although a large part of the increase in electricity prices over the last decade is justified: o Retail prices have risen faster than underlying increases in generation costs; Cabinet Paper, para 19-82 (pp4-21) o Retail margins in many areas are high and retail competition is weaker outside the main centres (and particularly in the South Island); and o Some generators have market power in dry years. The review also concluded that sufficient new generation is being built and the quality and diversity of investment in generation is generally good. The Discussion Paper, Volume II, contains a review of competition in and the performance of the wholesale market (Appendix 13) and the Retail market (Appendix 14). (See Further Information ). The Cabinet paper has a detailed discussion of the causes of the weaknesses identified above, and main remedies. In summary, the causes and remedies are: o Transmission constraints. Remedies: improve processes for approving grid upgrades; introduce transmission hedges o SOE generator-retailers are not well-balanced geographically (resulting in weaker retail competition). Remedies: SOE asset swaps Discussion Document, Vol. II, Wholesale Market (Appendix 13, pp 90-100); Retail Market (Appendix 14, pp 101-112) 982068 13

(physical and virtual) o Absence of a liquid hedge market combined with vertical integration between generator-retailers (discouraging competition and new entry). Remedies: provide for a more liquid hedge market; allow lines businesses into retail o Multiplicity of complex line tariffs (making it costly for new retailers). Remedies: more standardisation of line tariffs o Apparent reluctance of consumers to switch retailers. Remedies: promote consumer switching o Weak competition in the wholesale market at times, especially in dry years. Remedies: improved demand-side participation; liquid hedge market; abolish reserve energy scheme; better disclosure and monitoring of wholesale market information; smart meters and tariffs. 982068 14