Part 2: Reasons for establishing the Electricity Commission

Electricity Commission: Review of the first five years.

2.1
In this Part, we summarise how the electricity sector operated before the Commission was established. We discuss:

2.2
This historical context is necessary to understand the original purpose of the Government Policy Statement, the rationale for establishing the Commission, and its functions and objectives.

The electricity sector before September 2003

2.3
During the decade before the Commission was set up, consecutive governments had pursued a strategy of removing barriers to competition in the electricity sector:

  • The Electricity Act 1992 (the Act) removed statutory barriers to competition in electricity retailing and line distribution.
  • The Electricity Industry Reform Act 1998 required ownership separation between lines companies and either electricity generation or retail companies by 1 January 2004. Most of the industry had achieved complete ownership separation by 1 April 1999. The Electricity Industry Reform Act 1998 also contained powers to regulate charges by lines companies for supply to domestic and rural customers. Price control could also be applied to all electricity distributors, to particular classes of distributor, or to individual electricity distributors.
  • The Electricity (Information Disclosure) Regulations 1999 required Transpower1 and electricity lines businesses to disclose a greater amount of information, including annual financial statements, prescribed terms and conditions of contracts, various performance measures, asset management plans, line charges, and the methodology used to determine those charges.

Self-regulating arrangements

2.4
Within this legislative framework, the industry had developed three self-regulating arrangements to govern the operation of the wholesale electricity market the New Zealand Electricity Market (NZEM), the Metering and Reconciliation Information Agreement (MARIA), and the Multilateral Agreement on Common Quality Standards (MACQS).

New Zealand Electricity Market

2.5
The NZEM was where most electricity was bought and sold. The NZEM was launched in October 1996 and operated under a self-regulating structure, with mechanisms for selecting a governance board; setting, changing, and enforcing its rules; and resolving disputes. The rules set out how electricity generation companies offered electricity into the market, how generated electricity would be "dispatched" (see the Appendix), and how prices were established. There were also rules for clearing and settling transactions, and how market surveillance and enforcement was carried out. Participants in the NZEM and service providers (for example, Transpower as the dispatcher) had to sign up to, and agree to abide by, the rules.

Metering and Reconciliation Information Agreement

2.6
The MARIA was a set of rules about metering and reconciliation standards that allowed electricity flows to be matched against contracts. The MARIA provided mechanisms for trading outside the NZEM. It included processes for selecting a governance board, changing the rules, resolving disputes, and enforcing the rules. The MARIA also contained rules that allowed consumers to switch retailers.

Multilateral Agreement on Common Quality Standards

2.7
The MACQS provided a mechanism for the grid users (that is, the entities that are connected to the national electricity transmission system) to determine the common elements of quality of electricity supply across the national grid, such as frequency specifications. It established an industry committee, the Grid Security Committee (GSC), to contract with Transpower to meet agreed quality levels. The GSC had to consult with industry participants, and set performance and technical standards necessary to maintain quality for entities connected to the national grid.

2.8
Electricity generation companies competed to supply electricity to retailers and consumers across the national grid, which was the physical hub of the wholesale electricity market. They did this in two ways:

  • contracting with retailers or end-user consumers to supply electricity directly; or
  • contracting with multiple parties - for example, through the NZEM. The NZEM provided the opportunity to buy and sell electricity through a spot market.2

2.9
About three-quarters of New Zealand's total electricity volume was traded through the NZEM. This amounted to some $1.2 billion of wholesale trading in 1999. The remainder was covered by bilateral contracts between electricity generation companies and consumers under the MARIA.

Guiding principles of the New Zealand Electricity Market

2.10
The NZEM's guiding principles were based in part on the Government's objectives. In summary, these principles provided that the rules and structures had to foster markets for electricity that:

  • supported the continuing availability of energy services at the lowest cost to the economy as a whole, consistent with sustainable development;
  • encouraged an environment in which electricity prices were set through the competitive interaction of buyers and sellers;
  • established prices that "cleared" the market, which meant that the amount of energy purchasers were willing to buy at the market price at any time equalled the amount of energy producers were willing to sell at that price at that time; and
  • allowed market participants to identify and take responsibility for managing risk.

2.11
The rules had to enable new buyers and sellers to enter the market and, in particular, could not unfairly disadvantage new electricity technologies or make it difficult for consumers to manage their use or consumption patterns (demand-side management). The rules had to comply with the Commerce Act 1986 and other relevant laws, providing for and maintaining a supervisory body that had the power to monitor and enforce the rules.

2.12
Within the NZEM, the Market Surveillance Committee (MSC) was set up to enforce the rules, educate market participants on their responsibilities, and promote transparency. The MSC was an independent body elected by market participants and service providers, and chaired by a retired Court of Appeal Judge.

Issues identified with market structure by the 2000 Ministerial inquiry

2.13
By early 2000, concerns about the sector resulted in a Ministerial inquiry to examine whether the regulatory arrangements for the transmission, distribution, and wholesale and retail sectors were best suited to ensuring that electricity was delivered in an efficient, reliable, and environmentally sustainable manner to all consumers. In June 2000, the report of this inquiry found that the regulatory regime was not meeting the Government's objectives.

2.14
The wholesale market was dominated by a small number of electricity generation companies and retailers that also dominated the market's governance bodies (NZEM and MARIA).

2.15
Market rules had been developed and implemented in keeping with the interests of those dominant companies. There was limited representation from other market interests. For example, there was a lack of progress in introducing a real-time market, which had in turn hampered greater participation by electricity purchasers and users.

2.16
There were also limited incentives to ensure that governance structures, which essentially were self-regulating, gave full effect to the market's guiding principles. There were few sanctions to ensure compliance.

2.17
There was, and still is, a significant degree of vertical integration, where the few electricity generation companies were also the electricity retail companies. This integration reduced the natural competitive tension between the interests of retailers and generators that would otherwise have served to discipline market behaviour.

2.18
Four electricity generation companies accounted for 85% of New Zealand's electricity generating capacity. Three of the companies, which controlled 60% of the market by generation capacity, had the Government as their major shareholder.

2.19
Questions were asked about the effect that this aggregation of market power may have had on competition and also the privileged position and responsibility the Government had as the predominant owner in the generation market.

2.20
Transpower was, and still is, a monopoly provider with no competition. Many participants in the industry questioned how Transpower recovered its charges, and claimed that Transpower's approach to setting prices lacked transparency. A number of participants also opposed Transpower's "apparently unilateral approach to pricing and contractual dealings".3 Under self-regulation:

  • there was no progress made on decisions on major capital investment;
  • there were significant unresolved issues around the Transmission Pricing Methodology; and
  • there was significant industry dissatisfaction with contracting arrangements - the Benchmark (Transmission) Agreements.

2.21
On the other hand, Transpower had no guarantee of recovering its charges because the threat of refusing to supply electricity to distribution companies lacked credibility. Some companies had refused to pay because they disagreed with Transpower's pricing methodology and some of the disputes had to be settled by the courts.

2.22
The distribution companies that made up the electricity network were also effectively monopoly operators in their areas.

2.23
Consumers and retailers in a given location were generally unable to choose an alternative company to transmit electricity to their homes or business premises. The lack of competition in the market meant that there were few incentives for any of the companies in the sector to minimise costs, and few constraints on the profits they earned.

2.24
In spite of regulations requiring market disclosure, the information available was poor and there was little meaningful or useful analysis of distribution companies' performance. The regulatory regime lacked credibility in the eyes of the market and many consumers. The process for exercising existing price control powers was considered too cumbersome and the powers of the Commerce Commission too limited and inflexible to be effective.

2.25
An important issue facing the sector at that time was whether the distribution part of the electricity sector should be further regulated - and if so, which entity should regulate it, and what powers the regulator should be given.

2.26
The June 2000 Ministerial inquiry report noted that, from April 1999, price differentials provided incentives for consumers to change retailers. However, in the next 12 months only 4.8% of consumers had switched to a different electricity retailer.

2.27
There was evidence of barriers to switching that were likely to have reduced consumers' willingness to change. These barriers included the unco-ordinated provision of services by distribution and retail companies, alleged anti-competitive practices, and unjustified disconnections.

Response to the Ministerial inquiry's recommendations

2.28
The inquiry's recommendations included strengthening and making mandatory the governance framework for the electricity industry, and replacing the existing governance bodies with a new single market structure.

2.29
The Government set up the Electricity Governance Establishment Committee (EGEC) to create a single governance structure. It replaced the three self-regulating arrangements - the NZEM, MARIA, and MACQS.

2.30
The task of the EGEC was to rationalise the industry's existing structures; to establish rules governing wholesale and retail prices, security of supply, and transmission and distribution; and to get the industry to agree to those rules.

2.31
In April 2003, the EGEC proposed a new set of rules as the framework for self-regulation. About this time, water levels in the hydro lakes were low4 and the country was dealing with a potential energy shortage for the second time in three years. This potential shortage prompted the "Target 10%" advertising campaign, which called for a voluntary reduction in power use. The continuity of electricity supply and the need for reserves of electricity in a dry year - when there is not enough rainfall to keep water levels high in the hydro lakes - were widely debated.

2.32
The first stage in implementing the proposed new rules was a referendum5 to gauge the level of support for them. Votes were allocated equally to each of three classes: consumers, traders (generators and retailers), and transporters (lines companies and Transpower). The referendum failed to achieve the support needed to allow the new rules to proceed.

2.33
On 20 May 2003, as part of a package of decisions on the security of electricity supply, the Government announced that it was establishing the Commission - moving away from a voluntary model based on industry contracts, to a statutory, regulation-based model.

1: Transpower is the State-owned enterprise that transmits electricity through the national grid. It is a monopoly provider. See the Appendix for more information.

2: The buying and selling of wholesale electricity is done through a "pool" where electricity generation companies offer electricity to the market, and retailers and major users bid to buy the electricity. This market is called the "spot", or the "physical wholesale", market.

3: Inquiry into the Electricity Industry: June 2000 Report to the Minister of Energy, Ministry of Economic Development, Wellington, page 24 (available at www.med.govt.nz).

4: Low water levels in the country's hydro lakes are significant because hydroelectric power generates about 60-70% of our electricity.

5: The referendum was conducted in April and May 2003. For more information, see our July 2005 report The Electricity Commission: Contracting with service providers, page 7.

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