Improving electricity market performance: preliminary Ministerial report

Monday 31 August 2009

In April 2009 the Minister of Energy and Resources appointed the Electricity Technical Advisory Group to work with the Ministry of Economic Development (MED) to review the performance of the electricity market and its governance arrangements and make recommendations on improvements.

The first report which sets out the preliminary recommendations on improvements was released on 12 August 2009.

Overview

The report identifies 29 recommendations regarding the governance, functioning and contestability of the electricity market.

In our view, these provide a sensible series of initiatives which are worthy of further debate.

The report recommends initiatives:

• To improve the management of dry years.

• To help restrain the upward pressure on generation costs.

• To improve procedures for upgrading transmission services.

• To improve retail competition and help restrain prices.

• To support these changes by improving governance of the electricity sector.

Importantly, the review was able to critically examine and reach objective views about some of the key structural issues facing the industry. These are set out in the Preliminary Conclusions section of the report and repeated below:

Preliminary Conclusions of the Electricity Technical Advisory Group A well-functioning electricity market should provide a reliable supply of electricity at competitive prices, that is, prices which are as low as possible consistent with ensuring reliable supply over the long term. Current electricity market arrangements are seen by many as falling short of this objective, with apparently excess price increases (especially for residential consumers) and frequent supply crises. There appears to be some substance to these views. However, it should also be noted that: In the large part the increase in prices is justified because: the cost of generating electricity has increased, particularly with the run down of the Maui gas field; and the cost of building new capacity to meet increasing demand for electricity has risen sharply – and is continuing to rise. We need to build, every year, enough new capacity to generate 700-800 GWh/year, at a capital cost of $400 million - $500 million, to keep up with rising demand. Sufficient new generation is being built to meet increased demand and the quality of investment in generation is generally good. New Zealand's hydro-based system is vulnerable to dry years, and we have experienced a series of dry years over the last decade. On occasion, public conservation campaigns are required because demand savings can be lower cost than building expensive spare generating capacity to cover every contingency. Notwithstanding these important caveats: The rate at which retail prices have risen, especially for residential consumers, appears excessive when compared to the increase in the cost of new supply. The way in which dry years are managed can be substantially improved. The reliability and capacity of the transmission system can be improved. The main causes of these problems are: Insufficient competition in the retail market, especially outside the main centres, combined with scope on occasion for the exercise of market power in the wholesale market. In dry years, there are incentives for some market participants to seek to shift increased costs to consumers through public conservation campaigns, rather than manage the risks themselves. There is a backlog of investment in the transmission system, which will take some years to clear. Many also regard the governance arrangements for the sector as unsatisfactory. The Electricity Commission has too many objectives and functions and is seen to be insufficiently independent from government. There is also an unnecessary degree of overlap with the Commerce Commission in regulatory responsibilities for transmission issues.

The report has been welcomed by the Minister as offering practical solutions to many complex problems facing the electricity sector.

Submissions can be made on the report up until Wednesday, 16 September 2009.

Copies of the report can be accessed at www.med.govt.nz

Wish list for electricity market reform

In June, Bell Gully published a Wish list for electricity market reform in which we set out our key priorities for the Ministerial Review.

A key aim of that wish list was the need to reduce New Zealand's vulnerability to dry year risk. In this context, we noted an obvious solution of building more (non-hydro) generation capacity to reduce New Zealand's reliance on our mostly hydro-generation system. Of real interest to us is that the report has undertaken an objective economic analysis of this issue and concluded that New Zealand has sufficient generation capacity. The report concludes that mitigating dry year risk is more about managing our existing generation and transmission capacity more efficiently. Moreover, as noted above, the report concludes that it may not be economically efficient to build excess "spare" generation capacity to mitigate dry year risk compared to reducing demand for electricity in dry years through appropriate public conservation programmes. A careful balance will still need to be reached though between pure economic efficiency and what we see as the very-real need to avoid any perception (both in New Zealand and internationally) that New Zealand has an ongoing risk that electricity supply to business may need to be rationed in dry years.

The other key aspect of the report relates to recommended reforms to make the retail sector more competitive to ensure wholesale and retail customers are not being overcharged for electricity. This is discussed in more detail below.

Issues and commentary on recommendations

Transmission

We are pleased to see that the report has confirmed as a priority the need to fix the national grid and recognises the urgent need for major ongoing investment in the national grid. The report recommends that the current test for approving new investment in the transmission grid be amended to make it "clearer, simpler and less prescriptive, and to take account of wider competition benefits". The report also recommends that the role of approving major grid upgrades be moved from the Electricity Commission to the Commerce Commission.

Comment

Consistent with our wish list for reform, we see these as important first steps in improving the speed and efficiency of the current approval processes to result in much needed investment in the transmission grid.

Wholesale and retail competition

The shortcomings of the wholesale market indentified in the report, include:

• Short term market power: There is currently scope for the exercise of short term market power in the spot market when the market is tight. For example, in a dry year or behind a transmission constraint, a generator may elect to hold back capacity by overpricing its offers and this can in turn impact significantly on the spot price.

  Comment

  We note that there may often be legitimate reasons to withhold water during dry years other than to exercise market power. These reasons include the value placed on that water by the generator and hedging retail exposure.

• Hedge market: The hedge market is not as transparent and as developed as it should be. This problem is exacerbated by the tendency for the hedge market to develop on a regional basis which reflects the applicable transmission constraints. Further, the markets as between the two islands differ because of the constraints on the HVDC system. These shortcomings mean that retailers are not incentivised to compete in some regions because of the price risk from transmission constraints at certain grid exit points.

• Re-allocation of generation assets: The allocation of generation assets between the three SOEs is not well balanced, for example, Meridian Energy generates almost exclusively in the South Island while Genesis Energy and Mighty River Power generate exclusively in the North Island. This reduces the scope for competitive rivalry between those generators when there are transmission constraints on the HVDC system.

  In dry years there is less scope for competition between the SOEs which in turn fosters claims of certain SOEs having undue market power.

• Demand side participation: With the exception of utilising load reduction by major users when spot prices are high for a sustained period demand side participation in the wholesale market is not well developed.

• Ancillary Services: The costs of ancillary services obtained by the system operator are recovered through the pricing of the electricity supplied to consumers. The report indicates there is a view that the provision of ancillary services such as instantaneous reserves and frequency keeping is not competitive.

• Pricing: The report concludes that prices for both domestic and commercial consumers rose quite steeply over the period since 2002.

  The average retail profit margins are generally higher when compared to the eastern states of Australia and the UK. Further, there appear to be regional variations which suggest that retail margins are higher in situations where the distribution network in question involves a small number of consumers and where there a fewer retailers actively seeking to increase their customer base.

The report indicates that there is a wide range of options for improving the performance of the wholesale and retail markets. A number of options were considered but rejected. These included the vertical separation of generation and retail, wholesale and retail price caps, the mandatory offering of some hedges and the re-amalgamation of the SOEs.

The report notes that the option relating to the mandatory offering of hedges should be looked at further if the proposals to restructure the SOE generation portfolio are not proceeded with.

The measures that the report suggests for the promotion of competition in the wholesale and retail markets include:

• Restructure SOE generation assets: The report focussed on three options which require varying degrees of change to increase competitive tension between the three SOEs. The first option involves the creation of a new SOE and asset swaps between the existing SOEs. The second option involves the transfer of the Huntly generating plant to Solid Energy with some asset swaps between the existing SOEs. Both these options have been rejected by the Government (at the time it released the Report) on the basis of cost and timeliness which leaves the third option involving the transfer of the Huntly generating plant (e3p and p40) to Meridian Energy and the transfer of the Manapouri hydro station and the White Hill wind farm to Genesis Energy.

  The third option is intended to reduce Meridian's dominance in the South Island and achieve a better spread of flexible thermal and hydro resources. This spread is also intended to create competitive tension in the context of the reaction of generators to a dry year. However, the Government has stated that it will need to be convinced that this option is worth pursuing.

  Comment

  It will be interesting to see if the third option will get further traction. As noted, we understand the Minister remains to be convinced and has questioned whether the objectives behind the third option asset swap could be achieved contractually rather than going to the extent of a change of ownership. The reorganisation of assets will be complex and may create more problems than it solves because of the difficulty in "fitting" some of the assets into existing asset portfolios. We think that some form of contractual arrangement is most likely and is best.

  Some of the issues relating to lack of competition will also be assisted by fixing the transmission grid to remove the constraints in the HVDC link that occurred during last winter between the North and South Islands. This effectively meant that New Zealand had two independent electricity systems for critical periods over a dry winter – exacerbating the supply/demand imbalance.

• Transmission hedges

  One of the reasons retail completion is limited in some regions is the price risk that is faced by the retailers due to transmission constraints affecting those regions. The availability of some form of transmission hedging mechanism would allow wholesale purchasers to manage the transmission risks.

  Transmission hedges were initially proposed in the mid 1990s, however, the mechanism for hedging transmission risk was never implemented. One of the reasons for the delay was the need to upgrade Transpower's market systems (IT and software) used to support the wholesale market.

  The report notes that while there is some debate about the nature of the transmission hedging mechanism, it recommends that such a mechanism be put in place as a matter of priority to facilitate greater retail competition in regions where there are transmission constraints.

  The report suggests that transparency of the hedge market will be improved if the SOE generators are required to disclose their individual risk positions (as the publicly listed generator/retailers are required to do). The rationale being that this would enable the independent generators (such as TrustPower, Contact Energy, Todd Energy and the line companies) to identify new investment opportunities and it would also impose a risk management discipline on the SOE boards.

• Demand side participation

  An improvement in demand side participation would widen the number of options available to address contingent events such as the outage of a generator. Further, effective demand side participation would act as a counterweight to the role of electricity generators in determining the spot price especially in times when the market is under stress. It may also enable the deferment of supply side infrastructure.

  However, to have an effective demand side response the market needs to be aware of the real time price of the electricity in advance rather than relying on forecast spot prices.

  Again, one of the reasons advanced for not being able to develop effective demand side participation has been the inability of Transpower's market reporting systems to cater for the capturing and dissemination of this information on a real time basis.

  Comment

  Given that Transpower has now completed the upgrade of its market systems it should be possible to design and implement the necessary information exchange systems to facilitate an effective demand side market.

• Retailing by local lines companies

  Currently local lines companies are only permitted to retail electricity in their network area from generation which they have built. The report notes that while many lines companies are unlikely to be keen on getting back into retailing, there may be a case for lines companies to become involved in retailing in remote areas where there is an absence of competition. The report advocates the relaxation of the current restrictions on line companies retailing electricity but restricts this to a stated maximum and precludes line companies from being able to acquire retail customers rather than growing their retail base organically.

  Comment

  As stated in our wish list for reform we question whether it would be better to remove all restrictions on electricity line companies being able to enter the retail market, so long as their line and retail/ generation businesses are operated on a transparent and stand alone basis. We think it better to accept that there is no regulatory policy basis any more for the separation requirement (in that this is now met by specific regulation of line network businesses) and letting market forces decide. This is because retailing electricity is a low margin activity and the lines companies have disposed of their systems for pricing and billing and are unlikely to have adequate generation portfolios to support growing a customer base. Accordingly, it seems to us that there will be a cost barrier to entry into the retail market unless a lines company can quickly achieve size and scale of operations. The ability of line companies to enter the retail market will also be assisted by the development of a more liquid hedge market such that line companies can effectively have "virtual" generation capacity to provide a back up hedge of their retail operations.

  The issue may also be addressed by lines companies actively encouraging the development of distributed/embedded generation by themselves or in partnership with third parties in the affected area. This approach may enable relevant lines companies to provide electricity from an "alternative source" as contemplated by the Electricity (Continuance of Supply) Amendment Bill.

• Standardised line tariffs

  The diversity of the tariff structures applicable to the various distribution networks throughout New Zealand are possibly a factor which discourages new retailers from extending their retail activities to a wider range of smaller electricity distribution networks.

  The report recommends that the work being undertaken to standardise tariffs be progressed.

• Smart metering

  The report notes that smart metering and tariffs which encourage consumers to better mange their electricity consumption have a potential to significantly improve energy efficiency and load management with consequent cost reductions.

  The report recommends that standards and guidelines on smart meters make provision for the equipment to have energy efficiency capability, allow open access communications and readily permit switching by customers. Coupled with the smart metering capability, consumers should be offered pricing which incentivises them to manage their electricity consumption, through load shifting and conservation.

  Comment

  Smart tariffs and smart meters have the potential to improve energy efficiency and load management by giving the individual consumer the ability to directly influence the amount of electricity used and the total price it pays. They also allow electricity retailers to provide much quicker price signals to allow consumers to manage their electricity costs.

• Market data

  The New Zealand market currently releases data about the wholesale market some two weeks after the relevant transaction. The report recommends adopting the Australian model which provides for all market data to be released in an easily readable format the following day.

• Customer switching

  The report suggests that greater customer activism would be very beneficial. If customers become more active in shopping around this will force the retailers to become more competitive.

  To facilitate this the report suggests improving the Powerswitch website to provide up to date information and shortening the time frame in which retailers are required to switch customers with smart meters to three days instead of 23.

Security of supply and dry years

The report concludes that overall sufficient investment is taking place in generation, however, the market is still vulnerable to dry years because of the reliance on hydro generation which in dry years is effectively "run of river" with very little storage capacity. Building sufficient thermal generation to totally cover dry year risk is uneconomic so the least cost approach is to use temporary conservation campaigns to reduce demand.

The report has looked at the responses by the electricity market and the Government to recent dry years and has identified the following issues and suggests ways of addressing them.

• Responsible Parties

  It is essential that everyone understands who is responsible for dealing with the management of security of supply issues and the initiation and management conservation campaigns.

  The report recommends that an Electricity Market Authority (EMA) be established with responsibility for developing the rules dealing with security of supply and that the system operator have responsibility for emergency management. A Security and Reliability Council will monitor the system operator's performance and report to the EMA. The Minister will be responsible for triggering any public conservation campaign.

• Shifting risk

  The report notes that there is a perception that generators and large commercial consumers attempt to shift the risk and attendant costs for dry years to the end use consumers by seeking the use of the reserve generation capacity (Whirinaki) and national conservation programmes. The costs incurred in using reserve generation and in conducting the conservation programmes are ultimately recovered from the end use consumer through the price of electricity.

  To address this concern about "shifting risk" the report suggests requiring retailers to pay a sum (i.e., $10 per week with a mechanism to increase it in proportion to the national savings achieved) to each customer by way of a credit during any electricity conservation programme. The rationale being that the imposition of such a payment when aggregated across all the retailer's customers may encourage the retailer to address the shortfall in electricity by hedging or by investing in new or improved generation.

  Comment

  This proposal which compensates consumers affected by conservation campaigns is likely to increase costs. In practical terms the retailers would compare the cost of the compensation with the cost of the options of arranging hedging or investing in new or improved generation. These options would only be selected if they were considered cheaper than making the compensation payments. Further, the imposition of a compensation payment may be at odds with the desire to reduce the upward pressure on costs.

  Mandatory tariff structures (smart tariffs) which adjust according to the electricity being saved over a sustained period may be an alternative. This would encourage individual consumers who are in a position to do so to actually provide meaningful demand side management during the security risk period.

• Reserve energy scheme - Whirinaki

  The reserve energy scheme which involves the use of the Whirinaki power station distorts the market and in practical terms is limited by the transmission constraints in the Hawkes Bay area. The operating costs of the scheme are intended to be recovered by the spot revenue and the fixed costs are recovered by a levy.

  The reserve energy scheme effectively places an artificial cap on the spot price of electricity at the time of a shortage. In doing so it reduces the incentive for market participants to manage their supply risks.

  The report suggests that the reserve energy scheme be dispensed with and the Whirinaki generation plant disposed of (transferred to an SOE or sold). Alternatively, if the Government wants to retain the reserve energy mechanism then the generation plant should be sold or transferred to an SOE and its "standing costs" allocated to the parties that directly benefit from it (i.e., the parties who are exposed to spot prices) by way of a surcharge on the spot prices during the period of its operation.

  Comment

  As noted in our wish list for reform, it would also be helpful if a long-term gas sale agreement could be part of the sale/transfer package as this will have a key bearing on the functioning and utility of any restructured Whirinaki going forward.

• Floor on spot prices

  To remove the incentive for generators and retailers to push for public conservation campaigns which shift costs onto consumers in general and in order to encourage better management of dry year risk the report suggests the imposition of a floor on spot prices when a public conservation campaign and enforced power cuts are triggered by the Government.

  The report notes that the imposition of a floor price may encourage hydro generators to contract with owners of thermal plant to cover dry year risk. It may also provide an incentive to develop back up generation such as "peaker plant".

• Dispatch of demand response

  An additional tool for assisting in the management of dry year risk is the suggestion that the System Operator should be permitted to include demand side response offers in the "offer stack" which can be dispatched in the same way as generation offers.

• Disclosure of SOE risk

  Publicly listed generator retailers are required to disclose material information about their risk positions to the market place, however, SOEs are not subject to the same discipline.

  The report recommends that in the interests of transparency and a level playing field, the SOEs should be required to disclose such information on an ongoing basis.

• Reserve water

  Some hydro generation station catchments have the ability to access water for generation but restrictions are placed on accessing this water by the relevant resource consents. In 1992 special legislation was enacted which overrode the resource consents to allow water in Lake Pukaki to be accessed. The report notes that the Government seriously considered this type of legislation in 2008.

  The report suggests that the Government explore the possibility of clarifying when and how this reserve water could be used. It suggests capping the revenue of the generator using this type of water to reduce the incentive to rely on it.

Governance

The report is not clear as to the priority afforded to the issue of restructuring the governance of the electricity sector (it appears as the last set of recommendations). However, it seems fundamental to get the governance restructuring in place as part of changing and allocating new and existing regulatory and other responsibilities.

The criticisms of the current governance structure, some of which are highlighted in the report, include the following:

• Political risk: There is potential for political interference in the decisions of the Electricity Commission (EC) because the EC is not independent of the Government, it is effectively an agent of the Minister. In addition to its role as regulator, the EC is expected to implement the Government's policies as they apply to the electricity industry. The potential delays and/or costs arising from this political risk are a disincentive for investors in the electricity market and infrastructure.

• Two entities: The regulation of investment in the transmission sector involves two entities, the EC and the Commerce Commission. For example, the EC currently approves investments in the national grid while the Commerce Commission oversees the expenditure which Transpower New Zealand Limited (Transpower, as grid owner) incurs in maintaining the grid. This issue of regulatory overlap has already given rise to confusion about whether the Commerce Commission is required to re-litigate what the EC has already decided. An attempt has already been made to address this confusion between the roles of the two Commissions by way of a memorandum of understanding.

• Multitude of functions and duplication: There is a perception that the EC has too many functions and expectations placed on it by the Government and by industry participants. It is required to perform the role of regulator (i.e., monitoring and enforcing the Electricity Governance Rules 2003 (EGRs)) as well as developing the electricity market in accordance with the Government Policy Statement (GPS) for the electricity industry.

  The EC has obligations to perform under the EGRs for example, under Part F dealing with investments in transmission. In this context there seems to be duplication in some work streams with the work being undertaken by other agencies such as the Commerce Commission. Another work area of the EC where there is the perception of duplication is electricity conservation and energy efficiency which is similar to the work undertaken by the Energy Efficiency and Conservation Authority (EECA).

Taken together, these criticisms suggest that the overall governance structure for the electricity industry is confusing and is not currently promoting the timely resolution of issues which in turn has cost implications for participants in the electricity market and ultimately end use consumers. To address these criticisms the report proposes:

• Electricity Market Authority: Replacing the EC with an Electricity Market Authority (EMA). The EMA will be an independent crown entity under the Crown Entities Act 2004 with a majority of the members being nominated by business and consumer groups and by electricity industry participants.

  The EMA's sole objective will be to ensure the efficiency of the electricity market for the long term benefit of consumers. Its functions would be to develop and approve market rules (it will take over responsibility for the EGRs) and to monitor compliance with those rules. Other public policy objectives related to the electricity industry would be dealt with by institutions such as the Commerce Commission, EECA and the MED.

  Comment

  In practical terms, the EMA will take over the responsibility which the EC currently performs as the regulator of the electricity industry in overseeing the application and development of the EGRs.

  The issue of changes to existing EGRs or how new EGRs are to be handled will need to be addressed. The report suggests that retaining the involvement of the Minister may provide checks and balances in the process of changing or making the EGRs. However, on balance the report suggests that the EMA should be empowered to make rules covering technical matters involving market operations and would have an ability to recommend non-technical rule changes to the Minister.

  The issue of how the GPS for the electricity industry is to be implemented will need to be addressed. Will the EMA be required to have regard to the GPS in a similar manner to the economic policy statements provided to the Commerce Commission?

  The EMA will need to have a more proactive and timely approach to investigating and making decisions on complaints about breaches of the EGRs. The current processes for investigating and making decisions on complaints takes too long, the processes need refining so that complaints are quickly investigated and resolved.

• Major grid upgrades: The process for the approval of major upgrades of the national grid is to be made the responsibility of the Commerce Commission as part of its existing regulatory role for Transpower under Part 4 of the Commerce Act. The reliability and service standards, transmission pricing methodology and grid investment test would still be set by the EMA. The Commerce Commission would carry out its assessment of any investment proposal in the light of these rules.

  Comment

  We agree that having the Commerce Commission review the grid investment test makes sense as part of the regulatory role carried out in relation to Transpower. It will be important for the Commerce Commission to be appropriately resourced to carry out these additional functions.

• Functions to System Operator: A number of functions which are currently undertaken by the EC are to be transferred to the System Operator. These functions include information about and forecasts on security of supply, emergency management, the contracting for market operations (such as clearance and reconciliation) and the operation of any reserve energy facility.

  Comment

  In our wish list for reform we identified that a fundamental guiding factor for reform initiatives is to simplify what is a very complex industry. Having reviewed the report, we appreciate that in breaking up the EC's existing regulatory functions and having new and other governance structures to deal with these there is a natural trade off with simplicity. We agree that this can not really be avoided in this case. Even though the report recommends more governance bodies are created this added layer of complexity should be off set by clarity of role. One question we raised in our wish list for reform which we think remains valid is to question whether it would be better for the (new) EMA to take the lead on emergency management of electricity in dry years. It would seem better to us to have a body independent of Transpower undertaking this role given Transpower's other role as owner/operator of the national grid and ongoing transmission constraints. It could also mean that there would not be a need for a separate Security and Reliability Council (referred to below) which would remove one additional layer of governance from the industry.

  If the transfer of functions to the system operator or the EMA proceeds it will be necessary to ensure that the relevant party has adequate resources and IT systems and software in place to provide the required level of information and forecasting from the outset.

• Security and Reliability Council: The EMA is to set up and service a Security and Reliability Council comprised of senior persons from the electricity market who are to monitor and provide advice on the system operator's performance of its functions and on security of supply issues generally.

  Comment

  The council could play a useful monitoring and advisory function however, the council's role will need to be clarified. Is it to be advisory only or will it have some standing which will enable it to make a complaint to the EMA about a breach of the EGRs by the system operator? Further, what standing (if any) will its recommendations for example, to improve systems or take certain action have?

• MED and EECA: The functions relating to consumer equity type issues (which presumably would, for example, include administering the guidelines for vulnerable consumers) are to be transferred to the MED.

  The functions of the EC relating to energy conservation and efficiency are to be transferred to the EECA.

  Comment

  This makes sense to us.

Other reviews

The report notes that other Government reviews and policy development projects are underway in relation to climate change, the Resource Management Act, gas exploration, geothermal reserves, model retail pricing, Transpower's pricing methodology and mandatory guidelines for smart metering. The report recommends that these studies and policy projects take account of the recommendations arising out of the report in the context of the electricity industry.