Statement to the Commerce Commission of the Economic Policy of the Government: Market Power in the Electricity Sector To the Commerce Commission Pursuant to section 26 of the Commerce Act 1986, I hereby transmit to the Commerce Commission a statement of the economic policy of the Government in relation to market power in the electricity sector. Electricity Objectives The Government's overall energy policy objective is to ensure the continuing availability of energy services at the lowest cost to the economy as a whole consistent with sustainable development. Electricity is a key input into the production and use of goods and services in both industry and households. The achievement of the Government's overall energy policy objective is therefore important to both New Zealand's international competitiveness and the quality and standard of living of consumers. Specific goals for achieving this objective are that: Electricity prices should signal the full cost of providing each extra unit of electricity; and Electricity costs and prices should be subject to strong and sustained downward pressure. The Government considers that the above objective and goals are best achieved by: Strong competition in all sectors of the electricity industry where competition is possible (electricity generation and retailing); and Robust regulation which replicates competitive pressure in the natural monopoly sectors of the electricity industry (electricity distribution and transmission). Government Reforms To achieve these objectives the Government has recently taken a series of measures including: Splitting ECNZ into 3 competing State-owned enterprises; Requiring the ownership separation of electricity line and retail businesses; Requiring the industry to develop low cost systems to enable consumers to switch suppliers; and Enhancing the credibility of the threat of price control on electricity lines businesses. The Government has also recently announced its intention to sell Contact Energy Limited. Contact Energy owns, inter alia, a portfolio of hydro and thermal generating stations and it has purchased the customer base of a number of electricity supply businesses. Government Views on Market Power in Electricity Markets The Government has concluded that the following factors are important in considering market power issues in the electricity sector: Competition in the Physical Spot Market The price of electricity in the spot market is set by competition for dispatch between generating stations in the wholesale electricity market. The effectiveness of competition in the physical spot market is determined in particular by: the number and physical characteristics of stations competing at the margin under various hydrological conditions; the portfolios of stations under common ownership and the ability and incentives this provides for manipulating the market; the extent to which electricity is not competitively dispatched through the wholesale market as a consequence of long-term supply contracts and/or vertical integration of generation and retail businesses. When determining the optimal configuration for the split of ECNZ to ensure effective competition, the Government considered that an assessment of market shares alone was unlikely to provide robust information on market power issues in the spot market. Therefore, the Government found it necessary to undertake modelling to test the effect on competition of different combinations of stations. Having determined that ECNZ should be split into 3 companies in order to achieve optimal outcomes, the Government would be concerned if any future aggregation of stations resulted in the ability to exercise market power in a material way. Competition in the Contracts Market Long-term contracts for electricity, most of which hedge against spot market prices, play a vital role in signalling expectations of longer-term supply and demand conditions. This is particularly important for signalling: emerging ``dry year'' conditions, to which New Zealand is particularly vulnerable; the need for and timing of investment in new generation capacity; and the value of investments in demand side management and energy efficiency. Aggregation of vertically integrated generation and retail companies, while likely providing benefits in terms of efficient management of risk and minimising transaction costs, may affect the quality of price signals in the marketplace. Competition in Retailing The Government has sought to facilitate strong competition in the retail market by requiring the full and effective separation of line and energy businesses. This is expected to facilitate open access to lines for competing retailers. It also removes scope for lines businesses to cross subsidise electricity retailing and generation activities. The Government has also stated to the electricity industry that it expects the industry to put in place, by 1 April 1999, low cost arrangements, such as ``profiling'', to allow consumers to readily switch retail supplier. The Government has announced that it is prepared to regulate for the introduction of such arrangements if this target is not met. In the recent retail mergers and take-overs, which have occurred as part of the ownership separation of line and energy businesses, meters at customer premises have generally been sold to the retail business. This raises the possibility that access to meters may be used by some retailers to frustrate competition. In addition to Commerce Act remedies for the parties, the Government has advised the industry that it is monitoring developments and that if significant problems emerge it will take action to address the situation. Signed at Wellington this 21st day of December 1998. Hon. MAX BRADFORD, Minister for Enterprise and Commerce.