Issues highlighted in the MED consultation paper on "Investment in Electricity Generation by Lines Companies"

Garry Downs, Partner and Louise Hill, Senior Associate | May 2006

Introduction

On 26 April 2006 the Ministry of Economic Development (MED) released a consultation paper entitled "Investment in Electricity Generation by Lines Companies", which outlines MED's favoured approaches for reforming the Electricity Industry Reform Act 1998 (EIRA), the law which effectively prohibits cross-involvement of lines companies in retail or generation businesses.

This consultation paper follows up on a consultation paper released in March 2006 entitled "Facilitating Investment in Generation by Lines Companies: a discussion note".

Key points

Reason for review:
There are some benefits from lines companies investing which are not being realised due to the legislative barriers placed on their activities by EIRA and there are potential efficiency gains from close co-ordination of lines and distributed generation operations.

MED supports these options:

• Allowing lines companies to trade in financial instruments up to the nominal generation capacity of their permitted generating plant to allow lines companies to better manage risk.
  
  
• Removing the arms length rules when generation is connected to an unrelated network.

MED does not support these options:

• Raising the threshold for arms length separation, as the risk of anti-competitive behaviour by lines companies may be significantly greater than any potential long-term benefit to electricity consumers.
  
  
• Less onerous arms length requirements for generation projects between the thresholds of 5MW or 2% and 50MW or 20%, such as allowing staff, managers and/or directors to provide services for both the lines and generation parts of the distribution company.
  
  
• Providing lines companies with more flexibility to decide how they will meet arms length obligations.
  
  
• Making the arms length rules more specific. Additionally, if criteria is to be included in the legislation to guide the Commerce Commission and distribution companies in applications for exemptions from the provisions of EIRA, the criteria should be guidance only.

Next steps:
MED is seeking the views of interested parties. Consultation closes on 25 May 2006.

Reasons behind the consultation

MED considers that there are some benefits from lines companies investing which are not being realised due to the legislative barriers placed on their activities by EIRA and that there are potential efficiency gains obtainable from close co-ordination of lines and distributed generation operations.

MED states that distributors are well-placed to enter generation and retail markets because they:

• are more likely than national generators to identify and develop local generation options because they have strong relationships with local communities and good knowledge of local energy resources;
  
  
• have existing knowledge and involvement in the electricity industry;
  
  
• can readily identify opportunities and exploit synergies with coordination between line and generation and demand-side operations; and
  
  
• can realise economies of scope by making use of common resources such as operations staff, control centres, etc.

MED considers that reducing barriers to entry for distribution companies may increase the level of competition in generation markets, which should place downward pressure on prices for consumers, provided that lines companies do not have incentives to cross-subsidise or use regional market power to reduce competition. However, under EIRA some potential projects may have difficulty being commercially viable because:

• lines companies cannot hedge the financial risks of selling energy at spot prices which may make potential generation projects costly, because the alternatives (selling on the spot market, selling to other retailers or selling to end consumers) are impractical;
  
  
• compliance costs associated with corporate separation and arms length rules may be too high for smaller projects.

Options

The options identified by MED are:

• allow the generation entity owned by a lines company’s owners to trade in financial instruments up to the nominal generation capacity of their permitted generating plant;
  
  
• in relation to changes to the arms length rules:
  
  
  • raise the threshold for arms length separation above the current minimum level of 5MW or 2%;
    
    
  • raise the threshold for arms length separation up to the current cross-ownership limits of 50MW or 20%;
    
    
  • introduce less onerous arms length requirements for generation projects between the thresholds of 5MW or 2% and 50MW or 20%, for example accounting and information separation could be required but staff, managers and/or directors may be able to provide services for both the lines and generation parts of the distribution company;
    
    
  • provide lines companies with more flexibility to decide how they will meet arms length obligations;
    
    
  • remove the requirement for lines companies to comply with arms length rules when generation owned by a lines company is connected to a different distribution network or the transmission grid, and retail customers (if any) are outside the lines company's network;
    
    
• reducing legislative uncertainty:
  
  
  • provide criteria in legislation to guide the Commerce Commission and distribution companies in applications for exemptions from the provisions of EIRA;
    
    
  • redraft the provisions relating to arms length rules to make the rules more detailed and specific, reducing uncertainty.

MED's conclusions on options

The MED stated that it considers that the regulatory framework under EIRA is still necessary and therefore is not considering a high level review of the purpose of the Act at this stage.

Moreover, the MED noted that the issues of competition levels in the electricity market are currently being investigated by the Commerce Commission and also being looked at by the Electricity Commission. Any potential review of the purpose of EIRA would be a consequence of the outcomes of these studies.

However, MED still considers that it is appropriate to look at several possible changes within the parameters of the current framework with a view to removing unnecessary barriers to lines companies' ability to invest in generation.

The MED considered the benefits and costs/risks of each of the options described above (a summary of the benefits and costs/risks for each option is set out in the attached table) and concluded in relation to each option as follows:

• on balance, the MED considered that the risks of allowing lines businesses to trade in hedges and other financial instruments are low and there is a good case for allowing this sort of trade to allow lines companies to better manage their trading risks for the output from the generation stations they own;
  
  
• in relation to the arms length rules:
  
  
  
  • MED does not support the proposal to raise the threshold for arms length separation above the current minimum level of 5MW or 2% or raise the threshold for arms length separation up to the current cross-ownership limits of 50MW or 20%. MED considers that the risk of anti-competitive behaviour by lines companies if the threshold was raised to 50MW may be significantly greater than any potential long-term benefit to electricity consumers;
    
    
  • MED does not support the proposal to introduce less onerous arms length requirements for generation projects between the thresholds of 5MW or 2% and 50MW or 20%, such as by requiring accounting and information separation but allowing staff, managers and/or directors to provide services for both the lines and generation parts of the distribution company. MED considers that the risk of anti-competitive behaviour by lines companies from making the arms length rules less onerous may be greater than any long-term benefit to electricity consumers;
    
    
  • MED does not support the proposal to provide lines companies with more flexibility to decide how they will meet arms length obligations. MED considers that the current exemptions regime would take into account cases where lines companies sought additional flexibility in applying arms length rules and does not consider there is a necessity for a separate process, as any process for assessment would be sufficiently similar to the current exemptions process;
    
    
  • MED concludes that there is a case for removing the arms length rules when generation is connected to an unrelated network;
    
    
• reducing legislative uncertainty:
  
  
  • MED concludes that more information is needed from stakeholders on whether it would be beneficial to provide criteria in the EIRA to guide the Commerce Commission and distribution companies in applications for exemptions from the provisions of EIRA. However, MED considers that any additional criteria would be included as something that may be taken into account, rather than as requirements. MED considers that it is unclear the extent to which the exemptions process needs changing;
    
    
  • MED does not support reviewing the arms length rules to make the rules more detailed and specific, reducing uncertainty.

Click here to view a summary of benefits and costs/risks identified by MED in relation to each proposal and MED's conclusions.