Ponder, consult before action

By JOHN SMALL*

I have three words of advice on the electricity industry for the Government: please don't act! Changes are certainly required, but the urgent need right now is for analysis and debate rather than a leap of faith.

Strong leaders should be capable of genuine consultation. Without this, the success of the next phase in the evolution of this industry will be mainly determined by luck.

The last time a Government felt real pressure to do something about the industry was in 1998, when Max Bradford rushed through the vertical split of lines and energy, then a horizontal split in the generation sector.

Only one of these changes (the generation split) made any sense at the time, even to an economist. The lines/energy split was costly, unnecessary and damaging to the subsequent development of the industry.

A brief review of this episode underlines the reason for caution and analysis at this stage.

The putative reason for splitting lines and energy was that this would stop firms using monopoly services (lines) to cross-subsidise competitive ones (energy trading). At the time, there was a Commerce Act section 36 complaint before the Commerce Commission, and the idea of regulating monopoly services was not discussed in polite company.

The Government faced a choice between a structural solution (the split) and a behavioural one (regulating lines companies) and opted for the former.

Structural solutions are often preferred to behavioural solutions if all other things are the same. But all other things are almost never the same, and the implications of this decision seem to have not been thought through properly.

In the generation sector, the horizontal split was intended to increase competition between generators, and would have done so quite durably if this was the only change. But the lines/energy split virtually guaranteed there would be much less competition at the wholesale level as generators bought into retailing.

Competition shifted from the wholesale level to the retail, where it has been strangled by switching costs and transmission constraints. And the lack of an active hedge market at the wholesale layer deprives users and potential investors of long-term pricing signals.

In the lines sector, the split simply made it even more obvious that these firms were monopolies and should be subject to genuine oversight, if not direct regulation. Far from avoiding regulation, therefore, the split made it more likely.

If the split had never happened, the lines firms would almost certainly still be regulated. The thresholds regime being developed by the commission could possibly have been harder and more costly to implement if the lines firms were also trading energy, though the difference would be minor.

In short, one structural solution was the undoing of another, and we did not avoid the behavioural solution. Hindsight is a wonderful thing, but at least some of these effects were predicted in 1998. Unfortunately, they were mainly predicted after the changes had been announced.

Why was there no consultation? Because the feedback was sure to have been negative, the Government felt under pressure to do something, and this was the best plan they could come up with in the time available.

Let us please not have a repeat of 1998. It is clear that the Government has a responsibility to redesign this industry soon. But time spent considering the options is a tiny price to pay to avoid creating another mess.

To get it right this time we need to start with sensible and transparent consultation.

* John Small is Head of Economics at the University of Auckland