Dialogue: Energy bill risks subverting the market

By ALEX SUNDAKOV*

Parliament's commerce committee is considering the Energy Industry Bill - the law that would implement the Government's October 2000 Power Package policy. Yet, as drafted, there is some risk that the bill would subvert the Government's objectives.

The main concern relates to the price control regime for the lines companies.

Broadly speaking, international experience suggests two types of regulatory regimes for natural monopolies. The older - and now largely discredited - method focuses on regulating the rate of return earned by such companies. In essence, this approach aims to protect consumers by capping the profits that can be earned. But this creates more problems than it solves.

This is because high profits can be earned in two ways: by using a firm's monopoly power to extract high prices; or by undertaking high-risk entrepreneurial investments, where a high profit represents a reward for risk-taking. The first way to earn high profits is socially undesirable, but the second unambiguously improves social welfare. Hence, any regulatory regime that focuses on excessive profits needs to be able to distinguish between the two sources of high income.

The level of investment and innovation would be reduced by the degree to which regulations claw back profits from entrepreneurial activities. Firms will be reluctant to take risks if they have to carry the cost of failure, but regulations prevent them from capturing the benefits of success.

The difficulty in discriminating between the good and the bad reasons for high profits has been one of the main reasons for the growing dissatisfaction with the rate of return regulations.

The alternative approach is to impose price caps on monopoly businesses. This is often referred to as CPI-X method of regulation, where prices are allowed to increase by the rate of inflation minus some factor, which captures the expected rate of productivity improvements. Price control regulations, such as the CPI-X methodology, have evolved in response to the incentive effects of rate of return regulation.

In essence, a CPI-X approach says that, as long as we observe ongoing declines in the real price to consumers and improvements in quality, we will not be concerned about the profitability of the business, even if it is a monopoly. Hence, in this setting, the decision on when to apply regulations would not be driven by the profitability of any individual business.

Rather, firms would be selected for regulation on the basis of their relative price and quality performance. This more modern approach to monopoly regulation was precisely what the Government envisaged. On the face of it, this is what the bill sets out to provide.

But in practice, the bill creates a strong probability that the regime, as implemented, would mirror a rate of return regulation, with all the consequent economic costs.

This is because the bill:

* Highlights excess profit as a key basis for intervention.

* Allows price control to be put on all the activities of a lines company.

* Requires the Commerce Commission to target intervention based on the nature of the shareholding and the size of the company.

Once high profits are used as a tool for selecting firms for the imposition of price control, and the intervention can be applied to the entire business, the effects of price control become almost indistinguishable from rate of return regulation.

All of this could have been a theoretical oddity if the electricity lines business was a mature business with few opportunities for entrepreneurship. But this is not the case. There are significant scope opportunities in network businesses. Trenching costs, network maintenance and network tracking costs can all be reduced through multi-network operations. For example, UnitedNetworks has recently enjoyed a much publicised low-cost roll-out of a fibre-optic telecommunications network, using facilities from their gas network.

In fact, New Zealand's small size and low population density may make such scope economies particularly important, since we are unlikely to enjoy many economies of scale. New Zealand may need joint networks to keep costs down because separate networks may be much more costly, and in some cases perhaps not even viable.

Another important area for potential diversification by electricity lines businesses is in distributed generation. The Government aims to encourage distributed generation as a means of reducing environmental costs since it cuts transmission losses and encourages the use of local renewable resources. However, de facto rate of return regulation would discourage this.

These opportunities to expand the scope of business involve a degree of risk, and investors will inevitably be seeking to be compensated for such risks. Yet, if the law picks on companies that make higher profits or grow bigger, investors are likely to look elsewhere. All of us could be worse off as a result. Hence, the criteria for selecting lines businesses for regulation are absolutely critical for ensuring that the Government's objectives in relation to consumer welfare and environmental effects are achieved.

The problems discussed in this article can still be resolved at the select committee stage of the bill.

In general terms, the changes that are needed include:

* Narrowing the scope of activities on which price regulation can be imposed. I would suggest a dual test: that price controls could apply only on services directly related to the business of being an electricity line owner, and only to activities in which there is a substantial degree of market power.

* Defining excessive profits explicitly as profits derived from the exercise of market power.

* Removing references to the size of the business and the nature of its shareholding.

* Directing the commission towards defining thresholds in terms of efficiency and service quality rather than profits.

* Providing certainty for long-term investments by subjecting ministers' regulation-making powers to the usual procedural checks and balances.

* Providing certainty for long-term investments by subjecting ministers' regulation making powers to the usual procedural checks and balances.

Such amendments now would greatly increase the likelihood that the bill will achieve the Government's objectives.

* Alex Sundakov is a director of NZIER