New Zealand Yearbook of New Zealand Jurisprudence
Last Updated: 12 April 2015
Why Did Electricity Self-Regulation Fail?
In December 2000 a Government Policy Statement was issued on electricity industry reform.' By itself the Statement had no direct legal effect, but it clearly deserved and received careful consideration. It was a substantial document covering most aspects of the electricity industry. It followed an earlier Ministerial Inquiry into the industry which was established by the Minister of Energy immediately following the change of government in 1999. The Inquiry presented its report in June 2000 and the final Policy Statement (an earlier draft had been issued in October) in large measure adopted the Inquiry's recommendations. The Policy Statement began in this way:
The Government's overall objective is to ensure that electricity is delivered in an efficient, fair, reliable and environmentally sustainable manner to all classes of consumer. To meet this objective, the Government favours industry solutions where possible, but is prepared to use regulatory solutions where necessary. This Policy Statement sets out the Government's expectations for industry action and its views on governance matters.
Any possible doubt as to the government's seriousness was immediately dispelled by the introduction to Parliament that same December of legislation (ultimately enacted as the Electricity Amendment Act 2001) which contemplated both the formal recognition of electricity governance organisations and the establishment of a new Crown entity, to be called the Electricity Governance Board. In other words, as the Ministerial
• Deputy Chair, Commerce Commission, and previously in legal practice in Buddle Findlay; before then, was active in national politics, serving in Cabinet 1984-1990. Chaired the Ministerial Inquiry into the Electricity Industry and the Electricity Governance Establishment Committee. I am grateful (as always) for comments on a draft of this paper by Kieran Murray, who, at an early stage, advised the Inquiry and was also one of EGEC's advisers. I am also grateful for the support of my fellow Inquiry members and of EGEC's members and staff. It was a pleasure to work with them all. The views expressed in this article, however, are my own.
Government Policy Statement: Further Development of New Zealand's Electricity Supply (Wellington: Ministry of Economic Development, December 2000).
Inquiry had contemplated, the industry was to be presented with a challenge; either it established new governance arrangements which met the government's overall objective and detailed requirements, or the government would do that itself.
The notion that New Zealand's electricity industry might regulate itself was by no means novel. By 2000 no less than three private multilateral agreements or contracts governed different aspects of the industry. In 1994 MARIA (the Metering and Reconciliation Information Agreement) allowed sales and purchases of electricity to be measured consistently. Next in time was NZEM (the New Zealand Electricity Market), which from 1996 provided the rules governing New Zealand's wholesale electricity market. And in 1999 MACQS (the Multilateral Agreement on Common Quality Services) provided a means for standards to be agreed governing the quality (chiefly the voltage range and frequency) of electricity transported across the national grid.
Each of these agreements set up governing bodies elected by participants in the industry. Each agreement was a private contract entered into by a number of parties. Each was enforceable in the first instance through a set of internal sanctions such as (in the case of NZEM) the Market Surveillance Committee, although none sought to exclude the jurisdiction of the civil courts. As private sector agreements, each was capable of evolution through processes of amendment provided in the agreement itself.
Another notable feature was that each of these private agreements had been set up at the behest of the government. MARIA and NZEM reflected the then government's desire to see a wholesale market established. MACQS originated with the requirement outlined in Transpower's 1997 Statement of Corporate Intent to `provid[e] services at a quality and quantity ... demanded through a process of agreement with customers of those services [and] ... to establish processes and a contractual framework ... to facilitate [this]'.
So the notion of multilateral arrangements negotiated and run by the industry at the behest of the government (or at least with its underlying support) was not new. This was not the first government to 'favour industry solutions'. Nor by any means was it the first to threaten a regulatory alternative. But this time the government spelled out the detail of what it was looking for and the alternative that awaited if the industry failed to agree. The incentives (to agree and to disagree) were both starker and different from previously.
If the primary question we are seeking to answer is why self-regulation failed, it may be worth first addressing the related question, what do we mean by failure? In what sense did self-regulation fail? The simplest answer is that in May 2003 an overall majority of the generators, retailers, lines companies and electricity consumers rejected the rules the industry had by then drawn up in response to the Government Policy Statement. The outcome disclosed a margin of roughly 60 per cent against to 40 per cent in favour of the proposed rules.
As a result of that vote, the industry's previous multilateral arrangements will by March 2004 have been replaced by regulations and rules administered by a government-appointed body now called the Electricity Commission. In contrast to the previous system of 'self-regulation', the rules governing the industry are now promulgated by the government. And the Electricity Commission is appointed entirely by the government. The chief sense in which a vestige of self-regulation might be thought to linger is perhaps that the Commission's initial rules and regulations have been based substantially on the rejected industry Rulebook, which (rather than starting again) was used by officials as a 'reference template' for the new rules.
II. THE MINISTERIAL INQUIRY (FEBRUARY-JUNE 2000)
Before describing the series of events which led from the December 2000 Policy Statement to the demise of industry self-regulation, let me sketch one further piece of background. The Ministerial Inquiry which got underway in February 2000 had wide terms of reference. Its essential task was to assess the then regulatory regime and to recommend any changes thought appropriate. Although the terms of reference asked eleven specific questions, the terms of reference allowed, if they did not specifically invite, a general stocktake of the industry. After some fourteen years of hectic change that seemed appropriate.
Prior to the change of government in 1999 the principal area of public concern in relation to the industry had seemed to be the rising cost of electricity to domestic consumers as a result of the corporatisation of electricity distribution companies and the removal of their previously exclusive franchise areas. Despite the introduction of retail competition, many saw a need to regulate the remaining monopoly element in the supply chain, that is (arguably), the charges levied by lines companies. As to this matter, the Inquiry ultimately recommended that the Commerce Commission (New Zealand's omnibus trade practice regulator) be given the power to control charges levied by individual lines companies.
As the Inquiry conducted its public hearings a number of concerns in relation to the operation of the wholesale market also became evident. First and foremost was the difficulty that consumers allegedly faced in engaging with the wholesale market. Although directly connected customers could choose to purchase through the wholesale market, smaller customers found it difficult to respond to the market, that is, to its changing half-hourly wholesale prices. The market was said to be `supply-dominated'.
Another feature of New Zealand's market arrangements in 1999/2000 related to the transmission of electricity across the high-voltage grid. MARIA and NZEM addressed the sale and purchase of quantities of energy, but not their transmission from point to point. There was no industry agreement governing who should pay for common transmission investment, nor the way in which transmission services would be charged for. Some parties argued that this ran the risk of leading to under-investment in transmission. And whereas disputes about the pricing of energy were being settled within the industry without resort to the courts, several high-profile disputes about the price of transmission services had gone to court.
With this background in mind, the Ministerial Inquiry recommended new governance arrangements for the industry. Although no explicit note of this was made in the Inquiry's report, the Inquiry was aware of industry plans to amalgamate NZEM and MARIA. The Inquiry went one further and recommended the replacement of all three existing agreements with a new body, a majority of whose members should be independent of the industry. The Inquiry also recommended the adoption of rules governing the pricing of transmission services. These and the other recommendations of the Inquiry were adopted almost in their entirety by the government.
The Policy Statement of December 2000 invited the industry to create a new Electricity Governance Board. This Board would be responsible for the development and enforcement of rules addressing transmission pricing and investment, a real time wholesale market, the disclosure of hydro spill, the publication of information on electricity hedge prices, the establishment of financial transmission rights (in effect transmission hedges) as well as the existing function of the three industry bodies and a number of other matters. As the Inquiry had recommended, a majority of the Governance Board were to be independent of the industry, and, significantly, compliance with these industry rules was to be compulsory.
III. THE INDUSTRY'S RESPONSE
At first the industry responded positively to the challenge of the December 2000 Policy Statement. Industry chief executives indicated their support for the proposed new structure. An Electricity Governance Establishment Committee was soon formed. This comprised two representatives of each of the three industry agreements, two consumer representatives and a representative each from Transpower and the distribution companies, which recognised that distribution (and for that matter, consumer) interests were not well covered by the three existing agreements. Over the course of 2001 draft rules amalgamating the three contracts and addressing the areas of transmission pricing and investment were drawn up. Three working groups, addressing respectively governance, transmission, and the amalgamation of the three existing agreements, handled the bulk of this work. After two rounds of consultation, in December 2001 the Establishment Committee submitted the resulting draft rules to the Commerce Commission for approval. None of the three multilateral agreements was comprehensive and to some extent NZEM and MARIA provided alternative means of wholesale trading. On their face, the proposed rules were a comprehensive arrangement replacing previously voluntary, alternative arrangements —hence the need for Commerce Commission approval. The Commission had a lot on its plate that year, so by the time the application was advertised and interested parties had formulated their submissions, it was June 2002 before the Commission was able to conduct formal hearings. The Commission delivered its decision in September 2002.3 In summary, the new rules were approved, subject to compliance with four conditions, two of which required minor amendments to the proposed draft rules.
By the end of the year these amendments had been drafted and agreed, but by then further issues had become apparent. In particular Transpower and Meridian raised a number of concerns. For the first four months of 2003 the Establishment Committee strove to resolve these. By April the Committee had reached the point of exhaustion and resolved to conduct a formal referendum of the industry. The Committee had previously decided to allocate voting rights in the referendum as to one-third to generators and retailers, one-third to transporters (that is, Transpower and lines entities) and one-third to consumers. Within these three classes the votes of generators, retailers and consumers were allocated on the basis of
3 Commerce Commission, Application by Electricity Governance Board Lid, Decision
No. 473, 30 Sept 2002.
relative volumes of electricity bought or sold, and in relation to the transport class on the basis of relative asset values.
When the votes were tallied, traders supported the new rules by a margin of 66 per cent for, 34 per cent against. Essentially all generator/retailers voted in favour, except Meridian. Transporters supported the new rules by the narrower margin of 53 per cent for and 47 per cent against. That is, the lines companies generally favoured the rules, but Transpower opposed them. For reasons that were never made clear, PowerCo (the second largest lines company) abstained. Consumers on the other hand were overwhelmingly opposed to the new rules. Only 4 per cent (just Federated Farmers) supported them versus 96 per cent against. Weighting the three classes equally the overall result was therefore 41 per cent support and 59 per cent opposition. Within days of this result, the government reiterated its previous warning that it would promulgate its own rules — although this also took longer than first anticipated.
Doubtless there can be many explanations of the referendum outcome. My perspective is that of the Chair of the Establishment Committee and the Chair of the earlier Inquiry. I write this summary now not to re-open old wounds or to seek to influence the historical record, but in order to ensure that there is at least this much of a record available. My understanding is as follows.
IV. TRANSPOWER'S CONCERNS
The party with the greatest number of concerns about the proposed industry Rulebook was undoubtedly Transpower. Transpower opposed the new agreement in front of the Commerce Commission and lodged a cross-appeal (in support of the appeal lodged by Comalco) against the Commission's approval. In December 2002, two months after the Commission's approval, Transpower wrote to the Establishment Committee raising 32 concerns with the proposed industry Rulebook. By March 2003 this list had been whittled down to four remaining issues. These were:
Let me briefly elaborate on each of these points.
As submitted to the Commerce Commission, the draft rules had no expiry date. By early 2003, what Transpower sought was an agreement which lasted just four years — that being the maximum period for which the Commerce Commission's authorisation was to last. But there would have been a significant difference between the expiry of the Commission's authorisation and the expiry of the agreement itself. In the first case, one could anticipate the industry seeking a renewed approval from the Commission before its authorisation expired. If that date were missed, however, much lawful activity could still continue. The arrangements as a whole would not have come to an end. Transpower's proposal appeared to pose that risk. It was a risk that most of the rest of the industry was unwilling to run.
The problem of new entrants was less stark, but just as elusive to resolve. In essence the problem arose because of the voluntary nature of any industry agreement. Generally speaking nothing obliges parties to enter into a private contract. While the Government Policy Statement had said: `compliance with the rules will be compulsory ...' no law enabled the industry to compel this result. Instead, the draft industry rules went to elaborate lengths to achieve this outcome in practice. In particular, they provided that the rules would not come into effect until Transpower was satisfied that enough parties had joined so that it was confident of meeting its security and other obligations. And while no law obliged participants, having joined, to stay inside the Rulebook, other provisions made it clear that they could not leave without negotiating equivalent arrangements with Transpower. Although these provisions were elaborate, they did not satisfy Transpower.
Transpower's third source of concern related to the powers of the proposed industry governing body. Although the government had required only that the majority of the new Board members be independent, the Establishment Committee had early on resolved to recommend a wholly independent governing board, i.e. a board none of whose members were directors, employees or significant shareholders of an industry participant. Whatever the advantage of such independence, the contentious issue related to the governing board's proposed powers —especially its powers in relation to future amendments to the agreement. In the event that the rules were felt to be unsatisfactory or insufficient, anyone could propose an amendment. Proposed amendments would be considered by working parties representative of relevant interests who would judge the proposals against the guiding principles to which the entire Rulebook was expressed to be subject. These principles followed
similar principles in each of the three existing industry rulebooks, and also reflected the guiding principles in the Government Policy Statement. Their resolution had also proved controversial, but was not at the final point of voting a significant source of remaining controversy.
What did concern Transpower and others was that proposals to amend the new Rulebook could not simply be adopted by the governing board following consideration by the relevant working party. If a significant minority of participants wished it, amendments could be put to a vote. In other words, to use Transpower's language, the board lacked 'executive authority'.
This issue was argued in front of the Commerce Commission and the Commission itself proposed two amendments which in some circumstances would have enhanced the board's authority. These amendments were both adopted, but they did not go far enough to satisfy Transpower. As with a number of other issues, the essential problem lay in the fundamentally private nature of the industry rules. One way of viewing them was as akin to a company constitution over which a board of directors might preside. Investors typically engage with a particular company knowing its constitution. They will also know that as a minority shareholder they can be outvoted. But few companies provide that boards of directors can unilaterally change the rules — as Transpower appeared to wish here.
Transpower's fourth issue in one sense did not relate to the proposed rules at all, but rather to the vexed issue of what its customers should pay for using the transmission grid. This was something that the new rules might ultimately address — once a transmission pricing methodology had been devised and approved in accordance with the new rules. In the expectation that a binding means of determining transmission prices would emerge from the new system of industry governance, Transpower had obtained temporary statutory backing for its existing pricing methodology. This took the form of section 19 of the Electricity Amendment Act 2001 — otherwise the legislative backdrop to the Establishment Committee's efforts. Section 19 however was a temporary provision. It was due to expire on 26 July 2003 and could be extended only for a period of up to six months. By the first months of 2003, Transpower had begun to fear that there would not be sufficient time between the coming into force of the industry Rulebook and the expiry of its authority to apply its previous pricing methodology. So it sought to achieve a collateral bargain, whereby the industry agreed to extend that pricing methodology beyond January 2004, Unsurprisingly (since the industry had never
agreed to that methodology in the first place), the industry balked at that. In particular, Meridian, which had long disputed the way in which Transpower charged for the high-voltage direct current (HVDC) component of the grid, was not prepared to acquiesce in this element of Transpower's demands.
V. MERIDIAN'S CONCERNS
For its part, Meridian had its own objections to the Rulebook. These related especially to the way in which it was proposed to exclude Comalco from the coverage of the Rulebook. Transpower was also concerned about this issue, as were the other large generators. But Meridian had the greatest concern and on this account ultimately voted against the Rulebook. Comalco, as well as being New Zealand's largest single electricity consumer, was Meridian's customer. Indeed, perhaps something approaching half of Meridian's total sales go to Comalco.
As early as the Commerce Commission hearings, Comalco had signalled its wariness of the new industry Rulebook. Its position was that it had a long-term contact with Meridian (and indirectly, for transmission services, with Transpower). It was happy with its present arrangements and saw no reason why it should expose itself to the risk that these arrangements might be altered or disrupted by the new rules. Comalco indicated that, for its part, it did not intend to join the new agreement, and at one point it even argued that if Meridian entered the new arrangements, it would be putting itself in breach of its obligations to Comalco. To say the least, this created a significant problem for Meridian.
The answer seemed to be to exclude Comalco altogether from the new arrangements. Although it might have seemed regrettable to begin a new agreement by excluding some 15 per cent of New Zealand's total consumption of electricity, an exemption could perhaps be justified on the basis that it was unreasonable to seek to override long-term existing contractual commitments. In the event however it proved impossible to translate that broad principle into an agreed set of detailed arrangements. Meridian, Comalco, and Transpower all put forward differing drafts of exclusionary or `ring-fencing' clauses. The other generators took a close interest in the issue and the Establishment Committee sought to act as an `honest broker'. In the end, however, what one participant described as a `narrow but deep' chasm between the parties could not be bridged.
It is probably also the case that Meridian had a degree of lingering disquiet over the proposed rules relating to transmission investment and
pricing. These were new and untested. Although they had been the subject of many months of work they represented a degree of compromise between many participants, especially Meridian and Transpower, and must have involved a degree of risk simply on account of that uncertainty. For Meridian, however, the main problem was how to deal with Comalco. Ironically this issue might have been much less intractable had the larger generators (including Meridian) and Transpower not insisted earlier that all trading should take place within a single 'gross' pool — removing the option of bilateral contracts that had previously been available under MARIA.
VI. THE CONCERNS OF CONSUMER GROUPS
If Transpower and Meridian were the largest single entities in the `opposition camp' by the time of the referendum, the largest group of interests opposed to the draft arrangements were the consumers. It is striking that all consumer groups, save only Federated Farmers, voted against the industry Rulebook. Why was that? Whereas Meridian was concerned with a small number and Transpower with a rather larger number of specific issues, the consumer groups had felt aggrieved over an even wider range of issues and in a more general sense. It might even be said that some of them had never been entirely comfortable with the process from the outset.
Perhaps the largest single area of disagreement, which in some ways symbolises the difference in approach between consumer groups and the generators/retailers, related to what was known as 'chapter by chapter' voting. Like the issue of the Governance Board's authority to which it was often linked, the choice between 'chapter by chapter' voting or `across the board' voting related to future changes to the rules. Recall that in the event of a disagreement with a significant change to the rules, parties to those rules would be entitled to vote on proposed amendments. But which parties? And on what basis would votes be allocated?
Early on in 2001, before the rules were submitted to the Commerce Commission, the Governance Working Group recommended that the Rulebook be divided into chapters addressing different subjects. Thus the Rulebook proposed a chapter on trading rules, a chapter on metering, one on common quality, another on transmission and so on. This was obviously a convenient way of organising the new agreement. Next, the Governance Working Group proposed that votes in respect of changes proposed to any chapter should be allocated to the parties directly interested in that subject (that is, the parties who would be bound by those
rules), rather than in relation to the Rulebook as a whole. The effect of this was to exclude consumers, other than those who traded directly in the wholesale market, from votes in relation to a number of chapters — the trading chapter, for example. Similarly consumers were not to be allocated votes in relation to the metering rules. On the other hand, it was proposed that consumers would receive votes in relation to the common quality chapter, on the footing that some of them had been able to vote in relation to the same set of issues under the MACQS agreement.
Many consumer groups, especially the CC93 Coalition (made up of the Consumers Institute, Federated Farmers, the Chambers of Commerce and the Major Energy Users Group) with whom the Establishment Committee largely dealt, objected strenuously. On the other hand the generator/ retailers and lines companies other than Transpower took the view that the value of their investments would be at risk if consumers were able to change (for example) the way in which electricity was traded in the wholesale market.
Perhaps the key point here is that although consumer groups had been given voting rights under the MACQS Agreement, they did not have such rights in relation to NZEM and MARIA. The task of amalgamating these three agreements therefore gave rise to significant potential changes in the relative stakes or interests engaged in the industry. Several generator/ retailers felt the considerable value of their assets would have been at risk if the voting mechanisms sought by consumers were adopted. The consumer groups did little to dispel this apprehension. It is perhaps unsurprising that such issues proved difficult to resolve. Consumer groups also shared Transpower's support for an 'executive' board. And there were a number of other disagreements.
VII. WHY WAS SELF-REGULATION REJECTED?
But let us turn from the particular complaints of particular parties to see if any general conclusions can be drawn as to why self-regulation failed. The most straightforward answer is simply that the proposed rules were rejected at the industry's referendum. And rejected by a majority who knew that the government's response would be to promulgate its own (as yet undrafted) regulations. Peeling that answer back one layer, one might equally say that the rules failed because the industry chose to hold a referendum. It seems worth noting that the Government Policy Statement to which the rules sought to respond had not itself required a formal vote. Why then did the industry commit itself to holding this ballot? The answer is partly that a similar mechanism had been used prior to the
establishment of NZEM; partly also that a commitment to hold a referendum had been made to consumer groups in order to demonstrate to them that the rules were not a fait accompli being foisted on them by the other industry players.
Equally, the question might be asked why were consumer groups included in the referendum? It is noteworthy that the vote to introduce NZEM was held amongst generator/retailers and directly connected consumers only, not the wider range of interest groups accorded a third of the votes in May 2003. This question is harder to answer. The truth seems to be that at no stage was the alternative of excluding consumer groups ever contemplated. Four consumer groups, who combined as the CC93 coalition, had sought and been granted representation on the Establishment Committee. And the Government Policy Statement seemed to contemplate the involvement of consumers in the drafting process. Indeed, the disquiet at the industry's apparent supply-side dominance had been one of the themes emerging from the Ministerial Inquiry Report. It is hard to imagine that the process of renovating (rather than establishing in the first place) industry self-governance could by 2001 have proceeded without consumer involvement. The exclusion of consumers from the referendum was simply never considered.
On the other hand, if the inclusion of consumer groups in the referendum is understandable, one difference in the nature of consumer groups as compared to other participants in the industry was little remarked on at the time. It is simply that, unlike other industry participants, consumer groups faced only weak incentives to agree to any new rules. The process embarked on might perhaps be compared to the process in the mid 1980s of deregulating New Zealand's financial sector. Although what came to be described as 'financial deregulation' took a rather different path from that followed by the electricity industry, one might perhaps imagine the government of the day inviting the banking industry to draw up self-governance rules. In which case that industry might conceivably have asked itself the question: 'Do you suppose consumers will agree to banks setting interest rates? Or will they want the chance to vote on the formula to be used?' The analogy may seem far-fetched and it does of course highlight the key difference between the two sectors: that interest rates are set in a market with many players, whereas New Zealand's wholesale electricity prices are established in a market with fewer players and whose very nature requires an agreed set of trading rules. One might ask: why would consumer groups ever have agreed to arrangements the rest of the industry supported?
One possible answer might have been because the government wanted them to. It is worth recalling that it was not only the industry that favoured self-regulation. This was the stated policy of the government. At this point, however, we need also to remember the changing backdrop to the drawn-out process of negotiating and approving these new rules. The year 2003 was a difficult one for the electricity industry in a physical sense. It began with the threat of low lake levels, causing spot electricity prices to soar. In the event the onset of wet weather in May, and active conservation measures, saw off this threat. But it seems fair to say that by the time the industry had given up trying to fine-tune its agreement and sought to test support in its referendum, the government had become indifferent to the outcome.
The `straggle-muster' of reluctant supporters that the Minister of Energy had earlier foreshadowed to the Establishment Committee, did not occur. Instead key players, that is Transpower, Meridian and the vast majority of consumer groups, concluded they were free to vote for government regulation. Some might have hoped that the defeat of this particular Rulebook would have allowed the opportunity for a further round of bargaining. But by the time of the final vote the government had made it clear that failure would lead directly to regulation. This result had been so clearly signalled that those who voted against the Rulebook must have been prepared to accept, if they did not actually prefer, that outcome.
In summary then, New Zealand's seven year 'experiment' in the self-regulation of its electricity industry (or to put the matter slightly differently, the seven-year exception to the general pattern world-wide of publicly-regulated wholesale electricity markets) failed because there was no longer enough support for a contractual rather than a regulatory approach. It is worth remembering that the NZEM was adopted only narrowly in 1996 in a vote in which most consumer groups did not participate. In fact, of those who participated in the NZEM referendum, a greater majority voted seven years later in favour of the revised rules. Nevertheless, by 2003, when the wider industry (including consumer groups) was challenged to agree on new rules, it was too easy for a number of parties, especially consumers, to withhold their support.
In addition, it seems plain that the process of replacing the existing agreements took too long — nearly two and a half years. Over that time, the agenda of issues the parties were seeking to address changed and grew considerably. The result was too many conflicting objectives,
leading ultimately to the loss of support for a contractual approach. In the writer's view, the outcome was by no means inevitable. Different choices by several actors at several points along the way might have produced a different result. Those who remain concerned at the sight of a major industry succumbing to the risks of regulation will have taken little comfort from the thought that this outcome was preferred by a majority of participants. Nevertheless, that is how things must be — at least for the meantime — in the world of democracies and private agreements.