Submission to the New South Wales Committee of Inquiry Into Sale Of Electricity Assets

Submission

EXECUTIVE SUMMARY

Privatisation of the New South Wales electricity assets would bring immense benefits to the people of the State as taxpayers, consumers and workers.

Electricity supply industries are undergoing change throughout the world in recognition that the industry no longer needs to be operated as a single integrated entity.  Commercial rivalry among suppliers at both the generation and retail levels brings greater attention to cost cutting and meeting consumer needs.  The National Electricity Market means that no business can avoid continuously seeking improvements in its levels of service, and in pursuing cost reductions.

Privatisation of the State's electricity assets would inject at least $22 billion into development.  Such a sum presents an outstanding opportunity to repay debt, reduce taxes on business and employment that impede job creation, and increase infrastructure expenditure in areas not readily suitable for private capital provision.

The privatisation process in NSW can also benefit from the Victorian sale experience, which has demonstrated the value of electricity industry assets.  NSW has scope to float rather than trade-sale parts of its industry, thereby fostering significant Australian equity holdings.

In addition, privatisation offers scope to build upon the structural reform presently in place.  In this respect, it allows the Government further to split up the generator businesses and energyAustralia so that greater competition is fostered and the assets attract a wider degree of investor interest.

In terms of present employment, increased competition is likely to force some initial reductions in electricity industry jobs irrespective of any privatisation plans.  These will mainly be in distribution.  Generation in NSW is already relatively efficient and job losses will be minor.  Moreover, domestic and overseas business development opportunities available to private sector firms may well offset these losses.  More importantly, any job losses through rationalisations in the wake of privatisation will be dwarfed by the tens of thousands of new jobs that will follow from the effective increase in investment funds from by the privatisation proceeds.

Private ownership would also avoid conflict of interest situations.  These occur because the Government as the owner of particular businesses has a vested interest in outcomes that favour those businesses and, through its taxation powers, has the ability to negate any adverse outcomes on those businesses.

Privatisation will not have any adverse effects on customer service obligations or the environment.  These facets of the electricity industry are subject to regulation or direct Government expenditure.  In fact, private ownership, by removing a direct financial interest of the Government on these matters, is likely to lead to improved outcomes.  These will be reinforced by the commercial interest that private businesses have to foster their corporate images in the communities they serve.

INTRODUCTION:  THE SOCIAL
USEFULNESS OF ELECTRICITY ASSETS

Electricity in NSW accounts for over 2 per cent of state GSP.  Electrification has long been recognised as fundamental to the modern economy -- and in the Soviet Union in the 1920's electrification was equated to socialism, the ultimate accolade at that time.

Electricity is the essential commodity that is the building block of society's income generating capacity and the means to give its citizens the fundamental levels of comfort and consumer expectations required by the modern economy.  But the social usefulness of the assets is severely reduced if they are not operated at maximum efficiency.  Social usefulness is ill served by assets that incur excessive costs that must be borne by the taxpayer either in subsidies or in inadequate returns.

THE IMPACT OF PUBLIC OWNERSHIP ON
CONSUMERS AND THE ENVIRONMENT

CONSUMER ORIENTATION

As with many other essential aspects of a modern society, food, housing, transport, communications, etc. there is no reason why production and distribution of electricity should be under government ownership.  Indeed, all the evidence is that the provision of goods and services is more efficiently undertaken by privately owned businesses.

There are many reasons why this should be so.  Not the least of which is the intrinsically greater flexibility of private sector bodies, motivated by the goal of maximising shareholder wealth, to adapt their products to shifting consumer needs and to pare unnecessary costs.  In competitive markets, commercial rivalry will force lower costs to be passed on in lower prices.  To forego opportunities to reduce costs puts at risk the viability of private businesses.  By contrast, Government owned businesses are able to survive without such a heavy focus on these costs because they do not face the threat of takeover by others able to spot and implement the opportunities for profit by making savings.

In addition, private ownership markedly reduces the risk of government interference in the terms and conditions under which goods and services are provided.  This better allows the operation of the competitive market conditions that all states and territories have agreed to under CoAG.

Hence, while in principle there is no reason why private rather than public ownership should offer better outcomes to the consumer, the former is spurred more forcefully by profit considerations that require a very close customer focus.  Private businesses flourish when they can establish and hold customer loyalty and avoid poor reputations.  Indeed, the reform process in the Australian electricity industry was stimulated by observations of increased efficiency and lower costs observed in the mainly privately owned US industry and by the gains that were rapidly being seen in the newly privatised UK industry.

In Victoria, prior to privatisation, resolute government action from 1990 resulted in considerable savings in costs and improvements in efficiency.  Yet, in the period post privatisation of most of the businesses, further substantial improvements were brought about as a result of the focus on increasing shareholder value.  As illustrated in Table 1, this cost reduction process had not been at the expense of customer service.

Table 1:  Victorian Electricity Industry Performance Indicators

	1990/1	1993/4	1996
Average System Outage (minutes)	490	251.7	175
Availability of Generators	79.8	82.7	92
Generator Labour Productivity (GWh/employee)	6.7	16.2
Monthly Disconnections (residential)		2800	1380

With respect to system outages, the measurements prior to 1994 excluded the 12 per cent of electricity that was distributed through the municipal authorities, which were generally far inferior to the SECV.  Hence the figures are far better than they appear to be.

In terms of other measures, privatisation has brought vast reductions in customer prices for contestable customers and reduced numbers of disconnections.  The private businesses have taken energetic steps in this latter direction partly to avoid the costs of re-connecting households and partly to raise their image in the communities they serve.

ENVIRONMENTAL ISSUES

In terms of environmental outcomes, public ownership brings neither a positive nor a negative outcome.  Such outcomes in terms of discharges from generators, visual impacts of wires, etc. can be and are legislated for irrespective of ownership.

Private businesses in fact often pay greater attention to environmental considerations because they do not have a government shareholder that seeks to shield them from cost disabilities and liabilities.  Moreover, environmental care is part of private business's overall marketing strategies and many private businesses are keen to tap the increasing market that this can bring.

Among both the privatised Victorian businesses and the publicly owned NSW businesses, there are firms that are seeking to position themselves to win customers by selling "green" power generated from new renewable sources.

EMPLOYMENT, SKILLS, TRAINING AND THE PROTECTION OF THE EXISTING WORKFORCE

In the past, many State Governments to a greater or lesser extent used their own corporations as means of providing jobs over and above the levels required for commercial operations.  They were able to do so because State electricity businesses were insulated from inter-state or intra-state competition

State Governments in effect subsidised the operations of their utilities by accepting a lower rate of return on the assets the taxpayer had sunk into them.  In Victoria, the net profit of the SECV was around $150 million per year in each of the four years 1989-92.  As the assets have been shown to be worth at least $20 billion this represented a return of less than one per cent.  The former Pacific Power, which would have had a market value of at least $12 billion did little better.  The business earned a net profit averaging $420 million per annum in the four years to 1995.  This represents a return of, at best, a little over 3 per cent on the assets.

This poor performance on the part of the State owned businesses is compounded by the fact that both Pacific Power and the SECV charged prices that were far higher than justified in a commercial market.  The following Figure, drawn from the NSW Energy Reform Statement of 1995, illustrates the 20 per cent real price reduction required.

Figure 1

The bulk of the price reductions are to come from generation costs, which as the following figure illustrates accounts for nearly 60 per cent of NSW overall electricity costs.

Figure 2

Given that vesting contract prices in NSW were set at $44.5 per MWh and that pool prices are presently some $20 per MWh (with some contract prices known to be around $14 per MWh), such a target would appear to be readily achievable.  However, the present low prices are a reflection of the customer segmentation that is still possible in the present transition to a national market as most customer load is not able to take advantage of the unregulated prices.

The present dual price structure reflects other inefficiencies that resulted from the previous monopolistic arrangements.  Many electricity businesses were operating in monopoly situations and were able to load their excessive costs on to customers particularly those customers who had little political power and little option but to remain captive of the supplier rather than relocate;  this usually meant smaller businesses and, though electricity was a relatively low proportion of the business' aggregate costs, the policy had an insidious, cumulative effect on competitiveness.

With open markets such approaches are not possible since buyers at low prices would find ways to on-sell to the penalised buyers.  In anticipation of this, regulated price reductions have been put in place in both NSW and Victoria that mean considerable customer benefits and a re-weighting of tariffs to remove the discrimination against smaller business customers.

There are now irresistible pressures on the remaining impediments to efficiency.  These are centred upon the competition reforms agreed to by all Australian government jurisdictions in April 1995 and applied to electricity in June 1996.  These reforms require freedom of trade between the states, commercialisation of state enterprises, elimination of access to natural monopolies and non-discrimination.  These measures and the progress to date of the national market for electricity are outlined in the Attachment.

It is certainly not desirable to return to the featherbedding and other inefficiencies that characterised Australian electricity industry for many decades.  The present arrangements mean it is also not possible.

The contemporary world is characterised by continuous structural change.  Where businesses -- private or publicly owned -- receive government favours that insulate them from this change, their inefficiencies are manifest in higher prices for consumers and reduced competitiveness for businesses.  The upshot of both these factors is fewer jobs throughout the economy.

Ironically, the way to sustainable job creation and skill levels that match needs is efficient production levels, which may in the first instance impact adversely on jobs.  The alternative is to face mounting losses in profits, with adverse impacts on the revenues available to the Government, and/or a loss of market share to new businesses or interstate competitors that have lowered their costs and designed their products to meet market needs.

Specific Measures likely to be Necessary

The spot prices in the NSW part of the national market are averaging only a little over $20.  These barely cover O&M costs and are only two thirds of the full costs of production.  NSW generators are cushioned from the full effects of the low spot prices, and the even lower contract prices, by the vesting prices that apply to 60 per cent of the customer load.

Nonetheless, the present trends demonstrate excess capacity in the NSW system.  In Victoria market forces have forced one generator into a care and maintenance basis.  Something similar is likely to be required in NSW with Munmorah (which has 290 employees) and part of Liddell (which has 320 employees) being the highest cost plants.

In this respect, NSW generation has avoided the excessive hiring practices of Victoria's SECV.  In Victoria, the 10,000 former employees in generation have been reduced to 3,400 (which includes contractors) under reformed Government ownership and latterly under private ownership.  NSW generators carry far more efficient staffing levels and job reductions either under privatisation or continued government ownership will be far more modest.

Similar pressure to reduce over-manning is likely, on a more disbursed basis, with the distribution businesses, and has already been recognised by the former management of energyAustralia.

The point about any possible job losses as a result of reform or privatisation in NSW is that they will be dwarfed by the opportunities for increased jobs.  Compared to the existing 11,500 MW of NSW capacity, private power plants under construction in China, India, S. Korea, Pakistan, Indonesia, Vietnam, Malaysia and the Philippines total some 78,000 MW. ⁽¹⁾  Only an efficient NSW industry would be able to offer credible bids for a significant share of this burgeoning business, and provide opportunities for far more jobs than would be lost as a result of the needed rationalisation.

IMPACT ON SPECIFIC GROUPS

Government owned electricity supply systems put in place various concessions to reduce costs to different types of consumer.  These are normally defined as Community Service Obligations (CSOs) and reflect a transfer of costs from other users (or the taxpayer).  At the core of CSOs are concessional tariffs to particular users, like pensioners, or equalising costs to those living in areas where power is more expensive to deliver.

Other obligations cover such matters as tree clearing, undergrounding of wires, concessional wires charges to small users, and extended payment terms for those in arrears.  Still other obligations form a part of the licence conditions.  These include requirements to supply within a particular territory, to form customer consultative committees and to maintain power supply failures within specified limits.

Most of the obligations that result in uncommercial costs on the industry have long been recognised and the Government makes explicit payment for them to the various corporations.  Some, for example disconnection policy, are undergoing experimentation in particular businesses.  Thus, in order to promote a strong public image, some of the privatised Victorian retailers have adopted a policy of avoiding disconnecting customers unable to pay their bills by offering telephone warnings in advance of any such action.

The point about all these obligations is that they can be maintained equally under a privatised regime as under one in government ownership.

WHETHER THE ORIGINAL PURPOSE OF THE ENTERPRISES'
OWNERSHIP ARRANGEMENTS REMAIN RELEVANT

There was a number of different reasons behind government exclusive or predominant ownership of electricity assets that was the norm in Australia and a great many other countries until recent years.

These included the view that electricity

• was a public service and a natural monopoly and that rivalry would add unnecessary disruption;
• its instantaneous supply and demand characteristics and its non-storability meant it had to be handled in an integrated manner under a single ownership structure;
• it could be used as a tool to further a selective industry policy under which favoured activities could be given assistance (at the expense of other activities or the taxpayer);
• it could be used to promote certain or regional social goals;
• it could be used to soak up unemployment or as a mechanism for expanding training opportunities.

Whatever the original justification, none of these reasons remain valid today, the first three of which the NSW Government has already abandoned.  Rival organisations are in place under separate boards of directors and the natural monopoly aspects have been carefully defined and subjected to regulatory oversight.

Tariff orders are in place which, explicitly or implicitly, will prevent preferential treatment of certain industries.

And while the Government still wishes to promote certain social goals in electricity provision and prevent wide regional disparities, it now does so through the mechanism of explicit CSO's that can be put in place with equal effect irrespective of ownership structures.

Similarly, it is not part of Government policy to require businesses -- government or privately owned -- to carry costs that a commercially operated business would consider to be imprudent.  Corporatised businesses are, like private enterprises, charged with maximising shareholders' value in the entities.

Since corporatisation, the NSW electricity businesses have also moved rapidly to reduce their staffing levels.  Each of the six retail businesses has reduced its workforce by 10-25 per cent.  However, a consultancy study reportedly recommended the largest distributor, energyAustralia, cut its workforce to 1,800 from 3,800 (which is already a reduction from 4,500). ⁽²⁾  The response of the board of energyAustralia in rejecting the report and dismissing the CEO does not appear consistent with the hard-nosed commercial framework within which businesses should operate.

Measures that result in excessive costs being carried, especially by businesses with market power, will bring excessive costs to customers.  The NSW consumer will forfeit gain both as a direct customer and as an income earner if high costs result in businesses paying higher prices, foregone capital investment and reduced competitiveness.

As a government owned industry, from the 1970s onwards the NSW electricity supply industry was much more commercially operated than that of Victoria (though less so than the Queensland system).  But all electricity businesses in Australia are improving their efficiency levels and each state has an interest in ensuring it remains competitive.  In this respect, studies by the Bureau of Industry Economics ⁽³⁾ put US investor-owned utilities Total Factor Productivity growth achieved between 1975/75 and 1993/4 at 50 per cent more than NSW.

The same analysis showed electricity sales per employee in NSW during 1993/4 to be lower than the average for thermal based systems in Australia and less than half the levels achieved in the better Canadian systems.

OTHER SOCIAL, REDISTRIBUTIVE AND
REGULATORY ROLES THAT HAVE EVOLVED

SOCIAL AND REDISTRIBUTIVE ROLES

In discussing CSOs it is apparent that government ownership has spawned goals and expectations of electricity supply arrangements and the terms and conditions of these to particular parties that were not originally present.  Some of these have been due to electricity supply being hostage to political demands as well as those of the marketplace which dominate the conditions of supply of goods and services in general.

The NSW Government may wish to retain some of these obligations, even where they impose a cost that other customers (or the taxpayer) must carry.  But its corporatisation procedures are designed to ensure that any such costs are explicitly provided for rather than hidden.

Among the issues that proved most tendentious in the Victorian corporatistion/privatisation were the risks that the cross subsidies that had favoured rural users would be unwound.  The Victorian Government took steps to avoid this by reassigning asset values on which line charges are based to reduce distribution tariffs in rural areas.

Such measures result in subsequent pressures.  Line charges that are boosted above their true costs bring incentives for by-pass.  Requirements that each distributor should "postage stamp" the line charges in its area are already resulting in tensions between distributors in diverse territories from customers who can readily observe lower charges in adjacent areas.  These tensions will however be present irrespective of whether or not the entities are privatised.

REGULATORY ROLES

As the Treasurer makes clear in his discussion paper A Plan for a Secure New South Wales, the present arrangements for electricity supply are not deregulation.  Indeed, there is a plethora of oversighting bodies.  At the national level these include the ACCC, the NCC, NEMMCO, and NECA.  Within NSW these include IPART on price regulation, the Department of Energy on retail licensing, the Office of Fair Trading for customer matters, and Transgrid on the market operations.

Some rationalisation of these bodies is necessary.  In particular, the licensing role of the Department of Energy seems to be redundant, especially in a national market where State Governments have expressed a view in favour of mutual recognition.  In fact, the different bodies in NSW has already led to some confusion where the market operator has not been aware of particular retailers and failed to inform them of changed procedures for reassigning customers.

RETENTION VALUES AGAINST SALE VALUES

Various values have been set as estimates of the State's electricity assets if sold to private entities or if floated to the public.  The precise sale value cannot be determined and much will depend on the mode of sale and the regulatory conditions.  In Victoria, which is only two thirds the size of the NSW system, generators and distributor/retailers will, with the completion of the sale process, have brought in some $20 billion.  This is a sum far in excess of that expected by the Victorian Government at the time the asset sales were planned.

The NSW Government 1997/8 revenue from its electricity assets is estimated to be $656 million in dividends plus $221 million in tax equivalent payments.  Even if the NSW assets were to fetch only the $20 billion achieved in Victoria -- and there is every reason to expect 30-40 per cent more -- this would represent an effective dividend and tax return of less than 4.4 per cent.  At the $22 billion Arthur Andersen valuation offered by the Treasurer, Mr. Egan, ⁽⁴⁾ this is less than 4 per cent.

Such a low return is typically to be found only among share assets that are expected to show very strong profit growth.  It is difficult to justify continued ownership by the Government if private sector entities value the assets at such a high level.

Even placing the funds from asset sales that realised $22 billion in long term Commonwealth bonds would give a yield the State a saving of $663 million plus that part of the (Commonwealth) tax equivalence of $221 million which would go indirectly to the people of NSW.  The Victorian Government budget papers estimate the revenue effect of that State's privatisation of $18 billion of assets as a net $718 million positive impact on the budget in 1997/98. ⁽⁵⁾  Given the Victorian experience and the 1997/8 revenue from electricity businesses estimated in the NSW budget papers, the Treasurer's estimated savings to the NSW taxpayer could be highly conservative.

The Treasurer has offered a considerable number of expenditure options from the increased revenue the sale process would bring in.  These range from retiring debt to rebuilding roads, hospitals and sewerage systems to improving disabled accommodation and building schools.  Many of these expenditures are not mutually exclusive and a higher level of sale return would offer even greater scope for tax reductions.

Other alternatives to disbursing the fiscal windfall that a sale of electricity assets would bring are lowering of taxes on business and consumers.  In this respect, following the recent budgets in Victoria and NSW, the Victorian Treasurer has claimed that for the first time for a number of years Victorian taxes are lower than those in NSW.  Mr Stockdale claimed that the 1997/8 tax burden in NSW had risen to $2,112 per head compared with $1,916 per head in Victoria. ⁽⁶⁾

The budgetary measures that might be taken in the wake of the increased revenue from electricity industry asset sales are political decisions.  What is certain is that with the sales the scope for a mix of tax cuts and needed expenditures elsewhere presents enviable alternatives that are not present in the absence of the sales.  The sale process would result in an injection of $20 billion plus into the NSW economy.  Irrespective of the manner of sale or the way the sale proceeds are used, much of that will incremental to the sums available within NSW.  Whether the proceeds are used in construction of new infrastructure or a lighter tax load on NSW industries and consumers, the sale process will result in the creation of many thousands of new jobs.

The privatisation process in NSW can also benefit from the Victorian sale experience, which has demonstrated the value of electricity industry assets.  NSW has scope to float rather than trade-sale parts of its industry, thereby fostering significant Australian equity holdings.

CURRENT MARKET STRUCTURE AND
ADMINISTRATIVE ECONOMIES OF SCALE

The notion of an electricity market that is a natural monopoly has long been discredited.  Only the poles and wires aspects can be so regarded, and NZ with virtually no regulation over the distribution of electricity has taken the view that monopolistic behaviour of the wires business is highly circumscribed by the ability of customers to by-pass their host distributor.

NSW already has competition in the retailing and generating sectors.  It is however the view of the Energy Forum that many of the entities in these two sectors are excessively large and could in the future exercise market dominance.  Thus, both Delta and Macquarie with four and two stations respectively each have over twice the capacity of the largest Victorian generator and over three times the capacity of the largest Queensland generator.  Similarly, with energyAustralia and to a lesser extent Integral Energy, the NSW Government has created two very large retail/distribution entities.  EnergyAustralia approaches the size of the entire Victorian system and has more than half of the NSW market.  Integral Energy, covering the western suburbs of Sydney, is 40 per cent larger than the two biggest Victorian distribution companies.

There has been considerable debate about the optimum size for distributors and retailers.  That debate is dictated partly by geography and customer profiles and partly by a perception that there are some economies of scale in retailing and in distribution.  The evidence for such economies has never been persuasive.

In most electricity supply industries, retailing and distribution represents almost one third of electricity costs.

Table 2 shows the relative size of Australian distributor/retailers.

Table 2:  The Size of Australian Retailers

Retail business	Number of customers (000s)	Sales (GWh) (000s)
Victoria
Powercor	537	7.3
Solaris	234	3.5
CitiPower	233	4.4
United Energy	527	6.4
Eastern Energy	470	5.1
NSW
Energy Australia	1306	20
Integral Energy	681	11.8
NorthPower	336	3.4
Advance Energy	113	1.77
Energy South	218	3.4
Australian Inland Energy	21	0.3
ETSA	700	9.2
Queensland
SEQUEB	874	11.7
Capricornia	87	1.4
Far North	92	0.7
Mackay	48	0.7
North Queensland	93	1
South West	91	0.5
Wide Bay	85	0.5
HEC	239	8

Source:  ESAA

The greater part of a distributor/retailer's assets and workforce are employed in the distribution aspects of the business.  Typically, distribution will contribute 90 per cent of profitability.  However, the ten per cent of profit deriving from retail activity plays a vital role in promoting customer orientation and, seeking out innovative marketing approaches, and achieving a better match between energy supplies and demands.

DISTRIBUTION

Distribution involves breaking down the high voltage power and reticulating it locally to the vast bulk of customers not on the high voltage network.  The main functions are "poles and wires" business operations -- maintenance and expansion of the network in response to customer demand.  Much of this work can be and is increasingly outsourced.

In New Zealand, a 1989 Ministry of Energy report found the optimum size of distributor/retailers to be about 2000 GWh.  London Economics work has tended to show much higher levels of scale economies -- around 25,000 GWh or half the total NSW load. ⁽⁷⁾

New Zealand, with a population of 3.5 million, inherited 61 distributors but a spate of takeover activity is reducing this number to a level forecast to become as few as 10.  At that number each would average 150,000 customers.

Norway, with a population of 4.5 million has some 200 distributors, while Switzerland has 1,600 distributors based on local communities.

Reviewing the evidence, the Queensland Electricity Industry Task Force ⁽⁸⁾ cited submissions to it that claimed economies of scale on the basis of better access to capital markets, retention and training of skilled workforce, synergies in pooling information technology and administrative and billing functions.  In its analysis, the Task Force tended to emphasise the location specific factors.  It said, "... network scale economy measures need to be interpreted carefully.  It is not sufficient to simply compare the average costs of production with output.  The characteristics of the network, in terms of its density is the key driver.  For example a distributor that serves a densely populated area (high customer density) will be more efficient than a distribution entity that serves a sparsely populated area with customers that consume a comparatively low amount of energy."

Nonetheless, the Queensland Electricity Task Force came out in favour of amalgamating the distributors other than SEQEB into two groupings.  The Queensland Government has decided to retain the seven existing distributors, noting that these distribution corporations will be subjected to extensive regulation to ensure that costs are minimised.  However, it is to split off the retailing functions from the distributors and divide the initial market between three retailers along lines recommended by the Task Force.  The government sees this as providing advantages of capitalising on the trading opportunities a competitive electricity market offers.

In Victoria the choice of five distributors/host retailers was determined by the need to ensure competition and a wish to create businesses that would be attractive to private sector buyers.  Part of this entailed designing territories that had an even spread of customers and giving each retailer/distributor a sizeable urban population.  It was also complicated by the existence of 13 metropolitan local authority owned retail/distributors which were tied to the SEC and many of which were extremely inefficient.

New South Wales amalgamated its previous 25 electricity distribution businesses into six firms, and has taken steps to open the retail market to competition both between these firms and between new businesses.  As previously discussed, energyAustralia is very large.

There are risks in creating a dominant retailer/distributor like energyAustralia in that it could exercise undue market power over customer information and line charges that could give it an unfair advantage over its competitors.  The Victorian distribution businesses appear to have demonstrated that there are no economies of scale beyond the 200,000 plus customer size in this industry.  The smaller businesses consider that improved work practices and savings in overhead costs have resulted from bringing supervisory levels closer to the working operations.

A major safeguard against distributors charging customers higher prices than those warranted by their costs is the ability of a customer or rival distributors to by-pass part of the distributor's system.  Under the Victorian regime there is some ambiguity in the ability to by-pass prior to the year 2000, stemming from the conditions under which distributors were sold.  The NSW regime clearly allows by-pass.  This will ensure from the outset that there are tighter disciplines on cost-reflective tariffs.

RETAILING

Energy retailing entails:

• making bulk contracts and purchasing from the pool and subdividing these to meet the needs of different customers or customer classes
• metering and billing.

The UK regulator, OFFER, has estimated retail costs as follows:

Figure 3

In a competitive market, retailers will need to be customer focussed in order to win and maintain market share.  This is already entailing a much more active business stance in those markets where customers are contestable.  It is leading retailers to pay particular attention to market research, seeking matching load and power profiles, ensuring that tariffs are cost-reflective and seeking custom by offering advice on energy management.  Some retailers (e.g. United Energy in Victoria) are also seeking to develop synergies by offering retail services in similar businesses like telecommunications.  It is widely anticipated that electricity retailers will offer gas and water services once these utilities are opened to competition.

Under a competitive market, retailers need to manage price risks in a system where price is volatile, and market risks where customers are free to take their business to a rival.  In Victoria some 40 per cent of contestable customers have contracted for power with a non-host retailer.  Similar changes have been experienced in the UK.  New Zealand however has seen only 7.5 per cent of power being delivered to customers in competing retailers' territories.  This is largely due to all customers in New Zealand being contestable and the difficulty of the 50 per cent of the load comprising small users to justify the added costs of sophisticated metering without which rival retailers are reluctant to seek business.

With regard to optimum size, David Harbord, London Economic and Fay, Richwhite ⁽⁹⁾ found in an analysis of US retailers that costs were 10 per cent lower for retailers of between 10-20 GWh than for both smaller and larger retailers.  The same data however found that costs per customer increased with size.

It is difficult to find persuasive evidence of economies accruing to size of retailer per se.  This is not to dispute the potential for negotiating lower prices where high volumes are purchased.  In Norway, brokers have emerged to undertake power purchasing on behalf of retail/distributors.  The 750 kWh per year customer contestability program in Victoria demonstrated the ability of customers being able to obtain considerable discounts by acting in large groupings and negotiating favourable terms from rival suppliers.

GENERATION

The efficiency of generation in NSW is at levels comparable to those in Victoria.  In terms of thermal efficiency, NSW black coal generators convert more coal to energy than do the Victorian brown coal generators because of the latters' intrinsically lower quality coal.

In most respects recognition was received of the greater operational efficiency of private sector generators as long ago as the 1989 Industry Commission report on electricity.  In Victoria, the privately owned Anglesea power station consistently outperformed newer SECV stations, as did the Mission Energy operated Loy Yang B station.

Such local evidence of superior private sector operational efficiency reinforced the overseas experience.  This was documented by the BIE in its benchmarking of electricity.  In terms of electricity sold per employee, which is of course only a partial indicator of cost-efficiency, this showed NSW to have achieved less than one third the productivity of comparable thermal based Canadian systems and considerably less than Victoria.  But NSW generators, for the most part operate with lean labour forces as shown in Table 3, and the efficiency savings are most likely to be found in distribution and transmission.

In terms of availability, the poor levels in both States five years ago, with availabilities averaging about 80 per cent, have been transformed in recent years.  Three of the privatised Victorian brown coal generators now operate at over 95 per cent availability which is close to world's best practice.  Impressive gains have also been made been made by NSW generators, though only one presently operates at the 95 per cent availability level.

Forced outage rates have shown comparable levels of improvement in both states, although again the rates are somewhat higher in NSW.

The table below documents some of the changes that have taken place.  Although NSW has achieved considerable gains over recent years, it would appear that new management with a sharp focus on commercial efficiency would see opportunities for further gains.  This is likely to increase the price of the assets would realise.

1994/95 Efficiency Estimates

	Output (GWh) per Employee 1996/7	Equivalent Availability Factor	Forced Outage Factor	Thermal Efficiency
Loy Yang Power	26*	94.3	2.1
Yallourn	16*	88.6	5.1	30
Hazelwood	16*	92.6	2.8	24
Southern Hydro		88.8	1.2
Ecogen		96	0.9	36.9
Loy Yang B		96.3	0.9	31
Eraring	41	95.5	1.5	36.3
Munmorah	3	77.9	9.5	32.7
Vales Point	26	83.8	2.9	36.2
Bayswater	50	91.7	2.9	36.8
Liddell	16	88	5	32.9
Wallerawang	13	74.6	7.5	32.2
Mount Piper	38	90.6	5.1	35.9

Source:  ESAA and individual businesses.

* Figures for Victoria are not directly comparable with NSW because they
include coal mining and some head office staff excluded in the NSW figures.

There is no evidence that smaller entities whether generation or distribution, are less efficient than larger ones.  While it is theoretically possible to achieve cost savings with large integrated utilities, the information requirements to do so have prevented them being realised.  In the process, the larger entities tend to lose the entrepreneurial elan and become excessively bureaucratised.

Deficiencies in the existing arrangements of public ownership are revealed in the present struggle for the 750 MWh per year customers in NSW.  Retailers have been offering very low prices to customers, in the main backed by contracts from generators.  Whereas a vesting price of around $44.5 per MWh for captive customers represented the Government's best view on the long term price of electricity, contracts have been signed at a reported price of $14 per MWh.  Our information is that purely in terms of O&M and coal costs, the average NSW generator costs are Delta $23/MWh, and Pacific Power and Macquarie $19/MWh.

The NSW generators are not covering their costs at present contract prices and are only able to offer the low prices prevailing because the vesting contracts allow cross subsidisation.  This is in effect a transfer from domestic and small business customers to large customers.  Table 4 summarises our estimates of the costs of the three main NSW generation businesses.

Table 4:  NSW Costs of Generation per MWh

	O&M plus Coal	Total Costs exc. Profit
Delta	23	33
Pacific Power	19	33
Macquarie	19	30

The total costs of NSW generators are probably lower than those of their Victorian counterparts because the latter have had their capital revalued to market prices as a result of the sale process.  O&M costs in Victoria are lower because of cheaper coal and are estimated at $10-$15 for the three main ex-SECV generators, Loy Yang Power, Yallourn Energy and Hazelwood Power.

The very low contract prices being negotiated for contestable customers would have been a factor in the NSW Government determining to impose a new tax at 0.55 cents per kwh on these sales in the 1997/8 budget.  The tax is estimated to raise $100 million.  It has drawn criticism from the Commonwealth Government, customers and business groups and from interstate competitors.  It effectively allows the Government as shareholder to be indifferent as to the market behaviour of the entities it owns since they can win business while allowing the shareholder to recoup losses where that business is gained at uncommercial prices.

Over the longer term such merging of roles between governments as owners and governments as revenue raisers is inconsistent with the free and fair trade provisions of the CoAG agreements.  The National Competition Council has been charged with reporting to the Commonwealth the performance of the different jurisdictions in meeting their obligations.  Should the NCC advise that the behaviour of a jurisdiction is not in accordance with the principles agreed, payment may be withheld.

Irrespective of whether or not the new tax on electricity had an anti-competitive effect, a government which stands to gain by such measures through the assets it owns is vulnerable to the charge of interfering with market processes in contravention to its obligations under the CoAG agreements.  This adds a further forceful reason why the assets should be privatised.

TRANSMISSION

The NSW transmission business, Transgrid, is responsible both for the network, and for the power exchange and system security services.  In Victoria these two functions are split in Victoria between Powernet and VPX.  This is in accordance with the National Electricity Code and allows decisions to be taken that cannot be claimed to carry a vested interest.

A complex matter with regard to transmission is how to ensure that there are efficiency drivers in place for a facility that involves a considerable degree of natural monopoly.  The national market envisages incentives to ensure the appropriate expenditure on transmission through permitting "entrepreneurial" interconnects, whereby businesses will build lines where they spot an opportunity for profit and charge those using the facility.

The precise means of arranging for such charges has not been fully explored.  Moreover, the traditional planning mechanism remain in place so that the system controller can direct new developments and augmentations with the costs borne collectively.  A "free" resource of this nature tends to freeze out the opportunities for profit driven activity.  In doing so it leaves inadequate incentives for efficient location.  It would, for example, leave a cogeneration facility relatively indifferent about whether it locates in Botany near to the centre of demand or at Armidale where its usefulness would require considerable expenditure in transmission lines.

The means to ensure efficiency in transmission is not yet resolved.  However, the housing of system security and transmission within one entity, as in NSW, gives rise to perverse incentives since the same business has nothing to lose by requiring augmentations which are paid for by a levy on other bodies.

Divorcing the system control functions from the transmission business would not fully resolve the present deficiency in the national market whereby transmission is centrally planned rather than market driven but it would move a step towards this.  Moreover, such a divorce is essential if the transmission business is to be sold since it would be totally inconsistent to have one market player standing to gain by dint of its abilities to impose costs on others.

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Attachment:
THE EXISTING REFORM AGENDA

HILMER REPORT

The microeconomic reform process which is driving structural change in the Australian electricity industry commenced before, but is consistent with, the recommendations of the report of the Committee of Inquiry into National Competition Policy, commissioned by the Australian Government in 1992 ("the Hilmer Report").

Previous government inquiries had established that there was considerable scope for increased efficiency and competition in the Australian electricity industries.  The Hilmer Report pointed out that the introduction of effective competition into markets traditionally supplied by public monopolies often required more than the removal of regulatory restrictions on competition.  The excess market power held by such public monopolies is likely to impede the introduction of effective competition, and therefore reform requires the dismantling of monopolies in addition to the removal of regulatory restrictions on competition.

The Hilmer Report identified three separate types of structural reform which may be required in any particular industry:

• the separation of regulatory and commercial functions which could create a potential conflict of interest in a competitive market;
• the separation of natural monopoly elements from potentially competitive activities, because control over access to a natural monopoly might be used to stifle or prevent competition in the market, or if not exercised in that way the potential to do so may deter new entrants into the market;  and
• the separation of potentially competitive activities by splitting or dismantling entities with substantial market power into a number of distinct competitive entities capable of competing with each other.

COUNCIL OF AUSTRALIAN GOVERNMENTS

In April 1995, the Council of Australian Governments ("COAG") signed the National Competition Policy Agreements ("NCP Agreements") which adopted the recommendations of the Hilmer Report and formalised the Governments' intent to promote a more competitive domestic trading environment and improve Australia's position in the international market.  To that end, the NCP Agreements lay down a set of principles for the structural reform and prices oversight of public monopolies and hence have significant application to the electricity supply industry.

The guiding objectives determined by the COAG in the building of the national electricity market ("NEM") were:

• freedom of choice for electricity buyers;
• non-discriminatory access to the interconnected transmission and distribution networks;
• merit order dispatch based on bid price;
• no discriminatory legislative or regulatory barriers to entry for new participants in electricity generation or retail supply;
• no barriers to inter-state or intra-state trade;  and
• uniform and cost reflective grid pricing.

ADOPTION OF HILMER AND COAG INITIATIVES VIA SPECIAL PAYMENT MECHANISM

One of the measures agreed to in the NCP Agreements was the development of an interim competitive NEM during 1997 and completion of the transition to a fully competitive NEM by 1 July 1999.

The incentive, to meet this deadline, was provided by the NCP Agreements themselves.  Under the NCP Agreements, the Commonwealth agreed to make special payments to States and Territories that made satisfactory progress in implementing the national competition policy reforms.  If a State or Territory does not take the required action within the specified time, its share of the payments will be withheld.  The National Competition Council ("NCC") will assess, prior to 1July 1997, 1 July 1999 and 1 July 2001, whether the conditions for payments to the States and Territories, to commence from those dates, have been met.

The money which has been allocated to these special payments is set out in Figure 4 below (estimated nominal $ million).

Figure 4:  Competition Payments

1997-1998	428
1998-1999	646
1999-2000	1113
2000-2001	1369
2001-2002	1888
2002-2003	2184
2003-2004	2499
2004-2005	2833
2005-2006	3188
TOTAL	16147

Source:  National Competition Council Brochure (October 1996)

PROGRESS TO DATE

The NEM was first scheduled to commence on July 1994.  The scheduled commencement date has been deferred a number of times.

It was determined in late 1996 that there would be a phased implementation of the NEM.  These stages would be known as NEM1 (Phase 1 and Phase 2), NEM2 and NEM3.  More particularly:

NEM1 Phase 1 commenced April 1997 and links the Victorian and New South Wales markets.  That is:

• electricity will flow in and between the State markets based on competitive bid offers received in both markets;
• initial limits on flows between markets will be progressively removed;
• power system security responsibilities will remain with each State;  and
• separate Snowy Traders in each State will manage the bidding into each State market;

NEM1 Phase 2 (1 July 1997) will see:

• the removal of initial limitations on interstate trading;
• power system security managed on a national basis;
• a single entity being responsible for Snowy participation in the NEM;
• a common approach to ancillary services;  and
• a NEM approach to losses;

NEM2 will commence after the National Electricity Law is enacted and the Code is authorised by the Australian Competition and Consumer Commission ("ACCC") and accepted as an access undertaking.  As systems consistent with the Code's market rules (Chapter 3) and system security (Chapter 4) provisions of the Code are not envisaged to be available at that stage, these elements will still be governed by the provisions of State codes.  However, other chapters of the Code will apply.  NEM2 is anticipated to start in mid-1997, but it is not expected to have any material impact on wholesale market trading;  and

NEM3 is the fully operative national market.  It is anticipated to start in early 1998, once NEMMCO has fully tested and taken delivery of the national market systems.  That is, when all chapters of the Code apply and the State codes no longer apply.

EXPECTED ACTUAL COMMENCEMENT

A significant step towards implementing the NEM took place in May 1996, when the Governments of New South Wales, Victoria, Queensland, South Australia and the Australian Capital Territory executed an intergovernmental agreement to introduce the NEM through legislation ("the National Electricity Law") to apply in each jurisdiction.

As required by that agreement, in June 1996 South Australia enacted "lead legislation" containing the National Electricity Law (which in turn provides for the establishment of the National Electricity Code ("the Code").  The other participating jurisdictions are now in the course of preparing their own "application legislation" to apply the National Electricity Law and the Code.

The Code has been prepared through a consultative process conducted by the participating jurisdictions and involving industry participants.  The Code was submitted to the ACCC in December 1996 for authorisation under Part VII of the Trade Practices Act 1974 (Cth).  Accompanying the Code was a draft access regime, which is also being examined by the ACCC pursuant to Part IIIA of that Act.

The commencement of the National Electricity Law and the Code in each jurisdiction will not take place until the ACCC has authorised the Code and accepted as an access undertaking.  While the expected commencement of NEM1 (Phase 1) is 14 days after a positive determination is received from the ACCC, the National Electricity Law and the Code are currently scheduled to commence mid 1998.

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ENDNOTES

1.  The Economist 14 June 1997, p. 72.

2.  Australian Financial Review, September 26, p. 40.

3.  Electricity 1996, International Benchmarking, Productivity Commission, Canberra 1996.

4.  A Plan for a Secure New South Wales, Discussion Paper to Pacific Power and the Electricity Unions, 22 May 1997.

5.  Victorian 1997/98 Budget No. 2 p.131.  The Auditor General's Report estimated somewhat lower savings than this, at $549 million in 1997/8.

6.  Hansard, 21 May 1997.

7.  "Economies of Scale in the Electricity Generation and Distribution Sector", Report to the NSW Treasury, London Economics, August 1994.

8.  Reform of the Queensland Electricity Supply Industry, Volume II p. 164, December 1996.

9.  "Introducing Competition in Electricity Retailing in NSW:  Market Power Considerations", David Harbord and Associates, London Economics and Fay, Richwhite, Final Report Volume 2 p. 22-32.