The ORG's Discussion Paper on Powercor's Application for a Variation to their Distribution Licence to Include the Docklands Area

Submission

BACKGROUND AND CONCLUSIONS

The ORG is considering whether to vary the Powercor distribution licence so that it may distribute electricity in the Docklands site in competition with the host distributor, CitiPower.  The Powercor application is couched in terms of it being an "inset" licence rather than posing a direct threat that might strand some of CitiPower's existing assets.

The ORG recognises that competition tends to enhance efficiency and that contestability is adequate to confer these benefits.  It points out that the licences for the five distribution businesses were non-exclusive.  Powercor has sought the right to distribute electricity in the Docklands "inset".

The ORG has said the key issue

• is to determine whether it is appropriate for Powercor to have this right and thus for more than one licence holder to have the right to distribute power in the Docklands area.

There may have been assurances offered to the distribution businesses at the time of their sale that they would have exclusive franchises to their territories, although the ORG offers no information on this matter.  If any such assurances were given, they would form an important part of the property rights that the businesses hold, even though any such assurances would have been inconsistent with the competitive principles which form the basis of the Victorian and national markets.

Abstracting from such matters, in general, we believe that the ORG should confirm the general principle that by-pass is automatically allowed and that dual supply to an area is permitted.  We believe that this principle is so fundamental to the competitive market that in the future such matters should proceed without the businesses concerned having to justify this to the ORG.  In other words, any business with a distribution license should automatically be able to build or take over existing lines in any part of the State.  This right should not be confined to greenfield sites.

ADDRESSING "INSET" APPOINTMENTS

COMPETITION AND REGULATION

The application is for an "inset".  If this implies some exclusivity to distribute in the area, it would seem to offer little advantage to the existing regime.  To be sure a form of auction will have been held and a winner selected by the users.  But if the successful firm is then granted a franchise over the area, little has been gained in terms of placing the discipline of contestability over the new supplier.

The ORG should reconsider some of the basic premises on which its discussion Paper is based.  Thus, in addressing the basic considerations relating to inset appointments (p.6,7):

• It seems to suggest that once firms have embarked on competition, they may subsequently collude to raise the price so that their average costs are covered.  The fact is that such collusion is both rare and illegal.  In suggesting that this requires continued regulation, the ORG could be accused of wishing to retain regulation for the benefit of its own workload.  It would be just as reasonable to require continued regulation of electricity generation or of the two airlines or supermarket prices or any other business where competition is limited.
• The ORG is concerned to protect businesses from making unfortunate decisions on behalf of their shareholders when it argues, "There is a legitimate public policy concern about the possibility of unnecessary and inefficient duplication of network.  Even if shareholders rather than consumers were forced to bear the costs."  This places the Regulator in a position where He arbitrates each possible piece of competitive provision against some vague economic welfare criteria­the imprecision of which is the very reason why market forces rather than government control is preferred.
• The suggestion that the inset grant could be made conditional on the new provider compensating the incumbent is akin to arguing that if another motor manufacturer is permitted to build cars, he should compensate any factory owners who lose business as a result.  This is utterly different to any of the criteria that normally apply in business and would lead to a much more cautious approach to competition and undermine efficiency.

DISTORTIONS TO COST REFLECTIVE PRICES

ORG recognises that "postage stamp" pricing can bring departures from cost reflective prices and this can lead to distortions to incentives for efficient investment and demand management.  The present arrangements also set in place a cross subsidy from urban to rural customers.  The cross subsidy is a charge on metropolitan distributors.  In the case of CitiPower, this raised the ODRC value of their assets by 27% ($129 m) and the Transmission Use of System charges by 28% ($5.9 m per annum).  This may give incentives to non-host distributors (not just rural distributors) to offer by-pass, because the incumbent is loaded with excessive costs.  The latter should however have incentives to meet any competitive threat by lowering prices, if necessary to marginal costs.

Nonetheless, there is merit in the ORG view that the level playing field should recognise regulatory impositions on incumbents and, if it is not possible to have these unwound, require the same imposition on all providers for the same area.  That said, it is almost certainly impracticable to estimate the full nature of the impositions in each area that might be contested.  It is also difficult to reconcile the present market arrangements with the notion of a regulator imposing an equalisation tax on each new contestant (and an equalisation subsidy on those seeking rural business?).  Even so, requiring the new entrant to offer compensation to the incumbent in the event that the latter faces stranded assets is not a sound approach.

Also unfounded are the ORG's fears that the outcome will be an increase in prices to existing customers.  This certainly would not eventuate where there is a close proximity of alternative lines.  In such circumstances, raising prices to existing customers is likely to be a prelude to the incumbent losing even more of the market and converting a partially stranded asset to one that is fully stranded.  It is far more likely that the two sources will provide on-going competition to the benefit of consumers.  In this respect, the evidence is that prices tend to be lower in those US locations where electricity is supplied by more than one line, than where a monopoly is mandated.

The transfer of income with the asset value adjustments and the TUOS equalisation involved substantial sums.  In the case of the asset values, the three metropolitan distribution businesses had their values raised by $326 million and the costs of TUOS increased by $23 million per year until the year 2000, reducing by 20% in each of the future five year periods.

In any consideration of the present situation in the light of the newly discovered potential for competition in distribution, these matters will need to be addressed.  One way of doing so would be:

• to reallocate the annual TUOS charge to distribution businesses operating within each of the original host territories on some methodology that would leave each paying a fair amount;
• to simply consider the asset value adjustment as a fait accompli and proceed as if it makes little difference.

With regard to the asset values, two factors are worth noting.  First, the buyers had no assurances about future tariff levels beyond the year 2000 review.  Secondly, the prices paid were in all cases were around twice those of the higher of the adjusted or original valuation.  Even though these valuations reflected an expected revenue stream, this could not be thought of as being locked in at the current level of returns.

The present issue raises fundamental matters of market design which must be reviewed in the light of sound theory of regulatory management and whatever assurances were offered in the past by the Government to the future owners.

The Discussion Paper skirts these fundamental issues.  Indeed, the Discussion Paper sets out conditions and objections to market based approaches that offer the impression of an agency established to thwart rather than promote competition.

RECOMMENDED APPROACH

INSET APPOINTMENT APPLICATIONS

The ORG sought responses to its checklist (section 6.7), which comprised the following:

1. What are the full circumstances surrounding the inset appointment application, for example, in terms of the nature of the development, the proposed source of supply and the characteristics of the supplier and the customer or customers?
2. Is the application based on an agreement with the customer(s) which covers the full costs of operating the infrastructure, including the capital costs?
3. What is the basis of this agreement?
• Has there been an open, competitive tendering process relating to the supply?
• Did the selection process reflect the appropriate efficiency criteria?
• Has there been competitive neutrality between the potential suppliers to the inset area in so far as is relevant to the appropriate decision making efficiency criteria?
• What are the underlying factors which make the inset appointment applicant a more efficient supplier for the area than the incumbent licence holder.
4. If the inset appointment applicant is not the final consumer, is it appropriate for the regulator to determine a separate tariff to cover the inset area?
5. In the case of by-pass, do the agreed terms and conditions of supply fall within the bounds of what is currently permitted in the licensed area?

The Office invited specific comments on the issues raised including:

• the appropriateness of the checklist of questions for review;
• the efficiency based decision making criteria;  and
• the appropriate ways to deal with the short term impacts of inset appointments on incumbent operators.

With regard to these matters, we make the following suggestions:

• ORG should view by-pass as a means which allows regulation to be reduced.  There should not even be a specific requirement to seek approval and any "inset" appointments unless those appointments are for some exclusive franchise (and exclusive franchises should never be permitted).  Nor is it of consequence whether or not a tender process has been entered into;  consumers can only gain by increased competition and the Regulator should not specify how that competition should be put in place.

TRANSITIONAL ARRANGEMENTS, PRIVATIZATION ADJUSTMENTS AND COMPETITIVE NEUTRALITY

The ORG invited Submissions (section 7) to address the following questions on this issue:

• Are the adjustments to asset values and prices made by the government at the time of privatisation relevant to the assessment of Powercor's application?
• If so, what adjustments are necessary to ensure that the decision made in relation to the inset appointment reflects a competitively neutral situation between Powercor and CitiPower?
• If Powercor was to reduce charges in the Docklands area, to what extent will they be a result of real efficiencies and savings rather than the result of price distortions arising from Government imposed distortions prior to privatisation?

With regard to these issues we make the following recommendations:

• Postage stamp charges that do not fully reflect costs are inevitable to some degree in all businesses.  Competition will force the least cost reflective of these to be unwound.  As regards asset values, competitive forces require any by-passed or partly by-passed assets to be written down to a realistic value.  The originally specified asset values also become less relevant in setting rates where evidence of potential by-pass is provided by competitive incursions or tenders.
• The best approach is to accept the prices that are in-place but to allow them to be undercut or adjusted as the market determines.  This should be married to a wider approach which recognises this intrinsic contestability of distribution systems.  A major corollary of the approach would be not to impose a CPI-X regime on distribution systems but instead apply the existing price level, adjusted simply by the increase in the CPI as though this was the price contracted by customers.  This will allow the prices that are in excess of the competitive market levels to gradually unwind.

PROMOTING COMPETITION, FACILITATING ENTRY AND PREVENTION OF MISUSE OF MONOPOLY OR MARKET POWER

The ORG invited Submissions (section 8.1) to address the following questions on this issue:

• Is competition at the construction stage sufficient to extract the benefits without changes to the current licensing arrangements?
• To what extent will the approval of Powercor's licence variation promote competition in the electricity supply industry?
• Would overlapping distribution areas impose an appropriate level of "competitive discipline", as submitted by Powercor?
• Can the Office be satisfied that sufficient or effective competition will exist with more than one licensee approved to supply the Docklands area to enable the relaxation of price controls?
• What considerations need to be addressed in assessing the competition efficiency trade-off resulting from the Powercor application?

With regard to these matters, the we submit that:

• Competition in construction is useful but, like out-sourcing elements of a government monopoly, it only addresses part of the efficiency promoting possibilities.
• Approval of Powercor's licence variation will promote competition but a much more comprehensive statement along these lines is necessary.  The Powercor proposal illustrates the considerable potential for competition across Victoria's distribution businesses.  Its implications go beyond the need for regulation in the particular, a matter upon which in the absence of government assurances prior to privatisation, there should be no dispute.  All regulation of distribution line prices should be replaced by a requirement that distributors price no higher than the current level adjusted for inflation.
• In other words, the competitive rivalry we are observing demonstrates the real potential for "light handed" regulation and an abandonment of the highly intrusive regulatory approach presently being contemplated.

EFFICIENT AND ECONOMIC ELECTRICITY SYSTEM AND PROTECTING THE INTERESTS OF CONSUMERS

The ORG invited Submissions (sections 8.2 and 8.3) to address specifically the following questions:

• To what extent, if any, should the Office consider stranded assets?  If so, on what basis should compensation be determined?
• Is the least cost method appropriate for determining whether to grant Powercor a licence to cover Docklands?
• Is there a difference in the pricing implications between the normal network expansion and expansion via a discrete inset network?  Does it matter?
• Is there a minimum size that the Office needs to take into account in determining if a site is to be issued with an inset distribution licence?
• Should Docklands be regarded as a "Greenfield" site?
• Are CitiPower's assets in and around the area significant?
• To what extent, if any, should the Office consider stranded assets?  If so, on what basis should compensation be determined?
• How do the tariffs proposed by Powercor for Docklands compare with those of CitiPower?
• Should the Office allow more than one network service provider to distribute electricity in the Docklands?
• Is the development of dual (or more) networks in the Docklands likely to be economically efficient?
• How will the granting of Powercor's application or otherwise impact on the interests of existing and future customers in Powercor's and CitiPower's existing licensed areas as well as future customers in the Docklands?
• How can the Office be assured, in granting a distribution licence to Powercor to supply the Docklands area, that the interests of consumers will be protected without knowing Powercor's proposed tariffs?
• If Powercor was to charge lower tariffs in the Docklands area than CitiPower, to what extent will they be a result of real efficiencies and savings rather than the result of cross-subsidy by other Powercor customers or the consequences of the urban/rural cross-subsidy arrangements?
• Will Powercor's proposed network design result in an acceptable technical standard for reliability?
• How will the approval or otherwise of Powercor's licence variation affect the financial viability of the industry?

The issues arising on the efficient and economic electricity systems and customer protection raised in Parts 8.2 and 8.3 seek answers to a great many questions that are superfluous to the central issue of how to promote competition and ensure as small a role as possible for the regulator.  Perhaps the pinnacle of this is the question that seeks views on how the proposal will affect the financial viability of the industry.  The ORG's role is to act as a surrogate for a market outcome where competition is considered unlikely to provide this.  To frustrate the development of competitive provision is not only inimical to the ORG's charter but extends the Office's role into that of a central planner.  The following material addresses the questions posed:

• Contrary to statements in the section, the Office will need to undertake little in the way of investigation of CitiPower's or any other assets in the region.  There should be no protection of incumbents.  There should be no oversight of the conditions or tendering process Powercor was involved in.  Those selecting Powercor can be deemed better placed than the ORG to make a decision in the best interests of themselves and parties for whom they act as agent.  There is no need to review the tariffs Powercor proposes;  at worst, the other users in the area have the existing tariff as a fall-back and cannot be made worse off by the additional competition.
• As previously discussed, it is alien to market philosophies to do what the ORG contemplates doing and require a firm to compensate a competitor when it has taken business from it.  The only context in which such a measure may be contemplated is one where certain property rights were granted by the government.
• Under the proposals of this submission there would be no need for the ORG to consider whether the tariffs proposed by Powercor are subsidised by other Powercor customers.  It is, moreover, impossible to conceive that such a subsidy may be possible or in Powercor's interests to pursue.  If Powercor is making high profits on its established customer base, it would not be in the interests of the firm's shareholders to dissipate these on unprofitable ventures.
• Again as previously discussed, there is no case for the ORG to concern itself that there are too many distributors capable of supplying a region.  This is the case even if this means cut-throat competition.  It is inappropriate for the ORG to see a role for itself in protecting businesses' shareholders from the consequences of unwise actions on the part of the businesses themselves.  The shareholders willingly take on this risk and are both better placed and better motivated than any regulator to ensure the executives they appoint are looking after their interests.
• Nor is the reliability of a new and duplicated system a matter that should concern to the ORG.  Users have different trade-offs between price and reliability and a duplicated line offers an excellent opportunity to allow diversity in this regard.

SHOULD THERE BE A SEPARATE LICENSE OR AN AMENDMENT MADE?

The ORG invited Submissions (section 8.5) to address the following questions on this issue:

• Should Powercor be required to hold a separate licence specific to the Docklands and if so how should the fee be determined?
• How should the Office ensure regulatory separation between the Docklands and Powercor's other distribution area if the inset appointment is approved?

On the issue of whether a separate licence is required, we would put the following points:

• Licensing is required only to ensure that a particular pricing regime is in place.  Under the light handed regulatory proposals of this submission, the licensing role would be vastly reduced.  There need be no price control in areas subject to more than one source of supply and a licence to extend into these areas should not be required.  Licence costs are largely to offset the cost incurred by the ORG and under the proposals of this submission those costs would be reduced considerably.