First it deregulated generation.

Then distribution (no more exclusive franchise).

Only now is New Zealand turning

to the wholesale market.

A decade ago New Zealand's economy was suffering from prolonged stagnation. The country relied too much on the public sector. In 1987, before the first reform efforts began, New Zealand's electricity industry (em with its generation and transmission monopolies (em was owned and operated by the central government. Ownership and operation of distribution fell to local governmental organizations, such as the Auckland Electric Power Board (now Mercury Energy).

Today, however, under a system of light-handed regulation proposed and carried out under two different political parties (Labour and National), New Zealand maintains no explicit price controls for either the competitive or the natural monopoly segments of the electricity industry.

How did New Zealand get from there to here?

Privatization, Deregulation,

and Consolidation

Since 1987 the New Zealand electricity industry has undertaken many major reforms. The process began in April 1987 with the formation of the Electricity Corporation of New Zealand (ECNZ) from the Ministry of Energy's government monopoly in electric generation and transmission. Over the next 10 years, the reforms led to deregulation of the generation and retailing sectors, plus the introduction of the so-called "light-handed" regulatory framework. The next important step will occur on October 1, 1996, with the introduction of an open, competitive wholesale electricity market. (See sidebar, "Industry Milestones.")

While this process was taking place (deregulation, reform, and privatization), the industry was also consolidating. In 1995 only 41 electric energy companies made regulatory disclosures. That total marked a decline from 44 electric energy companies in 1994, 49 companies in 1992, and 61 companies in 1986. The consolidation has occurred largely through mergers and takeovers among domestic distributors.

In addition, investment has come in from outside the New Zealand electricity industry. For example, Fletcher Challenge Ltd., a New Zealand-based multinational natural resources company, has invested as a minority stakeholder in the distribution and generation sectors. UtiliCorp United now owns a large share of Power New Zealand (the country's second-largest distribution company) and has attempted to purchase a majority share. UtiliCorp also owns a share of WEL, an electricity distributor based in Hamilton, New Zealand. Several other foreign firms have shown interest in building generation capacity or owning distribution companies. The most successful of these has been Canadian-based Trans Alta Energy Corp., which has invested in distribution and generation assets in New Zealand.

All of this has occurred as New Zealand has developed a philosophy of "light-handed" regulation for the electricity and other sectors of the economy. Under light-handed regulation, there is no explicit regulatory authority responsible for price or other regulation of the electricity industry. Three documents form the centerpiece of this regime:

s Deregulation. The Electricity Act of 1992 eliminated much industry regulation, but provided explicitly for backup regulatory authority for electricity prices charged to domestic (i.e., residential) customers through March 31, 1997.

s Information Disclosure. These new regulations, promulgated in 1994 under the broader Electricity Regulations, have advanced retail competition by requiring the development of (and a basis for) local line charges (i.e, the wheeling charges for distribution). Also, the rules have created a framework for separating line costs (em which are associated with a natural monopoly service (em from energy costs (em which are viewed as a competitive service. Through disclosure of financial information by function, private parties and governmental agencies can determine whether prices are competitive.

s Antitrust Oversight. The Commerce Act of 1986 forms the basic antitrust law in New

Zealand. It allows the Commerce Commission to impose price controls on any industry if it uncovers misuse of market power on the part of any private party.

This scheme for light-handed regulation imposes no explicit price controls or other regulation for either the competitive or the natural monopoly segments of the electricity industry. Thus, no formal authority exists to supervise, guide, or oversee such competition issues as the proper basis or level for interconnection fees or line charges. Instead, the simple disclosure of information by private parties (em with evaluation by government agencies and the ensuing threat of regulation (em is considered sufficient to discipline industry players.

These actions by the government and the private sector have created the conditions for

vigorous competition in many sectors of the New Zealand electricity industry. Transmission, with its natural monopoly characteristics, is the only segment of the industry where competition has been slow to develop.

Transmission Sector

Trans Power, the state-owned electric transmission company, occupies a dominant position in high-voltage, intercompany transmission. While Trans Power enjoys no explicit monopoly, bypass opportunities are limited to the margin. Even so, Trans Power has lost new investment opportunities to competitors, notably the supply to a major industrial complex at Lichfield in the central North Island. The current dispute over the valuation of Trans Power assets and the resulting

transmission charges have made bypass of keen interest to both generators and downstream customers.

Trans Power also holds responsibility for generation dispatch and all pooling and integration functions. Connection to the grid by new generators and offtake of energy from Trans Power is open to any party that meets the appropriate technical requirements.

Generation Sector

Until recently, ECNZ owned about 96 percent of all generation capacity, including all of the large thermal and hydroelectric capacity in New Zealand. Concern over ECNZ's ability to overwhelm any competitive initiatives in generation led to its breakup.

While several proposals were considered, ultimately the decision was made to split the company into two state-owned enterprises (at this time privatization is not being considered). The larger of these (em still known as ECNZ (em retains the large hydroelectric plants for several river

systems and the Huntly thermal plant, the nation's largest gas-fired power plant. The smaller (em known as Contact Energy Ltd. (em holds all the geothermal capacity, some thermal and hydro capacity, and all of the rights to purchase natural gas. Several of ECNZ's smaller hydroelectric facilities will also be sold to independent power producers or local distribution companies.

Market share for ECNZ has declined to about 67 percent. This figure is expected to decline to about 60 percent by 2000. In addition, some restrictions limit ECNZ in building new capacity and contracting with power purchasers until its market share declines to 45 percent or less. Contact Energy will account for about 25 percent of generation assets by the late 1990s. Actual competition between Contact and ECNZ, based on separate ownership of their assets, will not commence until late 1996, with the introduction of the open competitive wholesale electricity market.

Entry into the generation market is allowed on strictly commercial terms, with no entry barriers. Generators must seek contracts to sell to downstream customers and/or sell to the spot market. No capacity licenses are required for entry. However, generators must still obtain all relevant environmental consents for each station.

Entry into generation has been active. Many geothermal, gas-fired, and other projects have been proposed and many are being built. Among the most important:

s The Southdown cogeneration facility, a 114-megawatt (Mw), gas-fired, combined-cycle plant scheduled for competition in late 1996 in a joint venture between Trans Alta and Mercury Energy, the nation's largest distribution company.

s The 350-Mw Taranaki Combined Cycle plant, a gas-fired facility to be completed by mid-1998 by Mercury, Trans Alta, and Fletcher Challenge.

Distribution Sector

Local distribution companies no longer enjoy an exclusive franchise. Open competition prevails for construction and ownership of new (or rebuilt) network assets. Moreover, vigorous competition has emerged in the construction of distribution networks in many new residential, commercial, and industrial developments. Competition has flourished to a lesser degree for ownership of new and rebuilt network assets; many anticipate that local companies will retain ownership of the vast majority of network assets within their service areas for the foreseeable future.

The New Zealand Commerce Commission has determined that distribution is a natural monopoly (em whether provided by the existing distribution company or a new developer (em although competition for the provision of duplicate lines may prove feasible in some limited and special circumstances. In recognition of this natural monopoly, and to prevent monopoly services from subsidizing competitive services, the industry disclosure regulations have mandated separation of line and energy charges.

The Table presents information on competition for the construction of new network assets in the service territory of Mercury Energy. The data, current through late 1995, demonstrate that competitors have made inroads, although the incumbent has retained most of its share. Competitors have been most successful in constructing new commercial subdivisions.

Competition in the market for ownership of new network assets has been slower to develop, although a few substantial examples exist. Further, competitive bidding for construction and ownership has begun to force existing distributors to reevaluate line charges across customer classes to reduce or eliminate anomalous pricing and explicit cross-subsidies.

Competition in construction and ownership of new network assets has brought about major shifts in strategy among electricity distributors. For example, since most of New Zealand's growth remains concentrated in the Auckland area, some distributors from outside the area, notably Bay of Plenty Electricity and TrustPower, have apparently determined that they must become owners of substantial network assets in the Auckland region. More interesting, WEL, the Hamilton-based electricity distributor, has announced a strategy of becoming a full-service "network" owner in its former service territory by constructing and owning reticulation networks that include gas, electricity, cable television, and telephone lines.

Retailing Sector

Beginning in 1993, under the Electricity Act of 1992, competition for retailing was allowed for

any customer whose annual

consumption was less than 0.5 gigawatt-hours (500 megawatt-hours). Retail competition was allowed for all other customers beginning on April 1, 1994. These actions have provoked fierce competition in this market, particularly for the larger customers, as companies have attempted to maintain or build market share.

Among the competitors that have emerged number distribution companies, firms associated or affiliated with distribution companies (such as Pacific Energy, which is owned by three distribution utilities), and independent energy traders. Off-network sales have flourished despite the virtual absence of competition in generation, at least as of mid-1996.

The Figure presents data on the growth of off-network sales in New Zealand. Monthly off-network sales have increased by about 200 percent in the two years since competition was allowed to serve larger customers. Currently, off-network sales account for approximately 5 percent of all retail sales and one-eighth of all "contested" retail sales, excluding direct sales by ECNZ and retail sales to households. To date, margins have remained quite low in this business, with most companies purchasing at the ECNZ hedge price and adding a small fee for management. More recently, spot prices have declined below the ECNZ hedge price. As a result, some contested customers are receiving the lower price and sharing the risk with suppliers that the spot prices may subsequently rise above the hedge price.

These off-network sales understate the significance of the retail competition that has taken place. While the incumbent distribution company has prevailed in other competitions to supply retail services, the result has generally been lower prices for electricity purchasers than would have prevailed without retail competition.

Typically, but not always, the distribution company owns the meters and reads them, while the retailer is responsible for billing the customer. As with the generation market, no licenses are required for entry: Entry is a strictly commercial proposition, with success dependent on market factors and company performance. Competition is enhanced by requiring distributors to grant equal access to all retail competitors and to disclose their line charges as well as the basis for their determination.

Outlook

Within a very short time, competition in generation, construction and ownership of network assets, and, particularly, retailing has begun in earnest in New Zealand. Consolidation continues, with a further shakeout expected.

Among the most significant developments:

s Efficiency. Gains have occurred throughout the industry. For example, unit costs for ECNZ fell by approximately 24 percent between 1987 and 1994. Many firms now contract out some of their service functions, including line services, to force their employees to compete with private-sector providers.

s Marketing. New models have emerged. Companies in slower-growing regions are targeting the Auckland region. Some firms, such as WEL, focus on providing network functions; other distributors are emphasizing vertical integration.

s Pricing. The country has made significant progress toward rational pricing in the electricity industry, eliminating subsidies that had developed under explicit regulation and government ownership.

Further benefits are expected with the advent of competition in generation, planned for October 1996, as the effective separation of Contact Energy and ECNZ is completed and substantial private-sector generation comes on line. t

Christopher Pleatsikas is a senior economist at the Law & Economics Consulting Group in Emeryville, CA. He has advised several New Zealand energy and telecommunications companies on a variety of issues, including mergers and acquisitions, antitrust, and competitive market strategies. He has a PhD in regional economics from the University of Pennsylvania. Bruce Turner is general manager for wholesale supply at Mercury Energy, New Zealand's largest electricity distribution company. He has been active in the electricity reform process through various industry working groups. Turner has a BA in commerce and an MA in engineering from the University of Auckland.

Industry Milestones (1987-96)

1987 - ECNZ (G&T) Formed. Electricity Corporation of New Zealand (ECNZ) formed from Ministry of Energy's former monopoly in electricity generation and transmission.

1988 - ECNZ Deregulated. Generation deregulated, obligation to supply removed for ECNZ in December 1988, removing much of ECNZ's regulatory role.

1993 - Retailers (Distr.) Formed. Energy Companies Act of 1992 allows formation of energy supply (local distribution) companies, directs programs for corporatization and privatization (1993-94). Currently, all local distributors have been corporatized; many have been privatized, either by distribution of shares to customers or community, or through Initial Public Offerings.

1994 - Retailer Deregulation. By April 1994, Electricity Act of 1992 eliminated exclusive franchises, obligation to serve, and price controls for the retail sector.

1994 - Information Disclosure. New Zealand introduces "light-handed" regulation, aided by Electricity Regulations of 1994.

1994 - Trans Power (Grid) Formed. Trans Power, separated from ECNZ in July, becomes owner-operator of national transmission grid and electricity dispatch authority.

1995 - ECNZ (Gen.) Splits. Announced mid-1995, effective February 1, 1996, ECNZ splits into two separate state-owned enterprises: A larger half, still known as ECNZ, and a new company, known as Contact Energy Ltd.

1996 - Wholesale Market Forms. Evolving from an ECNZ internal operation, an open, competitive, wholesale market will commence operation on October 1.

Generating Mix

. Early Development. Early on, New Zealand generating sector is dominated by hydroelectric capacity. First large thermal stations constructed during the 1960s.

. Diversification. Plans to balance capacity mix in 1970s with several large gas-fired stations are thwarted by sharp drop in demand growth following worldwide energy price hikes after 1973.

. Current. Hydroelectric resources now make up about 75 percent of generating capacity, although gas-fired and geothermal capacity make important contributions.

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