Amalgamate them

We've just had a big report commissioned from Frontier Economics into the workings of our electricity markets, with two peer reviews of its conclusions (one from NERA UK and another from a consortium of experts), and we've had the government's response to its recommendations, plus you might like to read the ministerial press release.

It's fair to say that the overwhelming reaction, including mine, has been that the government response have been too timid. That's not just me moaning: as Bryce Edwards of the Integrity Institute put it in his September 30 newsletter, "What’s striking is how broad the consensus is that these reforms are inadequate. From typically pro-market business voices to worker advocates, nearly everyone agrees the government needed to go much further".

There's one example in particular I'd like to highlight.

Frontier looked at the electricity distribution businesses (EDBs) - or 'lines businesses' as they're sometime called - who are the folks that operate the poles and lines that carry the current from the national grid to your place. New Zealand has 29 of them. On average their charges amount to about a quarter of your electricity bill. Even before all this latest analysis, I'd have argued that 29 is an absurd number for a country our size: it's almost the emblematic dead weight example of high fixed cost overkill.

Unsurprisingly, Frontier said (p112) that "Our key finding in this chapter is that the current electricity distribution industry is too fragmented with too many small EDBs (relative to the size of the country), many of whom are exempt from price-quality regulation designed to promote the long-term interests of consumers. These EDBs are likely to be operating well below minimum efficient scale. This, in turn, is limiting the ability of most EDBs to:

    • Operate and invest efficiently; and

    • Innovate to deliver services more effectively to consumers".

Their recommendation? "The first-best option would be to amalgamate the existing 29 EDBs into a small number (say five) large regional EDBs" (p133), and they even drew a map of what they might look like (see p135). Plus they recommended changes to how these regional natural monopolies should be regulated by the Commerce Commission, arguing (p5) that each should be considered on its own needs: "The implication being that individualised ex-ante price regulation applies to all EDBs. The intention being to ensure that the necessary investment is occurring to deliver the energy transition in New Zealand, and so avoid the prospect of a future bow wave of investment needs and reduced service performance in the interim".

So what did the two sets of peer reviewers reckon?

NERA agreed on amalgamation. "A consolidation and harmonisation of EDBs could achieve economies of scale, facilitate effective regulation and potentially improve quality of service to customers at lower prices" (p21). There's room for debate about exactly how many of the 'Super EDBs' and where they should operate - "Further detail is required on how the optimal number and size of Super EDBs can be determined" (p21) - which is fair comment, but they saw value in the amalgamation idea. They were cooler on the customised price regulation ideas: they weren't so sure that the current system was getting in the way of making necessary investments.

The other review group also were on board the amalgamation bus and drew this handy little diagram (p5) assessing Frontier's main ideas, where as you can see 'EDB Reform' (amalgamation plus the regulatory changes to incentivise investment) scrubbed up rather well. While the group made a general point that you might need to do more tyrekicking about any of these options - "each deserves much more scrutiny and analysis than can be accomplished within the timeframe of the current policy proceeding" (p4) - it said (p5) that "Of the four major proposals, the restructuring and reform of the EDBs strikes us as the most worthy of further consideration, given that it is backed by both qualitative economic logic and some empirical evidence".

Even the government itself said, in its response to Frontier's recommendation, "Agree with the diagnosis", but then said it wouldn't follow through on the idea: "Agree with diagnosis, but not with the forced amalgamation of EDBs. Instead, Government is encouraging greater efficiency and the EA [Electricity Authority] and Commerce Commission are progressing measures to promote greater alignment and innovation". 

It expanded on its reasons here: "Forced amalgamation would be expensive, complex, and undermine local decision-making. Rather than forcibly reducing the number of EDBs, the Government will make networks more efficient and innovative by encouraging greater standardisation and collaboration, strengthening governance and accountability, and improving network regulation".

To be fair, Frontier did have a look at something along the lines of the government's preferred option. Option 3 in its report (p139) "would be to retain the existing 29 EDBs as they are, but require them to coordinate with other EDBs within defined regions to generate better efficiency and operational outcomes", but it concluded (p140) that for a broad range of reasons it was "likely to be the least effective model for rationalisation".

Personally I find the government's rationale unconvincing. I doubt if it would be expensive: whatever up-front one-off restructuring costs are involved will surely be repaid in spades over the years as the current fixed costs of too many, too small EDBs are eradicated. I doubt if it is especially complex: if we can mesh the former separate cities of Auckland into one, we can surely mesh the EDBs. And I don't rate the local decision-making point especially highly. If the choice is between local control and the poles falling down on the one side, and consolidation and uninterrupted electricity supply on the other, and I think that is indeed the actual choice, I'll have the lights staying on, thanks.