The Commerce Commission has issued Requests for Proposals from consultants to assist it in preparing material on the substantive issues arising in its inquiry into price control for electricity line businesses. Early next year, the Commission is proposing to issue discussion papers on approaches to price control, and to the valuation of line business assets. The consultants' work will feed into the preparation of these papers.

Commission Chair John Belgrave indicated that getting the consultancy work underway would be the next major step in the Commission's inquiry, which is being conducted under the current legislation. The Government recently announced its proposals for changing the legislation to give the Commission wider powers for implementing a price control regime for electricity line businesses. These changes to legislation are expected next year.

The Commission previously issued a paper outlining the issues it had preliminarily identified with price control of line businesses, and the process it proposed to use to deal with them.

"A range of comments have been made by the industry and other interested parties in submissions to the Commission on this preliminary paper. The comments, which have generally been supportive of the Commission's proposed approach, have been very helpful, and are being taken into account for the work now being initiated, and in planning the Commision's future work", said Mr Belgrave.

"It is proposed that the Commission will in due course build up its in-house capability in respect of electricity price control. In the meantime the use of external expertise is vital to get major work underway quickly.

"The Commission will, throughout its inquiry, be adopting as open and transparent processs as possible. There will be close communication with industry and other parties to ensure that existing knowledge and information can be drawn on, and to allow the various parties to make their views known."

Media contact: John Belgrave, Chair, Phone: work (04) 498 0963

Ken Heaton, General Manager, Phone: work (04) 498 0962

REQUEST FOR PROPOSALS

PRICE CONTROL OF ELECTRICITY LINE BUSINESSES

Please find attached a Request for Proposals to undertake the preparation of material for the Commission to use in two related discussion papers. The Commission proposes to release the discussion papers early next year.

In preparing the material the consultants will be required to work closely with Commission staff on an inter-active basis. The consultants will also be required to confer closely with the industry and other interested parties, so as to draw effectively on existing experience and knowledge as far as possible, and to inform interested parties of their thinking.

Consortia of consultants, or sub-contracting, will be acceptable. However, proposals should clearly specify how the work will be organised, who will be engaged to carry out specific items of work, and which of the consultants will have responsibility for the overall contract.

It may be necessary for the Commission to require that the contractors withdraw from work for line businesses in New Zealand, during the term of the contract, where there could be, or be perceived to be, a conflict of interest. Consultants are invited to indicate any possible conflicts and how they would propose to deal with them.

Consultants are invited to submit proposals to the Commission by close of business Wednesday 22 November. The substantive proposals should be no more than 12 pages (CVs and background materials being additional).

In the process of selecting consultants the Commission is likely to short-list consultancies on the basis of the written proposals, and to then request that the short-listed candidates orally present their proposals to the Commission.

In addition to submitting proposals for the body of work specified in the request, consultants are also invited to lodge expressions of interest in undertaking a review of the work. This review, which will be lesser body of work, is likely to required around March 2001.

For your information a list is attached of all the parties to whom this request has been issued.

Any enquiries regarding the submission of proposals should be made to:

Andrew Smith Chief Advisor

Tel: (644) 498 0961 Fax: (644) 498 0092 E-mail: andrew.smith@comcom.govt.nz

Submissions should be sent to: E-mail: electricity@comcom.govt.nz

REQUEST FOR PROPOSALS

PRICE CONTROL OF ELECTRICITY LINE BUSINESSES

PREPARATION OF MATERIAL FOR DISCUSSION PAPERS:

(1) PRICE CONTROL METHODOLOGIES

(2) ASSET VALUATION METHODOLOGIES

8 November 2000

INTRODUCTION

1. Subsequent to the Ministerial Inquiry into the Electricity Industry the Government has decided, inter alia, that the Commerce Commission should:

(a) assume responsibility for developing and implementing a regime of price control for electricity line businesses - the control should be targeted at those businesses for which control would be most appropriate, but all distribution businesses (of which there are some 30) and Transpower, the national transmitter could potentially be targeted;

(b) review the asset valuation methodology and mandate the future methodology to be applied;

(c) arrange for the re-calculation of electricity distribution and transmission asset values on a common basis.

2. The Government proposes to introduce new legislation that will give the Commission powers to undertake the price control function and undertake asset valuations. In the meantime the Commission has initiated a price control investigation of electricity line businesses under s 54 of the existing Commerce Act. As a first step in this investigation the Commission is proposing to prepare and issue discussion papers on the key issues involved.

3. This Request for Proposals (RFP) is for the preparation of material that the Commission will be able to draw on for the discussion papers. It is proposed that the Commission will issue two discussion papers in tandem around the end of March 2001. The papers will be on:

(a) price control methodologies; and

a. asset valuation methodologies.

4 How assets are valued could impact significantly on what price control levels may be appropriate. It may be noted that for distribution businesses, the return of capital and the return on capital can jointly comprise some 60% of the costs (excluding transmission charges) that such businesses have to cover by line charge revenue.

5 Price control and asset valuation are potentially strongly linked, and it would be undesirable if conflicts arose between the approaches taken to each. For this reason it is proposed that the two discussion papers be released in tandem. Accordingly this RFP also seeks the preparation of material for the discussion papers on a joint basis. It should be noted, however, that the preparation of material by consultants for the two papers does not necessarily have to be done simultaneously. It may prove appropriate to develop material on broad approaches to price control prior to preparing more specific material on supporting asset valuation methodologies.

MATERIAL ON PRICE CONTROL METHODOLOGIES

Objective

6. The objective is to prepare material for a discussion paper on price control methodologies. The paper will outline the key issues in devising and implementing a price control regime for electricity line businesses in New Zealand.

7. The paper will focus on high level issues, describing them and outlining in general terms the types of options available for dealing with each. The paper will also raise questions as to the pros and cons, and desirability, of the various options. When drafting material of this nature the consultancy should take care to make as clear as possible what the basis is for assessing the pros and cons (ie be clear about the counterfactual). In addition the consultancy is required to suggest which option or options should be earmarked for further investigation or development.

8 The Commission proposes issuing the discussion paper around the end of March 2001, seeking submissions from interested parties. The responses received will inform the Commission and assist it in formulating its approach to price control. It is envisaged that in the course of developing its approach, the Commission will issue further discussion papers focusing on more detailed issues.

Issues to be covered

9 This section outlines some of the issues that must be covered in the material prepared by the consultancy. Many issues are inter-linked. The itemisation of issues here is not necessarily comprehensive. Consideration needs to be given to all electricity line businesses, that is Transpower as well as the local distributors.

10 Issues include:

a. To what degree are electricity line function services supplied in a market where competition is limited?

? What is the appropriate market definition?

? What impacts do activities such as distributed generation and energy efficiency, which may be viewed as competing with line services, have?

(b) What should the objectives be of imposing a regulatory regime?

It should be noted that while the economic regulation proposed is referred to as 'price control', there is interest in approaches other than control of prices. These approaches include, for example, options such as revenue control, and information disclosure (ie the public disclosure of information) as a disciplinary device.

? Should there be concern with the level of prices?

? Should there be concern with the level of costs?

? Should there be concern with profits (including any potential for monopoly profits)?

? How should costs and profits be measured, particularly bearing in mind questions as to how the costs associated with past investments should be measured?

? Should there be concern with the various types of economic efficiency (productive, dynamic and allocative efficiencies)?

? Should there be concern with how benefits (economic surpluses) are shared between owners and consumers?

? Should there be concern with the administrative and transaction costs of a regulatory regime (ie costs to the regulator, costs to those regulated or potentially regulated, and costs that might fall to others such as users of line services)?

? In setting objectives for a regulatory regime, what balance should there be in relation to the various concerns outlined above?

(c) Should quality and reliability of supply be taken into account?

If a line business is expressly subject to price, revenue, cost or profit control, then there is a risk that the resulting constraints may be met, but the level of service deteriorate. Generally it becomes less economic to maintain the same quality and reliability standards in less densely populated areas.

? What, if any, should be the objectives in relation to quality and reliability of supply?

(d) Do differing ownership and governance arrangements, and the resulting incentive structures impact on what is achievable through price control?

Some distributors have private ownership, some have local authority ownership, and Transpower is State owned. Through its Statement of Corporate Intent (SCI), Transpower has special governance arrangements.

Many distributors have forms of trust ownership. Some of these are expressly consumer trusts, others operate effectively as consumer trusts. Some of the businesses have an incentive to make profits. Many of the trusts do not have such an incentive.

? Given the differing incentive structures arising from the differing ownership and governance arrangements what can regulation be expected to achieve?

? Should the approach to regulation take into account differing ownership and governance arrangements?

(e) Given inherent incentives, what types of overall regulatory approaches might be used to enhance the achievement of the objectives?

? Should prices be controlled (eg by CPI-X price caps) (given that the prices in question are charges for the use of line services, not prices to end-consumers of electricity)?

? Should revenue be controlled (eg by CPI-X revenue caps)?

? Should costs be controlled?

? Should profits be controlled (eg by rate of return or sliding scale regulation)?

? Should quality be controlled?

? Should information disclosure (ie public disclosure of information) be used?

? Should there be a combination of the above and, if so, what combination?

? Should businesses that have different ownership/incentive structures be subject to differing controls (eg profit oriented businesses subject to price controls, and non-profit oriented businesses subject to information disclosure)?

? How do the different approaches compare in terms of enhancing the achievement of the objectives?

(f) If control is to be applied to prices, revenue, costs, profits or quality, how should this be done? For example:

? Should control be applied for specified time periods, or should control continue to apply if certain conditions hold (eg if prices, revenue, costs or profits exceed, or quality fall below, specified thresholds)?

? If something like CPI-X type regulation is considered, how frequently should any price or revenue caps be re-set?

? If caps are applied to revenue, costs or profits, how should the caps be adjusted to allow for changing demand (eg kWh conveyed and numbers of consumers served departing from forecast levels)?

? Should control levels take into account that different line businesses are subject to varying unavoidable factors (eg customer density and customer mix)?

? In setting controls, what is the appropriate approach for doing this? For example, should control levels be determined from:

? a comparative analysis of price and/or financial indicators across line businesses, or

? assessing the financing requirements of a line business in terms of the required return on capital, return of capital and required operating expenditure, or

? using a cashflow model of a line business to assess the required cash inflow to match required cash outflow, or

? a combination of approaches such as those outlined above?

? Should there be rewards or penalties applied to line businesses that have prices, revenue, costs, profits or quality exceeding or falling below specified thresholds?

? Should users of line services be compensated by line businesses when performance parameters fall below specified thresholds?

? What are the implications of the various choices of approach for achievement of the objectives?

(g) What should be the objectives of targeting businesses for control?

? Should there be an objective to constrain businesses from performing unsatisfactorily in the future, or should there be an element of 'claw-back' for past unsatisfactory performance, or both?

? How much can targeting enhance the achievement of the objectives of imposing a regulatory regime?

(h) If targeting is to be used, how should this be done?

? Should businesses be targeted on the basis of prices, revenue, costs, profits or quality, or a combination of these?

? Should differing incentive structures arising from differing ownership arrangements be taken into account in devising an approach to targeting?

? Should targeting take into account that different line businesses are subject to varying unavoidable factors (eg customer density and customer mix)?

? Should targeting be based on absolute measures of performance, or relative measures (ie using benchmarking)?

? Should targeting be based on historical performance, or should it be based on businesses' forward plans?

? How do the different approaches to targeting compare in terms of enhancing the achievement of the objectives?

(i) What should be the objectives of public disclosure of information?

Most end-users of electricity will have limited interest in the performance of line businesses. What they will be interested in is the bills from their retailer and the service received - most will have no direct relationship with line businesses. Those that will have a particular interest in the performance of line businesses will be retailers, generators, major electricity users (some of whom do contract directly for line services), and the owners and management of the line businesses.

? How much can information disclosure enhance the achievement of the objectives of imposing a regulatory regime?

(j) If information disclosure is to be used, how should this be done?

? What types of information should be disclosed and with what frequency?

? What types of analysis should be undertaken on line business statistics and information and how should this be presented?

(k) Given the development of material, as outlined above, what is suggested for further work beyond the discussion paper?

? What particular types of option should be ruled out from further consideration as unlikely to be effective in enhancing the achievement of the objectives?

? What particular option or options should be subject to further examination or development?

MATERIAL ON ASSET VALUATION METHODOLOGIES

Background

11 Previously the Optimised Deprival Valuation (ODV) methodology has been mandated. This has been done through an ODV handbook issued by the Ministry of Economic Development, pursuant to the Electricity (Information Disclosure) Regulations 1999 (and earlier versions of these regulations):

'Handbook for Optimised Deprival Valuation of System Fixed Assets of Electricity Line Businesses, Fourth Edition, October 2000'.

This document may be found under Information Disclosure on the website of the Ministry of Economic Development:

http://www.med.govt.nz

Objective

12. The objective is to prepare material for a discussion paper that considers the advantages and disadvantages of the options available for valuing the assets of electricity line businesses. When doing this, the consultancy should make sure the counterfactual is clear.

13 The Commission proposes issuing the discussion paper around the end of March 2001, seeking submissions from interested parties. The responses received will be used by the Commission in coming to a view as to the appropriate methodology to adopt.

Issues to be covered

14 This section indicates in more detail the context within which the discussion paper should be prepared, and the issues that must be covered in the material prepared by the consultancy. Consideration needs to be given to all electricity line businesses, that is Transpower as well as the local distributors.

Uses for Asset Valuations

15 The principal uses to which asset valuations could be put are:

Targeting for Price Control

(a) to provide a basis for the Commission to judge whether the rate of return being achieved by a particular line business provides cause for 'targeting' the line business (rate of return may or may not be a criterion for targeting);

Implementing Price Control

(b) to provide a basis for the Commission to set appropriate price, revenue, cost or profit controls; and

Information Disclosure

(c) to provide a basis for publicly disclosing costs or rates of return of line businesses in a clear and consistent manner such that the public can judge whether these are at appropriate levels.

Criteria to be Taken into Account in Deciding on an Asset Valuation Methodology

16 Consideration should be given among other things to which of the following criteria should be taken into account, and what balance should be struck between competing objectives:

a. users of line services do not pay excessive or monopoly prices for the use of the services;

b. owners of line businesses receive adequate returns of capital and on capital in respect of their past investments;

c. owners of line businesses are given an incentive to maintain existing line services so as to ensure sustainability of the businesses, where it is economically efficient to do so;

d. owners of line businesses are given an incentive to make future investments in fixed system assets, where such investments would be economically efficient at the time of investment; and

e. there is a consistency of approach allowing the financial performance of different line businesses to be compared.

17 Recognition needs to be given to the past regulatory environment. Since 1994 there has been in place a 'light handed' regulatory regime that has, inter alia, involved the mandatory application of Optimised Deprival Values (ODVs) according to a specified methodology. Also prior to the formal promulgation of regulations in 1994 the design of the regime had been widely disseminated.

18 Sale and purchase, investment and other decisions have been made in the context of the regulatory environment in place. Accordingly the question may arise as to what weight should be given to the fact that a change to a methodology that gave significantly different valuations would impact on the balance of benefits (economic surpluses) between owners of line businesses and users of line services.

19. Also, given that the ODV methodology has been in place for some time, with a knowledge and understanding of the methodology having built up, the question may arise as to what weight should be given to transitional costs.

High Level Options for Valuation

Existing Assets

20 Options for valuing existing assets include:

a. valuing at zero;

b. valuing at historical cost (book value); and

c. valuing at some sort of current economic value (this might be viewed, for example, as replacement cost, depreciated replacement cost, optimised depreciated replacement cost, or optimised deprival value - see paragraph 23).

Future Investments

21 Options for valuing new assets at the time they are put in place, and subsequently, include:

a. initially valuing at cost (consistent with this it may be appropriate to require prior regulatory approval of investments?), and subsequently valuing at depreciated cost;

b. initially valuing at cost, and later periodically valuing at economic value; and

c. initially valuing at economic value, and later periodically carrying out economic re-valuations.

22 Above the term 'economic value' is used in a broad sense to convey the idea of a value determined in a manner consistent with economically rational decision-making. Optimised Deprival Values (ODVs) are particular estimates of such a value. The ODV methodology which has been applied in New Zealand has required that ODVs be calculated as the aggregate over network segments of the lesser of:

? optimised depreciated replacement cost (where the optimisation provides for the latest, most efficient technology to provide the same line service); and

? economic value (here 'economic value' is used in a more restricted sense; here it applies only when the line service is rendered uneconomic by alternative electricity supply options, and it is equivalent to the maximum net earning power (on a cashflow basis) of the lines, given the alternatives).

More Detailed Aspects of Valuation

23 As well as high level decisions being necessary as to the approach to asset valuation, decisions on detailed aspects of valuation are required. The current ODV methodology prescribes the lives and values to be assumed for specific kinds of assets. It is not proposed that the discussion paper deal with such low level, detailed technical issues. These will be considered and decided on later. However, there is a range of intermediate level issues on which material is sought from the consultancy for potential inclusion in the discussion paper.

24 Issues on which material is sought includes options for handling the following:

(a) cash assets;

a. head office buildings, office furniture and equipment, motor vehicles, tools, plant and machinery, works under construction, and non-network stores and spares and land;

b. stores and spares of network equipment;

c. equipment that has been fully depreciated but still has remaining life;

d. easements;

e. shared assets (some electricity line businesses operate as part of multi-utility enterprises - United Networks runs such an enterprise);

f. redundant or obsolete assets;

g. equipment with spare capacity (including when this has been installed to handle projected load growth);

h. assets for which grants or contributions has been made by users of line services; and

i. uneconomic assets (ie network assets for which 'economic values' are applied under the current ODV methodology).

CONDUCT OF CONSULTANCY

25 The Commission wishes that through the consultancy there be weekly informal progress reports from the consultant as well as more formal reports when significant stages are reached. The Commission wishes to receive a draft issues paper by Wednesday 28 February 2001. A final product should, subject to timely feedback from the Commission, be forwarded to the Commission by Wednesday 21 March 2001.

TENDERS

26 Information in tenders for carrying out the work should include:

? the persons who would carry out the preparation of each of the papers and their relevant experience;

? any other relevant expertise which the consultancy may be able to bring to bear on the work;

? schedules for preparing each of the papers, together with proposals for significant reporting dates;

? indications of how the linkages between price control and asset valuation questions would be managed;

? the cost of preparing each of the papers and the total cost (a per diem cost quote only will not be adequate);

? a breakdown of the costs by components of the work for preparing each of the papers.

27 The contact person in the Commission is:

Andrew Smith Tel: (64 4) 498 0961

Chief Advisor Fax: (64 4) 498 0092

Commerce Commission Email: andrew.smith@comcom.govt.nz

PO Box 2351

WELLINGTON

28 Tenders should be sent to electricity@comcom.govt.nz by close of business Wednesday 22 November 2000.