Electricity reforms and Contact Energy Ltd

- Sue Newberry and Bill Rosenberg

Sue Newberry is a senior lecturer in financial accounting at the University of Canterbury. Contact Energy was the runner-up in the 2004 Roger Award for the Worst Transnational Corporation Operating In Aotearoa/New Zealand. Ed.

Supposedly, competitive markets satisfy all - shareholders, consumers and citizens alike. This key assumption, or statement of faith, underpins New Zealand’s economic reforms of the last 20 years. That assumption might be reasonable for some goods and services, but others require public policy efforts to create workable competition. And some services exist for which even workable competition is not practical. Electricity is one such example (Easton, 1995; Coyle, 2000). New Zealand has responded to this reality by pretending that there do not exist markets in which even workable competition is not practical (Easton, 1995).

New Zealand’s 1986 Commerce Act helped to establish the competitive aspects of what has become known as New Zealand’s light-handed regulatory regime, and the removal of statutory monopolies followed soon after. This development accompanied one of the earliest reforms to New Zealand’s public sector which required the corporatisation of those Government departments that were trading enterprises. The 1986 State-Owned Enterprises (SOEs) Act required these corporatised departments to be incorporated under the Companies Act, and each was required to "operate as a successful business" (State Owned Enterprises Act 1986, s.14). This development was followed by a programme of privatisation of SOEs which was unpopular from the start, but became increasingly contentious as it proceeded.

These steps taken in New Zealand are similar to some of those long advocated by the World Bank as ideal ways to proceed with privatising reforms. Recognising that political acceptability and practicality are always problems with efforts to privatise, the World Bank (1995) proposed various ways to proceed (note: the printed Watchdog contains a complex diagram which cannot be reproduced here). Creating SOEs is an important early step. After that, if the development of competition is possible and disposal (divestiture) of the SOEs is feasible, then the introduction of competition and competitive bidding represent steps along that path towards privatisation. If the development of competition is not possible, the SOE having, in effect, a natural monopoly, then regulation, the unbundling of large firms by carving off parts of their operations to create smaller ones (and the potential for competition in those areas), or contracting the functions of the SOE to the private sector by competitive bidding, and the imposition of pricing and credit regimes, represent appropriate steps along that path. All of these processes may be observed in the reforms to New Zealand’s electricity sector.

Supposedly, the first wave of reform to New Zealand’s electricity sector - deregulation and the promotion of competition - "was about efficiency, competition and accountability to customers" (Douglas, 1995). The creation as an SOE of the Electricity Corporation of New Zealand (ECNZ) resulted in a monopoly in electricity generation and transmission which, presumably, could not be sold off in one piece. This implied the need for "unbundling" and Transpower Ltd was created to separate electricity generation and transmission, leaving generation with ECNZ. Contact Energy was split out from the ECNZ in November 1995, the intention being to create competition and, eventually, privatisation of electricity generation. Comment at the time condemned the Government’s approach to energy as "na´ve", and warned that New Zealand would face an enormous energy problem in the next decade. This was partly because the Maui natural gas field was expected to run out, possibly by 2006, and partly because the likely outcome of privatisation was "overseas ownership of a vital national supply". One day, overseas ownership "could exact a price far beyond the cost of electricity it has generated" (Press, 29/11/95, editorial). In this article, we trace the way Contact has responded to, and taken advantage of, this environment.

Contact Energy Ltd As An SOE

Contact Energy Ltd began life as an SOE on February 1, 1996. It had a simple, single company structure without subsidiaries. Consistent with other SOEs, its liabilities were not guaranteed by the Crown. Contact was financed with $1.627 billion comprising a $1.208 billion Crown investment in its shares and $419 million of Crown loans. It was required to "purchase" the assets and liabilities assigned to it at the book values reported by ECNZ, the effect of this requirement being to relieve ECNZ from reporting gains or losses on disposal of those assets and liabilities. Contact paid out the $1.627billion, $1.578 billion to ECNZ for its assets and liabilities, and $49 million to the Crown (1).

Contact’s assets included several generation plants plus ECNZ’s gas purchase contracts. The generation plants consisted of Clyde and Roxburgh in the South Island, and New Plymouth, Stratford, Wairakei, Ohaki, Whirinaki, and Otahuhu in the North Island. Contact was required to adjust its assets to "economic fair value" within one year. The "cost" to Contact of the generation plant was $1.452.5 billion but the following year when Contact revalued the plant to an economic fair value based on discounted future cash flows, it reduced that cost figure by $204.3 million. Contact also received the rights to 43% of the Maui gas field. The "cost" to Contact of these rights was $47.8 million, and Contract wrote off all of that in the subsequent year. Contact also declared that the liabilities transferred to it were understated and adjusted these upwards by $41.1 million. In total, therefore, in the year after it was split out from ECNZ, Contact’s adjustments to its assets and liabilities to bring them to economic fair value involved write-downs totalling $293.2 million. Contact then borrowed to pay a special dividend of $150 million to its shareholders (in effect, the Crown).

Contact’s core business was "primarily the generation, wholesale marketing and trading of electricity and the purchase, wholesale marketing and trading of gas from Maui and other gas fields" (Annual Report, 1996). According to Contact’s Chairman, Phil Pryke, Contact was a "thriving business that is aggressively pursuing opportunities to deliver superior value to its customers and shareholders". It had recognised "from the start … that serving our customers would be a key element to the company’s success". In 1997, however, the Chairman reported that the Government had required Contact to do two things: "first to create a viable business and second to promote competition in the wholesale electricity and gas markets". As may be seen from the nature of the wholesale market that was developed, neither of these requirements necessarily serve, nor deliver superior value to, Contact’s customers.

Contact helped to create the wholesale electricity market which commenced operations from October 1, 1996. This market uses the price sought by the highest successful bidder in the market as the wholesale market spot price. The pricing system has not worked well anywhere and, in New Zealand, seems to contribute to increased wholesale prices and increased values attributed to power stations. Thermal stations incur higher operating costs than hydro stations so the wholesale electricity price is usually set by a thermal power station. This affects power station valuations because they are determined by electricity prices. Any price increase automatically increases the valuation of every power station on the generating system (Noble, 2002). Electricity generators will, therefore, do best as generation capacity becomes scarce, either because of scarce or run-down generation facilities, or because of fuel scarcity, as is becoming increasingly apparent with the coming exhaustion of the Maui gas field. Either way, prices rise.

Contact regarded itself as "a generation business with a limited number of mainly wholesale power customers" until 1998. In that year, the Chairman reported on developments that would alter the "future financial structure and shape of the company’s business". Another controversial wave of reforms in 1998 required further "unbundling". ECNZ was split into several State-owned generating companies, and generating, transmission and retail businesses were required to be separated. This forced divestment at local government level where combined transmission and retail businesses were common. Energy Minister Max Bradford claimed that promoting competition in the electricity sector would bring price reductions, with gains flowing through to household and small business consumers. He identified long-term efficiency gains as the objective of the reforms (Bradford, 1998).

"Excellent Investment Opportunities"

As Bradford explained proudly to an Asia Pacific Economic Cooperation (APEC) meeting of electricity business interests in 1999, New Zealand offered "excellent investment opportunities" through its predictable and transparent regulatory framework and its lack of restrictions on foreign ownership. New Zealand had no electricity industry regulation or regulators, and relied on the general competition law set by the Commerce Act. "Above all", he said, New Zealand has "no formalised ‘energy plan’" (Bradford, 1999). Security of ongoing electricity supply would not be a problem because Bradford believed competitive conditions and accessible information would solve everything: "Rising electricity prices will act as an early warning mechanism of an impending shortage," and these "better price signals" will assist all, generators, retailers and consumers alike, to manage their "future supply risks".

Contact responded to these reforms in two key ways. It commenced a "retail acquisition strategy" by buying up electricity supply businesses, paying part of the purchase price for the customer base. Contact also began "to aggressively pursue business expansion to secure and enhance future earnings capabilities. This effort has been focused on the New Zealand and Australian energy markets, which are becoming one geographic business area in the electricity sector".

Contact regarded New Zealand as "characterised by increasing competition and over-capacity in the next few years". This made it unlikely that any major new generation capacity would be developed until "demand growth begins to absorb spare capacity". As we will see, this was a short term and self-serving view. However, Contact had updated with more modern technology some of the "relatively old and inefficient thermal plant" it had been allocated at its inception. The "flagship development" of this update programme was the 390 megawatt (MW) Otahuhu B combined cycle plant which was to be commissioned in 1999.

Despite Bradford’s claims to APEC, Australia seemed to be a better place for his own SOE, Contact, to do business. Contact bought a 27.7% share in Southern Hydro Ltd in Victoria, Australia, and a 17% share in Oakey Power Holdings Pty Ltd in Queensland where a gas-fired plant was under construction. Contact had secured an ongoing operations and maintenance role for both these facilities, and regarded them as a foundation for future expansion in Australia. The 1998 Annual Report revealed $102 million invested in those Australian developments.

Contact’s Chairman reported the Government’s intention to sell Contact. This sale proceeded in April 1999 when 40% of Contact’s shares were sold for $1.208 billion ($5 per share) to Edison Mission Energy Taupo Ltd, a 79% subsidiary of the Edison Mission Energy Company (EMET) of the USA. The other 21% of EMET was owned by "other unknown third party shareholders" of the USA (Rosenberg, 1999). Comment at the time reflected shock at the high price Edison paid for its strategic holding, and the likelihood of power price rises to follow. The remaining 60% of the shares were floated on the sharemarket at $3.10, the issue being over-subscribed. The terms of this float were such that sharebrokers earned a greater commission from issuing shares to overseas shareholders than they did from issuing them to local shareholders. Many of the shares went to shareholders overseas (Gaynor, 1999). After the float, Gaynor assessed Contact as about 62% overseas owned.

Because the Crown had retained ownership of Contact’s shares until about half way through the 1999 financial year, in addition to the price it received from selling the shares, it also received another dividend of $28.9 million. In early April 1999, Contact announced an unaudited net surplus after tax for the six month period October 1, 1998 to March 31, 1999 of $54.4 million resulting from revenue for the half-year of $364.8 million.

In summary, during Contact’s time as an SOE, in which the Crown held an equity investment of $1.208 billion in 100% of Contact’s shares, Contact was required to pay $1.578 billion for ECNZ’s assets and liabilities, and a further $49 million to the Crown. Contact then wrote off $293.2 million, thus suggesting the assets and liabilities it had purchased were worth only $1.284.8 billion. Excluding these write-downs, Contact reported profits over those three and a half years of $268.5 million and paid dividends to the Crown of $273.9 million. It reported depreciation expense (a non-cash item) of $184.1 million for the three and a half years, and investments in property, plant and equipment for the three years of $176 million. The Crown then sold to Edison just 40% of Contact’s shares for $1.208 billion, exactly the amount of its equity investment in 100% of Contact’s shares, and floated the remaining 60% of Contact’s shares on the share market. According to Contact’s Chairman, the sale of Contact "delivered $2.3 billion to the New Zealand government". Whether the sale of Contact would bear out Max Bradford’s touching faith in the wonders of competitive markets was another matter.

Contact Energy Ltd As A Subsidiary Of Edison Mission Energy

1999 was a year of transformation for Contact. In less than a year, Contact went from "having fewer than 100 customers and one shareholder to being a company that serves over 485,000 customers and almost 190,000 shareholders". Edison held its stake in Contact until October 2004. During that time, Contact’s reported revenues increased by 50% from $854.7 million in 1999 to $1.277 billion in 2004, most of the increase arising from electricity revenue. Contact’s reported profits changed very little, sitting around the $100 million to $120 million mark annually. This period brought into clear focus the inherent conflict of interests in a market where workable competition is not practical. The most obvious conflict is between consumers of an essential infrastructure service, especially small consumers, and a company intent on securing future earnings capacity to benefit its shareholders. Another conflict emerges from the shareholder structure created by the Government as part of the privatisation – a cornerstone shareholder (Edison) may be expected to look after its own interests to the potential detriment of other shareholders.

Three Edison staff members were appointed to Contact’s Board in 1999. This gave Edison three voting members on the eight member Board. Edison’s ownership of 40% of Contact’s shares brought changes to Contact’s earlier strategies. Edison’s prior business interests in Victoria gave rise to regulatory issues arising from its involvement in Contact because of Contact’s investment in the Southern Hydro power scheme in Victoria. Contact was required to dispose of this interest, although Edison agreed to indemnify Contact for any losses suffered as a result.

Significant Changes To Accounting Policies

Immediately following Edison’s investment, Contact made some significant changes in its accounting policies. One key change was the decision that Contact’s rights to the Maui gas field should now be regarded as an asset. Whereas in 1996 Contact had written off the value of those rights ($47.8 million at the time), Contact reversed that decision in 1999 and reported an asset of $60.4 million. This increased 1999’s reported profits by the same amount.

Another key change related to the amount Contact records for its assets. From 1996, Contact had reported its assets at the "cost" for which it had obtained them from ECNZ, subsequently written them down to what is known as their recoverable amount, the present value of future cash flows expected to be earned from them. At the time, the implications of this write-down were that Contact had paid ECNZ more for its assets than it could hope to earn from them. Other than recognising depreciation on these values, Contact made no further adjustments to its reported asset values. After Edison purchased its interest in Contact, however, Contact decided to revalue its assets three yearly and to re- value them to a value determined by assessing the present value of its future cash flows (2). Contact’s asset valuations were therefore based on the electricity prices it anticipated receiving. If prices rose, so would its valuation of its assets.

By this time the wholesale market was in operation and, as noted above, the values of all generation facilities, hydro and gas-fired alike, had become a function of the wholesale electricity price as set by the highest successful bidder in the wholesale market. The Press editorial comment of 1995, that overseas ownership of New Zealand’s electricity generation facilities could eventually "exact a price far beyond the cost of electricity it has generated", was beginning to look prophetic (Press, 29/11/95, editorial). This is because of the inherent circularity when higher reported asset values (driven by rising prices) result in higher depreciation charges. This reduces apparent profit at the same time as increased (revalued) dollar values are reported for assets. The net result is to reduce the apparent rate of profit, expressed as a return on asset values. The falling rate of return is then used to justify higher prices.

During the five years under Edison’s influence and control, Contact took the reported asset values up to more than double the amount Contact had paid to buy them. It revalued its assets four times, reporting valuation increases totalling $2.09 billion. Those asset values increased, not because of increased investment, but because the increasing scarcity of generated electricity allowed the extraction of increased prices, a point Contact acknowledged following the 2002 revaluation (Annual Report, 2002, p3) (3). In part, Contact’s own actions increased that scarcity. For example, Contact decided it no longer needed plant to cope with peak load demand and, in September 1999, announced the closure of its 200MW gas-fired power station in Stratford (NZ Press Association [NZPA], 24/9/99).

In 2000, Contact’s Chief Executive and Managing Director, Paul Anthony, resigned, receiving a $2.5 million termination payment in addition to his other remuneration. Assessments of the total payout to him ranged from $4 million to $6.8 million. Anthony remained a member of the Board, which was reduced to seven, and Edison’s Stephen Barrett was appointed Chief Executive. This gave Edison three voting members on a reduced (seven member) Board plus the Chief Executive. In 2001, Barrett’s status was changed to Chief Executive and Managing Director and the Board size was reduced to six. One of Edison’s appointees retired. This left Edison with its appointed Chief Executive playing a dual role (Managing Director as well), and this gave Edison 50% of the voting power on the Board. By this time, Edison also held a 50% shareholding in Contact. The Board was increased back to eight members in 2003 with the 50% relative voting power retained. Questions soon arose whether Contact’s Board was acting in the interests of all of its shareholders, or whether instead it was acting in Edison’s interests.

Edison Mission Energy Taupo had borrowed to finance its investment in Contact, using Contact’s shares as security. EMET had granted a mortgage and charge over its shares in Contact in favour of Edison Contact Investments Ltd which, in turn, granted charges over the shares to Credit Suisse First Boston, Edison Contact Finance Ltd, Credit Agricole Indosuez Australia Ltd, SG Australia Ltd and the Development Bank of Singapore Ltd (Annual Report, 1999). When Contact’s share price fell in 2000, the value of the security for the amount EMET had borrowed also fell. EMET was required to have debt of no more than 65% of the value of its Contact shareholding and when the share price fell below $2.55, that requirement was breached. Continuation of the breach would have required Edison Mission Energy to guarantee EMET’s debt, probably by issuing a letter of credit (Bloomberg, 15/5/00; NZPA, 18/5/00; Press, 5/6/00). Edison pondered aloud about increasing its stake in Contact, and Contact announced a programme of share repurchases for up to 5% of its issued shares (NZPA, 24/5/00). The share price rose again. During 2000 and 2001, Contact repurchased 27.3 million shares for $73.5 million, at an average price of $2.65. This repurchase programme helped to support Contact’s share price. Arguably, Contact’s deployment of its financial resources to repurchase its own shares allowed Edison to avoid having to use its financial resources to support EMET. The repurchase programme also reduced the total number of shares on issue, thus effectively increasing EMET’s stake in Contact to more than 50%.

Blame It On The Weather

While adequate generation capacity and fuel remained, weather conditions could depress Contact’s earnings. A warm damp winter in 2000 meant high lake levels and reduced demand for electricity, especially at the retail level, and lowered profits ($97 million). Contact’s Chairman opened his 2001 report by commenting on the effect of weather on Contact’s earnings: "We have repeatedly said that Contact does well when the weather is dry and cold". Winter 2001 had "brought drought, low hydro lake levels and the threat of power blackouts". Contact had delayed "mothballing" a unit at its Stratford station, readied its Otahuhu A facility for use, and despite its "mission" to "sell energy", took part in an advertising campaign promoting energy conservation (Annual Report, 2001).

Although Contact claimed New Zealand as its number one priority "to the extent that opportunities arise and can be acquired at reasonable prices", it regarded the New Zealand market as "constrained". Contact intended "to build the next power station in New Zealand once new capacity is required" but considered that "current wholesale prices do not justify the construction of new plant". Instead, Contact’s "strong balance sheet and cashflows" would allow Contact to "grow its business in Australia" (Annual Report, 2001).

Contact and Edison entered a joint venture, called Valcon, to invest in a 300MW peaking plant at Valley Power in Victoria, Australia. Both invested in this joint venture through subsidiaries, Edison through its subsidiary, Valley Power Pty Ltd, and Contact through its subsidiaries, Contact Peaker NZ Ltd and Contact Peaker Aust Pty Ltd. During 2000 and 2001, Contact decommissioned its Stratford (NZ) power station, and sold that plant plus "surplus units" from its Whirinaki (NZ) station through plant manufacturers, Pratt & Whitney to Edison Mission Energy. Contact did not report the sale price obtained for this plant, but it reported gains on sale of $43 million. Through its subsidiary, Valley Power Pty Ltd, Edison Mission Energy "invested" that plant in the Valcon joint venture. Contact subsequently reported that it had loaned Valley Power Pty Ltd $44.2 million, this loan suggesting that Contact either had not received payment, or had not received full payment, for the Stratford and Whirinaki plant it had reported selling to Edison.

In 2001 Contact reported that it had invested A$66 million in the Valcon joint venture, and this gave it "an approximate 40% interest" (Annual Report, 2001, p18). This investment had been made through Contact Peaker NZ Ltd and, in its Annual Report Contact reported a loan to Contact Peaker NZ Ltd of NZ$73.9 million. Contact’s involvement in this joint venture angered some of Contact’s shareholders because the investment represented 4.9% of Contact’s shareholders’ funds. Listing rules required Contact to obtain formal shareholder approval and an independent appraisal for an investment of 5% or more of shareholders’ funds. Contact intended this joint venture to proceed in two stages, each of which if taken separately would be less than the 5%. In other words, Contact would be avoiding the requirements of the listing rules through technicalities. The Stock Exchange’s Market Surveillance Panel said the two part deal would require approval and Contact decided not to proceed to the second stage. Shareholders questioned whether Contact was being run for the benefit of all shareholders, or just for the benefit of Edison (Williams, 2002). The Shareholders Association awarded Contact the "Golden Glob" for this deal because Edison seemed to be "using Contact’s balance sheet to access funds in a ‘transparent pursuit of self-interest’ without taking the issue back to Contact shareholders" (NZPA, 17/12/02). Contact stated that at the time of the decision not to proceed with the second stage, the project had been experiencing delays and cost increases but subsequently commented on satisfactory returns.

Since 2001, Contact has provided few details about this Valcon joint venture, merely stating that its financial results are immaterial in relation to Contact’s overall financial results. Contact does, however, report an ongoing obligation to pay Valley Power Pty Ltd for the lease of the generation plant used in the Valcon joint venture and makes annual lease payments to Valley Power Pty Ltd. It recorded the leased assets at $80.8 million and, in 2003 and 2004, made lease payments of $6.7 million and $4.2 million respectively. In other words, as part of its involvement in the Valcon joint venture, Contact is paying Edison’s subsidiary, Valley Power Pty Ltd, for lease payments on the generation plant from Whirinaki and Stratford that Contact had "sold" to Edison. Edison presumably leases that plant to Valley Power Pty Ltd. Worse, mounting concerns about ongoing security of electricity supply in New Zealand resulted in the New Zealand taxpayer footing a $150 million bill for replacement plant at Whirinaki. We will return to this later.

New Zealand’s weather-related energy crisis of 2001 was followed by the announcement that "generation constraints are emerging more quickly than earlier anticipated". The Maui natural gas field’s reserves were found to be dramatically reduced, and security of future electricity supply became a recurring theme. In 2002, New Zealand went through a "transition … from the abundant energy supplies enjoyed over the last generation to a new era in which security of supply will be less certain … [and] will require the development of new energy sources" (Annual Report, 2002, p3). "2003 went down as a year when New Zealand went from being a country where energy is relatively abundant to one where energy will increasingly be scarce" (Annual Report, 2003, p2), and the 2004 Annual Report contained a section headed "Energy Security" noting again the coming depletion of the Maui gas field, and making the point that new energy sources would be more costly (2004, p 5).

Putting Up Power Prices

In 2003, Contact spelled out the "urgent" need for additional investment in generating capacity and the "new reality": "New Zealand faces an unavoidable choice – relatively low cost electricity, and under-investment in the electricity system and the likelihood of power shortages; or higher priced electricity and a reliable power supply … This new reality has nothing to do with regulatory systems or market structures and everything to do with the fact that previously plentiful, low cost sources of energy are now all but exhausted… It may be tempting to assume that this environment suits electricity companies very well. It does not. If we cannot find new fuel sources for our existing and future power stations, then we face serious constraints on our capacity to grow an integrated portfolio of generation and retail assets" (Annual Report, 2003, p3). Contact anticipated New Zealand’s residential tariffs rising to a level comparable with Australia and the United States, arguing that "such an increase over the next few years is inevitable if New Zealand is to maintain security of electricity supply" (ibid.).

In 2004, Contact associated the need for rising tariffs with rising costs faced by all New Zealand energy suppliers, including Contact, even though 50% of Contact’s generation capacity comes from hydro and geothermal power stations whose costs are not affected by rising gas prices (Steeman, 28/9/04). Independent energy consultant, John Noble, dismisses such claims as sophistry (Noble, 2003). This is partly because even with higher costs for gas, the cost of electricity is less than current prices. As is evident from the way the wholesale market works, even if only one generator bids an increased price, if that price bid is successful it sets the spot price for all. Because the values attributed to all electricity generating facilities are a function of prices, as the prices increase so do the values, regardless of generating costs. Generators then seek to earn a "commercial" return on these higher values, without acknowledging that the higher values do not result from their increased investment or from them incurring increased costs. The higher values arise because the supply of electricity is a vital service and the consequences of major disruptions to that service are unpleasant: "Although higher energy prices will be unpopular, their impact would pale in comparison to the impacts of interrupted, unreliable energy supplies. Major power blackouts of recent months in the United States, Europe and Japan have demonstrated how disruptive the absence of electricity can be. We do not want that here, but, without wanting to indulge in any scaremongering, it is a possibility" (Annual Report, 2004, p 4-5).

Noble believes the electricity generation companies are trying to force consumers to contribute the funds now with which the generators might build new generation capacity. This view is confirmed by Energy Minister, Pete Hodgson, in his comment that "electricity prices had to rise to encourage investment in new power stations" (Steeman, 24/11/04). The problem with this argument is that no matter how high the price of electricity, or what claims are made to extract increased prices, the electricity generation companies are not obliged to build new generation capacity. They are free to decide for themselves how to use that money. The State-owned electricity generation companies have been paying the money to the Crown as special dividends. Both Meridian and Contact have been trying to expand into Australia. In 2004, Contact reported its investment in another three Australian subsidiaries as part of its effort to operate an integrated energy business in Australia: Contact Avalanche Holdings Ltd, Red Energy Ltd and Contact Finance Pty Ltd.

From the time Contact was privatised, it has reported efforts to "revitalise" its asset base which consisted of generating facilities, both in New Zealand and Australia, and retail customer bases. In 1999, the revitalisation consisted of three main projects: the Otahuhu B plant (NZ) which had encountered technical problems delaying commissioning; a co-generation facility with the New Zealand Cooperative Dairy Company Ltd (NZCDC) providing electricity and steam to NZCDC’s dairy processing facility at Te Rapa, and a 282MW gas-fired peaking plant (Oakey) in Queensland for which Contact was providing project management. In 2000, Contact purchased a 55MW geothermal power station (Poihipi Road) which it integrated with its Wairakei operation and increased to 25% its stake in the Oakey project in Queensland.

In 2001 and 2002, Contact talked about but did not proceed with the development of a 400MW gas-fired power station at its Otahuhu site in Auckland. "To commit the approximately $400 million required for a new combined cycle gas turbine plant, an investor will want first to secure sufficient gas to be confident of at least the initial phase of the plant’s approximately 30 year operating life. … To achieve its timely construction, the trade-offs between price, environment, and security of supply will need to be carefully weighed. Until now, price and environmental considerations have been uppermost. Security of supply is now the principal priority and this will come at a cost" (Annual Report, 2002, p5). In 2003, Contact talked again about building a $100 million power station in Auckland or near Napier but said it would "pause" if the Government tried to "cap wholesale power prices or centralise control of generation" (Weir, 2/5/03).

In 2003, Contact reported its acquisition of the Taranaki Combined Cycle (TCC) power station. This increased Contact’s generation capacity by 357MW or around 20% and allowed continued growth in Contact’s retail customer bases. Contact also restored oil-burning capability to the 400MW New Plymouth plant (although it had no resource consent to do so); and reported plans to add binary cycle plant, which would allow the use of both steam and hot water for generation. This would boost Wairakei’s output and was to be funded from increased debt.

Objecting To Government Regulation

When the Government established the Electricity Commission, Contact objected, arguing that the Commission would make matters worse. Contact’s directors regarded the Commissioner’s powers as "potentially so extensive as to increase uncertainty for would-be investors in new generation. At worst, they could lead to under investment in generation and chronic energy shortages" (Annual Report, 2003, p3). Such under-investment and energy shortage problems had, of course, already emerged and, as is apparent from the events outlined above, Contact had contributed to them. Still, in 2003, Contact reported "assisting" the Crown to overcome them. In 2003, Contact leased to the Crown its Whirinaki site for construction of a 155MW diesel-fired power station for use in electricity shortages. In addition to receiving lease fee income, Contact would earn project management, and operation and maintenance fees. Industry sources pointed out that the new Whirinaki generation plant for which the Government was paying $150 million, was almost identical to the Whirinaki plant Contact had sold to Edison just two years earlier for about $20 million (Foreman, 2003). Contact also reported its assistance in overcoming energy shortages by engaging with SOE Genesis in a joint feasibility study to explore the use of liquefied natural gas (LNG) as a fuel alternative. "LNG is a new fuel to New Zealand and new facilities to offload LNG from ocean tankers would almost certainly require significant investment from more than one party". Any such solution would, of course, be more expensive (Annual Report, 2003, p8). As noted in Contact’s 2004 Annual Report, "the investment needed to satisfy energy demand will not continue if investors sense that policy makers are unwilling to allow necessary price adjustments to occur" (p6).

Contact had reported 485,000 customers in 1999, but by 2003 its customer base had grown to 97,500 gas customers and 522,000 electricity customers. It had achieved this largely by "buying" customer bases which it capitalised as assets and amortised* annually. Some customers clearly objected to Contact’s behaviour and attitudes, and in 2003 Contact acknowledged its need to invest in customer satisfaction. Contact conducted an advertising campaign in 2004, its first effort since the share float in 1999, showing a "new face to its shareholders, customers and the public at large…. At the core of the campaign was the notion that every option available to us involves a trade-off between three critical factors – the security of the electricity supply, the impact of electricity generation options on the environment, and the price of electricity required to make each option work" (Annual Report, 2004, p20). Contact called these three critical factors the "triangle" of choices. By the end of the 2004 financial year, Contact’s gas customers had fallen to 90,000 and its electricity customers to 508,000. * Amortised. For physical assets, such as generation plant, the amount "written off" each year as if there is some kind of using up of those assets is called depreciation. When the "assets" concerned are not physical ones, then the amount written off each year is called amortisation. When Contact Energy purchased electricity retail operations, much of the purchase price was for the customer base, in other words Contact paid big amounts for the hapless consumers. A part of the amount paid for each customer base is written off each year and that part written off is called amortisation. SN.

From mid-2003, Contact’s share price began to rise as rumours circulated that Edison was about to sell its holding in an effort to reduce its own debt (Steeman, 19/11/03). In 2004, Australian company, Origin Energy bought Edison’s holding. Origin is an oil and gas explorer as well as an electricity retailer and generator (Steeman, 22/11/04). The Chairman’s report in the 2004 Annual Report was signed by Contact’s new Chairman, Grant King of Origin Energy.

In summary, Contact’s time under Edison commenced with Edison paying $1.208 billion for 40% of Contact’s shares, and then lifting that shareholding to 51%, by mid-2001. It sold those shares for $1.650 billion (Steeman, 23/2/05). Excluding the $60.4 million from the gas reserves accounting policy reversal, during its years under Edison, Contact reported profits of $752.3 million, paid out dividends of $658.1 million and repurchased shares of $73.5 million. Contact paid capital expenditure of $430 million and reported paying investments of $62 million. Some of Contact’s capital expenditure and investment was in Australia, rather than New Zealand, and it is difficult to determine how much was reinvested in New Zealand because, for reporting purposes, Contact regards Australia and New Zealand as one geographical area and so doesn’t provide any analysis. This suggests that Contact’s Australian activities and investment are relatively small.

Contact Energy Ltd As A Subsidiary Of Origin Energy

After Edison Mission Energy sold its holding in Contact to Origin Energy, Contact’s Board membership changed, with Edison appointees replaced by Origin appointees. The Board announced that Contact no longer sought to create an integrated energy business in Australia and intended to sell its start-up energy retailer, Red Energy Ltd, to New South Wales-based Snowy Hydro Ltd (Annual Report, 2004, p10). Origin was "stretched" to maintain its credit rating and market speculation raised the possibility that Contact would make a massive payout to shareholders of up to $1.15 billion (Steeman, 19/1/05). Such a return was considered likely to suit Origin which had debt-funded its purchase of Contact’s shares. In the event, no such payment proceeded, the new Origin chairman, Grant King, commenting that it would be "imprudent" for Contact to make a large cash payout to shareholders only to borrow it again when "the next level of investment becomes quite clear" (Steeman, 23/2/05). Given that the comments in Contact’s 2004 Chairman’s report were signed by King, whether Origin’s attitudes to New Zealand’s electricity consumers are more charitable than Edison’s remains to be seen.

Contact Energy Ltd And Its Activities In New Zealand’s Electricity "Market"

Contact Energy Ltd is simply a company, acting as companies are expected to act - in shareholders’ interests. Because Contact has a single dominant, or cornerstone, shareholder, it is apparent that some of its actions benefit that shareholder to the disadvantage and possible detriment of the other shareholders. This preferential treatment was evident with Contact’s share repurchase and its joint venture in Valcon. When the cornerstone shareholder is domiciled outside New Zealand, as was Edison, and as is Origin Energy, then neither consumers nor New Zealand-based shareholders seem likely to benefit much from such a company’s activities. While Contact deserves criticism for its activities, we should not expect it to behave otherwise. Contact’s existence and its ability to act as it does, results from na´ve public policy processes. While public criticism might deter Contact from some of its activities, only public policy change is likely to be effective in the longer run. It is useful, therefore, in reviewing Contact’s activities and behaviour, to reconsider some of the beliefs and claims of our public policy makers.

Competitive market assumptions tend to be used to suggest that in a competitive market, shareholders’ interests will be met by keeping consumers happy. The generation and supply of electricity is not, and never has been, a competitive market. The nature of New Zealand’s electricity "market" is such that a company like Contact does not need to even try to keep consumers happy. All it has to do is to corner a section of the market. Over time, Contact has sought to increase its market share in New Zealand without expanding overall generating capacity. It has bought up capacity from other generators, for example, the Poihipi Road generator and the Taranaki Combined Cycle generator, while disposing of some of its pre-existing generating capacity, the plants at Stratford and Whirinaki. At the same time, Contact has increased its customer base by "buying" customers and offering inducements, such as fly-buy points. In October 2004, newspaper commentary referred to Contact as just "a month away from conquering" the retail residential market in the South Island" (Gorman, 15/10/04). Contact was expected by early 2005 to be New Zealand’s second largest electricity retailer. Developments like these help Contact to increase its profits, without any threat of dampening electricity prices.

Supporters of an electricity market believe that "price signals" will prompt the whole electricity system, including investment in new generation and transmission lines, to operate efficiently. Max Bradford’s speech to APEC exemplifies such beliefs, even to the extent of suggesting formalised energy planning is unnecessary. Similarly Pete Hodgson seems to think that price signals will save the day, although Hodgson does at least see a need for some Government intervention, albeit quite weak. These supporters hang on to their beliefs that a competitive market for electricity will emerge in the face of mounting evidence to the contrary. According to Eugene Coyle, a consulting economist on restructuring and deregulation, with experience particularly of the electricity industry: "The standard theory of competition fails in industries where the product sold is an undifferentiated commodity, and, separately, where production requires large fixed investment, or ‘overhead costs.’ Electric power has both characteristics. Because of the product and cost characteristics of electric power, severe price discrimination is certain to occur in deregulated electric power, and small business and residential customers will be the targets". Ultimately, says Coyle, what will unfold from attempts to create a competitive market is "producer cooperation and/or collusion to frustrate competition".

To some extent, the Electricity Commission and the existence of the Whirinaki reserve generation plant may help to restrain efforts to collude or frustrate competition, but we should understand the nature of the "market" forces that have been unleashed in New Zealand. In its "aggressive" pursuit of business expansion, and security and enhancement of its future earnings abilities, Contact has both forecast a looming generation capacity crisis and helped to contribute to it. Contact’s drive to secure its future earnings has contributed to New Zealand’s "new reality" of an uncertain and insecure future electricity supply which will, of course, cost more, and more, and more. The costs to us as consumers have little to do with generation costs incurred by electricity generators, and everything to do with prices that consumers and policy makers will tolerate in an effort to avoid the spectre of major electricity disruptions. Contract’s frequent statements on pricing and security should be seen in that light. As Contact assures us, "without wanting to indulge in any scaremongering", major electricity disruptions are a possibility. Indeed, reading between the lines of Contact’s repeated warnings of such a possibility, and taking into account recent reports about such disruptions in the United States and elsewhere, it is not unreasonable to suggest that Contact may help to make it so. And that too would be a logical outcome of the efforts to create an electricity "market" in New Zealand.

Endnotes

1. Possibly this $49 million was to reimburse the Crown for the costs of establishing Contact.

2. A new and controversial accounting standard was under preparation which requires those companies revaluing their assets to report them at their "highest and best use" value.

3. The revaluations were: $673.3 million in 1999; $24 million in 2000; $843 million in 2002; and $550 million in 2004, a total of $2,090.3 billion.

References

Bloomberg, (2000), ‘Edison guarantee after Contact breach’, Press, 16/5/00, p15.

Briloff, A., (2004), ‘Accounting scholars in the groves of academe: In Pari Delicto’, Critical Perspectives on Accounting, Vol. 15, No. 6-7, pp. 787-796.

Bradford, M. (1998), ‘Lively debate on electricity reforms is based on ‘misunderstanding’’, Press, 15/7/98, p 7.

Bradford, M. (1999), ‘Speech to APEC energy business network’ 6/9/99).

Coyle, E. (2000), ‘Price discrimination, electronic redlining, and price fixing in deregulated electric power’, American Public Power Association, Washington DC.

Easton, B., (1995), ‘Competitive electricity: whatever the equation, power prices will rise", Listener, 8/7/95, p56.

Foreman, M. (2003), ‘Power station shut and sold – by mistake’, The Independent, 6/8/03, p3.

Gaynor, B., 1999, "Govt should encourage local investing", NZ Herald, 15/5/99, Business.

Gorman, P., 15/10/04, ‘Contact Energy in Westland’, Press, 15/10/04, pB10.

Huck, P., 1999, "Image of power greenie queried’, NZ Herald, 6/4/99, pA11.

Noble, J. (2002), ‘Why our electricity prices are rising’, The Independent, 13/2/02, p10.

---., (2003), ‘A great power rip-off’, Press, 5/8/03, pA7.

NZPA, 1999, ‘Contact to close Stratford station’, Press, 24/9/99, p8..

---., 18/5/00, ‘Edison guarantee’, Press, 18/5/00, p17.

---., 24/5/00, ‘Contact in dark on rise’, Press, 24/5/00, p23.

---., 2002, ‘Contact awarded "Golden Glob"’, Press, 17/12/02, pC1.

Press, 2000, ‘Edison reprieve’, Press, 5/6/00, p26.

Rosenberg, B. (1999), ‘The deformation: "reforms" continue to wreck the electricity industry’, http://canterbury.cyberplace.org.nz/community/CAFCA/publications/Electricity/index.html

Steeman, M. 19/11/03, ‘Contact takeover possible’, Press, 19/11/03, pB9.

---., 28/9/04, ‘Call made to reject Origin takeover bid’, Press, 28/9/04, pC2.

---., 22/11/04, ‘Surge in Contact profit likely’, Press, 22/11/04, pB3.

---., 19/1/01, ‘Talk of capital return lifts Contact’s shares’, Press, 19/01/05, pC4.

---., 23/02/05, ‘Aussie tips growth at Contact’, The Press, 23/2/05, pC7.

Weir, J. (2003), ‘Power station proposal’, Press, 2/5/03, pB3.

Williams, A. (2002), ‘Contact actions curious – Arcus’ (Press, 28/5/02, p7).

World Bank (1995), ‘Policy research report: Bureaucrats in business – the economics and politics of government ownership’, New York: Oxford University Press.


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