Light-Handed Regulation Of The Energy Sectors
- Geoff Bertram
This is a revised version of a paper written for a series of lectures on regulation, organised by Brian Easton for the New Zealand Fabian Society in 2012.
“Light-handed regulation: Allows the firm discretion in how it meets regulatory targets. Regulation that is not intrusive, in contrast to command and control or … cost of service regulation. This process is designed to reduce information requirements and high compliance costs, while introducing clear incentives for good performance” http://regulationbodyofknowledge.org/glossary/l/light-handed-regulation/
“Government failure” was a recurrent theme in policy discourse in New Zealand back in the 1980s. Driven by an ideologically-evangelistic Treasury, and given wings by the anecdotal disasters of policy in the Think Big programme, the idea took root that Government could do virtually nothing right whereas the private sector was better at (almost) everything. The outcome was a “self-hating state” (1) in which officials and ministers loudly proclaimed their own institution’s ineffectiveness and proneness to rent-seeking and capture, then used this as their excuse to abdicate from serious engagement with the core regulatory functions of Government in a mixed capitalist economy. In the process they converted the New Zealand government into the inept, rent-seeking bungler of neo-liberal propaganda (and of their own imaginations). Nowhere was this process more apparent than in the application of the doctrine of deregulation - mislabelled for public relations (PR) purposes “light- handed regulation” - to services formerly provided universally and cheaply by the Government as part of the Welfare State social contract hammered out in the mid-20th Century. In telecommunications and rail, electricity and gas, ports and airports, radio and television, the neo-liberal agenda swept through: more market, less State intervention, privatisation wherever and whenever possible, enthusiasm for financial engineering and novel accounting techniques, wholesale abandonment or suppression of regulatory and legal arrangements that had evolved to provide basic protection against monopoly for workers and the mass of small consumers and citizens. The outcomes of this epidemic of social irresponsibility at the heart of Government provide the subject matter of this series of lectures.
In this paper I focus on two energy sectors – electricity and gas – and especially the first of these, since the electricity sector provides an especially clear-cut demonstration of the downside of the neo-liberal project from the standpoint of the ordinary citizen and consumer. My focus is on transfers of wealth, because the unifying theme of energy sector policy since 1986 has been to facilitate the gouging of wealth, from the poor and the powerless, for the benefit of the rich, the strong, and the Treasury. The wealth transfers in energy, taken on their own, account for only a part of the enormous growth of income and wealth inequality across the New Zealand economy over the past two decades – only a few percentage points of gross domestic product (GDP), a few billion dollars here and a few billion dollars there, have been shifted from poor to rich via electricity and gas pricing – but the sector’s history provides a microcosm of the general orientation of Government policy towards greater inequality across society and worsening poverty at the bottom, under both Labour and National administrations.
A Note On Wealth Transfers
Wealth transfers come in many forms: donations and gifts, Lotto wins and welfare benefits; taxes; monopoly profits, financial scams, outright robbery. Society is not indifferent amongst these, because some involve voluntary or legislatively approved transfers of wealth to deserving recipients, whereas others such as robbery involve coercion of unwilling parties from whom wealth is transferred (it is one of the ironies of neo-liberal thought that taxes – subject to democratic decisions by the legislature – are stigmatised, whereas monopoly profits, which lack democratic mandate, are not).
Between 1986 and 1993 there was vigorous debate in policy circles over the question of whether monopoly profit-taking involved any detriment to the public. Unsurprisingly, Treasury and the Business Round Table led the charge for those who said not, and in 1992 they won a key debate within officialdom over the “public benefit test” (2). The outcome was that, with no referral to Parliament, the official position was adopted that wealth transfers have no effect on public welfare (3), which in turn means that the taking of monopoly rents by price-gouging customers is of no concern to the Commerce Commission or the courts – unless for some political reason the Government of the day decides that a particular example requires intervention, in which case Part IV of the Commerce Act gives the relevant Minister the power to trigger a long, cumbersome process of inquiry which might eventually lead to regulation.
Thus, when the Commerce Commission uncovered evidence of excess profit-taking estimated as some $4 billion by electricity generators in the wholesale market during the early 2000s, it took no action, noting that: “The exercise of market power to earn market power rents is not by itself a contravention of the Commerce Act, but is a lawful, rational exploitation of the ability and incentives available to the generators”. (4) Similarly, in its 2003 Gas Inquiry the Commission noted that: “A net public benefit analysis considers net total welfare effects. Under this analysis, any deadweight efficiency loss due to allocatively inefficient prices would count as a net public detriment, but any transfer of wealth from consumers to suppliers (or vice versa) would not…[E]xcess returns being reduced, with a transfer of wealth from suppliers to consumers …[would constitute] a net benefit to acquirers. [However] [t]he increase in consumers’ wealth is matched by a reduction in suppliers’ wealth (resulting in zero net public benefit)”. (5)
This official stance was correctly read by private sector investors, as well as by Treasury officials, as a licence to exercise any market power they could acquire, for the purpose of extracting wealth from those consumer groups that lacked the power to resist. Large industry obviously could look after itself through its sector organisations Major Electricity Users Group (MEUG) and Major Gas Users Group (MGUG); but the only channel through which aggrieved small consumers could seek redress was political (6), and the political/regulatory machinery moves slowly. In the two New Zealand energy sectors covered in this paper, there have been three examples.
They were freed from price control in 1993. By the time a political decision to investigate the resulting excess profit-taking was taken in 2003 they had nailed down something in the order of half a billion dollars of bare wealth transfers, crystallised in asset revaluations with associated price rises to fund the associated so-called “capital costs”. The subsequent Commerce Commission investigation took a further 18 months, after which provisional non-binding “authorisations” were made to check further monopoly behaviour, but leaving the companies in full and undisturbed possessions of their gains from a decade of predation, which meant consumers were left paying the higher prices (7). In 2008 Powerco and Vector were given “customised price-quality paths” under their new Authorisations (8). Meantime the Commerce Amendment Act 2008 introduced changes to the regulatory procedures under Part 4 (which now covers gas and electricity and specified airport services). Commission was required to produce “input methodologies” for consumer price index (CPI) price caps on regulated sectors by 30 June 2010. The first draft gas “default price-quantity paths” were released in October 2012 for consultation (9), and were to come into effect in July 2013. Thus there was an unregulated ten year free-for-all, followed by a full, dreary, ten year process to get regulation in place. At the end of the process the monopolists’ books are fatter, and consumers are worse off, than would have been the case had there been any actual regulation in the 1990s – or if a political decision had been possible to claw back the monopolists’ gains, as the “bring out the club” rhetoric” of the early 1990s had suggested might happen.
Electricity Distribution Networks
They were corporatised and deregulated in 1994 and given official encouragement to double their asset valuations and pass the resulting increased charges on to customers. By 2000 they had booked $2 billion of wealth transfers crystallised in the form of ODV asset valuations, sustained by steeply increased profits. Those profits came from increasing margins as operating costs were driven down while prices rose. (10) In 2000 a Ministerial Inquiry suggested regulation be considered and a 2001 amendment to the Commerce Act required the Commerce Commission to "set thresholds for the declaration of control in relation to large electricity lines businesses" (11), but after lengthy hearings, the Commission decided that it was not its role to engage in retrospective analysis of lines company profitability or asset revaluations since 1993. The main reasons given by the Commission were, ironically, mainly to do with the alleged lack of relevant information after nearly a decade of mandatory information disclosure (12). Asset revaluations were allowed to stand, and reclassified as “historic cost”. The Commission in 2001 introduced an investigatory “thresholds regime” against which lines companies performance could be assessed – with no penalty specified for breaches. “If one or more of the (price or quality) thresholds were breached by a lines business, the Commission could further examine the business through a post-breach inquiry and, if required, control their prices, revenue or quality”. (13) For the five year period 2004-2009 the threshold regime continued with a vaguely defined freeze on asset revaluations. In 2008 new legislation empowered the Commission to set “input methodologies” for a CPI-X* regulatory regime; price caps were finally set in 2010 and the regime is now in force. The Input Methodology for the 2010 price setting exercise finally brought in “financial capital maintenance” to prevent revaluations causing wealth transfers, and refused attempts by companies to revalue up from the 2004 ODVs which had been rolled forward with some indexation. (14) The deregulated free-for-all lasted effectively for a decade, 1994-2004, and the imposition of CPI-X regulation took a further half-decade. The 2010 price reset process was highly contentious and became enmeshed in two years of litigation between the Commission and Vector, which was resolved in the Commission’s favour by the Supreme Court in 2012. (15) The $2.3 billion of wealth transfers from consumers, and associated higher lines charges than would have prevailed under regulation, were left untouched – retrospectively clawing back consumers’ losses was not something the Commission felt able to tackle. *”Price cap regulation is sometimes called ‘CPI – X’, after the basic formula employed to set price caps. This takes the rate of inflation, measured by the Consumer Price Index and subtracts expected efficiency savings X. The system is intended to provide incentives for efficiency savings, as any savings above the predicted rate X can be passed on to shareholders, at least until the price caps are next reviewed (usually every five years). A key part of the system is that the rate X is based not only a firm's past performance, but on the performance of other firms in the industry: X is intended to be a proxy for a competitive market, in industries which are natural monopolies”. Wikipedia.
Electricity Generation & Retail Activities
They were corporatised and part-privatised between 1986 and 1999, and subjected to no price or profit regulation whatever, nor even to requirements to disclose information beyond what was required by normal company annual reporting practices. Between 1999 and 2012 they booked $11 billion of wealth transfers crystallised in asset revaluations, much of which was extracted in cash dividends and sale proceeds to various private and public owners – but mostly to the Government, which was the leading predator in this market, cheered on by both major parties in Parliament. As of the end of 2012 there was no sign of any political interest in price regulation of the five firms that make up an effective cartel: in April 2013 Labour and the Greens finally adopted policies aimed at regulating the gentailers’ pricing and asset valuations, but the National government’s official policy remains that everything can be fixed by market competition, with the Electricity Authority devoting its attention to supposedly-pro-competitive interventions that have had little visible effect on prices or asset values. The Government is now in the process of part-privatising its three SOE gentailers, a process which will make it politically far more difficult to wind back bloated asset valuations or provide pricing relief to small consumers in the face of entrenched opposition from the industry and its hired gun consultants and lobbyists.
Figure 1 summarises the two decades of predation. (16)
Trends In Energy Sector Prices, Profits, Asset Values And Investment
Figure 2 is a chart tracing the evolution of the real retail price paid for electricity by the most vulnerable and captive groups of consumers – residentials – since the late 1970s, in ten countries which “reformed” their electricity sectors. Since the start of New Zealand’s reforms in 1986 there have been only four years, 1990 and 1998-2001, when residential consumers have not faced price escalation at around 4% above the economy-wide inflation rate. (Not coincidentally, 1998-2001 were the years of the widely-derided “Bradford reforms” which briefly gave life to the notion of actual competitive pressure coming to bear on the industry’s dominant players. Once Max Bradford had been disposed of, and the uncertainty and upheaval of his structural reshuffling had ceased, the business as usual price escalator for residentials slipped back into gear.)
Source: International Energy Agency database downloaded July 2012 from Organisation for Economic Cooperation and Development (OECD) Library .
Source: International Energy Agency database downloaded July 2012 from OECD Library http://www.oecd-ilibrary.org/energy/dta/end-use-prices/indices-of-energy-prices-by-sector_data-00444-en.
Figure 3 traces the same data for the industrial sector. The contrast between the residential price and the industrial price speaks volumes about the relative leverage enjoyed by industrial interests compared with domestics. Industry is more organised, has some genuine political “voice”, and in particular large industrials (which account for around half the sector’s total electricity use) are represented by a powerful lobby group, MEUG, which wields serious countervailing power against the generator-retailers. Consequently, the real price to industry in 2011 was the same as in 1986, after a global financial crisis (GFC)-induced drop from levels reached through steady upward price pressure in the mid-1990s and early 2000s. Averaging across all the electricity sector’s customers (including commercial users, who faced falling real prices but do not appear in Figures 2 and 3), Figure 4 shows the average overall real price trends for electricity – downward until the 1990s when restructuring kicked in, then steadily up (except for the Max Bradford “electricity reforms” interlude) until 2009, then softening under the impact of economic recession and strategic overbuilding of generation capacity by the big five.
Source: Prices and volumes from Energy Data File 2012 Table I.1a and Table G.5a. Deflated by the author using CPI for residential and producers price index (Inputs) for commercial and industrial, but using CPI for years before the PPI series begins
Figures 5 and 6 tell the same story for natural gas.
A second indicator of industry performance is investment, both in maintaining existing capacity and in expanding capacity to meet future needs. Figure 7 shows the collapse of new investment after 1991, followed by the onset of violent fluctuations as cycles of boom and slump replaced the steady pace of the old administratively determined investment programmes.
Investment performance of “electricity, gas and water” sector, 1972-2007 (17)
Source: National accounts published by Statistics New Zealand. The published sectoral data ends at 2007.
Installed generating capacity in the New Zealand electricity system, 1945-2011
Source: 1945-1975 data assembled from annual reports of the New Zealand Electricity Department; 1975-2011 from Ministry of Economic Development Energy Data File 2012, p.112 Table G.3a
Figure 8 shows trends in generation capacity in electricity, again highlighting the unstable investment track post-reform, and the consequences of new construction during the 1990s being offset by the profit-driven destruction of much of the system’s dry-year reserve thermal capacity. (18) Meantime the transmission grid was allowed to run down for a decade and a half while large cash dividends were extracted from Transpower by Treasury. The grid assets inevitably deteriorated and eventually key components began to fail, a process dramatically illustrated by a blackout of much of Auckland in June 2006, and by the 2007 reduction in the capacity of the inter-island high-voltage direct current (HVDC) link which is a key part of the grid backbone (19).
A third key indicator of performance is capital value. Figure 9 shows the book value of fixed assets in generation, retail and distribution lines (i.e. the electricity industry excluding the Transpower grid) since 1979. Until 1994, assets were valued in the way a traditional (“heavy handed”) regulator would have done, on the basis of historic cost (actual past investment outlays, net of accumulated depreciation). Over the following five years the distribution lines companies marked up their $2 billion of historic cost to $4 billion of “optimised deprival value”, an arcane concept foisted on the industry by the Government which, in effect, allowed assets to be revalued to replacement cost with the resulting higher “capital charges” passed through to consumers – a technique for driving up prices relative to costs, which effectively transferred $2 billion of wealth from consumers to the companies. Then, starting in 1999, the vertically integrated generator-retailers marked up their asset values using the techniques of so-called “fair value” accounting, which capitalises the expected future earning capacity of the assets. For this technique to produce rising valuations, operating margins have to rise to provide the required revenue stream; and since operating costs were not falling for these companies, the increasing margins to underpin asset revaluations rested entirely upon the driving-up of prices. By 2011 these “fair value” revaluations had reached $11.4 billion while distribution lines asset revaluations were approaching $4 billion. Altogether the bare wealth transfer from consumers embodied in these asset revaluations totalled $15 billion, which meant that electricity was being priced off an asset base more than double what a traditional regulator would have allowed.
To put this in context, suppose (optimistically) that capital charges are recovered on this $13 billion of fictional capital at a 7-8% rate of return - $1 billion annually. Then, consumers in aggregate are being required to pay this sum as a levy to sustain the industry’s unilateral appropriation of $13 billion of wealth from them – that is, to allow investors to recover $1 billion more than would have provided a fair return on past investment spending. Relative to total annual sales revenue of $38 billion this is only 3%; but the burden of servicing the revaluations is carried not by all consumers but by the politically disenfranchised residential consumers, whose total annual expenditure on electricity is $15 billion (20). So 8% of their bill is this levy.
To add insult to injury, consumers also have to pay for an uncontrolled blowout of operating costs in the retail market, where the five-gentailer cartel continues to reign supreme and financial engineering, advertising, playing competitive games, high salaries and expenses have all played a part. Figure 10 shows the rise in the reported operating costs of the five gentailers since their cartel was consolidated in 2001. Figure 11 shows how the cost blowout has been concentrated in retail, metering, market services and “governance” expenses. The average electricity user in 1990 paid less than a cent per kilowatt hour (kWh - in 2011 dollars) for these services; by 2010 they were approaching five cents/kWh on average across all users; and nearly nine cents/kWh for residential customers – 40% of the residential price (the additional costs for gentailers of the much-hyped “what’s my number” campaign and encouragement of customer churn by the Electricity Authority can be expected to show up in both operating expenses and residential prices).
Figure 10: Gentailers’ real operating expenses (not including depreciation) 1979-2011
Source: Assembled by author from annual financial statements. Deflated using the PPI (Inputs). Note the absence of data for the retail businesses of distributors 1994-2999.
Breakdown of final electricity retail price excl GST, 1990 and 2010
Source: 1990 from Electricity Statistics 1990 & 2010 based on Electricity Authority Fact Sheet 3 p.1, with the four sectors aggregated to the total using sectoral consumption weights from Energy Data File 2011 p.118 Table G.6a.
The record to date shows the symptoms that in most jurisdictions would long ago have triggered public outrage and policy changes to bring in more effective regulation. It is noteworthy that in New Zealand the political will to regulate showed up for the natural monopoly gas pipelines and electricity networks only after they had locked in their wealth transfers from a shift to monopolistic limit pricing. In relation to electricity generation and retailing the policy network remained virtually unchanged until the Labour/Greens policy launch in April 2013, which was triggered by the rush by Treasury to raise several billion dollars in cash by unloading shares in the three bloated electricity SOEs onto private investors. The new Labour/Greens policy position puts at risk several billion dollars of so-called “fair value” in the SOE books, which Treasury is converting to cash revenue via the share floats.
Some Regulatory Theory
Light-handed regulation, as originally proposed in economic theory, was not deregulation. It was dreamed up, primarily in the UK, as a set of institutional arrangements and regulatory procedures that would allow greater scope for regulated businesses to exercise creativity and entrepreneurship free of detailed day-to-day regulatory intervention, while still meeting a regulator’s goals. To put the idea in context, a little history is needed. In the USA, public utilities such as electricity and gas were always supplied mainly by the private sector. Experience of anticompetitive profit-taking behaviour by railroads in the 19th Century and oil pipelines in the early 20th Century had resulted in the Sherman Act and the Clayton Act outlawing profiteering by natural monopolies. Over the first half of the 20th Century the institutional arrangements for regulation developed in the form of Public Utility Commissions which set utility rates and controlled profits. For several decades the regulated industries were able to use creative accountancy devices - such as asset revaluations and manipulation of depreciation and depletion allowances - to subvert the effectiveness of regulators, but the US Supreme Court’s Hope Natural Gas decision of 1944 outlawed these practices and ruled that regulation should allow only a fair return on actual capital expenditures, recorded at historic cost. The resulting regulatory system, stigmatised by neo-liberals as “heavy-handed regulation”, remains largely intact and has been reasonably effective in achieving the primary goal of blocking the use of monopoly power to gouge excess profits out of consumers(21).
In the UK and many former British colonies, the problem of natural monopoly was solved by the alternative route of nationalisation. State-owned monopolies provided essential services to the mass of the population at (or, sometimes, below) cost, under political/bureaucratic control and management. The neo-liberal campaign for privatisation of these public utilities had to confront the issue of how monopoly profiteering could be restrained once private owners were endowed with the market power to gouge consumers. The answer most congenial to the business community (and to Rightwing fractions of the economics profession) was to throw consumers to the market wolves, but this answer was judged politically unsaleable in Margaret Thatcher’s UK and so regulation was introduced at the same time as privatisation. US regulatory practice, notwithstanding its decades-long track record, was deemed too intrusive. Stephen Littlechild, one of the intellectual architects of the Thatcher revolution, argued that privatisation under the watchful eye and light hand of a dedicated, skilled, but arms-length, regulator could deliver a win-win outcome: falling prices for consumers and healthy profits for the new private owners, all funded out of the efficiencies and cost reductions that (he took it for granted) would flow from private ownership and commercially-oriented management replacing the supposedly hidebound and wasteful nationalised industry managements (22).
In place of the “heavy-handed” cost-of-service regulation used in the USA, Litlechild’s light-handed alternative was “RPI-X” which put a sinking lid on final prices of electricity, gas, telecoms and so on, and then left private managements free to work out for themselves how to reduce costs while maintaining standards of service. This arrangement was light-handed so far as detailed intervention went, but actually very tightly constrained insofar as the price cap was made binding on the privatised businesses by credible enforcement relying on the ultimate coercive power of the State. If enforced, an RPI-X cap meant that whether the privatisation experiment succeeded or failed in reducing costs, consumers would benefit from lower prices for unchanged or improved services – in other words, better value for their money. Any failure by private owners to realise efficiency gains under RPI-X would simply reduce their own profits. The Littlechild vision did not contemplate allowing privatised entities to secure monopoly profits by the easy route of raising prices; his focus was on efficiency gains.
New Zealand neo-liberals loved the privatisation part of Thatcherism but found Littlechild’s version of light-handed regulation still too restrictive. Throwing consumers to the market wolves was politically feasible in New Zealand, in contrast to the UK, and so the specialist regulatory agencies for electricity, gas, water and telecoms set up by Thatcher were not imitated here. Treasury had formed the view in the 1980s that the main problem with State ownership here was not so much allocative or productive inefficiency as low profits, and a series of Treasury documents made the case for exploiting the monopoly power of State Coal, the New Zealand Electricity Department, and other State-owned entities, in order to secure more revenue to balance the budget by driving prices up to “long-run marginal cost” in place of the previous social-service philosophy of recovering only average cost (including the cost of new investments).
Hence, as privatisation and its halfway house version corporatisation, were applied to New Zealand’s State-owned energy assets, the air was filled with generic claims that consumers would benefit from efficiency gains – but there was no sign of the CPI-X price caps that, if enforced, could have guaranteed that outcome. Instead, officials argued that prices had to rise to fund new investments (23), while at the same time claiming that the scale of the required price rises would be “disciplined” by two separate processes: market competition for those parts of the energy sector labelled as potentially competitive; and for the rest, a process of information disclosure, which allegedly would enable consumers and others to identify abuses of monopoly power and react in some (generally unspecified) ways that would clip the monopolists’ wings. If this exposure to public scrutiny failed to persuade the new commercial managements of Electricity Corporation of New Zealand, Natural Gas Corporation, Telecom and so on to restrain their profit-taking, the suggested remedy was political: the Government could step in to impose some sort of regulatory action, if it was genuinely concerned to restrain the taking of excess profits by what used to be essential services.
1990s’ NZ Reforms Were Not Light-Handed
To be clear: New Zealand in the 1990s did not implement at all, with respect to prices and profits of the utility sectors, the form of regulation described elsewhere as “light-handed”. What passed for light-handed regulation here comprised simply information disclosure and the political threat of formal regulation under Part IV of the Commerce Act. Market competition and information disclosure do not amount to regulation even if rigorously enforced (which they were not in New Zealand). As officials explained at the time (emphasis added): “Information disclosure is the alternative to price control which has the least distortionary effect on the use of resources by firms … Potential competitors can use the information to ensure that they are given access to essential facilities … at reasonable prices. (24) [The Electricity Information Disclosure Regulations are aimed] to make transparent the performance of electricity businesses with market power, and to facilitate negotiations by customers with these businesses and recourse to the provisions of the Commerce Act. (25) If the conditions for access being required by the [facility] owner are too onerous (and are anticompetitive in intent) then an appropriately structured information disclosure regime will provide sufficient information to enable the discriminated party to take action under the Commerce Act…” (26)
State Abdicated Good Behaviour Responsibility
The State, in short, simply abdicated to customers and potential competitors the responsibility for enforcing good behaviour. Unless, and until, a political decision was made to initiate actual regulation, no regulatory institutions would oversee the behaviour of monopolists and cartels; the sole discipline would be transparency and a frequently stated hope that the companies would self-regulate in a socially responsible fashion, notwithstanding the fiduciary duty of their boards to maximise shareholder returns. For the first decade of reform these remained the only notional restraints on profiteering. Attempts to use the courts to force providers of essential services to charge no more than fair and reasonable prices were unsuccessful because David Caygill’s Commerce Act 1986, as interpreted by the Privy Council in Telecom Corporation of New Zealand Ltd v Clear Communications Ltd 1 NZLR 385, had suppressed the old common law rights of consumers (27). Successive Ministers of Energy puffed out their chests and issued solemn warnings about their ability to “bring out the club” (Doug Kidd’s expression) if companies erred, but these threats were revealed as hollow when tested by company managements (the economist’s technical term for this is incentive incompatibility: it is one thing to threaten in advance, it is quite another to act to reverse price rises after the fact when faced with a fait accompli). Many years into the reforms an “Electricity Complaints Commissioner” was set up in 2001 – but was prohibited by the terms of reference from inquiring into complaints about pricing. Confronted with complaints, Ministers and officials still routinely talk as though consumers have avenues of legal redress open to them, but are never able to explain where those avenues lie. (28) The Electricity Authority, set up in 2010 as the latest boutique non-regulator, took pains to secure a Memorandum of Understanding with the Minister of Energy explicitly relieving it of any responsibility for considering issues of “fairness” in the electricity market (29): “Consideration of fairness or equity issues is not part of the Authority’s objective or functions. The Act provides for the Minister of Energy and Resources to recommend the Governor-General make regulations relating to domestic and small business consumers for fairness reasons, after consulting with the Minister of Consumer Affairs and obtaining and considering advice from the Authority”.
I spent much of the 1990s gathering data from the information disclosure process to see how effective it might be in disciplining companies’ profit-taking, and that research yielded a series of reports and publications to which interested readers are referred for details. (30) The bottom line was that effectively no discipline applied other than that of the unregulated market. Both the level and structure of energy prices evolved to reflect the market power of companies in the various industry segments. Where natural monopoly prevailed, limit pricing was the norm: price was pushed up to the level at which new entry – Demsetz’ “competition for the market” – was only just deterred. Where markets were potentially competitive – in electricity generation, primary gas production and processing, and energy retailing – a variety of anticompetitive practices were allowed to run free without falling foul of the weakly drafted provisions of the Commerce Act. Most spectacularly, vertical integration of generation and retail in electricity, and across the whole supply chain in gas, made possible the establishment and entrenchment of de facto cartels which proceeded to erect self-serving market rules under the banner of “industry self-regulation”, foreclosing new entry and raising retail prices in tandem, with the greatest price hikes falling where the imbalance of power between suppliers and consumers was greatest – the residential market.
Conspicuous Failure Of Political Will
At every step along the way there was an abundance of political rhetoric, promising consumers the long-term benefits that were the ostensible aim of the competition law regime, but there was a conspicuous failure of political will when it came to delivering on threats to regulate. Company managements steadily pushed the envelope on pricing, profits and asset values and were often as surprised as anyone by the Government’s repeated unwillingness to react. In the late 1990s there was much talk by ministers in the then National government about the possible introduction of an CPI-X price control regime, and surveys of gas industry executives showed general expectation that regulation was looming up, but the election of a Labour government in 1999 put paid to that - the incoming Ministers were quickly persuaded by officials in the key departments (Ministry of Commerce and Treasury) to differentiate themselves from previous Minister Max Bradford by disowning his interventionist ideas.
The refusal throughout the 1990s to regulate even when confronted by blatant abuses seems to have had two causes:
Inside players in the energy sectors in the early 1990s were clearly and increasingly aware that the Government was not merely unwilling to resort to direct political intervention to block profiteering and looting – the Government itself was positioning as one of the leading profiteers and looters. This rise of the “Predator State” (31) was not unique to New Zealand, but it was bad news for small consumers (whose experience in the past two decades is reminiscent of the notorious exercise in tax-farming by the French State under Louis XIV and his successors - a process which levied huge profits for the Crown and its private sector cronies by price gouging the common people through devices such as the salt tax, and which came to an end only in 1789, with the French Revolution).
The New Zealand State’s objectives changed in tandem with the official adoption of deregulation (misnamed light-handed regulation) and SOE corporatisation/privatisation. The defence of the new policies using arguments from the old order of nationalised essential facilities was never more than a smokescreen for a new age of corporate looting, in which the State was not simply complicit but a central player in its own right. The irony is that when the State sets out to loot its own enterprises, the resulting wealth transfers are internalised in a way that makes them particularly hard to analyse from a welfare perspective. Those groups of consumers that lack organised muscle sufficient to hold predation at bay (in the New Zealand case this means primarily residential users) are gouged for cash, most of which eventually turns up in the public accounts as revenues derived from SOE profits or share floats. These arguably reduce taxes for some part of the population – probably richer and more powerful than the gouged consumers, in which case the overall effect is regressive for income and wealth distribution. Along the way a new class of corporate SOE managers predate on the revenue flows to secure high salaries, bonuses, luxuriously appointed office buildings, and fat expense accounts. Where privatisation removes assets from State ownership at prices below the true capitalised value of subsequent monopoly rents, the private shareholders are enriched by the pricing and accounting behaviours that are given legitimacy by public policy and SOE practices.
An important implication of the preceding paragraph is that there is no necessary reason in principle why a Government with genuine social democratic policy goals could not have opted to privatise, decentralise, and light-handedly regulate its electricity sector and to have come out the other end with a working, democratically oriented, socially responsible result (ignore for the purposes of this argument the reflection that a genuinely social democratic Government would not have found the case for privatisation or corporatisation compelling – though it could have been comfortable with a light-handed approach to regulation). Abandonment of the old social democratic moral compass, and its replacement by subservience to financial and large corporate interests, was at the heart of the New Zealand reforms and largely accounts for the outcomes of reform. A social democratic Government would not have lost the ability and will to regulate properly, even if it opted to stay its hand provisionally. A social democratic Government would have continued to plan in order to overcome the problem of coordinating large interdependent energy investment decisions, even if they were decentralised in private sector hands. A social democratic Government would have had an open mind regarding the relative efficiency of private versus State management and would have avoided dogmatic adherence to the neo-liberal vision, while demanding improvements, wherever feasible, in state sector management (to see what might have been, one could look at Denmark, notwithstanding the obvious differences of detail).
Failure To Confront Well-Entrenched Monopolies
To conclude, I reproduce a passage from a 1999 paper I wrote about self-regulation and information disclosure (32) “[T]he reluctance of the Government to confront the issue of blatant profit-taking by well entrenched natural monopolies has been nothing short of extraordinary. The oft-repeated threat by Ministers and officials to ‘resort to price control’ if industry failed to meet Government's objectives had little credibility to begin with, given the political constraints and incentives faced by those same Ministers and officials. By now the emptiness of the threat is a standing joke. The absence from the information disclosure regulations of provisions that would force disclosure of monopoly profits, and enable individual customers to benchmark the prices charged to them against competitive standards may well be attributable to the capture by key vested interests of a weak, under-resourced, and often apparently demoralised State regulatory apparatus.
“Both of these points recall a distinction made by the Swedish economist Gunnar Myrdal in his 1968 book “Asian Drama”, written about South Asia at the time of the East Asian takeoff. Myrdal drew a distinction between ‘hard states’ and ‘soft states’. Hard states were those which developed and maintained the effective ability and willingness to enforce their policy goals if required. Because such states have effective monitoring mechanisms, it is credible for private sector players to assume they will be caught out if they misbehave, so the incentives to flout policy goals are greatly reduced. At the same time because the State has fully credible capacity to step in and impose outcomes both ruthlessly and efficiently, the need for it actually to do so is dramatically reduced. Light-handed regulation, to be effective, requires a hard state on the sidelines”.
NZ Is “Soft State”
“Soft states, in contrast, lack the capacity and the will to dictate key outcomes. ‘There is a unwillingness among the rulers to impose obligations on the governed and a corresponding unwillingness on their part to obey rules laid down by democratic procedures’. Soft states do not maintain the analytical capacity to monitor effectively, nor to design surgically efficient policy interventions. They lack enforcement machinery sufficient to give credibility to their stated aims. It is therefore rational for the private sector to treat them with a degree of contempt and to engage in strategic behaviour which is directly subversive of the declared goals of policy. Light-handed regulation under these conditions is simply non-regulation, punctuated by periodic blundering interventions which tend to do more harm than good.
“The New Zealand State has made itself soft in this sense, and this softness has contributed directly to the poor results from the structural reform programme of the past decade, measured in terms of the things that really matter for an economy in the long run: growth, productive investment, sustainability, and the elimination of poverty. Gas industry managements have responded directly to the incentives created by policy design, and their responses have been appropriate in terms of serving faithfully the interests of their shareholders. Our problem is that what is good for gas company balance sheets and shareholders is not necessarily best for New Zealand. If the economy as a whole has lost out as a result of regulatory failure, however, the blame lies squarely with Government, not with the industry”.