Report to the Trustees of the Network Tasman Trust on the Proposal to Vary the Trust Deed

29 Rata Road Hataitai Wellington 6021 AD Jenkins Ltd Phone: 0274 57 5758 E-Mail: [email protected]

Report to the Trustees of the Network Tasman Trust on the proposal to vary the Trust Deed

9 December 2015 Addendum: April 2016

For clarity, the 2nd paragraph on page 3 of this report has been amended as follows (and the list referred to appended):

NTL falls into that 4th group of non-exempt companies, along with two other electricity distributors - Top Energy Ltd and EA Networks Ltd. A fourth comparable company – The Lines Company Ltd – is non-exempt because 3 of its 6 trustees are appointed (i.e. consumer-elected trustees do not make up a majority of the trust). For clarity, a full list of regulated (i.e. non-exempt) companies, with brief explanations of why they do not qualify for exemption, is attached as Appendix 2 to this report.

Introduction

I have reviewed the submissions received on this proposal, and attended the public meeting arranged by the Network Tasman Trust on 26 November, where a number of submitters presented. I am familiar with the issues and positions involved, and with the regulatory environment applying to Network Tasman Ltd (‘NTL’) and to the Trust. In undertaking this review I have considered the arguments put forward for and against the proposed change, and also the implications of either retaining the status quo or amending the Trust Deed in the context of wider regulatory, pricing and technological pressures facing electricity distribution businesses.

My CV is appended to this report.

Background

The effect of the proposed changes would be to enable NTL to be included in the list of electricity distribution businesses that are exempted from price and quality regulation by the Commerce Commission, as it would then comply with Section 54D of the Commerce Act.

At present the following 12 companies are exempt from price-quality regulation. All of these are relatively small, trust-owned companies with much in common with NTL:

Buller Electricity Ltd Counties Power Ltd Electra Ltd MainPower NZ Ltd Marlborough Lines Ltd Network Waitaki Ltd Northpower Ltd Scanpower Ltd The Power Company Ltd Waipa Networks Ltd WEL Networks Ltd Westpower Ltd

As noted in NTL’s submission, in recommending to Parliament that this exemption be created, the Commerce Select Committee commented that “We consider the lighter handed regulatory regime is suitable, as consumers own these electricity lines businesses and therefore are best placed to ensure the businesses act in their interests.”

The electricity distribution businesses that do not qualify for this s 54D exemption fall into four categories:

1. Relatively large companies, where the compliance costs associated with regulation are less material.

2. Companies owned or part-owned by local bodies, where direct consumer oversight is not exercised through a Trust.

3. Companies that are wholly or partly owned by private interests (or by non-exempt companies).

4. Companies with limitations in their Trust Deeds that mean they do not meet the requirements for unimpeded consumer oversight through elected Trustees.

NTL falls into that 4th group of non-exempt companies, along with two other electricity distributors - Top Energy Ltd and EA Networks Ltd. A fourth comparable company – The Lines Company Ltd – is non-exempt because 3 of its 6 trustees are appointed (i.e. consumer-elected trustees do not make up a majority of the trust). For clarity, a full list of regulated (i.e. non- exempt) companies, with brief explanations of why they do not qualify for exemption, is attached as Appendix 2 to this report.

• Top Energy is non-exempt because its Trustees are selected by a panel of local MPs and the Northland Regional Council, from a pool nominated by consumers.

• EA Networks is non-exempt because it has an unusual governance arrangement, where the Ashburton District Council holds the majority of shares in a non-voting form.

The arguments for and against the proposed change

The reasons identified for proposing the changes to the Trust Deed are set out in the 20 November 2015 submission by NTL, and were further developed at the public meeting.

The key reasons for changing the Trust Deed are financial and operational, and in particular reflect additional costs and uncertainties arising from the new regulatory requirements introduced by the Commerce Commission with effect from 1 April 2015, and the changing business environment associated with so-called transformative technologies that are now emerging.

In support of the changes, it was argued that:

• Removing the provision for the appointment of a Trustee by the three consumers paying highest line charges would have no material impact on the day-to-day operations of NTL or on network pricing arrangements, as the Trust’s role is strictly circumscribed by the Trust Deed and by the underlying legislation.

• NTL is unique in being the only consumer-owned lines company where major users appoint a Trustee, meaning that the majority of lines company trusts operate without having this unusual status applying to a small number of consumers.

• To the extent provided for by legislation, it is the Trustees’ role - rather than the Commerce Commission’s and the Electricity Authority’s – to ensure that the interests of consumers are represented fairly.

• Exemption from price-quality regulation would not remove NTL’s requirement to comply with the Information Disclosure provisions applying to all electricity distributors under Part 4 of the Commerce Act.

• The Commerce Commission’s control regime, as it applies to non-exempt companies, is becoming increasingly detailed and intrusive, at a time when NTL needs increasing room to move rapidly as new technologies emerge.

Opponents of the proposed changes have put forward a fairly broad range of arguments. The ones that I consider to be material or deserving consideration are:

• The purpose of the change is to avoid price-quality controls, and this is not in the interests of consumers. Prices could rise dramatically without regulation.

• The cost savings that would result from achieving exempt status are illusory as they are mainly circular.

• Having a Trustee appointed by the three high-paying consumers means that industry- focused expertise will always be available to assist the Trust in its deliberations.

• A ‘big business’ appointee is a safeguard against the elected Trustees failing to block an imprudent investment decision by NTL, or a drive to sell NTL or its key assets.

• The Trust is not as well equipped as the regulators to protect consumer interests, and self- regulation is inadequate.

• The current arrangements have resulted in NTL having very low distribution charges compared with its peers, so why change?

• Given the Trust’s fundamental responsibility to promote consumer interests, additional consultation should be undertaken before the changes to the Trust Deed are considered.

Notably, Nelson City Council (one of the three high-paying consumers currently appointing the non-elected Trustee) submitted that it did not oppose the proposed change but suggested the inclusion of pricing monitoring against a ‘related industry group’ of regulated lines companies, and the inclusion of a requirement in the Statement of Corporate Intent to meet regulatory ‘Pricing Principle Guidelines’.

Other arguments put forward failed to recognize the scope of the existing regulatory regime. For example, several submitters maintained that profits could be used imprudently without regulatory oversight, whereas the relevant regulatory regime (Part 4 of the Commerce Act) does not control the way profits are applied. All electricity distribution companies, including exempt ones, are required to provide detailed information on their unregulated activities as part of the mandatory Information Disclosure regime, and this requirement would continue to apply if NTL were to become exempt from price/quality control.

Discussion

The proposal does not appear to be well understood by many of the submitters, and the suggestion from a number of them that additional consultation occur does not seem unreasonable. Here there is a clear focus by the regulators of electricity and distribution businesses on promoting consultation with consumers on issues that cause significant confusion or concern. The detailed information disclosure requirements of sub-part 4 of Part 4 of the Commerce Act are designed to ensure that sufficient information is readily available to interested persons to assess whether the purposes of the Act in relation to a spectrum of consumer interests are being met, although – without further analysis – much of this information is not easy to understand.1 Accordingly, it would seem appropriate for the Trust to ensure that consumers are adequately briefed during consultative exercises of this type.

The Commerce Act’s information disclosure provisions are designed to give consumers the data needed to ensure that their electricity distributor is behaving reasonably. The purpose of the legislation applying to electricity lines businesses is to promote outcomes where those businesses:

(a) have incentives to innovate and to invest, including in replacement, upgraded, and new assets; and (b) have incentives to improve efficiency and provide services at a quality that reflects consumer demands; and (c) share with consumers the benefits of efficiency gains … including through lower prices; and (d) are limited in their ability to extract excess profits.2

This legislative umbrella, supported by the consumer ownership and governance arrangements applying to Trusts, seems to provide adequate reassurance to the consumers of the 12 exempt companies listed above that no additional protective measures are necessary. I am not aware of any significant pressures in any of those trust controlled areas for changes that would result in either the imposition of price-quality controls, or the incorporation of special arrangements in Trust Deeds similar to Rule 2.5 of the Network Tasman Trust Deed.

As the relative performances of the exempt companies, vs NTL’s, were queried by several submitters, it is useful to use the information disclosure outputs to gain a perspective of this:

Distribution and Transmission Revenue Exempt 2013-14 Trust-Owned (c/kWh) Companies Distribution Transmission Total

Buller Electricity 12.95 12.95 Counties Power 8.26 8.26 Electra 6.59 2.23 8.82 MainPower 6.10 2.25 8.35 Marlborough Lines 8.94 8.94

1 Sections 52A and 53A of the Commerce Act 1986 2 Section 52A of the Commerce Act 1986

Network Waitaki 3.79 2.20 5.99 Northpower 5.53 0.69 6.22 Scanpower 10.35 10.35 The Power Company 5.61 2.28 7.90 Waipa Networks 6.35 6.35 WEL Networks 7.71 7.71 Westpower 5.72 1.64 7.36 Average 7.33 1.88 8.27

Network Tasman 4.42 2.37 6.79

Comparisons based on c/kWh can be misleading, as wide variations exist e.g. in customer densities, peak loads and in volumes of electricity consumed by large users vs numbers of domestic consumers. Superficially (using total transmission-inclusive prices, as no disaggregated data is available for 6 of the 12 companies) NTL compares favourably – i.e. has a lower c/kWh average charge – with all but 3 of the exempt companies.

Customer density tends to be the best indicator of relative operating and capital costs, and the following comparison suggests that NTL’s performance would be similar to most of the exempt group once this is taken into account, as two thirds of the group have significantly fewer consumers per km of line than NTL does.

Customer Density Exempt Trust- 2013-14 Owned (ICPs/km) Companies

Buller Electricity 7.20 Counties Power 12.40 Electra 18.60 MainPower 7.90 Marlborough Lines 7.30 Network Waitaki 6.40 Northpower 9.30 Scanpower 6.40 The Power Company 3.90 Waipa Networks 11.50 WEL Networks 16.40 Westpower 5.90 Average 9.43

Network Tasman 11.10

Summing up on this point, I do not believe that there is any material evidence from available data (including other disclosure data not cited above) that suggests that NTL’s non-exempt status is resulting in significantly more favourable consumer outcomes, compared with the outcomes experienced by consumers in the 12 exempt companies.

Some of the discussion at the public meeting focused on the relevance of the cost savings associated with joining the group of exempt companies, and a number of the submitters also highlighted this. This is an area that invites subjective judgments and, in my view, it is more useful to look at the relative merits of the business environments that will exist in the exempt or non-exempt situations.

There are four different but potentially complementary exposures or signals associated with exempt/non-exempt status:

• Investment & operational signals • Exposure to imposed asset value erosion • Exposure to inappropriate commercial restrictions • Exposure to unpredictable costs

(a) Investment & operational signals

The Commerce Commission is required to deliver a ‘one-size-fits-all’ price/quality regime to all lines companies, unless they attempt to opt out by applying for a ‘Customised Price Path’ or ‘CPP’ (which does not appear to be an attractive alternative for a company such as NTL).

Over the past 6 years this regime has become increasingly complex, a trend that appears very likely to continue. For example, the quality of service requirements have been extended to create incentives and disincentives (in the form of financial penalties) for the duration and frequency of power supply outages. These requirements have different impacts on companies, depending on uncontrollable factors such as local weather patterns, the frequency of vehicles hitting poles, the percentage of undergrounded lines, the proportion of very old assets, the degree to which customers are supplied via single lines rather than urban networks, etc.

In NTL’s case several of these factors create additional exposures to these financial penalties – notably the high proportion of rural lines, and the age of parts of the network:

Percentage of older lines NTL Industry (km) Average Pre-1940 5.7% 0.7% 1940-49 5.1% 1.1% 1950-59 18.6% 6.0% 1960-69 18.5% 12.9%

Percentage of rural circuits 84.9% 58.2%

Despite these disadvantages, NTL has consistently bettered the industry averages for the various power quality indices. However, there is clearly a degree of additional exposure overhanging the company’s operations because of these realities.

The argument was put forward at the public meeting that penalties and incentives for quality will balance out, and be circular anyway (as the ‘incentives’ take the form of loadings on charges to consumers that will presumably be added to customer rebates). I do not think that this is a realistic view. Any penalties will result in reduced income, which in turn implies reduced rebates along with an intangible but real cost to NTL in the form of bad publicity and an associated loss of goodwill. Similarly, the trustees would face the prospect of eroded electoral support, and also of overseeing the erosion of asset values due to the impacts on goodwill and on returns on assets. These are adequate reasons for NTL, with Trust support, to respond to the Commission’s financial penalty signals.

Also, NTL will face pressures to make investments that specifically target the defined quality of supply indices. This may not be the most efficient investment objective for the company but is an example of the drive facing non-exempt companies to dance to the regulator’s tune, rather than to local priorities.

(b) Exposure to imposed asset value erosion

The regulatory regime is based on a set of Input Methodologies (‘IMs’) that are reset by the Commerce Commission periodically. One of the most critical of these is the weighted cost of capital (‘WACC’) where the Commission again attempts to find a one- size-fits-all cost of raising money that does not deliver what it considers to be a windfall margin to the larger companies that the regime is focused on. The recent trend has been for the industry WACC IM to be reduced at successive resets. A reduction in WACC translates over time to a reduction in asset values. This exposure may be compounded for NTL if it is unable to raise money at rates that the much larger electricity distributors can obtain.

Similarly, the Commission also sets a Regulatory Asset Base (‘RAB’) IM. This is adjusted annually by indexing against inflation, with an adjustment for allowable revenue. While this direct adjustment of non-exempt companies’ asset values normally has only a marginal impact when compared with WACC adjustments, it results in delays and uncertainties in asset depreciation rates.

Given the primary Trustee objective to “in particular to optimize the return on assets of the Company”3 it would appear reasonable and prudent for the Trust to seek exempt status in order to remove its exposure to imposed asset value erosion.

The Commerce Commission is showing considerably more interest in activities that have not previously been regulated, such as the use of associated businesses for contracted

3 Clause 12.9 of the Network Tasman Trust Deed

work, the numbers of quotes received from external contractors for particular operations, and so forth.

Over the past year, a suite of new information disclosure requirements has been imposed on all electricity distributors – i.e. both exempt and non-exempt companies. The 199-page document (plus companion documents) listing the amendments and associated changes can be viewed at http://www.comcom.govt.nz/regulated- industries/electricity/electricity-information-disclosure/amendments-to-information- disclosure-requirements-2015/

While some of the vast array of information now required to be disclosed will be of value to consumers, much of it is clearly designed by the Commission to assist it in its assessments and inquiries targeted at non-exempt companies.

Over time I would expect this widening of the Commission’s ambit to result in additional commercial rigidities, where the path of least resistance for regulated companies would be to do things like acceding to Commission ‘guidance’ to accept the lowest bid rather than paying more for a proven contractor, and so forth.

(d) Exposure to unpredictable costs

While all businesses face some degree of exposure to the unpredictable, smaller companies are considerably more exposed than larger ones. For example, the loss of one or two large customers will have far more significance to a company with only a handful of such loads than it would have on one of the companies supplying the major urban areas. The resultant costs involve reduced asset loadings, lost direct income, and unenviable pressures to increase costs to other customers while recognizing the pressure that this creates for further customer closures to occur.

The only option that the Commerce Commission is able to offer non-exempt companies placed in such a situation is the provision in the Commerce Act to apply for a Customised Price Path (‘CPP’). Orion is the only lines company that has applied for a CPP to date, and – as was discussed at the public hearing – this resulted in very large costs and an elaborate and protracted process, despite the obvious need to make early and decisive investments following the Canterbury earthquakes. The Commission is aware that the CPP option has not proved appealing to other non-exempt companies, and may attempt to streamline some of the processes. Nevertheless, it is constrained by the requirement of the Commerce Act to provide a standard process for all companies, regardless of size.

I am aware that several of the largest electricity distributors have considered and rejected the CPP option, while Orion’s experience was not an inspiring one. Accordingly, it is fair to assume that NTL would be significantly disadvantaged if an unforeseen event forced it into considering a CPP.

On the other hand, even if it becomes exempt from price/quality control, NTL may face major difficulties in accommodating a major event such as a cyclone or earthquake without simply resorting to price increases. Nevertheless, it would face fewer restraints or uncertainties in taking preemptive steps (e.g. emulating Unison Networks and Transpower in establishing a self-insurance ‘captive’ – both put in place before

regulation was imposed) or in arriving at a ‘rescue package’ based around local capital raising etc.

Other Considerations

Notwithstanding the various economic and commercial issues covered above, I recognize that the group of three larger users, as defined in the Schedule of Rules attached to the Trust Deed, currently enjoys a unique position because it can add its own nominee to the elected Trustees. It is reasonable to consider whether or not removing this privilege would unduly disadvantage larger users.

First, as was raised at the public meeting, Section 54H(3)(c) of Part 4 of the Commerce Act enables “25% of the persons who are non-residential consumers (either by number or consumption of that class of consumer) of the supplier as at that date” to petition the Commerce Commission to have an exempt company brought into the price/quality regime. In the case of the NTL large users group this is a fairly powerful safeguard, as – in contrast to many of the larger electricity distributors – just a small number of large users attached to the NTL network would be able meet the 25% of volume threshold and thus be entitled to petition the Commission. I would expect such a petition to be effective if NTL were to do something that was inconsistent with the consumer-focused Purpose statement of Part 4 of the Commerce Act.

Second, as several submitters alluded to, it is likely that the person nominated by the 3 large users would have specialised knowledge of commercial operations and, probably, of the electricity industry. It is fair to assume that such a person would be able to make a useful contribution to the Trust when it is considering technical or commercial matters.

Here the Trust’s primary roles of representing the interests of consumers, distributing (etc.) dividends for the benefit of consumers, and encouraging and facilitating the company to be a successful business by optimising the return on its assets, need to be considered. These roles are at arms length from the operations of NTL.

The other trusts owning electricity distributors perform similar roles and appear to manage competently, with their trustees all being elected by consumers. Options such as the hiring of specialist advisers exist and, in many cases, trustees with commercial and/or electricity industry expertise have emerged from the election process.

The argument that the presence of a business-nominated trustee acts as a protection against imprudent investments or asset sales fails for those same reasons. In fact, elected trustees are a very appropriate safeguard against an unjustifiable sale of NTL or its primary assets.

On balance, I do not consider the argument that the nomination process is necessary to ensure that the Trust has specialised ‘in house’ expertise to be a compelling one.

Finally, it is not a recognized democratic principle to give what amounts to extra voting rights to a group based on financial substance, however that is measured. In fact, it can be argued that large electricity users by their nature have more commercial negotiating power in contracting for delivered electricity than other consumers, and are adequately

equipped to look after their own interests without being given special status on the Trust.

Conclusion

Given the importance of consumer consultation based on full and frank information, I agree with a number of submitters who suggested that the Trust extend the consultation period now that commentary on initial views is available.

Notwithstanding this, based on my experience I consider that the current exposure that NTL has to additional risks and costs associated with it being locked into the price- quality regulatory regime is significant, and that it would be in the best interests of consumers – and consistent with the objectives of the Network Tasman Trust Deed – to proceed with the proposed amendments to that Deed in order to remove that exposure. In particular, I base this view on the clear additional burdens and pressures that the regulatory regime creates for the few small trust-owned companies that it applies to. Essentially, companies such as NTL do not fit easily into the one-size-fits-all price- quality requirements applying to the much larger electricity distributors.

I do not consider that removing the entitlement of larger users to nominate a Trustee would materially disadvantage them and, while I acknowledge the argument that the three larger users are likely to nominate a person with appropriate commercial skills, my experience has been that the great majority of trusts consistently attract suitably skilled members through the normal election process.

Appendix 1

Regulated Electricity Distributors

Company Reason for non-exemption from regulation

Alpine Energy Not fully trust-owned Aurora Energy Not trust-owned Centralines Operated by Unison Ltd (would not be exempt anyway as 3 of 7 trustees appointed) Eastland Networks An integrated utility group operating in 3 regulated industries (electricity distribution, airports & ports) EA Networks Not fully trust-owned Electricity Invercargill Not trust-owned Horizon Energy Has had broad listed shareholding but status may change Nelson Electricity Not directly controlled by trust Network Tasman One appointed trustee Orion NZ Not trust-owned OtagoNet JV Not fully trust-owned Powerco Not trust-owned The Lines Company Three appointed directors Top Energy Trustees appointed Unison Above Commerce Act size threshold Vector Above Commerce Act size threshold Wellington Electric Lines Not trust-owned

29 Rata Road Hataitai Wellington 6021 AD Jenkins Ltd Phone: 0274 57 5758 E-Mail: [email protected]

Appendix 2

Alan Jenkins: Experience and Qualifications

I have had a long career in the electricity industry and the energy sector, with roles including:

• Chief Executive, Electricity Networks Association (2000-15)

• Adviser to the Electricity Supply Association of New Zealand (1990-2000)\

• General Manager, Ministry of Energy (to the MoE’s dissolution in 1999)

My various roles with the Ministry of Energy included heading its Policy, and Oil & Gas Divisions.

Since my retirement in 2015 I have worked as a consultant via AD Jenkins Ltd, including a contracted part-time role as Executive Officer to Energy Trusts of New Zealand Inc.

I have BA (Hons) and MPP degrees, with the latter including Masters level passes in law and economics.