TABLE OF CONTENTS Page Abbreviations vii Terms of Reference viii EXECUTIVE SUMMARY ix 1 INTRODUCTION 1 1.1 Background to this project 1 1.2 Public participation in this project 3 1.3 Report structure 4 2 REFORM OF THE ELECTRICITY SUPPLY INDUSTRY 5 2.1 Early development 5 2.2 Processes of reform 6 2.3 The benefits of reform 8 3 THE NATIONAL ELECTRICITY MARKET 15 3.1 Characteristics of electricity 15 3.2 Development of a national market 16 3.3 Major market participants 27 4 PACIFIC POWER : WHAT SCOPE FOR MARKET POWER ? 41 4.1 Introduction 41 4.2 Defining the relevant market 43 4.3 Indicators of market power 51 4.4 Assessment of market power 71 iii DOES PACIFIC POWER HAVE MARKET POWER ? 5 EXPLOITING MARKET POWER 73 5.1 Balancing capacity and demand in the electricity market 73 5.2 Some key features of the market 76 5.3 How might generators behave in the presence of market power? 89 5.4 Results of economic modelling 98 5.5 The costs of market power 104 5.6 Assessment of the consequences of market power 109 6 OPTIONS FOR ADDRESSING MARKET POWER 113 6.1 Regulatory action 113 6.2 Increasing the capacity of the interconnections 116 6.3 Disaggregation 118 6.4 Summing up 130 APPENDICES A Ministerial correspondence 135 B Participation in the inquiry 139 C Economies of scale and scope 143 D How long will the excess generating capacity last? 155 REFERENCES 161 iv TABLE OF CONTENTS TABLES: 3.1 Electricity generating capacity and output in New South Wales, 1993–94 3.2 Electricity generating capacity and output in Victoria, 1993–94 3.3 Victoria’s interstate trade in electricity, 1993–94 4.1 Estimated market for electricity, New South Wales, 1993–94 4.2 Pacific Power’s estimates of physically contestable electricity market shares 4.3 Electricity and energy consumption in the national electricity market, 1993–94 4.4 Relative capital costs of different generation plant, 1994 5.1 Capacity and peak demand 5.2 Operating characteristics of major generators 5.3 Victorian Pool Price Working Group model results: average scenario pool prices, 1996–2000 5.4 Basis for simulated disaggregation of Pacific Power 6.1 Interconnection augmentation options D.1 Average diversity factors in the four-state region, 1988–93 FIGURES: 2.1 Real prices (selected integrated GTEs), 1989–90 to 1993–94 2.2 Payments to government (integrated GTEs), 1989–90 to 1993–94 3.1 Pacific Power power stations 3.2 New South Wales electricity flows, 1993–94 3.3 Electricity generation in the interconnected system, 1993–94 3.4 Major wholesale electricity purchasers in the four states, 1993–94 4.1 Major interstate transmission linkages in eastern Australia v DOES PACIFIC POWER HAVE MARKET POWER ? 5.1(a) Illustrative winter load trace for New South Wales 5.1(b) Illustrative summer load trace for New South Wales D.1 Forecast electricity consumption and capacity levels in New South Wales, 1994–2006 D.2 Forecast electricity consumption and capacity levels in the four-state region, 1994–2006 BOXES: 3.1 Distinguishing characteristics of electricity 3.2 Objectives of the National Grid Protocol 3.3 Inter-regional hedging 3.4 Generating technologies 4.1 Competition from new entrants using natural gas-fired plant 5.1 Outlook for excess generating capacity 5.2 Spot and contract prices 5.3 Impact of prices bid by Pacific Power: a stylised example 5.4 Some short term gaming strategies 5.5 The United Kingdom experience vi ABBREVIATIONS ABARE Australian Bureau of Agricultural and Resource Economics ACCC Australian Competition and Consumer Commission AESIRB Australian Electricity Supply Industry Research Board COAG Council of Australian Governments ERDC Electricity Research and Development Corporation ESAA Electricity Supply Association of Australia ESIRU Electricity Supply Industry Reform Unit (Victoria) ETSA Electricity Trust of South Australia GTE government trading enterprise kWh kilowatt-hours MW megawatts NECA National Electricity Code Administrator NEMMCO National Electricity Market Management Company NGMC National Grid Management Council OFFER Office of Electricity Regulation (United Kingdom) QEC Queensland Electricity Commission SECV State Electricity Commission of Victoria SMHEA Snowy Mountains Hydro-Electric Authority SMP system marginal price TFP total factor productivity vii TERMS OF REFERENCE Industry Commission Research Project into Implications for the National Electricity Market of NSW Generation Options The Industry Commission is requested to undertake a review of the electricity generation industry in New South Wales to determine the implications for competition of the market power that could be exercised by Pacific Power operating as a single entity. In undertaking this review, the Industry Commission should have regard to the consistency of Pacific Power’s market position in the electricity generation sector with: • the principles for structural reform of public monopolies contained in the Competition Principles Agreement; and • the operation of a competitive national electricity market. In relation to its assessment of market power in the electricity generation industry, the review should specifically examine (but without limitation) the ability of Pacific Power to: • set prices for the market for significant periods of time to increase revenue or profit without engendering actions by customers or competitors which cause it to lose market share; • force an allocation of capacity onto the market so that more efficient plant is kept idle and less efficient plant operates for significant periods of time; • drive out competitors that are more efficient; and • prevent entry of new capacity that is more efficient. The review should assess whether likely patterns of usage and capacity constraints of major interconnectors would contribute to the extent of Pacific Power’s market power in relation to consumers in New South Wales or relevant regions within the State. The review should also consider the implications for electricity consumers and competition of alternative structures of the electricity generation industry in New South Wales, including the trade-off between benefits from a competitive generation sector and the costs association with the possible loss of economies of scale and scope. The Industry Commission is requested to report within 45 days of receiving these terms of reference. viii EXECUTIVE SUMMARY This report assesses the market power that could be exercised by Pacific Power — the nation’s largest electricity generation business — and the implications of alternative structures for the generation sector in New South Wales. The report follows a request by the New South Wales Government to the Commonwealth Assistant Treasurer, asking that the Industry Commission examine these matters within 45 days. A national electricity market Australia’s electricity supply industry is in the midst of far-reaching change. It is evolving from a system in which electricity supply in each jurisdiction was the sole responsibility of a large, vertically integrated publicly owned authority, to a competitive environment in which corporatised and private utilities will compete in the generation and retailing of electricity. Reforms thus far, while not all directed at enhancing competition, have resulted in substantial improvements in efficiency: industry-wide productivity has increased, real electricity prices have fallen, payments to governments have risen and debt levels have declined significantly. Pacific Power itself has achieved productivity increases of around 35 per cent since 1987–88, as well as improving its generating plant efficiency, lowering its prices and increasing its profitability. If competitive pressures can be increased, further improvements in efficiency are possible. To this end, governments are working towards the establishment of a national electricity market, to permit direct competition among generators and among retailers in the participating jurisdictions. At present, only the electricity grids of South Australia, Victoria and New South Wales (including the ACT) are linked, but it is likely that Queensland will also be connected by the time the national market becomes fully operational in 1999. Tasmania may, at some future time, also be linked into the interconnected system. Assessing Pacific Power’s market power The potential gains in efficiency and lower prices from the national market depend on achieving effective competition among the suppliers within that market. In the case of electricity generation, this means first, that each participant would need to minimise its production costs, and second, that no ix DOES PACIFIC POWER HAVE MARKET POWER ? generating company, acting alone or in concert, would find it profitable to price above costs. Otherwise, the loss of market share to rivals (and entrants) would be too great. If Pacific Power had market power, it would have the ability to charge higher prices — whether reflecting higher costs or higher profits — than would be possible under more competitive conditions. Assessing whether a firm has market power is inherently difficult. There is no single indicator or definitive set of procedures that can provide a precise answer. Moreover, there are firms in most markets that will have a degree of market power from time to time. Consequently, assessments of market power, and whether its costs warrant government action, inevitably involve a degree of judgment. The Industry Commission’s approach to assessing Pacific Power’s market power has involved: • defining the relevant markets; • determining Pacific Power’s share

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