The planned review this year by the New Zealand Electricity Authority into the efficiency of distribution network company arrangements will almost certainly address the issue of sector consolidation.
Some in the industry believe New Zealand has too many distribution businesses (EDBs) and that a good number of them lack the scale to provide services at lowest cost. Others argue that the close relationship the small EDBs have with their community is more important than shaving a few cents off electricity bills through greater efficiency. Whatever the precise scope of the Authority’s project, the review is going to attract some heat.
Meanwhile, as we wait for the Authority’s project to start, the results of a similar review in Ontario, Canada have recently come in. The review found that “consolidation is a proven method to curb costs, ensure the broadest adoption of technological innovation and make the necessary funding available at the lowest price”. It recommended a consolidation of Ontario’s electricity distribution sector from 73 EDBs to between 8 and 12 larger EDBs, with consolidation to be completed within 2 years.
There is plenty to be learned from the Ontario review that is relevant to the New Zealand Authority’s project. This article discusses the main lessons.
The Ontario review
The Ontario Distribution Sector Review Panel (Panel) was established to report to the Ontario Government on how to improve efficiencies in the sector with the aim of reducing the financial cost of electricity distribution for consumers. The Government asked the Panel to look at whether a restructured distribution system could lead to price stability, a more efficient and reliable system configuration, as well as fairness and value for money.
Two key factors influenced the Panel’s recommendation that the number of EDBs be consolidated: the potential for cost efficiencies and the need to develop the necessary scale to implement major technological change.
Potential for cost efficiencies
The potential for cost efficiencies is a common rationale for consolidation, with smaller firms having an incentive to aggregate to capture the benefits that come from economies of scale.
The Panel found plenty of evidence that consolidating the number of EDBs would generate cost efficiencies. For example:
- 2011 operating expenditure per customer was, on average, 75% higher for small EDBs (under 12,500 customers) than for large EDBs (100,000 to 500,000 customers)
- financing costs for the EDB shrank as its customer base grew, and
- previous EDB mergers had achieved operating expenditure savings of between 11% and 13%.
The Panel concluded that consolidation in the sector could result in annual savings of $70 per customer in 10 years.
Developing scale to implement technological change
The more interesting part of the review focussed on the capability of EDBs to implement major technological change. The Panel made much of the fact that we are entering into a “new world of electricity” where existing distribution network technology will no longer meet the needs of an increasingly energy-intensive society. It estimated that the investment needed to transform Ontario’s distribution network technology “will cost billions of dollars”.
So what is this “new world of electricity”? More than anything, it is about the smart grid. The smart grid involves “the application of real time information, communication and emerging trends in new power system technologies that will improve capacity utilisation, asset management practices and reliability on the modern network”.1 In other words, the smart grid leverages the rapid developments in communications and information technology to run electricity networks in a way that improves the efficiency, reliability, and economics of electricity supply. The Panel put it this way:
The future for electricity distribution is computerized and data-driven. If this were the recording industry, it would be like jumping from LPs to digital MP3 files.
This future is exciting. Imagine washing machines or fridges with built in Wi-Fi connectivity which allows you to remotely turn those appliances on or off. Or a self-healing network which automatically reroutes power around outages. Picture a smart-phone app which not only tells electricity customers the location of a power outage, but how many people are affected, whether crews are on site, and when power will be restored. In fact, there is no need to imagine – these are real examples detailed in the Ontario review.The Panel considered that the structure of the distribution sector was holding back development of the smart grid and other technology:
The current fragmented nature of Ontario’s electricity distribution system, with its large number of small distributors, is a barrier to the innovation that is needed in the sector, and that its customers deserve.
Essentially, the Panel saw that small EDBs did not have the scale to implement a once-in-a-generation investment in new technology.
Lessons for New Zealand
Like Ontario, the distribution sector in New Zealand is characterised by a large number of small EDBs. Vector, Powerco and Orion serve over half of the 2 million customers in New Zealand, with 26 other distributors serving the rest. Twenty of those distributors each have less than a 2% share of customers across the industry. There are surely some lessons to be learned from the Ontario review.
Lesson one: larger EDBs tend to be more cost efficient
The first lesson is that larger EDBs tend to be more cost efficient, and this should alert us to the possibility that much of the New Zealand distribution sector is not optimally efficient. However, this is a question of fact, and the evidence is at best mixed.
The following graph attempts – in a rather rough way – to show the relative efficiency of EDBs in New Zealand. If the rule that larger EDBs tend to be more cost efficient held true for the New Zealand sector, we would expect to see operating costs as a percentage of the total assets of the EDB decline as the number of customers per EDB went up.
It is difficult to see that this is the case in New Zealand. There is a trend line consistent with the rule, but it cannot be said to reflect a close relationship. And more strikingly, the graph shows a large efficiency range for small EDBs, which suggests that EDB size is not the most significant factor affecting efficiency. Other factors may be playing at least as significant a role, such as the age and physical condition of the respective networks.
The New Zealand Commerce Commission recently came to similar conclusions:2
The level of efficient operating and capital expenditure does not just depend on the scale of network (such as that measured by the number of customers or the length of network) but also on other factors such as changes in the cost of inputs, and other characteristics of distributors, including the condition of assets, the growth in new connections, and the geographic characteristics of a network.
These factors need to be taken into account when assessing a distributor’s efficiency relative to other distributors and a given distributor’s efficiency over time. Without a closer look at these factors, it is not possible to draw any firm conclusions about whether electricity distributors are operating and investing efficiently.
While we need to be alive to the possibility that greater cost efficiencies can be achieved through consolidation, the current evidence isn’t robust enough to base any decisions on. Let’s hope that the New Zealand Authority tackles this issue head on with sound analysis to back its findings.
Lesson two: smaller EDBs may not have the capability to implement game-changing technology
The second lesson is that EDBs need to have sufficient scale to implement the major technological change that will drive us into the new world of electricity. It is sometimes more art than science to know just what “sufficient scale” is, but the Ontario review does give us a useful benchmark.
The Panel received submissions with suggestions for sufficient scale ranging from 500,000 to 800,000 customers per EDB. In the end, the Panel settled on a minimum of 400,000 customers per EDB.
Most of New Zealand’s distributors do not come close to the Panel’s 400,000 figure. Vector (531,000 customers) and Powerco (320,000 customers) are the only EDBs that are in the ballpark. Although Ontario’s population – at 12 million – is much larger than New Zealand’s, this does not affect the relevant consideration which is the size of the customer base needed to spread the fixed cost of service sufficiently to support large scale technological investment.
This suggests that most of our EDBs do not have the scale to push through the technological changes that will propel New Zealand’s electricity system into the new world of electricity. There is a risk that two classes of electricity consumers will develop: those served by EDBs with sufficient scale, and those served by EDBs without scale, with all the attendant disadvantages that entails.
Unfortunately, those EDBs without scale often operate in regions with stunted economic growth, adding a further stress to their economic difficulties.
A case for consolidation exists, but is it politically too hard?
We believe there is a case for consolidation in New Zealand’s electricity distribution sector and will be watching closely to see what comes of the Authority’s review. At the same time, we recognise that restructuring the sector in New Zealand is likely to be more difficult than it is in Ontario.
The Ontario Panel noted that its stakeholders were “not wedded to the status quo” and that there was widespread recognition that significant reform was needed. This is probably not true of New Zealand where local or community control of EDBs is important to Kiwi consumers and where the corporatisation programme of the early 1990s was sold to the public on the basis that ownership would remain in local hands.
Eventually, however, we think that access to new consumer technologies and the other (potentially large) benefits of rationalisation will overwhelm these considerations and generate a constituency for change. Consolidation is likely to be a matter of when, not if.
This article was written by Richard Davidson, Solicitor at Chapman Tripp.