NSW Electricity Privatisation, Vertical Integration And The TPA

The Report of the Owen Inquiry into electricity supply in New South Wales, released on 11 September 2007¹, essentially contained three key messages:

1. New South Wales needs to prepare for increased electricity demand and so requires additional, private investment in power generation to secure generation capacity and electricity supply into the future.
2. This would be most efficiently achieved by the Government divesting itself of both its electricity retail businesses and power generation interests.
3. If the Government does not wish to sell generation, appropriately structured long-term leasing of current generation assets would be a viable alternative².

In announcing his government's response two months later, New South Wales Premier, Morris Iemma, said the Government would lease existing electricity generators to private operators, while keeping them in public ownership, and move the retail lists and functions to private operators³.

One of the options being considered in relation to the privatisation of these assets is an IPO of one of the retailers in a vehicle that includes meaningful interests in generation assets. Even if the sale process does not formally staple generation and retail interests, it is likely that bidders will want to acquire both a retail and generating asset.

The Owen Inquiry Report and its recommendations, and the Government's response, brings to the fore the question of vertical integration in the electricity industry and Australia's Trade Practices Act, and the ACCC's long-standing interest in this whole area.

Vertical integration

The electricity industry naturally tends towards vertical integration. Increased vertical integration between retailers and generators is evident, for example, in Australian states that have disaggregated and privatised their electricity assets⁴ through mergers and through direct investment by retailers in generation capacity⁵.

Incentives for generators and retailers to vertically integrate to form 'gentailers' include physically hedging against pool market price risk, acquiring physical assets that provide collateral for financiers and NEM operators, and economies of scale⁶. Cost savings can be directly passed on to the consumer.

The Loy Yang case

Vertical integration can also have anti-competitive effects through vertical foreclosure, however. In Australian Gas Light Company v ACCC [2003] FCA 1525 (the Loy Yang case), for example, the Federal Court considered the bundling of generation and retail providers in relation to restrictive trade practices provisions.

In light of the Owen Inquiry Report and its recommendations, it is timely to consider the Loy Yang case and the Trade Practices Act, and the concerns of the ACCC.

In Loy Yang, the ACCC claimed that the relevant partial vertical integration – the AGL acquisition of a stake in Loy Yang Power – would result in:

• exercise of generator market power as a result of a thinning of hedge markets;
• encouragement of anti-competitive vertical integration by other industry participants; and
• likelihood of exercise of market power by AGL.

The ACCC repeated similar concerns regarding the effects of vertical integration in the electricity industry in 2005⁷.

Ultimately, the ACCC was not able to convince the Federal Court that the AGL acquisition would result in anti-competitive effects. The Federal Court did not reject the possibility of substantial lessening of competition as argued by the ACCC, however, only the likelihood of this effect based on the evidence presented to support the claim.

This is important in the context of any proposed privatisation of the electricity industry in New South Wales.

Where to from here?

The ACCC has recognised that in the UK, where six major vertically integrated generator-retailers were created, prices did come down and vertical integration did not appear to adversely impact electricity prices because appropriate horizontal market structures were in place⁸.

Further, a US report suggests that in a vertically integrated electricity supply, third party independent system operators that control the distribution network can minimise the ability to foreclose⁹.

While the ACCC has consistently demonstrated concern about re-integration following privatisation, there are clearly powerful commercial drivers towards vertical integration.

The battle to retain substantially vertically separated generation and retail electricity markets may already have been lost. The key questions going forward, and especially in New South Wales if the Owen recommendations are implemented, are likely to be around how many vertically integrated gen-tailers are required in a NEM region to ensure a competitive market.

Footnotes

^{1. Owen Inquiry Report into Electricity Supply in NSW (released 11/9/07) http://www.premiers.nsw.gov.au/WorkAndBusiness/DoingBusinessInNSW/OwenInquiryIntoElectricitySupplyInNSW.htm (Accessed 10 October 2007) (Inquiry).}

^{2. Ibid., 7-21.}

^{3. News Release, Premier of New South Wales, Australia: "NSW Government acts to secure State’s energy supply", 10 December 2007.}

^{4. Acacia CRE, "The Effectiveness of the Trade Practices Act to guide mergers in the Australian electricity market", 22 November 2006, 3, 8 & 12 http://www.erig.gov.au/assets/documents/erig/TPA_effectiveness_review_Acacia20070413120417.pdf}

^{5. Ibid.}

^{6. Acacia CRE Report, ibid, n 3, 7. Some of these advantages were claimed by the AGL in the Loy Yang Case as expected benefits of the part ownership of a share in the consortium buying Loy Yang Power, paragraph 197.}

^{7. ACCC, Cross-ownership Rules for the Energy Sector, Submission to Victorian Department of Infrastructure, April 2005, 7 http://www.doi.vic.gov.au/doi/doielect.nsf/2a6bd98dee287482ca256915001cff0c/a2feb1738e8f2535ca256fef001bd78d/$FILE/ACCC.pdf}

^{8. Ibid., 8.}

^{9. Bushnell, J., Mansur, E. T. and Saravia, C., Vertical Arrangements, Market Structure, and Competition: An Analysis of Restructured U.S. Electricity Markets, Centre for the Study of Energy Markets, Working Paper 126, February 2005 (presented to the ACCC Regulatory Conference 2006 – Gold Coast, Queensland), 5.}

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