I. Introduction
1. The Council welcomes the opportunity to provide its comments on this important issue facing Hong Kong consumers. The Council welcomes the Government's view, as expressed in the Consultation Paper, that any future proposals on the development of the electricity market should:
a. ensure that reliable, safe and efficient electricity supply will continue to be delivered to consumers at reasonable prices;
b. address major criticisms and perceived shortcomings of the current regulatory regime; and
c. have regard to environmental concerns.
2. The Council notes that the consultation paper indicates that this is the first stage of a two-stage consultation process, and that the views obtained during the initial stage will be considered when the government formulates proposals on the framework for the future development of the electricity market. Accordingly, the Council understands that the questions to be resolved at this stage will be largely focused on what broad policy direction should be applied to the future development of the electricity market in Hong Kong. In essence, the questions are:
a. whether policies should be developed to introduce competitive forces into the supply of electricity, as against continuing with the current Scheme of Control Arrangements (SCA); and
b. what regulatory measures should introduced to guide the future development of the electricity sector
Consumer Concerns
3. The Council is aware of the findings of a public opinion household survey conducted by the Government on electricity supply in Hong Kong. Although amongst the six aspects of electricity supply, only 35% of consumers considered "low electricity tariff" as the most important while around 50% of consumers considered "reliability supply" more important, 44% of households indicated they would use less electricity if the tariff rate were increased. This implies that electricity cost is a major concern to some consumers.
4. The survey also indicated that around 50% of respondents did not know that the power companies are regulated by the Government, indicating that the regulatory regime is not transparent. 88% of households considered that the permitted return rate for the electricity companies should be adjusted according to the economic situation of Hong Kong implying that electricity costs of the Hong Kong should reflect current economic conditions.
5. With regard to the findings, this current Council submission examines the following issues and makes Council recommendations for the Government's consideration:
a. Future Policy Direction
b. The Extent of Competition
c. Concerns Expressed by Incumbents and Some Commentators on Competition
d. Regulatory Oversight
e. Regulatory Institution
II. Future Policy Direction
Introducing Competition
6. The Council accepts that reliability of electricity supply is of great importance to consumers. The Government Consultation Paper has noted the high reliability rating achieved by both Hong Kong suppliers, Hong Kong Electric Company Ltd (HEC) and China Light and Power Hong Kong Ltd (CLP). However, the paper has also noted that the current SCA regime is not without drawbacks and criticisms of the SCAs arise particularly with regard to those aspects that are less acceptable by the community during periods of economic downturn. The paper notes (at paragraph 2.7) for example:
a. the permitted rate of return of 13.5% on fixed assets and the additional 1.5% on assets financed by shareholders' funds are considered high in present-day economic climate;
b. the permitted return, based on fixed assets, is perceived to have encouraged over-investment;
c. the permitted rate of return fixed over a 15-year period lacks flexibility, as amendments to the SCAs cannot be made without consent of the parties involved; and
d. the annual tariff and auditing reviews lack transparency.
7. Experience has shown that the maintenance of competitive pressures in various markets for goods and services is the best guarantee for ensuring that economically efficient decisions are made in the marketplace. Given the Government's broad policy stance to enhance competition in the economy, the Council believes it is imperative for the Government to consider all reasonable measures to remove market imperfections and distortions that limit market contestability, so as to improve consumer welfare without jeopardising supply reliability and the environment.
8. Whilst the SCA regime has served business and residential consumers well, at least insofar as reliability of service is concerned, the Council believes that the opportunity presented by the SCA review should be used to consider introducing some measure of competitive pressure into the electricity sector as a means of ensuring that Hong Kong's overall interest is best served, if not possible in the near term, then on a long term basis. Such a policy commitment towards introducing competitive pressures would be wholly compatible with the government's policy in previously monopolized sectors. A notable example being the development of competition in the telecommunications sector, which was successfully begun in the early nineties.
9. An important factor in this regard is that unlike many other economies which have had to privatise government owned entities in the reform of their energy sectors, the two electricity producers in Hong Kong are private sector operations and therefore should be well placed to efficiently adapt to any market forces disciplines that are put before them in the future.
Experience in other countries
10. The Council's understanding from overseas experience, is that there are benefits in introducing competition into electricity markets. In Australia, electricity prices in certain states have reportedly been reduced by 25% to 30% since reform. In Japan, tariffs decreased about 11% from 1997 to 2002. [1] Competition in US electricity markets has reportedly resulted in new products being offered to end-users. For example, large end-users are offered interruptible contracts, where reliability is explicitly priced. In some states, end-users are offered "green" electricity, according to which a specified percentage of electric power is generated from specified (renewable) fuels.
11. In the U.K. the energy regulator, the Office of Gas and Electricity Markets (OFGEM) has stated that:
"All customers have been able to change their gas or electricity supplier since May 1999. Since then, over 19 million customers have changed supplier, seeing savings of up to ￡100 on their energy bills. Average energy prices have fallen by 13 per cent in real terms since competition began. The current rate of switching (38 per cent in electricity and 37 per cent in gas) is higher than in any other comparable industry...
As a result of the competitive pressures introduced ... industrial customers have so far saved ￡1.5 billion pounds and domestic customer's ￡500 million pounds in lower electricity prices." [2]
12. While Hong Kong can draw on overseas experience in electricity market reform particularly in the area of 'green' electricity, the Council considers that there are many factors intrinsic to Hong Kong that differentiate it from other jurisdictions. For example, the ownership structure of the incumbents, power sources of electricity generators, and the scope and the scale of the geographic market, all of which will affect the cost of any reform and subsequent benefits to consumers.
III. The Extent of Competition
A fully competitive model
13. The Consultation Paper makes the point that there are no exclusive franchises in Hong Kong and that anyone can enter the sector now by constructing their own generation and distribution systems. However, while there might not be any legal impediments to constructing another electricity generation and distribution system, there are substantial economic constraints such as intensive capital investment with long payback periods, the availability of suitable land for distribution network development and accessibility to the power grid of the two incumbents.
14. Other jurisdictions have deregulated their sectors in order to introduce competition in different ways. The most intensive competitive model is one that creates administrative systems to support wholesale markets (into which multiple generators supply), a common carrier distribution system, and competitive rivalry at the residential and commercial retail level (drawing supply from the wholesale market).
15. Singapore for example, has recently introduced the New Electricity Market (NEM) that has taken over from a previous pooling system to a fully competitive wholesale and retail market based system. Residential consumers in Singapore do not have access to competitive sources of supply at the present time. However, when that does occur, the experience of consumers in Singapore may shed light on the extent to which any immediate benefits might arise to residential consumers in Hong Kong by introducing a similar level of competition.
Competition at the generation level
16. Under the current SOC the incumbents are allowed, upon application to the Government, to make further investments in their generation capacity so as to meet projected demand. The Council believes that when this stage occurs, an opportunity arises for potential new entrants to consider
a. entering the sector by building competing generation plant; and (upon entering into appropriate agreements with the incumbents)
b. accessing the two current distribution networks to reach a viable number of customers.
17. If this opportunity is presented, either of the two following scenarios could possibly eventuate:
18. Firstly, a potential new entrant could identify major customers that could be signed up under individual power purchasing agreements (PPAs) to take its projected generation capacity; and thereby justify the investment.
19. Secondly, a major customer of the incumbents could consider whether it should begin generating its own capacity, and apart from satisfying its own requirements could on sell any spare capacity, either to the incumbents or other commercial parties through a PPA.
20. Whilst introducing competition at this level only is not likely to bring any immediate benefits to residential consumers in the short term, benefits will arise in lowering the costs of commercial interests that can arrange suitable PPAs, with resultant benefits to the economy as a whole; and also laying the foundation for more open competition into the future.
21. The Council believes that in order to bring about benefits to the economy as a whole, it would support the notion of introducing competition at the generation level, and the development of policies that would support access to current distribution systems by new entrants, in order to access customers signed up to PPAs. Scope for competition at this level would be limited to possible competition for new power plants procured against long term PPAs, either by the existing generators or by other customers. Once this is achieved, competition at other levels, such as on selling bulk purchases could be considered into the future.
IV. Concerns Expressed by Incumbents and Some Commentators on Competition
Reliability of Supply
22. The Council notes that in their arguments in support of retaining the current arrangements, the incumbents have raised the issue of reliability of supply and have argued that
a. reliability of supply in Hong Kong is a more critical issue than that which applies in other economies that have deregulated their electricity sectors; and
b. threats to reliability of supply may be posed by firms competing with each other over the same distribution grid. In particular, they have pointed to black out experiences in South Australia and North America as examples.
23. As noted earlier, the Council acknowledges that reliability of supply is a critical issue for Hong Kong, but it would be similar to any other large metropolis with a high concentration of multi storey buildings; such as New York. The real issue is what threats would result from introducing some form of competition into the supply of electricity.
24. In comparison with other economies where competition has been introduced, and supply problems have emerged, it can be seen that there are significant differences between the situation in Hong Kong that diminish the possibility that similar threats to supply will arise in Hong Kong.
25. To begin with, Hong Kong does not have the same geographical characteristics of Australia or North America, or even the UK where there is a widely dispersed power grid over a large geographic area and where the number of physical threats to major grid links, from bushfire, storm damage and accidental breakage, are as great. Hong Kong's distribution system is largely confined to a small condensed geographic area.
26. Apart from technical issues, another concern in jurisdictions that have deregulated electricity sectors has been that since the adoption of competition there has been a tendency towards cost cutting and delays in constructing capacity. This has been raised as an issue in both Australia and North America and the possibility of it arising in Hong Kong has also been suggested.
27. However, it needs to be recognised that both Australia and North America are federal government systems where different states (which are run by separate state governments with incumbent electricity suppliers) contended with each other in the creation of a national market for electricity. Electricity deregulation, particularly in Australia was initially begun on the assumption that a strong national grid was a precursor to a national market. Nevertheless, due to various reasons, possibly state government rivalries in maintaining revenue streams from ownership of utilities, and difficulty in getting planning approval, the initial objective of a strong national grid was not and still has not been achieved.
28. Hong Kong, being essentially a 'city state' does not suffer the same dispersed political and jurisdictional problems, and it can be reasonably assumed that oversight of the sector and coordination of effort will be easier to achieve than in other jurisdictions.
Increased Costs
29. It has been suggested that the introduction of competition increases the likelihood of additional costs in setting up adequate systems and incentives for reinvestment and maintenance to ensure that reliability of supply is maintained, and that the distribution grid in Hong Kong is capable of meeting the demands that competitive supply will bring about. For example, this raises the issue of significantly increasing the size of the interconnector linking HEC and CLP.
30. It has also been suggested that the costs of introducing competition will eventually all be borne by consumers (although the Council does not necessarily accept that this should be the case), and that the benefits will only be achieved in the long run, with resultant increases in efficiency that competitive pressures can be expected to bring to the economy.
31. It is pertinent to note that the consultation paper does not provide any forecasting on what costs might be incurred for different regulatory scenarios, which leaves respondents at a disadvantage in deciding on what position to take. Nevertheless, the Council believes that benefit of the doubt should favour introducing competition into the sector but that more detailed information needs to be provided on the possible economic benefits of competition derived from new entry and expanded interconnection between the incumbents; and the costs that will be incurred to ensure reliability.
32. In this regard, the Council requests that in order to facilitate informed discussions, the Government should disclose their risk assessments about different impacts on the reliability of electricity supply in Hong Kong against different scenarios i.e. limited competition between two incumbents; limited competition between third party generators and the incumbents; or open competition between third party generators and the incumbents.
V. Regulatory Oversight
33. The Council understands that introducing competition into a sector such as electricity takes time and is to be undertaken with caution. This is particularly so where a limited degree of competition is introduced at an early stage and has not reached a level of maturity at which it can be relied upon to meet the expectations of all consumers. The Council would therefore recommend that in the above limited competition scenario, regulatory measures must be introduced to ensure reasonable residential tariffs. These measures cover areas raised in the consultation paper such as tariff review mechanisms, regulating tariffs, permitted rates of return and investment by suppliers.
Tariff review mechanisms
34. Reasonable pricing is a stated objective of Government policy, and the Council understands that a number of possible options were discussed by the Energy Advisory Committee (EAC) in 2002, for example:
a. The pros and cons of utilising a flat rate, time of use rates, and volume discounts; and
b. The process for undertaking tariff reviews.
35. In regard to tariff review processes, a number of options were identified, such as
a. Annual Tariff Review with the Government, i.e. maintaining the status quo
b. Annual Tariff Review with the Government and Making Public Available Information
c. Annual Review of Tariff with Public Hearing
d. More Frequent Tariff Setting Process
36. As for tariff structure, the Council's preliminary observations are that overseas experience suggests a flexible tariff structure is preferable as it could enhance efficiency in energy consumption. In addition, making the information provided to the Government in the tariff review process available to the public, would enhance transparency. An annual review of tariffs could also provide an opportunity for all concerned parties to express their views on pertinent issues; such as the cost data and information submitted by the power companies. Information has not been provided on the deliberations of the EAC on these matters, which would assist in commenting further on the issues involved.
Regulating tariff levels
37. Since the availability of an alternative supply source for a majority of consumers, i.e. from market competition over the near to medium term, does not appear feasible, the only viable avenue within this time frame, in order to ensure:
a. that consumers are being charged optimal available prices from the private sector; and
b. that they enjoy stable supply of power,
is to maintain some regulation over residential tariffs. In this regard, appropriate regulatory processes would be required to identify costs of generation and distribution.
38. There are currently measures in place that unbundle costs of generation and network provision, for the purposes of the SCA that could serve as the basis for these controls. Examples of approaches could be introducing a CPI type price control or a performance based ratemaking scheme for networks drawing on international benchmarking. Such schemes could introduce a performance scheme for generation, which rewards high availability of plant; low operation and maintenance costs; and efficient fuel purchasing (for example by comparing either purchase costs or cost changes to an international index). In addition, references could be drawn to returns that are obtained from comparable, alternative investments such as the rates of return for other utilities.
Permitted rates of return
39. The consultation paper, at paragraph 2.7, has noted that one of the drawbacks and criticisms of the SCA is that the 13.5% rate of return on fixed assets and the additional 1.5% on assets financed by shareholders' funds are considered high in present economic climate. The Consultation Paper provides information on other deregulated economies and notes that in the US, the cost of capital approach is usually applied to determine the permitted rate of return, which is applied to either an asset or equity base. Typical permitted rate of return for vertically integrated investor owned electricity supply utilities is in the range of 6-13%. In the UK and Australia, the regulators do not regulate the return directly but set initial price or revenue caps, leading to typical rates of return for regulated electric utilities in the range of 6-7% and 6-9% respectively.
Perceived over investment
40. The consultation paper also notes that the permitted return, based on fixed assets, is perceived to have encouraged over investment. More information needs to be provided on whether this has actually occurred, and a number of questions arise in this regard, as follows:
a. Would existing generation capacity in Hong Kong verses projected demand enable adequate coverage of supply over a period in time without further capital investment being made until alternative stable supply from the Mainland becomes a reality. Following from this,
i. Would a reduction in or exclusion of new capital expenditure investment be passed through to consumers through reductions in tariff rates?
ii. What is the assessment of associated risk of building a utility supply plant that hinges on the Mainland coming on stream as a stable supplier as well as a better price?
b. What is the understanding of the investment cycle (if any) on the generation/distribution facilities of the incumbents. An understanding of the capital expenditure profile cycle of the industry, to complement an answer to the above question (a) could help to test the boundaries for variation on the existing SCA, such as its continued duration.
c. What is the current margin for back up supply. The fact that CLP is currently able to supply to the Mainland raises a question whether consumers could be paying for over protection of stability.
41. In view of the above issues on reasonable tariffs and over investment, the Council believes a number of questions arise that require further information from the Government.
a. Should CLP and HEC be treated merely as commercial concerns, or should be regarded differently because they provide an essential service that is critical not only for Hong Kong's economy to function, but for the daily well being of its citizens.
b. If the incumbents are to be treated differently to purely commercial concerns, to which utilities should they be compared; either locally or in other jurisdictions.
c. Once their status is established, the government needs to determine whether the current claims and counter claims on returns are justified; on what basis their returns should be measured; and what measures should be introduced to ensure maximum efficiency in providing the service which can in turn maintain downward pressure on costs and retail prices. For example, that the assets identified in calculating allowable returns must be used and useful for supplying into relevant markets.
d. If the incumbents are to face increased competition in the future from other electricity generators, then the basis upon which the above questions can be answered will differ compared to the situation where they both benefit from continuing to remain as electricity supply monopolies within their respective markets.
42. There are a number of ways in which appropriate tariff regulatory measures can be placed on market participants, depending on whether some form of competition is introduced or the SCA is continued with modification. With regard to the latter scenario, the consultation paper does not contain adequate financial/cost data to enable any quantitative/financial analysis on the permitted rate of return under the current SCA as a basis or indicator for what may be optimal permitted rate of return. Without that, given all other key parameters such as
a. ensuring stability of supply;
b. existence of a privately held power sector; and
c. that the lack of alternative viable supply sources is not going to change over the medium term
any comments on matters of consumer protection under an extension to the SCA would as a consequence be difficult to undertake.
43. In view of the fact that the government's consultation exercise is a two staged process and that the main decision now is what broad policy direction the government should take, the Council prefers to give feedback on
a. the regulatory measures with regard to tariffs;
b. as well as other arrangements, for example rules governing bilateral agreements or the establishment of a regulatory framework supported by legislation
at the next consultation phase.
VI. Regulatory Institution
44. The consultation paper raised the question whether the creation of a separate regulatory institution to oversee the electricity sector might be perceived as government intrusion into private business operation. The Council does not agree, given the extent of useful and appropriate regulatory measures that are currently undertaken in the economy; and the importance of electricity as part of Hong Kong's overall energy sector to the well being of citizens and economy as a whole. In fact, the SCA itself is a government mechanism that crosses into the realm of private property and private business operation. Such safeguards are a legitimate response to safeguard public interests that can accommodate both private and public interests; if properly implemented.
45. The concerns expressed by the current private interests are also unconvincing, given the success of the Office of the Telecommunications Authority (OFTA) in overseeing the transition from monopoly to a competitive market in the telecommunications sector. Other advanced economies have constructed similar independent regulatory authorities to oversee their energy sectors. A comparable body would be required, particularly to oversee Government's policy in this sector and to address any problems that might arise in the negotiation stage where a potential new entrant is seeking access to the natural monopoly elements of the electricity distribution network; in similar way that OFTA administers access issues in telecommunications.
46. The Council believes that notwithstanding the different policy directions the government may decide to take in the sector, an appropriate regulatory environment is necessary to allow for a focused approach to meeting not only Hong Kong's future electricity supply, but all energy needs.
47. The Council recommends that the Government should as a matter of priority establish an appropriate regulatory authority to oversee Hong Kong's future energy needs, and the roles it should have. The functions of the proposed authority would be to set an agenda for the energy sector as a whole (including electricity, gas and petroleum based products) and coordinate the various regulatory and policy activities that affect the way in which energy is supplied, distributed and consumed in Hong Kong.
48. It is suggested that the proposed authority should have the following specific features:
a. That the board governing the authority should comprise representatives from government, representatives of users and independent persons with industry expertise. Insofar as industry input is concerned, representatives could be invited to invited to attend meetings of the board to provide input, or sit on specialist committees providing advice to the board.
b. That the authority be staffed by specialists in relevant economic and technical areas who will be recruited specifically for the work of the authority, and not rotated to other government departments as a matter of course.
c. That the authority be tasked with the role of overseeing the energy sector as a licensing body (similar to the role of OFTA) to administer legislation aimed at either introducing more competition into the sector or (if the competitive path is not chosen by the Government) the modification and ongoing administration of SCA type arrangements;
d. That regardless of whether competition or modification of the SCA is chosen, the board's role should be to ascertain the reasonableness of electricity pricing, and to address other concerns raised by the public, such as environmental concerns. In particular, if the SCA is continued, it should be a condition of the SCA that the operators are required to make available full and transparent information to the regulator and to the public that is sufficient to enable adequate debate on matters raised in the SCA.
e. If the SCA approach is chosen, oversight by the board should be made a condition of the SCA arrangements, with specific review periods.
Notes:
1. "Overview of Electricity Markets in Other Economies", Reference Materials - Future Development of the Electricity Market in Hong Kong Stage I Consultation, 2005
2. See www.ofgem.gov.uk website under "Competition Explained"
