Contact Energy Pricing in the Invercargill Area

File: RN 2/6/3/1

20 January 2004

Minister of Energy

Contact Energy Pricing in the Invercargill Area - A Case Study

Executive Summary

Nationally, there have been some significant electricity retail price increases over the last two years. This report gives the results of a specific case study, looking at the retailer margin, without investigating the drivers for the underlying wholesale price.

The ultimate question is whether or not the price is fair. If retailers are simply passing on rising costs that they face, then the retail price rises may be reasonable. If the price increases are a result of greater profit being taken by retailers, then the increases may be an indicator of competition failure and are a cause for concern.

Contact Energy has recently increased its electricity retail prices in the Invercargill area. In light of the reaction from the local community, and a preliminary assessment that the retail margin over the line charge appeared relatively high, Contact's pricing in the Invercargill area was selected for a case study.

The report:

- looks at the buildup of the current cost (with a focus on Contact's standard domestic tariff in the Invercargill area),

- looks at how costs are allocated in terms of fixed and variable charges comparing relative contributions from the line company and retailer,

- looks at how the overall price has varied with the changing wholesale price over time,

- makes a comparison with current charges nationally,

- makes a comparison over time with equivalent retail prices offered by Meridian (the only competition for domestic retail custom in the Invercargill area),

- looks at switching as an indication of the effectiveness of competition,

- then draws some final conclusions.

The report concludes, with respect to Contact's charging for domestic customers in the Invercargill area:

- Contact has passed on recent cost increases.

- While the actual return that Contact is getting on its Invercargill customer base is unknown, it would appear that the current domestic tariff will yield a return in the middle to high end of the reasonably expected range based on international benchmarking of costs.

- A volatile wholesale price has affected Contact's margin for Invercargill customers, but the margin that Contact is now obtaining for domestic customers is at a similar level to the margin for the previous retailer before the 1998 reforms.

- Contact does have competition in the area. There is Meridian at the domestic and small to medium enterprise level, and a wider range of retailers for larger customers.

- Contact's market share has been eroded from a position of nearly total dominance 5 years ago as the incumbent retailer to around 65% by volume.

- This suggests that competition is working in the area in the sense that Contact's higher pricing and associated margins are leading to it losing custom.

Contact Energy Pricing in the Invercargill Area - A Case Study

Purpose of Report

1 To report on Contact Energy's electricity pricing in the Invercargill area as a case study on pricing.

Analysis

Introduction

2 Nationally, there have been some significant electricity retail price increases over the last two years. It is considered useful to undertake a specific case study to look at underlying trends.

3 If retailers are simply passing on the costs that they face, then the price rises might be considered reasonable. If these retail increases are a result of greater profit being taken by retailers, then the increases may be an indicator of competition failure and are a cause for concern.

Recent Contact Price Movements in the Invercargill Area

4 Contact retail electricity prices in Invercargill rose by around 13-14% for an average 8000 kWh/annum domestic consumer on 1 October 2003. This increase follows a 9-11% increase in September 2002.

5 There are two network companies supplying different areas in Invercargill (Electricity Invercargill and The Power Company) operated by PowerNet. Contact has separate tariffs in each area. A comparison of Contact's "energy charge" in both areas shows that their Invercargill prices are now in the top 10% of national domestic "energy charges".

Breakdown of Retailer Costs

6 For this Case Study, Contact was invited to outline the basis for their Invercargill tariffs. A verbal presentation was provided to Ministry officials, on a confidential basis. The focus of the presentation was on the current domestic tariff associated with the dominant meter configuration for a consumer in the Electricity Invercargill area. Consequently, this Case Study has a similar focus initially. In addition there was some discussion around the appropriate calculation of line charges.

7 The following table shows a breakdown of Contact's costs in the Electricity Invercargill network area for an 8,000kWh pa domestic consumer. This table assumes that Contact does the minimum of repackaging of costs i.e. fixed costs are passed on as fixed costs, variable costs are passed on as variable costs. It is also understood that there are few costs associated with the "cost to serve" that are variabilised. This table uses Contact's estimate of line company costs to better understand their overall cost breakdown.

Annual Costs excl GST incl GST

Variable Line Cost $ 291 3.64 4.09 c/kWh

Fixed Line Cost $ 190 52.05 58.56 c/day

Energy Component $ 548 6.85 7.71 c/kWh

Meter Lease $ 52 14.25 16.03 c/day

Margin & "Cost To Serve" $ 139 38.11 42.88 c/day

Prompt Payment Discount $ 136

GST $ 172

$ 1,528

Line Charges

8 The Ministry has reviewed the line costs as calculated by Contact. The Ministry monitors line charges set by line companies, and reports these on a quarterly basis. In the case of tariffs administered by PowerNet (and these include tariffs for both Electricity Invercargill and The Power Company), there are some unusual features that complicate the monitoring. Contact and the Ministry use different methods of assessing these charges. The Ministry's approximate method for assessing the variable component was suggested by PowerNet, and has been checked and confirmed by PowerNet.

9 The Ministry calculates the variable line charge to be $276/customer/year compared with Contact's estimate of $291/customer/year (only a 5% difference). Contact uses the GXP (before loss) variable charge and applies "within day and within year shapes and losses" to model a customer profile for peak (day) and seasonal (year) consumption. The Ministry uses a translated "at the customer meter" rate provided by PowerNet, and assumes 75% of consumption is during the day . On an average annual basis, the difference is small and will not be discussed further.

Energy Component

10 The energy component should reflect the wholesale price of energy faced by Contact. There are vagaries in the movement of the spot market price. However, retail operations can be soundly based on fixed price contracts. There is probably around 85% cover of all market sales by fixed price contracts. For large industrial and commercial customers, these contracts would typically be of a 2-5 year term. However, based on the annual revisions of retail tariffs by the various retailers, which cover the bulk of sales, these should be regarded as having a one year term.

11 Contact has advised that Invercargill customers will be the first to feel the full impact of wholesale price increases that occurred at the beginning of 2003. An implication of this is that 6.85c/kWh closely approximates the underlying wholesale cost to the domestic market (in the Invercargill area), at least over Contact's financial year from 1 October to 30 September. This value can be compared with published national fixed price contract indices through appropriate corrections.

a Both Electricity Invercargill and The Power Company use Grid Exit Point pricing, which means that the retailers must absorb local line losses into their charges - this would add about 4% to the price in the Electricity Invercargill area and about 9% in the Power Company area .

b Price comparisons are frequently made using a Haywards reference point (Wellington). Because of transmission losses and the relative location of generating stations, the nodal prices in Invercargill can be about 93.5% of those at Haywards, and are amongst the lowest in the country.

c Further, because of the profile of consumption of a domestic consumer, tending to consume more during periods when the mean spot market price is high (e.g. consuming more between 7am and 11pm and more during winter due to heating requirements), a domestic consumer would be expected to have a roughly 10% uplift in price over a base-loaded consumer as assumed in fixed price contract indices.

12 The price would convert to a 6.4c/kWh price when adjusted to a Haywards nodal price using the corrections indicated above. In contrast, prices obtained by New Zealand Tariff and Fuels (NZTF) Consultants, and as displayed on the Comit-free website, have all been around 7c/kWh since March 2003.

Meter Lease

13 The predominant meter configuration in the Invercargill area is dual meter. The following breakdown of costs (excl GST, on a per customer basis) was given by Contact:

Item Cost (c/day) Qty Total Cost

(c/day)

Meter 4.2 2 8.4

Relay 6.0 1 6.0

14.4

The 14.4 c/day equates to $52 per annum.

14 NGC who owns and leases out a large number of meters (they are one of the largest players in the New Zealand market) has indicated that the cost of dual meters (including maintenance) is between 13.8 c/day and 16.0 c/day. This level of cost is supported by several line companies that lease dual meter arrangements, and by other retailers on a confidential basis. This suggests that the meter costs provided by Contact are reasonable.

Margin and "Cost to Serve"

15 The retailer's cost to service each customer can be broken down into several areas. The typical components that make up the cost to serve are as follows:

- retail operations (process centre costs, call centre costs, postage and billing, payment costs)

- meter reading

- tariff management

- delivery and reconciliation

- retail overhead (e.g. marketing)

- risk management

- IT

The following costs would be expected to come out of the margin:

- capital costs

- compliance costs

- electricity market costs

- bad debts and credit management

- head office overhead allocation

16 These areas are typically customer-specific (i.e. independent of consumption) and so are generally incorporated into a fixed charge. The Ministry is not privy to the actual costs for all the components.

17 Contact's performance expectations are driven by the need to compete for scarce capital and ensure there are funds to reinvest in the business. As such, Contact will seek performance consistent with that for other international investments. In this light it is appropriate to make a comparison with international benchmarks. A bench-marking exercise has been carried out by the Regulator General in Victoria, Australia with a view to regulated prices that would allow adequate returns to retail investors for distribution companies. Similarly a review of regulated retail electricity prices in New South Wales, Australia was undertaken by the Independent Pricing and Regulatory Tribunal of New South Wales. These studies suggest the following would seem reasonable:

- "Cost to serve" - AU$45 to AU$90 per customer pa (equivalent to NZ$50 to NZ$100 per customer pa)

- Net retail profit margin of 1.5 to 2.5% - this needs to cover the cost of acquiring customers.

- Risk management cost of 1.0 to 2.5% - this is required to cover the uncertainties in the competitive market .

18 Taking the combined energy, meter and line company cost in paragraph 7 of $1070, then from the above the combined retail margin and risk management should cost Contact between 2.5 and 5.0%, that is between $27 and $54/customer/year. Adding on the "cost to serve" from the above brings the total benchmarked "cost to serve plus margin" range to $77-154/customer/year compared with Contact's value of $139/customer/year. On this basis, the domestic Invercargill charges are at the high end of the reasonable range in terms of international benchmarking. However, see the following comments on the effects of Low Fixed Charge tariffs on Contact's relative performance.

Comment on the Effect of Low Fixed Charge Tariffs

19 The Government is working to see the implementation of a Low Fixed Charge (LFC) policy. Essentially this policy means that domestic consumers using less than 8,000kWh pa who select the LFC tariff option will pay less than they would on a standard tariff option. To ensure that a retailer remains revenue-neutral, there should be an offsetting increase in either the fixed or variable component of the standard tariff. While an exact calculation of the effect is not possible because of absence of data on customer load profiles, the offset could be of the order of $20-30/customer/year for the situation where all consumers who could change to an LFC tariff do make the change. In practice, only a relatively small proportion of those consumers eligible for this tariff option has taken it up. The implication is that Contact's position relative to the benchmark range calculated above would have been reduced by some intermediate amount, say $5-10/customer/year.

20 To summarise the above points, Contact's combined "cost to serve" plus margin would have been in the range $130 - 135/customer/year compared with a benchmarked range of $80 - 150/customer/year. The conclusion is that Contact's "cost to serve" and margin are in the middle to high end of the reasonably expected range.

Prompt Payment Discount and GST

21 New Zealand retailers are typically offering between 5 and 15% prompt payment discount (PPD), so Contact's 10% discount is normal. GST allowance is required.

Comparison of Retailer and Line Company Charges

22 The following paragraphs compare Contact's charges with the line company charges.

23 In general, both line companies and retailers have fixed and variable components to their pricing. Figures One and Two below illustrate the fixed and variable components of the final retail charge in Invercargill for April 1998 , June 2001 and November 2003. In the figures, the line company costs are shown below the solid line while the balance of costs ("energy" charge ) are shown above the line. In Figures One and Two below, the fixed component of the line charge has been subtracted from the total retail fixed charge. Similarly, the variable component of the line charge has been subtracted from the retail variable charge. Data are based on standard electricity plans, exclude GST, include prompt payment discount and are in dollars per annum for an 8,000kWh per annum consumer.

24 In April 1998, the only fixed charge in the retail tariff was associated with a "line" charge, and there were two variable charges - a "line" and "energy" charge. Following the sale of the retail operations to Contact, the customer saw a retail tariff with fixed and variable components without knowing the relative contributions between line and other retail-related charges.

Figure One: Contact ("Energy" Charge) and Electricity Invercargill (Line Company), Fixed Vs Variable Charge, $ per annum for 8000kWh customer (excl GST and after PPD)

Figure Two: Contact ("Energy" Charge) and The Power Company (Line Company), Fixed Vs Variable Charge, $ per annum for 8000kWh customer (excl GST and after PPD)

25 From the preceding figures it is clear that, despite the transfer of the $52/customer/year meter costs from line charges to retail operations after line-retail separation was effected in 1998/99, the line companies did not reduce their charges. However, this would have directly impacted on the retailer and would have been a cost that they would have an incentive to pass on to the consumer. The significance of this can be seen when it is recognised that by June 2001 Contact had increased its portion of the tariff in Electricity Invercargill area by $99 and in The Power Company area by $52/customer/year.

26 For Contact, the fixed cost component (after deduction of the line charge fixed cost component) equates to $191/customer/year. This converts to a 52c/day charge in comparison with a national average of around 40c/day. However other retailers may be variabilising a greater proportion of their costs to serve customers.

Electricity Prices and Underlying Wholesale Price Movement

27 The following paragraphs look at how the retail costs minus lines costs ("energy" costs) have moved relative to wholesale price.

28 The pseudo "energy" charge (as described above) is usually given as a cent per kilowatt hour figure. So for the typical 8000kWh per annum consumer, cost to serve components, such as meter reading at around $15 per annum which equate to a charge of 0.19 c/kWh, make up a small but significant portion of the overall pseudo "energy" charge. This can lead to confusion when retailers advise a lower actual energy charge compared to industry players who can only determine a pseudo "energy" charge.

29 Figures in this analysis are for an 8,000 kWh per annum customer, exclude GST, are after deduction of PPD and are in cents per kWh. The "energy" charges have been adjusted to a common Grid Exit Point (GXP) to standardise for location, and have then been weighted by customer numbers in each network area to derive a national average.

Figure Three: Electricity Price Movements (for an 8000kWh per annum domestic customer, excl GST and after PPD)

30 Figure Three shows a comparison of Invercargill prices with the national weighted (GXP adjusted) average "energy" charge for incumbent retailers (now referred to as the national average) for domestic electricity since March 1998. The Invercargill prices are also GXP adjusted. The NZTF Fixed Price Contract Index is an indicator of wholesale electricity price movements and is also contained in Figure Three.

31 Invercargill prices have been set about 1c/kWh above the national average since Contact's purchase of the retail business in October 1998, and were around 3 cents above the NZTF index until June 2001. At that time, the NZTF index indicates a significant increase (around 1.5 to 2 cents) in the wholesale electricity price, followed by another similar increase in April 2003. The effect of these wholesale price increases has progressively been passed through in the national average, which has increased, so far, from 6.05 c/kWh in May 2001 to 8.15 c/kWh in November 2003, or 2.10 c/kWh compared to the 3-4 c/kWh increase in NZTF index. Allowing for Contact's previous two increases, the approximate 3c/kWh gap between the NZTF index and "energy" charges in the Invercargill area that existed in late 1998 has now been restored.

32 The national average "energy" price is probably yet to reflect the full increased wholesale electricity costs indicated by the NZTF index.

Comparison with Other Retailer Charges

Price Comparison at a National Level

33 Further comparison of Invercargill prices shows that while the "energy" charges are towards the high end of the distribution, they are still in the range of charges of retailers nationally.

34 Figure Four shows the distribution of "energy" charges (excluding GST) as of August 2003, and Figure Five as of November 2003. It separates retailers that are incumbent, and retailers that have increased prices in the last quarter. As illustrated in Figures Four and Five, "energy" charges have tended to cluster around 6.5-9 cents/kWh, but are now moving toward 7-10 cents/kWh.

Figure Four: "Energy" Charges (GXP adjusted, excl GST and after PPD) August 2003

Figure Five: "Energy" Charges (GXP adjusted, excl GST and after PPD) November 2003

35 Based on the movement of Invercargill tariffs shown in Figure Three, it appears that the "energy" charge paid by Contact's Invercargill consumers has been in the upper range of the distribution of tariffs for at least 5 years (more so for those supplied by The Power Company in this area).

Retail Price Comparison at a Local Level

36 Meridian Energy is a competitor to Contact for domestic retail customers in the Invercargill area (and there are additional competitors for large commercial and industrial consumers). Figure Six shows the relative movement of retail prices for these two competitors (based on the standard domestic tariff). Meridian has been able to generally maintain a competitive advantage over Contact for any consumers who wish to switch.

Figure Six: Comparison between Retailer Prices in Electricity Invercargill (EI) and The Power Company (TPC) Network Areas (excl GST and after PPD)

37 The line companies disclose information on electricity conveyed on behalf of each retailer. This is an aggregate number for each retailer including all classes of consumer. Figure Seven shows the continued erosion of Contact's market share in both Electricity Invercargill and The Power Company areas as consumers across all classes switch to competitors.

Figure Seven: Erosion of Contact Market Share due to Consumer Switching

Conclusions

38 Contact domestic charges in the Invercargill area have been looked at as a case study.

39 It has been found that:

- Contact has now passed on cost increases.

- While the actual return that Contact is getting on its Invercargill customer base is unknown, it would appear that the current domestic tariff will yield a return in the middle to high end of the reasonably expected range based on international benchmarking of costs.

- A volatile wholesale price has affected Contact's margin for Invercargill customers, but the margin that Contact is now obtaining for domestic consumers is at a similar level to the previous retailer before the 1998 reforms.

- Contact does have competition in the area. There is Meridian at the domestic and small to medium enterprise level, and a wider range of retailers for larger customers.

- Contact's market share has been eroded from a position of nearly total dominance 5 years ago as the incumbent retailer to around 65% by volume.

- This suggests that competition is working in the area in the sense that Contact's higher pricing and associated margins are leading to it losing custom.

Recommended Action

This report is for noting.

Brian White

Senior Advisor

Energy Market Monitoring

Resources and Networks Branch

Hon Pete Hodgson

Minister of Energy

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