In doing so, the Auditor-General must appraise and report on those matters which are, or may be, material to the financial soundness of the public accounts and the accounts of individual public authorities. Consequently, when there is a period of substantial structural reform in the South Australian economy, or in sectors of the economy in which public authorities play a key role, Audit must understand that process of reform and consider the risks and benefits that may have an influence on the State's finances. Given this responsibility, Audit has chosen in 1998 to continue its 1997 focus upon the reform of the South Australian Electricity Supply Industry (ESI)¹⁶. It should be noted that the comments herein report the position as at the end of August 1998.

To understand the risks it is necessary to place the current and proposed reforms to the ESI in context. In Part A.3 of my Report to Parliament for the year ended 30June1997 I set out, in some detail, the context, drivers, and nature of the reform of the ESI. Certain information has been reiterated in this commentary in order that the reader is able to more fully understand the background against which developments have taken place.

The following represents a summary of significant factors impacting on the reforms to the ESI. The summary is not concerned with those activities of the Electricity Reform and Sales Unit (ERSU) within the Department of Treasury and Finance relating to the sale of ETSA Corporation and Optima Energy.

Further commentary regarding the developments associated with assets sales is included separately in the Part A - Audit Overview of this Report.

Since 1991 Australian Governments (latterly through the Council of Australian Governments [COAG]), have made a series of decisions in relation to the implementation of the National Competition Policy and related reforms, which have resulted in the restructuring of the Australian electricity industry.

South Australia is party to agreements relating to the reform of Australia's electricity industry including COAG Agreement, June1993; COAG Agreement, February1994; COAG Agreement, August1994; Competition Principles Agreement, April1995; Conduct Code Agreement, April1995; Agreement to Implement the National Competition Policy and Related Reforms, April1995; and Leaders' Forum Agreement, April1996¹⁷.

These inter-governmental agreements required South Australia to:

• restructure the State electricity businesses;
• implement certain regulatory structures in relation to the restructured State electricity businesses;
• participate in the National Electricity Market.

In addition, under the Agreement to Implement the National Competition Policy and Related Reforms the Commonwealth Government agreed to pay to South Australia certain amounts contingent upon compliance with various COAG agreements relating to:

• competition policy;
• electricity reform;
• gas reform;
• water reform;
• road transport reforms;
• national standards.

The primary objective of the reform process anticipated in the various inter-governmental agreements relating to national competition policy and Australia's electricity industry is the introduction of competition into the generation and supply of electricity.

Throughout Australia the electricity industry developed on the basis of vertically integrated government-owned monopoly utilities. Historically, investment by governments in electricity infrastructure and the monopoly characteristics of electricity utilities reflected both the substantial capital investments necessary to develop that infrastructure and the significant economies of scale and scope achieved through the establishment of single vertically integrated businesses. However, by the late 1980s and early 1990s there was considerable momentum for the structural reform of Australia's electricity industry to make it competitive and more efficient.

In 1991 the Industry Commission released its report, 'Energy Generation and Distribution'. At the Special Premiers' Conference in July1991 the National Grid Management Council (NGMC) was established to develop a proposal for a National Electricity Market (NEM). The NGMC recommended the restructuring of government-owned electricity entities in southern and eastern Australia consistent with the 'multiple network corporation (MNC) model'. The MNC model developed by the NGMC involved the restructuring of government-owned electricity utilities to achieve:

• the separation of transmission¹⁸ and distribution functions (network businesses such as ETSA Transmission Corporation and the 'wires business¹⁹' of ETSA Power Corporation);
• the separation of generation functions (generation businesses such as Optima Energy);
• the separation of retail functions (retail businesses such as the 'non-wires' business of ETSA Power Corporation);
• the separation of the system management functions (such as ordering and dispatch of electricity) into a Systems Operator.

The MNC model has been further developed by the NGMC and by the New South Wales and Victorian governments. The NGMC model has been developed into a prototype for the NEM. New South Wales and Victoria, who have pursued the reform of their electricity industries in parallel with the NGMC developments, have adopted fairly similar models. The generic model involves:

• separate and competing electricity generation units;
• the transmission of high voltage electricity through State-based transmission grids which are linked to each other;
• the supply of electricity by competing generators into a central pool (the wholesale market pool);
• the purchase of electricity by retailers and 'contestable²⁰' customers in the wholesale market from a pool, with financial risks managed through bilateral contractual arrangements; competition between electricity retailers who purchase electricity in the wholesale market for the business of supplying 'contestable' customers;
• supply of electricity on a regional franchise basis to household and small business customers who are not 'contestable';
• an open access regime for the distribution of electricity to consumers through the distribution networks of local distributors (ie distributors are required to give access to their distribution networks, [the 'wires'], to competing retailers).

This structure effectively creates two separate major electricity markets:

• a wholesale market in which generators supply electricity for purchase by 'contestable' customers and retailers/distributors;
• a retail market in which retailers compete with each other to supply 'contestable' customers.

Small business customers and householders will not be able to choose between competing retailers until a specified date. Customers who are not able to choose which retailer supplies them with electricity are described as 'franchise customers' because they remain captive to their local regional monopoly retailer.

The Government has announced that all customers in South Australia will become contestable by 2003.

The COAG reform program requires that the eastern States of Australia implement the MNC model and that a national market be developed which allows for competitive interstate trade in electricity.

The NGMC has developed a national electricity code (the NEM Code²¹) which contains detailed principles, rules and procedures for the operation of the NEM. The NEM Code includes requirements on market participants and rules for:

• the operation of the spot market;
• the dispatch of electricity;
• transmission pricing;
• network security.

The NEM Code will be monitored and enforced by the National Electricity Code Administrator (NECA) and implemented by the National Electricity Market Management Company (NEMMCO). The NEM Code will have the force of law in South Australia upon proclamation of the National Electricity (South Australia) Act1996.

The NEM is expected to be operational in late 1998 and South Australia is expected to join the NEM at that time. In 1996, New South Wales, Victoria and the Australian Capital Territory agreed to adopt a staged approach to the introduction of the NEM and have already adopted interstate market arrangements called the NEM 1 and NEM 1 Phase 2²².

In the NEM all electricity generators above a certain size (30 MW) will be required to compete by bidding their electricity output into a 'pool'. In the pool, competitive prices will be set half hourly by the central matching (a Systems Operator - NEMMCO) of generator bids with customer demand. The Systems Operator will also be responsible for dispatching electricity across the transmission network owned by separate transmission network operators in each State (Transgrid, GPU Powernet Victoria and ETSA Transmission Corporation).

The competing retailers will then compete to supply the 'contestable' customers in the retail market. Retail competition will be achieved through an access regime under which the distributor which owns the 'wires' (which provide a connection between the high voltage transmission network and the customer premises) is required to provide retailers with access to the distribution network. Retailers/distributors will also supply the franchise customers using the electricity purchased in the competitive wholesale market.

The NEM Code directly regulates all aspects of A and D and contains principles for the State/Regional regulation of E and F.

The South Australian Government has a direct interest in the electricity industry in its role

as a:

• generator, through its ownership of Optima Energy;
• transmitter, through its ownership of ETSA Transmission Corporation;
• distributor, through its ownership of ETSA Power Corporation;
• retailer, through its ownership of ETSA Power Corporation.

In addition, the Government has, and will have, a role in the regulation of the industry within the State.

My 1997 Report observed that there were five broad categories of risks associated with the implementation of the NEM. The risks can be categorised as:

Audit recognised that there are many opportunities available to both the South Australian Government, the ETSA corporations and Optima Energy to manage the risks associated with the entry of South Australia into the NEM.

Further, the maintenance of effective risk management approaches, systems, processes and procedures by both the corporations and the central government agencies to support the established control framework will be crucial to the satisfactory management of those risks.

Since last year's Report there have been significant developments in both the move towards the NEM, and the management of risks associated with the approaching national electricity market. As a result, the remainder of this commentary on electricity reforms in South Australia focuses on:

• developments that have taken place in 1997-98;
• the current status of the State's preparedness for the commencement of the NEM;
• some specific matters that Audit considers need to be addressed as part of the NEM.

As indicated previously, the operations of the NEM are to be governed by the NEM Code which contains detailed principles, rules and procedures for the operation of the NEM. The NEM Code also includes derogations to allow jurisdictional based arrangements, which depart from the requirements of the NEM Code, to continue either over a transitional period or indefinitely. State and Territory governments retain responsibility for environmental issues, retail arrangements and general electricity industry regulatory issues.

Under the Trade Practices Act 1974 the Australian Competition and Consumer Commission (ACCC) is required to authorise the NEM Code on the basis that the public benefits of the arrangement outweigh any anti-competitive aspects that the NEM Code may contain.

In December1997 the ACCC granted authorisation of the NEM Code subject to a number of conditions associated mainly with jurisdictional derogations. These conditions are being actioned by the relevant bodies and jurisdictions as part of the preparations for market commencement.

At the time of making these observations the NEM Code had been lodged with the ACCC for final authorisation.

The authorisation of the NEM Code by the ACCC represents a critical step in the move to commence the NEM as it formalises the rules that underpin the market. Knowledge of the rules will allow those responsible for the practical implementation of the NEM to appraise the risks that go with the market.

In February1998 the South Australian Government announced proposed reforms for the South Australian electricity supply industry involving the restructure and sale of ETSA Corporation and Optima Energy. The Government indicated that the reforms, to be completed over a two year period, will consist of three stages, namely:

• a three month preparatory period for information gathering and for a detailed study of proposed market reforms and business structures;
• a period of implementation of the reforms and for restructuring ETSA Corporation and Optima Energy over three to nine months;
• the sale of the businesses over approximately a one year period.

To facilitate the reform and sale process the Government established an Electricity Reform and Sales Unit (ERSU) within the Department of Treasury and Finance.

On 30June1998 the Government released further details of the proposed restructuring and sale process. Elements of the proposed restructuring process were:

• subdivision of the generation function into three competing businesses and the provision of incentives for the construction of a new power station;
• creation of a Gas Trader Company to manage the existing gas contracts and trade in gas;
• separation of the transmission entity from ETSA Corporation;
• establishing the distribution and retail functions of ETSA Power Corporation as separate subsidiary entities;
• establishment of an Independent Regulator and an Energy Industry Ombudsman (to be funded by industry);
• creation of a sustainable energy development agency (to be funded by industry);
• establishment of a regional transmission and capacity planning entity within Government.

The Electricity Corporations (Restructuring and Disposal) Bill1998 was introduced to Parliament in March1998 to facilitate the restructure and disposal of the Government owned corporations associated with the supply of electricity in South Australia. In addition, further legislation was introduced into Parliament in July 1998. This legislation comprised:

• Independent Industry Regulator Bill 1998;
• Sustainable Energy Bill 1998;
• Electricity (Miscellaneous) Amendment Bill 1998.

While there is now greater certainty in the rules underpinning the operations of the NEM, many of the underlying risks that were discussed in my 1997 Report, and which were described previously in this commentary, still remain. Many of the developments that have taken place, including the Government's announcement on 30June1998, represent an approach to the management of those risks.

As the commencement of the market nears, the importance of continuing to identify and implement arrangements to manage those risks and receive the benefits of industry reforms will become a key issue for the State of South Australia.

In developing an understanding of both the risks to the industry participants, and the benefits associated with electricity reforms, it is important to recognise that the ESI incorporates discrete functions eg generation, transmission, distribution and retail. Each of these functions requires independent analysis of the risks and benefits attributable to that function. To analyse risks for the ESI as a whole can be misleading. It is important, therefore, to separately identify the risks (and the impact of those risks) associated with the generation, transmission, distribution and retail functions of the ESI.

Further, such analysis needs to recognise the extent to which the discrete industry functions impact on the cost of electricity. For example, the following chart provides an indicative cost break-up of the final cost of electricity to a household or small business:

Source: NEMMCO National Market Implementation Education Program

Consequently, the risks and benefits of electricity reform need to be considered in the context of the respective functions of the industry. While it might be relatively simple to introduce competition between retailers (particularly given the low barriers to entry), the impact of increased competition amongst generators is likely to be more critical. On the other hand, it is necessary to consider regulatory risk. Given that more than half of the final cost of electricity (and an even higher proportion of likely returns) is represented by the cost of transmission and distribution, the regulatory risk with respect to those industry functions is high and must be a significant consideration in determining the benefits to be achieved from the reform process.

When the concept of the NEM was established, a competitive NEM was expected to commence in July1995. Although that original date was not met, an interim market comprising NSW, Victoria and the ACT started in May1997. The full market (including South Australia) was rescheduled to commence in March1998. The commencement was deferred to May1998, and has since been deferred further. At the time of preparation of this Report, the commencement date is expected to be November1998.

Audit notes that, to ensure a smooth transition to the NEM, a trial of all systems associated with the operation of the national market will be initiated by NEMMCO in September 1998.

Whilst a number of critical issues affecting the delay are not attributable to, nor are they the direct responsibility of, South Australia, there remains a number of key steps to be undertaken before the market can commence in South Australia.

To manage these key steps, the Department of Treasury and Finance engaged consultants to review and report on South Australia's jurisdictional readiness. The review included an assessment of:

• South Australia's published and/or proclaimed legislative, regulatory and administrative arrangements to enable the State's participation in the NEM;
• the remaining critical tasks as required under the National Electricity Law and the NEM Code to ensure that South Australia is ready to participate and perform functions critical to the successful operation of the NEM.

The review conducted in March1998 identified a number of outstanding issues, including:

• requirements under the National Electricity Law;
• South Australian regulatory issues, including the appointment of a pricing regulator;
• clarification of regulatory responsibilities;
• areas where existing legislation may be inconsistent with the National Electricity Regime;
• the determination and announcement of the contestability timetable;
• obtaining satisfaction that NEMMCO's market systems perform in an acceptable manner in relation to market operations and security;
• obtaining satisfaction that NEMMCO is adequately staffed and equipped to effectively discharge its system security responsibilities.

The resolution of the outstanding issues is being managed through the Electricity Reform and Sales Unit. At the time of preparing this commentary Audit was advised that:

As South Australia heads towards participation in the NEM, there are a number of issues which Audit considers need to be addressed by the Government. In some cases these issues will need to be finalised prior to the commencement of the NEM, while others will need to be considered in terms of the consequences of entering the NEM.

As noted previously, on 30June1998, the Government announced a number of initiatives associated with the proposed restructuring and sale process for the Government owned electricity corporations. The approach adopted in the preparation of this commentary has been to identify a number of key issues, and, where the resolution of the issues may be achieved by the proposed reforms, to recognise how those reforms may impact.

A discussion of the major issues follows.

Audit notes that the introduction of competition into highly regulated monopoly industries (particularly those with a history of government ownership) has required government intervention to restructure those industries and to introduce competition in a phased manner.

A potentially substantial risk to consumers can arise where governments seek to reform publicly owned utilities at the same time as putting those businesses up for sale. The public policy objective in the introduction of competition is to enhance the long term interests of consumers through lower product prices. In adopting this approach, it is possible for the introduction of competition to devalue the Government's investment in those utility businesses.

Alternatively, the maximisation of a sale price can also be to the detriment of consumers as any purchaser will be looking to obtain a suitable return on investment through prices charged for the product.

The Deputy Chairman of the ACCC, Mr Allan Asher, has recently commented upon the possible tension between the implementation of national competition policy and State-based privatisation programs in an article published in the APPEA Journal:

When South Australia enters the NEM, Audit has been advised that transmission and distribution charges will be regulated as follows:

• Transmission revenues and prices · will be determined in accordance with an electricity pricing order issued by the Government until January 2003. From January 2001, the ACCC will commence the regulation of transmission revenues and prices, as provided for under Chapter 6 of the NEM Code. However, transmission prices will remain averaged throughout the State until January 2003 under the terms of South Australia's derogations to the Code, consistent with the pricing order.
• Distribution revenues and prices will initially be determined in accordance with an electricity pricing order issued by the Government. In the longer term (post 1 January 2003), distribution prices will be regulated by the South Australian Independent Industry Regulator ·²⁵

Although the industry regulator will be State based:

• the ACCC and the COAG Competition Principles Agreement require the regulator to be statutorily independent of the Government;
• the regulator will be required to regulate distribution charges in accordance with principles and guidelines set out in Chapter 6 of the NEM Code.

As a result of this regime, there is potential for a regulatory risk to arise from any conflict between the current pricing structures and the requirements of the pricing rules contained in the NEM Code.

Chapter 6 of the NEM Code requires the introduction of what is referred to as 'cost-reflective network pricing' or CRNP. CRNP requires the transmission and distribution charges paid by individual customers to be calculated on the basis of the costs of supplying those services. Where customers are located in sparsely populated remote rural areas, the cost of transmitting and distributing electricity to and within those regions is higher than such costs in densely populated regions located close to the area of supply.

Historically in Australia, transmission and distribution charges levied on customers (as a component of their total electricity bills) have not been cost-reflective. Customers have generally been charged on a 'postage-stamp' basis. That is, they have paid prices which contain transmission and distribution components that have been the same irrespective of where they live. Where customers have been charged on a 'postage-stamp basis', the introduction of CRNP may require distributors to increase prices in remote and sparsely populated areas. Queensland, Victoria and New South Wales have or are introducing CRNP in a staged manner in order to prevent 'price shocks' to customers.

South Australia had sought from the ACCC acceptance of a number of derogations from the operation of Chapter 6 of the NEM Code. In particular, South Australia had proposed a series of network pricing derogations which would have run from the year 2000 to the year 2010 on the basis that differential prices would have adverse economic and social impacts on customers in rural regions without any offsetting competitive benefits. Those proposed derogations would have deferred the application of CRNP.

While the NEM Code requires the introduction of CRNP, the future operation of this requirement is uncertain. The NEM Code was authorised by the ACCC in December1997, subject to certain amendments including some to Chapter 6 (dealing with transmission and distribution pricing).

NECA is currently undertaking a review of Chapter 6 and consequently businesses such as ETSA Transmission Corporation, ETSA Power Corporation and Optima Energy face considerable uncertainty with respect to the future rules under which transmission and distribution charges will be regulated.

In its December1997 determination on the NEM Code, the ACCC rejected one of the proposed South Australian transmission pricing derogations relating to the sunset date of 2010 and stated:

The South Australian Government has now agreed that the derogation will have a sunset date of 31 December 2002. A revised derogation has been submitted to the ACCC for approval.

If the Government chooses to continue the existing policy of 'statewide' pricing for transmission and distribution charges, it may be necessary to make payments out of the Consolidated Account to meet what can be described as a community service obligation (CSO). The extent of any CSO will be dependent upon the extent to which the CRNP is used to set electricity prices throughout the State of South Australia.

As indicated previously, the ACCC has a key role in the determination of network charges, both with respect to transmission assets (directly) and distribution assets (indirectly).

The NEM Code envisages that the ACCC will develop a set of guidelines outlining how its powers to regulate revenues will be exercised. In this context the ACCC is currently finalising a 'Statement of Regulatory Intent' for the regulation of transmission revenues, covering such aspects as the determination of:

• the asset base and its valuation;
• fair rate of return on assets;
• operating and maintenance expenditure.

Given that the major returns in the ESI currently come from returns on transmission and distribution infrastructure, the outcome of the above and similar reviews are likely to have a material impact on the profitability of the transmission and distribution businesses.

As an example, a recent draft determination by regulators in another jurisdiction (the ACCC and the Office of Regulator-General, Victoria) proposed to reduce the weighted average cost of capital from 10.9 percent to 7 percent in calculating the regulated rate of return allowable for certain gas transmission and distribution assets. While the weighted average cost of capital relevant to gas pipeline assets in Victoria may not be relevant to electricity transmission and distribution assets in South Australia, the example does demonstrate the degree of regulatory risk borne by asset owners in the gas and electricity industries.

In April1998, the Government published a Notice of Prices for Network Services for the period from the start of the NEM to 30June1999. Any variation to the weighted average cost of capital implicit in the prices established in that Notice will have an impact on the value of the State's electricity Network Services businesses.

'Blackhole' money refers principally to the settlement surplus that results from NEMMCO receipts and payments not being equal, due to a difference in regional pool prices.

Due to a number of factors, including surplus generation capacity and lower fuel costs in the other States, South Australia currently imports a significant quantity of power from Victoria using the 500 MW interconnector. Audit understands that the settlement surpluses arising from the South Australia - Victoria interconnector may be in the order of $80 million per year but this amount will be dependent upon actual pool prices and the quantity of electricity imported into South Australia.

In accordance with the NEM Code, NECA, which is responsible for making the final decision on the allocation of the settlement surpluses, has established a panel to consider a recommendation made by NEMMCO as to the manner in which the surpluses are to be distributed.

The recommendation of NEMMCO, which was made after consultation from all interested parties, was that surplus settlement revenues be allocated across a particular interconnect in accordance with the value of the interconnect assets in the two regions. In the case of the South Australia-Victoria interconnect, this would result in approximately half of the surplus settlement revenues being allocated to Victoria.

The extent to which settlement residues are allocated to South Australia will have an effect on the average cost of electricity to South Australian retailers and consequently the consumers of that electricity.

At the time of preparing this commentary NECA had yet to reach a final decision.

Reform of the Australian electricity industry must be understood in the context of reform of the gas industry. This is particularly the case in South Australia where approximately 50percent of all electricity generated by Optima Energy is fuelled by gas.

This percentage is likely to increase if the proposed new gas-fired power station is built.

Gas is both a fuel source for the generation of electricity and competes with it as a source of energy to end-users. Technological change, particularly in low cost gas-fired electricity generators and co-generators (where gas is used as the input into generation plants which produce both electricity and other by-products such as steam) increasingly means that it is economic for large industrial energy users to build mini-co-generation plants, using gas as the input, to supply their energy needs.

Over time, this technological change and reforms to both the electricity and gas industries may mean that instead of having separate electricity and gas markets a single energy market may eventuate in South Australia particularly for large energy users.

In South Australia, reform of the gas industry is also fundamental to the introduction of competition in the generation of electricity as new electricity plants may use gas as the input fuel rather than coal.

The building of either co-generation or gas-fired plants will be dependent upon both Optima Energy and new entrants obtaining a secure supply of gas. Because of the fundamental role played by gas as a necessary input for co-generation and gas-fired electricity generators, the future of the South Australian electricity industry is inextricably linked with reform of the South Australian gas industry.

Recent Government reforms relating to the ESI included the announcement that a Gas Trader company was to be established to manage the existing gas contracts of the electricity corporations and trade in gas. The objectives of the Gas Trader will be to:

• profitably manage the current gas purchase, haulage and retail sales contracts of the ETSA corporations and Optima Energy;
• supply Torrens Island Power Station and the proposed new gas fired power station;
• seek new customers, including new entrants to the South Australian electricity generation industry;
• source new supply contracts from existing and new gas fields and pipe contractors.

A significant risk faced by consumers of electricity will arise from the potential market power of Optima Energy. If Optima Energy has market power in the supply of electricity in the South Australian wholesale market, it will have the ability to control the price at which it supplies that electricity without being subject to the constraint of competition.

In its 1996 report, 'Electricity Industry in South Australia', the Industry Commission at page119 observed:

The main reasons the Industry Commission believed that ETSA Generation would have market power were:

• the base load of demand in South Australia rarely fell below 800 MW while the maximum capacity of the South Australia - Victoria interconnector was 500 MW; consequently ETSA Generation would always be able to set the price of the 300 MW in respect of which there was no alternative source of supply;
• transmission losses incurred in the transmission of electricity from Victoria and South Australia can be up to 18 percent which places a 'wedge' between the price of electricity generated within South Australia and electricity imported from Victoria. This 'wedge' gave ETSA Generation a price advantage over the Victorian generators.

When the ACCC authorised the NEM Code in December1997, it recognised that the presence of market power could be a factor limiting the public benefit from the new market arrangements. Further, the ACCC noted that such power existed in South Australia.

Consultants appointed by the ACCC identified that:

While the ACCC recognised that the initial reforms of the ESI market structure were a matter for individual jurisdictions, it did urge the South Australian Government to consider effective regulation of electricity generation in this State.

There are, however, a number of other mechanisms available which could impact on Optima Energy's market power including:

• subdividing Optima Energy into competing generating companies;
• imposing 'vesting contracts' on Optima Energy which fix the price at which it supplies electricity to ETSA Power Corporation;
• prohibiting Optima Energy from expanding its generation capacity until such time as there is new privately owned generation capacity built in South Australia or the capacity of interconnectors between South Australia and other States are expanded;
• establishing an interconnector between South Australia and New South Wales.

On 17February1998 the Government announced that Optima Energy was to be subdivided into competing generating businesses.

The Government has also indicated that:

In addition, on 30June1998 the Government announced that it would provide incentives to establish an extra 500MW of generation capacity within the South Australian region.

On the other hand, the proposed establishment of a South Australia-New South Wales interconnector (previously known as Riverlink) was rejected by NEMMCO as a regulated asset in the short term as it was deemed that it would not maximise the benefits to customers.

A further risk faced by the South Australian electricity supply industry, and through it the citizens of South Australia, is the risk that demand for electricity will exceed available supply.

Prior to the NEM, accountability for supply reliability and system security remained with each State Government and the electricity industry in that State. Supply reliability and system security was therefore managed on a State by State basis. The States determined the need to invest in additional generation capacity and electricity networks to meet public expectations regarding the reliability of electricity supply.

Reserves, primarily in the form of additional generating capacity, were used to reduce the risk that electricity consumption would need to be interrupted in response to a power system contingency. For example, to ensure sufficient generation capacity in 1997-98 South Australia installed new gas turbines at Snuggery and Port Lincoln and improved the output on hot summer days of the Playford B Power Station at Port Augusta.

In the NEM, the reliability of supply is expected to be determined by market forces. However, the importance electricity holds in the community is accounted for in the NEM Code by means of:

• NECA's establishment of a Reliability Panel to determine the power system reliability standards to apply in the NEM and guidelines for market intervention by NEMMCO;
• NEMMCO's power, for a transitional period, to contract with market participants to provide sufficient reserves to meet the prescribed reliability standards.

In addition, upon commencement of the NEM an annual Statement of Opportunities will be prepared by NEMMCO to provide market participants with information to assess the need for additional capacity in the NEM. This is consistent with the approach to be taken in the new market that:

As an interim measure to the requirement to provide a Statement of Opportunities, NEMMCO has published a paper on the Summer Outlook for the Interconnected Power System of Victoria, South Australia and New South Wales.

With respect to the situation in South Australia there have been a number of views as to when additional supply may be needed in the region, including:

• the Industry Commission at page 40 in its 1996 Report, 'The Electricity Industry in South Australia', stated that:

• the Premier of South Australia in a speech on 1 December1997 indicated a shortfall in peaking capacity was predicted in the year 2001;
• the NEMMCO paper on the Summer Outlook for the Interconnected Power System of Victoria, South Australia and New South Wales concluded that there is a high probability that there will be sufficient reserves in South Australia in 1998-99 and possibly further. The issue of capacity beyond the 1998-99 year is to be addressed as part of the Statement of Opportunities to be issued by NEMMCO in March1999.

In introducing competition to the South Australian electricity industry the South Australian Government and consumers will be relying, to a large extent, on market forces to address the issue of expansion of capacity.

Notwithstanding this, the Government has identified a need for additional monitoring outside the market mechanisms. On 30June1998 it announced that as part of the electricity reforms to be implemented, the Government would:

• provide incentives for the construction of a new 500 MW gas-fired power station by 2002;
• establish its own regional transmission and capacity planning function to monitor the need for system upgrades to ensure security of supply throughout the State.

Such initiatives demonstrate that, at least in the short term, the Government recognises the need for active involvement in an area which the NEM Code expects to be driven by market forces. Such involvement will require the Government to carefully balance its responsibilities to ensure the secure supply of an essential service without compromising the operation of market forces.

Irrespective of the effectiveness of competition in the generation and supply of electricity the functions of transmission and distribution of electricity (the 'poles and wires') will remain as monopolies. The activities of transmission and distribution of electricity are 'natural monopolies'. That is, the economies of scale that could be achieved in the provision of these services are so significant that it would be grossly inefficient for an entity to duplicate the infrastructure in order to be in a position to introduce competition.

In South Australia the transmission network is owned and operated by ETSA Transmission Corporation while the distribution network is owned and operated by ETSA Power Corporation.

The ESI reforms address the risks to consumers in the monopoly supply of transmission and distribution services by imposing, in Chapter 5 of the NEM Code, requirements upon operators of transmission and distribution systems to maintain those systems in a 'satisfactory operating state'. However, there is no clear definition in the NEM Code as to what that state is. Audit understands that the Independent Regulator will be required to set standards in this area, and these are to be backed up with fines for non-compliance, together with the potential for loss of licences.

Audit considers that the establishment of well defined performance standards for network assets, together with appropriate penalties for non-compliance will be critical.

Such standards will ensure that conflicts are avoided between:

• the application of commercial asset management decisions aimed at maximising returns to the network owners;
• the expectation of consumers relating to the availability and quality of electricity supplies.

For consumers purchasing electricity in the retail market, the ability to choose between competing suppliers will be introduced in a staged manner. At the time of preparing this commentary, Audit was advised that the contestability timetable for electricity was as follows:

Small consumers of electricity face additional risks on the entry of South Australia into the NEM as a consequence of the practical and economic impediments to the introduction of competition.

In Victoria and New South Wales the introduction of contestability in the supply of electricity to large volume consumers has involved the installation of 'smart meters'. 'Smart meters' measure electricity consumption in half-hourly periods and can be 'remotely' read using electronic means. The installation of 'smart meters' means that a consumer can be charged for the electricity consumed on the basis of time of consumption and permits the accurate real-time measurement of consumption. Where a contestable consumer enters into a supply agreement with an electricity retailer which is not the local electricity retailer, real-time measurement of consumption is necessary to allow the contracted retailer to pay for the cost of supplying the electricity to the consumer using the local distributor's 'wires'.

Audit understands that 'smart meters' are expensive. Because of the small volumes of electricity consumed by small customers, it may not be economic to install 'smart meters' for these classes of consumers. One interstate study identified that where a 'smart meter' was installed, the metering costs could be in excess of $600per year for a customer.

A major project has been initiated under NEMMCO to consider the metering options for smaller customers in the NEM, but if reasonably cheap solutions are not developed, small consumers may tend to remain captive to their local electricity retailers. Consumers who are unable to choose their electricity supplier are referred to as 'franchise customers', and, as they have no choice in selecting their electricity supplier, may be exposed to the risks of monopoly prices.

Audit understands that the prices to franchise customers are likely to be regulated through an Electricity Pricing Order (EPO), such that during an interim period (until the end of 2002) prices will rise by no more than inflation. This will be achieved by the use of 'vesting' contracts between the retailer (currently ETSA Power Corporation) and the Government owned generator (Optima Energy).

• Quality and reasonableness of supply - In the UK standards have been set for performance covering customer services such as restoration of supply, account enquiries, appointments and meter reading. Some of the standards are 'guaranteed' and backed by financial penalties. In New South Wales, the conditions attaching to licences require retailers to participate in the development of industry codes of conduct and to adopt the Customer Charter Code. The Customer Charter Code requires retailers to establish a customer consultative group and standard form contracts. Victorian retailers are required, as a consequence of licence conditions, to comply with a range of codes of conduct which set minimum business standards. These standards include quality and reliability of supply, debt collection and billing practices, standard form contracts, and customer complaint handling mechanisms.
• Certainty of supply - In the current market arrangements in both New South Wales and Victoria local distributors must act as 'suppliers of last resort' for all customers. Under the Electricity Supply Act1995 (NSW), where other retailers are unable to supply customers, for whatever reason, the local distributor is required to supply the customer. New South Wales is in the process of developing a Code of Practice for suppliers of last resort.

In South Australia such formal processes have yet to be established. However, the recent reforms announced by the Government include a regulatory framework which is intended to safeguard the interest of consumers. This includes the establishment of an Energy Industry Ombudsman and an Independent Regulator, whose role will include the monitoring of specified performance standards.

Audit considers that the development and implementation of the performance standards prior to the commencement of the NEM is essential to ensure that the rights and obligations of both customers and other industry participants are recognised.

One of the most significant consequences of the electricity reforms is the opening-up of the South Australian electricity supply industry to new entrants. Entry of new participants in the South Australian electricity supply industry may occur for different functions in the industry, and includes:

• new State-based generation capacity;
• new suppliers of electricity into the wholesale market pool through additional interconnection with other regions;
• new electricity retailers supplying retail customers;
• self supply by large volume electricity consumers.

The likelihood and consequences of new entrants need to be assessed separately for each of the industry functions.

At the generation level, Optima Energy will face competition in the supply of electricity into the wholesale market. Under the NEM Code, Optima Energy will be required to dispatch its output into the wholesale market pool by bidding in the spot market. Similarly, new entrants in the form of new State-based generators will compete with Optima Energy in that spot market and may take market share from Optima Energy.

While Optima Energy will be required to dispatch electricity into the wholesale market pool, it may also choose to enter into bilateral financial contracts with purchasers in the wholesale market. Optima Energy will also compete with other sources of supply in winning bilateral financial contracts in the wholesale market.

However, in the short term there are factors which immunise Optima Energy from the risk of loss of market share, including:

• the tight balance between the supply of, and demand for, electricity in South Australia;
• the limited capacity of the Victorian-South Australian interconnector;
• the lead time in the commissioning of new generation facilities.

As the competitive South Australian electricity supply market matures, it is likely that Optima Energy will be subject to increasing market pressures from alternative suppliers.

At the retail level, ETSA Power Corporation is likely to face substantial competition in the retailing of electricity to contestable customers. Once South Australia enters the NEM, new entrant retailers will be able to participate in the market and compete with ETSA Power Corporation for contestable customers.

While it is impossible to predict how many contestable customers ETSA Power Corporation may lose to new entrants, the number of lost customers may be significant if the experience in Victoria and New South Wales is replicated in South Australia. The Electricity Supply Association of Australia (ESAA) has reported that in New South Wales and Victoria (with 25retailers competing for around 5500 contestable customers) more than 55 percent of customers have changed their retailer since the market began in those States.

The nature of the structural and competitive reforms to the South Australian electricity supply industry are likely to mean that the financial consequences of poor management are greater than those that would arise in the absence of that reform process. To put it simply, the South Australian electricity supply industry is in the midst of a process of reform from an industry in which the former Electricity Trust of South Australia operated as an effective monopolist, to an industry in which some aspects of the State electricity businesses will participate in a complex, highly regulated, dynamic and competitive market which extends beyond the boundaries of South Australia. By its very nature, the move to a NEM demands a high level of expertise in the management of the State electricity businesses. While the risks of poor management are subjective and qualitative in nature, the consequences of poor management will have a quantitative impact upon the value of the Government's investment in these businesses.

Audit considers that it will be critical that the Government owned electricity businesses competing in a competitive market are subject to a control environment which provides a balance between ensuring:

• the businesses have the opportunity to take necessary commercial risks;
• the minimisation of the risks of reduced dividend paid to Government or the need for the Government to exercise any guarantees in relation to the electricity businesses in which it has an interest.

As mentioned previously under the heading 'Government Announced Reforms', the Government announced a proposal to restructure and sell the State's electricity businesses. In the event that those businesses are unconditionally sold, Audit expects that the aforementioned risks from the participation in a competitive market will not exist for Government.