The Undesirable Trading Situation ("UTS") of 26 March 2011 and subsequent litigation subjected the UTS provisions of the Electricity Industry Participation Code 2010 ("Code") to extensive scrutiny.  In light of that experience, the Electricity Authority ("Authority") has proposed amendments to the UTS provisions.  Although the Authority believes the proposals are not fundamental changes, this Alert considers whether the proposals, combined with the work of the Wholesale Advisory Group ("WAG") on net pivotal situations, may in fact have significant implications for market certainty.

Background

On 18 March 2013, following its review of the UTS provisions in the Code, the Authority released a consultation paper proposing a number of amendments.   The Authority has characterised its review as looking at "predominantly technical" drafting issues identified during the investigation of whether the 26 March 2011 events constituted a UTS, and as also taking into account comments by the High Court in relation to the drafting of the UTS provisions.1

The events of 26 March 2011 are well known to market participants and observers, and essentially involved a situation where a generator was "net pivotal" for certain trading periods.  Broadly speaking, net pivotal means that the generator's output is required to meet demand, and the generator can supply more electricity than it needs to meet its own retail obligations.  The result is that the generator can offer electricity into the market at high prices.

Although economists will argue about whether high prices resulting from net pivotal situations are a good or bad thing, it is clear that for the period that a net pivotal situation exists, competitive forces do not limit prices.  Accordingly, the WAG is undertaking a project to assess whether net pivotal situations raise efficiency concerns and, if so, what solutions might be available.

UTS review

UTS provisions are included in market rules as a backstop.  Market rules cannot include specific provisions to cater for every possible eventuality, so UTS provisions often provide power for a regulator to intervene in the market if practices or events threaten confidence in the market and/or orderly trading.

Currently, the Code defines a UTS to be any contingency or event:

That threatens, or may threaten, trading on the wholesale market for electricity and that would, or would be likely to, preclude the maintenance of orderly trading or proper settlement of trades.

Such a contingency or event can only be a UTS if, in the reasonable opinion of the Authority, it cannot satisfactorily be resolved by any other mechanism available under the Code - thereby reinforcing the backstop nature of the UTS provisions.  The definition also lists examples of matters that may satisfy the requirements above, including manipulative trading, misleading or deceptive conduct in relation to trading, and unwarranted speculation.

The Authority has proposed the following key changes to the definition of a UTS:

  • Amend the definition of "wholesale market" to specify that a UTS can occur in the electricity spot market, markets for ancillary services (eg instantaneous reserves), and hedge markets (including FTRs).
  • Refocus the UTS definition around what the Authority perceives to be the core concern from a policy perspective - namely maintenance of market confidence and integrity.  The existing key requirement of a threat to trading or orderly settlement of trades would no longer appear in the definition, although it would be listed as an example of a situation that could amount to a UTS (if it threatened confidence in or integrity of the market).  
  • Moving the examples of matters that might constitute a UTS from the definition of UTS to the substantive UTS part of the Code to make it clear that they are examples of situations that may constitute a UTS, if the other elements of the definition are satisfied.

Although these changes have been presented as relatively minor, it seems there is potential for significant consequences in practice and the Authority's proposal could significantly broaden the types of matters subject to intervention.  In particular:

  1. as the "trading" in UTS suggests, the current provisions are very much focused on trading activity, and not the less precise concept of integrity and confidence in markets.  If confidence in the market is to become the key test, then further consideration should be given to clarifying whose confidence counts - eg should the views of non-market participants be taken into account?;  and
  2. given that the Code does not govern trades in hedge markets, it is not clear that there is a good case for subjecting such markets to UTS provisions.

UTS claims have been relatively few in number over the years, so it will be interesting to see whether the changes (if implemented) would encourage more claims for a more diverse range of reasons, thereby increasing market uncertainty.

Further, the Authority's decision on a UTS can only be appealed on a question of law (and not the merits).  Broadly speaking, the threshold for an error of law is that the Authority applied the incorrect legal test and/or it was simply not possible on the evidence available to conclude that the legal test had been satisfied (Bryson v Three Foot Six Ltd [2005] 3 NZLR 721 (SC); Vodafone NZ Ltd v Telecom NZ Ltd [2011] NZSC 138).  A definition that is more imprecise, and that confers greater discretion on the Authority, will inevitably be more difficult to challenge on those grounds. 

Further proposals in relation to process and remedy are to:

  1. introduce a time limit of 10 business days from the situation occurring for commencing a UTS investigation;
  2. clarify that a UTS remedy may be applied to any aspect of the industry that the Authority can regulate in the Code under section 32 of the Electricity Industry Act 2010 ("Act").  An example given by the Authority is that action may be required in the metering market to preserve integrity of or confidence in the wholesale market; and
  3. remove the requirement that any direction from the Authority must not be inconsistent with the Code.  Key in this respect is that it is very difficult to provide a remedy of setting new market prices in a way that is consistent with the Code.  

Pricing in Pivotal Supplier Situations Discussion Paper

The WAG was established to provide independent advice on the development of the Code and market facilitation.

In early July 2012 the Authority requested as a "highest priority" input and advice from the WAG in considering issues associated with pivotal supplier situations.  At the end of that month, the Authority released its market performance review of net pivotal situations that had occurred at Tekapo A and Cobb.2  The Authority found that, compared to historical patterns, generators were recently adopting new pricing strategies when they found themselves to be net pivotal.  It was perhaps not a coincidence that those strategies included offering at the $3,000/MWh level set by the Authority to remedy the 26 March 2011 UTS.

The Authority's view was that it is difficult to tell if high prices due to net pivotal events are efficient, which means parties exposed to those prices publicly question or criticise them, thereby making confidence in the market a key issue.  Accordingly, it felt that "the growing issue of net pivotal generation warrants the Authority's immediate attention to determine whether Code amendments can address the above concerns in ways that deliver long-term benefits to consumers".3

The Authority presented some potential solutions to be considered as part of the WAG project, including early gate closure for declared net pivotal generators (to facilitate demand side response), administratively determined price, and adjustments to the way the pricing model works in net pivotal situations.  The Authority also determined underlying design principles, which were that any proposed remedy must:

  1. be able to be described and understood by participants;
  2. ensure that the party best able to fix (or prevent) the net pivotal situation is incentivised to do so; and
  3. lead to efficient and predictable outcomes across a broad range of net pivotal generation manifestations.

The WAG is currently developing a discussion paper focussing on efficiency issues that could arise from pivotal supplier situations, the extent pivotal supplier situations are occurring under current arrangements, and possible options for addressing pivotal supplier situations. 

The WAG has identified a range of options to address the risks of efficiency losses from pivotal supplier situations and assessed these on the basis of their effectiveness and their potential to create unintended adverse impacts and/or significant implementation costs.  The two preferred options are to:

  • include conduct provisions in the Code, focussing on prohibition of market manipulation and a requirement to act in good faith and observe high standards of conduct, and potentially a requirement not to abuse dominant market position; and
  • improve grid availability incentives by amending the net benefit test that Transpower must apply when considering requests to alter planned outages.  A key change would be requiring the consideration of competition effects to allow participants to seek a modification to planned outages where they can show it will increase competition benefits.

The WAG does not favour early gate closure or price capping options raised by the Authority.  

Relationship between the processes

The WAG paper states that there are difficulties using the UTS provisions to deal with net pivotal situations, because there is a high threshold for triggering them and it is not clear that a net pivotal situation threatens or may threaten trading.  Further, the impact of net pivotal situations could be cumulative, whereas the UTS is event specific.

Interestingly, the Authority's proposed amendments to the UTS provisions would address those concerns.

The WAG paper also states that a more targeted approach is preferred to provide greater certainty.  This should also reduce the scope of the UTS provisions, given that the UTS provisions can only be invoked if there is no other remedy under the Code.4  It is questionable whether this addresses the matter in the correct order.  One could argue just as forcefully that there is no need for general conduct provisions because they are effectively embodied in the UTS provisions.

It is also of note that the WAG considered the status quo as an option, under which other pro-competitive measures soon to be implemented may assist (eg the introduction of FTRs and dispatchable demand).  It is not clear why this is not a preferred option, given that the Authority's view is that the 26 March 2011 UTS may not have occurred if such mechanisms were in place.5

Further, it is questionable whether general conduct provisions are consistent with the Authority's principles for a solution, including that the party best able to fix or prevent the problem has incentives to do so, and that it will lead to efficient and predictable outcomes.  It should be remembered that in relation to the 26 March 2011 event, the individual decisions of numerous participants combined to create the UTS and, if any one of those decisions had not been made, no UTS would have occurred.  The Authority also found that there was no manipulative or other improper conduct.

It remains to be seen how the options will be viewed by stakeholders, but it may be that encouraging better consideration of competition effects in relation to proposed grid outages is perceived as the cleanest and best targeted solution, with the least risk of unintended and/or uncertain outcomes.

It might also be asked whether the proposed UTS amendments are being overly influenced by concerns about net pivotal situations.  The current UTS provisions have been in place since the Electricity Governance Rules were adopted in 2003.  Over that time, the provisions have been invoked on a number of occasions without concerns being raised regarding their clarity and operation.  Although it is not unusual or controversial for difficult incidents to test legislative provisions to a greater degree and therefore uncover technical problems, it might be argued, as some industry participants did, that the real problem here is that the UTS provisions were not meant to be invoked in a net pivotal situation (in the absence of manipulative or other trading conduct that satisfies the UTS test in itself).

If that position is correct, then it might also be argued that the better approach is to avoid making any amendments to the UTS provisions that broaden the Authority's discretion to intervene in the market, which carries the risk of regulatory uncertainty and unintended consequences.

If net pivotal situations are deemed to be problematic (which remains unclear in the WAG draft paper), then it seems that attention should be focussed on developing specific and targeted solutions.  As indicated above, more work may be required in that respect.  

Submissions on the papers are due as follows:

  • For the Authority's UTS review on Wednesday 1 May.
  • For the WAG's discussion paper the date will be announced when the final discussion paper is published.