The Australian Gas Light Company
ABN 95 052 167 405

North Sydney
AGL Centre, 111 Pacific Highway
North Sydney NSW 2060
Locked Bag 944
North Sydney NSW 2059

Telephone 02 9921 2585
Facsimile 02 9957 3871

18 January 2005

NCP Inquiry
Productivity Commission
PO Box 80
Belconnen ACT 2616

By email: ncp@pc.gov.au
Productivity Commission Review of National Competition Policy Reforms – Discussion Draft

The Australian Gas Light Company (AGL) makes this supplementary submission to further the debate over whether there is a case for special merger rules for the electricity sector.  In particular AGL wishes to comment on the submission of the Australian Competition and Consumer Commission (ACCC) dated 10 December 2004 and its Appendix B (Dr Darryl Biggar: “The exercise of Market Power in the NEM: An analysis of Price-Spike events in the NEM January-June 2003”).

AGL does not consider that the paper by Dr Biggar provides a reliable basis for any regulatory or policy response. 

Firstly, a study of behaviour in the spot electricity market can not be used to draw conclusions about generator market power.  Generators’ revenue is made up of sales at prices set in both the spot market and under hedge contracts, options and other derivatives.  To quote from the National Generators Forum submission to this review (submission number DR 220 dated 17 December 2004): 
Generator Incentives to influence spot market outcomes are diminished once they have hedged their expected output.  To undertake an assessment of the NEM on the basis of spot price outcomes ignores the real economic outcomes and focuses only on the residual energy not traded in the hedge market.

Similarly, Justice French noted (AGL v ACCC (No3) [2003] FCA 1525 at paragraph 382):
There is...a degree of unreality involved in separating out and identifying separate markets for the sale of electricity and the provision of derivative contracts. ... [D]erivative contracts ought to be regarded as an integral part of the pricing and payment arrangements between generators and retailers in relation to the underlying product, which is electrical energy, and which they deal with 'as if' it had been sold from supplier to retailer. 

In fact the behaviour described in Dr Biggar’s paper is open to the interpretation that generators do not have market power.  The behaviour in question is characterised as being designed to achieve a higher pool price than would otherwise be expected.  A higher pool price is only of benefit, however, to generators that have at least part of their revenue coming from sales through the spot market.  That is, they are less than fully hedged.  But if the generators concerned were truly able to exercise market power it would be in their interests to do so through the hedge market, by holding out for inflated prices in long term hedge contracts for their full expected output.  Such a strategy would lock in the higher prices for a certain volume over an extended period of time and would be preferable to relying on the uncertainty of opportunities that may arise in the spot market.  That is, they would be fully hedged.  

Secondly, it is an established principle of competition law that a firm can only possess a requisite degree of market power where it can increase prices during a sustained period. The attachment to this letter details two key flaws in Dr Biggar’s analysis which arise from a lack of recognition of this principle.  In summary the flaws are:

1.	The analysis has been undertaken on the basis of discrete and limited trading intervals, thereby failing to distinguish the significant from the insignificant; and

2.	The analysis has not taken account of competitive entry and expansion.   That is, the analysis fails to identify the significant competitive effects of generation sector entry and expansion which historically have taken place within a period of just a few months.  

Contrary to the conclusions drawn by Dr Biggar, his work may (subject to further factual investigation) suggest that the appropriate response is for adjustments to be made to the regulatory environment governing the National Electricity Market’s regional boundaries and interconnection investment.   

If you have any queries about this supplementary submission, please contact my office on (02) 9921 2585.

Yours sincerely

Dr Robert Wiles
General Manager, Regulation and Policy

Attachment A
Dr. Biggar’s basic thesis is as follows:
•	NEM trading statistics suggest that Victorian baseload generators regularly withhold capacity during peak price periods (defined as periods in which the spot price exceeds $80/MWh). In many such periods, NSW baseload generators withdraw an even higher quantity of capacity;
•	Such conduct by Victorian baseload generators may be explained either by their playing a secondary role in the exercise of market power by NSW generators, or by an attempt to relieve constraints on exports to high price regions (thereby “importing” the higher price) and to induce constraints on imports from lower-priced regions; 
•	Based on a limited empirical examination Dr Biggar concludes that (at times) the Victorian baseload generators do engage in bidding to relieve constraints and “import” high prices from adjacent regions; and
•	If actions taken by Victorian baseload generators reduce the incidence and intensity of interconnector constraints, neither the frequency of such constraints nor the degree of price separation between regions during these periods, provides reliable information in defining the geographic dimension of relevant markets within the electricity industry. 

Alleged market power arising from bidding to “import” high prices from adjacent regions
Dr. Biggar suggests that a firm has market power when it is “able to increase profit by withdrawing output below the output that it would sell in a competitive market, thereby increasing the price.”  This definition of market power is a crucial step towards his conclusion that several Victorian and NSW generators possess market power.
However, it is an established principle of competition law that a firm possesses the requisite degree of market power for regulatory action only where it can increase prices during a sustained period.  Frontier Economics’ paper which, along