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The following is the full text of a speech by the Acting Secretary for Economic Services, Ms Maria Kwan, at the symposium on Lessons of the California Crisis for Power Market Design today (May 18):

The Californian Experience - Relevance and Challenges to Hong Kong

Chairman, Distinguished Speakers, Ladies and Gentlemen,

I am greatly honoured to be invited to address this illustrious forum alongside experts on electricity de-regulation from the United States, the Mainland and Hong Kong. The symposium is timely for Hong Kong as we are looking ahead to the future, and I would like to congratulate the organisers on their efforts.

I understand that a number of speakers have already analysed the Californian experience in some detail and there have been some interesting discussions. I cannot profess to be any more knowledgeable or insightful. I will therefore confine myself to some broad observations before setting out challenges we face as we try to map out broad directions for our future electricity supply regime.

The Californian experience

From the information we have, and we have in fact only started looking into the market restructuring experience of a few countries, the Californian experience appears quite unique in that it seems to be confronted by problems on all fronts. It is characterised by power shortage and rolling blackouts. Consumers face huge increase in tariff and some of the utilities are on the brink of bankruptcies. It has also become a political saga. In the main, it seems to be a "no win" for all.

Why has this come about? It would appear that there was a complete mismatch between demand and supply at the time when the decision to leave things more to the market started to take effect. On the one hand, demand has apparently been increasing due to a booming economy and the hot weather. It also appears fairly inelastic probably because market signals were neither timely nor adequate. The price cap in place in effect shield consumers from early realisation of the real price of the electricity they are getting. In other words, the market signals essential to the effective functioning of a market may well be reaching only half the market i.e. only suppliers instead of both consumers and suppliers. On the supply side, it is marked by the low availability of generation capacity because of aging equipment, transmission constraints and the absence of timely investment in new facilities. To some extent, the situation seems to have been aggravated by generators trying to manipulate the market. Also, some of the market arrangements which may have been designed to facilitate competition in turn inhibits risk hedging.

I am not in a position to do a critique of the Californian situation and have no intention of doing so. From my own experience, I can appreciate that in matters relating to electricity supply, policy makers could well be walking a tight rope balancing various interests which may sometimes not be easy to reconcile in the overall equation. I am therefore looking at it more as something that make us stay on guard when we consider what would be in the overall interest of Hong Kong in the future regime.

In this respect, the Californian experience is instructive in many ways. Some of the lessons that came out of it provide considerable food for thought. I will look at one or two below.

From what we have heard and gathered, the Californian experience seems to point to sufficient or even excess generation capacity as a pre-requisite and a fundamental condition for the market to work. It is seen as necessary to cushion against pressure on price increase as a result of rising demand and to allow time for market force to function. It also brings into focus the need to have adequate transmission and distribution infrastructure to avoid bottlenecks and constraints to system operation. The challenge is how to ensure timely and continued investment to ensure adequate and reliable supply and yet bring economic benefits to consumers who may not have the same time horizon to see beyond the present.

Another impression is that there seems to be a divergence of value at different levels. Whilst there is a belief that de-regulation, competition and giving a choice to consumers would bring greater economic efficiency and hence lower prices, there is also a concern that this needs to be ensured through administratively determined price caps. The pricing mechanisms at the wholesale versus the retail level also do not appear to be aligned. In effect, different parts of the system seems to pull in different directions to the detriment of the overall interest of all concerned.

The Hong Kong market

Now let me turn to the Hong Kong market. In keeping with our free market economic philosophy, electricity in Hong Kong is supplied by two investor-owned companies, which are regulated by their respective Scheme of Control Agreements (SCAs) with the Government. The SCAs last for 15 years. They are not franchises and do not provide exclusive rights to supply electricity. However, for geographical and historical reasons, the two companies have their own de facto supply area. The SCAs regulate the profit of the power companies, and allow them a reasonable return so as to encourage them to continue making the investments required for ensuring sufficient electricity to meet demand.

Hong Kong's electricity supply sector is vertically integrated. In other words, the two power companies construct, own, maintain and operate their generation and transmission/distribution facilities and supply electricity to consumers at the retail level. They are interconnected only by cables having a total capacity of 720 MVA, which are primarily used for emergency backup.

Study on Electricity Supply Regime for the future

We are currently considering the electricity supply regime for the future. The SCAs are due to expire in 2008 and we need to work out the post 2008 regime early. We have a completely open mind at this stage.

The Californian experience is a timely reminder of the complexity of electricity market restructuring. It underscores the care that would need to be exercised but it has not put us off. The verdict on market de-regulation is still out and California seems to have quite a unique experience compared to other places which have also embarked on market restructuring.

What is clear at this stage is that if we were to embark on any reform, we need to have clear objectives. We need to have "buy-in" from players involved and the community at large. We need to align capacity and market design and arrangements with the objectives set.

Many people may have their own views as to which way the future electricity supply regime should go. Some may want competition, whether at wholesale or retail level or both. Others may want consumers to be given a choice. Still others would like lower tariffs. In going for any particular approach, we need to be very clear as to what the real objectives are because there are many sides to an equation. For example, should we be going for competition as a means to an end or an end in itself? Some people believe that competition would increase economic efficiency and lower prices. Others have noted that de-regulation would in fact mean more regulation and a more complex regulatory regime which would indirectly add to operating costs. Others mentioned that stakeholders may need to build in a higher profit margin to cushion again increased risk in a competitive environment. Furthermore, price may vary depending on weather, fuel price and investment cycle. Therefore whether and when lower tariff may be realised could well depend on whether and if so, when a fully competitive market could kick in.

In Hong Kong, the twinfold objectives of electricity supply are both to ensure adequate and reliable supply through encouraging continued and timely investment in generation, transmission and distribution facilities, and to ensure supply is provided to consumers at lowest possible reasonable cost. Whilst we would wish and very much hope to bring additional economic benefits to consumers in the future electricity supply regime, we feel that the adequacy and reliability of supply should not be compromised in the process.

As electricity supply affects both people's lives and business alike, "buy in" of stakeholders and the community at large to changes, if any, contemplated will be very important. The challenge is that different segments of the community may have different time horizons and different focus. Also we need to make people understand exactly the full implications including benefits and risks of different options once they are formulated. For example, adequacy and reliability of supply hinges on continued and timely investment in the necessary infrastructure.

Of equal importance is that we need to think through what capacity, structure and procedures would deliver the results intended and whether different objectives could be reconciled and made to work.

In considering the way ahead, we also need to take into account some of the structural shortcomings of Hong Kong. For example, we have only a limited number of electricity suppliers, the supply of land for new generation facilities is very limited and our local electricity market is relatively small.

We also need to bear in mind that currently electricity cannot be economically stored on a large scale and that supply and demand need to be balanced instantaneously or electricity supply would be adversely affected with potentially significant social and economic costs. On the other hand, increase in supply either in the form of additional generation capacity or interconnection capacity has a long lead time after the need has been identified. Furthermore, demand is relatively inelastic as not many users would on his or her own volition curtail their own load even at times of tight supply. The result is that interaction between demand and supply may not be as responsive as desired.

In a totally competitive market, the role of centralised planning of new generation facilities would greatly diminished. It would be left to the market to interpret the market signals e.g. movement in electricity prices, shortage of supply and decide whether and when to plan for new facilities. In this respect, both the demand and supply side of the market should probably be involved for the market to operate efficiently.

Environmental protection is also a factor that should not be ignored in any market restructuring. With increased public awareness of the need for sustainable development, it is imperative that the environmental implications would need to be taken into account in developing any future market regime. The challenge there is a question of balance between competing priorities.

Against the background and challenges described above, the Government has announced that it hopes to map out the broad direction for future development of the electricity supply sector before the next interim review of the SCAs scheduled for 2003.

On the technical front, we are looking further into the issue of increased interconnection. To this end, we have early this year started a detailed technical study on increasing interconnection between the two power companies. The objective of the study is to resolve the technical issues to enable the taking forward of increased interconnection between the power systems of the two power companies to meet the needs under different including competitive market structures. It would also examine the corresponding impacts on the transmission network of the two power companies including interconnection transfer capability, system stability, load flow and other aspects associated with the reliability of electricity supply to Hong Kong consumers. The findings and recommendations of the study are expected to facilitate us to identify a viable and practicable option or options for increasing the interconnection capacity between the two power companies to meet the needs of different possible market structures and operations. We expect the study to be completed around the end of this year.

In parallel, my bureau, the Economic Services Bureau and the Electrical and Mechanical Services Department are examining market restructuring experience in other places with a view to identifying practicable options for the Hong Kong market in future. We have paid brief visits to regulators, grid operators, power companies and other players in the electricity markets in the United Kingdom, the United States and Australia last year to study the regulatory and institutional structure there and the operation of their competitive market. We have been given very useful information to work in.

In the remaining part of this year and the next, we will examine the experience in these and other places in greater detail to see what are all the lessons that could be learned.

To this end, we are recruiting an Electricity Advisor to serve as our in-house consultant to provide expert support although we do not preclude the commissioning of consultancies if deemed necessary as we go along. In addition, we have also established a multi-disciplinary team of engineers, economist and support staff for the task. Apart from conducting necessary researches and other work for the review, we will explore opportunities of attaching members of the team to regulatory authorities overseas to gain some first hand knowledge and experience of a restructured electricity market.

As we proceed with further evaluation of various aspects of a competitive market, it would be prudent for us to also examine whether there are other forms of administrative regulatory arrangements that could equally bring benefits to consumers.

At the same time, we are looking across the border for potential sources of electricity supply. We have visited Guangdong to understand more about the development of the electricity market there and explore scope for further cooperation with them. Although the Mainland is also pushing ahead with market reform of the power industry with a view to privatisation and introducing competition, the situation is still very fluid. In addition, we have been advised that the electricity supply situation in Guangdong is expected to continue to be tight in the next few years. It is unlikely that they would be in a position to provide us with economic supply of electricity in the short term. Notwithstanding that, we will continue to maintain liaison with the Mainland authorities to keep in view developments there.

Lastly, I would emphasise once again that our mind is completely open at this stage. We are all "eyes and ears" and we want to learn more about the do's and don'ts from other people's experience. At a later stage, after we crystallise our thinking, we will work out various options as a basis for further discussions with stakeholders concerned and among the community at large. But our target is still to map out broad directions before the interim review of the SCAs in 2003.

Thank you.

End/Friday, May 18, 2001

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