Skip to main content

Consumer Council Submission on Stage II Consultation Future Development of Hong Kong Electricity Market (Full Report)

  • Consultation Papers
  • 2006.04.11

An executive summary of the submission can be viewed on the Consumer Council website .

Introduction

  1. Power supply is essential to Hong Kong's economy and access to it is a fundamental right of consumers. The Consumer Council welcomes the opportunity to provide input to the Government's Stage II consultation on the 'Future Development of Hong Kong Electricity Market' from the consumers' perspective.
     
  2. The Government's overall stated policy objective is to ensure that the public continues to enjoy reliable, safe and efficient energy supplies at 'reasonable prices' and that there is 'economical supply'. The Council supports the Government objectives and welcomes its proactive stance in reviewing the current arrangements and its commitment to maintaining ongoing oversight of the arrangements into the future.
     
  3. The comments in this submission by the Consumer Council are framed in terms of its commitment to, and its statutory function of upholding consumer rights in the marketplace. The rights that have relevance to the electricity sector, to varying degrees, are as follows:
  • The right to satisfaction of basic needs - To have access to basic, essential goods and services, notably basic utility services such as power and clean water, adequate food, clothing, shelter, health care, education and sanitation.
  • The right to safety - To be protected against products, production processes and services which are hazardous to health or life.
     
  • The right to be informed - To be given the facts needed to understand important issues that affect consumer welfare, to make an informed choice, and to be protected against dishonest or misleading advertising and labelling.
     
  • The right to choose - To be able to select from a range of products and services, offered at competitive prices with an assurance of satisfactory quality, e.g., opening up of the electricity market at an opportune time.
     
  • The right to be heard - To have consumer interests represented in the making and execution of government policy, and in the development of products and services.
     
  • The right to redress - To receive a fair settlement of just claims, including compensation for misrepresentation, shoddy goods or unsatisfactory services.
     
  • The right to a healthy environment - To live and work in an environment which is non-threatening to the well-being of present and future generations.

Consumer Sentiments

  1. The Council's wealth of experience in serving Hong Kong's consumers has given it insight into the concerns that consumers have regarding the electricity sector, specifically,
  • Electricity is not a discretionary purchase for any consumer in Hong Kong. It is a critical necessity for everyday living. Consumers consider electricity tariffs to be high and should be kept as low as possible, notwithstanding the views advanced by the power companies that electricity tariffs are low and that electricity only represents 1.7% of an average consumer's household expenditure.
     
  • However, for low-income families, it is at a higher rate of 2.7% [ 1 ] . Another survey conducted in 2005 found 89.6% of low income families interviewed expressed concern over their water, electricity, gas and telephone bills, which together constituted 12.3% of their household income. These families have yet to benefit from Hong Kong's economic recovery. The companies also contend that Hong Kong tariffs are at a comparable level with other large cosmopolitan cities that have experienced market reforms and in comparison with prices paid by consumers in the Mainland. However, comparative price studies are typically difficult to resolve with precision and must be viewed in context of the operating environment.
     
  • Consumers also note that the power suppliers have enjoyed substantial profits from their privileged positions as exclusive suppliers of a critical service. Consumers are under the impression that current tariffs have been set at a high level with the Government's permission. They expect a substantial tariff reduction upon expiry of the current SOC agreements with the companies.
     
  • Members of the public perceive, rightly or wrongly, that the SOC has worked as a protective shield to the power companies, enabling them to earn huge profits.
     
  • Consumers are generally satisfied with the reliability of supply of the companies and expect that to continue
     
  • Consumers have expressed deep concern over the deterioration of air quality
     
  • with the use of electricity being an essential service for all, consumers expect Government to have a strong commitment towards protecting their rights in regard to the prices paid for the service and protecting the environment, through exercising firm regulatory oversight
  1. The following comments by the Council address specific issues of concern to consumers that relate to their consumer rights and sentiments expressed:.

Reliability

  1. Reliability of electricity supply is of extreme importance, as it is fundamental to the well being of the Hong Kong community, and its economy. Notwithstanding the fundamental issue of prices paid for a service, the Consumer Council appreciates the efforts that the two power suppliers, the CLP and HEC groups, have made in setting a high standard of reliability in electricity supply.
     
  2. Consumers have come to expect that the tariffs they are paying now have played their part in maintaining this high standard, and that the standards will continue, given the investments that have been made to date and their contribution to those investments. The Council also expects that maintaining a high standard of reliability into the future will not incur costs, on a comparative basis, above the levels currently paid by consumers.

Prices and Profits

  1. Prices are undoubtedly of fundamental importance for consumers, particularly when they are faced with a de facto monopoly supplier.
     
  2. The accounts of the CLP group in 2005 show that the profit before finance costs and taxation on their business in Hong Kong (HK$9,508m) [ 2 ] represented 79% of the total profit before finance costs and taxation (HK$12,059m) [ 3 ] . The fixed assets and investments in CLP Power Hong Kong equalled HK$42,415m [ 4 ] , representing 59% of total fixed assets and interests in jointly or fully controlled companies of HK$72,146 in 2004 [ 5 ] .
     
  3. HEC group announced in March 2006 that its income in 2005 before finance costs and tax on their business in Hong Kong (HK$6,594m) [ 6 ] represented 72% of the total earning before finance costs and tax (HK$9,189m) [ 7 ] . Its fixed assets and investment in the electricity business in Hong Kong equalled HK$45,353m [ 8 ] , representing 84% of total fixed assets and interest in associates of HK$54,190m [ 9 ] in 2004.
     
  4. CLP and HEC's regulated business under SOC yielded extremely high returns (Return on Equity) of 25% and 20% in 2004 respectively, much higher than that achieved at their group business at 19.5% [ 10 ] and 16.6% [ 11 ] respectively ( Annex I ).
     
  5. These figures are very high for regulated electricity suppliers that are low risk businesses, because of their captive customer base and also the 'fuel cost pass through' feature. The target regulated return on equity for a typical US integrated utility is around 11% [ 12 ] p.a. This high return seems to explain why CLP Group has a very low debt/total capital ratio of 30% compared with the typical US utility ratio of slightly over 50%, and the allowance by the UK regulator Ofgem of 57% for distribution networks [ 13 ] .
     
  6. The companies should be congratulated for having achieved such astounding successes, however, it also begs the question whether consumers should also benefit from a fair share of it, having regard to the risk free environment and high levels of profit enjoyed by the power suppliers under the Scheme of Control (SOC) arrangements. The public expects to see a cut of electricity bill by a reasonable and substantial magnitude.

Need for an effective regulatory framework

Regulatory Instrument

The Scheme of Control Arrangements

  1. As a regulatory model, the Government has proposed that bi-lateral arrangements, similar to the present arrangements, be continued for the time being.
     
  2. Some sectors of the community see legislation as the preferred tool to balance Government power (representing wider public interests) and that of the power companies, as against relying on a bilateral contractual relationship through a SOC. The Government has recognized that "as the market continues to develop, it will be necessary to put in place additional regulatory arrangements, including legislation, to ensure reliable and adequate supply. We (Government) will commence (our) preparation work in this regard." [ 14 ] The Council welcomes this approach.
     
  3. Hong Kong is entering an important transitional period. The Council appreciates that the vital work that needs to be undertaken, in terms of preparing for new industry regulations, legislation and a designated independent agency to carry out industry oversight, will take time. Therefore, continuing with the SOC arrangements for a ten year period, with periodic reviews, is not unreasonable as a transitional move towards a regulatory environment that can accommodate some form of market liberalisation in the future.
     
  4. It is important for the SOC arrangements to specifically include transitional expectations within the terms and conditions between Government and the power suppliers. The reason being that a primary difficulty with SOC arrangements is the inherent inflexibility to deal with any future changes that may be required in the generation, distribution and retailing of energy, unless some expectation of future Government policy goals is accommodated within the arrangements and accepted as a condition by the power suppliers.
     
  5. If obligations are not included in the SOC arrangements to accept future changes to the sector, it can be assumed that the power suppliers' actions would more than likely be in accordance with their own objectives, which may not always be compatible with the Government's policy objectives.
     
  6. The Government will need to study the feasibility of the extent of liberalization in the market that can reasonably take place. For example, whether it should be liberalized down to the retail level. The Council believes that it is incumbent on the Government to provide sufficient signals and attempt to draw a 'road map' within the new SOC arrangements, to cover at least two important issues.
  • First, to provide some indication for future alternative energy suppliers and related businesses as to what general expectations there are for the future of the sector. This will assist any new players that might consider entering the sector to understand, if only in a general manner, what prospects might arise in the future.
     
  • Second, to create a legal obligation on the part of the power suppliers to accommodate any future requirements that are indicated by Government, in its efforts at varying the manner in which the sector operates.
  1. As an illustration with regard to the latter point, some future consideration might be given to moving to a licensing system with different rules for different categories of sector participant. For example, environmental regulation on power generation licensees, universal access obligations on transmission-distribution licensees and complaint-handling requirements on service provider licensees. This form of licensing is a common mechanism used in other jurisdictions that have experienced market liberalisation and may well be desired by Hong Kong in the near future. In this regard, the Council notes that the Government has indicated it will be differentiating between assets that reflect different investment risks associated with different operations in the supply chain, when deciding on permissible returns for those assets.

Calculating a reasonable return

  1. The Government has proposed to adopt a two pronged approach using fixed assets and performance as a base for determining return under the SOC arrangements, and that its integrated approach will reflect the cost of raising capital and the risks.

The Rate Base

  1. Government proposes to continue to adopt a fixed asset approach using returns on Average Net Fixed Assets (ROA) as the base rather than Return on Equity (ROE) as the rate base.
     
  2. The Council understands that an equity based approach, using shareholder funds would increase the level of transparency in calculations, and eliminate the administrative burden faced by Government in regulating against excessive asset accumulation. However, even under an equities based approach, it could still be possible for the power suppliers to use debt issued by their holding companies to finance the equity of the power supplier that is the party identified in the SOC, to engage in excessive asset accumulation. Therefore, the Council considers ROA is an acceptable base for calculation, subject to safeguards to be discussed below.
     
  3. The Council notes the concern that has been expressed that using an asset base for calculating permissible returns might induce excessive asset accumulation. Whilst the ROA approach provides an incentive for continued investment in assets as a target return on such investments is assured, the power companies' capital expenditure on new and replacement assets is also under regulatory oversight to ensure proper investment. Therefore the companies should not be able to inflate the assets excessively.
     
  4. Furthermore, in order for consumers to enjoy any benefits arising from an increase in investments resulting in an enlarged asset base, the Council considers that a well defined performance base rate making scheme should be developed. The Council understands that performance based rating schemes as applied overseas typically require
  • agreement on price limits, which are based on productivity trends together with a target rate of return;
     
  • the sharing between consumers and shareholders of under and over performance, compared with the target return.

Permitted Rate of Return

  1. Government has proposed to adopt an integrated approach in determining the permitted rate of return to reflect the cost of raising capital and risks, which will be in the range of 7% to 11%. The actual rate may have to take into account the prevailing market conditions.
     
  2. There is a need for transparency in calculating the return at the outset in order to be transparent and to avoid any problems in the future.
     
  3. The Council welcomes the following safeguards in the new SOC agreements:
    1. "(a) all development plans relating to electricity supply of the power companies to be approved by the Government;
    2. (b) the key components for determining the permitted rate of return to be reviewed, and the permitted rate of return to be adjusted where appropriate, every five years to reflect the prevailing economic conditions, having regard to the need to provide a stable regulatory environment to facilitate long-term investments and the potential implications on tariffs. This will be different from the existing arrangement whereby the permitted rate of return is fixed for the period of the agreement; and
    3. (c) all tariff adjustments to be approved by the Government, as opposed to the existing arrangement whereby Government's approval is not required if projected basic tariff rate of a year is not higher than the most recently approved basic tariff rate by more than 7%" [ 15 ]

Differentiating assets

  1. The consultation paper states that with the different operations in the supply chain, i.e., generation versus transmission and distribution, it proposes to give a lower rate of return for generation assets and a further lower rate for transmission and distribution assets. This is welcomed by the Council.

Encouraging the use of renewable energy (RE)

  1. As a means of enhancing consumers' right to a healthy environment, the Council welcomes the Government's proposals to promote the use of RE with a view to meeting the 1% - 2% RE target by 2012 as stated in the First Sustainable Development Strategy promulgated by Government in May 2005.
     
  2. Nevertheless, the policy of encouraging RE raises a number of complex issues that should be considered further, in the context of reviewing the SOC arrangements.

Technological advances

  1. In its response to the previous consultation on sustainable development, the Council noted that the Government's current proposal and target of using RE of 1-2% of energy consumption limited the scope of market development. RE expert opinion indicated that there was economic benefit of using RE such as solar energy as a main supply at the household level, and that the technology for widespread use would be widely available in near future. To a large extent the practicality of RE technology is an unknown quantity, and the market might well be able to sustain a much higher level of technology adoption.

Asset based returns calculations

  1. The Government proposes to provide financial incentives to power companies to enable grid connection/access for individual RE systems and the use of assets as a base for calculating returns. In order to satisfy mounting public expectation for emissions reduction, the power suppliers may be induced to haphazardly invest in technologies that are neither proven nor efficient; whilst at the same time increasing their asset base. Strict scrutiny would therefore be appropriate on the type of technology employed by the power suppliers.

Fuel cost pass through

  1. The application of the fuel cost pass through mechanism does not work in principle as a means of encouraging the power suppliers to utilize low cost generation or renewable energy. The Government may need to consider what disciplines could be applied on the fuel cost pass through mechanism to ensure that low cost fuel options are adopted.

Setting targets

  1. The 1-2% RE power generation target should only be set as a minimum standard for power suppliers to achieve. This is because a set target is intrinsically inflexible and may be set too low to achieve better environmental standards. The two companies have declared commitments to 'Corporate Social Responsibility'. Therefore, an alternative could be to encourage competitive performance on RE and environmental measures between the power suppliers, as a form of self motivation towards achieving goals.

Proposed Interconnection with other suppliers

  1. The Government states that it will develop regulatory arrangements to enable grid access for new electricity suppliers, enhanced interconnection between the two power suppliers, and for enhanced interconnection between Hong Kong and Guangdong. The Government also plans to liaise with Mainland authorities to explore how technical constraints on relevant infrastructure on the Mainland might need to be addressed.
     
  2. In the eventuality of new entrants supplying electricity generated in the Mainland to Hong Kong, the Government may need to specify identical environmental standards for the power generation plants in the Mainland. In any event, power companies, being holding companies of their investments in the Mainland, should in the spirit of discharging their good corporate social responsibilities, adopt in the Mainland same environmental standards to the power generation plants as in Hong Kong.

Implications for reliability

  1. The issue of supply from the Mainland has not been thoroughly discussed and to a large extent is an unknown quantity. However, the Council understands that there are three types of supply from the Mainland:
  1. firm supply from a dedicated plant linked by a feeder line to Hong Kong, and not strongly linked to the Mainland system;
     
  2. allegedly firm supply by a plant that is integral with the Mainland system, and supplies might be cut to support the Mainland; and 
     
  3. economy interchange to take short term advantage of diversity of demand and lower demand periods when the marginal costs of the systems might differ. 
  1. It would appear that only the second type of supply would pose any threat to reliability of supply in Hong Kong and that at least two options could be safely pursued. In order to reduce uncertainties in the electricity sector, thus affecting the investment incentives of the incumbent power companies and any potential entrants into Hong Kong, the Council suggests that the Government should ideally start the assessment immediately.

Local interconnection

  1. Under the current proposals, the Government will request the two power companies to voluntarily achieve the objectives of economic efficiency and emission reduction through interconnection. It is stated that in the medium term, the Government will work with the two power companies to review and harmonize the planning criteria and reliability standards for an interconnected power system, and make preparations for the future. The preparation will cover both technical and regulatory aspects such as conducting power system planning and utilization studies and power flow assessments; and drawing up a relevant legislative framework.
     
  2. This proposal is welcomed. However, the Council does not consider that these matters should be left on a voluntary basis as the power companies could understandably be reluctant to introduce measures to restrict their business and profitability. The SOC would therefore need to be carefully drafted to place legal obligations on the power suppliers to achieve the Government's objectives.

Cherry Picking by New Entrants

  1. The Council is aware of a problem that may arise if market liberalization occurs in the electricity sector, and 'cherry picking' takes place, whereby one or more suppliers capture low transaction cost customers (i.e. large commercial entities) which are therefore more profitable customers, and another supplier is left to service the high transaction cost customers (i.e. residential consumers).
     
  2. The extent to which this constitutes a real concern depends on the extent to which the Hong Kong market is liberalized, and the extent to which competing suppliers are able to capture certain customers at a price that puts other suppliers at a disadvantage because of universal service obligations. The Council expects that the Government will consider measures to ensure that residential consumers are not disadvantaged by having to pay higher tariffs as a consequence of efficiency gains made for commercial customers due to the introduction of competing suppliers. For example, two possible measures could be
  • a form of price freeze for residential consumers at the onset of competition; and
     
  • competing suppliers being required to fund universal service obligations for residential consumers, through the payment of an industry levy.

Transparency

  1. The Government has stated that it would request power companies to make available more information to the public, such as details of new development projects, electricity sales and growth rates, provided that no commercially sensitive information would be disclosed.
     
  2. This increase in transparency is welcomed. The Council further suggests that in defining what information might be considered 'commercial in confidence', the Government should be mindful that electricity is not supplied into what could in any terms be described as a normal competitive market, with proportionate concerns on commercial in confidence information. In negotiating pricing outcomes for electricity, the Government is acting on behalf of the community that has a critical need for the power companies' services. Moreover, these services are provided as a de facto monopoly. In considering how far transparency should go in relation to costing and pricing information on electricity, the wider community's interests should not be wholly subsumed by arguments as to 'commercial confidentiality'.
     
  3. At the very least, it would seem appropriate that the Government require as a condition of a new SOC, that the companies be required to publish a comprehensive range of performance and financial data for public scrutiny. Full disclosure requirements, similar to those overseas, could enhance transparency by requiring separate account reporting by the different licensee segments of power generation, distribution and service provision. 

 

Annex I

Table 1: Profit Margins and Financial Returns of the Power Companies under the Scheme of Control

 

China Light & Power Ltd.

Hong Kong Electric Ltd.

YearProfit MarginInterest + Net return on SOC Fixed AssetNet return / Shareholder fundProfit MarginInterest + Net return on SOC Fixed Asset Net reutnr / Shareholders fund
9534%13%25%44%13%23%
9634%13%27%46%14%24%
9732%14%26%48%14%23%
9830%14%26%45%14%23%
9930%14%25%50%14%22%
0029%14%25%48%14%22%
0129%14%26%52%14%22%
0230%14%27%52%14%26%
0333%14%25%53%14%22%
0433%14%25%48%14%20%

Table 2: Profit Margins and Financial Returns of CLP Holdings Ltd. and HEC Holdings Ltd. 

YearChina Light & Power Ltd.Hong Kong Electric Ltd.
Profit MarginProfit on AssetProfit / Shareholders FundReturn on EquityProfit MarginProfit on AssetProfit / Capital & Reserve
9526%15%22%24%56%14%27%
9626%16%22%24%51%13%24%
9728%18%14%18%55%13%25%
9829%18%16%16%51%13%23%
9926%14%19%16%54%13%21%
0023%12%16%17%49%11%20%
0123%11%17%17%57%13%21%
0225%11%18%18%57%12%20%
0326%11%19%19%54%11%17%
0427%11%19%20%55%11%17%

Notes:

  1. Calculations are based on figures from the Scheme of Control Reports and Summary Reports in the Annual Report 2004 of CLP Holdings Ltd., Annual Report 1999 and Annual Report 2004 of HEC Holdings Ltd.
  2. Profit margins of the power companies under the Scheme of Control = Net Return/Total Electricity Sales.
  3. Profit margins of the holding companies = Profit Attributable to Shareholders/Turnover.
  4. Profit attributable to shareholders of CLP Holdings excludes profit from Hok Un development.
  5. Profit on Asset of the holding companies = Profit Attributable to Shareholders/Total Assets Less Current Assets.
  6. Return on equity figures of CLP Holdings are cited from page169 of the Annual Report 2004 of CLP Holdings Ltd.

Footnotes:

  1. 1999/2000 Household Expenditure Survey and the Rebasing of the Consumer Price Indices, p.88. It is assumed that the lowest 25% quartile expenditure group to be low-income families
  2. CLP Holdings Limited, CLP Holdings Limited 2005 Annual Results, CLP Holdings Limited 2006. p.23.
  3. Calculated from figures of profit before financing and taxation, finance income and minority interest. Ibid, p.23.
  4. CLP Holdings Limited, CLP Holdings Annual Report 2004, CLP Holdings Limited 2005, p.168.
  5. Calculated from the figures of fixed assets, interests in jointly controlled entities and interests in associated companies of the consolidated balance sheet. See CLP Holdings Limited 2005 Annual Results, p.16.
  6. Calculated from the figures of operating profit, finance costs and share of profits less losses of associates, Hongkong Electric Holdings Limited, Hongkong Electric Holdings Limited 2005 Annual Results, Hongkong Electric Holdings Limited 2006, p.17.
  7. Calculated from the figures of profit before taxation and finance costs, Hongkong Electric Holdings Limited 2005 Annual Results, p.17.
  8. Hongkong Electric Limited Annual Report 2004, p.76.
  9. Calculated from the figures of fixed assets and interests in associates of the consolidated balance sheet. Hongkong Electric Holdings Limited 2005 Annual Results, p.9.
  10. E-Finet.com, Profile and Financials: Financial Ratios, 2006 
  11. E-finet.com.
  12. Major US rate case decisions - January 2004 to December 2005, supplemental study, Regulatory Focus, 12 January 2006.
  13. The Office of Gas and Electricity Markets, Electricity Distribution Price Control Review Final Proposal, The Office of Gas and Electricity Markets 2004, p. 108 (para 8.52.) www.ofgem.gov.uk
  14. HKSAR Economic Development and Labour Bureau Consultation Paper on Future Development of the Electricity Market in Hong Kong - Stage II Consultatiion - Hong Kong Special Administrative Region 2005, para 2.34, p. 14.
  15. HKSAR Economic Development and Labour Bureau Consultation Paper on Future Development of the Electricity Market in Hong Kong, Stage II Consultation, Hong Kong Special Administrative Region, 2005, para. 2.40, p. 16