on 10 November 1998.
Legislative Council Panel on Economic Services
INTERIM REVIEW OF SCHEME OF CONTROL AGREEMENTS
This paper provides the information requested by members of the Panel when they discussed agenda item III at their meeting on 26 October, 1998.
The issues covered in the interim review of the Scheme of Control Agreements (SCAs), the respective stances of the Government and the two power companies on these issues and the final outcome of the issues under review
2. The interim review has covered issues ranging from those of direct concern to the public to those concerning processes and arrangements for administering the SCAs by the Government. It should be noted that, as provided in the SCAs, any amendments to the SCAs must be by mutual agreement of both parties. The issues and the stances of various parties are explained in the following paragraphs.
Excess generating capacity
3. In the light of the experience in the deferral of construction of the Black Point plant last year as demand was growing at a lower rate than forecast, we requested the power companies to consider giving up the return on investment in additional generating units installed in future if these give rise to excess capacity. At present under the SCAs shareholders of the companies are entitled to a return on investment in electricity facilities irrespective of whether they give rise to excess capacity.
4. The power companies were prepared to accept a new provision to discourage excess capacity provided it took into account the unavoidable uncertainties in forecasting demand. On the other hand, they were concerned that they must still be required to ensure sufficient facilities are put in place to meet growth in demand.
5. We have reached agreement in principle with the power companies. The information paper provided to members on 26 October, 1998 summarises the major terms of this agreement. Under this agreement a proportion of the machinery and equipment costs of the new generating unit installed, if it gives rise to excess capacity, will be excluded from the fixed assets for calculating the return to shareholders. Also new generating units will generally be approved in future by the Government individually, rather than as a series of units, and their installation will be conditional on demand.
Rate of permitted return
6. In the light of the changes in investment climate since the current SCAs became effective, we requested the power companies to consider lowering the rates of permitted return.
7. The power companies considered our proposal unacceptable, pointing out that the rates of return are vital and fundamental terms in the SCAs which were agreed with the Government in 1991/92 when the current SCAs were last negotiated. They accepted that certain risks had reduced but others had increased and that risk and return under the SCAs must be considered in total. They considered that the agreed terms of the SCAs on the basis of which substantial investments and contracts (some of which extend beyond the term of the current SCAs) are made by them should not be changed. They were also concerned that any such changes could put at risk the favourable loan financing terms which benefit consumers and are secured on the strength of these fundamental terms of the SCAs.
8. After discussion and negotiation the power companies have agreed to accept lowering the return on fixed assets financed by additional customers deposits collected in future. The information paper of 26 October, 1998 has explained this agreement in more detail.
Alternative form of price regulation and performance indicators/benchmarks
9. We had requested the power companies to look into the feasibility of adopting a price-capping mechanism (e.g. CPI - X) for setting tariffs to replace the existing cost-plus one (i.e. cost + return). It was expected that a price-capping mechanism should provide the power companies with the incentive to improve their operating efficiencies and make future tariff adjustments more acceptable to the consuming public as these adjustments would then be automatically capped below inflation.
10. The power companies came back with observations that price control (e.g. CPI - X) is rarely applied to fully integrated power businesses (combined generation, transmission, and distribution) as is the position in Hong Kong today. A change of regulation in this respect would require a complete re-negotiation of the SCAs rather than an interim review.
11. We agreed with the power companies not to pursue the price-capping concept further. We recognise that the existing monitoring arrangements (periodic financial reviews, annual tariff and auditing reviews) provide the Government with sufficient means to control the setting of tariffs. The approval of a basic tariff rate in the Financial Plan serves, to a certain extent, the price-capping purpose. The power companies are also accountable for their tariff adjustments as the legislature is briefed by them on justifications for making such adjustments each time. Furthermore, the power companies have made significant efforts to reduce costs and keep tariff increases below the general level of inflation. However, we agreed to further improve the existing arrangements by increasing the accountability of the power companies on their performance through establishment of performance indicators/benchmarks. The information paper of 26 October 1998 has explained this in more detail.
Demand side management (DSM)
12. We considered DSM as one of the obligations of the power companies and requested that it be included in the SCAs, although each of the power companies have already entered into a separate DSM agreement with the Government. The power companies have agreed and amendment will be made to the SCAs accordingly.
13. We considered that both power companies should have a strong commitment in the SCAs with regard to environmental protection and conservation and requested that CLP/Exxon should have a statement on environmental obligation in their SCA similar to that in HEC's.
14. CLP/Exxon emphasised strongly that they had always followed high environmental standards and awareness and would continue to do so.
15. After discussion CLP/Exxon have agreed to include in their SCA a provision to recognise explicitly that, in addition to following applicable law and regulations, the companies undertake to conduct their business in a manner compatible with the balanced environmental and economic needs of the community.
Treatment of fuel costs
16. We proposed to the power companies to review the treatment of fuel cost which has recently become a major element in annual tariff adjustments.
17. The power companies have maintained that fuel cost is beyond their control and must remain a pass-through to consumers as provided under the SCAs. They recognised the need to minimise the fluctuation in the year-over-year tariff adjustments due to fuel costs and have agreed to provide more longer term financial forecast figures for consideration by the Government during the annual tariff reviews. This will enable both sides to take a more forward looking view when considering the level of necessary tariff adjustment at each annual tariff review, taking into account the need to keep the Fuel Clause Adjustment Account at a reasonable level while minimising the fluctuation in tariff adjustments.
18. It was agreed that both sides would follow up this issue at the annual tariff reviews.
Useful life and depreciation of fixed assets
19. We proposed to the power companies that they review the periods of useful life and depreciation for their plant and facilities in the light of the current technological standards and practices as there appears room for their extension and hence a reduction in costs to the consuming public.
20. The power companies were prepared to conduct such a review but pointed out that there were various factors involved in a decision on whether to extend life or replace assets. Extended life would reduce annual depreciation charges and delay the need for expenditure on new plant. However, old assets might operate less reliably and less efficiently than more advanced new plant, and the environmental impact might be greater.
21. The power companies have agreed to conduct a careful review and forward proposals for our consideration. We will examine their proposals with the assistance of our electricity consultants.
Term of the current SCAs
22. The power companies were concerned that they had made major investments over the last few years, and would have to continue to do so in the future to maintain a reliable electricity supply. By its nature the power industry requires long term planning and investment and many such investments are now extending well beyond the current term of the SCAs. The investment risks increase as time passes. CLP/Exxon requested the Government to consider extending the term of the current SCAs.
23. CLP/Exxon have agreed not to pursue this issue further on our advice that it was too early to discuss the future of the SCAs which have just passed one third of their fifteen-year tenure.
Administrative issues and textual amendments
24. We raised a number of minor administrative issues and textural amendments to the SCAs which do not involve matters of principle. Both sides discussed these issues and have agreed on proposed amendments to the SCAs as appropriate. The effects of these amendments are to streamline processes for Government monitoring of the activities of the power companies and to clarify and up-date wording in the SCAs.
The details and implementation timetable for the proposed modifications to the SCAs
25. The agreements in principle reached with the two power companies in the interim review are subject to the approval of the Executive Council. We expect to finalise all the details of the agreed amendments to the SCAs and related arrangements and submit them for the approval of Executive Council in early 1999. The proposed amendments would take effect from the financial years beginning on 1.10.1998 for CLP/Exxon and 1.1.1999 for HEC respectively.
The basis for determining the minimum reserve capacity of 30% and the permitted return of 13.5%
26. At the Panel meeting of 26 October, 1998 we mentioned that we considered a reserve margin of about 30% as not excessive. This was to give members a broad idea of the subject of reserve capacity requirements without the need to go into technical details. To be more precise the criterion for determining minimum reserve capacity is based on maintaining an adequate standard of reliability in electricity supply, after allowing for the planned or unforeseen outage of generating units, fluctuation in demand and operational needs. The main criterion in use by the two power companies is "loss of load probability (LOLP)" i.e. the probability of power interruption in terms of hours or days per year. It is the benchmark for capacity planning and is commonly used world-wide in the electrcity supply industry. If the installed capacity of a system cannot fulfil the LOLP criterion for a particular year, then additional capacity will be needed for that year to ensure that the standard of reliability of supply is maintained. Its effect can be expressed in terms of the equivalent reserve margin.
27. For indication purposes, the minimum reserve margin required in order to fulfil the LOLP criterion for future capacity additions would be around 25%. Additional capacity would be needed in order to prevent the reserve margin from falling below this level. The additional capacity installed would inevitably raise this margin above the required minimum level in the year to about 35% to 40%, depending on the overall size of the system and of the capacity of the unit added. The average of the actual reserve margins over a number of years spanning those before and after capacity additions would be around 30%.
28. The permitted return of 13.5% is a ceiling that applies to fixed assets financed by loans and other sources such as the Development Fund and Customers Deposits. It is subject to deduction of actual interest charges up to 8% and an 8% charge on the average balance of the Development Fund. The terms were negotiated in 1991/92 for the current SCAs but followed similar levels in previous SCAs. The effect is that the actual net return to shareholders is about 12.0% p.a. of the average net fixed assets.
The forecast demand and generating capacity of China Light and Power Company Limited (CLP) and Hongkong Electric Company Limited (HEC) in the next ten years
29. The information requested has no bearing on the interim review. However, we have asked the power companies to provide the information. For CLP they expect that demand will grow at an annual rate of between 2% and 4%, but there could be significant fluctuations above and below these levels during individual years. In any event, they will conduct a review of their demand and capacity situation with the Government in the fourth quarter of 1999 in accordance with the agreement with Government on deferral of Black Point units 7 and 8. Please see Annex A. For HEC, they expect that demand will grow at an annual rate of approximately 4% over a period of ten years to 2008. Please see Annex B. HEC considers that the growth rate is lower than that forecast by them in January 1998. They consider that it is not the right time to make public their latest forecasts in detail which are the subject of a study being conducted by the Government.
The progress of the proposals to increase the interconnection capacity between CLP and HEC and to promote competition in the electricity supply sector
30. We commissioned in May this year a consultancy study on the feasibility of increasing interconnection between CLP and HEC and promoting competition in the electricity supply industry in Hong Kong. The study is approaching completion. The consultants will present their findings to the Energy Advisory Committee within the next few weeks. Subject to the advice of the Energy Advisory Committee, we expect to conduct a public consultation on the report early next year for the Government to formulate the way forward. Members will be briefed in due course.
The provisions on environmental obligation in the SCAs of both CLP and HEC and how these provisions were actually put into effect
31. Under its SCA with the Government HEC is required to provide its service in a manner consistent with, amongst other things, Government policy objectives on energy efficiency and conservation in the light of the need to protect the local and global environment and to meet international obligations. There is no such a specific requirement in CLP/Exxon's SCA. As explained in Paras. 13 to 15 above, CLP/Exxon have agreed to include an environmental obligation in their SCA.
32. The power companies are required to comply with the standards contained in the various environmental laws and regulations. These deal essentially with the emissions and discharges of pollutants originating from the power generating facilities and with environmental impact assessment on proposed expansion or decommissioning of power plants. The power companies have a good record of legislative compliance.
33. Although no energy efficiency performance targets for power generation are set in the SCAs, we accept that the two power companies measure up well by international standards. We acknowledge that the power companies have been working in a responsible manner and have made commendable efforts on the environmental front. For example, we were pleased to see CLP's recent and publicly available Corporate Environmental Report. As long as the power companies continue to do so, we would not see the need to introduce mandatory requirements.
The outcome in respect of the proposal to extend the useful life of plant and facilities owned by CLP and HEC and its details
34. The information is provided in Paras. 19 to 21 above.
Economic Services Bureau
6 November 1998
CLP's forecast of maximum demand for electricity
and generating capacity
# Demand in 1999 and after is forecast to grow by between 2% to 4% p.a.
* Capacity does not include Black Point units nos. 7 and 8. The timetable for the installation of these 2 units is subject to review in fourth quarter of 1999.
HEC's forecast of maximum demand for electricity
and generating capacity
# Demand in 1999 and after is forecast to grow at approximately 4% p.a.
* Capacity does not include any future additions which are subject to study and approval by the Government.