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● the overall pricing structure should include a variable element that reflects the marginal costs of supply in order to provide an incentive to minimise network constraints.

System Expansion and Replacement Principles

15. To ensure investment efficiency, it should be left to industry participants, wherever possible, to make investment decisions that benefit grid users (in terms of increased security and reliability and/or lower costs from losses and constraints). The industry should be encouraged to evaluate alternatives to grid expansion and replacement, such as distributed generation and demand-side solutions.

16. To assist in the application of this principle, Transpower should produce annually a rolling 5-year Statement of Investment Opportunities in relation to forecasts of medium term system adequacy. The Statement of Investment Opportunities will assist grid users to identify opportunities for generation (including distributed generation) and demand-side management (including energy efficiency and load management), and to determine whether these are more appropriate than further investment in the grid by Transpower.

17. In addition to those circumstances where Transpower and grid users have voluntarily agreed, grid expansion and replacement should take place where the Governance Board is satisfied that:

● the costs arising from (a) grid constraints and (b) risks relating to security exceed the costs of relieving those constraints and risks through investment in the grid; and

● alternative responses by industry participants and/or grid users (such as distributed generation and demand-side management) are not and are unlikely to be adequate to resolve the issue.

18. Where the Governance Board concludes that investment by Transpower is necessary, the cost of that investment should be recoverable by Transpower in accordance with the pricing methodology determined by Transpower and agreed with the Governance Board.

Implementation Guidelines

19. The following guidelines are to be considered when applying the above principles:

● where the principles conflict, those conflicts should be resolved in a manner that is most consistent with the Government’s energy policy objectives; and

● the application of the principles should take into account practical considerations, transaction costs and the desirability of consistency and certainty.

ATTACHMENT 2

MANAGEMENT OF ELECTRICITY SUPPLY RISK

This document is issued as an attachment to the Government Policy Statement entitled "Further Development of New Zealand’s Electricity Industry", dated February 2002.

“Dry-year” Risk

1. A key risk to the security of electricity supply in New Zealand is climatic uncertainty. We rely heavily on hydro generation and New Zealand has limited water storage capacity. Unusually low rainfall, or “dry years”, can create electricity shortages. The economy will continue to face this risk for the foreseeable future.

Government’s Objectives

2. The Government’s objective is to provide a framework which will ensure that dry-year and other supply risks are managed prudently at least cost to the economy.

3. Previous governments’ Policy Statements concerning the management of dry-year risk have emphasised:

● the expectation that electricity industry participants should ensure that they take responsibility for managing dry-year and other supply risks; and

● that the Government will not step in to protect those who fail to provide adequate protection.

4. If industry participants did not take such action, and a government stepped in, the likelihood of future supply shortages would increase as a result of weaker incentives on buyers and sellers of electricity to arrange appropriate risk management strategies.

5. It is timely to reiterate the current Government’s expectations of industry participants and the principles that should be observed in managing electricity supply risks.

Expectations and Principles:

(a) Dry-year and other supply risks should be managed in such a way as to minimise overall costs to the economy.

(b) Responsibility for managing risks relating to supply rests with market participants.

(c) Generators are responsible for providing protection against supply risk at a quality and quantity that is demanded by their customers and established in contracts.

(d) Spot and contract prices in the wholesale market should signal the changing risks of a dry year.

(e) A range of mechanisms is available to industry participants to manage dry-year and other supply risks, within and outside the wholesale market.

(f) The trade-off between the costs of supply and protection measures should be made by those at risk.

(g) The wholesale market rules should not be biased against any particular protection mechanism.

(h) The Government is not expected to step in to protect wholesale buyers who fail to put in place adequate protection arrangements.