Brian Fallow on the economy

Brian Fallow is the Herald's Economics Editor

Brian Fallow: Show us first that power is broken

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There must be other ways of dealing with energy poverty than upending the electricity market.

Photo / Christine Cornege
Photo / Christine Cornege

The onus is on those calling for radical, disruptive change to something as important as the electricity sector to demonstrate that it is broken and needs fixing.

So far they haven't.

First, let's calibrate the scale a bit.

Electricity makes up just under 4 per cent of the consumers price index. CPI weightings reflect the results of what very large surveys show households spend their money on.

It is an average, of course. For some households the power bill will be a lot more than 4 per cent of their outgoings.

When David Shearer announced last Thursday Labour's policy of inserting a new single buyer between the supply and demand sides of the electricity industry, he talked about hearing from families with young children that they often cannot afford to heat their homes properly.

But if energy poverty is an issue, there must be more targeted ways of dealing with it than upending the electricity market.

Only a minority of residential consumers' power bills reflect the cost of the energy itself. Most of it is the cost of getting the energy to them, through the national grid and local lines networks, plus electricity retailers' overheads and profit margins, plus GST - all things outside the scope of Opposition parties' proposed reforms.

So this is all an argument about whittling down what is a little more than 1 per cent of the cost of living.

The fact that residential power prices have been rising faster than the CPI is not per se a scandal or evidence of market failure.

Relative prices change. House prices, for example, are also outstripping the CPI. That is not evidence that the housing market is failing to perform as a competitive market should.

Much of the rise in household electricity prices over the past 20 years can be explained by factors less sinister than hydro generators extracting "super profits".

The reforms of the 1990s spelled the end of a system where local body politicians on power boards ensured a cross-subsidy from commercial to residential power users.

In the early 2000s the redetermination of the Maui gas field's remaining reserves saw the price of gas for the newly built combined cycle gas turbine power stations nearly double.

And latterly consumers have had to pick up the bill for about $5 billion of catch-up spending on the national grid - spending intended not only to keep the lights on but to get rid of bottlenecks which impair retail competition in parts of the country.

The heart of the problem Labour and the Greens have with the existing market model is that it is "unfair" that wholesale electricity prices reflect marginal rather than average cost.

The spot price is the price of the most expensive generation that needs to run in any given half-hour period to ensure that all the demand in that period is met.

It is the price all the electricity retailers have to pay and all the generators dispatched receive, regardless of what it cost them to generate the power or if they offered power at a lower price.

But since all the big power companies are vertically integrated - that is, they are both generators and retailers and therefore on both sides of the wholesale market - the extent to which they are exposed to the spot price will depend on the extent to which they are net sellers or net buyers in any given half-hour period, and at different connection points on the grid.

As well as the natural hedge of vertical integration, they have a number of contractual hedging options to manage the spot price risk. Complicated, isn't it?

A report for the Commerce Commission by respected US economist Frank Wolak concluded that market power was being exercised in the wholesale electricity market.

Since then we have had an industry review headed by Brent Layton which recommended pro-competitive changes, including asset swaps among SOEs, which have been implemented.

It would be interesting to see if a repeat of the Wolak study now still detected the same problems.

In the meantime the Electricity Authority cites various metrics which point to increased competition.

In any case the idea of prices being set at the margin is hardly some discredited neo-liberal doctrine from the 1980s. It is commonplace.

What is novel is the Opposition's idea that the buyers of a commodity should pay suppliers different prices depending on the supplier's costs.

Suppose there are two neighbouring dairy farmers, one of whom inherited his farm 20 years ago while the other bought his land recently and has just completed an expensive dairy conversion.

Fonterra will pay them both the same price in cents per kilogram of milk solids.

It will not use its market power to offer the older guy a lower price on the grounds that he has a much bigger profit margin and has capitalised a lot of free rainfall into his balance sheet.

That might be an argument for a capital gains tax, but not for differential pricing at the farm gate based on historical costs.

It would not be fair, or efficient.

Whatever model New Zealand has for its electricity system has to be able to cope with wide swings from year to year in how much rain and snow falls in the catchments of the hydro lakes, which have limited storage capacity.

In the first half of last year the system was severely tested. Inflows into the South Island lakes were the lowest on record.

Did you notice? Neither did I.

The Electricity Authority, reporting the previous Wednesday on the market's performance last year, said it had worked well compared with past dry years. Power flowed south across Cook Strait earlier and water in the southern lakes was conserved.

Labour's finance spokesman, David Parker, who is the architect of this policy, looked closely at the single buyer model when he was Minister of Energy in another, less severe, dry year, 2006.

"At that time we had transmission constraints and generation margins [a buffer of spare capacity] that were so tight that we had weekly reviews in Cabinet. At that point the absolute priority was energy security margins and therefore we didn't want to do anything that might cause an investor strike," he says.

"Security of supply is paramount. It is not that we were comfortable with the profits that were being extracted under the long-run marginal cost model.

"Now New Zealand's electricity generation margins are better than they have been for a long time, so if there was ever a time you could actually do this it is now. During that period of transition will generators be slower to invest in new kit? Yes."

Officials' advice then was that it would take a couple of years to implement a transition to a single-buyer model. Or so they guessed; they could not find any example of another jurisdiction making that change.

The same excess capacity - even without the possible closure of the Tiwai Pt aluminium smelter - that Parker sees as a window of opportunity for radical structural change in the electricity sector, equity analysts see as putting downward pressure on wholesale electricity prices anyway.

- NZ Herald

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