Brian Fallow 's Opinion

The Economics Editor of the NZ Herald

Brian Fallow: SOE sales folly without smelter sorted

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Demand for power is growing slowly. There is overcapacity in generation. Photo / Supplied
Demand for power is growing slowly. There is overcapacity in generation. Photo / Supplied

When the Prime Minister outlines the Government's plans for the year ahead he will no doubt be clear that it is not going to shrink from doing something foolish just because it is unpopular.

It is folly to press on, full steam ahead, with the partial privatisation of the state-owned power companies when the future of the Tiwai Pt aluminium smelter is unresolved.

It would be no better to capitulate to Rio Tinto's demands for a better deal merely in order to remove that dark shadow of uncertainty overhanging the electricity industry, in order to get the floats away.

Demand for power is growing slowly. There is overcapacity in generation.

Were the demand side to shrink by 14 per cent over three years, if the smelter closed, it would have huge implications.

If Meridian's Manapouri hydro station - which was built for the smelter, and vice versa - were widowed, its life would not be over.

It is New Zealand's cheapest power and if it became available to the rest of the country it would have no problem getting dispatched.

The question would be which - and whose - other power stations would then become surplus to the system's requirements.

The consequences for Genesis' coal-fired plant at Huntly, and for Solid Energy which supplies it with coal, would be grave. Good for the planet, maybe, but not for the Government's asset sales programme.

And would it end there? How much would it reduce the need to run other companies' combined-cycle gas-fired plants? How would it affect the prices at which generators offer power into the wholesale market? Meridian would find itself massively "long generation", that is, producing twice as much power as it needs to satisfy its remaining customers.

It is a commercially uncomfortable position to be in and could be expected to trigger a fresh wave of retail competition.

Good for consumers but not for the profit margins of companies the Government is trying to sell.

In these circumstances any projections for the forward price path for electricity and the earnings of power companies would be dodgy indeed.

Either the Government would have to accept a lower price for its shares - an uncertainty discount - or investors would be at risk of paying too much.

When he announced last year that the float of Mighty River Power was scheduled for the June quarter this year John Key was asked whether he thought the issue of the smelter contract would be resolved by then. "Probably not," he said.

Meridian at this stage is only saying that the negotiations are continuing and can offer no guidance as to when they might be concluded.

Late last week Rio Tinto announced that when it reports its full-year results next month it will write down the value of its global aluminium assets by between US$10-11 billion ( around $12.5 billion).

Since then world aluminium prices have been on a roller-coaster ride. They more than halved between July 2008 and February 2009. They recovered most (78 per cent) of that drop by April 2011, only to drop by a third by August last year. Since then prices have been rising again but so far have only clawed back an eighth of the most recent peak-to-trough decline.

Much of that volatility can no doubt be laid at the door of external factors - the global financial crisis and its echo in the European sovereign debt crisis, offset by China's massive post-GFC stimulus and more recently the spillover effects from major central banks' moves to pump liquidity into their economies on a spectacular scale.

However, the suspicion is that some of the aluminium industry's woes are internal and structural. Smelters are often built, not so much with a particularly keen eye on demand as to exploit energy resources otherwise too remote to develop.

In the case of Manapouri and Tiwai, however, the opportunity cost of supplying the smelter is a long way from zero. Manapouri would not be a stranded asset were the smelter to close.

It is understood, though Meridian will not confirm this, that Rio would have to give three years' notice of closure and that its contracted demand would step down progressively over that period.

Transpower has indicated that to upgrade the national grid in Otago to facilitate the flow of Manapouri power north would take three years and cost something over $100 million - not a huge sum in the context of a multibillion-dollar grid upgrade - and the new Pole 3 link between the South and North Islands is due to be completed well within that time frame.

Meridian is a large company by New Zealand standards but it is small fry compared with Rio. The contract was negotiated in good faith and while metal prices have swung wildly since then, that possibility can hardly have come as a surprise to one of the world's largest mining groups. In any case some of the metal price risk is borne by Meridian; we know that because it carries hedging to mitigate that risk.

Rio's latest operational data shows that production from the Tiwai smelter fell 9 per cent last year compared with the year before.

But that cannot be seen as a reflection on the new power contract.

It was not in force last year and it has long been the smelter's policy to buy some single-digit proportion of its power requirements on the spot market. A dry year meant spot prices were high last year.

The essential commercial question for Rio Tinto is whether the new contract saddles it with power prices at which the smelter is worth more to it dead than alive.

Rio could seek to buy itself a better deal from Meridian, with a lump sum compensation for renegotiation. Or it could demerge its Pacific Aluminium business listing it separately so that it does not weigh on the Rio share price.

But to return to the politics of the situation, the interests of Meridian may not be the same as those of its shareholder, the Government, whose priority seems to be to ensure that some of us end up owning more of the SOEs while the rest of us own less of them. That raises tricky governance issues.

The interests of the country are different again. With our trade deficit widening again, and overseas debt levels already lapping around our national nostrils, to imperil a $1 billion export industry is something to be avoided. But not at all costs.

- NZ Herald

Brian Fallow

The Economics Editor of the NZ Herald

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