Brian Fallow on the economy

Brian Fallow is the Herald's Economics Editor

Brian Fallow: Electricity chief zaps regulation scheme

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Brent Layton has plenty of reasons why the Labour-Greens economic plan for power generation won't work.

Dr Brent Layton. Photo / NZPA
Dr Brent Layton. Photo / NZPA

The wholesale electricity market is competitive, Electricity Authority chairman Brent Layton insists.

"There are more major generators in New Zealand than there are major banks, petrol companies or telephone providers. There are, in addition, another 70 generating entities," Layton said yesterday in a wide-ranging assault on the economic case the Opposition parties have put up.

And replacing the market with a system where asset values determine prices, rather than the other way around, would not benefit consumers in the long term, he says.

Labour and the Greens propose replacing the wholesale electricity market with a centralised decision maker, New Zealand Power, which would enter into long-term contracts to buy power from generators, at prices anchored on their historic costs, and hold tenders for new generation capacity.

It is an idea considered at least four times over the past 20 years, and found wanting from the standpoint of the long-term interests of consumers, Layton says.

One criticism of the status quo is that wholesale power prices tend to be high when the hydro system is short of water, even though the generators do not have to pay for the water turning their turbines.

But what matters economically is the opportunity cost of the water, Layton says.

The opportunity cost of using water today to generate power is the value of using it instead to generate some time in the future or for some other use like irrigation or recreation.

During a drought water has significant economic value, if only because the costs to society of running out of electricity are high. By reflecting the opportunity cost of water at any point, the market provides signals for non-hydro generators to boost production when water is scarce, and for users who can to reduce load to do so.

"This does not mean, however, that hydro-generators are making super-profits under the current market. The capital cost of hydro-generation is much higher than, for example, a gas-fired turbine. The operating costs are the other way round, with the gas-fired plant more expensive than the hydro plant.

"If hydro-generation had a distinct total cost advantage over other types of generation because its fuel, water, is free, one would expect to see all new and replacement capacity to be hydro-generation. This is not the case."

The Opposition parties have cited, as evidence the wholesale market is not competitive, a study by Stanford professor Frank Wolak, which the Commerce Commission commissioned and which concluded that the four largest generators exploited market power to collect $4.3 billion in excess profit in dry years between 2001 and mid-2007.

But the subsequent ministerial review of the sector, which Layton chaired, having considered three peer reviews of the Wolak report, rejected his conclusion for five reasons he spelled out yesterday.

He says no detailed analysis had been done to establish that any excessive prices in the wholesale market had been passed on to consumers, rather than simply being wealth transfers among generators.

The commission just assumed they would be passed on, and cancelled that part of the exercise. The Layton review did acknowledge there was some scope for exercise of short-term market power in the wholesale market and made recommendations, all of which have been acted on, to address that, including the fostering of a deeper and more transparent hedge market.

In addition, Transpower has been spending billions upgrading the national grid, relieving bottlenecks, which is a fundamentally pro-competitive development.

"A further criticism of the wholesale market is that the general rise in wholesale prices has led to windfall profits for generators with existing plant that was built when equipment prices were much lower and this is unfair to consumers," Layton says.

"According to these critics, consumers should be able to buy electricity produced by old plant at prices based on the plant's depreciated historic cost and current fuel and other operating costs. Sometimes this is expressed as wholesale electricity prices should reflect average costs of production, not marginal costs."

This is a bit of a straw man argument on Layton's part, inasmuch as Labour's David Parker is clear that what he means by historic cost is the value at which the assets were transferred to Contact Energy and the (former) SOEs in the 1990s, rather than what they cost to build in the first place.

Nevertheless Parker readily accepts that the regulated value of those assets, which would drive the prices at which the new single buyer would buy power they generate, would be less than their current value. That is the point of the exercise.

But Layton argues that, in any case, to now say generators' return on capital will be set by regulators, and windfall gains will not be permitted, breaches the implicit bargain entered into by the Crown when it transferred the assets.

"It can be open to a regulator to do such a thing, but the consequence would be to have a chilling effect on investment in the electricity sector, and probably elsewhere. This would not bring long-term benefits to consumers," Layton said.

If taken at face value, the claim that the proposed changes to the electricity sector would save households an average $300 a year means they would have to yield about $500 million a year.

"There is no capacity to extract from the wholesale market $500 million a year of super profits," Layton said.

"Given the size of the expropriation required to raise, say, $500 million a year would be about $7 billion, the chilling effect on investment in New Zealand is likely to be large, widespread and long lived. Either the Government will be forced to build future plants ... or shortages of electricity ... will be likely."

Parker believes the changes would take two years and that the time to do it is ripe, as there is enough excess generating capacity to cover such a period of "investor uncertainty".

But Layton argues it would take a small army of bureaucrats, consultants and lawyers five years to determine the appropriate amounts to to pay existing generators to cover their operating and capital costs.

He estimates the transition to the new system would cost about $180 million, and a further $30 million a year to run it.

- NZ Herald

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