Brian Fallow 's Opinion

The Economics Editor of the NZ Herald

Brian Fallow: Power policy needs more illumination

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Analysing Labour / Green plan hampered by continuing lack of clarity nearly a year after it was announced.

Hydro generators may not have to pay for water, it still has a cost and water they use is not available for other purposes, now or later. Photo / NZ Herald
Hydro generators may not have to pay for water, it still has a cost and water they use is not available for other purposes, now or later. Photo / NZ Herald

Does the electricity market entrench the ripping off of consumers?

Would replacing it with a single buyer model address the issue of energy hardship among some households?

When Labour and the Greens insist the answer to those questions is yes, they are not assisted by the facts.

A mounting pile of critiques of the New Zealand Power proposal attests to that, though analysing the policy is hampered by the continuing lack of detail around it nearly a year after it was announced.

NZ Power, a new independent Crown entity, will act as a single buyer of wholesale electricity, Labour says.

"Each generator will be paid a fair return for their actual costs. The fair return will be calculated by NZ Power on the basis of their historic capital costs, possibly adjusted by inflation, plus operating costs like fuel, depreciation and maintenance."

We have yet to hear what would count as a fair return.

Nor is it entirely clear what will count as the historic costs on which a return will be permitted.

Labour's finance spokesman David Parker, the architect of this policy, has indicated he has in mind the values placed on the assets when vested, that is when ECNZ was split up into Meridian, Mighty River and Genesis in the late 1990s.

The populist appeal of all this rests on the idea that the owners of hydro generation assets must be making out like bandits.

Their fuel, water, is free and the capital costs were met by the people of New Zealand years ago.

Yet the wholesale market delivers to all generators the price of the most expensive power offered into the market in any given half-hour period needed to ensure that all the demand in that period is met.

Torrents of windfall gains must be flowing into the generators' coffers at the expense of the poor old consumer, whose power bills have been rising relentlessly for years. While Meridian, Mighty River and Genesis were wholly state-owned that was perhaps tolerable but their partial privatisation changes that.

That, in brief, is the popular version of the NZ Power policy.

But this is a complex industry and the gulf is wide and deep between slogans and practical policy design that does not do more harm than good.

Critics of the policy point out that while hydro generators may not have to pay for water, it still has a cost - an opportunity cost to the country as a whole.

Water a generator puts through its turbines is water that will not be available later in the year when the demand for power, and therefore the value of water to generate it, could be much higher.

The market's ability to signal the scarcity value of water has helped keep the lights on.

Reverting to the system where a central planner makes the calls to conserve water and burn gas instead poses risks and the likelihood that the costs of miscalculation would fall on the taxpayer rather than the power companies.

Parker has indicated that he still sees a role for the spot market. That suggests that not all of the power generated would be purchased at a regulated price, so as to retain some of the efficiency gains from marginal pricing.

But quite how that would work when NZ Power is deciding whose plant runs when is not altogether obvious.

And what the relative volumes would be and the effect on the economics of generation are entirely unclear at this stage.

On the sunk capital costs, the Electricity Authority last month published research intended to "dispel the myth" of cheap hydro, when a rate of return on the high upfront capital costs is factored in.

"The modelling suggests residential consumers are currently paying close to the total cost to serve them based on historical costs, while other consumers are paying less than total cost," it concluded.

Its results indicated that between 1974 and the mid-2000s residential consumers were paying a whole lot less than the full cost of the power they consumed.

Critics of that work cavil at the assumed cost of capital, saying 10 per cent is too high, and argue that it was well understood that the cost of building the hydro dams was to be split between consumers and taxpayers, reflecting the importance of electrification for economic development.

Did the taxpayers get their money's worth? Undoubtedly. Look around you, it is a developed country.

Academic economist Geoff Bertram points to the $11 billion of upward revaluations to the book value of the SOEs' generation assets since 1999 as a measure of windfall gains they have enjoyed under the market model. He sees it as an unjustifiable wealth transfer from consumers to the companies.

The first point to make about that is that in a competitive market - in this the generator/retailers differ from the lines companies like Vector - it is (expected) market prices which drive asset values, not the other way around.

Secondly, if there has been an $11 billion transfer where has it gone?

It is not to be found in the profits of the SOEs or their privately owned competitors.

Castalia Strategic Advisers, citing analysis by Ernst & Young for the Treasury, says that over the 10 years to 2011 the three SOEs earned an average of 1.1 percentage points above the cost of capital calculated on the historic cost, that is, with the revaluations stripped out.

That is an average of $54 million a year between the three of them. Hardly egregious profiteering.

Meanwhile Infratil, a major shareholder in Trustpower, said in a report last September that the average return to Trustpower and Contact shareholders (weighted for their relative size) in dividends and share price gains since 1999 has been 10.3 per cent per annum, or 7.8 per cent in real terms.

"OK as far as returns go," it said, "but hardly excessive."

On the issue of energy hardship - the struggle some households face to heat their homes to a decent standard - that is clearly a multi-dimensional problem including not only electricity prices but incomes, the insulation standards of buildings, the ability to afford more efficient appliances like heat pumps and geographical location.

It is worth remembering that power bills account for just 3.6 per cent of average household expenditure, according to Statistics New Zealand's 2013 household economic survey.

And only about a quarter of the average residential power bill is generation. The rest is the cost of getting the power to us over the national grid and local lines networks, retailers' overheads and margins, and GST.

So the costs and risks involved in scrapping the wholesale electricity market have to be weighed against the benefits of maybe compressing a bit a cost which represents about 1 per cent of the cost of living of the average household.

Surely there is a more targeted policy option to address fuel poverty.

The more promising approach to curbing residential power prices - which on Electricity Authority figures are around the middle of the pack among the 18 developed countries they looked at - is to do everything possible to increase competitive pressure on retail margins.

More transparency about how much of our power bills goes where, and readily comparable tariffs, would help.

- NZ Herald

Brian Fallow

The Economics Editor of the NZ Herald

Brian Fallow is the New Zealand Herald's economics editor. A Southlander happily transplanted to Wellington, he has been a journalist since 1984 and has covered the economy and related areas of public policy for the Herald since 1995. Why the economy? Because it is where we all live and because the forces at work in it can really mess up people's lives if we are not careful.

Read more by Brian Fallow

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