Brian Fallow: Setting record straight on power

The difficulty in a predominantly hydro system is deciding what the opportunity cost of water is in any given dam at any given time. Photo / Simon Baker

The Labour Party probably regrets invoking the work of Professor Frank Wolak when making the case that New Zealand's electricity system is broken and in need of a radical overhaul.

Announcing its policy alongside the Greens in April it cited as evidence that the electricity market is not competitive "a 2009 report by international expert Frank Wolak which concluded that between 2001 and 2007 the four big generators extracted super profits of 18 per cent ($4.3 billion) which came at the expense of higher prices for consumers".

Having put those words in the Stanford economist's mouth, Labour's finance spokesman David Parker got to hear him spit them out, when he gave a lecture to the Victoria University's Institute for the Study of Competition and Regulation in Wellington last week.

Wolak also made it clear he is no fan of cost-based systems such as Labour is peddling, where - instead of a market where generators offer power at whatever prices they see fit - the system operator, armed with a mathematical model and the technical specifications of the various generating units, decides which will run at any given time.

He had never said the generators were making excess profits, he insisted. That would require making a judgment about what cost of capital is needed to ensure the system's requirements for capital investment are met.

Rather, the work he undertook for the Commerce Commission compared prices actually struck in the spot market with an ideal benchmark of perfectly competitive market conditions.

Wolak derived tests for occasions - typically during dry years, of which there were three in the period he looked at - when a generator had both the ability and the incentive to exercise unilateral market power, that is, to jack up the price at which the market would clear.

The incentive leg of the test is important because the power companies are vertically integrated generator/retailers, both selling into and buying from the same market. There is no point in driving up the price if you are a net buyer.

"When the ability and incentive to raise the price are positive and big, do we see suppliers submit higher offer prices? The answer is yes. There is strong evidence that is precisely what happens," he said.

"So congratulations, suppliers. You are doing a good job of maximising profits and responding to competitive conditions."

A good job, that is, of discharging their obligation to their shareholders.

The result, nonetheless, in the period he looked at was $4.3 billion in "profits due to market inefficiencies" during dry years. "The exercise of unilateral market power imposes little cost on consumers when there is plenty of water".

Wolak also noted - in a just saying sort of way - a widening gap between residential power prices (after the costs of transmission and distribution and GST are stripped out) and average wholesale prices for electricity.

So what about an alternative cost-based system, adopted in several Latin American countries, where instead of generators competing to be dispatched on the basis of the prices they offer, the system operator decides which will run and what the spot price will be, based on its information about various units' variable operating costs?

The difficulty with this in a predominantly hydro system is deciding what the opportunity cost of water is in any given dam at any given time, that is, what future value is forgone by sending it through the turbines, and doing that involves trusting the mathematical innards of some black-box model.

One problem is that a key input for such a model is setting a cost of shortage. If it is set too low - and the political pressure is to do that - wholesale prices will be low in normal years but the risk of power shortages in dry years is high.

"Brazil, Chile and other cost-based markets have faced several shortage periods, when firm load had to be curtailed."

Wolak counsels against going that route. It's far better, he suggests, to make the wholesale market more competitive by making the demand side more responsive to price signals.

"If you are this close to the finish line with the actual market and this far away in the cost-based market, why do it?"

With widespread use of smart meters it should be possible to make the demand side of the wholesale market more price-elastic and so limit the opportunities for generators to jack up prices.

Wolak acknowledges it will be easier for higher-income consumers to take actions to reduce their power bills.

To deal with energy poverty and the equity issues associated with higher residential power prices, all United States states and most industrialised countries provide subsidised electricity to low-income consumers, he said.

When asked about a single-buyer market, another feature of the Labour/Greens policy, Wolak was dismissive.

If the single buyer simply aggregated the demand that was there anyway, and did not reduce demand in response to higher prices, there would be no competitive benefit, just extra overheads.

Parker raised what he sees as the main flaw of the current market structure: that as it drives prices towards the marginal cost of new generation - as it needs to, to ensure investment in generation - the returns to generators whose fuel is water and whose plant was constructed decades ago grow fatter and fatter.

When those returns flowed back to the Crown, that was one thing. But the value of that public water resource was now being privatised, Parker said.

Wolak readily agreed that that equity issue was not one he had addressed. Or wanted to.

"How do you divide the spoils? That's what you [politicians] do."