Dialogue: Electricity market got it right during winter of discontent

Contrary to criticism, the electricity market met the challenges of a difficult winter precisely as intended, writes CHRIS RUSSELL*.

Market participants and external pundits have written much about the electricity market's performance during this year's cold, dry winter.

John Blakeley, in a Dialogue article, joined the fray, but made a number of wrong assertions.

First, he said the market was based on an ill-fitting market model that clearly failed to meet the needs of consumers or the electricity industry as a whole.

In fact, the market met the challenges posed by a winter of high demand and tight supply, performing precisely as it was designed to do.

The market, and its nodal pricing system, was established against a backdrop of the 1992 electricity shortage. The electricity shortage review committee highlighted the need for improved price signals and, in particular, recommended that removal of the existing price cap be explored.

It noted that the spot price at the time could not be relied upon to provide adequate early warning of an electricity shortage so mitigating measures could be taken.

When the design of the proposed wholesale market was being finalised in 1996, there was a strong desire to establish a pricing mechanism that would give early warning of impending shortage. In this context, the existing market arrangements were most effective in responding to the circumstances that developed this year.

The market delivered price signals that drew appropriate market responses - including the reactivation of old generation plants and the relief of transmission constraints - and were consistent with the intention of the design.

Mr Blakeley said several generators planned to significantly increase their wholesale electricity prices, ostensibly to finance new generation investment. This is untrue. Market mechanisms, not individual generators, dictate the wholesale price of electricity.

He also said that increasing retail prices to finance the building of new generation would deprive consumers of the benefit of low-priced electricity from the legacy of the hydro-power station network.

But this winter proved convincingly that hydro-generated energy does not always come cheap. When water in the lakes is plentiful, hydro-electricity may well be offered at lower prices than alternative forms of generation. But when water is scarce it is likely to be valued at higher prices, perhaps higher than electricity generated by means typically more expensive when water is plentiful. This is, fundamentally, a market at work.

Furthermore, an increase in retail prices could be viewed as unsurprising after a winter of prolonged high wholesale prices. Such price rises also give a firm incentive for consumers to continue to be mindful of their electricity usage, something Mr Blakeley suggested was lamentably absent during the winter.

Mr Blakeley also makes some interesting observations on the practice of hydro-spill. There are a number of reasons why generators need to spill water from lakes used for electricity generation. But ensuring the price of electricity is kept high is not generally considered to be one of them.

In fact, the main motive for generators to practise hydro-spill is legislative. The Resource Management Act imposes strict requirements on hydro-generating stations, including allowable minimum and maximum operating levels for hydro-lakes. Generators may be required to spill water from the lakes to comply with the requirements of the act.

Finally, Mr Blakeley's assertion that in February there were no hedges available to retailers wishing to limit their exposure to spot-market prices during the coming winter was without foundation.

It has been publicly acknowledged that hedges were on offer. That companies in the market for hedge cover may not have considered them desirable at the price being offered is another issue altogether.

In its report on the alleged undesirable situation in the electricity market during May and June this year, the independent market surveillance committee said: "The information available to the committee is that some financial hedges were available to market participants who wished to take them. Had they been taken, those financial hedges would have provided reasonable cover for, among others, the winter period."

This electricity market is not perfect. It is comparatively new and still developing and maturing. But it did perform successfully during the winter and, given the opportunity, could continue to evolve to meet the needs of consumers and the industry as a whole.

Instead of being criticised for failing to grapple with the problems of the electricity market, the Government should be commended for recognising that it is appropriate for any issues associated with New Zealand's relatively immature market to first be addressed by the electricity industry itself.

* Chris Russell is the chief executive of M-co, the New Zealand electricity market administrator.