Dialogue: Investment incentive required

By DR KEITH TURNER*

In June, it was alleged that high spot prices had been manipulated. We now know that New Zealand has had its driest year in its major water storage catchments.

The problem, caused by low inflows, was compounded by a lack of transmission investment in the past 10 years, and no incentives to reconfigure the transmission system to meet changed market conditions.

The result emphasises how little hydro storage New Zealand has compared with other countries.

Where hydro systems in Canada, Australia and Norway may have up to three years storage, our South Island lakes have about 10 weeks of total annual production.

This makes inflows critical, and more influential on spot prices than lake levels.

Our plight also emphasises the importance of overcoming Transpower's disincentive to invest and the need to match changed market conditions.

There is no fundamental design problem with New Zealand's wholesale electricity spot market.

High spot prices are a natural market outcome when supply is short.

The incentives that high prices create for all those exposed - generator, retailer and end-users - are appropriate.

NZEM, the New Zealand Electricity Market, is designed to allow prices to rise. There is no price cap, so incentives to lift supply or cut demand are critical to those exposed to a rapidly increasing spot price.

There was an element of market immaturity.

The national savings campaign was called because market participants had not experienced extremes of risk before.

This meant some did not take risk management contracts late last year and did not recognise the early autumn market signals.

The risk management issues of this year are clear.

Earlier and better information should ensure the parties make informed decisions and should, as a result, increase demand for risk management products.

The wholesale market is not constrained by vertical integration.

New Zealand's hydro variability means that a proportion of generation will always be sold at spot.

Indeed, the potential for mismatched generation to retail/contracts, the unders and overs, may be greater here than in other countries.

Vertical integration allows for greater price certainty for consumers.

Most electricity consumers want price certainty and had this over the winter.

This also provides certainty for investment. or in demand management options.

More uncertainty in investment will increase the risk of future shortages.

Retail competition has disciplined pricing.

Contract prices over the past four years for industrial/large commercial customers have effectively replicated spot with no margin for dry year risk.

This is unsustainable, and the market is resetting. Intense competition at the residential level has impeded retailers' ability to pass on the impact of rapidly increasing spot prices to customers.

Risk management decisions are a natural part of business; there is no need to separate generation-retail, or to impose a requirement to contract on generators, retailers or end-users. To do so would only dull incentives to monitor market conditions and respond.

A system of pre-agreed identifiable triggers is needed, allowing the transmission network to reconfigure to meet market conditions.

New Zealand will have water shortages again.

The delays and uncertainty that occurred before Transpower reduced security on North Island transmission assets and called for additional South Island reserves were unnecessary, and made the shortage worse.

A financial instrument that sharpens Transpower's incentives to maximise the ability of the transmission system to transfer energy, as opposed to focusing almost solely on achieving a specific level of system reliability, would assist greatly.

Transmission pricing and investment incentives have been uncertain for 10 years.

As a result of the various regulatory reviews, Government Policy Statements and legislative decisions, the industry is removing one of the main problems associated with Transpower's reluctance to invest - its ability to recover costs.

However, the transmission investment rules must be practical, and the resulting pricing methodology must not undermine market efficiency.

* Dr Keith Turner is chief executive of Meridian Energy.