Market participants have two main ways of managing the price risk.
One is vertical integration, where the same company has both generation and electricity retailing businesses. The better the match between the amount of power they generate and the amount they need to satisfy their customers, the less exposed they are to the spot market.
The other method is to buy and sell hedges - contracts which lock in future prices and volumes for generators on the one hand and retailers or major industrial users on the other.
As things stand, vertical integration is in the ascendancy.
The hedge market, if you can call it a market, is illiquid and opaque. The contracts are deep, dark commercial secrets between the parties. They are not standardised and little or no secondary trading takes place in them.
The challenge for the generators now is to show that vertical integration and a viable hedge market can co-exist.
If not, the emerging structure of four or five vertically integrated generator/retailers poses a formidable barrier to new entry. It threatens to become the sort of cosy oligopoly familiar from the oil industry before the advent of Challenge and Gull.
The four fragments of the old ECNZ - Contact, Meridian, Genesis and Mighty River Power - have bought up most of the retail businesses that used to belong to the local lines companies until former Energy Minister Max Bradford forced ownership separation upon them.
The problem lies not so much in vertical integration per se, but in the increasing trend towards a balance between the amount of electricity these integrated companies generate and the amount they need to satisfy their own customers.
The demise of Natural Gas Corp's electricity retailing arm, On Energy - whether through its own commercial misjudgment or predatory behaviour on the part of the baby ECNZs - has made this worse.
Its 500,000 former customers were sold off in job lots to Meridian and Genesis.
The upshot is that Contact Energy has 20 per cent of the country's generation capacity and 22 per cent of its customers.
Meridian, with the lion's share of South Island hydro capacity, has 23 per cent of generation and 13 per cent of customers (less of a mismatch than it may appear because one of those customers is Comalco).
Mighty River Power, owner of Mercury and First Electric, has 11 per cent of generation and 13 per cent of customers.
Genesis, once seen as the runt of the ECNZ litter, has 16 per cent of generation capacity but 26 per cent of power consumers.
Trustpower is also a net retailer with 4 per cent of generation, but 16 per cent of customers.
With the loss of its retail business, NGC has gone from being the biggest net retailer to a pure generator, whose 5 per cent share of generation is wholly contestable.
These figures, from M-co which operates the wholesale market, are only rough indications of the degree of balance or mismatch within these vertically integrated companies. Share of generation capacity is not the same as a share of actual generation; it depends how much of the time plant is operating.
Likewise, a head count of customers can only be a crude proxy for share of actual consumption.
But the figures still indicate that the generator/retailers are to a substantial degree insulated against the fluctuations of the wholesale market. To the extent that the amount they sell into the market overlaps the amount they buy, the spot price is irrelevant to them.
The more of that self-hedging there is, the less contestable power is left over for net retailers or large industrial users to buy though hedge contracts with the generators.
Three large forestry concerns, in submissions to the Government's review of the winter crisis, complained of the difficulty of securing hedge contracts.
Carter Holt Harvey's energy manager, Russell Longuet, said they were unable to get hedges from the end of February until early this month.
Norske Skog Tasman general manager Mark Oughton said that obtaining reasonable hedge contracts in the lead-up to winter was increasingly difficult. Being unhedged would have cost the company tens of millions of dollars over the winter. Instead, the company curtailed newsprint production by around 20 per cent, running down inventories.
Pan Pac Forest Products managing director Stuart McKinley said Pan Pac had gone into the winter only 60 per cent hedged, that being the maximum level available from the market at the beginning of the year. With spot prices peaking at about seven times the level that could reasonably have been expected, Pan Pac had to cut production by up to 40 per cent.
Network Tasman, as a lines company, was merely an "interested and informed bystander" of the wholesale market, said its commercial manager, Colin Starnes.
But he submitted that "a lack of liquidity and transparency in the hedge market, and the dependency of some firms on their competitors for hedge contracts, encourage greater market price instability and opportunistic behaviour in dry years. This exposure enabled a death blow to be dealt to On Energy's retail business."
Mr Starnes goes further, arguing net generators had a common incentive to see wholesale prices rise to unprecedented levels with little fear of a significant reduction in demand. "It can be argued that this was achieved by withholding reserve plant and allowing [lake] storage levels to decay for longer than was probably necessary or desirable."
The electricity market's watchdog, the market surveillance committee, after investigating events of May and June, said that only a small number had been willing to enter into new hedge transactions of any size with net retailers to cover the winter period.
Infratil, a major shareholder in Trustpower, in an analysis of the crisis, says: "The common view is that you have to own generation at the same level and in the same region as you sell power or you will eventually be put out of business."
But Infratil does not share this view.
Entering the retail market is a risky proposition, it says. But so is owning a single generation plant, which might break down or, if hydro, be hit by a dry year.
A properly structured hedge contract portfolio tailored to match the retail customer base might be the better way to go.
Infratil calls for the state-owned generators (Genesis, Meridian and Mighty River) to be made to sell their retail businesses. That, it says, would increase competition in the generation and retail markets and increase the liquidity of the contract market.
But the chief executive of market operator M-co, Chris Russell, says: "There is a lot you can do to increase transparency before you have to go through compulsory divestment - for example, establishing separate accounting and reporting structures [with the vertically integrated firms]. If they had to report retail and generation separately, you would see where the profits are and if there was any transfer pricing."
Mr Longuet said: "We would suggest that a retailer could obtain hedges from any generator but that any hedges it obtains for its parent generator would require that generator offer, say, at least 25 per cent into the wholesale market at the same price as provided to its retailer."
Mr Russell said that everyone would benefit hugely from a more transparent forward price.
One of the results of the winter crisis has been a request from Energy Minister Pete Hodgson to come up with a mechanism for a transparent forward price, Mr Russell said.
"It's quite a balancing act, preserving confidentiality in a small market. We have got to come up with some mechanism which reveals the levels at which transactions have been undertaken but does not disclose who is contracting at those levels, and that's quite difficult," he said.
"We would like to have something for the industry to seriously consider within weeks. Certainly before Christmas."
* Tomorrow in Forum: Meridian and the Major Energy Users Group put their case.
Power to the People Supplement
Energy Efficiency and Conservation Authority
