Clayton's market clueless

By BRIAN FALLOW

Turn off a light, says Energy Minister Pete Hodgson, and you may save someone else's job.

What sort of market is it when even with steeply higher wholesale prices the Government still feels the need to appeal to consumers' altruism or patriotism to get them to cut back consumption?

A striking feature of the New Zealand electricity market is that the great majority of consumers, by number and by usage, are insulated against the spot price.

They have no direct incentive to economise when the market is signalling that supply is getting short. In terms of short-term price signals it is a Clayton's market.

Faced with the possibility - and it is still only a possibility - of the second winter of power shortages in three years it is tempting to conclude that we are looking at some sort of market failure.

But the Government's criticisms of how the market is working have concentrated on the supply side, not the demand side.

According to Deputy Prime Minister Michael Cullen, it is an "interesting open question" whether the market's signals of long-run marginal prices produce enough new investment in generation.

Hodgson puts the issue like this: "We have got to decide as New Zealanders whether we want to avoid dry-year risk and pay a little more for our electricity for that avoidance. Do we want more security, for which we are prepared to pay a slightly higher price? Or are we prepared to run into trouble every now and again with winter and continue to have lower-priced electricity?"

The implication is that market forces alone will not ensure an adequate safety margin of reserve generating capacity to cope with dry-year risk.

If that is right, it raises thorny questions about who should own that extra (by definition non-commercial) reserve generating capacity. How should it be paid for, and how could it be integrated operationally with the wholesale market?

But there are two ways of addressing the risk of a gap between supply and demand in dry years. Ensuring more supply is one, but the other - ensuring less demand - may be economically more efficient.

When the radical reforms that set up the present structure were being thrashed out the question of security of supply naturally arose.

How could we be sure that the lights would stay on if it was no longer anybody's responsibility to ensure they did?

Have no fear, the reformers said, the hidden hand of the market will provide. When the hydrology indicates a mounting risk of shortages the spot price will rise and then two things will happen:

* More expensive thermal generation will be offered into the market (and that has occurred this year), and

* Power users will respond to the same signals by scaling back their demand.

The problem is that only a limited part of the demand side is exposed to spot prices.

No one compiles hard data on how much of final electricity consumption is paid for at the spot price and how much at a fixed price.

But the Reserve Bank took a stab at estimating it during the 2001 winter crisis. After talking to the market operator, M-co, it concluded that, of the 75 per cent of final consumption that passed through the wholesale market pool (the rest is bilaterally contracted by very large users like Comalco), only a fifth was at spot. Other industry observers think this is on the high side.

Why isn't it more?

Clearly the extent to which consumers are able and willing to adjust their consumption in response to price signals varies widely.

Many will have no appetite for that risk, but others will if it is worth their while.

What policymakers need to consider is that the electricity retailers (three of which are state-owned) have not yet adequately tested how much appetite there is for that risk, or how much value consumers place on avoiding it, in the range of deals they make available, especially to commercial customers.

In the past, load management schemes between power companies and their larger customers have smacked of a command economy. Typically the user got a lower price in exchange for the power company having the right to cut their supply with little or no warning.

The more modern approach, typified by a scheme Meridian Energy has been running for more than a year, gives larger consumers a choice and notice, as well as a financial incentive to shed load.

Meridian posts on a website a day in advance the price at which it will buy back power in half-hour blocks over the 24 hours ahead. If a customer pledges to reduce consumption, time-of-use metering data is used to reconcile actual usage with a baseline agreed in advance.

Uptake has been limited.

A simpler system, for commercial customers who elect to have some portion of their supply at spot, alerts them by email when the spot price crosses some prearranged threshold.

Nobody can be sure how much "give" there is on the demand side; that is, how much energy might be saved in times of looming shortage if more consumers were exposed to the wholesale price.

But a study by the Energy Efficiency and Conservation Authority last year indicates it might be substantial. It estimated that the "demand response potential" (or ability to shed load) of the 300 largest industrial sites in New Zealand is of the order of 400MW.

That is equivalent to the capacity of a large new gas-fired power station, or to nearly three years' worth of normal growth in demand.

In any case, is it fair to argue that the market has failed to deliver adequate investment in new generation?

It is arguable that the lack of timely new generation investment is just bad luck. The industry has been caught short by the prospect that the Maui gas field will run out two years earlier than expected.

The end of Maui represents a fundamental change. New Zealand gets most of its electricity from hydro dams but there is relatively little storage capacity in the hydro system.

Hitherto the hand-to-mouth character of the hydro side has been compensated for by the comfort of the giant Maui field, acting as a store of fuel for thermal power stations which could be drawn on more or less at will.

The transition to life after Maui and reliance on smaller gas fields like Pohokura is not just about adjusting to a more expensive gas supply but also to the loss of much of that flexibility and fuel security.

The determination that Maui's remaining reserves are smaller than had been estimated has foreshortened the transition and given urgency to commercial negotiations between the owners of the Pohokura field - Shell, Todd and Preussag - and thermal generators. In that context a panic-stricken stance by the Government would only strengthen the vendors' hand.

Some observers also cite regulatory uncertainty as deterring investment in new generation.

In addition to the Resource Management Act and a carbon tax, there is uncertainty about the industry's governance arrangements.

The problem

* Electricity prices reveal a risk of power shortages this winter.

* Most consumers have little incentive to use less power - they pay the same for electricity regardless of how little there is.

* The electricity market does not balance supply and demand.

* Uncertainty about gas supply hinders construction of more thermal power stations.

Some solutions

* Build emergency power-generation capacity.

* Manage demand by exposing more consumers to real electricity prices.

Herald Feature: Electricity

Energy Efficiency and Conservation Authority