Brian Fallow: Let's use what we have first

Chances are New Zealand taxpayers and electricity consumers will end up bailing out Origin Energy's Australian shareholders from a risky investment their company made little more than a year ago.

I came out of Monday's press briefing on the proposed merger of Origin and its subsidiary, Contact Energy, with the uneasy feeling that we are being hustled further down the path to a future in which electricity prices are driven by an ever more costly imported fuel - liquefied natural gas.

Prominent among the reasons advanced for supporting the merger is "the ability to better manage the strategic challenges that Contact Energy faces in a fuel-scarce New Zealand".

Excuse me? When did New Zealand become fuel scarce? By the standards of the island continent perhaps, but we still have at least eight billion tonnes of coal in the ground and no shortage of windy hilltops.

What they mean, of course, is that a crunch is looming in natural gas supplies from about 2011, unless a lot more is found soon - a problem for Contact which has invested heavily in gas-fired electricity generation.

Origin, of course, knew that when it bought Edison Mission's controlling stake in Contact in October 2004.

Happily for Contact's shareholders - not only Origin but about 200,000 Kiwi minorities - state-owned Genesis Energy is in a similar hole.

And the Government has deepened that hole by providing Genesis with an insurance policy against there not being enough gas down the track, in order to approve its E3P combined cycle gas turbine plant to be built at Huntly.

That decision, no doubt, came as a relief in the boardrooms of Contact and Origin.

Contact has been clear the costs of building an infrastructure for LNG are likely to be too large for a single party like itself to bear alone.

It said the risks would need be spread across gas users, gas suppliers and the Government.

Underwriting E3P's gas supply risk could be seen as a shareholder assuming some risk to make a project bankable.

But it could also be seen as the Government intervening in a decision that should have been left to the market.

And having lost its virginity, so to speak, it may be more amenable to backing an LNG future, if only to avoid having that guarantee called on.

Contact and Genesis say the preferred outcome will be to find enough natural gas to keep their turbines spinning without recourse to LNG but that it is prudent to explore the option as a backstop.

Time is running out for discoveries that would avert the need to commit to LNG to run existing gas-fired plant.

Taking 2011 as the year in which new supplies must be on line and allowing a three-year lead time to build a regasification plant either in Taranaki or near Whangarei and the associated pipelines, a go/no-go decision would have to be made by 2008. So the companies are expected to begin the process of seeking resource consents this year.

The problem is that a decision to go for LNG is gravid with consequence not only for the two generators concerned, and their customers, but for the future of the electricity sector and the economy as a whole.

Even though the intention is to start with a facility to import 60 petajoules a year, roughly half of national demand, most likely that would be only the beginning.

LNG would establish squatter's rights, if you like, as the fuel of choice for future thermal generation. It would create a situation in which the marginal cost of expanding existing LNG facilities might well be lower than, say, extending the national grid down to Southland's vast lignite deposits.

Yet there are some reasons to dread an LNG-dependent future:

* We would be relying on an imported fuel for much of our electricity supply, a step backward in terms of national energy security.

* There would be an exchange rate risk.

* LNG is traded under long-term contracts but at prices linked to international oil prices. And they are only going one way: up.

* LNG prices would effectively set the wholesale price of electricity much of the time.

That is because of the way the wholesale electricity market works. The spot price is the price of the most expensive generation needed to satisfy demand in any given half-hour period. Much of the time that is from a thermal power station.

Industries alarmed by the (still live) prospect of a carbon tax flowing through to their power bills would contemplate without joy the potential level and variability of spot prices under LNG - such electricity would not come cheap.

The Ministry of Economic Development is in the process of updating these numbers but its most recent published estimate of the relative cost of different sources of electricity had wind power and South Island coal, even with a carbon tax, cheaper than LNG for the next 20 years.

Energy Minister David Parker has promised a national energy strategy to be put out for consultation later this year. The country faces big and fateful decisions: The choice between renewables and fossil fuels, and between domestic gas (if more is found), domestic coal and imported LNG.

The proponents of LNG dismiss coal, and especially lignite, as dirty and stranded at the wrong end of the country in terms of where the electricity load is. But it is still closer than Australian or Indonesian natural gas fields.

Because of climate change concerns, a lot of money is being spent around the world on clean coal technologies, including carbon capture and storage. The idea is that instead of sending carbon dioxide from a large point source like a coal-fired power station up a chimney you poke it into suitable geological structures underground or under the sea where you can be confident it will stay put.

It might not be economic to do that now but if you were to build large lignite-powered generation in the far south, it would make sense to future-proof it by designing it so that that technology could be incorporated later. At least the technical and commercial feasibility of that scenario should be explored as assiduously as LNG.

Likewise the cost of associated upgrading of the national grid and of ongoing transmission losses should be quantified so that they can be compared with the cost of LNG infrastructure.

Origin has more than 2200PJ of proven and probable gas reserves.

Phil Pryke, chairman of Contact's independent directors, may well be right that from the standpoint of the Contact minority shareholders it makes sense to spread the risks of LNG investment over a larger and more diversified company.

"If we ended up going down the LNG route, the ability in effect to hedge the gas cost in that environment within our own business is greatly enhanced, thus reducing the risk," he said. But what is good for the Contact minorities might nonetheless end up foreclosing what are, from a national point of view, better options.