Stephen Gale: The myth of cheap power

Increases in electricity prices are fuelling debate about New Zealand losing the competitive advantage it is thought to have enjoyed from cheap electricity. Some even wistfully suggest that it was all much better when the government ran things and there was no electricity market.

In reality, New Zealand's golden era of "cheap electricity" - based on the great government-sponsored hydro schemes - is a myth.

The confusion comes partly from a period in the 1990s when power prices to a small group of large industrial users directly connected to the transmission grid were, indeed, low. However, those low prices were the result of over-supply and could not be sustained once demand growth caught up with the capacity of the power system.

Overall, prices have been stable. Apart from inflation, the national average price of electricity delivered has been largely unchanged for 25 years (see the Ministry of Economic Development January 2005 Energy Datafile, p135).

But the key point is that even today's wholesale prices of around 7c or 8c/kWh (that is, excluding transmission, distribution and retailing costs) are generally less than the great hydro schemes of the past were expected to cost when they were proposed and substantially less than many of them actually did cost.

The golden era myth is based on "cheap hydro" - the idea that New Zealand was blessed with unusually suitable terrain for low-cost dams to back up huge reservoirs and was, therefore, able to produce practically free clean-green power. The reality is quite different.

Even if the hydro schemes had been built without cost over-runs, they would have had to sell electricity at more than today's wholesale prices to cover their full costs.

As the chart shows, the actual costs of most of the projects came in well ahead of today's prices and the costs expected now for new electricity supplies.

Despite frequent cost over-runs, hydro still appeared then to be preferable to coal. When the government tried coal technology, it didn't turn out much better.

At that time, coal-based generation was expected to cost around 9c/kWh in today's money. However, when the coal-fired Huntly power station was commissioned in 1984, its unit cost was 18.5c/kWh.

The cost over-runs in these supply schemes did not feed through into prices. They were absorbed by taxpayers (as the investors).

A significant portion of the proceeds from the high-profile privatisations of the 1980s went on repaying the debts incurred by the government to pay for its investment errors. But this is generally how an electricity supply system should work. Customers should not be forced to pay for investment errors.

Maui gas could have ushered in a period of cheap power. But New Zealand kept building hydro plants too quickly, for too long. We accumulated an electricity capacity surplus and were not in a good position to take full advantage of Maui.

The huge gas field was discovered in 1969 and the government agreed to pay for development (through a so-called "take-or-pay" contract, which meant paying for the gas whether it was used or not).

The Maui contract price and take-or-pay production profile were based on the assumption that much of the gas would be needed in electricity generation in the 80s to cope with the forecast high growth in demand.

However, by 1979, planners had come to realise that demand growth had been massively over-estimated and, combined with the hydro power surplus, it was hard to find anything useful to do with Maui gas other than leaving it in the ground for later.

Nevertheless, against a background of the oil price shocks of the 1970s, the embarrassment paying for gas not utilised and pressure from field owners to increase offtakes ( to allow access to the light crude oil that came up with the gas), government dedicated a substantial block of gas to export in the form of methanol and synthetic petrol.

Even if there had been no hydro surplus, and we had used most of Maui in electricity generation as originally planned, it is not clear that resulting electricity prices would have been much lower than present levels.

This is because the build-up in electricity demand and, hence, gas offtakes would have been slow - about a third of the rate at which the gas was being paid for under the Maui contract - making the average cost of gas (payments divided by actual offtake) quite high.

What does this history tell us? Simply, that harking back to the mythical days of government-built cheap hydro is a dangerous delusion.

The main aim of electricity reforms was to reduce investment errors. There were certainly plenty under central planning.

As for the market model, it's still too early to say. But any focus on price movements should not be blurred by a myth.

* Stephen Gale specialises in energy economics for international strategic advisory firm Castalia. He worked in the Ministry of Energy in the early 1980s. Later, as a consultant, he participated in the design of the wholesale electricity market and has been active in access and pricing issues.