Fool's power paradise lost

By BRIAN FALLOW

Consumers are starting to feel the pain of adjustment from a fool's paradise in the electricity market.

It is little consolation that some of the cost of that adjustment has already been borne by the mainly Australian shareholders of Natural Gas Corporation.

When supply contracts to commercial users had been based on a wholesale price around $35 a megawatt/hour (3.5c/kWh), transition to a world where the price is closer to $50 represents a steep increase.

"The theory of the market," says Genesis chief executive Murray Jackson, "is that it has to level out at the long-run marginal cost, which has got to be $48 to $52."

How then did prices get so low, not only on the wholesale spot market but in the deals offered to commercial users?

It was a buyer's market in the late 1990s because:

* A lot of new thermal generating capacity came on stream.

* Water was plentiful in the hydro system.

* Winters were mild.

"You had declining and low wholesale prices through the late 1990s and that left a very strong impression that it was permanent," says Mighty River Power chief executive Doug Heffernan.

"But this year the winter was cold, even in Auckland, so demand shot up, that extra generating capacity had been eaten away and you got poor inflows in the hydro lakes."

Another factor was the advent of competition between electricity retailers. Some retailers, Mr Jackson says, had incentives put on the basis of the volume they sold, not the price.

Meridian chief executive Keith Turner says the dry-year risk margin was driven out of hedge prices by players who did not understand the magnitude of that risk.

"We live on a knife edge," Dr Turner says.

Normally two-thirds of the power generated comes from hydro generation, but there is very little storage capacity in the hydro lakes. They can store only the equivalent of 15 per cent of a year's normal hydro production or 10 per cent of total production. Compare that five weeks of storage with Norway's two years or Canada's one.

Variability in inflows to the lakes can add or subtract 3500 gigawatt hours from the normal hydro supply. A swing of up to 7000 gigawatt hours is a huge change in a national market of around 38,000 gigawatt hours, Dr Turner says.

In terms of price the risks have also gone up.

"In a wet year, when the market is oversupplied, prices may be 20 or 30 per cent below a mean year, but in a dry year they can rise to three or five times the mean."

That reflects the cost of very expensive thermal generation capacity that has to be called on.

The generators portray the winter crisis as a salutary shock, a painful lesson in risk management to an immature market.

"There needs to be a move away from everything being one- or two-year physical contracts," Dr Heffernan says.

"If people looked at longer-term contracts the premium required to deal with the hydrological risk would be spread over a longer period."

Because of the risk that a buyer's circumstances might change over a period as long as 10 years, say, the nature of the contracts has to change, from bilateral agreements to physically supply a given quantity at at a given price for a given period, to standardised, tradeable financial instruments. "If you had a standard instrument you could see buyers taking long-term positions and trading out of them if their circumstances changed," Dr Turner says.

In short, it would be the foundation for a secondary market.

Buyers should also spread their risk by having a portfolio of hedge contracts with different maturities, just as prudence dictates not having all your debt maturing at the same time.

"We will happily do those deals. Just don't ask us to do it in the middle of a shortage," Dr Turner says.

One of the more glaring deficiencies of the existing hedge market is the absence of any forward price information in the public domain. Buyers can shop around. But they cannot see the prices of deals already done.

All three state-owned generators profess to have no objection to doing that.

Dr Heffernan also supports calls for the prices at which the generator/retailers bid and offer on the spot market to be disclosed after a lag of perhaps 30 days.

"It would put a tension on market participants' behaviour if what was done in the middle of winter, say, could be discovered in hindsight," he says.

"If you don't have transparency, conspiracy theories abound and that's not helpful to maturing the market."