Brian Fallow: A quick plug for electricity's hole

A gaping hole exists in the middle of the electricity industry.

It is the absence of a deep, liquid and transparent market in electricity hedges.

Consider how much easier life would be right now if there were a standard tradeable instrument entitling the holder to consume a given quantity of electricity in a given period for a given price.

A market in such instruments would fulfil the primary function of any market, to allow scarce resources to flow to whomever values them most.

It would test how much "give" or elasticity there is in the demand side of the electricity sector when supply is short.

It would allow businesses to manage what for many is a material risk just as they can manage fluctuations in exchange rates or interest rates.

And it would indicate forward prices, valuable information for people contemplating investment in generation or energy efficiency, among others.

Instead of such a market we have a murky mishmash of bilateral contracts between power users and their suppliers.

How is a business considering a hedge contract on offer from its power company supposed to tell if it is fair?

Some forward price information is available from M-co which runs the spot market, but there is no information on volumes to support those prices.

And because price is only one element of the terms of diverse contracts, aggregated information on price is liable to bundle together apples, oranges and downright lemons.

While customised bilateral hedge contracts clearly have attractions, anecdotally consumers complain of what might politely be called asymmetries in some of the deals on offer, such as binding the user for two years but allowing the power company to bail out on three weeks' notice.

Then there is the vexed issue of whether enough hedges are available.

Major users, smarting from very high spot prices, complain that when they went to market for hedges they were not there.

They accuse the vertically integrated generator/retailers of concentrating on building up their relatively secure retail base of residential and small business customers, leaving larger and more demanding users to the rigours of the spot market.

On this view the "gentailers" have sought to manage the inherent risk of dry years by vertical integration, laying off the risk on to larger customers abandoned to the spot market.

The generators' response tends to be that users are happy to go spot when prices, reflecting the perceived risk of a dry year, are low. It is only when they see the tsunami coming that they dash for shelter.

In the absence of any aggregate volume information on hedge contracts it is impossible to say where the truth lies on the spectrum between those two positions. The review of the 2001 winter crisis concluded that the market for hedges had not been unreasonably short.

As it is, if a business has got a hedge its options in the current environment are to congratulate itself on its foresight and carry on consuming normally or to heed patriotic appeals to cut consumption.

It cannot sell the right to buy power at that price to someone else who might value it more. There is no secondary market, so the Government is keen to encourage schemes like Meridian Energy's Demand Exchange.

It at least provides a mechanism for larger users to profit from higher spot prices by selling back power they would otherwise have consumed at a higher price than they would have paid if they had consumed it.

It works like this: A day ahead Meridian posts a price for each one-hour block at which it will buy back power from its larger customers.

The tricky part, of course, is to quantify how much load the user has shed, that is by how much it has cut consumption in the period concerned compared with what it would otherwise have been.

This is done by an independent third party, a firm called Demand Response, which uses data from the user's time-of-use meter to establish a profile of its normal consumption.

If actual consumption in the agreed period falls below what the profile says it would have been, the user is credited with the difference at the posted price.

Meridian sets the price below what it expects the spot price to be at each hourly period the next day.

The scheme started as a pilot in 2001. Uptake has been stimulated by the power crisis but it still only involves just over 20 companies, up from six a year ago.

Meridian is coy about how much power it has bought back this way but says it is not a huge amount.

The Government wants to see more such exchanges up and running and has announced plans to spend $700,000 next year and $450,000 the year after fostering them.

It says it expects demand exchanges to produce electricity savings of up to 100GWh a year by 2006, but that is only 0.2 per cent of current consumption.

Clearly such schemes, while better than nothing, are a poor substitute for a liquid, transparent secondary market in electricity hedges.

Why then has one not developed?

Some industry analysts blame the emergence of vertically integrated generator/retailers, intent on self-hedging by getting the nearest possible match between the amount they generate and the needs of their relatively immobile customers, like households and small businesses. This has reduced their incentive to develop the hedge market.

Others see it as a chicken-and-egg question, arguing that if a deep hedge market had developed generators would not have felt the need to vertically integrate to the extent they have.

Another problem is nodal pricing. There is no single spot price for any half-hour period, but a range of prices depending on which of 250 places power is drawn from the national grid. The differences reflect transmission constraints and losses.

It is likely that the mandate of the soon-to-be-established Electricity Commission will include a brief to foster a liquid and transparent hedge market.

The design issues are formidable. But the intrinsic advantages of a market are too great for it to be left in the too-hard basket.