Brian Fallow: Asset swap idea bold but flawed

The Tiwai Point aluminum smelter's owners are opposed to splitting the facility's power intake between two companies. Photo / Dean Purcell

One of the more radical proposals of the ministerial review of electricity is an asset swap between two of the state-owned generators, Meridian and Genesis.

The review's interim report suggests Meridian hand over the Manapouri hydro scheme to Genesis, in return for Genesis's new gas-fired plant at Huntly.

The industry has not exactly leapt to its feet as one man to applaud this idea, to judge from the submissions the review has received.

The issue is competition, or the lack of it, at the retail end of the electricity industry.

You would think having five vertically integrated generator/retailers would provide plenty of competition in a country this size.

The problem is that there isn't a single national electricity market but a string of regional ones generated (so to speak) by bottlenecks in the national grid.

At certain places and times the diameter of the transmission pipe is not wide enough to handle the optimal flow of juice through it.

This becomes a commercial problem for the generator/retailers because of a feature of the market called nodal pricing. There isn't a single wholesale price every half hour; it varies among some 250 offtake points or nodes on the grid and the variances can be large between points upstream and downstream of a grid constraint.

This presents a financial risk for the generator/retailers. If they are selling power into the system upstream of a bottleneck but have to buy power downstream to supply their customers there, they are liable to be on the wrong end of a price differential.

So they have responded by concentrating their retailing activities in regions where they have generation plant. That provides a kind of physical hedge against the price risk arising from this combination of grid bottlenecks and nodal pricing.

But when combined with the particular carve-up of the former ECNZ's power stations among the SOEs and Contact Energy, this has left parts of the country, especially outside the main centres, with too few retailers for healthy competition.

The review regards this as a major cause of the trend for retail, especially residential, prices to rise faster than the cost of generation.

In addition there is the evidence in the Wolak report of market power in the wholesale market in dry years. That in turn reflects the fact that when the lakes are low there is little competition between thermal generators, with Genesis having nearly all the SOE thermal generation.

So the review, a collaboration between an expert committee chaired by Dr Brent Layton and MED officials, has recommended an asset swap which would mean one more generator in both islands and reduce Meridian's dominance in the south. It should also reduce the problem of market power in dry years.

So what's not to like?

It treats the symptoms but not the cause.

The underlying problem is the transmission constraints which are the legacy of years of underinvestment in the national grid. Transpower is working on that but it will take years and cost billions of dollars.

But in the meantime, surely financial markets are adept at devising financial instruments to manage all sorts of risk?

A lot of work has been done over the years to design transmission hedges for the New Zealand context. It seems to be fiendishly difficult and it still runs up against the problem of physical constraints in the system.

As officials put it, Meridian has around 66 per cent of the generation capacity in the South Island even after including the capacity to import power over the interisland link (excluding that, its share is 75 per cent).

"Any party wanting to retail in the South Island will be wary of generator market power in that island, even with access to market hedges," they say. Transmission hedges will help, in short, but will not eliminate local market power.

The trouble with the asset swap proposed is that Manapouri's output is effectively pre-empted by the Tiwai Point aluminium smelter, at least until 2030.

The smelter was built to provide a market for Manapouri. The nexus of the two constitutes a machine for turning Fiordland rain into US dollars.

Transferring ownership of Manapouri will not in itself free up power to supply other consumers.

The smelter's owners, Rio Tinto Alcan, are opposed. They point to a benefit of Manapouri and the Waitaki river dams being run by the same power company.

One has peak water flows in the winter, the other in the summer. That complementarity is helpful, to say the least, in supplying a plant whose load (barring the rare outage) is continuous.

Clearly any restructuring of the SOEs would need to keep Rio, which has only recently renegotiated its contract with Meridian, whole.

Officials from the Treasury and the Department of Prime Minister and Cabinet warn the idea of dealing with that through back-to-back contracts between Meridian and Genesis, which are after all expected to compete, is "fraught with danger".

"The risk is that in a shortage both parties will will seek to gain an advantage, for example by conserving their own water levels, at the expense of the other." It is likely, they say, to be a lawyer's feast.

They also worry about the inevitable distraction to both companies at a time when the Government is also demanding better financial performance from them.

Rio and Genesis themselves advocate, though with something less than ardour, an alternative asset swap under which Meridian would lose the lower Waitaki dams instead of Manapouri.

That would give Genesis a worthwhile share of southern hydro capacity, excluding that required to supply the smelter, and therewith the basis for a retailing presence in the south. But Meridian has voiced concerns about the complications of having more than one operator on the same river.

A better way of fostering retail competition, it suggests, would be to require generators to put a (small) proportion of their generation into a hedge market like that recently set up by the ASX.

But there is another possible approach which the review was perhaps too quick to reject: to cut the Gordian knot, abolish nodal prices altogether, and have a single national wholesale price (every half hour) or a single North Island and South Island price.

Some in the industry argue that while economists and engineers like nodal pricing because of all the information it provides, in practice it has been more trouble than it is worth.

Who, after all, is supposed to act on that information?

Nodal pricing is supposed to give signals about where to locate new generation, but the focus has shifted to renewable generation, which has to be built where the resource is.

It is also supposed to signal where transmission upgrades are needed. But surely Transpower has figured that out by now.

The problem that seems to concern the review about dispensing with nodal prices is the possibility that when supply is tight in one part of the country (in the south for instance during a dry year) without nodal prices some generation capacity in that region might not run because wholesale prices were too low, or there would not be enough incentive for major users of power to reduce their demand.

Really? And even if that is true is it not possible to deal with the problem in some more straightforward way?

It is hard to shake the impression that what the review is proposing is a solution that might not work to a problem than need not exist.