Brian Fallow: Ruling puts regulator on slippery slope

Huntly Power Station may be old and ugly but as March 26 showed, when it is needed it really is needed. Photo / Christine Cornege

Electricity consumers and taxpayers alike have been badly served by the new Electricity Authority in its first major decision as regulator.

The authority has ruled that a spike in prices on the spot market for seven hours on March 26 constituted an "undesirable trading situation" and it has over-ridden the market prices, resetting them at a level about 85 per cent lower.

The decision has split the industry. Many players, including those with no particular axe to grind in the case themselves, believe the authority has got it badly wrong.

It creates a moral hazard, rewarding risky behaviour while penalising the prudent and agile. It is therefore likely to encourage more of the former and less of the latter.

It is liable to retard the development of the market in hedge contracts, which insure parties against extremes in spot prices, making wholesale prices overall more volatile to the long-term detriment of consumers.

It imperils security of supply by casting doubt over the future of Genesis Energy's 1000MW coal-fired plant at Huntly which for the foreseeable future is likely to be needed to keep the lights on in dry years.

It also complicates the Government's plans to partially privatise the state-owned generator/retailers.

The regulatory uncertainty the authority's decision has engendered is liable to reduce the price the Crown gets.

The way the spot market works is that generators offer electricity from their various power stations at whatever price they choose for any given half-hour period.

The result is a stack of offers ordered by price.

The spot price, which all the generators that are called on get, is the price of the marginal generator needed to meet demand in that period. That is the point at which supply and demand intersect and the market clears.

A further complication is that the price can differ at more than 200 offtake points on the national grid.

Prices can vary by location because of constraints or bottlenecks on the grid that physically limit how much power can flow through them.

This puts a generator on the right side of such a constraint, that is, on the side where the demand is, in a position of market power while the constraint lasts.

Whether it makes sense for them to exploit that advantage, however, also depends on whether they are net buyers (because the generators also have retail customers) or net sellers on the tight side of the constraint - in the jargon, whether they are net pivotal.

On the afternoon of Saturday, March 26 Genesis found itself in the net pivotal position from Hamilton north. It was in a position to name its price.

It made out like a bandit while it could, commanding a price of $20,000 a megawatt hour.

That compares with an average wholesale price of around $60/MWh for the March quarter as a whole.

So was this an outrageous, greedy, market-subversive abuse of transient market power, as two of its sister SOEs, Mighty River Power and Meridian, and around 30 consumers impaled on the price spike promptly claimed?

It is hard to draw that conclusion from the factual account in the Electricity Authority's report on the incident.

First of all this is, or was hitherto supposed to be, a market with no price cap.

Offering power at very high prices is not per se a breach of the rules, nor is it unusual behaviour on Genesis' part; it is just that rarely are those prices the ones that prevail.

Second, Genesis did not engineer the situation. It resulted from a series of decisions on the part of other players.

Transpower was doing work on the grid which created a bottleneck. This was notified well in advance.

Contact Energy nevertheless thought the price would still be too low for it to be worth cranking up its plant in Taranaki and offering it into the market.

This was a miscalculation on its part as it turned out.

But to be fair Contact is not one of the companies complaining; on the contrary it is critical of the authority's decision.

Third, Transpower, the system operator, offers indicative forecasts of pricing ahead of real time. It underestimated the eventual load in this case.

That is not unusual.

Even so, for a couple of hours on the Friday afternoon, a day before the event, its forecast prices did hit the $20,000 level Genesis had offered power from Huntly at - providing some warning to alert market participants.

Mighty River responded by offering power from its small Southdown plant in Auckland and the forecast prices fell again.

Mighty River at that stage rejected the offer of a hedge from Genesis at prices which in hindsight would have been a bargain - a miscalculation on its part. Genesis played by the rules. The authority concluded its behaviour was not unlawful. It was not manipulative - it had not caused the grid constraint to bind - nor was it deceptive.

So why is it to be denied the prices at which it offered, well in advance, power which turned out to be needed to prevent a blackout in Auckland?

The authority says that parties exposed to spot prices from Hamilton north "had good reason to believe the exceptionally high offer prices at Huntly would not translate into market prices until it was too late for them to take action [to avoid having to pay that price]".

They were the victims of a market squeeze.

If those high prices were allowed to stand it would undermine confidence in the market, the authority concluded.

But hang on. Some spot market participants did respond to the price signals, including paper maker Norske Skog which reduced production.

The authority's decision unjustly penalises it, it says.

Contact objects to the retrospective nature of the authority's intervention.

"Retrospective resetting of prices will create regulatory uncertainty, risks disincentivising parties from putting appropriate risk management in place and could dampen investor confidence in projects that support security of supply," it says.

Vector, which is on the lines rather than energy side of the industry and can therefore be seen as impartial, argues that "exposure to the spot market is a commercial decision and risk that should not be socialised among other market participants".

The authority's approach "signals a low and uncertain threshold for future regulatory intervention. This will heighten the risk for investment and entry into the electricity industry and ... increase the cost of funding from offshore investors."

A key reason for the chorus of outrage after March 26, and apparently for the authority's decision, was that most of the generally large consumers who have "time-of-use" contracts with their power companies - designed to lower their average power costs by exposing them to spot prices - were not forewarned of the possibility of exceptionally high prices for March 26 and did not have time to curtail their demand or organise alternative supply.

Well, tough. That is an issue between them and their own power companies, which fell down on the job, not Genesis or the market.

If they want the benefits of exposure to the spot market but are not prepared to actively manage that risk themselves, they don't deserve to be bailed out by the regulator.

The background problem to all this is the industry's failure to sort out the future of the coal-fired power station at Huntly.

Big and old and ugly and emissions-intensive it may be, but as the event of March 26 showed, when it is needed it really is needed.

As Genesis has long contended, it costs a lot to keep the plant on line and it is not a charity.

Attempts to defray those costs by negotiating long-term hedge contracts with other generator/retailers - which set a floor price for it and a ceiling price for the counterparty - have met with limited success.

The second best option of taking advantage of the rare opportunities the spot market provides has now been closed off by the authority's ruling.

What is Genesis supposed to do now? Ignore its statutory obligation to act in a commercial fashion? Or phase the plant out, to the peril of security of supply in dry years?