Brian Fallow: Cracking down on power plays

The electricity industry is one you can rely on.

You can rely on it to deliver relentless price increases, year after year, three times faster than general inflation.

And you can rely on it for a fright every other year about whether the lights will stay on through the winter.

We did not, in short, need a four-year inquiry by the Commerce Commission to tell us that "there are serious systemic issues" with the current market structure.

An extensive study undertaken for the commission by Professor Frank Wolak concluded that between 2001 - 2007 the four large generators had exercised unilateral market power to push wholesale prices well above what they would have been in competitive market conditions, to the tune of $4.3 billion over that period.

The market's defenders, however, run this argument: Prices need to rise to the level which makes new investment in generation capacity economic. It is not their fault that cheap Maui gas has run out or that there is stiff global competition for wind turbines. Relative prices change.

The market is just telling us the truth. We may not like the message, but don't shoot the messenger. And by the way the lights have stayed on, haven't they?

All well and good, but the wholesale electricity market has some peculiar and troubling features. One is that it is the same companies on both sides of the market.

There is a high level of vertical integration between the generation and retailing levels of the industry.

It may well make sense for the power companies to manage their dry-year risk in this way. But it means offloading that risk on to someone else, most likely the large users.

Large users the commission talked to were in no doubt they confronted an oligopoly. "Most ... indicated they believe there was only limited competition in the wholesale market.

"They believe the bulk of a generator's electricity went to satisfy its own retail arm's load requirements, leaving little to offer other parties," the commission said.

Another peculiarity of the market is that there is a spot market but no liquid and transparent secondary hedge market that would generate, so to speak, a forward price curve. That might encourage new generators or retailers to enter the market.

It would give large electricity consumers, including potential new ones, some indication of future prices.

In times when the physical market is tight it would allow those firms which have hedges to decide whether to reduce their load and sell them to someone who valued them more.

Another telling feature of the market is that there has been no new entry to speak of and the market shares of the "gentailers" have been remarkably stable over time.

An obvious response for the beleaguered generators to make to the commission's conclusion that they have been regularly making profits well in excess of those available in a competitive market is that if that were true it would have attracted new entrants but there have been none.

The commission considered the barriers to entry: tortuous consent processes under the Resource Management Act feature prominently and regulatory uncertainty, like the on-again, off-again ban on thermal generation, as well as deficiencies of the hedge market.

It concludes that the possibility of new entry is not sufficient to constrain the exercise of market power by Contact, Genesis, Meridian and Mighty River Power.

Energy Minster Gerry Brownlee has set up a ministerial review, chaired by Brent Layton, to inquire into these matters.

One idea it might consider is a system which requires generators to offer all of the power they generate on an arm's-length, contestable basis to all-comers, including their own retailing arms.

In that context it is notable that NZX has acquired M-co, the company which operates the wholesale market, while its Australian counterpart, ASX, has just announced plans to offer a trading platform for New Zealand electricity derivatives.

Attempts to set up such markets in the past have foundered on resistance from the vertically integrated gentailers. But Brownlee's reaction to the commission's report, and the fact that he has set up the Layton committee, may be a signal to the generators that the game is up.

The commission gives short shrift to the idea that the generators need those market power rents (prices above what a competitive market would deliver) to ensure enough investment in new generation occurs to maintain security of supply.

"The point is that as demand increases competitive rents will also increase. Furthermore, competitive rents provide a much better signal than market power rents that investment in new plant is needed, because they only arise on average when demand gets close to available capacity," the commission said.

"In contrast, market power rents arise on a haphazard basis, depending mainly on low hydro water storage levels, and as they arise periodically cannot provide a consistent signal that new investment is needed."

Bart van Campen of Auckland University's Energy Centre cautions against interpreting Professor Wolak's work as demonstrating a transfer of wealth of $4.3 billion from consumers to generators. It is likely to be much less than that, he said.

"During dry years the actual retail price consumers pay is well under the spot price. In theory the retailer will pay the generator the spot price but since they are vertically integrated this amounts to an internal transfer of funds between different arms of the same company, with zero net effect."

But the Electricity Commission last year published a breakdown of changes in the major components of the final price residential consumers paid between 1999 - 2006. The majority of the increase reflected higher wholesale energy prices. It dwarfed increases in line charges and in retailers' operating costs and margins.

Something, after all, has been driving consumer electricity prices relentlessly higher. Residential power prices rose by two-thirds between 2000 and 2007 - or 5 per cent a year in real terms, according to the Ministry of Economic Development.

The Commerce Commission concluded that "a likely candidate to explain the upward trend in retail prices is the recurrent exercise of market power in the wholesale market that was identified by Professor Wolak".

They leave it at that. The commission does not propose to do any further work on pass-through or competition at the retail level.

Van Campen say natural gas prices doubled between 2000 - 2007. "Even in a perfectly competitive market wholesale and retail prices would have risen significantly."

Clearly the Layton committee has much to mull over.