Brian Fallow: Keeping lights on shouldn't be hard

In a key respect the ministerial review into the electricity market is a reassuring document.

We could be forgiven for thinking New Zealand's electricity supply is a hand-to-mouth affair. Public appeals to conserve power have been made in 2001, 2003 and last year, and foreshadowed in 2006.

Yet the review says investment in new generating capacity is more than keeping up with demand growth and is sufficient to maintain a decent security of supply margin. The margin cannot be proof against all contingencies, of course, in a system which is still predominantly hydro and has limited storage capacity in the lakes.

But a margin of 30 per cent ought to mean that save-power campaigns are a whole lot less frequent than they have become.

The problem is not a lack of physical capacity in the system as a whole. It is that the incentives on the generator/retailers to manage their risks and optimise the use of their collective resources are all wrong.

To put it more bluntly than the report, the system incentivises them to make out like bandits when the hydrology favours them, knowing they can troop off to the Government looking for a conservation campaign if the system gets short.

Energy Minister Gerry Brownlee has made it clear they have gone to that well too often.

The review suggests a range of measures to improve the incentives on the generators, especially Meridian and Genesis, to contract among themselves to better manage their risks and their resources.

One is to scrap the reserve generation scheme introduced after the 2003 winter scare. If the spot price reaches $200 a megawatt/hour (equivalent to 20c per unit in your power bill) the peaking Whirinaki plant kicks in.

That price effectively caps generators' price risk in a dry year. Last year it was not even enough to cover the cost of the diesel used to run the plant.

The advisory group headed by Brent Layton recommends Whirinaki be transferred to one of the state-owned generators or sold.

And they suggest the level at which an administered price should kick in on the spot market be raised to $500/MWh. If a predominantly hydro generator like Meridian had to pay 50c for a unit it could only sell for 20c it would be keener to cover that risk by buying a hedge from a thermal generator like Genesis.

Such hedges are two-way bargains. They don't just provide insurance for the hydro generator of an alternative supply and known price when inflows to the lakes dwindle to a meagre trickle, they also provide an income for the thermal generators during times when their capacity is surplus to the system's requirements.

That will become increasingly important when carbon pricing comes in, most likely at the start of 2011, driving up the cost of power from Genesis's 1000MW coal-fired plant at Huntly.

From the standpoint of climate change the sooner it is relegated to a reserve role in the system the better. But Genesis chief executive Albert Brantley has made it clear that the not insubstantial costs of maintaining that back-up capacity will have to be covered by someone.

The second measure the review recommends is to require the generators to pay a rebate to consumers if a public conservation campaign is undertaken, starting at $10 a week and rising the longer it lasts. Again it creates a financial incentive for them to avoid such an outcome if they can.

But another of the review's recommendation's could work the other way, reducing the need generators might feel to hedge.

In the interests of increasing competition and relieving some upward pressure on prices, it suggests an asset swap between Meridian and Genesis. It would prise the jewel from Meridian's crown, the Manapouri hydro scheme, and transfer it to Genesis. Genesis in turn would lose its best asset, the e3p gas combined cycle plant at Huntly, which would go to Meridian.

The proposal would create a better geographical spread, and a better balance of hydro and thermal generation assets, within the SOEs than that which resulted from the break-up of ECNZ in the late 1990s.

Combined with constraints in the national grid, the historical carve-up of ECNZ has seen the SOE generators very largely confine their retailing activities to the island where their generation is concentrated. Meridian in particular is seen as dominant in the south.

But an assets swap looks like a crude and draconian option. It is likely to lead to a period of distracting indigestion as Meridian, an all-renewables generator, learns how to run a thermal plant while Genesis, which has coal dust under its corporate fingernails, gets a hydro scheme at the other end of the country.

Manapouri and the Tiwai Point aluminium smelter were built for each other. Together they constitute a machine for turning Fiordland rain into export dollars. Manapouri's output is fully committed to the smelter, so it is not clear transferring ownership of it would increase the ability of Genesis to compete for other customers in the south.

And to the extent that it creates a physical hedge within each generator it could reduce the pressure on them to hedge contractually.

Perhaps it should be seen as a threat intended to concentrate the minds of the two SOEs, a way of saying: "Do the hedge deal, for heaven's sake, or we will perform this reciprocal organ transplant on you."

Five generator/retailers would surely be competition enough if they competed with each other nationwide.

That they do not is most of all a result of the risk of transmission bottlenecks in the national grid. The risk is that the price a generator gets for injecting power into the system on one side of the constraint is less than the price it would have to pay to take power off on the other side.

In the long run the best way of relieving that is it to upgrade the grid, but that will take years.

In the meantime the obvious solution, urged by the review, is to develop financial instruments to manage locational risk. They are apparently tricky to design but other countries with nodal pricing - different wholesale prices at different offtake points on the grid - have them.

Giving Transpower or the proposed Electricity Market Authority the task, and a deadline, should help.

The other main way the review seeks to boost competitive pressure in the retail electricity market is to scrap the law prohibiting the lines companies from retailing electricity, which has been in place since the Bradford reforms of the 1990s.

Some of them might be keen - if they have some generation capacity of their own and if they can get hedges from the big generators to cover themselves when, for example, the wind doesn't blow.

But increasing the number of players does not of itself alter the long-run marginal cost of generation.