Dialogue: Market will resolve power conundrum

By JIM EAGLES

It is easy to sympathise with the Government as it wrestles with the question of how to respond to the rising clamour about the workings of the electricity market.

On the one hand, international ratings agency Standard and Poor's has led a chorus of concern about the failure of the market to tell consumers they ought to be conserving power.

On the other hand, the Consumers Institute has echoed growing public fears by demanding that the Government act to stop rising electricity prices being passed on to domestic consumers. And businesses hit by higher prices have been calling on the state to ease their pain and even reimburse their losses.

How should the Government answer such conflicting demands?

To answer that question it may be worth considering what markets are supposed to achieve.

A market - whether it be for mandarins or electricity - is a device for allocating resources and encouraging sensible decision-making.

If mandarins are in short supply, the price is likely to go up, encouraging consumers to buy other fruit and giving growers an incentive to plant more trees.

If there is a surplus, the price is likely to go down, encouraging consumers to buy more but causing growers to think about switching to other crops.

In the case of electricity, because of the cold, dry winter, water needed to turn the power station turbines is running short. As a result, the price of electricity on the spot market has gone up, theoretically encouraging consumers to use less power, thus conserving the water in our hydro lakes.

The problem, as Standard and Poor's pointed out, is that, so far, the average consumer has barely been affected, and so has no financial reason to use less electricity.

When NGC tried to raise its power prices, other - state-owned - retailers made it clear they were not going to move. Faced with the likelihood of losing customers to cheaper retailers, NGC backed down ( selling its customers soon after and dropping out of the market).

Why did it happen? The suspicion has to be that the state-owned enterprises felt it would be politically unacceptable for them to take financial advantage of the power shortage.

Unlike other electricity retailers, they produce all their own power and so face no cost pressures from the hydro shortage. Just imagine the outcry if the SOEs had pushed up household power accounts and simply pocketed the money.

But, as state-owned Mighty River Power has demonstrated, there is more than one way to pass on market signals. It adopted the economically sensible - and politically acceptable - course of giving its consumers financial incentives to save electricity, which could then be sold at higher prices on the spot market.

Other companies are now following suit - under Government pressure.

And there have been other price signals around. Prices have rocketed on the electricity wholesale market as businesses chase the limited supplies.

Surely that's what the market is supposed to do? The companies hurt by the high spot prices are those without long-term contracts.

Some have found it cheaper to buy a lot of their power on the spot market. Others felt they could save money by signing short-term contracts that allowed them to move to whoever was offering the best deal.

We didn't hear any squeaks from those companies when they were using the system to get cheaper power than anyone else.

So why should we listen to the squeaks when the system has moved against them? Isn't it just a timely reminder that markets tend to move up and down and people who play them do so at their own risk?

Those higher spot market prices have certainly given the affected companies a strong incentive to save electricity, and some have cut back production as a result (though nowhere near as sharply as during the 1992 power crisis).

The developing shortage has also provided strong incentives for more power stations to be built.

When the present shortage is over, a lot of those companies who previously bought on the spot market or through short-term contracts are presumably going to want long-term security of supply.

Big customers like that will be highly sought-after once normality returns, because most of the time supply exceeds demand. So power generators will have an incentive to ensure they can produce the power to meet their extra customers' needs.

Furthermore, the really large customers who have been burned by the shortage, including any surviving power retailers with a lack of generating capacity, will have a strong incentive to consider providing more of their own electricity.

In fact, there are already plans for new hydro and thermal power station, although hitherto they have been criticised as unnecessary. The promoters of those projects now have even more reason to proceed.

Overall - as the electricity market surveillance committee recently found - nothing particularly untoward is going on in the market. The country is merely coming to terms with the workings of a new system.

The time may come when the system needs tweaking. It would, for instance, be preferable for the SOEs to have a less dominant position.

It is certainly a pity that the retail market seems to be getting less competitive. Perhaps generation and retailing should be separate. The price-setting mechanism may turn out to need fine-tuning.

But - as rugby fans can testify - it is a mistake to make new rules before the players have had time to assess the impact of the old ones.

By the time it is all over and the hydro lakes have filled up, those involved will know a lot more about how to use the market properly.

Some companies will have learned a valuable lesson in the risks of buying on the spot market instead of signing long-term contracts.

Those who want to build new power stations will have been encouraged.

Power retailers should have seen that giving customers incentives to conserve can pay dividends.

In fact, in all likelihood New Zealand will survive this electricity crisis better than it did under the old system in 1992, in which case the market will surely deserve some of the credit.