Dialogue: Power market loses the competitive urge

By BRIAN FALLOW

Competition in the electricity sector may be alive but lately it is not looking well.

In recent weeks we have seen Mighty River Power and Trust Power exchange 40,000 retail customers, allowing Mighty River to pull out of the Wellington and Christchurch markets and concentrate on its home patch in the Auckland region.

Another state-owned generator/retailer, Meridian, sought to abandon some of its commercial customers to the vagaries of the spot market, though it has subsequently been forced to relent.

Telecom put its power requirements up for grabs and the result apparently was less than a piranha-like feeding frenzy.

The rate of retail customer "churn" has been declining over the past six months. The 12,595 consumers who switched electricity supplier in January represent a drop from 31,573 a year earlier and a peak of 71,762 in June 2000.

The Government's review of last winter's power crisis said that one of its consequences was that there was now significantly less retail competition, especially with the demise of On Energy and the takeover of its customer base by Genesis and Meridian.

The report concluded that the Government should warn the incumbent generator/retailers that if effective retail competition did not eventuate it would consider further measures, including mandatory tendering of hedges (fixed volume, fixed price contracts) or even the separation of retail and generation businesses.

So what underlies this picture of competitive torpor? What are the impediments to the sort of vigorous national retail competition we were promised would result from Max Bradford's restructuring of the industry three years ago?

One view is that it is a cyclical thing. While demand for electricity grows at a fairly steady 1.7 per cent or so a year, new generation capacity tends to be added in big chunks.

When there is overcapacity in generation it is a buyer's market; when capacity is tight, like now, it is a seller's market.

On this view when the additional power stations planned by Contact at Otahuhu and Genesis at Huntly, plus additional hydro in the south, come on stream the balance of power will tilt in the consumer's favour.

But it is also possible that the supply constraint will just move upstream from generation to the gas fields. The smaller, more complex gas fields that will have to take over from the giant Maui deposit may not be able to replicate one of its most useful characteristics, the ability to ramp up output quickly in times of hydro shortage.

In the meantime, says Transpower general manager Bill Heaps, "the supply side has got the upper hand and they will pass on as much risk as they can to end consumers".

The risks are substantial, as Meridian chief executive Keith Turner stressed when appearing before Parliament's commerce select committee a week ago. The hydro lakes can store only about 15 per cent of annual hydro generation. The whole system lives on the knife edge of inflows.

"We cannot continue to take the sort of risk exposure we carried last winter. We did not raise our prices and we met our obligations, even though it meant buying 30 per cent of our requirements on the spot market at prices often as high as $250 a megawatt hour to meet fixed price obligations at $50 a megawatt hour or below," Dr Turner said.

"We invest in very long-term assets with 50 or 60 year lives. We need a long-term revenue stream to underpin those assets to get debt. We have just done a $920 million debt refinancing and you can't do that without a clear risk management strategy."

Meridian's strategy is to have a customer base - "and I am talking about long-term, loyal, reliable customers who don't shop around" - to absorb 80 to 85 per cent of its total mean annual generation.

It has the equivalent of 650,000 residential customers in its Comalco contract, and the purchase of 150,000 customers from On Energy when it went under, on top of the 85,000 it already had, has pushed Meridian over that 80-85 per cent comfort threshold.

Hence the decision - since reversed - not to offer to renew fixed price contracts to commercial customers, whose requirements would equate to about 4 per cent of Meridian's normal production.

"There are other suppliers offering fixed price contracts but at prices much higher than these customers are paying now. We think they will get a better deal by going on spot," Dr Turner said.

But the MPs quizzing Dr Turner clearly struggled to understand how on the one hand these customers could represent an insupportable level of financial risk for Meridian, but on the other that it could be commercially smart for them to expose themselves fully to the spot price.

In addition to the dry year risk driving Meridian's strategy, electricity retailers and generators face another sort of risk, which arises from transmission constraints on the national grid.

New Zealand's electricity market has "nodal pricing", where wholesale prices vary not only through time but by location.

If power is being taken off the national grid downstream of a bottleneck that restricts the flow of cheaper power there, the price at that offtake point will be higher. This is supposed to provide price signals to guide new investment in the long term, and encourage demand-side management in the short term.

The main choke points are the Cook Strait cables and in the central North Island near Taupo.

One effect of transmission constraints, concedes Transpower's Bill Heaps, is the potential regionalisation of retail markets.

Electricity retailers can respond to transmission constraints either by building extra generation close to their own customer load - as Genesis and Contact plan to do in the upper North Island - or by concentrating on acquiring customers around their generation assets, like Mighty River or Meridian.

Transmission bottlenecks are not the only factors tending to regionalise retail markets, however.

Explaining his customer swap with Trust Power, Mighty River chief executive Doug Heffernan pointed to the back office costs of having to deal with up to 30 different line companies, each with several different tariff structures. In addition marketing and branding costs could be uneconomic if you were not already No 2 in a market.

Mr Heaps says Transpower wants to make the grid as unconstrained as possible to enable a more competitive market.

But relieving a transmission constraint may not be the lowest cost solution. Building extra generation closer to the load may be cheaper, or managing that load more efficiently.

This raises the thorny questions of how it is decided, in today's market environment, which solution is adopted, which transmission capital expenditure gets undertaken and who pays for it.

"The problem is that in a multilateral environment you often get brinkmanship and it is the weakest party, who needs it most, who ends up paying the price," Mr Heaps says. Others can free ride.

Rules which attempt to address the problem have been drafted for the new industry governance structure that is still in gestation.

"When a new transmission investment proposal is put forward there is a voting mechanism by which all affected parties vote on the solution they want to see," Mr Heaps said.

But Dr Turner described the rules as novel, untried and hastily put together.

The yet-to-be-established Electricity Governance Board would suffer from split accountability and confused objectives, he said.

"In Australia conflicts among transmitters, generators and consumers are resolved by a regulator. An outcome is achieved and something is done. It is a big ask to find a voluntary industry solution to those sorts of debates, which inevitably occur."

Dr Turner argues that the effects of physical constraints in the grid are exacerbated by the conservative way Transpower is required to operate it.

Transpower's cardinal objective is security of supply.

During the winter crisis when, unusually, power was flowing from the North to the South Island, electricity generated in Taranaki, which normally flows north, was "islanded" until Transpower was persuaded to make an operational change.

The effect was to allow Taranaki electricity to flow south at the expense of reduced security of supply to Taranaki consumers, including major industrial ones.

It was not an easy decision, Mr Heaps says. "We did it for system security reasons because New Zealand could have run out of hydro."

He rejects calls for Transpower to be empowered to make similar decisions when the security of the system is not at risk, but only to relieve price pressures.

That would compromise Transpower's independence as the market operator. It would involve reacting to, and trying to anticipate, market behaviour by the generators. It would be a slippery slope.

Dr Turner told the MPs that some grid constraints could be relieved for a modest outlay.

Mr Heaps said Transpower was already doing that: "We are taking steps across the Central North Island to increase efficiency, for example tightening up the wires so they don't sag no much."

Meanwhile. it has designed financial instruments called financial transmission rights designed to allow electricity retailers or major users to hedge against transmission constraints.

The pool of money to underwrite this insurance is the surplus, called loss rentals, arising from the differences between nodal prices and the market-clearing price which generators get.

This money now goes to line companies, some of whom pass it on to the retailers, while others pocket it. Transpower believes these tens of millions of dollars a year would be better used to finance a way of mitigating the financial risk transmission constraints give rise to.

But generators have designs on that money. Mighty River and Trust Power are pressing for a rule change by the New Zealand Electricity Market that would see the money rebated to retailers.

We are left with an industry structure dominated by four state-owned enterprises, three of them vertically integrated generator/retailers, and the national grid operator Transpower, each acting to minimise its own risk and maximise its own bottom line.

The effect may just be to transmit the risk to the consumer.