Electricity supply security: Hodgson's speech

Speech by the Energy Minister, the Hon Pete Hodgson:

Today I am announcing the Government's plans for the future of the electricity sector.

Our overall policy objective is to have electricity supplied in an efficient, fair, reliable and environmentally sustainable way. It is the reliability, or security, of supply that we are concerned with today.

In particular we have been preoccupied with the lack of commercial incentive for generators to provide for adequate supply security, not in an ordinary year or a dry year, but in a very dry year.

Most of 2001 was very dry, the driest on record for 70 years. So far 2003 looks at least as bad. There are early indications from climate science that we may be in for an extended period of dry weather, as experienced from 1947 to 1976. It seems possible that the new dry period began in 1998. We need an electricity system that copes better with extremes.

To achieve this we will need more reserve generation to run in very dry years. Such plant will not run often enough to pay for itself by normal commercial investment criteria. We cannot therefore rely on the market to deliver it.

A related concern is the extreme price volatility in the spot market in dry years. Moderate price variability is a normal and essential feature of any market. But the spot price volatility in New Zealand's electricity market has reached unacceptable levels.

Our solution begins with the establishment of an Electricity Commission.

The electricity industry has tried to set up a new self-governance regime. On Friday that process stalled. Legislation passed in 2001 gave me the power to appoint a body to oversee the industry in the event of such a failure. I am now using that power.

I intend to appoint seven Commissioners. These positions will be advertised nationally and internationally this month. I hope to have the Commission running within three months, even if some Commissioners are interim appointments.

The Commission will pick up routine governance functions from existing industry bodies. Commencement rules for the Commission will be based on the rulebook developed by the recent industry processes, suitably amended to take account of the establishment and decision-making role of the Commission. Draft commencement rules will be put out for a brief period of consultation by the end of June.

But it is the new powers and duties of the Commission that matter today.

The Commission will be directed to manage the sector such that electricity demand can be met in a 1 in 60 dry year without the need for national conservation campaigns.

This standard would have avoided conservation campaigns in 1992 and 2001 — and, so far, this year.

The requirement for the system to handle a 1 in 60 dry year was in fact recommended by the inquiry into the 1992 crisis, as a temporary measure until the wholesale market formed. Since then the market – the industry – has been deemed responsible for managing dry year risk. It has not done that to our satisfaction. We have concluded that coping with a 1 in 60 dry year without needing special conservation campaigns is an appropriate level of security for a modern nation.

The question has been how to regulate the market to deliver a higher level of security.

We have taken lessons from electricity markets elsewhere, including the United States, Brazil and Australia. A variety of measures has been tried, abandoned or proposed in other places and we have examined many of them, with the help of external experts, practitioners and analysts.

We have chosen a relatively simple solution.

The Electricity Commission will contract with generators for the provision of dry year reserve generation capacity and fuel. It will withhold those reserves from the market until dry year conditions look likely, at which point they will be released into the market at a high price.

At this stage the Government is not specifying what that price should be. There will be a range of views on that and we are reserving our judgement for the moment. But the price must be high enough to ensure that ordinary new generation does not have to compete often with reserve generation. A low price would deter investment in the new generation capacity we need, as a matter of course, to keep up with economic and population growth.

Setting the price for reserve generation will significantly reduce spot market volatility in dry years. Prices above that of the reserve generation will be relatively rare, so the range of variability will be much narrower than it is today. A high price will, however, ensure that the market continues to deliver the price signals and opportunities it is designed to deliver.

The cost of ensuring we have adequate reserve generation will depend ultimately on the decisions the Commission makes about the range of plant required. But our estimate is that the effect on average prices over the long run should be well under half a cent per unit of electricity. The cost is low because the reserve generation portfolio will comprise relatively low capital cost plant, plus heavily depreciated old plant. The fuel, though costly, will be rarely used.

The Commission will have the power to recover the cost of reserve generation in the manner it judges to be most efficient, for example through a levy.

The details of this solution matter and the key issues are set out in the documents released today. This is the Government's preferred policy position. It will be open for comment over the next six weeks, then will form part of a legislative package due to be introduced in August or September.

We expect to be able to assemble the necessary portfolio of reserve generation within about three years. It will be mostly or entirely thermal, using coal, oil, gas or diesel. It is likely to include some new stations, along with some older existing thermal stations. The mixture will change over time as generation technologies change and as new, efficient baseload plants are built, freeing up older plants for reserves.

It is important to remember that a lot of ordinary generation investment is being made now. Since 1999 more than 500 megawatts has been commissioned: over the next three years about another 700 megawatts is planned, plus Contact's proposed diesel plant at Otahuhu or Whirinaki. The problem we are addressing today is not a shortage of ordinary generation to meet normal growth in electricity demand, but a specific problem with provision of reserve generation for very dry years.

Renewable energy is expected to dominate ordinary generation investment over the next 20 years, simply because it is economic. There will be significant new wind, geothermal and hydro generation. Some combined cycle gas plant and cogeneration will be part of the mix, but the dominance of renewables will ensure our electricity system makes continued progress towards environmental sustainability.

Several other important changes will be made to the system as part of this package.

The opportunities for lines companies to invest in both ordinary and reserve generation will be increased. They can already invest in new renewable generation without limit. We will amend the law so they can own reserve generation without limit and ordinary generation up to 25 megawatts or 10 per cent of their load.

To encourage the development of small or very small generation projects that are connected to local lines, rather than the national grid, we will regulate lines charges to ensure such generators pay no more than is reasonable for the additional costs that lines companies incur.

The Electricity Commission will have the power to require generators to offer long-term electricity hedge contracts into the market, for a nominated proportion of their reliable capacity, if it decides this is necessary. This can be used to safeguard against under-investment in ordinary generation, if that becomes a concern. Related powers to require electricity retailers and major electricity users to hedge a set proportion of their consumption might also be needed, so they are also provided for.

Modelling and forecasting of future supply and demand is not up to scratch and this too becomes a responsibility of the new Commission. It will also have new powers to require disclosure of information including coal stockpiles and more timely data on gas discoveries and reserves. It will require publication of amalgamated figures for the total quantity and price of all hedge contracts. Markets work best with good information and this one needs more of it.

Transmission investment and pricing will also be addressed by the Commission. The national grid is in a mostly satisfactory shape, but there is no agreement in the industry about who is responsible for making decisions about new transmission investments and who should pay for them. This means that when new transmission investment is needed Transpower has no certainty it can get paid for it, which means Transpower is under-investing in the grid, or soon will be. The Commission will be charged with resolving this issue urgently.

On the demand side the market can also be improved. Demand side energy exchanges, which enable consumers to on-sell electricity they have contracted for but do not need, must be made available nationwide. The Commission will also be charged with improving the industry's ability to manage ripple control for water heating, which has deteriorated following the split of line and energy companies.

There is more detail, but let me wrap up by repeating the main points of today's announcement:

 a new Electricity Commission will be established and charged with maintaining security of supply to a 1:60 dry year risk level without public conservation campaigns;

 it will do this by contracting with generators for reserve generation and fuel for use in very dry years;

 this reserve generation will be ring-fenced from the market to ensure that enough ordinary new generation will continue to be built;

 the additional cost of the reserve generation overall will be less than half a cent a unit;

 spot price volatility in dry years will be significantly reduced; and

 new ordinary generation will still be based predominantly on renewable resources, ensuring continued progress towards environmental sustainability.

We are confident that the result of these changes will be an electricity system that business and domestic consumers will be able to count on, with much more confidence, for a reliable and fairly priced supply of power.