Forward contracts to make lights work

By CHRISTOPHER RUSSELL*

For the second time in three years New Zealanders are being implored to save power and pray for rain. Whether we pay heed or choose to ignore it, the fact remains - we are facing a winter electricity shortage.

It is tempting to pin the blame for high prices on the electricity market. Indeed, some pundits say the only way forward is a step backwards - replacing the market with one centralised buyer. Such a far-reaching proposal is not only unhelpful but empirically unsound.

The "single-buyer model" is similar to what the Californian Government did when it had an electricity crisis. It cost that Government (and, therefore, the taxpayer) more than $140 billion. It had to make the two largest Government borrowings in history, and now taxpayers are saddled with a bill for interest alone of $1.2 billion a year.

Other Governments have also tried this approach and dropped it in favour of markets, and they continue to do this in increasing numbers.

The faults of the single-buyer model are so serious that the World Bank has labelled it "dangerous" and linked it with corruption, weak payment discipline, and big contingent liabilities on the Government.

New Zealand's electricity market is not perfect, but it can be developed and improved to mitigate the extreme effects we felt in 2001 and face again this winter. The market should not be regarded as the root cause of the unsatisfactory situation in which we find ourselves. It was designed to reflect realities about supply and demand, which is exactly what it has done and continues to do.

There are two reasons for today's situation. First, there is a short-term shortage of water for hydro-generation. To combat this we all need to reduce our consumption in the short term and get generation plants going that use other fuels. This is what the spot market is telling us through rising wholesale prices. It's an important message and we cannot ignore it.

Second, the Maui gas field is running out. Maui has provided us with cheap, reliable gas for nearly 30 years, but now it is running down and the cost of alternative fuels - including other gas fields - is much higher. Gas fuels just under a third of our electricity supply, and as our economy grows we are less able to rely on cheap hydro-generation than we have in the past. So we will have to find different, and probably more expensive, fuel sources.

Wholesale prices will fall when the lakes are replenished, but the rising costs of fuel mean we cannot escape a long-term upward trend in the electricity price. This is a fact the nation must accept. This trend would occur with or without a market.

For all but two winters of the market's existence we have had some of the lowest electricity prices in the OECD. In one of those winters, the market helped us to avoid blackouts and it is helping us to avoid them this winter by giving us early - and clear - price signals. Like it or not, the market provides vital signals to consumers and generators of impending fuel shortages and encourages them to act early.

That we find ourselves in the same situation this winter as in 2001 has prompted people to ask some valid questions about whether the market, through a short-term spot price, can ensure we have enough generation capacity to ensure our lives are not unduly disrupted in a dry year.

Economists would reply with a resounding "no". Generation investments are typically for 20 to 30 years, whereas the spot price changes every half hour.

This is why companies should enter into long-term electricity contracts that specify the price for a number of years, or provide them with cash payments to offset high spot prices. These are called forward and hedge contracts. Both types of contracts protect electricity users from price spikes and provide generators the money and incentive to invest in generation and fuel supply.

Some would say the contracts market has not developed sufficiently here. The sensible thing to do is to work out whether an effective contracts market can be developed and, if not, what can we do about it?

The Government is considering building, or centrally contracting for, reserve generation (also called standby generation). But there may be significant challenges with this option. For example, how much should it build; how much should it pay; and what price should it charge?

Depending on the design, this may not ensure existing generators bear the risk of failing to secure adequate fuel supplies for dry-year conditions, or failing to conduct plant maintenance before winter shortages become apparent. Instead, consumers may be left with the risks of supply-side failure through paying high spot prices.

Another approach could involve requiring electricity users to protect themselves against high prices by using forward or hedge contracts. Some cannot see how this increases electricity supply in a dry year. It's simple: generators can sell long-term contracts to finance investment and use the forward contract prices to work out when new investment is required. It also provides strong incentives for generators to secure the fuel supplies to operate in dry years.

This is how it works in all sorts of commodity markets, including some of the most successful electricity markets in the world.

We need to debate these issues openly and rationally. And we need to design solutions that work. Unfortunately, some people are using the shortage to spread fear and misinformation, and propose restructuring that won't solve the problem.

We cannot do much to make it rain this winter, but we can fix the problem for future ones. To come up with a pragmatic solution, we need knowledgeable people to develop solutions based on facts and good analysis, and expose their ideas to rigorous debate.

* Christopher Russell is the chief executive of M-co, the electricity market administrator.