Dialogue: Power model generates problems

The Government has failed to grapple with the problems of the electricity market, writes JOHN BLAKELEY*.

Over the past year, the New Zealand electricity market has been shown to be based on an ill-fitting market model that clearly failed to meet the needs of consumers or the electricity industry as a whole.

While generators were profiting from soaring spot prices, some large suppliers were being squeezed financially, directly affecting larger electricity consumers, to whom these prices could be passed on.

Resulting from these events, several generators said last week they planned to significantly increase their wholesale electricity prices. These will be passed on to consumers over the next few months.

This represents yet another failure of the electricity market to deliver power at the cheapest possible price to consumers. We were told by the previous Minister of Energy, Max Bradford, that his "reforms" would lower the price of electricity. The opposite is occurring.

The reason being given for this latest increase is that it is necessary to have a price rise to meet the cost of building new power stations. These stations are considered necessary because of the supply problems experienced last winter, which arose from low water flows into the southern hydro-lakes.

The Electricity Corporation tried this line of argument about 10 years ago and it was met with outrage by the public and a firm "no" from the Government of the day, which was seeking to keep a lid on inflation.

ECNZ was then the dominant electricity generator, and the public and the Government could see that if the price rose to a level necessary to make a new power station immediately profitable, this would mean windfall profits for the corporation from their existing power stations built and paid off over many years.

Now that the electricity generation system has been fragmented into six generating companies of significant size, it appears that at least some of these companies feel they can try on the same argument.

Effectively, this will deprive the consumer of the benefit of low-priced electricity from the legacy of a hydro-power station network built up from about 1930 to 1990, and still producing about 65 per cent of our electricity requirements.

This benefit is planned to be swept aside. We will be expected to pay a price for every unit of wholesale electricity we consume equivalent to the cost of electricity produced from the most economical type of new facility. At the moment, this is a combined cycle natural gas-fired power station.

Will these companies manage to sell the electricity consumer this price-rise argument because of the mysteries of the operation of the electricity market, which nobody seems to understand fully? Only time will tell.

Last week, the Energy Minister, Pete Hodgson, announced only minor changes to the electricity market following the review of the winter problems.

Disappointingly, the minister has not made a firmer attempt to grapple with at least five significant ways in which the electricity market failed.

First, it failed to prevent large-scale spilling of water from southern hydro-lakes in January and February. This water would have been handy if it had still been there to be used during the winter.

The problem seems to be that the creators of the market have assumed that water which would otherwise be spilled would have a low value for electricity generation. But, in practice, it appears that generators prefer to spill water to keep the price up rather than substantially lower the price so that more power is sent to the North Island.

A large quantity of water was wasted through this spillage and it could have been used to generate electricity. At the same time, thermal power stations in the North Island continued to burn natural gas to generate electricity.

The minister has announced plans to require the generators to declare any spilling which takes place, in an attempt to prevent market manipulation. But it is unclear whether generators will have to justify such spilling.

Second, the market failed to provide On Energy (and to a lesser extent other electricity suppliers) with sufficient hedge cover to prevent them being overexposed to spot market prices during the winter.

In February, On Energy, with about 450,000 retail customers and comparatively small generation capacity, was in the market to buy a lot of power, especially to cover its needs over the coming winter.

Normally this is done by hedging contracts to cover 85 to 90 per cent of likely supply needs. But the company found there were no hedges available, and both Meridian and Genesis, as Government-owned generators, advised that there would not be any available until about October, because they were securing their own retail needs before selling electricity on the market.

This meant On Energy was entering a winter completely exposed to spot market prices, and everybody else in the market knew this. The result was that On Energy collapsed and was forced out of the market.

Responding to this, Mr Hodgson has said that in future officials would "keep under review" a requirement that electricity generators tender hedges for a percentage of their dry-year capacity.

Third, the market failed to send price signals to most consumers about the need to save electricity. Instead, we saw Government-sponsored advertisements on television beseeching us to save power.

As On Energy was announcing the necessity to raise its prices in June, other generators announced they would not be raising their prices over the winter. Customers left On Energy in droves rather than face price signals which should rationally make them curtail energy use.

Fourth, and perhaps most important, the market failed to use all the available generating capacity. In his submission to the post-winter electricity review, Bryan Leyland provided information which showed that on average, during the critical months of July and August, there was 400MW of unused thermal generating capacity at Huntly and New Plymouth.

Do we really need new power stations if the market is not able to use effectively all the available capacity? Perhaps this is what we should be concentrating on doing.

Fifth, the market failed to solve the problems of transmission constraints (preventing electricity being easily distributed around the country as required) and of who should pay to fix this. That partly explains the unused thermal capacity.

During the winter the minister had to intervene to try to solve some of the transmission constraint problems. Clearly, there is a need for more than tinkering around the edges, as in Mr Hodgson's announcement.

What is needed is a full-scale reorganisation of the electricity market to better serve consumers and the electricity industry - and to keep price rises to a minimum.

* John Blakeley is a research fellow at the Unitec Institute of Technology.