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A dissenting business view on the Greens/Labour NZ Power policy

COMMENT

Since the release of the NZ Power proposal there has not been a solid, logical debate about what NZ Power might mean, and the current problems inherent in the electricity market.

What we witnessed this month in New Zealand politics reminded me of a line from Bob Edlin in Management magazine a few weeks ago, Bob said “If scorn is better than robust debate at shaping good policy, we are in good hands”.

That pretty well summed up the government’s response to the NZ Power proposal from Labour and the Greens. Business New Zealand and other organisations urged Labour and the Greens to revoke the policy in an open letter.

The letter reads to say that higher electricity prices would better serve New Zealand businesses incentives to innovate. Would this really be the case? These are echoes of the comments made by the same group before the unbundling the local loop.

Sadly, scorn, distortions and exaggerated characterisations heaped on ideas and individuals seem to be an ingrained response from many; dismissing any new ideas at odds with the status quo.

Not very different

Take a look at Wikipedia’s entry on the New Zealand electricity market and you don’t have to read very far to see there is already a single regulator that balances supply, demand and price. Not very different than NZ Power as we read the proposal.

The key difference is the pricing mechanism, not the entire system. Currently, we have a Long Run Marginal Cost approach (LRMC), where the regulator balances the market in terms of supply and demand and pays all generators according to the highest cost generator required to supply in the market.

Prices escalate based on the cost of new generation and fuel; higher electricity prices justify ever higher prices for electricity. It is clear that those generators who burn fuel to generate electricity have higher operating costs than the hydro, geothermal and wind generators, nevertheless, all are paid the highest price.

The intention of the current pricing is to avoid stranding the assets that burn fuel and so cost more to generate electricity. Or, put another way, LRMC guarantees that all generators are profitable and low-cost generators become super profitable.

This is important when new generation is in the hands of the market, and/or reserve margins are small; it is less so otherwise.

Perverse incentives

LRMC introduces some perverse incentives, bid less volume and make more money by ensuring the highest cost generators remain in the market and over time tend to run the market towards a supply deficit.

These are gaming opportunities (ship less make more) that tends to bias incentives away from new large-scale low-cost electricity generation.

These are perverse outcomes that have the opportunity to damage the rest of the economy because electricity costs more than might otherwise be the case.

On the consumption side, industrial users have the power to negotiate closer to actual cost, this power wanes for smaller industrial, commercial and domestic users, and it shows in the prices paid. Moving from LRMC to average cost removes the perverse incentives and requires generation assets to stand or fall on their merits.

From what I have read, generator prices would be subject to oversight by the regulator based on operating costs and a fair return on capital costs (similar to Transpower and the lines companies) and they would bid into the market much as they do now.

The difference is they would be paid their bid price and the more volume they ship the more they would be paid.

Removes windfalls

This has the impact of removing windfalls from the low cost generators and ensuring the lowest cost available electricity is actually shipped. Industry should anticipate lower prices based on buying power and over time should see the lower price trend anchored average prices, not the LRMC of the last generation needed to supply.

The downside is that the assets associated with expensive generation might be more often pushed out of the market when the lower cost generators ship all they can. Returns on all generating assets fall to a level dictated by a competitive supply market, in volume terms, not one supported by the LRMC approach.

Under the LRMC approach all generators are incentivised to add small and expensive generating plant as the system makes more money when the most expensive watt is in the market. There is no incentive for large-scale, low-cost generation that tends to be expensive to build but cheap to run.

Managed by tender from NZ Power or left to the generators, the average cost approach tends to incentivise lower cost watts into the system.

It is not that difficult to understand that for electricity price and supply security the average cost approach intrinsically aligns incentives for the wider economy and the electricity system. The generator windfall of shipping less but making more is removed, but then that is the best outcome for the economy as a whole.

Note this analysis has nothing to do with the politics of left or right, or a retreat to the ideology of market primacy; absent competition markets need regulation.

It is about balancing the trade-offs between a tendency to support the expensive generators and pass windfalls to the lower cost generators, or introducing a system bias to ship the lowest cost watts available to the benefit of the wider economy.

John Walley is chief executive of the New Zealand Manufacturers and Exporters Association.

More by John Walley

Comments and questions
47

Sensible points made by John. It is good to have a clear-headed, more rational discussion of the issue.

Good article, counters alot of the scare mongering (e.g. backouts). A market design that allows spot market prices to range from $50/MWhr to over $1000/MHw in a 24 hr period has some serious issues.

On first glance, this statement rings my cr*p detector:

"Generators who burn fuel to generate electricity have higher operating costs than the hydro, geothermal and wind generators."

Since when is it OK to ignore capital costs? Since when did coal-fired power stations generate more expensive electricity than wind?

Also: "there is already a single regulator that balances supply, demand and price."

Not my reading of the wikipaedia article. There is an active market that sets the price, not a bureaucratic regulator. One moment Walley complains that generators game the market, the next he claims there is a regulator setting the price.

On this evidence, he may know what he is talking about but he is raising my doubts. Barriers to hydro and coal generation, along with distribution monopolies, seem to be the main factors causing high prices. That prices rise and fall with demand vs supply seems to indicate the generation market is working properly within the constraints the politicians have created.

In reply to your first comment, one might argue something like

"Generators who burn fuel to generate electricity have higher operating costs than the hydro, geothermal and wind generators."

Since when is it OK to ignore capital costs? Since when did coal-fired power stations generate more expensive electricity than wind?

His argument seems to run like this:
1) Generators that require fuels such as coal and gas to power them cost more than freely provided sources such as wind and hydro.
2) Operating Costs for such plants are higher than hydro or wind farm generators.
3) Therefore, in the long term, coal and gas fired generators are most likely going to cost more than hydro and wind generators.

To support premise one, it is entailed by the by the formulation of the statement that coal and gas are more expanisive to purshase than wind or water (since the latter are free).

To support premise two. It is true that he does not address the capital costs of settting up such facilities. Nonetheless, the conclusion (3) would strongly suggest that in the long run hydro and wind generation is going to be much cheaper than coal- or gas-fired generators.

At last, a real contribution to discussion of the issues. As CEO of the Manufacturers and Exporters Association, we can expect him to be concerned about high power pricers for his members. He is not playing politics - simply raising valid points for discussion. Well done and thank you.

Yes, but John Walley is also the guy who thinks we can fiddle with the exchange rate successfully. There has definitely been hysteria about the Labour-Greens policy, and central purchaser models are in use around the world. That doesn't necessarily make them better than what we have. I am inherently suspicious of a lobbyist who always seems to think the answers to his member's problems are somewhere out there in somebody else's hands. That is a route to disempowerment (no pun intended).

Take a look at what is happening overseas with similar market structures and you see the same distortions and overpricing that NZ suffers from.
The UK system, in particular, favours the least efficient power producers (in terms of total cost inc capitalisation per watt).
Deliberately done to try to incentivise alternative power, but like EEC agriculture subsidies, has turned into a self-serving monster.

An irrelevant observation in the New Zealand context. The wholesale electricity market has favoured renewables here because they represent the most rational next unit of generation. It's ironic the Greens favour a policy that would incentivise the use for longer of older, fossil-fuel generation.

I could not care in the least what corrupt pro-National business thinks. They can go back to hell were they came from.

And I can't see any justification for this claim: "There is no incentive for large-scale, low-cost generation that tends to be expensive to build but cheap to run."

That completely contradicts the claim that generators with low costs are making windfall profits because of marginal cost pricing. Obviously that creates a huge incentive.

I think the whole article is ill-considered nonsense.

You like the current Enron style system that Bradford created? You must have shares in the power industry.

No, I don't invest in businesses Governments can stuff up. Electricity prices fell after Bradford's reforms until Labour stuffed it up again. They stabilized during this current administration. You don't know what you are talking about.

The solution to lower prices is competitive markets and easy entry for competitors. Remove the barriers to cheap generation and the ETS nonsense and prices will fall under privatisation.

Agree with you, Alan - in theory the solution is a competitive generation market.

The problem is that the dumbos in NZ government - elected politicians of all parties and the incompetent bureaucrats - have been unable to set the rules such that the generation market is competitive and operates to the benefit of both buyers and sellers (like a normal competitive market).

For example, the NZ generation "market" is dominated by companies that all have the same owner - the government. That ownership has limited competition and serves as a barrier to entry to real private generators.

In another example, the rules of this "market" are rigged to protect the current generators and provide barriers to entry to new players. A competitive generation market would allow small generators as well as large to enter the market.

Where are the small power producers in the NZ market? Non-existent. Where are the co-generators in the NZ market? Non-existent. Any new large generators looked at entering our market? None that I know of.

Same sorry old story since about 1995 in NZ - a political system that largely attracts the unknowing and un-principled and a civil service that is populated by brain-dead cheerleaders. I'm amazed NZ businesses in that time have provided any economic growth (read that as higher incomes) and jobs.

Alan, I don't think many people get the simple solution.

1. Privatise.
2,. Remove the barriers to entering the marketplace.

Technology may have advanced in the past few decades, but philosophically we are still in the dark ages.

Every day, we enjoy the benefits of the free market in areas where there is competition and few barriers to entering the marketplace. Food, drink, entertainment, air travel, computers, technology.

I can remember when computer memory was $1000 per MB. Now it's as low as 1c per MB ($10/GB). Even allowing for inflation of 1000%, the fact that you can buy 100,000 times as much for a dollar as you did 25 years ago is due to the marvel of competition.

I don't think we can conceive of how cheap power could become with no barriers to entering into the market.

Discussing the pro and cons of how the power market should be regulated is a wasted discussion. The govt should have nothing to do with the power market; it should not own power companies; it should not have regulations other than what is concerned with technical safety. And the global warming regulations need to torn up and burnt in a bonfire outside the Beehive. It's based on a lie.

At the moment there is no big demand to find better ways to generate power as the govt power companies have a captive market and no competition. I believe that with a truly unfettered power market that we could see prices drop to less than half of the current rate within 5 years. Perhaps to less than 1/3 within 10. And perhaps in 25 years hydro electricity as we know will be old technology.

Anyone who would dispute this need only ask themselves this:
Competition bought us the personal computer, the Apple Mac, the iPod, iPad, the iPhone, Playstations, TVs, flat screen TVs and so on. And always with a cost compared to income that drop many times over as time passed. Why? Competition.

If it is truly a good thing to have market controls, would it be good to place controls on food and technology? Would it be a good thing to eliminate competition and take us back to the technology of the 50s or 60s? Most people wouldn't last a day without their gadgets.

The only thing that is keeping electricity prices high is govt controlled monopolies and high barriers to entering the power market. L & G asking for more control is borderline insanity. It is a knee-jerk reaction by individuals that cannot think for themselves or make valid comparisons with things in the world around them. They are as dangerously immature in govt as putting 5 year olds in charge of the local candy store.

The ideas on power from L & G has less credibility than 'the emperor's new clothes'. It is impossible to cut prices, spend more on creating jobs and have everyone with more money in their pocket simply by passing a law. The only way possible would be through market forces with unrestricted competition.

Wow - that's a straw man. The cost of computer memory has come down for so many reasons: technological changes, increased demand, progress, south east asian sweatshops,etc. Competition is just a small part of that. Hardly a good argument for total free market anarchy in something so crucial to the everyday health and wellbeing of all New Zealanders.

A free market is not anarchy. It rewards efficiency and good service and encourages innovation. Anarchy is arbitrary decision-making by politicians and bureaucrats which hinders or simply blocks all of the above.

All the things you mention are results of no protected monopolies and free market competition. Technological changes are driven by competition; demand is driven by lowered prices as a result of no barriers to entering a market. The quickest way to kill technogical progress is to prevent entry to the marketplace and have it all govt owned.

This argument is obvious if you follow cause and effect. Sell off state assets; repeal laws preventing entry to the market place and prices will fall. It is as predictable as night following day.

Technological advancement is the byproduct of a free society not a socially and financially engineered society.

@PowerUp, Samuel, well said - both of you. Agree entirely.

Every discussion on the electricity sector ignores the fact that electricity supply is intrinsically linked to GDP, and as such so are prices. Electricity prices increased markedly above inflation from the late 90's to late 00's when Labour was in power because the economy was growing (not that Labour can take any credit for that). Since National coming to power in 2008 the economy has slowed (not that National can take any blame for that) therefore so has the increase in power prices. Saying Labour 'caused' high price increases is like saying they were responsible for the economy improving!

Incidentally, all the talk on power prices focusses on residential consumers (i.e. voters). I'm unsure if the same trend occured on the spot or hedge markets. There's an argument that residential prices should be high to discourage usage in what is essentially a non-GDP earning sector. Ideally more power should be available to industry and commerce, preferably as cheaply as possible...

The name for this particular mutually cutesy little discussion started by Alan 'Fox News' Wilkinson is known as a 'circle jerk'... and as for the comment by Patrick that average residential consumers (that's who you mean because high earners don't have a limit on the power they can afford) should be discouraged from using power because it's non GDP... what are we on this earth for? Your life priorities are completely distorted. You reveal yourself as punitive, mean and twisted, with obvious utter contempt for average earning people. It's disgusting and you need to think hard about your attitude and outlook on life. You all do.

"residential prices should be high to discourage usage in what is essentially a non-GDP earning sector"

Rubbish. This is the sort of nonsense we get when politicians are allowed to interfere in markets. Residential prices should be based on cost of delivery like everything else.

Yes, economic conditions affect demand. However New Zealand's modest growth during the socialist regime does not account for the massive escalation of prices. Constraints on production do.

Bit of a contrast to your first response which I thought was much more reasonable.

The more I checked it out, the more it failed the cr*p detector test so I said so. If you disagree produce some valid reasons as I did for my opinion.

Re. Once you have some cheap large-scale electricity up and running as a company (inherited from the formerly public companies actually), is it cheaper to increase your profits by making more large-scale cheap electricity generators at high capital cost, or ramping up the price with expensive low-volume electricity with a relatively low capital cost?

You assume no other company or competitor can supply the market more cheaply. If it does you just threw away money. But I think a lot of wind turbines got installed on the basis that the Government would not allow new hydro, coal or nuclear generation.

Correct.
The generators with 'low-costs' are not making windfall profits. Profits from the SOEs are ok compared to most Utilities around the world.

The 'windfall' profits idea is what Labour and Greens refer to with no proof. (don't say the Wolak report, that is widely discredited).

Alan says: "That completely contradicts the claim that generators with low costs are making windfall profits because of marginal cost pricing. Obviously that creates a huge incentive."

Which completely misses the point. If your selling price is determined by marginal cost then the last thing you want to do is drive the high cost marginal producers out of the market by building more large scale, low-cost generation. Because if you did then your new low-cost generation would become the marginal cost and reduce the entire industry's profits significantly.

People in business aren't stupid, if it is in their best interests to ensure the inefficient high cost producers survive then that is exactly what they will do.

The article makes very good sense to me. Perhaps you are just not understanding it?

You are a liar, mate. You're a brainwashed lover of money and National. Please keep your stupid rantings to your self in future, thank you.

Jimbo, nobody cares the worlds economy is about to collapse. You people are like a dictator moving around troops on the board that no longer exist.

A very good response to the blatantly political proposal of the Labour/Greens. If it ain't broke don't fix it.

Well it's broken. For decades it failed to deliver what it meant to be for NZ consumers, and that is cheaper electricity prices. Time for a change and a change of government.

I presume "barry", "dave" and "me" are one and the same raging fruitcakes about to implode. Where do we send the men in white coats?

Can I add Paul N to the list since he has now indulged his inevitable charmless, insulting frothing combined with advice to others he would do well to take onboard himself?

You should be proud of him Alan. He has learnt well from you.

What's your address for them Alan?

Are you saying that the low-cost generators should ship power and not make a greater profit per unit than high-cost generators?
I think you should clarify, or Alan W. is exactly correct.
I also believe what Messrs Walley, Norman and Shearer must also explain is:
Are they planning to force generators to "ship power" when they deem it best for their company to not "ship power"?
I think we must be told.

"Are they planning to force generators to 'ship power' when they deem it best for their company to not 'ship power'?"

Yes, they explicitly say so in their policy document: "It [NZPower] will have the ability to direct that available capacity be used, even if it has not been bid, thus avoiding the ability of generators to use market power to maximise short-term profits by withholding low-cost generation."

So the generators will be forced to sell, at a government-regulated price, something they are not offering. Expect some very empty lakes in the middle of winter because some bureaucrat thinks that "hydro power is cheap".

Not that I am against regulating to prevent undue exercise of market power in this small market, but there are better ways to achieve it than tearing up the whole system and starting again.

The so-called dissenting view all smells of a carefully co-ordinated campaign to me. As plain as the nose on your face.

"Since the release of the NZ Power proposal there has not been a solid, logical debate about what NZ Power might mean, and the current problems inherent in the electricity market."

In fact, there have been plenty of of logical commentaries (including Seamus Hogan's on this very site). This isn't one of them.

To take just one example: "It is not that difficult to understand that for electricity price and supply security the average cost approach intrinsically aligns incentives for the wider economy and the electricity system."
Well, yes it is actually. All remunerating average cost will do is ensure that high cost generation is not available when we need it. In other words, blackouts.

If that's in the best interests of exporters and manufacturers, never mind the "wider economy", then Gerry Brownlee is a contender for the next Olympic marathon.

So the argument is that we should consider any policy, no matter how stupid, and anyone who doesn't play along is unenlightened?

The underlying issue is the knowledge problem, can a government department reliably estimate the supply curve and pay accordingly? The onus is on NZ Power advocates to prove they can, because every piece of evidence we have is that they can't.

For the open market argument espoused by Alan W and others to work there would have to be a long line of power companies ready to descend on little old NZ and set up generation assets of their own. Looking, looking, nope - none in sight. The immature knee-jerk reaction of power companies might be to turn off high-cost generating assets. What would that do to their bottom line, though? The scary thing for everyone against the reforms being espoused is that it might actually encourage the high-cost generators to invest in lower-cost generating assets to maximise profits and retire the high-cost plant. Wow. Wouldn't that be a good thing?

"Looking, looking, nope - none in sight."

Why? Because the incumbents are protected from competition by Government ownership, prohibitions on resource usage, emissions and nuclear options as well as inadequate transmission infrastructure.

None of which will be addressed by the Labour/redGreen anti-competitive nonsense.

"Looking, looking, nope - none in sight."

Unfortunately we are so brainwashed by decades of state control We expect that solutions will happen in a particular way and we don't foresee what actually comes to pass.

We didn't foresee the emergence of the apple mac or the clone pc that challenged the large mainframe computers that made computing out of reach of the consumer. We didn't foresee the development of the transistor, or the Wright Brothers, or AC power, or the light bulb or thousands of other things, but they arrived.

It is not possible for anyone to speak on behalf of a nation or a planet and predict how inventive minds and unfettered competition will create devices or even better methods that save time and money.

"there would have to be a long line of power companies ready to descend on little old NZ and set up generation assets of their own"

That is only one of dozens of scenarios or solutions. What about someone spending the same amount of money as a good second hand car and dumping an Archimedes screw generator the size of a gym bag in the local creek and generating enough power for 10 homes? These are common in Canada and the USA.

A screw generator the size of a 44 Gallon drum in a river 4 feet deep anchored to either bank by steel cables generating enough power for over 100 homes. There were a few in NZ in the 80's a few decades ago before they were legislated against. Type "archimedes screw generators" into google, and you will see what I mean.

What about some of the more creative energy projects that linger in NZ garden sheds, never to see the light of day because the inventors are scared about being persecuted or taken away by MIBs in black panel vans?

What about fusion energy? Someone has probably got it working in their garden shed already in the same Rutherford split the atom, Richard William Pearse flew before the Wright brothers, and Burt Munro broke a world speed record with a bike made in a garden shed out of hand made bits.

But as to the power industry as it is now?

The answer still remains the same.
1. Privatise the power industry,
2. Remove all barriers to entry into the market.

Let the free market figure out how to produce power faster, cheaper, and in greater quantities. I think everyone would be amazed at how quickly NZ power prices would drop.

Actually, the starting point of Labour/Green's proposed policy that Walley supports is utterly wrong! The so-called "excess profits" being made generation companies are illusory, based on faulty analysis. One only has to look at the share price of Contact Energy, which has risen from the listing price of $3.10 in 1999 to just $5.25 today, a compound annual return of only 3.8%, to see this. If Contact Energy was gouging consumers, then their profit margin, and hence their share price, would be considerably higher!

Good logic. Trustpower has done better though - $2.93 Jan 2000 to $7.55 today = 7.35%. Probably some variations in quality of management and asset values.

Pricing will be impacted by reduced demand as our manufacturing moves off shore thanks to international "free" market impacts. Enjoy your cheap imported stuff while you can.

I agree Sandy, the international market is more "free", as you put it.

Economics 101 tells you that a country that has tariffs, barriers to entry in the market place, minimum wage laws or a high cost of labour or manufacturing due to high tax rates or govt interventionist policies will have a higher cost of manufacturing and will lose market share to those countries that don't. High power prices due to lack of competition means high cost of manufacturing and loss to overseas manufacturing.

In this instance, lack of competition is the cause; high prices and subsequent moving industry overseas is the result. Not the other way around. Remove the barriers to competition and the price will fall. And with it, many other costs and prices throughout industry will benefit from lowered costs. And the manufacturing will return.