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.
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.
