Structure of the Electricity Market
Thank you very much and it is a pleasure to speak to you this afternoon. The effectiveness of the electricity market seems to be a frequently discussed issue and certainly very topical since the Labour/Green proposal was announced earlier this year.
It is my sincere hope that I will be able to contribute to the debate and this afternoon I will be proposing some alternative options that should be considered when addressing rising electricity prices.
When electricity reform was first proposed in 1992, New Zealand was experiencing a high degree of prosperity that triggered the need for infrastructure expansion. The question of where the capital would come from was a key political concern. After years of paying down government debt, borrowing more for new generating plants was an unattractive proposition. It was also apparent that the price of electricity, which was among the lowest in the world at the time, were starting to rise as the low cost of depreciated hydro stations could not be sustained.
New Zealand Residential Electricity Prices
At that time, wholesale and retail electricity deregulation was happening in the United Kingdom, Norway, Australia, Canada, USA, and South America. Overcoming challenges of converting monopolies to competitors was looking very promising as international experiences were shared from place to place.
In early 1994, a multi-stakeholder committee was formed to propose a market structure that suited New Zealand’s unique characteristics. The committee was called the Wholesale Electricity Market Development Group (WEMDG) and included stakeholders from seven representative parts of the market.
After months of debate and analysis, the WEMDG board took two proposals out for public consultation. On May 27, 1994, a process (managed by SAGE Analytics) gathered input from 83 stakeholders representing new entrants, regulators, government departments, distribution companies, ECNZ, TransPower and consumer advocacy groups. The consultation directly compared the merits of a “Competitive Wholesale Market Model” and a “Single Buyer Monopoly Model”.
Consensus was achieved in support of the market model provided that ECNZ was separated in to 3 or 4 competing entities. As a member of WEMDG at the time, I can assure you that the Single Buyer Model was thoroughly evaluated through the process and was deemed to be not as robust as the market model. The primary driver being the desire to bring in outside sources of capital and the attraction of letting the market choose between the various technologies emerging to generate power.
The Single Buyer Monopoly Model had virtues. It allowed for the integration of competitive generation over time through international tenders and it contained ECNZ’s market power through contracts. However, at the time, it was considered less effective as the government’s balance sheet was deemed too important to be consumed with guarantees to electricity contracts.
In short, if competition could fairly and transparently send market signals to independent companies, it should be chosen over maintaining a state-owned monopoly that provided financial backing.
While consumer groups tended to disagree, it was quite clear that even with a state-owned monopoly, there was little prospect of government enacting price control as the international tender of contracts would ultimately set the prices. In the end, the price of electricity would be similar in either model as both models would converge at the long run marginal price of the lowest cost technology and it was time to concede that government could no longer set prices it could only set rules.
The break-up of ECNZ and formation of wholesale competition was implemented and delivered the expected outcomes. By 2000, multiple power plants were proposed using geothermal, natural gas and wind and consumers started to switch retailers. There were also early signs that new retail competition would occur and the number of competitors in the generation market was growing. Decisions made in 1999 to block distribution companies from selling retail energy led to generators becoming retailers. The end result was five vertical integrated competitors were formed and consumers started make choices of suppliers.
During the first ten years of deregulation, prices to industrial consumers remained flat, commercial customers saw prices reductions and residential consumers experienced price increases as cross subsidies were removed. All in all, the new market was able to hold prices reasonably well, manage the investment of $2.5 Billion in new capital and position New Zealand as a world-class example of a fully functioning deregulated model.
However, by 2001, a new set of economic realities started to come into play. The New Zealand economy blossomed in conjunction with most of the world at that time. The GDP tripled from 2000 to 2010 and demands on infrastructure reached unprecedented highs. After years of deferring transmission expenditure, large transmission projects were commissioned. At the same time, historic gas supply was depleting and new gas reserves were added and a much higher price.
By the end of the second decade of deregulation and additional $10 Billion was spent across the market and these costs needed to be recovered from consumers.
The First 20 Years
The importance of depleting natural gas supply was quite monumental. Since the competitive wholesale market was designed to minimize gas use, gas prices are a critical input into the determination of the hour-to-hour electricity price. The market, in effect, is indexed to the natural gas price. From 2000 to 2008, gas price nearly doubled which, expectedly, resulted in a doubling of the wholesale electricity price.
New Gas Sources at New Prices
There was a silver lining to rising gas prices. The resultant rise in wholesale electricity prices led to geothermal and wind projects becoming economic. The market signals were working as a blend of generation technologies were added through independent decision making across a multitude of board rooms all reading the market signals. Any mistakes in judgment would become the risk of those boards as is expected in a free market.
During the period of gas price escalation, transmission and distribution expansion topped $3.5 Billion. This means an addition $350 million would need to be recovered from consumers into the future.
TransPower Expediture Tripled Revenue Records
TransPower, who have done an exemplary job in catching up with system demands, must now turn to optimizing the assets and find new ways to curb capital expenditure.
The contemporaneous addition of transmission meant wholesale prices and gas price increases led to delivered electricity price rises of unprecedented magnitude. Residential consumers, who enjoyed prices in the order of 10 cents per kWh in 1994, were on average now facing prices of 20 to 25 cents.
Electricity Price – Second 10 Years
These price rises were no fault of the wholesale market design but a direct consequence of underlying cost increases that feed into the determination of price. However, this phenomenon was making it increasingly difficult to explain the virtues of electricity competition to a disheartened public.
To exasperate the perception, transmission and distribution pricing policies have led to low consumers taking a disproportionate amount of the cost allocation. For low users, price increased were more pronounced, and to some, an unfair allocation.
For example, a low user that prepays their electricity bill is facing a price of greater than 30 cents (compared to the wholesale component of that price is less than 10 cents). Most of their price impact is therefore delivery of the energy - not the energy itself.
Clearly, reforms that might affect the wholesale price will have little effect in changing the perception of high prices in this consumer class.
As an aside, it is worth noting that markets such as California and Ontario have reflected marginal price signals for delivered energy (through tiered pricing) and it may be a worthy consideration for New Zealand to relieve the pressure on frugal consumers or those who wish to apply energy efficiency strategies.
Comparison of Average Bill to Average Wages
The overall impact on prices for low users has moved from 10 cents in 1994 to 25 to 33 cents in 2013.
The resulting price pressure on low income earners, pensioners, those on government assistance and the partially employed has reached a level that requires focused attention. To illustrate, the amount of an average wage that goes to pay electricity bills has risen to level not experienced since World War 2.
Residential Consumer Perception
It then follows that with wholesale prices rising as a consequence of rising gas prices and delivered prices rising as a consequence of transmission and distribution investment that some sort of structural change is required to bring low user prices back in line.
The Labour/Green proposal is one option that solves a portion of the issue. It has the potential of lowering prices by reducing the hydro energy value and reflecting it in a lower tiered price. Given low user delivered prices are in the order of 30 cents, and wholesale prices are in the order of 10 cents, it will be difficult to create a difference for consumers through wholesale restructuring alone. It is also not clear what the impact of converting every generator to a fixed price contract would be, as some of those generators will cause the average wholesale price to rise; potential negating gains achieved through putting hydro values at a lower tier. Studying this in greater detail is a likely next step to be sure the benefits are achievable.
Notwithstanding the details of that particular option, overall, there seems to be a clear case to implement changes.
This presentation is effectively a call to action for the industry. It is now time that we collectively gather our thoughts and abilities to construct a solution to reverse the trends; particularly for the low users and those having difficulty covering the costs of this essential service.
To accomplish that, I would submit that a more complete list of options for reform can be summarized as follows:
A. Wholesale Price reforms
- Move to a single buyer model (as proposed by the Labour/Green proposal)
- Write-down hydro assets and build the lower value into wholesale prices in a tiered pricing model (another component of the Labour/Green proposal)
- Improve natural gas development to stimulate lower gas prices (and therefore electricity prices)
- Improve forward market liquidity to offset gentailers market power
B. Transmission and Distribution pricing reforms
- Replace fixed/variable prices with tiered lines charges
C. Retail Market Competition reforms
- Separate Generators from Retail (as proposed by the Labour/Green proposal)
- Remove GST from Residential electricity consumers
From this list, it would appear that several options are structural in nature and will create conditions for better pricing. The “Single Buyer Model” option and the “separation of generators from retailers” option for example.
Other options will engineer a better price for a specific class of customer such as tiered transmission and distribution charges or removing GST for some, or all, of the customer base.
From a regulatory point of view, it easier to implement engineered price structure options as the results are guaranteed. Other options tend to be less certain in their outcomes as they are usually based upon a belief that positive outcomes will arise.
While it can be demonstrated that wholesale competition is working, the dependence of the market on gas prices has led to higher prices. From a renewable energy perspective, this was very positive as it has created economic geothermal and wind generation and produced a supply inventory that could last for many years.
There are some natural pressures for prices to drop on the near horizon. The surplus of generation is expected to bring wholesale prices down. The potential closure of Tiwai Point aluminum smelter could extend the surplus for as long as ten more years. With greater liquidity of forward prices could mean these surpluses will be reflected in future retail market offers.
However, improvements in wholesale prices alone will not necessarily alleviate the political pressure to address prices low users face as the wholesale component is less than 30% of the total price they pay.
The Labour/Green proposal is a genuine attempt to bring incremental benefits to consumers. Single buyer models and tiered pricing of hydro assets can be made to work. However, any wholesale reform that re-instates a monopoly will create a new set of risks already considered in the WEMDG process of 1994. The concerns raised about a single buyer model still exist and may not deliver the benefits to residential consumers expected in aggregate.
If the focus is specifically on residential prices, further consideration should likely be given to reforms that materially improve those prices. Options like replacing fixed/variable pricing models with tiered lines charges and improving liquidity in the forward markets may deliver greater impact on residential consumer’s pocket books than a “single buyer” would.
Other elements of the Labour/Green proposal such as generation-retailer separation are worthy of consideration and may be possible without implementing a single buyer model. An analysis of those reform details should be included in any reform package.
Finally, it appears a solution that is geared specifically at low users would deliver the consumer outcomes most effectively without materially impacting the value of any industry participant. A win-win is possible, politically and economically, if we put our minds to it.