Power Struggles – by John Small

Pasted below is an article by John Small from Covec that was published in the Dom Post a couple of days ago. In it he argues that NZ Power should reduce prices and significantly improve retail competition, and new generation will still be fundable. He further states that there are some important details that need to be cleared up about valuation of generators’ assets. It’s a very useful and rational contribution to the debate as opposed to the hysterical missives from National and Business NZ.

Power Struggles
John Small, 9 May 2013

 Is the Labour/Green electricity reform proposal economic lunacy or a chance to finally get vengeance on a gang of bandits? Will the lights stay on? Will foreign investors desert us or punish us financially?

 These pressing questions are generating more heat than light. Maybe that’s because they’re difficult: the policy is after all silent on some crucial details, without which predictions are challenging. But we already know far more than you’d think from the angry reactions.

 Unlike what some are claiming, the concept is not inherently flawed. You don’t need to be an expert to see why.

 The main change is that there won’t be a single wholesale market price any more. Each power station will get paid what it actually needs to cover costs, instead of what the least efficient (most costly) station needs. That change alone will allow power bills to be slashed because about 60% of our power is from hydro stations and those generators get paid way more than they need. So there definitely are savings available: its not a mirage.

 If power stations are currently gaming the market (i.e. finding ways to jack up the price), that will also cease. This proposition has been argued and contested, but having money for price cuts doesn’t much rely on the outcome of that debate. Eliminating gaming is either an extra benefit or a sideshow, depending on whether you believe it happens or not.

 Retailers will still compete, but they’ll be buying their power from NZ Power. Depending on how NZPower operates (we’re going to need some details!), that could open the door to many new retailers which would intensify retail competition. Currently, electricity retailing is dominated by generators because that helps them avoid exposure to the spot market which is incredibly risky for a retailer. But retail competition is muted for the same reason: no retailer wants a market share out of whack with the market share of its affiliated generator.

 Those are the first round effects: lower prices and more retail competition. Both are good for consumers, but we also need to think a bit further ahead.

 The price cuts are targeted mostly at residential consumers, with commercial and industrial users in line for smaller cuts. Each of these groups will use more power when the price falls, so we’ll need to generate more, using extra resources. The amount of extra cost will depend on the details of retail pricing. For example, you could give everyone a block of cheap power with the rest priced normally: that would limit the extra generation cost and preserve incentives to invest in insulation etc. It’s a sensible idea from the Greens.

 Then there is the impact on the government’s accounts. Dividends from the SOE power companies will fall and if the budget is to be unaffected that means either more taxes or less spending elsewhere. This is a murky issue because asset sales are eroding the dividend stream anyway and also because we don’t know how the government will react. If taxes go up somewhere to compensate for lost revenue, that will affect people’s behaviour. On the other hand, the funds could be recouped from tax evaders. Or by cutting <insert your pet waste of public funds here>.

 What about the investors? The short story is that investors (including the government) will pay for the price cuts because they own the power stations whose revenues will be cut. In the longer run, there is a question over whether private investors will punish us by with-holding funds for new investment, either completely (cue horror stories) or by demanding higher rates of return. An investment strike is inconceivable: electricity is regulated everywhere and people are clearly willing to invest in extremely unstable countries. So capital will be available; the only question is the price and that depends on how risky the project is. For power station investors, the risk might well fall. A long-term contract with NZPower sounds a lot less risky than investing under the current industry configuration.

 Put all this together and we see that there are funds available for price cuts, retail competition could intensify and new generation will still be fundable. What could go possibly wrong?

 Two things: time and nerve. Assume that Labour/Greens form the next government and get cracking on their plan. First up will be enabling legislation to create NZ Power and define its mandate. Hopefully, they’d constitute NZ Power so that it was independent of politicians. But if they want this to be effective (i.e. to actually transfer significant cash to consumers) they will also need to say so very clearly in the legislation. In particular, that means spelling out how NZPower is to determine valuations of generation assets.

 The policy refers to paying generators on the basis of “historic cost” but what exactly does that mean? Intuitively we know that the public funds used to build most of our hydro stations have long ago been recouped through depreciation. In that case, the historic cost is zero. But modern accounting rules require them to be valued on the basis of their earning power, so achieving the stated policy goal means writing these book values down. To zero.

 Inevitably, there will be some messy cases, such as where old records have been lost or where someone bought the power station fairly recently for a large sum. If the policy architects have enough nerve they will tackle these problems upfront and make the legislation nice and clear. History suggests they’ll wimp out and punt the difficult issues to NZ Power along with a few vague principles. That approach would create lots of work for lawyers, add costs, and runs the risk of neutering the whole plan.

 Some other crucial details will also need to be spelled out, like how to run a competitive pool to get efficient dispatch while also regulating generators to cost. These are geek fodder.

 What if Tiwai Point closed? That works in the same direction as NZ Power: there would be less spare cash to redistribute, but the prevailing prices should also be a fair bit lower.

 The bottom line is that this policy is certainly bold, but its not crazy. It has the potential to stimulate competition and be a force for good, but it will be difficult to do and even harder to do well. 

 John Small is an economist and director of the consultancy firm Covec.

38 thoughts on “Power Struggles – by John Small

  1. The bottom line is that this policy is certainly bold, but its not crazy. It has the potential to stimulate competition and be a force for good, but it will be difficult to do and even harder to do well.

    And that is the bottom line. There’s a lot of folks who can’t see past conventional market-driven thinking who are alarmed, but there is just a process to work through.

    The real winner could be the environment; the currently-stupidly-implemented-pseudo-market takes no cognizance of the environmental possibilities of managing the energy generation mix, and works to select energy source based at best on second order issues, so there could be a dramatic improvement in pollution numbers to come out of this.

    I’d actually say the proposal is crazy, but not dumb. There are far larger possibilities than a few bucks off the power bill and a few ruffled feathers amongst investors and treasury accountants.

  2. And the Greens know this – working towards the environmental result is always part of the equation. Cheaper power for domestic users is simply the way to begin the discussion, not the only outcome looked for.

  3. The big five power companies have averaged under $650m profit over the last decade (average $515 under the last 4 years of National – 60% less than the $855m average of the last 4 years of Labour)

    There’s been a total failure by the Greens/Labour to explain how they will take a $650m profit, extract $750m in “excessive profits”, and still leave the companies with a “reasonable profit”.

    The numbers make no sense, which is why they can’t give any details.

  4. Yeah, I’m still trying to figure out from the MRP share offer book why in 2012 that MRP spent $650m more on “energy costs” than other parts of the accounts suggest they should have. There is a lack of detail.

  5. Photonz1, I’ve heard a story that they’re creating subsidiaries to make profits in all of the things that they would have done anyway, like office space, in order to make the government’s annual accounts not look embarrassing.

  6. dbuckley says “….and a few ruffled feathers amongst investors….”

    If you really think that, then like Shearer and Norman, you totally fail to understand how the sharemarkets and the economy works (why would they understand something they have zero experience in?)

    Investors shift large amounts of money between markets – bonds, and equities in NZ, Australia and international (my share broker is already booked out for consultations about reprioritising investments from NZ to offshore).

    Our sharemarket is worth $60b – it should be $250b if it kept pace with Australia over the last 20 years. When there’s confidence in the market, there’s billions of new investment in NZ each year.

    When there’s no confidence, New Zealand misses out and that money goes elsewhere, just like the jobs.

    As has been noted, the negative ramifications of the policy make the claim of saving a cup of coffee a week (per house – not per person) seem like peanuts

  7. Hopefully with the creation of NZPower, someone will finally take responsibility for ensuring that there actually is enough generation capacity to get us through dry years like 1992 or 2008. The SOE model did not ensure enough capacity.

    Trevor.

  8. Trevor – highly unlikely that there will be anywhere near enough investment under Kiwipower, if any at all – everyone will be wanting money OUT – not putting it in.

    Contact has already stated bluntly that the $2.5b they invested in new generation in the last five years WOULD NOT HAVE HAPPENED under the Labour/Greens scheme.

  9. Who in Contact said that? To me, it sounds like posturing.

    Under the Labour/Greens scheme, I would expect NZPower to negotiate with potential suppliers to develop and operate the required generation capacity and the appropriate pricing for that generation. As noted in the article, this would give the suppliers more certainty than the current market approach. The final pricing for new capacity may not be much different to the current prices anyway, but it should be easier for smaller players to enter the business, such as lines companies.

    Trevor.

  10. dbuckley says “….and a few ruffled feathers amongst investors….”

    If you really think that, then like Shearer and Norman, you totally fail to understand how the sharemarkets and the economy works

    Things I know (actually understanding a thing or two about how markets work):

    Firstly, all (competent) investors have their risks spread across multiple sectors, in the expectation that when a particular sector has a loss then the entire portfolio doesn’t tank. I assume you know enough about the way markets work to know that a competent investor can make a profit on a stock or sector tanking. I also assume you also know that the entire market arrangement is a gamble, and that there are no guarantees in stock investing, even the observed behaviour that over the long term, stock markets always rise.

    Secondly, there are a few energy companies listed on the NZX who may be negatively impacted by a change in how NZ chooses to operate its electricity industry, but almost all companies listed are not in that sector, but do pay money for electricity. All those (150+) listed companies will see their costs reduce. Thus the impact on the market as a whole will probably be positive rather than negative. That’s good news for (competent) investors.

    Its also good news for those companies (and others): they are getting what is, to all intents and purposes, a tax break. Invoking stereotypes, who’d have thought that, ay: a bunch of commies giving the capitalist pigs a tax break. But that is what it amounts to. Show me the company management who are going to stand up and say “No, I don’t want a tax break, that’s not what business needs at all”.

    For any company that exports, a reduction in input costs is also very good news.

    It’s also very good news for the dairy industry, which is a huge consumer of electricity, and will see its costs reduce. Whats good for Fonterra and it’s farmers is good for New Zealand, right?

    I say “may be negatively impacted” because it is probable that the changes wrought in arrangements will reduce the uncertainty in the current energy market, which currently is a risk to all players in it, and, as you are well aware, risk has cost associated with it.

    Because of the way our market currently works, savvy players are genetailers. MRP puts it as “The vertically integrated gentailers … are on both sides of the wholesale spot market (as sellers and buyers) allows them to better manage the risk of wholesale spot price variability.” This “variability” is a significant barrier to entry for new retailers, and the reduction of risk will allow pure retailers to enter the market, and these will almost certainly be commercial organisations, and who knows, maybe they too will look to list.

    To repeat, adding one word in brackets: I’d actually say the proposal is crazy, but not dumb. There are far larger possibilities than a few bucks off the power bill and a few ruffled feathers amongst (naive) investors and treasury accountants.

  11. Hopefully with the creation of NZPower, someone will finally take responsibility for ensuring that there actually is enough generation capacity to get us through dry years like 1992 or 2008.

    We have about twice as much installed generation available as the peak power need, so we have, by any measure, “plenty” of generation.

    There are two problems, however.

    Firstly, our choice of generation mix to actually use is determined by an inappropriate mechanism, a pseudo-market, that is at best a derivative of what generation mix makes sense. This leads to making wrong choices.

    The second is that as so much of our generation is really cheap to run, there is limited scope for investment in expensive to run generation.

    My opening gambit would be to transfer the ownership of Huntly from Genesis to Solid Energy, and expand Huntly. Its not a pretty solution in environmental terms, but for those years where we are stuck it would be an effective solution.

    My second suggestion is far more radical; instead of building more power stations, spend the same money on installing solar hot water heating on houses across New Zealand, and recover the money the same way one would recover the costs of a new power station, ie, through the electricity bill.

  12. “My second suggestion is far more radical; instead of building more power stations, spend the same money on installing solar hot water heating on houses across New Zealand, and recover the money the same way one would recover the costs of a new power station, ie, through the electricity bill.”

    Not just solar water heating, but pvc panels hooked into the grid – distributed power generation and distributed capital investment.

  13. That second suggestion might be better achieved by fitting Hot Water Heat Pumps nationwide. In most climate zones in NZ heat pumps outperform solar apparently. Solar tends to be more of a pain to install as well as requiring larger hot water cylinders to perform at it’s best.
    Either way I absolutely agree with the concept.

  14. dbuckley – New Zealand’s electricity industry is unlike most others in the world. Typically we are not limited by capacity. Instead we are limited by “fuel” – water for our hydro stations and wind for our wind farms. We can generate more power than we need until the lakes run dry and then we have a big problem. Until we get a large increase in other generation capacity, we are going to need Huntly as at least a dry-year reserve.

    The other problem is that much of our peak generation capacity is at the wrong end of the country. We need to add either more non-intermittent renewable generation (e.g. geothermal, run-of-river hydro) in the North Island, or beef up our inter-island link, or probably both. Wind farms, solar water heaters and solar PV arrays can cut down on our fossil fuel usage, but they aren’t much use in the middle of winter when we have cold, still, cloudy weather and electricity demand soars.

    Trevor.

  15. …fitting Hot Water Heat Pumps nationwide…

    The good news is that heat pumps are 300%+ efficient, and thus will use less electricity. The bad news is that they still use electricity.

    The idea of having directly heated water from solar is to get load off the electrical network where possible. As Trevor has pointed out, the prime constraint on hydro is water, but where possible it is the “best” of our generation options.

    This is an exercise in optimisation, and how you choose to optimise. heat pumps may be more efficient, but they dont acheive the goal I was selecting for, which is to reduce the GWh per year of electricity required as far as possible. Its not a perfect solution, nor a complete solution: sometimes the sun just doesnt shine! Fancy that, ay…

  16. dbuckley says “All those (150+) listed companies will see their costs reduce. Thus the impact on the market as a whole will probably be positive rather than negative. That’s good news for (competent) investors”

    Yeah right. Listed companies save perhaps $50m on electricity, and lose $750m in earnings, and billions more in investment, and you think that’s a net gain.

    The ramifications of the policy are significantly larger than what will be gained and lost in power prices.

    Fund managers have already stated they would shift money away from NZ if a the Greens/Labour nationalise power.

    I would certainly shift a significant portion of my portfolio to countries whose governments don’t rip off investors.

    And as Contact Energy’s CEO stated, the $2.5 billion they’ve recently invested in renewable generation would not have happened under the Labour/Greens scheme.

    Why would anybody invest money into new generation when there’s risk of losing money, and the maximum gain they’ll get is somewhere much less than the current 5% return?

  17. dbuckley says “My second suggestion is far more radical; instead of building more power stations, spend the same money on installing solar hot water heating on houses across New Zealand,”

    For much of NZ, the return from solar heating is too low to be financially feasible. You’d save more by putting the same money into an investment, and spend the dividends on your power bill.

    And then at the end you still have your lump sum investment instead of some old solar panels at the end of their life.

    That’s why the Solar Association came out against the Labour/Greens power plan.

  18. Why would anybody invest money into new generation when there’s risk of losing money, and the maximum gain they’ll get is somewhere much less than the current 5% return?

    Possibly because “anybody” is “everybody” in the form of the government and the government sees the requirement for new SUSTAINABLE generation as a priority that needs addressing for the good of the society.

    You make assumptions about private sector dominance implicitly. I doubt you even realize that you do it some of the time.

  19. Solar Hot Water in NZ requires rather more effort for rather less gain than in most places. Doesn’t mean it cannot or should not be done. Just that it is more effort.

    As for the ECONOMICS, there is reason to believe that the economics of the current energy mix is just a wee bit distorted… which makes a comparison based on dollars meaningless.

    Arranging for “cheap” electricity, and at the same time solar hot water heaters and tanks to reduce load is sensible in terms of power management. Something we do poorly enough and not often enough.

  20. Don’t worry Photo. All those, investors, that leave New Zealand will only stay away a little while and then come back.

    One thing you can absolutely rely on with capitalists, is greed.

    Anyway, where are they going to go. Betting against the next crash in the USA??

    To all the countries that have similar. regulatory risk.

    We can do without the rich pushing up share prices land and power prices with unproductive speculation, anyway. The problem is as the UK Labour Government noted, when they all said they would leave after a tax rise, is that the antisocial buggers won’t go. 7% less capital was withdrawn from UK by the rich AFTER THE TAX RISE.

    Tax cuts to the rich, and wage cuts, in New Zealand, resulted in much less investment in productive and new business.

    Photo and all the other greedy creeps are just mad because the Labour/Green plan will stop them doing an ENRON with New Zealand power prices.

  21. “For much of NZ, the return from solar heating is too low to be financially feasible. You’d save more by putting the same money into an investment, and spend the dividends on your power bill”.

    Having costed it for several house owners when I was building, your “investment” would have to return more than 12.5%. That is after borrowing money for the solar water heater.

    More Photo-shit.

  22. “Maximum gain less than 5% return”.

    A guaranteed 5% return year in year out looks like a pretty good investment, when you look at how many of the higher return ones became worthless, or worthies without the tax payer bailouts, in the GFC.

  23. The thing about photonz1’s “argument” is that its entirely emotional.

    “Oooh, look, 25 (or 500 or 20,000) people who all say they’re going to run away because they’re scared”. So what? For this to make a meaningful difference to NZ’s cost of capital you need *most* of the potential investors in NZ to actually run away (not just threaten). That’s a hell of a lot of people.

    Think of it in another market: lots of young kiwis leave because this is a low-wage economy. Does this push up our wages? Nope.

  24. Yeah right. Listed companies save perhaps $50m on electricity, and lose $750m in earnings, and billions more in investment, and you think that’s a net gain.

    For every one percent reduction in electricity prices, the commercial sector (excluding the smelter which has its own arrangements) will benefit by a annual reduction in costs of (I reckon) $88m.

    The ramifications of the policy are significantly larger than what will be gained and lost in power prices.

    Yes, they are. The possibilities haven’t even been worked out yet. But in the many posts that you have made on the subject, you have failed to see beyond Fund managers (and private investors) have already stated they would shift money away from NZ, Contact Energy’s wouldn’t have invested in renewable generation, and one other thing I cant remember at the mo.

    Why would anybody invest money into new generation when there’s risk of losing money, and the maximum gain they’ll get is somewhere much less than the current 5% return?

    Because they might not actually get less than the current return, and I’ve explained why before so I wont bother repeating it.

  25. jps says “For this to make a meaningful difference to NZ’s cost of capital you need *most* of the potential investors in NZ to actually run away (not just threaten).”

    Nonsense. Just a 1.5% change is a billion dollar loss of investment in NZ.

    And if money is shifting out away from the NZ market, you’d be nuts to put money in.

  26. dbuckley says “Because they might not actually get less than the current return, and I’ve explained why before so I wont bother repeating it.”

    If what you say is true, then the Labour/Greens claim of $750m in power savings must be false.

  27. hey photonz1, can you stick to the point for just a tick please?

    my comment was about what it would take to increase nz’s cost of capital. you say in effect “nonsense because if it does increase nz will be poorer”.

    your comment makes no sense because it contains a logical error. here’s an analogy:

    me: that building seems very well constructed
    you: nonsense, if it fell over there’d be a big mess

    see the problem?

  28. jps – in an age where few companies want to take on extra debt, a lot of companies have funded growth recently by issuing new shares.

    Several companies I have shares in have had new share offers this year.

    If even a small percentage of money moves out of the NZ market, that will very quickly change market sentiment and dry up share offers and IPOs (and therefore massively curtail any new investment in NZ).

    Rather than attracting new investment, companies will be forced to take on more debt, and all the extra interest costs that are incurred – both things that most companies have desperately been avoiding for the last five years.

  29. Hey, Photo twit.
    What do you think would happen to the NZ share market after an ENRON type failure of the power market?
    Caused by the part privatisation, and “free market” principles and de-regulation, you advocate.

    You forgot to say “the sky is gona fall” as well.

  30. The share market functions perfectly well in economies that are much more regulated than ours. In fact rather better than here.

    The wild west lack! of regulation means that many of us, remembering 1987, are very reluctant to put money in it.

  31. The NZ share market has been spectacularly unsuccessful in its main function. Raising funds for new business, or expansion. Which is why the NZX want floats of State owned enterprises to prop up its own value.

  32. I think photo is not understanding the way country risk premiums are actually set. (s)he sees it through the lens of an nzx investor, unaware perhaps(?) of the drivers of foreign exchange markets. nzx is a sideshow to these markets.

    sophisticated investors understand the difference between an essential service utility and the innovative entrepreneurs seeking capital via the nzx

  33. Kerry says “Having costed it for several house owners when I was building, your “investment” would have to return more than 12.5%. That is after borrowing money for the solar water heater. More Photo-shit.”

    12.5% is a six year pay off. With a loan, that’s just a four year pay off. Yet EECA says the average time when savings equal the cost of a solar system is 11 years in NZ.

    So for much of NZ it’s much longer than that. An investment with a 6.5% compounding interest will also get a return equal to the initial investment over 11 years.

    The difference is that with an investment, I still have my initial investment that I can sell. And it’s likely that it’s at least increased by inflation, if not more, rather than a devalued solar water system that is half way through it’s life.

  34. You cannot work out the value of real energy using fake dollars.

    All you can do is fool yourself if you try.

  35. Are you an accountant Photo. Can only think in short term time frames, and in terms of one household, one child, or one school. It is called “cannot see the wood for the trees” a common RWNJ failing..

    Anyway thanks for doing the sums for me. I would not have been able to do them for myself. Not being as “intelligent” as you.

    We installed solar heating, for customers, which are guaranteed for ten years. The likely life is at least 20.
    The early version on my house were installed in 1996. Still have plenty of life left. New versions are much better made and at least 30% more efficient.
    At least for the northern half of the country pay back is much less than 11 years..(Don’t think I would bother with solar water heating in Bluff). Though the clue there, for the statistically illiterate, Photo, is average! Photo has already conclusively shown that he has no idea of what “average” means.

    As you have kindly demonstrated for me, they will have paid back their cost within 4 years, on houses where I live, leaving at least 16 years of reduced power bills.

    Compared with all the “investors” in financial “weapons of mass destruction” who lost their shirts in the 80’s and again in this decade..

    Then there is the benefit to NZ as a whole in the decrease in power use. The savings in building power plant, buying energy from overseas and avoiding the increased debt to pay for it. And the world by helping to reduce AGW slightly.

    But that doesn’t count with Photo as anything he cannot put into a profit/loss ledger is way beyound his understanding.

  36. Photonz1 obviously has some accounting experience, otherwise he probably wouldn’t have come up with double accounting such as:
    “And it’s likely that it’s at least increased by inflation, if not more, rather than a devalued solar water system that is half way through it’s life.”
    To explain – the solar water system has lost value half way through its life due to its aging, but the cost of a replacement system has increased by inflation and the savings due to the reduction in other energy use have also increased with inflation, so its actual value to its owner in the dollars of the day is increased by inflation, but decreased by its aging.

    If photonz1 put his money into a bank account, the effective interest rate is reduced by inflation.

    However I cannot see how photonz1 came up with “With a loan, that’s just a four year pay off.” when discussing a 12.5% interest rate. (11:40pm)

    Trevor.

  37. I expect he was thinking of, “the magic of compound interest”.

    Otherwise known as the idea of an infinitely compounding expansion in money, without inflation. An obvious impossibility in a finite world.

    A spell that failed, not long ago, for myriads of US pension funds.

  38. Otherwise known as the idea of an infinitely compounding expansion in money supply. An obvious impossibility in a finite world, without inflation.

    Bloody text editor.

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