Russel Norman

Power Struggles – by John Small

by Russel Norman

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.

Published in Environment & Resource Management by Russel Norman on Wed, May 15th, 2013   

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