In defence of the New Zealand wholesale electricity market

Recently the New Zealand electricity sector has been taking a bit of a hammering. According to a Commerce Commission sanctioned report, consumers have been overcharged by $4.3b over a six year period (how’s that for a headline!). More specifically, the report concluded each of the four big generators – Meridian, Contact, Genesis and Mighty River – has been exercising the power the market’s design gives them to command unjustifiably high prices, at least during years when inflows to the hydro lakes are low as they were in 2001, 2003 and 2006.

New Zealand has two markets in electricity – the wholesale market and the retail market. The wholesale market is where generators sell their production to retailers (often the seller and purchaser are one and the same). These prices vary significantly depending on the conditions of that particular period (for example, how dry Southern Lakes are or whether a generation unit is out service).

The second market is the retail market, where retailers sell electricity to consumers. Prices here are typically very stable, with consumers seldom exposed to the vast variation that takes place period-on-period in the wholesale market.

In the long-run, the prices in the wholesale market feed through to the retail market. In other words, if a generator/retailer found themselves short of generation and thus had to buy excess generation on the wholesale spot market at relatively high rates, they would eventually pass through these additional costs to their consumers in the retail market.

The report is essentially saying that generator/retailers were able to use their dominance in the wholesale market to push up prices during periods of constrained supply, which consumers then ultimately had to pay for in the retail market.

The report also says that pricing in the wholesale electricity market is, in the absence of dry periods, typically competitive. A very important point made in the report is that no market is ‘textbook’ perfectly competitive and this is certainly the case in electricity, given its unique characteristics (in particular the need for supply to continuously meet demand).

Indeed, I would say that the wholesale electricity market is working almost exactly as intended. Pricing is commonly competitive except at times of tight supply, when generators are able to reap higher rewards that incentivise continued investment in generation (which is extremely expensive) so that ever-growing demand can be met into the future. And the Commerce Commission determined that the generators’ actions were a “lawful and rational exploitation of the opportunities the market gave them”. I doubt you’d be able to make nearly as impressive a headline out of that though…

  • ben

    Pricing is commonly competitive except at times of tight supply

    Eh?

    Are you saying low rainfall causes market failure?

    Given an energy shortage, would a competitive market look any different?

  • goonix

    @ben
    Perhaps I could have worded that better. I am paraphrasing the ComCom report, which states that market power is being flexed when its dry and is not being flexed when it isn’t dry.

    I’m not saying low rainfall is causing market failure, as the market is designed to encourage more generation to be built when supply is tight through returning higher prices at these times so that the fixed costs of investment can be recovered – the signals and incentives are exactly what you would want in order to alleviate shortage dynamically.

    Would a competitive market look any different? Well if competitive meant that ‘higher’ prices were never charged at times of tight supply I daresay the market would look quite different – no new generation would be built due to unsatisfactory returns and the country’s security of supply would be at risk in the long run as demand continues to increase.

  • Good post

  • “A very important point made in the report is that no market is ‘textbook’ perfectly competitive and this is certainly the case in electricity, given its unique characteristics (in particular the need for supply to continuously meet demand).”

    But am I right in thinking that the $4.3B figure comes from a comparison of what really happened v’s what would have happened if the market was competitive. If I’m right then this looks like a odd comparison since as noted in the quote the market isn’t competitive.

  • goonix

    @Paul Walker
    The point of ‘textbook’ competition being unrealistic is made in the paper. And then seemingly conveniently put to one side so that the analysis can take place. 😀

  • goonix :
    @Paul Walker
    The point of ‘textbook’ competition being unrealistic is made in the paper. And then seemingly conveniently put to one side so that the analysis can take place.

    Thanks. When I read the press release it looked to me as if the they had assumed a competitive market when getting to the $4.3b figure and that assumption didn’t make sense to me. I argue here that a better standard of comparison would have to be ask what alternative feasible, implementable industry structures are there and is the best of these likely to give better results? If so, then compare the New Zealand situation to this real world alternative and then see how large any excess earnings are.

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  • insider

    @Paul Walker

    I think you are right. I’ve read parts of it and I can’t find Wolak putting that number on it anywhere in his reports. It appears a number the ComCom worked out, presumably looking at the gap you cite and multiplying it over time. The fact they did so and publicised it to me is significant given they didn’t prosecute. Wonder if the number was done primarily for publicity?

    I say this because they way the market works does not to me support that conclusion. All generators get paid the same as the market clearing generator. If you bid much lower than that level and get dispatched, you still get paid the clearing rate. But the ComCom assumption seems to be that you have benefited from market power even though you didn’t exert it and have no choice, and that is considered a rip off (a technical economics terms in case you didn’t know).

    So I question the $4b figure as do a few others I know far more learned and most smarter than me.

  • the $4.3b comes from chapter 5, just sum up the “market power rents” in table 5.4.

    “Market power rents” are the difference between the price that would have occured in a competitive market (marginal cost of the most expensive generator that was dispatched) and the actual market clearing price. “competitive rents” are the difference between the total variable cost of the power dispatched and the “competitive” price.

    Figure 5.2 has a nice Econ 101 type graph that shows what he is calculating.

  • That’s why we have you agnitio. Cheers.

  • louise
  • @louise
    Cheers for the link louise, interesting stuff.

  • insider

    @agnitio

    Ah yes but the ComCom added it up…looks like a beat up to me

  • goonix
  • insider

    @goonix

    damn beat me to it

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