Question on the power price spikes

So some businesses are complaining that the spot price of electricity occasionally spikes when there is a shortage (and that these spikes are inconsistent).  They want government intervention.

My question is, if these spikes are such a concern – why don’t the businesses set up fixed price contracts with electricity retailers in the same way household do.  Also, the retailers are complaining about the wholesale price spike – but couldn’t they also set up contracts on a fixed rate?  Ultimately, knowing that the price can spike heavily in the face of a shortage of power, these businesses are CHOOSING to buy at the spot price (I guess it must be cheaper) – if that is what they choose to do then they should really face the risk of it.

Now if there was something anti-competitive about the setting of wholesale energy prices sure, go ahead and complain.  But if they spike because there is a significant shortage – and this price is just representing the underlying opportunity cost associated with providing that power – then having the spike occur is a GOOD thing.

This is because the price is saying “hey, at the current time there is a severe shortage of power, and unless you can create oodles of value from it you should think about stopping power usage for a short period of time”.  When it is placed in that context the spike seems reasonable, and all the complaining about it seems weird – so what is going on?

FYI:  Good comments from Rauparaha.

  • http://www.tvhe.co.nz rauparaha

    Well, it’s only good if people know the prices ex ante so they can re-allocate on production. It sounds from a skim of that article as if businesses are really complaining about having no warning about the spike and being unable to adjust their electricity usage.

  • http://www.tvhe.co.nz Matt Nolan

    @rauparaha

    Good point on the price spikes – it would be hard to change usage if you only find out afterwards! So I agree, there are issues with the extremely short term allocation mechanism in this case.

    However, ex-ante they would know that there is some probability that there would be a spike – and yet they are willing to take the risk of sitting on the spot price rather than getting a fixed price contract. As a result, they got burned by a risk they were willing to take – does that mean the government should regulate?

  • http://www.tvhe.co.nz rauparaha

    @Matt Nolan
    The government’s already made decisions that led to the current structure of the electricity market. 20,000% price spikes without notice are unlikely to be efficient so I don’t have a problem with them thinking about how they might improve allocative efficiency in such situations. I just don’t think it’s obvious that regulation — for instance, requiring significant price movements to be notified ex ante — is necessarily a bad idea.

  • http://www.tvhe.co.nz Matt Nolan

    @rauparaha

    “I just don’t think it’s obvious that regulation — for instance, requiring significant price movements to be notified ex ante — is necessarily a bad idea.”

    Agreed.

    But this still brings me back to the question of why these people are buying off the spot market instead of forming fixed price contracts. A spike in prices is a known risk, so generally there must be a counter-veiling benefit.

    It seems to me that if there was an issue in such a case, we wouldn’t need government imposed regulation per see – surely people would just move to the security of fixed price contracts? It isn’t clear to me that government regulation can improve outcomes beyond what is achievable between the firm, the generator, and the wholesaler.

  • Seamus Hogan

    @rauparaha

    “20,000% price spikes wihtout notice are unlikely to be efficient”.

    Why? The wholesale market sets prices ex post to equate supply to demand. In the very short-run (within half an hour), demand is, as you note, extremely inelastic (at least, until we get smart metres that control smart appliances). Short-run supply can also be very inelastic if there are transmission constraints. As a result, we get very high price volatility. So what is inefficient? Is it the fact that extremely high prices distort demand? That can’t be because of the low elasticity that allows them to occur. Or is it that demand doesn’t adjust enough to the underlying scarcity? In principle, one could enhance efficiency by having perfect foresight over prices, but what real-world institution could communicate future prices and still have those prices set by supply and demand? And if not set by supply and demand, how would predictability of future prices that don’t refelct real-time scarcity enhance efficiency?

  • http://www.tvhe.co.nz Matt Nolan

    @Seamus Hogan

    Good point. I would hazard a guess that Rauparaha was thinking along the lines of an information asymmetry leading to inefficiency – namely that if wholesalers had to give immediate notice to firms when wholesale prices spiked by x% or more, we might see more of a response.

    However, I’m not sure we would need government intervention for this to occur – I’m trying to understand what barriers prevent this from occurring in the market place to start with? There is competition in the wholesale industry, so if this is actually a big deal why don’t we get a market solution.

    My conclusion is that the market participants are just bleating for regulation in their favour – while Rauparaha feels that there is some barrier to the market solving this solvable information issue, and as a result regulation could be both welfare improving and increase allocative efficiency.

  • Miguel Sanchez

    Ummm, wasn’t this a planned outage? Transpower may not have signalled it in terms of prices, but surely users could have put two and two together?

  • http://www.tvhe.co.nz Matt Nolan

    @Miguel Sanchez

    Really, so there was explicit information – well that just makes the bleating even worse ;)

  • Kirk

    Yes a planned transmission outage which effectively cut Auckland off from electricity generated south of Huntly.

    That said, there was enough generation capacity to cover demand, so there was no shortage of power to Auckland and Northland.

    As The bulk of the generation capacity from Huntly north is owned by Genesis, Genesis could and did name their price.

  • http://www.tvhe.co.nz Matt Nolan

    @Kirk

    Aha, so there is a competitive issue. In this case there should be calls for the commerce commission to investigate rather than direct government regulation on price right.

    Either way, it sounds like you commenters are all boiling down the associated issues well in the comments here – well done

  • Miguel Sanchez

    No, you were right the first time Matt. It was perfectly foreseeable that Genesis would be given a temporary monopoly during the outage – why didn’t users plan around it?

    I suppose it’s possible that a fixed-price contract with Genesis would have incorporated the planned price spike and so wouldn’t have worked out any cheaper. But then at least Genesis would have had to reveal their intentions, and the buyers could have bleated about it before the fact rather than afterward.

  • http://www.tvhe.co.nz Matt Nolan

    @Miguel Sanchez

    Indeed.

    I agree it was foreseeable – I haven’t moved away from the fixed contract idea either. And I agree with you it is likely it wouldn’t have been cheaper in an ex-ante sense (hence why these places were taking the risk on the spot market) and then the information regarding the price risk would have been incorporated in the price.

    However, if there is a competition issue I don’t mind it being looked at by the Commerce Commission. It definitely doesn’t change the views I expressed in the post – but it is relevant in a more general sense.

    And overall, the bleating about regulation still annoys me epically ;)

  • Royal Albert Ross

    There is a particular issue about competition in electricity markets which is that the source of supply tends to be lumpy – large power stations being much more efficient than small ones. This is particularly the case in a small, isolated, widely dispersed market such as NZ. An event like this sends a strong signal that it would be desirable to have more than one power supplier able to generate and supply north of Auckland – but the market there is simply not big enough to justify the construction of two power stations. It is therefore probably inevitable that there will be an occasional natural monopoly, a case which may well justify more regulatory intervention. Other power stations may be in a similar position.

    What seems to me to be inexplicable here therefore, is not that Genesis took advantage of their temporary natural monopoly this time – it is that the same sort of behaviour doesn’t happen all the time. In fact it seems to me to be quite dangerous that it doesn’t, for it encourages politicians and market participants to base their approach on the assumption of public spirited self restraint by those in a position to make a killing. It’s a lovely idea, but sooner or later you’re going to get killed …

  • http://www.tvhe.co.nz Matt Nolan

    @Royal Albert Ross

    This is all fine, it is perfectly fine to say there is a competitive issue that needs to be investigated – in which case any regulation is at least justified rather than arbitrary.

    However, even within this context I STILL have the question “why weren’t these people on fixed price contracts”. They are complaining about the price spiking because they lost a bet on what spot prices would do – I can’t have much sympathy with that.

    As a result, this is the first question I’d ask myself before looking at the issue in any sort of detail.

  • Royal Albert Ross

    Not disagreeing, exactly, but I think the question is more fundamental. Seems the buyers weren’t on fixed price contracts because they had been lulled into a false optimisim that generators would never be so mean and nasty as to take advantage of a temporary piece of market power – or alternatively, that Government would never let them be. They were wrong on the first count and I share your hope that they will turn out to have been wrong on the second as well. There are many examples around the world of where things have gone horribly wrong when Governments have stepped in to regulate electricity prices.

    The question then is really, why had they been lulled into a false sense of optimism? Given the physical and topographical nature of this market, this can’t be the first time a generator has found itself in a position of temporary local monopoly – why hadn’t they been taking advantage, and so educating the demand side into more realistic expectations?

  • Miguel Sanchez

    Presumably because reputation matters, especially in a market like this where you’re likely to have the same players over long periods of time. My hazy recollection of game theory is that in an infinitely repeated game, the best strategy is to play nicely each time, unless the other guy screws you – in which case you switch to a hostile strategy and never go back. (Even when you’re co-operating it can pay to take steps to keep it that way, so the question of why the buyers didn’t use fixed-price contracts still stands.) So the question is not so much why they haven’t poisoned the well before, but why did they do it now?

  • http://www.tvhe.co.nz Matt Nolan

    @Royal Albert Ross

    “Seems the buyers weren’t on fixed price contracts because they had been lulled into a false optimisim”

    This isn’t policy relevant – they took on the risk, it is really their own fault if their belief structure was poor.

    “The question then is really, why had they been lulled into a false sense of optimism? Given the physical and topographical nature of this market, this can’t be the first time a generator has found itself in a position of temporary local monopoly – why hadn’t they been taking advantage, and so educating the demand side into more realistic expectations?”

    Surely the knowledge they now have, that prices can spike, is sufficient information for them. If they suffer from a spike in the future, it is their own fault – again why don’t they go onto a fixed term contract if it pains them so.

    We can’t regulate on the basis of “expected irrationality”.

    @Miguel Sanchez

    The old grim trigger. I am under the impression that isn’t a particularly popular strategy to study anymore because it appears to be empirically false.

    If it was an issue of reputation that kept spot prices now, it is very weird that they suddenly lifted the price at that one point in time without considering reputation. Overall, I am not sure how much I trust the description of the situation from any of the market participants – they are really just all speaking with their own interests at heart.

    And I still can’t believe the no-one will ask them why they didn’t use fixed price contracts if it is such a big, concerning, risk :P

  • Royal Albert Ross

    Sorry, I may not have been clear when I wrote “why hadn’t they been taking advantage” – I meant, why hadn’t the generators been taking advantage.

    I agree that Genesis have actually done both regulators and the demand side a huge favour by demonstrating to them that there are real risks in the NZ electricity market. It’s now crystal clear that you can either pay a predictable higher price to mitigate that risk, or you can take a lower price and live with the risk – in which case, you’ve no right to moan when the risk happens and you lose. Or the regulators can prevent supply side from profit-making at times of shortage, in which case they should not be surprised if the supply side declines to invest in the capacity to cover such times (California).

    Of course it’s true that the risk was always there. But my case was that the demand side had understandable cause to discount it – because previous experience had shown them that the supply side would act with public-spirited self-restraint in such circumstances. It would be interesting to know why the supply side didn’t on this occasion. Have Genesis recently appointed Montgomery Burns as Chairman?

  • Miguel Sanchez

    @Matt Nolan

    I’m not clear what “empirically false” means in this instance. Theory tells us what people should do, under a tightly defined set of conditions. If that’s not what people actually do, then it tells us which conditions we should be looking at.

    In this case, the “grim trigger” seems like a credible threat on the face of it – the buyers could ostracise Genesis and eventually drive them out of business by not dealing with them in the future, even though that would come at the cost of having to pay more for power from elsewhere. But maybe they can’t do that? And it still doesn’t answer the question of “why now” – has something changed to make the grim trigger less credible? I don’t know enough about the structure of the electricity market to say.

  • http://www.tvhe.co.nz Matt Nolan

    @Royal Albert Ross

    Fair call – it is an interesting issue. I hope that industrial economists are going to have a bunch of fun thinking about it.

    @Miguel Sanchez

    “I’m not clear what “empirically false” means in this instance. Theory tells us what people should do, under a tightly defined set of conditions. If that’s not what people actually do, then it tells us which conditions we should be looking at.”

    Perfect call – showing it does match the data tell us that either one of our core assumptions is false, or that one of our auxiliary assumptions is both false and actually a core part of the model.

    “In this case, the “grim trigger” seems like a credible threat on the face of it”

    This is the kicker, a grim trigger isn’t really a “credible threat” unless you can come up with a pre-commitment mechanism. It is sensitive to “trembling hands” – such that a mistake could throw us out of it. As a result, without some sort of observable “precommitment mechanism” this equilibrium would likely be too unstable to be relevant.

    However, you are right that the idea of trigger strategies – and the implied “stock of reputation” does have appealing properties for what we are looking at here. Within that context, it is understandable why a generator would make spot prices less variable than fundamentals would suggest. And it also points out that there is something strange about this specific situation – something else that we should look for rather than bemoaning competitive pressures as a catch all term.

    So I don’t disagree with your use of such things here, I’m just nervous about relying strictly on the grim trigger too much – for example I would rather prefer to look around for things like the threat of potential competition/regulation as a limiting factor on price in this case.

  • Miguel Sanchez

    Well I’d say that lobbying for regulation could be one aspect of a non-cooperative strategy once the grim trigger is, er, triggered. It’s the best strategy for the buyers at this stage, but maybe still not as good from them as the alternative of a cooperative, self-regulated market.

  • http://www.tvhe.co.nz Matt Nolan

    @Miguel Sanchez

    Lobbying for regulation is a required aspect here, I agree – as otherwise (as a natural monopoly) the wholesaler wouldn’t have to worry about entry or punishment. Without another supplier of power, the buyers can’t commit to a grim trigger.

    I’m not even sure if we could necessarily have a better form of market – maybe we could – but maybe we couldn’t. The spike in itself doesn’t change my view, or the information available to me regarding that. It will change the belief structures of buyers – we might see more fixed term contracts as a result – but it hasn’t changed the fundamentals the industry was based on.