Submitted by:
Grey Power welcomes this opportunity to comment on the government's proposals for improving NZ's security of supply.
Grey Power, in association with the Returned Services' Association and Age Concern, is acknowledged to represent the largest number of residential consumers of any organisation, as determined by the registration of voting rights for the Electricity Governance Establishment Committee.
1.1: "Ring Fenced" Reserve Capacity
For the reasons given below, Grey Power is not convinced that "ring fenced" reserve capacity is the most appropriate, or economically or socially efficient means of providing dry year reserve capacity. Grey Power believes that the various means available to achieve supply security should be investigated by the Electricity Commission when it is formed, and the selection of a method should be based on careful research and analysis.
To this end, we offer these preliminary comments, and have also answered the particular matters on which comments are sought listed in the Discussion Paper to the best of our ability within the caveat expressed above.
1.2: Dry Year Problems
We can identify two problems with dry year electricity supply shortages:
The social disruption caused to residential consumers by having to conserve electricity, suffer hot water cuts, etc..
The economic disruption caused to commercial and industrial consumers by conserving electricity (reduced lighting levels, etc) and by spot price volatility.
It is of course difficult to place an economic value on the social disruption.
From an
economist's point of view, its value is the additional amount that the affected consumers
would be prepared to pay to avoid such disruption. This has never been investigated, and has
to be considered unknown.
However, we emphasise that there is no evidence that residential consumers would prefer to pay a levy (estimated to average $40/year), plus the effect of the consequential goods and services price increases caused by increased electricity costs to industry and commerce, in order to avoid electricity conservation in dry years.
We note that the voluntary conservation efforts of residential consumers in 2001 and 2003 made a substantial contribution towards easing the crises.
Estimates of the effects on GDP of the last two dry year electricity shortages have been made: $500 million in 1992, and $200 million in 2001. Assuming these estimates are correct, it would have been uneconomic (from a national viewpoint) to spend more than this to have avoided the shortages.
This sets a limit on the spending to avoid economic disruption. However, commercial and industrial consumers may prefer to accept some increase in costs or reduction in production because of spot price volatility, rather than pay an increased electricity price.
The point is that residential and non-residential consumers may put different values on
avoiding shortages.
Many residential consumers may prefer to continue with voluntary
conservation measures, considering how infrequently dry years occur, than to pay an added cost.
It seems likely that the non-residential consumers will put a range of values on avoiding dry year shortage costs, depending on what business they are in. Therefore a one-size-fits-all approach (like a levy on all wholesale electricity) will almost certainly be both socially and economically inefficient.
1.3: Equity Considerations
There are also equity considerations.
If the scheme operates as planned, consumers on
retail (that is, fixed price variable quantity- residential and small business, for example)
contracts suffer few shortage effects, whereas large consumers with exposure to the spot
market will still face some increased costs because of spot price volatility during shortages.
Effectively, these consumers will be paying twice- the levy, and increased spot price costs.
1.4: Competition Issues
It is generally accepted, at least by consumers, that there is insufficient competition in the
generation market even in normal hydrological years. This causes prices to be higher than if
there were effective competition
"Ring fencing" the reserve capacity prevents it from
being used to increase this competition.
As a particular example, New Plymouth and (possibly) part of Huntly power station's capacity form a major part of the present dry year reserve capacity, but also compete to some extent in the normal market. The owners of this capacity will be forced to choose whether to declare it to be "ring fenced" dry year reserve (in which case it will be maintained and fuelled at the Commission's, or rather the consumers' expense) or deploy it in the market. It seems unlikely that part of New Plymouth or Huntly could be reserved.
Therefore the decision could swing relatively large blocks of generation in or out of the market, and consequently affect the trigger point (or price) at which the reserve would be brought into operation.
It would be preferable if the capacity were not "ring fenced". This means that it should not be subsidised by a levy, to prevent unfair competition. In Grey Power's opinion, there are other methods of financing the capacity that would not involve a subsidy, and therefore allow it to compete in the normal market.
1.5: Deployment of "Ring Fenced" Reserve Capacity
A key factor in avoiding the effects of dry year hydro shortages is the early deployment of thermal capacity. If the thermal stations are operated to conserve hydro storage early in a dry year, the capacity required is less than if they are required to make up the hydro shortfall over a shorter period.
There are two limitations:
The proposed "ring fenced" reserve capacity will probably have too high a production cost to be deployed in this way. Mandatory hedging is a possible solution to the problem, because it would limit the profits generators can make from shortage situations, and thus encourage early deployment of thermal generation in potentially dry years.
However, the Electricity Commission should have the power to require early intervention if necessary.
1.6: Spot Price Volatility and Gaming
One of the objectives of the proposal is to reduce spot price volatility. This can only be
achieved if there is competition at the margin in dry years.
If there is no competition
the generator on the margin can corner the market and charge what it likes for its generation.
In New Zealand the two largest generating companies control about 57% of the capacity, and are both net sellers of electricity. There will be circumstances in which either will be able to corner the market by withholding a portion of their uncontracted capacity (this type of gaming happened in Victoria, Australia, in the summer of 2000).
To avoid this possibility, there will need to be enough reserve capacity not only to make up for the hydro shortfall, but also for some portion of the uncontracted capacity of the generators that are capable of dominating the market.
The question that has to be investigated is how often this could occur with reference to particular levels of reserve capacity.
At a simpler level, it will also be possible at times for these generators to bring some of the reserve capacity into operation by withholding generation. This will increase the spot price to the reserve level, and all generators will benefit.
Thus, the provision of reserve capacity may not control spot price volatility to the extent expected.
1.7: Other Financing Possibilities
There are probably several ways that the reserve capacity could be financed without a levy, and thus become part of the normal market.
Two possibilities are capacity contracts (or financial capacity rights) and cap hedges (which would cap the effective spot price a consumer paid at a level of its choosing) .
A combination of both might be most suitable.
For example, the Commission could require
generators to offer hedge contract customers (including retailers) long term firm capacity
contracts or cap hedges up to a total decided by the Commission.
It would also require the
retailers to take out capacity contracts to cover the full extent of their retailing.
The generators would use the income from these contracts to build additional generation
capacity, and to store reserve thermal fuel, as necessary to ensure the contracts can be
supplied.
There would be no need to "ring fence" the reserve capacity, since it would not be subsidised.
The generators could choose the type of generation most suited to their needs.
Residential consumers would be protected from shortages and wholesale consumers could choose
the level of security they wanted with a combination of capacity contracts, cap hedges and
spot price exposure.
This would present both an economically and socially efficient
solution.
Ideally, competition would set the prices of the capacity contracts at reasonable levels (and incidentally reduce the cost of the conventional hedge contracts, which include capacity charges); but in the absence of competition, the Commission could negotiate.
It is possible that the generators would choose the cheapest option of peak capacity,
instead of aiming at an optimum generation portfolio.
The Commission will have the right to
require generators to offer hedge contracts up to a proportion of their firm capacity, which
could encourage the generators to balance their portfolios, and also provide a warning signal
as contract prices rise.
The cap hedges would have a similar effect and signal.
The Commision could then act to correct the balance. In any case, this effect would be less than with the "ring fenced" proposal, which would force predominantly low capital cost generation to be built.
We also note that there is no point in having reserve capacity unless its generation can be
delivered to consumers securely. If the government's proposal is followed, the Commission will
need to direct Transpower to reinforce the transmission system to cope in dry years
(paid for, presumably, by part of the levy)
Another possibility is for the Commission
to direct Transpower to offer sufficient financial transmission rights (FTRs) to hedge
contract customers, and to direct retailers to take up sufficient FTRs to ensure supply to
their retail consumers.
The necessary system reinforcement would be paid for by the FTRs, which could be part of the capacity contracts.
The Commission would not require to let tenders or control contacts if financing was
provided by, for example, capacity contracts, cap hedges and FTRs.
However, it would need to forecast the quantity of contracts, hedges and FTRs that needed
to be made available on a rolling basis over several years.
In either the case of "ring fenced" capacity or contract financed capacity, contract
length is critical. Before they would lend, financiers would typically require a long term
contract covering costs and income (10 to 20 years; we are aware of current joint venture
cogeneration contracts that have 20 year terms), an interest cover of at least 1.4, and
agreed settlement conditions at the end of the contract. The owner would probably seek to
have totally amortised its capital investment by the end of the contract.
Thus the contract length will tend to set the annual payments required by the owner.
The financing would affect the owners' gearing, and could reduce their ability to borrow more for additional generation (and their ability to pay special dividends funded by debt).
In the case of "ring fenced" capacity, the capital raised would be spent on capacity that
would not add to normal year generation. This could impact on the provision of normal
capacity increments.
In the case of non-"ring fenced" capacity, the generators would
have the choice (perhaps guided- even forcibly- by the Commission) of the type of capacity
to be installed.
The contracts would have to be reviewed on a yearly basis to take account of changing circumstances. A rolling contract arrangement could be the best solution.
2.2: What quantity of ring fenced capacity would be best and what is the best balance between new and existing generation in that portfolio?
To quote an overused phrase, "the market would decide" these quantities if the financing
were provided by contract.
However, if "ring fenced" capacity were provided according to the government's proposal,
we believe that the quantity should be decided in terms of economic efficiency. That is,
the cost of the reserve capacity should not exceed the estimated annualised impact of dry
year shortages on GDP.
We believe this would result in considerably less than a 1:60
security standard. Some arrangement should also be developed to ensure equity between
consumers exposed and not exposed to spot price volatility, for example by allowing hedge
contract consumers to take out reserve capacity hedges instead of paying the levy.
2.3: What are the optimal prices and conditions under which the reserve generation should be offered into the market for dispatch by the system operator?
Once again, in the case of capacity funded by contract, the generators could decide on
deployment.
In the case of "ring fenced" capacity, the signal for deployment would presumably be when
the spot prices rose to a level at which industrial production cuts were imminent. We have
no data on this, but believe that such cuts might start above 10c/kWh. This is likely to be
less than the variable production cost of the reserve capacity, so a decision would have to
be made on whether to susidise this cost from the levy in order to avoid economic disruption.
This would raise equity issues.
2.4: Is the levy on wholesale electricity prices to recover the Commission's costs for reserve generation fair and efficient, or would some other form of cost recovery be better?
Grey Power believes that recovering the Commission's cost by a levy on wholesale electricity prices would be neither fair nor efficient.
As stated above, it would be unfair if large consumers have to face spot price volatility and production cuts as well as pay a levy. Since different industrial consumers have different spot price cut off levels, it would not be possible to subsidise the reserve generation to overcome this problem.
The economically efficient level of the levy is the amount that different types of consumer
would be willing to pay to avoid dry year shortage problems. Therefore there should be
different levels of levy for different consumers, and by implication some level at which
shortages would not be covered.
A "one-size-fits-all" levy is therefore unlikely to
be economically efficient.
3: CONCLUSION
Grey Power contends that providing "ring fenced" dry year capacity by means of a levy on wholesale electricity would be neither economically nor socially efficient
Other forms of capacity provision and cost recovery are discussed above. We emphasise that we are not claiming that funding from capacity contracts, cap hedges and FTRs is the solution.
We believe that the Commission should make a careful analysis of the various funding methods before a decision is made.
June 12, 2003.
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