Pete Hodgson Speech - The electricity market: Winter 2003 and beyond

[Address to joint breakfast meeting of the Wellington branches of the Institute of Electrical Engineers, the Institute of Professional Engineers and the Institute of Electrical and Electronic Engineers: James Cook Hotel Grand Chancellor, Wellington.]

Thank you for the invitation to speak today.

My subject, the electricity market, is more topical today than you could have expected when it was chosen some weeks ago.

With current high wholesale electricity prices and the prospect of another dry winter in front of us, questions about the market's performance are being raised in many quarters. I have two distinct issues on my mind.

First is ensuring that we get through this winter, if it is a dry one, with the minimum possible disruption for consumers and the economy.

Second is the longer term question of whether the current market structure can deliver adequate security of electricity supply, or whether further government intervention is needed.

Before discussing these matters further, let me briefly run through what the government has been doing with the electricity industry for the past three and a half years.

A lot has happened, but many of those now commenting publicly on the issue have apparently forgotten, if they knew.

Labour went into the 1999 general election with a commitment to investigate the structural issues arising from the previous government’s electricity industry changes, by way of a formal inquiry.

We knew that many of the changes made under my predecessor Max Bradford were irreversible. The question was – and still is – how the new electricity system that we inherited could be made to work as well as possible.

I set up a ministerial inquiry, chaired by David Caygill, and it reported in June 2000. The essence of its findings was that the operation of the electricity market could be tuned up with a number of important but not radical changes.

The inquiry also recommended that these changes be made through a combination of regulation, where necessary, and industry self-governance where possible.

The government accepted the inquiry's recommendations and added some more initiatives of its own. We produced, in December 2000, a comprehensive statement of policy on the future development of the electricity industry. In August 2001 Parliament passed legislation that undid the sillier bits of the Bradford reforms and gave me back-up regulatory powers in case industry self-governance failed to deliver other necessary changes.

Now, after a much longer and more difficult process than anyone foresaw, the industry’s efforts to establish new self-governance arrangements are at last heading towards a vote. Either the industry will establish a governance board, or the Government will have to do so.

Either way, a number of significant improvements to the industry have been made in the meantime.

The office of the Electricity Complaints Commissioner has been established, low fixed charge tariffs are widely available for low power users, rules for the disclosure of hydro spill have been established, a real time pricing trial for the wholesale market is under way, market bids and offers are now routinely disclosed after two weeks, a hedge price index has been set up and the Commerce Commission has conducted an inquiry into price control on lines companies, resulting in a further price freeze.

Amidst these changes, of course, government and the industry also managed a record dry winter in 2001 — with the help of New Zealand consumers.

It has been a busy and challenging three and a half years.

Imagine my delight now at the prospect of another dry winter.

Demand is up about 5 percent on last year. Inflows into the main storage lakes were 70 percent of average for March and at the end of the month hydro storage stood at 76 percent of average for the time of year. At the same time, the redetermination of the remaining gas in the Maui field has created new uncertainty about gas availability for thermal electricity generation. Maui is running out ahead of schedule.

This uncertainty about gas means much more coal and fuel oil will have to be burnt this year — and next year, and the one after that. I have been closely engaged with the industry in recent weeks to satisfy myself that the necessary arrangements for coal supplies, in particular, are in place.

It has become clear to me as a result of these inquiries that the market does not have adequate access to information about thermal fuel supplies. Everyone has access to information about hydro storage, inflows and forecasts but the situation with gas and coal supplies is much less transparent.

This matters because hydro generators need a good understanding of the availability of thermal generation if they are to make good decisions about how to use their water. Markets work best when they are well informed. So I am making it clear to those holding the relevant information on thermal fuel supplies – including state agencies – that I want this data reaching the market sooner.

I have also made it clear to the leaders of the electricity industry that I expect them to be more active in leading an effective response to the prospect of a dry year than they were in 2001.

In that year the industry response was primarily led by me, by means of calling together a working group of industry and consumer leaders to look for ways to increase supply and reduce demand. The critical measure in the end was a government-led electricity savings campaign, though the industry pitched in willingly.

I told the industry in 2001 that an effective response to the supply difficulties of that year was crucial if it wanted the electricity market to survive. That message has been driven home even more firmly this year.

The industry has heard it well.

Until a couple of weeks ago, the industry’s Winter Power Group 2003, led by Transpower, was monitoring developments and planning responses to various dry winter scenarios.

This group, first set up in 2001, has done useful work on technical solutions to supply constraints, such as transmission improvements. It has also reviewed and updated a range of contingency plans.

But the stakes are higher this year. In response, the industry's Grid Security Committee has now formed a Winter Electricity Task Force to coordinate action over the next few months.

I am pleased that the GSC has picked up this task. It brings chief executives to the table and includes representation from consumers. The government’s Energy Efficiency and Conservation Authority is working closely with it. The GSC has secured the services of Patrick Strange, the former chief executive of Vector, to lead the task force. Dr Strange has a great deal of respect within the industry. He has discussed his approach to the role with me and I am confident he will be effective.

The GSC's view, which I share, is that it is still too early in the year to launch a full-strength public electricity savings campaign. It is the beginning of Autumn and – although the long-range forecast is not promising – it is still possible that Autumn rain will make such a campaign unnecessary.

It is, however, well worth reminding consumers of the savings they can make by simple, prudent measures. That message will be pushed out steadily by the industry from now on -- and can be stepped up gradually if the supply situation does not improve.

At the same time Winter Electricity Taskforce will coordinate work to ensure that the industry can maximise the amount of electricity it can produce this winter. This will mean further work with generators on contingency generation plans and further steps to minimise relevant constraints in electricity transmission. It is also likely to mean the provision of better information to the market, as I mentioned earlier.

As the situation develops, the taskforce will also provide regular updates for the public, to make sure the supply situation is clearly understood.

While the arrangements for this winter are at the top of my agenda right now, there are fundamental questions about the adequacy of the current electricity market being asked with increasing urgency by government, industry and other consumers.

This debate has been spurred by the recent leap in wholesale electricity prices. We do not have a supply crisis at this stage, but there are some large electricity consumers who argue that they are already dealing with a price crisis

These are circumstances in which you would expect wholesale electricity prices to climb steeply, as they have done. Hydro generators have been putting a high value on water and more expensive thermal generation has been running harder and earlier than it does in less anxious times. The uncertainty about thermal fuel supplies is also a factor.

The government is well aware that current spot market prices are punishing for major industrial electricity users exposed to them. Production has been cut back and the effects are flowing through to workers and suppliers.

The blunt truth is that many major electricity users are exposed to the spot price of power because they choose to be, because on average it is significantly cheaper than the going contract price. Last year major users paying the spot price saved many millions of dollars, with prices generally under 4 cents a unit.

The risk, of course, is that in periods of tight supply or uncertainty, spot prices can climb very rapidly and very high. It is a business decision to take that risk, cold comfort though that might be to businesses suffering as a result.

It is fair, however, to ask whether the extent of the volatility in wholesale prices is beyond a level that businesses can reasonably be expected to manage. It is one thing to take a risk, and another to take a risk that turns out to be larger than you could possibly be expected to gauge.

This question is valid whether or not you suspect that the extent of price volatility is due to abuse of market power. So far, efforts to substantiate such suspicions have come to nothing. But the absence of any evidence to settle that argument does not prevent us asking whether the degree of unpredictability is tolerable.

Electricity prices are an important factor in new investment, particularly in energy-intensive activities. New Zealand has a lot of energy-intensive industry – because of Think Big, because we rely so heavily on the primary industries, because we still have some of the cheapest electricity in the developed world. We turn large volumes of cheap power into aluminium, milk products and wood products. There are irrigation schemes in Canterbury that consume as much power as a small town.

Security for the electricity sector requires adequate and timely investment in generation and network infrastructures. Markets are a powerful tool to do this, yet the wrong market design can have serious implications.

Under-investment in the electricity sector is potentially very costly and disruptive to an economy. Debate continues internationally as to whether market signals are strong enough to stimulate adequate and timely investment, particularly in peaking capacity. In New Zealand the key issue is our ability to cope with dry years.

The incentives for the industry to build enough dry-year reserve generation in a timely fashion have not worked well enough, even if we acknowledge the unpredictability of the Maui redetermination. So the Government is asking what kind of adjustment or intervention is needed to improve security of supply.

Greater supply security should bring reduced price volatility. But it will come, inescapably, at a higher average price. Reserve generation is effectively insurance against dry years and there is a premium to pay.

The government is approaching this question with an open mind. We do not have a preferred option. There is a wide range of choices, many of which are not mutually exclusive. There will be options I have not even heard of yet.

Some of the suggestions that have come up so far are:

separation of generation from retail, which is being promoted by some major electricity users and market-minded analysts; mandatory tendering of hedges, also favoured by some major electricity users; a requirement for electricity retailers to contract with generators for more than 100 percent of forecast demand (such as proposed by the US Federal Energy Regulatory Commission) a levy, added to the spot price of power, to subsidise the cost of reserve generation; and a single wholesale buyer and seller of generation.

Even from that short list you can see that the spectrum is broad. Options like mandatory hedging or a requirement for retailers to contract for surplus generation would intervene in the wholesale market but leave it substantially intact. Separating generation and retail would leave the market intact, but have a large impact on the companies involved. Creating a new central buyer would significantly alter the nature of the wholesale market.

The range questions surrounding each option is broad too.

Will this, that or the other change ensure that new generation is built neither too soon nor too late? Will useful price signals be lost? Will dry year risk be adequately assessed and covered? How will consumers manage price risks? What are the odds of market failure or regulatory error? What are the administrative and compliance costs?

These are not easy questions and we will not be hasty in answering them. Change will also take time, particularly if new legislation is required.

In the meantime I will not be forgetting the unfinished business remaining from the Government Policy Statement of issued in December 2000.

Some of the changes that have been waiting for the industry to sort out its governance arrangements are directly relevant to long-term security of supply.

Take transmission pricing, for example.

For optimum security of supply, the regulatory environment must facilitate transmission investment. Yet under-investment on the national grid continues to be a concern.

That reflects not so much on Transpower as on the constraints within which it operates. Transpower cannot invest in grid upgrades without charging the cost back to generators. The absence of any rules for how this should be done has led inevitably to disputes, delays, stand-offs and even the absurdity of Transpower and another SOE slugging out their differences in Court.

The GPS requires rules to be developed for transmission pricing and for how investment decisions are to be made and paid for. That is still to be done.

Another example is the GPS requirement for electricity market rules to facilitate and promote demand side participation in the market.

Dry winters focus attention on supply, but the other half of the equation is just as important.

There has been far too little attention paid in this country, for far too long, to demand management. Managing demand and increasing efficiency is significantly cheaper than building new power stations.

Yet there is still no meaningful way for the demand side to participate in the New Zealand electricity market. There is no secondary trading. I cannot, if I have contracted for an amount of power I decide I no longer need, easily sell it back through the market to someone who wants it more than I do – my power company, for example.

The market badly needs more innovation in this area.

These and other changes required by the GPS are still outstanding. And I still have the ability to step in and achieve them by regulation if I have to.

The sooner the industry's governance is sorted out, the better. We need a body that can complete the market improvements the Government called for in 2000 and make any further changes we might decide are necessary. I must wind this up, but there are of course many other things going on in energy policy that you might want to explore by way of discussion.

They include: improved modelling of future supply and demand; the National Energy Efficiency and Conservation Strategy; action to achieve our renewable energy target; the development of a wholesale gas market; negotiations to open the Maui pipeline to gas from other fields; and the search for gas to replace Maui … to mention just a few.

I welcome questions, and I have no doubt that many of you are ready to tell me exactly what the Government should be doing with the electricity market. So fire away.

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