NZ Power likely to sap energy from the local capital market

JBWere Strategy Comment: NZ Power likely to sap energy from the local capital market

* The Labour/Greens announcement on electricity sector reform concerns us on two fronts: firstly, the move to a state buyer of power risks being a retrograde step for the New Zealand economy. Secondly, we believe it will prove damaging for New Zealand capital markets, and comes at an unfortunate time given the significant progress made here since 2010. We detail these two concerns below:

Government intervention in production usually doesn’t work

* The first blush of the NZ Power policy is another variation of models that have been tried, tested and failed for well over a century. That is, the state looks askance at the messy process of market-discovered price and production and figures it can do a better job. Labour says as much in their policy document stating “No one plans the New Zealand energy sector and ensures it operates for the benefit of all New Zealanders”. The idea of a central planner co-ordinating supply and prices is superficially alluring. But almost invariably it ends in either taxpayer funded over-supply or rationing. A brief look at New Zealand’s own history in the Energy sector provides ample evidence, with the Think Big projects of the 1970’s an example of well-meaning but ultimately financially crippling supply-side State intervention. The Clyde dam was built on price assumptions that are still distant 30 years later.

* It is illuminating that Labour cites California, Virginia, South Africa and Brazil as poster children for the centrally planned electricity model. A quick scan of media headlines in three out of the four markets from the last quarter alone shows significant supply problems:

“California Girds for Electricity Woes”, Wall St Journal February 2013
“Biggest Crisis Since 2008 Looms for South African Mines: Energy”, Bloomberg March 2013
“Fears grow of Brazil power shortages”, Financial Times January 2013

The Californian example highlights just one of the many ways a central planner can come unstuck:

“Changes in California's market have attracted lots of new generation; the state expects to have 44% more generating capacity than it needs next year. Grid officials say they expect the surplus to fall to 20% by 2022, though it will remain high for about a decade. However, the surplus generating capacity doesn't guarantee steady power flow. Even though California has a lot of plants, it doesn't have the right mix: Many of the solar and wind sources added in recent years have actually made the system more fragile, because they provide power intermittently.”

* The electricity market is extraordinarily complex – the notion that a central planner can sit, Wizard of Oz-like, making long term planning, production and price decisions more efficiently than thousands of minds working in a market process is hopeful. Of course there is a role for the Government in the economy, including the electricity sector. It is as a regulator, not a player.

* None of this is to say that the current system, which sets prices at the marginal cost of the most expensive generation, is perfect. Whist likely more efficient, there is a trade-off that electricity consumers bear versus an average price model. So a discussion on New Zealand’s electricity market is a worthwhile exercise. However, 1. New Zealand has had this debate before and found strongly in favour of the market model, and 2. we believe there should always be a strong bias toward the status quo given the increased risk and detrimental impact on investor sentiment that constantly changing regulatory regimes engender and for which NZ already has a poor reputation.

This policy will hurt NZ Capital Markets

* Labour built credibility in the 2000’s with its efforts to rejuvenate New Zealand’s capital markets, culminating in the Cullen fund and Kiwisaver. Of the two, Kiwisaver has proven to have a profoundly positive impact on New Zealand capital markets. New Zealanders have ~$1.5bn invested in the local equity market via this scheme. More importantly, the scheme is an illustration of how financial markets work in either a virtuous or vicious circle. Kiwisaver is an example of a virtuous circle, with fund inflows encouraging new floats such as Trade Me, and encouraging broader investor interest in the local equity market. This will in turn help future promising businesses raise capital via local investors rather than selling directly to offshore trade buyers.

* We believe the latest policy, as announced, will be an example of a vicious circle. Share prices in the electricity companies are already falling – which directly impacts New Zealanders savings via Kiwisaver. More importantly, it sends a worrying signal about the intentions of a Labour/Greens Government. The backbone of the New Zealand stock exchange is made up of companies that have regulatory exposure: Auckland Airport, Sky Television, Fletcher Building among them. The message from Labour/Greens to investors is that they will be giving little credence to the impact on corporate profitability in future regulatory decisions. While this may garner populist support, the flow on effect will be for investors to shun these assets, prices to fall and interest in the equity market to wane. This may sound extreme, but it is important to remember that investors in shares already bear considerable uncertainty just by being in the market. A further layer of risk from state intervention will be a bridge too far for many.

* JBWere is a case in point, as a Private Wealth advisor with ~$1bn of client funds invested directly in the New Zealand sharemarket. Support of the local market is important to us and our clients, but we can, and do, invest significant sums outside of this country. The steps the Labour/Greens are suggesting, if enacted, are significant enough for JBWere to consider a reduced allocation to the local sharemarket. We doubt we would be alone in making this judgement. Governments have learned through history that every action has a reaction. It is often the case that the reaction is unintended, unanticipated and unwelcome. We suspect the reaction of the local capital market would prove another example under these policy proposals.

ENDS

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