Bryan Leyland

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Why is electricity so expensive?
Bryan Leyland
1 November 2009

I am writing this article in response to Muriel's question "why is electricity so expensive"? There is a simple answer to this question. "The electricity 'market'". But explaining how and why it drives up prices and will continue to do so, is rather more complicated.  I will try to do just that.

New Zealand was one of the first countries to adopt an electricity market. The Wholesale Electricity Market Development Group (WEMDG) were given the job of designing  "a wholesale electricity market that …. would ensure that wholesale electricity is delivered at the lowest cost to the economy". In the end, it came down to two options. One option was what it is called a "single buyer" market the other, which they selected, was called a "Vickrey Auction" where each generator bids in at the lowest cost for which he is prepared to generate (or so the theory goes). The system operator determines the expected load, stacks up all the bids in price order and then pays all the generators at the price bid by the most expensive generator. In a power system that is almost entirely based on fossil fuel generation such as Australia's, this is a reasonably sensible system. Old, inefficient stations have to bid in at a high price while new efficient stations are able to bid at a lower price. So, in theory at least, new and efficient drives out old and inefficient.

With a single buyer market, there is an organisation that manages and coordinate the system and purchases electricity from each power station on the basis of a long-term contract. When new stations are needed tenders are invited from the genuinely competitive international market in building and operating power stations. If it had been adopted in New Zealand, a single buyer market would have guaranteed us a long term low-cost supply from the existing heavily depreciated hydro, geothermal and other power stations.  New stations would be more expensive but, as they only supplied about 25% of our total load, they would not have had a huge effect on the end price to the consumer.

WEMDG was advised that there was little to choose between the two schemes (which seems very odd to me) but they were warned that the single buyer market carried no risks because it would clearly work and it would provide electricity at the average cost of generation. They were also advised that the Vickrey Auction based market was untested anywhere in the world and hence represented a voyage into unknown territory.

For reasons that seem to be lost in the mists of time, the risky option was chosen.

To me at least, it was obvious from the beginning that the market had serious flaws. The major problem is that generators make money only if their power stations actually generate electricity. This totally ignores the fact that any power system must carry something like 20% of reserve capacity to cope with breakdowns, emergencies, unexpected and rapid increases in demand and the like. In New Zealand, we also need to have sufficient reserve capacity to get us through a drought. The generally accepted target is to get through a one in 20 year drought without a serious shortage. It follows that in most years, dry year reserve stations will generate very little but will run flat out during a dry year. At the moment, Huntly Power Station, which Genesis now say they cannot afford to continue to operate, serves this vital role.

A rational market design would have ensured that dry year reserve stations were adequately rewarded even when they were on standby. Our market does no such thing. Because they believed that "electricity is a commodity like any other" their theory was that as the price went up, the demand would go down by the 15% or so needed to compensate for the loss of generation during a drought. In economics 101 they should have learned that with true market commodities like tinned food you can always buy spaghettis if baked beans get too expensive.  Electricity is an essential commodity for which there is no alternative.

The situation with the New Zealand system is that when the hydro lakes are spilling water, (which does not happen very often) the price is very low. When the lake levels are normal, (which happens about 80% of the time) the price is driven by the most expensive generation - usually the thermal power stations.  When the lake levels are low, the hydro generators try to save water for their own consumers so they bid in a very high price for supplying any additional power to the spot market. At the same time, the thermal generators are running flat out, and so get the benefit of this high price.

The major reason for our rapidly increasing electricity prices is that the hydro stations that generate more than 60% of electricity get rewarded with a very high price even though their real cost of generation is very low. To make sure that this does not show up as a very high rate of return on the original asset value, all the generators have revalued their hydro stations by a factor of three or more. They are then able to claim that their return on asset value is moderate - or even quite low!

If the price of gas or coal increases, then the thermal stations put up the price, and, once again, the hydro generators benefit. The emissions trading scheme will increase the cost of thermal generation even more and, as a result, the consumers of New Zealand will finish up paying a carbon tax on electricity generated from hydropower!

If we get a Emissions Trading Scheme that values CO2 at $20 per tonne, the cost of electricity to the consumer will increase by about $800 million per annum. Something like $600 million of this will be windfall profits. The way the market works, it will be in the hydro generators financial interests to spill water to ensure that Huntly power station keeps on generating.  A very perverse result for a tax that was meant to hasten its demise!

In summary, electricity prices are high and will continu e to increase because:

• The electricity market rewards low-cost hydro generators with huge windfall profits;

• Lack of reserve capacity means that there will always be high prices and shortages during a drought;

• The construction of a new - and inevitably expensive - station puts up the price for everyone;

• Most of the time, there is no real competition and the price seems to be "a trade-off between greed and guilt".;

• The ETS will result in a very large price increase.

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