4. Approach
There are two aspects to this assignment, identifying the economic impact of the project, and identifying possible electricity price implications.
We have approached the evaluation of the economic impact from a national benefit perspective, adopting a discounted cash flow approach. The costs and benefits of the scheme have been estimated in detail for each year out to 2020. We have adopted a horizon of 2020 for the analysis because we consider that we have reasonable information on electricity generation technologies that might apply in that timeframe. Beyond 2020 a simplified approach is adopted to establish a residual value. The costs and benefits are discounted using estimates of the public sector discount rate (PSDR). At the request of MED the analysis has been undertaken using 10% per annum with sensitivities at 7.5% and 5%.4
The approach has been to:
- Agree likely electricity demand to 2020 with MED;
- Establish assumptions on generation technologies, development options and likely costs;
- Estimate likely fuel prices;
- Assess the impact of Project Aqua on the transmission network, including the HVDC transmission between the North and South Islands;
- Assess the impact of Project Aqua on security of supply;
- Develop two supply scenarios to meet electricity demand, one including Project Aqua and one excluding Project Aqua;
- Simulate future supply and demand for each scenario, forecasting capital expenditure on generation and transmission, fuel consumption and carbon emissions;
- Establish the net present value (NPV) difference in the cash flows between the two scenarios.
The approach has been to focus on the differences between the two scenarios, rather than to accurately establish the NPV cost of each scenario. For example, where investments are identical in capacity and timing in both scenarios, the costs have been ignored in the discounted cash flow analysis.
Several inputs to this process are speculative and it is feasible to establish arguments to support a range of alternative assumptions. Where this is the case, we have attempted to establish a plausible range and test the sensitivity of the conclusions to that range.
Identifying the possible effect of Project Aqua on wholesale electricity prices represents a more difficult exercise.
In an electricity market wholesale electricity prices are likely to fluctuate to reflect the varying balance between supply and demand. In New Zealand the variability of hydro production dictates that the market will move frequently from a surplus of supply (during wet periods when supply exceeds demand and the higher cost power stations shut down) to a balanced supply/demand situation (during dry periods when hydro-firming power stations would also be called upon to run). Wholesale electricity prices tend to follow this pattern, dropping considerably during wet periods and rising considerably during dry periods.
Over time it can be argued that wholesale electricity prices will average the long run marginal cost (LRMC) of new power station options.5 Prices will fluctuate around the LRMC on a daily basis, reflecting the daily balance between supply and demand, on a seasonal basis, reflecting the seasonal balance between supply and demand, and in response to hydro lake inflows. Over the long run, however, it can be argued that these price fluctuations will tend to average close to LRMC.
If this was not the case, and prices averaged lower than LRMC, for example, it would imply that new power station investments were being made on an uneconomic and unprofitable basis.
In order to assess the likely impact of Project Aqua on wholesale electricity prices, we have therefore estimated the likely path for LRMC based pricing outcomes for both the With and Without Aqua scenarios. It is important to recognise however, that the New Zealand electricity market has oligopoly characteristics that suggest electricity prices are likely to be determined by a more complex set of factors.6 It is therefore possible that Project Aqua could lead to little difference in either wholesale or retail electricity prices.
The overall approach to the task of assessing the impact of Project Aqua was agreed with MED at the commencement of the project.
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