Executive Summary
2. Officials consider that the spot market worked much as expected during winter 2001, with very high prices signalling an increasingly tight supply situation (record low hydro inflows) and record demand.
3. Officials also consider that the market overall would have worked better had the reforms specified in the Government Policy Statement of December 2000 been fully implemented (such as improved information disclosure, demand-side participation in the market, and mechanisms to invest in the grid to relieve transmission constraints). The Government should continue to press for implementation of as many of these measures as possible prior to next winter.
4. However the overall wholesale market demonstrated considerable immaturity. Some major retailers and large users went into the winter period seriously under-hedged against dry-year spot prices, notwithstanding a Government warning in December 2000 that the New Zealand electricity system is inherently volatile and subject to dry-year risk and that the Government would not step in to protect parties who failed to manage risk.
5. Officials believe that hedges for 2001 were available to buyers over the summer period (which is the optimal season for hedging for winter). It appears however that several years of warm wet winters, surplus generating capacity and record low spot prices affected buyers' assessments about investing in hedges.
6. As a consequence of experience in 2001, increased awareness of dry-year risk is likely to result in better risk management. More sophisticated (and liquid) hedge and contracting arrangements are likely to emerge. However, at the same time increased vertical integration between generators and retailers will reduce the need for financial hedges.
7. Most submitters agreed that the Government responded to the winter situation correctly, by running an effective conservation campaign and declining to cap spot prices.
8. New Zealand is facing the need to build new generation capacity in the next few years to meet rising demand. This means that wholesale market prices on average are likely to trend towards long run marginal cost (LRMC) which is set by the cost of new generating capacity. This will also lead to upwards pressure on retail prices, as retail margins adjust back to long-term averages. Officials consider there is no evidence at this stage that wholesale market prices will rise above LRMC on a sustained basis (this would signal the existence of market power in generation).
9. Finally, a consequence of the winter events is that there is now significantly less retail competition in the market, especially with the demise of On energy and the take-over of its customer base by Genesis and Meridian. The retail market is now dominated by five retailers, four of which have significant generation assets. There is a risk that only weak retail competition will result. Independent and new retailers may be put off by the need to buy hedges from their competitors.
10. Officials are split over whether, as a measure to improve market performance, the current requirement in the Government Policy Statement for disclosure of generator offers into the market after 3 months should be shortened to 2 weeks.
11. Officials consider that the Government should send a strong message to incumbent generators/retailers that it expects effective retail competition. The Government should warn incumbents that if this does not eventuate it will consider further measures, including mandatory tendering of hedges and separation of retail and generation businesses.
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