Opinion was divided on whether the market had responded effectively to the events of winter 2001. Those that thought it had said prices had risen in response to supply limitations and increased demand, sending signals about the need to reduce consumption.
Those that thought it had not pointed out that Government intervention, appealing to the public goodwill, had been necessary to achieve savings.
Some suggested that wholesale spot prices had over-reacted to the situation and reached unreasonably high levels.
Industrial consumers exposed to the spot market considered they had been unfairly disadvantaged relative to customers protected by hedges and retail contracts.
Some said that favourable market and environmental conditions during the preceding few years had made some electricity purchasers complacent, leading to a low level of risk preparedness.

Did the Market Respond Effectively to the Events of Winter 2001?

Opinion was divided on this issue. Those arguing in the affirmative pointed out that prices rose in response to limitations of supply and increased demand.
Some submitters suggested that no fundamental design problem existed with the spot market and expressed support for the current NZEM arrangements.
Some market participants had previously argued that the high spot prices represented an "undesirable situation" under the NZEM rules. This was examined and rejected by the Market Surveillance Committee.

"Rising spot prices prompted significant demand reductions and increased supply and spot prices tracked the costs associated with various alternatives to hydro generation (e.g. thermal generation/demand reduction) employed during the winter" - Contact.

"The nodal pricing system is designed so as to provide an early warning of impending shortage and ensure that the appropriate signals were created to ensure a balance in supply and demand both in the short-run and the long-run, throughout the country... It is the view of the NZEM Rules Committee that, on this basis, existing market arrangements were most effective in responding to the circumstances that developed through 2001... The factors that contributed to developments were clear to all and the market was effective in driving the appropriate responses. The model provided an early signal of impending shortage and provided further signals that more should be done to avert a crisis when early winter demand shot up to historically high levels... High spot prices are an expected outcome during times of shortage and are not evidence of a flawed market design" - NZEM.

AICon, Contact, Energy Management Assn, Federated Farmers, M-co, Meridian, Mighty River Power, Robbie Morrison, NZEM, Transpower

Similarly, several submissions pointed out that the market worked to ensure that no blackouts eventuated.

Contact, Energy Management Assn, Mighty River Power, Transpower, Waikato DHB

Other submissions, however, argued that the structure and/or rules of the market were not effective in dealing with the situation. It was pointed out that the Government needed to intervene by appealing to the public goodwill to conserve energy. This was cited as clear evidence that "either or both the structure and detailed market rules were inadequate" (MEUG).
Grey Power pointed out that high prices served to signal potential problems with supply, but questioned whether price signals should be allowed to cause serious disruption to the economy (this was reiterated in their cross-submission).

Business NZ, Comalco, Grey Power, MEUG, Robbie Morrison, Network Tasman, Pan Pac, Brian Tolley, TrustPower

The fact that spot prices reach unprecedented levels during winter 2001 was seen by many submitters as a significant contributor to the crisis. Prices were said to have over-reacted to the supply situation, leading to dramatic price spikes and the threat of loss of supply to consumers. Some suggested that the "crisis" involved excessively high wholesale prices rather than a national shortage of supply.

"[Spot energy prices were] well in excess of anything reasonably expected prior to the year and well in excess of the short run marginal cost of incremental thermal generation to displace higher priced hydro" - MEUG.

Alliant International, Business NZ, Fletcher Building, Grey Power, Health Sector EBG, Infratil, MEUG, Robbie Morrison, Network Tasman, NZEM, Norske Skog, Pan Pac, David Renouf, Transpower, TrustPower, Waikato DHB, Wallace Corporation, WEL Networks

In its cross-submission, NZEM reiterated its view that the market had responded appropriately, and disputed the assertion that the need for Government intervention reflected a failure of the market. It said that the action taken by the industry and the Government to reduce demand had been in response to signals provided by the market, and suggested that some submitters may expect too much from the market:

"The market could not miraculously produce additional generation. The maximum generation was being produced by prices moving to a level that allowed additional, higher priced generation to be dispatched" - NZEM.

Mark Pickup's cross-submission provided the following overview of the debate:

"Arguments are presented both for and against the market, often revolving around different interpretations of the exact same events... to an extent the exact truth does not matter, what is important is the perception of the truth. [Here] we have what we would term `a crisis of perception.' Assertions by the supply side and market operators that the market is functioning well and as expected, are simply not believed by the demand side participants who have suffered mostly in financial terms in the recent crisis... Unless consensus is achieved... on how to interpret some of these key issues then this will continue to undermine the efficiency of the market and affect the development of governance arrangements" - Mark Pickup.

Did Wholesale Market Prices Impact Unfairly on Large Industrial Consumers?

During winter 2001, industrial consumers exposed to the spot market or with expiring contracts bore the brunt of high wholesale prices while other users were shielded by hedges and competition among retailers for customers. The costs to industrial consumers had wide-ranging implications for production and exports, and risks to employment.

"... larger energy intensive manufacturers, most of whom had reasonable hedge to spot portfolios... never expected the unreasonable and excessive spot prices that eventuated" - MEUG.

"... the imbalance in demand side impact led to a wealth transfer from industrial load exposed to the spot market, and those time of use customers who came off contract during the winter, to domestic customers who did not save" - Alliant International.

"High price levels certainly sent signals to our company. From early June to the end of August, we curtailed newsprint production by around 20%, as we were able to combine inventory reduction requirements with the skyrocketing electricity price. However, that was also a loss of export sales and therefore foreign exchange of over 20 million dollars" - Norske Skog.

"The increased costs to the productive sector will be experienced for some years, due to the contract price ratchet that is now occurring. [There will be a severe] impact on NZ's reputation as a place to invest, especially for industry that is reliant to any extent on a secure power supply" - Comalco.

Alliant International, Business NZ, CHH, Energy Link, Fletcher Building, MEUG, Norske Skog, Pan Pac, Wallace Corporation

Was There Insufficient Appreciation of Risk By Purchasers?

Several submitters suggested that favourable market and environmental conditions during the preceding few years (since the inception of the market) had made retailers and industrial consumers complacent about market risk. Expectations of low prices led to a low uptake of hedges and consequent high spot market exposure. This insufficient risk preparedness resulted in significant costs to some purchasers.

"Since the market's origin... competition... drove prices down to [unprecedented] levels. Dry years, transmission constraints or long-term thermal outage risks were not adequately reflected... Exposure to the [spot] market provides both benefits and costs and sometimes those costs can be very high" - Mighty River Power.

Contact, Meridian, Mighty River Power, Network Tasman, Waikato DHB, WEL Networks

However, as discussed in section 2.5 (Hedge availability), some submitters argued that the limited availability of risk management instruments had left them exposed to the spot market. They suggested an increase in risk-aversion following winter 2001 was likely, and that both the supply and demand sides would be likely to seek greater hedge cover in future.
It was suggested that problems with inadequate risk protection related to the fact that the market is relatively new (and that some large industrial consumers may have lacked sufficient understanding of how the market would operate under dry-year conditions). Improvement can be expected over time as participants gain more experience (e.g. retailers and large consumers are more likely to purchase sufficient hedging in future).

Grey Power, Meridian, Network Tasman, WEL Networks

Grey Power expressed the view that energy retailers and large consumers will be likely to seek long-term contracts rather than trading on the spot market.

2.2 Supply Side

Summary of Key Points

New Zealand is heavily reliant on hydro-electricity and this inevitably means that New Zealand is exposed to dry year risk.
Concerns were raised over the timing of fully activating thermal plant during 2001. Delays were said to have contributed to excessively high spot prices. Others considered that thermal generation responded appropriately to price signals.
Concern was expressed about the management of hydro resources by generators.
Many said that New Zealand has inadequate reserve capacity and that existing market arrangements failed to adequately reward generators for providing reserve plant.
Barriers to the development of new renewable and distributed generation were noted.

New Zealand's Dependence on Hydro-Electricity

This was identified as a risk to supply security: because New Zealand depends heavily on hydro-electricity, the market is highly sensitive to adverse weather events. Dry years are a fact of life so the market will in future face conditions similar to winter 2001.

Federated Farmers, David MacClement, Natural Gas Corporation, Network Tasman, New Zealand Geothermal Association, Sinclair Knight Mertz, Sustainable Energy Forum, TrustPower

Network Tasman and Sinclair Knight Mertz argued the heavy dependence on hydro power limits the efficient operation of the market.

"A shortfall of hydro generation in this small market will inevitably lead to an increase in regional market dominance and price setting ability for thermal plant owners" - Network Tasman.

"The cost of fuel is virtually zero but the capital cost is high. Many stations are `run of river' and will spill if they are not able to generate, so run of river stations must bid in low and the stations with storage bid in at what they reckon the market will stand. Which most of the time is not much, and during a drought is very, very high. A business that loses money most years and hence needs to make huge profit during droughts is in the high risk category" - Sinclair Knight Mertz.

Management of Hydro Resources by Generators - In the Public Interest?

Several submissions expressed concern about the management of water resources by hydro generators.
Comalco said hydro levels were high during January 2001 but had fallen rapidly to low levels by June, during which time there had been low use of thermal generation. Comalco questioned whether generator strategies took account of the public interest.
TrustPower suggested that during 2001, Meridian continued to offer in at a high volume and low price levels until there was a significant change in the company's committed hedge position at the end of May. TrustPower believed that the significant price increase in the last few days of May reflected a lack of competition, whereby Meridian was able to influence the market price to its advantage.
Robbie Morrison suggested that, given the right circumstances, the high spot prices that can result from a supply shortage may even provide a perverse incentive to mis-manage hydro storage capacity. Grey Power's cross-submission agreed.
Meridian's cross-submission rejected Comalco's comments about the absence of community/public good in generator strategies. The submission argued Meridian had "acted with great care throughout a winter of extreme hydrology, balancing many competing interests and always in the context of the national interest in avoiding a shortfall in supply and enforced rationing."

Concerns about Hydro Spill

Network Tasman said that during the first quarter of 2001, South Island hydro storage was spilled while thermal plant was being dispatched. The spilling of hydro water while thermal (particularly gas) plant was being drawn on was regarded as a waste of resources. Some suggested that excessive hydro-spill might reflect abuse of market power by generators.

"Generators [may prefer] to spill some of the water rather than sending more electricity from the South Island to the North Island if this will lower the price. This is an extremely wasteful use of resources, replacing hydro energy which can be converted to electricity at near 100% efficiency with thermal energy mainly from natural gas at a much lower conversion efficiency and producing unnecessary greenhouse emissions" - Sustainable Energy Forum.

John Blakeley and Bruce Hunt, Network Tasman, David Renouf, Sustainable Energy Forum, Wallace Corporation

In its cross-submission, Meridian explained that its spilling during January 2001 was primarily required in order to comply with its resource consent conditions, and to avoid flood risk to the Tekapo community.

Impacts of RMA Requirements on Hydro Generation

Mighty River Power argued that the requirement to maintain minimum water flows in rivers, imposed under the Resource Management Act, creates a disadvantage to hydro-generators relative to thermal generators.
The Business Roundtable argued that Resource Management Act requirements create impediments to new investment.

Response of Thermal Generators during Winter 2001

A key issue regarding the response of the market to the situation was whether reserve thermal capacity was brought on line early enough, in response to the shortfall in hydro storage.
Many submitters argued that the commissioning of maximum thermal capacity was delayed - that it should have run earlier in the year, when the shortfall in hydro-capacity became apparent. While it was widely acknowledged that transmission constraints played a part, some submitters suggested the delay was a deliberate exercise of market power by generating companies.

"In a competitive market thermal generators would have entered the market as soon as spot prices exceeded the variable cost of production" - MEUG.

"High spot prices that should have `triggered' the entry to the market of the thermal generation. For reasons that remain unclear reserve thermal generation did not run at capacity until June or July. This indicates that thermal generators have excessive market power. This clearly contributed to the extraordinary price levels. The question must be asked as to whether the backup thermal units were withheld from the market in order to leverage up the prices on the spot market" - Business NZ.

"The reserve thermal plant on the system did not run at capacity until June and July. It is not clear why this delay occurred. Transmission constraints may have contributed, but we suspect the main reason was the exercise of market power" - Infratil.

Many suggested that spot prices reached artificially high levels due to the delayed introduction of reserve thermal capacity.

Business NZ, CHH, Comalco, Grey Power, Infratil, MEUG, Network Tasman, Pan Pac, Sinclair Knight Mertz, TrustPower, Wallace Corporation

In response, NZEM, Contact and Genesis argued that reserve thermal generation did respond appropriately. NZEM pointed out that thermal generation was increased incrementally as prices firmed, and production was increased over time as prices increased. Genesis pointed out that the Huntly power station generated significantly more electricity (and operated earlier) in 2001 than would be expected in a normal year.

"The strength of the supply response can be gauged by looking at generation from Huntly and New Plymouth (the only significant non-baseload thermal stations). Their production rose sharply in March when, after an extended period of low inflows, lake levels dipped below mean, and spot prices rose to around 5c/kWh. Production continued at this general level until late May when prices rose sharply with the onset of much tighter demand, and further deterioration in lake levels" - Contact.

Inadequate Reserve Capacity and Inadequate Incentives for Investment

Many submissions suggested that New Zealand has inadequate reserve capacity to call on in times of short supply (particularly in dry years). This was seen as a major contributor to the problems of winter 2001.
It was suggested that the current pricing system fails to adequately reward generators for providing reserve generation plant. Anyone building a power station to service peak demand periods may find it sitting idle for years in between peaks.
It was argued that because the market does not reward generators for maintaining reserve capacity during normal years, in times of short supply they are forced to seek high prices in order to justify the upkeep of this extra infrastructure. Generators have a natural interest in having as many assets as possible operating at full capacity.
AICon suggested that maintaining reserve plant represents a public good, and this is not recognised by the current approach of treating it on a purely commercial basis.

"Dry year conditions may only affect wholesale prices for three or four months in a five year period. As a result, it is a risky investment to build extra generation capacity simply to cover dry years" - Natural Gas Corporation.

"Lack of ongoing recognition of the value to the system of critical reserve capacity encourages owners of that capacity to behave extractively when the plant has to run in dry years" - Network Tasman.

"The current system works for base load generators and mid-range generators who will be getting more than their marginal cost most of the time... For generators, providing the reserve capacity needed to make the market work is a loss-making business. If there is no reserve capacity competition disappears and generators are no longer motivated to bid in at their marginal cost and the market fails" - Sinclair Knight Mertz.

"Before the reforms began... the Electricity Department had built a number of power stations for which there was no demand yet... The Department knew full well about the system's vulnerability to droughts, and they also knew that starving the economy of electricity in a hydro crisis would be far more costly than maintaining a few idle power stations... the reforms of the nineties designed the power crisis into the system [because there is no provision for encouraging provision of reserve capacity]... Our hydro lakes are narrow and deep. Without inflow, and at full generating load, the lakes go from full to empty in 54 days" - Peter Kammler.

AICon, Contact, Genesis, Grey Power, Meridian, Natural Gas Corporation, Network Tasman, Sinclair Knight Mertz, Sustainable Energy Forum, Todd Energy, Brian Tolley

In contrast, NZEM's original submission argued that the market does provide incentives for new generation investment.
NZEM's cross-submission pointed out that average prices seen in the market to date have not yet reached high enough levels to warrant investment in new generation plant. It estimated the minimum long-run marginal cost of additional generation at 4.8c/KWhr.

Barriers to New Renewable Generation

The New Zealand Geothermal Association pointed out that geothermal energy represents a clean, renewable source of energy and argued that New Zealand should make greater use of it.
They argued that development of geothermal generation is inhibited by competition from other cheaper power sources, natural gas in particular, because gas is so easy and cheap to develop. The disadvantage of using gas over thermal is that gas produces greenhouse gas emissions (that are not currently included in prices).

Barriers to Distributed Generation

According to Carter Holt Harvey, barriers to entry for co-generation plant and other distributed generation have limited the development of distributed generation (which has the potential to alleviate grid constraints, line losses and harmful emissions).
Transpower's cross-submission noted criticism of its policy regarding contracting with distributed generation by submitters who claimed that:

Transpower contracts exclusively with line companies to the disadvantage of small generators; and
Transpower's refusal to contract directly with distributed generators means that the only way a distributed generator can obtain the benefits it confers by way of "avoided" transmission costs is by building new lines to customers.

Transpower disagreed with this criticism, arguing that its policy does not create such barriers. Its policy is to "offer open access to the grid and contract with any distribution company, generator or major user that is physically connected to the grid... Transpower's pricing methods encourage investment in distributed generation to the extent that this investment genuinely reduces the demand for grid capacity."
NZEM's submission argued that there had been new investment in distributed generation since the inception the market, in direct response to nodal pricing signals.

2.3 Demand Side

Summary of Key Points

Wholesale price signals were not passed on to many consumers who are shielded by fixed price contracts. This limits demand side responsiveness to market signals.
It was suggested that the ability of consumers to respond to price signals, particularly short term price spikes, is limited.
Several submitters said the current market arrangements present barriers to demand side management, particularly in terms of access to information, lack of real time prices and the 2 hour bid rule.

Many Consumers Are Shielded from Price Signals

Many submissions pointed out that wholesale prices are not reflected in the prices faced by most consumers. Hedges and fixed price contracts shield consumers from price signals and retard demand side responsiveness. This was considered a contributor to the developments of winter 2001.
In order for prices to have an effect on demand, it is necessary for the price signal to be received by sufficient numbers of players who are able to respond and reduce their demand accordingly.
Competition among retailers for customers meant there was a delay in the spot market price signal reaching consumers not directly exposed to the spot market. This led to significant costs for retailers.
It was suggested that the limited exposure of consumers to wholesale market prices represents a failure by the market to provide adequate, timely incentives for demand reduction.

"Intense competition at the residential level has impeded the ability of retailers to pass on the impact of rapidly increasing spot prices to customers" - Meridian.

"The wholesale spot market `price signal' directly affects only about 15% of end consumers, the remaining 85% are immune through being on a tariff or having some form of price increase delay built into their contract" - Wallace Corporation.

"A significant problem in NZ's electricity markets is that the wholesale and retail markets which co-exist are out of alignment. As a result important price signals are not passed through to the majority of consumers while a minority see intensive price signals that they cannot manage... The lack of demand side response during winter 2001 suggests limitations of current market arrangements" - Bill Heaps (Transpower).

Alliant International, Business NZ, CHH, Contact, Federated Farmers, Fletcher Building, Genesis, Grey Power, Bill Heaps (Transpower), Infratil, Robbie Morrison, Norske Skog, Pan Pac, Meridian, MEUG, Network Tasman, Mark Pickup, Plastics New Zealand, Sinclair Knight Mertz, Transpower, TrustPower, WEL Networks, Wallace Corporation

Mighty River Power and Contact acknowledged the lack of direct price signals to retail consumers but explained that they had other means of facilitating demand reduction among their customers. Steps taken during winter 2001 by Mighty River Power, for example, included:

individual price rebates to mass market customers for reductions in use ("Project Save");
customised buy-back plans for large scale customers; and
an advertising campaign to encourage energy efficiency.

"Mass market customers did not face price increases during the winter period but they were sent signals to conserve via the Project Save initiative. Over 60% of residential customers received a rebate" - Mighty River Power.

Limited Demand Responsiveness to Price Signals

Several submitters suggested that demand side responsiveness to price signals is limited, particularly when it comes to short term price spikes.
Mighty River Power suggested that energy prices would need to go even higher than in winter 2001 before industrial consumers reduced demand. The company's experience in relation to its rebating of commercial customers for reduced consumption was that:

"... for most commercial customers even with rebates nearing 20 c/kWh little incentive exists to reduce demand. This is to be expected as the value added for most business outputs will generally be greater than the savings from reduced consumption" - Mighty River Power.

"The use of electricity is not responsive to short term price spikes. Companies have contracts to fill, employees to pay and bank loans to serve. They do not reduce their production just because electricity becomes more expensive for a time" - Peter Kammler.

Peter Kammler, David MacClement, Mighty River Power, Mark Pickup

Barriers to Demand Side Participation

Several submitters said the current market arrangements present barriers to demand side management, particularly in terms of access to timely information and the 2 hour bid rule.

"The present market gives no forward price signal and therefore neglects the ability of the demand side to ameliorate kW demand" - Brian Tolley.

CHH, Comalco, MEUG, Mighty River Power, Brian Tolley

In response to criticism about lack of opportunity for demand side participation, NZEM's submission argued that the market is an open one, with no artificial restrictions on membership, and that demand side response to prices is provided for. NZEM argued that the only limitation the rules impose on demand side response is through the two-hour rule that prohibits both purchases and sellers from changing bid or offer data within two hours of real time. MEUG also made this point.

2.4 Transmission

Summary of Key Points

Transmission constraints were widely regarded as a barrier to effective competition and market efficiency. Constraints exacerbated supply problems during winter 2001.
Recent grid investment was considered inadequate. There are inadequate incentives for transmission investment.
Transpower's focus on maintaining system security was seen to conflict with the need to relieve grid constraints. Transpower, however, explained that a grid entirely free of constraints would be economically inefficient.
Transmission losses represent a significant waste of energy.
Lines companies have different approaches to dealing with transmission rentals. This was seen as inequitable for consumers.

Transmission Constraints - Barriers to an Efficient Market

Submitters identified several areas affected by grid constraints, including:

North-south flow on the HVDC link (this, it was suggested, occurs semi-regularly);
eastwards from Taranaki;
the Tokaanu-Whakamaru circuit
between Bunnythorpe and Wellington, restricting generation from Taranaki and limiting the flow from north to south;
through the North Island when the Otahuhu power station is out of service (this occurred during 2000); and
from South Island hydro stations to north of Lake Taupo.

Business NZ, Energy Link, Infratil, Meridian, Natural Gas Corporation, Sinclair Knight Mertz

Transmission constraints were widely regarded as creating a barrier to effective nation-wide competition and market efficiency. Constraints on transfer between regions create market distortions because purchasers in some areas are unable to access the cheapest source of power in the country. It was suggested that grid constraints could lead to monopoly pricing opportunities for generators within constrained regions.
Grid constraints were said to have exacerbated supply problems during winter 2001, particularly in terms of north-south electricity transfer across the HVDC link, and from Taranaki to other parts of the North Island.
The Geothermal Association also argued that constraints on transmission throughout the North Island reduce the value of geothermal generation.
Network Tasman said that grid constraints physically and financially restricted the operation of reserve thermal plant.
Addressing transmission constraints by increasing the capacity of the grid was seen as an urgent priority.

"Existing suppliers have little ability to manage transmission constraint risk leading to suppliers retailing only in regions where they have a `natural' own generation hedge. This creates a barrier to nation-wide retail competition" - MEUG.

Business NZ, Comalco, Fletcher Building, Geothermal Assn, Grey Power, Health Sector EBG, Infratil, M-co, Meridian, MEUG, Mighty River Power, Robbie Morrison, Natural Gas Corporation, Network Tasman, Sinclair Knight Mertz, Brian Tolley, Transpower, TrustPower, Wallace Corporation, WEL Networks

In its cross-submission, Transpower disagreed with suggestions that transmission constraints were a frequent occurrence. Transpower explained that it is inefficient to construct a grid free from constraints under all dispatch scenarios, because this would involve providing excess capacity in some sectors of the grid that, most of the time, would not be utilised.
Transpower also argued that grid constraints did not necessarily create market distortion, provided market participants had the information and ability to decide whether to relieve the constraint or not.
On a related matter, there was criticism of the time it took during 2001 to reconfigure the grid in order to allow the transfer of power from north to south and out of Taranaki. This delay, it was argued, contributed to falling southern lake levels and increasing prices.
Meridian argued that Transpower lacked "incentives to dynamically reconfigure the transmission system to respond to changed market conditions."

"The solution could have, and should have in our view, been implemented much earlier, enabling Taranaki generation to operate at capacity" - Infratil.

"Discussions between the Minister and Transpower were needed before enhancements were made to the grid to relieve constraints in the middle to lower North Island" - Fletcher Building.

In response, Transpower's cross-submission explained that the process of reconfiguring the grid was complex, complicated by the commercial sensitivity of the decisions involved, and involved a process of consultation with industry and other stakeholders. NZEM's cross-submission also said this.

Transmission Losses

The national grid is affected by widespread loss problems, with significant costs in terms of wasted energy. According to Todd Energy, these losses are worth approximately $250 million per year (assuming a price of $100/MWh). It is therefore important that impediments are not placed in the way of reducing costs (Todd Energy, Sinclair Knight Mertz).

Transmission Rentals

Under current market arrangements, large price differentials between different parts of the country can arise when the transmission system is constrained. When this occurs there is an excess of funds paid by wholesale purchasers over the amount that generators receive (the excess is referred to as transmission rentals).
Under present arrangements this money is collected by Transpower and rebated to lines companies and wholesale purchasers. Some lines companies rebate the payment to their customers while others retain it.
The amount involved is significant - Contact estimated the value of transmission rentals between January and October 2001 submission at $80 million.
The discrepancy between the rebate distribution policies of different lines companies creates inequities among electricity consumers and gives a competitive advantage to those lines companies that retain the money.
Todd Energy argued that the rentals result from the marginal loss pricing (see section 2.7 (Marginal vs. average cost pricing).

"The first issue is whether distribution companies have passed all of the transmission rentals through to either retailers or consumers. If they have not or are using this windfall as working capital before rebating some time in the future at their discretion, then those distribution companies have exercised their market power to control the flow of transmission rental rebates to retailers and end users" - MEUG.

Business NZ, Contact, Infratil, MEUG, Todd Energy, Brian Tolley, TrustPower

Adequacy of Investment / Incentives

A range of submissions said significant threats existed to the security of supply because of shortcomings in the transmission network. Several submissions considered there had been insufficient investment in reinforcing or adding to the network in recent years. This was seen as a issue requiring urgent attention, given the impacts of grid constraints on the operation of the market (see section 2.4 - Transmission constraints).
It was suggested that spot prices have not provided an adequate signal for new transmission investment.

AICon, Business NZ, Grey Power, MEUG, NZEM, Sinclair Knight Mertz, Brian Tolley

A criticism made by several submitters was that Transpower's focus is on maintaining systems security rather than on enhancing the efficiency of the grid by, for example, relieving transmission constraints. It was argued that Transpower is reluctant to invest in new transmission infrastructure.

"In many cases, fixing the constraint will not add to Transpower's asset value so it is difficult for Transpower to recover the cost... Transpower will fix the problem only if someone else carries the commercial risk" - Sinclair Knight Mertz.

Business NZ, Fletcher Building, Grey Power, Meridian, Network Tasman, Sinclair Knight Mertz, TrustPower

Transpower agreed that the current market structure had failed to address persistent loss, constraint and security problems in transmission. Transpower said investment in transmission to cover abnormal operating conditions such as a dry-year event will not always be economically justifiable (because, like reserve generating plant, this capacity may lie idle for most of the time).

Concerns about Monopoly in Transmission

Several submissions raised concerns about the fact that the transmission side of the industry is not subject to competition and suggested that Transpower should be required to act in the interests of the public.

Grey Power, Sinclair Knight Mertz, TrustPower

In its cross-submission, Transpower argued that a single interconnected grid is the most efficient solution for New Zealand (as it is in other countries). Transpower explained that it operates within its Statement of Corporate Intent which requires it to act in a manner consistent with electricity being delivered in an efficient, fair, reliable and environmentally sustainable manner.
M-co suggested that greater transparency of information regarding transmission is needed, and expressed support for Transpower's efforts to improve the transparency of transmission system operating decisions and its moves to differentiate the management of each arm of its business.

2.5 Risk Management Instruments

Summary of Key Points

Submitters had widely varying perceptions of whether adequate hedges were available during 2001.
Some (principally consumers) argued that hedges were in short supply.
Generators argued that hedges were available, but at prices higher than buyers were prepared to pay. High prices reflected the risk faced by suppliers during a dry winter.
Some said that favourable market and environmental conditions during the preceding few years had led to a low level of risk preparedness.
It was pointed out that no effective tools currently exist to hedge against transmission loss and constraint risks.

Hedge Availability

A range of submitters argued that the primary hedge market lacks liquidity, especially during Autumn, making it difficult for wholesale purchasers to manage risk. This was cited by many as a contributor to developments during winter 2001.
The thin hedge market was blamed for the financial exposure of some energy retailers and consumers to unexpectedly high prices on the spot market (either because they were not hedged at all or because their hedge contracts expired part-way through the winter).
A shortage of hedges was also said to contribute to the lack of competition in the retail sector.
Some submitters blamed a lack of competition among generators for the non-availability of hedges. Others suggested that the lack of hedge market liquidity encouraged opportunistic behaviour among generators, who were seen to benefit from purchasers being exposed to the spot market.
MEUG argued that if the market was genuinely competitive, then hedges would be available even during a dry winter, and that competitive pressures could be expected to cap winter hedge prices at the cost of existing thermal generation.

"Approximately 60% of Pan Pac's electricity consumption was hedged (note that this was the maximum level of hedging that could be obtained in the market place at the beginning of the year) with the remaining 40% purchased from the wholesale electricity spot market. Pan Pac was forced to cut production by up to 40% because of unprecedented high wholesale spot prices" - Pan Pac.

"Gaining liquidity in the contracts market is perhaps the greatest impediment to a vibrant wholesale and retail market operating in NZ" - Alliant International.

Alliant International, Business NZ, CHH, Fletcher Building, Health Sector EBG, MEUG, Network Tasman, Norske Skog, Pan Pac, Trustpower

On the other hand, generators Mighty River Power and Contact argued that they did continue to offer hedges throughout the winter, though not at prices secured one year earlier. Contact pointed out that some major consumers declined the hedges they offered even though, they argued, these were priced at competitive rates.
However, Fletcher Building pointed out that because of the high price of hedges available during the winter, and the unavailability of short-term hedging during that period, purchasing the hedges on offer would have been uneconomic for their business. Business NZ agreed with this sentiment:

"...many [electricity consumers], coming off fixed term contracts, found there was an unwillingness to supply them with electricity or, where there was, it was on terms that saw their projected monthly accounts increase by very large percentage points" - Business NZ.

Pan Pac's cross-submission reiterated the view that hedges were not available during the period in question, and provided details of the company's experience in endeavouring (unsuccessfully) to secure hedges during January.
In its cross-submission, Contact argued that even if hedges had not been available during the winter, this could not be considered a "failure" of the hedge market:

"Hedge is an insurance product. Once an event is occurring, it is usually hard to obtain insurance for it. This phenomenon is not peculiar to the electricity hedge market. Insurance markets work in a similar manner. Indeed, we know of cases in insurance markets where even after an adverse event has passed, it is not possible to obtain insurance for similar events in the future... The existence of these issues does not lead people to conclude that insurance markets don't work" - Contact.

Several cross-submissions highlighted the difference in interpretation of the availability of hedges by the supply and demand sides. Meridian and NZEM made the point that the real issue appears to be differences in perception of what is a fair price for hedging risk, and differences in risk appetites among different market players.

Meridian, MEUG, NZEM

Ineffectiveness of the Secondary Hedge Market

Comalco, Business NZ and MEUG pointed out that there is no secondary hedge trading market. Business NZ suggested this was mainly because the development of such a market "is dependent on retailers offering flexible contracts, and these are not in evidence." MEUG argued that the lack of secondary market activity reflects a lack of competition in the primary hedge and spot electricity markets.

Unavailability of Transmission Risk Hedging Instruments

It was pointed out that during winter 2001 there were no effective tools available to hedge nodal price risk, leaving electricity buyers disadvantaged because of supply conditions and grid constraints.
The inability of retailers to manage constraint risks was said to limit retail competition.

"Buyers of wholesale energy had no effective tool to hedge nodal price risk across the grid at a time when regional market power of generators was enhanced through supply conditions and grid constraints" - Network Tasman.

"The high priced exposure to the spot market was accentuated for retailers by failure in the transmission market [due to] the absence of instruments to manage the risk arising from constraints" - Alliant International.

Alliant International, Business NZ, Infratil, Meridian, MEUG, Network Tasman, Sinclair Knight Mertz, Transpower, TrustPower

2.6 Retail Competition / Market Power / Vertical Integration Issues

Summary of Key Points

The vertical integration of generator/retailers was seen by many to limit market competition and restrict the availability of hedges. Vertical integration was regarded as a barrier to entry to the retail market.
Many submitters argued that the market is dominated by a relatively small number of generators, with limited opportunity for demand side influence. Some suggested the high spot prices of winter 2001 may have reflected the market power of generators.
NZEM disagreed that market power had been demonstrated. M-co said that if they did, then this was a matter for the Commerce Commission to deal with.
Note that section 2.4 (Transmission constraints) contains discussion of the impacts of constraints on the effectiveness of competition.

Lack of Effective Retail Competition

A number of submitters argued that limited competition in the retail market (including the absence of competition in some areas) has greatly disadvantaged consumers. According to MEUG, for example, there are no retailers prepared to accept new residential customers in Christchurch. The demise of On energy as a retailer has exacerbated this problem.
Vertical integration (combined with regional consolidation of the energy market) presents a barrier to entry for new retail competitors (see below).

"The range of [retail] alternatives available is very low due to the poorly functioning contracts market, and the absence of demand side responsibility for volume" - Alliant International.

"One contributing problem suggested is that lines company contracts are widely divergent and require national standardisation to facilitate competition in retail electricity provision" - Contact.

Alliant International, Contact, MEUG, Network Tasman

Vertical Integration

A wide range of submissions argued that the vertical integration of generator/retailers limits market competition. This is because of the "natural hedge" strategy adopted by vertically integrated companies (whereby they generate all of the energy requirements of their retail arms, thus effectively protecting their retail arms from the spot market price). As a consequence, these companies have greater market power than companies that only retail electricity.
Vertical integration exacerbates liquidity and informational problems within the hedge market.

"Vertical integration [reduces] competition by locking in the resources of one supply side participant to its matched demand side company, thus reducing the resource available for competitive bid to other counter parties" - Mark Pickup.

"[Under vertical integration it is not in generators' interests] to provide low price contracts or hedges to retailers in competition with their own retailing arm" - AICon.

"New entrant retailers have to rely on existing vertically integrated suppliers to negotiate a hedge or otherwise build their own generation" - MEUG.

AICon, Alliant International, Business NZ, CHH, Energy Link, Federated Farmers, Grey Power, MEUG, Natural Gas Corporation, Network Tasman, Norske Skog, Pan Pac, Mark Pickup, Transpower, TrustPower, Waikato DHB, WEL Networks

It was also suggested that vertical integration limits energy conservation:

"We suspect generators would rather encourage consumption and build power stations than have consumers respond. It takes standalone retailers to want to see products that allow consumers to help the retailer manage its purchasing risk" - Infratil.

Regionalisation - Exacerbating Competition Problems Associated With Vertical Integration?

Concern was expressed that competition is being and/or will be further reduced by a trend towards regional domination by integrated generator/retailers. In some cases this regional strength is exacerbated by transmission constraints. The departure of On energy from the retail market was seen to have exacerbated this problem. Infratil predicted the following outcomes from this trend:

Reduced choice available to end consumers; and
Rising retail prices.

"The market has now collapsed to a few vertically integrated regionally dominant suppliers. This has reduced choice to most consumers" - MEUG.

Fletcher Building, Grey Power, Infratil, M-co, MEUG, Natural Gas Corporation, Network Tasman, Mark Pickup, TrustPower, Wallace Corporation

The Health Sector EBG and Robbie Morrison pointed out that the unavailability of hedges and exposure to high spot prices have made suppliers reluctant to enter new contracts with customers. For example, the Health Sector EBG had difficulty securing bids from suppliers to replace its expired contract with Meridian:

"In quite a few cases, retailers with newly inherited customers carrying former TransAlta or On energy contracts were given little or no warning at expiry that their prices would rise to spot levels several times higher than their existing prices... This climate made suppliers reluctant to enter into new contracts."

Generator Domination of the Market

A range of submissions argued that a fundamental flaw in New Zealand's electricity market is the limited number of participants, particularly on the supply side. This, it was argued, limits the effectiveness of competition so the market cannot operate efficiently.
The wholesale price is strongly influenced by generators as there is limited opportunity for demand side bidding. The lack of influence that energy purchasers can have on the market limits its effectiveness in terms of rationing by price.
Transpower and Sinclair Knight Mertz pointed out that the short-term elasticity of demand for electricity is very low - it is a necessity without a readily-available substitute. This, they argued, creates a significant market advantage for suppliers.

Alliant International, Fletcher Building, Grey Power, Infratil, M-co, MEUG, Network Tasman, Plastics New Zealand, Sinclair Knight Metz, Todd Energy, Brian Tolley, Transpower, TrustPower, WEL Networks

Did High Spot Prices Reflect Generators' Market Power?

Some submitters raised questions about the market power of generators in relation to the high spot prices reached during winter 2001. They argued that the current pricing system, coupled with the small size of the market, creates opportunities (and incentives) for anti-competitive behaviour (e.g. reducing or inhibiting competition or reducing supply to force prices up).

"It was alleged that one generator, on seeing the shortage develop, refrained from making a sizeable proportion of their output available for hedge so as to exploit the rising spot prices" - Health Sector EBG.

AICon, Alliant International, Comalco, Energy Link, Grey Power, Health Sector EBG, MEUG, Robbie Morrison, Network Tasman, Transpower, Wallace Corporation

However AICon said despite the accusations, there was no clear evidence that generators had taken advantage of their position to over-inflate prices.
Contact argued (and provided graphs to support the assertion) that there appeared to be:

"...reasonable evidence to indicate that spot prices (at least in average terms) broadly reflected the costs of providing additional increments of generation or demand reduction" - Contact.

In its cross-submission, NZEM rejected the notion that the high spot prices had reflected an imbalance of market power, because if market power was being used in this way, high prices could be expected to occur over the long term, rather than simply as short term fluctuations.

Effects of Market Power In The Industry

Transpower listed the following risks to efficient market outcomes (and therefore consumer interest) arising from market power in the electricity industry:

In generation through withholding supply to profit from localised monopoly conditions created by grid constraints or drive spot prices higher, or offer behaviour that leads to prices set above economic cost;
In retail by reducing incentives to offer competitive tariffs, or developing new retail products, especially those that reward demand side participation; and
In the hedge market by limiting the availability of contracts, and creating barriers to retail market entry (largely through vertical integration).

Market Power Issues - A Matter for the Commerce Act

M-co's submission argued that, to the extent to which concerns exist over market power, there are already legal mechanisms in place to deal with these. M-co suggested that if these mechanisms are not considered effective, then the fault lies with the design of the Commerce Act, not the wholesale market rules.

2.7 Other Market Arrangement / Design Issues

Summary of Key Points

A wide range of submissions said market efficiency is hampered by the inability of participants to make informed decisions because of limited access to key information.
The system of rewarding cleared bids at the marginal clearing price was criticised as inefficient. Others disagreed, and said the alternative, "pay as bid" pricing, would result in higher prices overall and out-of-merit order generation.
It was suggested that current nodal pricing (including the use of marginal losses and constraints to determine prices) limits market efficiency. Other submissions explained that using marginal losses was the most efficient option.

Access to Market Information

A wide range of submissions said the efficient operation of the market is hampered by the inability of participants to access key information in order to make informed decisions. This includes consumer decisions about purchasing and demand reduction, and generator decisions about new investment.
It was suggested (e.g. by Business NZ) that a lack of market transparency in a number of areas (including pricing) advantages generators. Network Tasman suggested that a lack of public information about generator bidding behaviour encouraged the abuse of market power by generating companies. Many submissions called for more transparency in the operations of generators, especially vertically integrated ones.
NIWA suggested that demand side management during winter 2001 was hampered by a lack of clearly understandable, publicly available information on climatic conditions.

"Buyers of electricity, consumers with demand they could conserve and buyers of risk management products both prior to and during winter 2001 were frustrated in making informed decisions by the lack of appropriate and timely information" - MEUG.

"A possible cause of the delayed entry to the market of reserve thermal capacity was that the hydro generators had to guess at the price the backup thermal plant would actually run, and they found this difficult to do since the bids into the market are all confidential. This lack of transparency weakens the market's functioning and even encourages opportunistic bidding" - Infratil.

AICon, Alliant International, Business NZ, Comalco, Federated Farmers, Grey Power, Infratil, Health Sector EBG, MEUG, Network Tasman, NIWA, Orion

Transmission Costs and Dispatch Methods

Several submitters argued that transmission costs and dispatch methods have prevented least-cost dispatch, thereby limiting the effectiveness of the market. According to Todd Energy, the problem stems from the use of marginal losses in calculating wholesale market prices, which creates market distortion. Todd's description of the problem is summarised below:

The way the NZEM has bundled market supply and demand forces with the transmission of energy is to include non-market elements in its price determination. These non-market elements relate to losses. By using marginal losses, as opposed to average losses, significant market distortion is created, including:

in periods of drought, South Island hydro is encouraged to generate more by being given higher marginal prices than would be the case if actual losses were used. Then in periods of high rainfall, or flood, the South Island is given too low a marginal price and dispatches less than is optimal;
the average market price is higher than the competitive price so consumers and retailers are disadvantaged;
competition between generators is reduced; and
NZEM is currently dispatching more costly generation ahead of cheaper generation (Todd Energy).

CHH, Natural Gas Corporation, Todd Energy

Marginal vs. Average Cost Pricing

Criticism was made of the current wholesale market system of rewarding all cleared bids at the marginal clearing price.
Network Tasman argued this system provides an incentive for generators to bid up the price during conditions when shortages make dispatch highly probable (such as during a drought).

Health Sector EBG, Network Tasman, Pan Pac, Plastics New Zealand, Sinclair Knight Mertz, Todd Energy

In response, NZEM's submission argued that the current pricing model is based upon minimising the total cost of delivering the required amount of energy at the correct nodes. Nodal pricing establishes unique prices at each point of injection into, or off-take from, the national grid that reflect the differences in terms of marginal losses and transmission constraints between nodes.
Marginal cost pricing is inherent in nodal pricing. This means that electricity is priced at the cost of the next unit to be produced. NZEM said that average pricing, in which output is priced at the average price of its production, will tend to result in more output being produced than is efficient, and in the inefficient use of resources.
Contact's cross-submission explained that the use of offer price for payment had been considered during the initial design of the market rules, but this had been rejected on the grounds that it would encourage base-load generators to "guess" what the market clearing price would be, to ensure that they were not receiving less for their generation than other competitors.
Todd Energy argued that marginal loss pricing creates an incentive for generators to act anti-competitively:

"... each incremental unit of generation frequently results in a sharp fall in the marginal price received so that generators make more profit by cutting back on incremental generation. By cutting back generation the marginal price on all units of generation can be increased. The marginal increase in price more than compensates for the marginally lower level of generation. Thus the generator increases profits by cutting back generation due to marginal loss pricing" - Todd Energy.

In their cross-submissions, Transpower and Contact disagreed that using marginal losses created market distortion. Contact said that marginal losses had been chosen for the calculation because of their "superior economic efficiency characteristics."

"There really is no economically efficient option but for generators to be paid, and purchasers to pay, their local (nodal) clearing price. The nodal prices signal the market cost of system losses and constraints and provide the efficient signals for investment decisions in generation, transmission or demand side management" - Transpower.

2.8 Ownership Issues

Several submissions expressed concern that the Government's involvement in generation (through the SOE companies) exposed the public to unnecessary market risk and created imbalances in the market.
Federated Farmers argued that state involvement may create a disincentive to potential investors in generation, who may fear that pricing decisions will be subject to political influence.
The Business Roundtable argued that state domination of the industry restricts its development and impairs competition.
MUEG suggested there was a risk that SOE generators lacked the same capital market disciplines as private and listed companies.

Business Roundtable, Federated Farmers, Infratil, MEUG, TrustPower

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Printed: 26/11/2009