Something’s gotta give in the electricity industry

Monday, 2 September 2024

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ANALYSIS: Round and round the blades of the wind turbines go, just like the debate on electricity industry reform.

Over the past two weeks the country’s big four gentailers have reported a combined net profit of just under $1.1 billion at a time when factories have been suspending or closing down production altogether because of soaring energy costs.

Collectively, Meridian, Mercury, Genesis and Contact Energy have been investing less in new generation than the $1.3b they will pay shareholders in annual dividends this year.

Under pressure from Resources Minister Shane Jones in particular, the Electricity Authority has teamed up with the Commerce Commission to create an “Electricity Competition Task Force”.

But the biggest intervention it will consider is requiring the big four gentailers to supply power to rival retailers on the same terms they supply their own customers — and only then if other measures to improve competition don’t prove effective.

That reform could amount to “operational separation” of the gentailers’ retail arms, similar to the first step in the telco industry reforms in 2009, prior to the actual forced break-up of Telecom and the investment in ultrafast broadband a few years later.

The operational separation of Telecom precipitated the rapid growth of independent internet service providers such as Orcon and Callplus, which are now a part of 2degrees.

Similarly, the Electricity Authority’s backstop option would be a boon for independent electricity retailers that buy most of their electricity from the big four gentailers and which face regular price squeezes.

Margaret Cooney, chief operating officer of Octopus Energy, one such retailer, says the EA-ComCom taskforce is “welcome news”, while questioning the regulators’ track record in terms of actually following through on market fixes.

The suggested backstop “non-discrimination” clause is a red-herring when it comes to a meaningful reform of the power sector, whose key problem is not a lack of retail competition but one which lies much deeper under the bonnet.

The current electricity market model was designed by former National Party energy minister Max Bradford back in 1998 and has allowed the major gentailers to make extraordinary profits.

The Major Electricity Users Group (MEUG) estimated in 2021 that Meridian Energy alone made $3.5b in excess profits in the previous 20 years, a conclusion the company disputes.

Bradford’s reforms enabled the generators to often charge the same wholesale price for electricity regardless of whether it is generated almost for free from hydro dams, new renewable generation or from more expensive coal and gas.

The huge “producer surplus” that the majority state-owned generators can reap from their hydro schemes is an unusual feature of the New Zealand market, which is reflected in their consistently high profits.

When there is a chance of the hydro lakes running low due to dry weather, the gentailers can increase their spot-market prices to extraordinary levels to “conserve” their future generation potential, as they did this winter and also in 2021.

And if it rains a few weeks later, the lakes fill up and a drought proves to just be a scare — as was the case in 2021 and as appears to be unfolding now with recent hydro inflows — no-one of course gets a refund.

An electricity insider has suggested the gentailers’ approach to their wholesale pricing offers this winter was to just put it up and “see what sticks”.

Spot market prices — which underpin the prices that gentailers can charge big businesses and independent retailers for power under longer term contracts — sometimes exceeded $1000 a megawatt hour (MWh) in early August.

That is about 10 times the top of the “green zone” band in the pricing charts published by the NZX on behalf of the Electricity Authority.

Victoria University visiting scholar Geoff Bertram believes an initial moderation in wholesale power prices a couple of weeks ago can be directly attributed to Jones’ accusation of profiteering by gentailers and his threat to support market reforms.

So one feather in the cap for Jones there, perhaps.

Now, heavy rain appears to be hosing down the embers of the overheated wholesale market, with day-time spot market prices dropping back under $40/MWh on Thursday.

For a period on Friday, electricity was effectively free on the spot market, trading at just 3 cents per megawatt-hour.

The Bradford market model also disincentives investment in renewable energy to meet evening peaks in demand or hydro shortages during dry years, as there is no business case for building a wind or solar farm whose output might only occasionally be needed.

Rather, overbuilding renewables would be economic suicide for gentailers, as that could be expected to see wholesale electricity prices frequently competed down to zero.

That is often the situation in South Australia and Victoria, where Australian generators commonly can’t give away electricity during daylight hours.

As MEUG chairperson John Harbord has put it, generators are incentivised to keep the market on the “precipice of shortage”.

To date, the only comprehensive reform package that has been fleshed out as an alternative to the Bradford system is the “single buyer model”, which has been popular in Asia, Africa and the Middle-East since the 1990s.

Proposed as a solution here by then Labour energy spokesperson David Parker in 2013, it is a halfway house between a nationalised and a market-based power system that is designed to leave it to the private and public sectors to do what they each do best.

Under Parker’s model, a state-controlled monopoly would have paid a “fair price” for power generated from existing power plants, based on the cost of production plus a profit margin, and on-sold that to electricity retailers.

In consultation with retailers, it would have calculated out how much new generation was needed, and contracted with generators to supply that power, taking into account the Government’s climate change goals.

Power would then be provided to retailers at the blended price.

The proposal also had the advantage that the single buyer could serve as a “retailer of last resort” to serve vulnerable customers that other retailers were unwilling to serve.

The single-buyer model didn’t win over the public in 2014, perhaps because it wasn’t well understood but also because gentailers lobbied hard against it, knowing the impact it would have on their profit margins.

It remains out of favour ideologically with the current Government — and it appears now Labour — because it would represent a return to hybrid planned/market system.

Bertram was a vocal proponent of the single-buyer model, but believes its moment has passed.

He is now putting great stock in a reform touted by the Government last week that would ease restrictions on local lines companies investing in generation, which could include local wind farms, small solar farms or support for rooftop solar.

That announcement was somewhat overshadowed by confirmation from the Government on the same day that it would attempt to facilitate imports of liquefied natural gas, but Bertram views it as “huge”.

“Unless they get it wrong, it takes us back to the old Electricity Supply Authority model where entities in the local market ran the lines, ran the demand management side and organised the sale of energy,” he says.

“The local network is sitting there in a position like the single buyer. I don’t think the ‘single buyer model’ is any longer relevant as that was designed to fix the problem right up at the gentailer level.”

LNG imports may have the potential to put a cap on wholesale electricity prices in the absence of major structural reforms or the lines company-led transformation Bertram is hoping to see.

Meridian Energy chief executive Neal Barclay said on Wednesday that, at current prices, imported LNG could be used to produce electricity at a price of between $200 and $300 a megawatt hour.

Industry insiders say all that is required to generate electricity from LNG is something similar to modified 737 engine to act as the generating turbine.

Assuming there were no constraints on importing LNG and burning it for power, that would suggest no generators would need to offer electricity into the wholesale market at a price of more than $300/MW.

That is a high price, but one that’s less eye-watering than this winter’s offers.

Meridian chief financial officer Mike Roan is unsure if it will play out that way in practice.

“Will $300 be the cap? I don't know, but I like the logic,” he says.

“The logic is sound; if it's there, if it's available, the gas is providing the cap.”

Any attempt to curb gentailers’ profits will run into the complication that no-one can turn back time.

One billion dollar-plus annual dividend pay-outs have long been baked-in to their combined $34b NZX valuation, meaning that investors who lost out from any industry reforms would not necessarily be the same ones who gained from their past profits.

But the industry requires tens of billions of dollars of investment in new power stations and new and upgraded power lines in relatively short order.

The question for policy makers will be whether consumers and businesses can afford to foot the bill for that investment while also continuing to often pay top dollar for electricity from decades old hydro-electric schemes, or if something more has to give.

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