Bryan Leyland: Why electricity prices have increased

The Electricity Price Review has revealed that residential electricity prices have increased by about 80% above inflation since 1990. Why did this happen? We were promised that privatisation and the electricity market would reduce power prices.

An objective examination of the whole electricity industry and the effect of the reforms leads to some interesting conclusions.

Cross subsidies

Before the reforms many power boards cross subsidised residential consumers by overcharging commercial and industrial consumers. The removal of these subsidies is a factor in the increased residential prices.

The market

The Wholesale Market Electricity Development Group made a mistake when they rejected the recommended market model and chose a market that pays all generators the price bid by the most expensive generator selected to run. This would have been a good choice if New Zealand relied entirely on fossil fuel generation. New fossil fuel power stations produce cheaper power than older ones so such a market encourages the construction of new and better stations.

In New Zealand, the cheapest generation comes from old, low cost, depreciated hydro stations. The choice of a fossil fuel market structure pays these stations the much higher price needed by the most expensive fossil fuel station. Hydro stations then rack up their asset values to camouflage the fact that they are making windfall profits.

The recommended market model would have ensured that consumers would have continued to get low-cost electricity from the hydro stations that they had already paid for and built new stations that would give the lowest system costs in the long run.

The chosen market structure has led to wholesale prices increasing when they should have decreased to reflect the major reductions in operation and maintenance cost that followed on from privatisation.

Control of peak demand

Before the electricity reforms all electric water heaters in New Zealand were remotely controlled by the lines companies to reduce system peak demand by more than 10%. The reforms destroyed this world leading system. Most lines companies abandoned water heater control because the reforms did not allow them to fully recover of the costs of operating, maintaining and expanding the hot water control system.

As a result of abandoning hot water control, new power stations and a $960 million 400 kV line into Auckland were needed and millions more were spent on reinforcing transmission lines and distribution systems. All this to meet a peak demand that would not have existed with the recommended market.

Assets revalued

The reforms also allowed Transpower and lines companies to massively revalue their assets and use this increased value to justify charging consumers millions of dollars more for assets that consumers had largely paid for already. This is a major factor in the increased cost of electricity.

Traders and retailers

The electricity market also brought us traders and retailers who, it can be argued, serve no useful purpose whatsoever. The recommended market model did not need them.

In our market, traders often compete to get selected to generate. But when generation is in short supply competition is virtually non-existent and the price that they bid is “a trade-off between greed and guilt”. (On several occasions in the last few weeks wholesale prices have spiked to more than 10 times the normal price for no apparent reason.) As two retiring CEOs pointed out, the way to make money in the New Zealand market is to keep the system on the edge of a shortage. With the recommended market the system operator would have ensured that sufficient generating capacity was available and selected the generators that would give a reliable supply at the lowest cost.

Retailers increase consumer costs by spending millions of dollars trying to steal consumers from each other and pretending to compete in selling a commodity that is identical for everyone.

Conclusion

So what of the future? It does not look good. Transpower has warned that the risk of serious shortages and high prices in a dry year is rapidly increasing and no one has plans for new power stations that would mitigate this risk.

The government ignores dry year risk because it is hellbent on shutting Huntly down and limiting gas supplies and believes that exploiting wind and solar power will solve all the problems. Never mind that they are much more expensive, require backup when the wind doesn’t blow or the sun doesn’t shine and don’t make any useful contribution to meeting peak demand.

The best and cheapest way of mitigating the risk of blackouts in dry years is to ensure that Huntly continues to provide dry year reserve with two or three generating sets and 1 million tons of coal available.

The government should be taking steps to make sure that we have an economical and reliable supply into the future. If it wants to reduce CO2 – a gas that promotes plant growth and benefits our agricultural industries – it should contemplate the construction of a major and very expensive hydro pumped storage power station in the hills above Roxburgh that would solve the dry year problem. Only then can it ditch Huntly.

The New Zealand electricity market is a classic example of what happens when the politicians and the decision-makers do not understand power systems and how difficult it is to provide a reliable and economic supply. Choosing the wrong market model has cost the customer dearly.

Bryan Leyland is a consulting engineer in the power industry and owns a small hydropower scheme.