Let there be light, and market

The market approach to electricity is coming under scrutiny by consumers and media commentators in the wake of severe hydro shortages and high spot prices for electricity. This follows similar events in 2001, 2003 and 2006 when rainfall during summer and autumn were substantially below average before winter.

For some commentators high spot prices every two or three years seem to imply the market is not working, whereas in my view the opposite conclusion should be drawn. The spot market provides price signals of possible hydro shortages. Of course, the possibility of shortages occurs far more frequently than actual shortages, so it should not be surprising that hydro shortages seem to be occurring more frequently than ever. This is just the market doing its job.

Having said that, the droughts in 2001, 2003, and now in 2008 have been particularly severe, with hydro inflows around 75% of average for the first five months in each of those years. These inflows are the fourth, fifth, and sixth lowest in 82 years of records. The historical average for the last 82 years is for dry periods of this intensity to occur about once every eight years, whereas New Zealand has suffered three of them in the space of just seven years.

The hydro records also show that less severe droughts, when inflows over the January to May period were less than 85% of the average, occurred about once every four years since 1926. But over the last 10 years New Zealand has experienced seven such events. The 'weather gods' certainly haven’t been smiling on the New Zealand hydro system over the last decade.

Many readers may not realise the spot market for electricity – where generators, retailers and large industrial consumers buy and sell electricity on a half-hourly basis – was implemented in response to severe power rationing in 1992. The hydro shortage was so severe that voluntary power savings of 15 – 20% were eventually called for, and a potline at the Tiwai smelter was shut down. Dropping the potline was pretty drastic action but it was needed to achieve an immediate demand reduction of 5% for the country.

In 1992 the Electricity Corporation set wholesale prices a week ahead of time, and centrally managed the use of thermal and hydro resources. The Electricity Corporation maintained wholesale prices at about their normal levels until mid-May, despite low hydro lake levels right from the beginning of January, and when it did raise prices it faced a price cap of 15 cents a kilowatt-hour (kWh).

The severe rationing in 1992 occurred despite reasonable hydro inflows during January and February (about 95% of average). The Electricity Corporation generated power using the January and February inflows rather than using as much thermal generation as possible to conserve water and restore lake levels. The Electricity Corporation even closed down a thermal plant at Marsden on 12 March 1992 because it felt sure rainfall over autumn would be sufficient to meet electricity demand. The gas turbines at Stratford were not used to conserve hydro lakes until 8 May, and Otahuhu was not used for that purpose until 22 May 1992.

Put simply, the Electricity Corporation 'bet on the weather' because it wanted to keep prices low and because it took an 'engineering' approach to security of supply. If the usual rainfall patterns over mid-May to mid-June had occurred no one would have taken any notice of the risks the Electricity Corporation took with the country's power supply, but it lost that bet.

This contrasts with the situation under a spot market, where spot prices provide advanced warning of possible hydro shortages. The warning signals from high spot prices are more real because they carry large financial implications for buyers and sellers exposed to spot market prices. The low rainfall in 2008 means spot prices have been very high recently, reaching an average of 27.2 cents a kWh in May compared to 7.5 cents a kWh in normal months. The average prices for February, March and April were 13.8 cents, 12.9 cents, and 12.6 cents respectively.

The high spot prices in 2001, 2003, 2006, and now in 2008, have encouraged voluntary demand reductions well ahead of any need for public savings campaigns. The high spot prices have also ensured non-hydro generation has been used to its maximum given the fuel available to them. The net result is less reliance on public savings campaigns and a lower risk of 'black outs.'

The spot market is certainly not perfect but in my view it is performing a vital function in rationing electricity, preserving hydro generation, and helping us avoid 'black outs' this winter.

Carl Hansen is Chief Executive of M-co New Zealand and leads M-co's consulting practice.

DDI: +64 4 473 5240
E: carl.hansen@m-co.co.nz