The Politics of Low Hydro Inflows

As everybody knows low hydro inflows in 2008 have led to extraordinarily high spot market prices for electricity, just as occurred in 2001, 2003, and 2006 when there were similar episodes of prolonged dry weather over the summer and autumn months.

The 2006 and 2008 experiences are particularly important because they have occurred under the Government's policy of operating the electricity system to a 1-in-60 security of supply standard. In very simple terms, the 1-in-60 standard means that national power conservation campaigns should only be required once every 60 years.

It is time, I believe, to take stock of our experiences with the current approach to security of supply. It is a failure, in my view, if every time there are low hydro inflows the topic ends up in Cabinet, on the front pages of newspapers, and on the TV news. It simply isn't a sustainable model if high spot prices for electricity, and pictures of low lake levels, lead commentators to question the competence of energy ministers and lead to calls for central planning of generation investment.

The 1-in-60 security of supply standard is operationalised by the Electricity Commission calculating a 'minzone' for hydro lake levels - if lake levels stay above the minzone the risk of outages is less than 1.75%. They also calculate an emergency zone, which is the hydro level associated with a 10% risk of outages, and this is the point at which the Electricity Commission is empowered to start national conservation campaigns.

In essence the current approach to security of supply focuses on whether there is sufficient generation available to 'keep the lights on' throughout the winter period. In essence it is an 'engineering' approach because it uses hydro inflow data from the last 80 years to rationally calculate the risk of power shortages. It takes no account of the fear of electricity outages among consumers and politicians, whipped up by the media.

Regardless of the rationality of operating to a security of supply standard, the fears of ordinary voters are overwhelming in politician's minds and drive their incentives to intervene in the electricity market.

The problem with the 1-in-60 standard is that it is failing to comfort consumers that hydro supply risks are being managed appropriately. Rather than deflate concerns about risk, the minzone presents a "bright line" that some commentators see as a beacon signalling an apparently inevitable hydro crisis. Of course the emergency zone sends an even worse signal in that regard.

People fear things they don't understand or that they don't have any influence over. The fundamental problem for the electricity industry is that we don't have any mechanism for directly involving consumers in the cost/risk trade-off inherent in New Zealand's electricity system. For example if consumers could choose between high-priced contracts guaranteeing them supply and low-priced contracts with supply at risk, then a lot of the political heat would be taken out of electricity, but this isn't possible with current electricity network technology.

Another variant of this problem is the absence of floating retail tariffs for consumers. Unlike in the banking industry where borrowers can choose between fixed and floating interest rates, most electricity consumers have only fixed retail tariffs available to them. This may change over the next few years with the adoption of low-cost smart meters, but with the currently installed meters it isn't possible for retailers to offer variable prices to consumers to induce them to conserve electricity during hydro shortages.

Both factors leave the industry with politicians determining security of supply standards and the Commission deciding how to achieve them. The lack of individual choice over security of supply creates political risks that need to be reduced either by educating consumers to be rational about electricity supply risks or by operating hydro generation much more conservatively. Doing the latter may require the Commission to develop a new mechanism to encourage hydro generators to build up their lakes to above average levels by the start of summer and to conserve them more aggressively through the summer and autumn months. The market won't do this on its own because political risk is an externality to their commercial cost/risk trade-offs.

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