Monday, November 23, 2009

To transmit or not to transmit?

Once again the electrcity industry is struggling with the role of transmission in the power system. It is coming under the particular problem of transmission pricing and the role of locational signals for both generation and transmission.

Without getting into the details of locational pricing (which gets very complex very quickly) the fundamental question with transmission is whether one would rather have a local power station and no transmission or a remote power station with transmission. All the locational pricing is trying to do is to signal the preference between these two basic choices.

Local generation has its attraction. It means that you don't need expensive transmission. Potentially it can be smaller and less obtrusive. However, remote generation has significant benefits. A remote power station can be located to a large fuel source. The best renewable fuel sources are only rarely located in perfectly convenient locations. Remote power stations tend to be relatively large (which means it can be an advantage for them to be located remotely) but then require large transmission (which causes its own problems for those it passes). The costs of easements and access are making transmission more and more expensive.

Larger power stations located on good fuel sources have significant economies of scale, though. It gets proportionally cheaper to build something larger. Transmission has very large economies of scale. Once you have decided on the need for a transmission line it does not cost significantly more to make it larger. If you are supplying a small number of people then economies of scale don't matter much. If you are supplying large numbers, on the other hand, then the effective cost of the large power station and transmission line becomes very attractive. Currently large remote power stations with transmission still easily beat most local options on a per unit cost basis.

But there is more to transmission than just transport. I think that it is implicitly assumed that once the economics of a local generator outweigh the remote generator then transmission and remote generation will become redundant. This isn't as clear as it seems. One of the other benefits of a geographically distributed electricity network is that it contains many generating units of many different type of technology and many transmission lines criss-crossing between them. The larger the network the less susceptible it is to the failure of any single piece of generation or transmission. A single local generator is much less reliable, a single failure on a local generator completely disrupts supply.

One of the problems that we might find is that, at the point when we think we have rendered the remote power stations and transmission network redundant (thanks to cheap local generation), may be the point that find we need them more than ever. The technology required to give the local generator the same level of reliability and quality as a large electricity network is expensive. And reliability in our electricity supply is clearly something that we want.

The discussion about locational signals transmission has made the claim that transmission networks tend to be overbuilt. If one only considers the comparison between local and remote generation for energy supply this view looks attractive; but transmission upgrades are justified on the basis of reliability not energy supply. Some experts would claim that energy markets inherently price reliability and this may be true to an extent. My question, though, is this - are we so sure that we have priced all the benefits of a large electricity network? If we all have our local generators would we actually be willing to disconnect from the reliable supply?

Thursday, November 12, 2009

A policy of no policy

In this post
  • The Project Hayes windfarm has been turned down
  • It is not clear whether this decision is correct or not
  • This lack of clarity is a national energy policy failing
  • The Minister of Energy and the Government are not accepting their accountability for setting energy policy
  • Such a policy will not be popular with everyone as it must determine and make clear the trade offs between energy security and environmental purity
  • It is time to move past the purely aspirational and make the national policy decisions
  • Perfect outcomes with no compromises are for Walt Disney movies - not for real world energy policy
The recent news that the Project Hayes windfarm has been turned down makes quite obvious the energy policy failings in New Zealand. For the avoidance of doubt I am making no comment about whether the Project Hayes decision was correct or not. What I am observing is that the Hayes decision is not clear and how the Commissioners have found themselves in a ridiculous predicament.

New Zealand does not have any meaningful energy policy. Neither does it have any meaningful environmental policy despite a great deal of rhetoric to the contrary. This has been a significant policy failure of the previous government but the current government is doing little more than the purely superficial.

The Project Hayes example highlights this well. In a project such as Hayes the fundamental issue of the project's contribution to the country's energy supply versus the local and global environmental impacts must be a national policy issue. This doesn't mean that such a project should be considered at a national level (as this would merely promote the global above the local) but it should be considered within a very clear and unambiguous national policy and assessment framework.

The Commissioners in the Project Hayes case found themselves making self admitted subjective assessments (guesses in effect). All of the Commissioners found themselves in this predicament even the Commissioner with the dissenting minority report. All of them found that the evidence (the scope and content of which was entirely at the discretion of the proponent of the project) was inadequate for balancing all of the benefits and costs. This is unsurprising as the Commissioners have, unwittingly, found themeselves in the role of national energy policy makers where this is clearly not supposed to be their role.

Fundamentally, the level of contribution of renewable energy to New Zealand's increasing energy demands (and how important that is relative to various benefits of the local and global environment) is a national issue. These energy and environmental objectives of New Zealand need to be clearly presented in a national energy policy. No doubt the previous and current Minister of Energy would claim that we do have such policies. However, making the aspirational statements we want entirely renewable energy without any environmental impacts is as useful to energy policy as the anti-smacking legislation is to the genuine welfare of children. There are critical and unavoidable trade offs between energy supply and the environment and it is time for the Minister of Energy and the Government to accept this accountability. OK, so it will not be universally popular but that is the job and not doing it is unacceptable.

Part and parcel of this policy should be an assessment framework that guides the assessment of projects against the energy policy. This would not only ensure that the Commissioners deciding such projects were doing their jobs (rather than also doing the politicians job) but would also make it very clear to project proponents what standard they are to meet; and how they will meet them.

Some might argue that the call-in process facilitates the national policy objectives but I cannot agree with this proposition. The call-in process allows for political expediency rather than enforcing a clear statement of energy policy and an accountability to that policy. I think it is entirely appropriate that decisions for such project authorisations are made locally provided that there is clear and unavoidable guidance in how to balance the local with the global.

The Project Hayes decision makes these policy problems obvious but every wind project so far has suffered from the same problem (including the ones that have been accepted). One can argue indefinitely whether any decision is correct or wrong because it comes down, fundamentally, to the trade offs that we want to make as a society to have a balance between energy security and environmental purity. It is the Governments job to make this unpopular choice between the national benefit and cost and the local benefit and cost. If we prioritise the local environment then we will have to compromise on our renewable objectives. If we prioritise renewable energy then we will have to compromise some local environments. Perfect outcomes with no compromises are for Walt Disney movies - not for real world energy policy.

Thursday, November 5, 2009

Different viewpoint

Brian Leyland has long been seen as the independent commentator of the electricity industry. Mr Leyland often has quite different views to most in the industry and gets some traction from his seeming common sense. To an extent Mr Leyland does bring a common sense alternative view. To an extent, however, his comments can overlook some inconvenient realities.

The most recent example of Mr Leyland's views that I have read is available on

There are a few problems with the view given by Mr Leyland in this opinion piece. The piece is described as shedding light on the rising cost of power but some of the light being shone is pretty dim. As such it is worth shedding a bit more light on Mr Leyland's own commentary.

Mr Leyland selectively uses aspects of the original decision process about the New Zealand Electricity Market to suggest that a single buyer option would have been better. He describes the single buyer option as being considered lower risk (and therefore better?). It is important to note here that low risk was compared to what was deemed to be the current practice. In this context it is easy to see why a single buyer model might have been considered low risk. The status quo was a centrally planned network where engineers took all care but no responsibility, and either taxpayers or electricity purchasers pay for their mistakes. The single buyer model allows the network to be centrally planned by engineers who take all care but no responsibility, and either taxpayers or electricity purchasers would pay for their mistakes. Pretty low risk; for the engineers.

The bid based auction model that was implemented was designed entirely so that it would be private capital that took the risk. Arguably this has been watered down by maintaining much of the generating assets under government ownership but this doesn't seem to be the case. Even under the SOE model it is clear who is responsible for the use of money.

No doubt Mr Leyland would argue that the centrally planned network was better. The evidence is not kind to this point of view, however. While the dry years of the 2000s are in recent memory (and there had been a great deal of publicity and calls for voluntary savings) the country didn't run out of energy. If one looks back through history it will be found that energy rationing was very common under central planning, although the economy was very different then as well.

Under central planning New Zealand also had a history of building bad projects. Most went over time and over budget and many had significant engineering problems. I would challenge Mr Leyland to argue that projects under the electricity market have been as poorly managed as occurred previously. Mr Leyland would no doubt point out that potential shortages over the 2000s indicate how badly the market performs. I could easily make a strong argument that it was regulatory uncertainty during the 1990s that lead to the outcome that none of the restructured industry players of 1999 had workeable projects in the pipeline (which coincided with far longer development timetables than central planners ever had). Looking forward from today, each generator has many potential generation projects. Now that the development pipelines have been filled security of supply looks like less and less of an issue (although hydro dependency will always mean some risk).

Mr Leyland's comments on the Vickery auction make it sound like this is a mechanism designed to rip people off. In fact the auction methods used to overlay on industries where there traditionally haven't been markets are designed to replicate exactly how people behave in markets. They are abstractions, but they are intended to mimic how people trade not replace these methods. Now, I will agree with Mr Leyland, to an extent, that the industry can get carried away with its abstractions, and sometimes forgets the fundamentals, but this also happens under central planning. The justification usually given under central planning for errors of judgement is that people should have behaved the way that they should have done.

At the end of the day, though, the arguments that Mr Leyland uses for pricing problems are all static. Essentially Mr Leyland's arguments are that you could design a pricing methodology for electricity that would make it much cheaper now. In this he is right but this is not what the electricity market is designed for. The electricity market is designed for what is known as dynamic efficiency. This means that the intention of the electricity market design is to enable the most efficient investment in electricity generation and transmission, ie for the lowest electricity prices over time.

In other words the electricity market has a highest current price design based on generation projects that are relatively inexpensive and delivered on time, on spec and on budget. Mr Leyland's suggestion is, history suggests, priced 'fairly' (fairness will also be determined by the central planner) to allocate the cost of projects of impressive feats of costly engineering delivered over time, over budget, and usually with significant problems. His suggestion sounds attractive but actually costs everyone a lot more.

Now, let's be very clear. The reason that electricity costs keep rising is because we keep using more. As any country consumes more and more energy it gets harder and harder to supply. In this context harder means costlier. We have literally burned through one of our greatest energy resources (the Maui gas field) quite rapidly (we exported about a third of it) and now it gets harder and more expensive.

Sunday, November 1, 2009

Is there a free rider problem in New Zealand's retail electricity market?

I think there are problems in New Zealand's retail electricity market but the focus is always on the wholesale market. (see Obviously many people are upset at the significant increases in retail prices over recent years. The Electricity Commission's own analysis shows the issue quite well (see Chapter 2 of Although, unfortunately, the analysis doesn't go as far as to compare industrial, commercial and retail margins, only prices, therefore there is a degree of comparing apples and oranges. This is compounded because prices include both energy costs and lines costs. Nevertheless, it is clear that industrial prices have been quite flat (in real terms), commercial prices have dropped markedly and retail prices have gone up markedly. Interestingly the national average end use purchaser price has also remained relatively flat.

For most of New Zealand's history there have been significant cross-subsidies in the retail prices. Traditionally residential prices were arbitrarily low and commercial prices were arbitrarily high. Industrial prices have always been, effectively, wholesale prices. The reason for the historical cross subsidy from commercial to residential is easily explained. This occurred because electricity was delivered by monopolies with elected governors, and businesses don't vote. A simple case of responding to the incentives of the day.

It is clear that these historical cross subsidies have been removed and this is one reason why residential electricity prices have increased in excess of inflation. Now, though, the situation seems to have reversed with residential prices being significantly higher than commercial, but this may not be a cross subsidy. It may just be economic reality.

And what of industrial prices. To a degree the industrial price is lower because it is generally a wholesale price. But is there a degree of cross subsidisation here? There isn't really enough analysis to be able to conclude much at all. Let's instead consider a 'first principles' debate around allocative efficiency.

Allocative efficiency is that economic principle that says that resources should be allocated to their most valuable use. This roughly translates to - those that are willing to pay more should get all they want and people who are willing to pay the least should get less. It can also be translated into saying that those that get the most should pay the most and the those that get the least should pay the least. If we hold off for a moment on the distinction between commercial and residential (and treat them as one retail customer bloc) then let's compare them (together) to the industrial segment.

It looks to me that allocative efficiency is working properly here. Notwithstanding that industrial prices are generally wholesale prices they seem to pay the least. Industry is also the segment most likely to shut down when there is an energy shortage. As wholesale prices increase more then more industrials shut down. Prima facie this is what you would expect. Having said that the industrials (in general) have the same mantra during any energy shortage - why do we have to bear the brunt of energy shortages? Why don't retail customers bear the burden as well? Well, the easy economic answer is because industrial loads are willing to pay less than retail customers and, therefore, industrial loads should be the first off. In complaining that they shouldn't be shutting down, and that this is doing New Zealand economic damage, then there are two implicit sides to this potential debate:
  1. Allocative efficiency is working well and industrials are just engaging in political manouvering (a strong possibility), or
  2. Allocative efficiency is not working and industrial loads should not be first off (but, of course, this also means that they should pay more, ie there is currently a cross subsidy from industrial customers to retail customers)

The situation seems more clear when it comes to commercial and residential comparisons. Neither responds strongly to price signals and yet each pays significantly different prices. A cross subsidy seems most likely here.

So why might cross subsidies exist? Prevailing opinion would probably suggest that it is the evil retailers that are price gouging, but this does not make sense. As mentioned the national average end user purchase price is relatively constant over time in real terms. There is no obvious price gouging in end user prices. Maybe one could argue that retailers (or lines companies) are forcing cross subsidies - but why would they? There is no obvious financial benefit to a power company in forcing an unbalanced price structure. It is more likely that power companies (as with previous cross subsidies) are just responding to the incentives that they have.

There are two reasons I can currently think of why these incentives might exist. Both are a form of free rider problem. One potentially explains why there might exist a cross subsidy from retail customers to industry.

E Grant Read in his 2009 paper ( explains the relationship between contract prices and wholesale prices in electricity markets. Over time electricity generators must recover their fixed costs (costs that are incurred irrespective of how much they generate - plant costs, most labour, infrastructure, capital, etc) and variable costs (costs that are incurred when they generate - fuel, some maintenance, opportunity costs, etc), otherwise they would not invest. In the absence of any contracts then usually (during normal times and especially during times of surplus) the generators will only get variable costs paid out of the market. Only during times of shortage will generators be able to get a contribution to fixed costs. An unhedged electricity market should be highly volatile and have a high total price (high enough to cover all fixed and variable costs). If generators are highly hedged at the total price of generation then the electricity market should be far less volatile and have a lower price (equal to the average of variable costs only as settlements to hedge contracts will pay the fixed costs).

This is where a cross subsidy may, unwittingly, occur. If a retail market design problem meant that retail consumers are making a large contribution to fixed costs then those retail contracts would help stabilise the wholesale price and tend to clear a lower wholesale price. This would enable industrial customers to free ride in the sense that they could take the lower volatility and lower price in the wholesale market and, potentially, avoid some contribution to the fixed costs of generation. Although they would continue to be able to complain about the wholesale price and volatility.

If we look at the relationship between residential and commercial customers then another free riding problem may exist. I suspect that the commercial electricity price is dominated (by volume) by national scale business. These businesses tend to tender for their (relatively large) electricity supply whereas retail customers tend to either be approached or infrequently consider their suppliers (for relatively small load on an individual basis). This means that the larger businesses tend to offer retailers a single shot bid on a lucrative volume (large commercial businesses also tend to be low engagement and good payers). This design is likely to inherently mean that commercial (and possibly industrial) customers are likely to get offered average prices while residential customers will tend to get marginal prices (the full cost of continuing to supply energy at that time at that level). In fact residential customers may pay in excess of the marginal cost, to the extent that commercial (and industrial) customers might avoid fixed costs. Pure allocative efficiency suggests that everyone should face the marginal price.

Some people have argued that the problems with the retail electricity market are structural (relating to the number and type of competitors) and, often, that it is a problem with the wholesale market. I don't think that either proposition is correct. I think that the problem is fundamentally one of retail electricity market design; and let's face it the retail electricity market was never designed - it coalesced over time. Fixing the retail market design may have implications for both the electricity market structure and the wholesale electricity market but these outcomes shouldn't be the objective of fixing the retail market.

Obviously the arguments above are purely anecdotal . The analysis required to properly assess the efficacy and efficiency of the retail electricity market is complex and requires information not readily available; and, perhaps, this is part of the problem. Nevertheless, I don't believe that the electricity market in New Zealand (or any alternative) is ever going to work properly unless every part of it is considered as a policy whole. At the moment the retail component is a significant missing link in the policy debate in anything other than an anecdotal discussion.

The problem with correct information out of context

Deborah Coddington is an honest woman. She admits in her column
that she, with the Martinborough community, are "not opposed to wind farms per se" but that she, like the Martinborough community, don't want them anywhere near her. Fair enough. This is a real problem with renewable energy that New Zealanders will have to get their heads around. see

Ms Coddington reported that a recent Martinborough community meeting was addressed by a Mr Rob Morrison. Mr Morrison is, according to Coddington, a co-founder of the Copenhagen Climate Council (I don't doubt this I just haven't checked it); and an architect of the arrangements that may replace the Kyoto accord. Unfortunately I think the statements attributed to him in the column are generally out of context, misleading and somewhat disingenuous.

The points attributed to Mr Morrison are:
  • generating energy from wind costs twice as much as the price received
  • you can't store wind energy (yet)
  • it won't help with winter peaks in demand
  • it won't replace coal
  • it won't mean cheaper power and it means more expensive bills
  • New Zealand already has numerous choices to build generation capacity to meet future electricity demand

Well two out of six is... pretty bad actually.

Lets look at these assertions. "Generating energy from wind costs twice as much as the price received" - not necessarily true. I assume Mr Morrison is using information about many European wind projects where the very high "feed-in tariff" subsidies have lead to many uneconomic developments. New Zealand has no such subsidies but does have windfarms that are close to the money. New Zealand has some very good wind sites, with good average wind speeds, but not everywhere.

"You can't store wind energy (yet)" and "it won't help with winter peaks in demand" - both of these statements are true.

"It won't replace coal" - false. Mr Morrison may mean here that coal power stations will still be required to ensure security of supply under most renewable energy scenarios. If this is the statement that he is making then I agree (see but I still think the statement is misleading. Even under the scenario where the Huntly coal power station is retained for security of supply then all wind energy that can be delivered to demand (transmission can be an issue) will offset the marginal generator, which will normally be Huntly coal. Wind energy will be maximised and coal energy minimised. This is wind energy replacing coal energy even if the coal station is still required for energy security.

It is in Mr Morrisons assertions that "it won't mean cheaper power and it means more expensive bills" that I cannot but feel that Mr Morrison is being highly disingenuous. Contrary to popular opinion generators are unable to force any price they like in the wholesale electricity market. If a generator builds an uneconomic power station then they will lose money. But the best windfarms in New Zealand will be economic because there will be a device that significantly increases the cost of power and will mean more expensive bills. And that device is Mr Morrison's own Copenhagen Climate Change response. New Zealand's best windfarms will become economic because of a deemed cost of carbon (deemed by a market mechanism far more arbitrary than any electricity market) that will increase everyone's power bills.

And finally "New Zealand already has numerous choices to build generation capacity to meet future electricity demand" - false. New Zealand is in an energy crunch. We don't have significant proven energy reserves in gas, although the gas is probably there. Major hydro schemes are a no no, and there is limited further developments in any case. Geothermal is all go but is fundamentally limited. Solar and marine are possible future choices but are many years away from being commercial. Small distributed generation is mostly too expensive (there are significant economies of scale in electricity - although technology continually improves this). Wind is definitely a current part of New Zealand's energy future (but only those sites that have the consistently high wind speeds).

Mr Morrison suggests we use less and put the effort into energy efficiency. This I can also agree with. There is a lot of potential in energy efficiency. However, I believe everyone continues to underestimate the true opportunity costs in energy efficiency, which I believe is why there continues to be little take up. We don't yet understand these opportunity costs properly and, therefore, we don't yet have the correct policy levers to encourage energy efficiency. I agree that this should be properly focused on.

Mr Morrison reputedly calls on power companies to stop being sneaky, and this may be good advice. However, probably accidentally, there is a degree of sneakiness in Mr Morrison's own reported comments.

The final comment in Ms Coddington's article is "build your farms far away from people." I'm sorry. It's just not that simple.