Price turmoil undermines market failure claim

Friday 3rd August 2001

NEVILLE BENNETT explains what's really going wrong in the electricity 'crisis'

The furore over electricity prices has been coupled with the protracted blackout of the Auckland CBD as evidence privatisation leads to "market failure."

However, the evidence is that the market is functioning and the problem does not stem from any systemic or structural failure. Rather, the climate has been extreme with an unusually dry, cold winter that has stoked demand while constraining supply by low rainfall. The inflow to supply dams is the lowest in 70 years.

It would be perfectly possible to guard against any similar price spikes in the future but the trade-off would be unacceptably high, for the only means of guaranteeing low prices in the future would be to pay now for a huge increase in supply capacity.

Such an increase would be woefully inefficient. Much of the potentially available electricity would not be consumed in most years; thus the marginal investment would rarely pay a return on the capital invested. No business would contemplate such an unprofitable enterprise but a state might, even though much taxpayer money would be wasted on useless, idle, depreciating assets.

The New Zealand market is not entirely perfect as it has a limited number of participants, and it has been widely reported as having oligopolist tendencies. It is now received wisdom those businesses that combine generation and retailing are strong but retailers will go to the wall.

This is strange as a few years ago some large foreign-owned businesses studied the market and deliberately made a huge investment in the retail part. This suggests the retailers are not inevitably at a disadvantage and the present situation is an aberration.

Nevertheless, there have been calls for state involvement, although it is known this would impair efficiency as governments are not responsive to consumer preferences and the absence of competition would remove incentives to drive down costs.

Governments are sometimes tempted to regulate markets by price controls. California has imposed price caps on electricity to prevent profiteering by suppliers and has ordered that some ratepayers get rebates. Such action is likely to have unintended consequences, especially if the price is set at too low a level.

Cheap electricity allows politicians to glow in public approval but it increases the demand at the same time when it is discouraging future supply. Business sees no incentive to invest when the price is unprofitable.

The US Federal Energy Regulatory Commission has been so heavyhanded that in the past five years the Californian economy has grown by a third, electricity demand has grown by a quarter, but generating supply has fallen as capital has been withdrawn.

The New Zealand government is doing everything it can to encourage capital flight by its Electricity Industry Bill that gives the minister draconian powers. He can set prices, force generators to produce and even run businesses. He seems to be almost above the rule of law in that he can take what action he likes for six months even if a court rules his action illegal.

This is tantamount to madness. It will scare off investors, not just in the electricity industry. Any country that threatens such arbitrary interventions is unlikely to remain long in the competitive list.

Nor are such regulations at all necessary. The New Zealand market had operated well and was cleared of any suggestion of an "undesirable situation" by the Market Surveillance Committee (MSC). The MSC conducted an investigation over a month and contacted all participants. Its report specifically rejected any evidence of the use of "opportunistic market power" or manipulation - see NBR website or <www.m-co.co.nz>.

The operations of the market are worth a little explanation, as readers may glean an understanding of why prices spike when climatic conditions turn adverse. The market deals with half-hour blocks of power passing through 250 exit points on the national grid. Users buy power offered by generators but the price is set for each block by the last amount of power offered and accepted.

Some suppliers may find producing at high volume inconvenient and are chary of offering power at all times. They may enter an auction at a late stage if the spot price is worthwhile. The highest price goes to all suppliers; this is very satisfying for low-cost suppliers and may be a sufficient price for marginal suppliers.

The system functions to ensure consumers get the amount of power they want. The market balances supply and demand. But as power has become more scarce, and demand is high, the price of marginal production had grown steeply.

Ultimately all markets function in this way. An excellent example is the world market for oil. Rather than the few participants in the New Zealand electricity market, the global oil market had a multitude of buyers and sellers (and many sellers are not in the Opec cartel). But prices recently rose from a steady $US10 to $US30 before falling back to US$25. Note, too, that the oil price initially overshot before settling back.

The behaviour of markets can be illustrated with a simple example. Suppose we are considering the consumption of a fixed stock of power over a two-month period - say July and August. In the futures market the spot price for power in July is 20c and the August price is 25c. Then suppose a fall in supply in August. How would a futures market react to a change in information and market conditions?

Generally the August price would rise, say to 30c. But if the price rises from 25c to 30c some suppliers would withhold some of their power off the July market, where they would get a price of 20c, and reserve it for sale on the August market at 30c, or 50% higher. The market would start to re-allocate resources.

Eventually the July price will rise because supply has fallen and the August price will fall because there will be greater than anticipated supply. The futures market has functioned in this example to deal with a change in information and to provide a mechanism for a new allocation of resources.

This simple model may help to explain why spot prices spiked. It may suggest, too, the highest prices may have been reached, that the market overshot but that prices will fall to a lower level now all relevant information has been absorbed and new conservation measures are in hand.

Clearly the market has functioned quite efficiently. Moreover, the domestic consumption element (which comprises about a third of total use) has not paid higher prices at all, because they have contracts. These contracts protect them from receiving price signals that might give them incentives to save power. However, some retailers are offering incentive to consumers who curb their consumption.

Obviously some business consumers are suffering because they have some exposure to the spot market because they did not wish to, or could not obtain, a fixed-price contract. A remedy is perhaps needed for the thin financial hedge market.

No doubt the market can develop and add further outcomes of efficient investment and pricing.

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