The Shoeshine Column: NGC meltdown sounds market deathknell

Friday 22nd June 2001

During the Californian power crisis workers returned to their jobs at an aluminium smelter after the Christmas break to find the gates shut. The company, so the story goes, found itself in an enviable position.

The price of its major input - power - had hit $US10,000 a megawatt hour on the wholesale market but it had supply entitlement under a fixed-price contract at a tiny fraction of that cost.

As the company could make far more selling power than it could making aluminium, management just shut the plant down and sent the workforce home on full pay - for four months.

Recent dire warnings of a California-style power crisis here in Godzone have had Shoeshine daydreaming of an extended paid holiday. That's unlikely to happen but there's little doubt a major power market shakeup is under way.

Catching the rough end of the stick is Natural Gas Corporation which is rumoured at one point to have been losing $3 million a day. Its shares, which hit a high of 171c last August, last week changed hands at 90c.

NGC is a "net retailer." It has 584,000 power and gas customers to supply but not nearly enough of its own generation to cover their demand.

It has to buy the difference on the wholesale electricity market where power prices have spiked as high as $200 a megawatt hour in recent days, from $35 an hour earlier this year.

The dramatic rise is due to low rainfall, which has emptied the dams which power much of the country's generation. Most people therefore blame NGC's predicament on the Almighty. NGC blames Meridian Energy chief executive Keith Turner, who considers himself only slightly less powerful.

In the hot seat is NGC boss John Barton, a secondee from the company's owner, Australian Gas Light. The Kiwi outfit's fortunes don't usually occupy much attention among the top brass in North Sydney but the red-ink riptide has knocked the parent's share price too. Lately AGL headkickers have been swarming over NGC's Petone headquarters.

Locals have been scratching their heads. How on earth, they ask, could an old hand like AGL have allowed its subsidiary to be so exposed to the vagaries of the weather and wholesale power prices?

Barton's explanation is that it had no choice. The only way to cover its power shortfall was to sign fixed- priced contracts with those whose generation capacity exceeds demand from their own retail customers - the "net generators" such as Meridian, Contact Energy and Mighty River Power.

But these recalcitrants had refused to offer NGC cover on commercial terms.

On the face of it Barton's arguments make no sense. Electricity can't be stored in large quantities, so plainly no more or less power is generated than is consumed. If a buyer like NGC is exposed to an upward hike in the market price then there will be corresponding downside exposure for net generators.

The trouble is, the risks don't cancel each other out. The market is skewed in favour of the generators.

A retailer's upside exposure is theoretically unlimited. Nobody has suggested our market power price could ever reach $US10,000 ($24,000) an hour but the Yanks probably didn't see it coming either.

Generators' downside risk is limited by their short-run marginal cost of production. If the wholesale price falls below the cost, in the first instance, of gas-powered generation they simply switch off their turbines.

NGC's real mistake hasn't been so much in taking on too many retail customers, or even in failing to hedge, as in failing to understand how the market is changing under the impetus of former energy minister Max Bradford's electricity reforms.

The state-owned generators' "vesting hedges," which they inherited when ECNZ was split up, are beginning to roll out. As they do, the generators are considering the optimum balance between managing risk making money.

Net generators like Contact Energy and Genesis have come to the conclusion they need a balanced portfolio of customers and capacity, with some limited exposure to the wholesale market.

At some point somebody's going to have to build new plant. But as things stand the first builder will have to beat a path to NGC's door for a customer hedge.

So the game is to acquire NGC's "excess" customers. This is where retailers like NGC's business model falls apart. It's not that the generators won't make hedges available - they'll just offer them at a price at which NGC can make money but they can still underbid.

Say, for instance, NGC wants to take on a high-volume, low-cost industrial customer on a supply contract at $45 an hour. A generator like Meridian can offer NGC a hedge at $41, allowing NGC to cover its exposure. But it can offer the customer supply at $39 and still make money.

NGC, having realised retailers carry more risk than generators, wants the government to spread the risk by "ring-fencing" the net generators' power-pumping operations from their retailing arms. Energy minister Pete Hodgson has so far been unimpressed, saying the market is working as his predecessor Max Bradford intended it to work.

Shoeshine's guess is that the retail model will prove to be unworkable for anyone. Simply put, no one will be able to be a big net retailer unless someone is prepared to be a big net generator. And that's not the way the generators want to go.

Already NGC is rumoured to be talking to Meridian about shedding some of its retail customer base.

If things shake out into the model Contact and Genesis are pursuing, the wholesale market will shrivel into a mere clearing house for odds and ends.

From a risk-management point of view that makes perfect sense - no more NGC-style meltdowns. But Max Bradford's vision of a thriving, competitive wholesale market driving down consumer prices looks like a dead duck already.

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