Thursday, April 27, 2006

Brian Fallow: Market blocks electric shock

We flick the switch with a high degree of confidence that electricity will flow.

But behind the switch lies an industry entangled in uncertainties and beset by risks, and where no single party is responsible for keeping the lights on.

Directors sitting around the board table of an electricity generator - or a major power user for that matter - and wrestling with a major investment decision have a daunting list of things they need to know but don't.

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UNCERTAINTY NO 1: COMALCO

Will Comalco's Tiwai Point aluminium smelter still be there after 2012, when its existing power supply contract with Meridian Energy runs out?

The smelter consumes about 14 per cent of the country's electricity production, equivalent to about six years' of growth in demand.

Electricity is a critical cost for the smelter. The price it pays is based on the average spot price of the previous year - and that has been climbing.

If it is going to be out of the picture, the focus shifts at once from generation investment to transmission, because the smelter is hard-wired to the Manapouri power scheme and it would require substantial investment in the grid to make that electricity available to consumers further north.

There is a theory that one reason the Electricity Commission will deliver a negative, make-do-and-mend decision today on Transpower's plans for a new line into Auckland is that it wants to preserve the option of a direct-current spine to the national grid, allowing power to flow with less spillage from the energy-rich south of the country to the metropolis.

But it won't say so because it does not want to be seen as interfering in a commercial negotiation or as keen to see a major export industry killed off.

Comalco and Meridian are due to conclude their renegotiation of the power contract next year.

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UNCERTAINTY NO 2: GAS

Natural gas is the fuel of choice for fossil fuel-fired generation. But the giant Maui gas field is running out and the successor fields, Pohukura and Kupe, are much smaller, so the need to find new gas supplies is urgent.

The geological prospects are reasonably good, apparently, but there is a global shortage of drilling rigs and time is running out before the gas-guzzling generators, Contact Energy and Genesis Energy, will need to commit to importing liquefied natural gas to keep their plants going.

That would be a fateful decision, however, because by and large it is the thermal generators that set the wholesale price of electricity, and it is probably not desirable that electricity prices should become linked to world oil prices (as LNG prices in the Asia-Pacific region are) and hostage to the gyrations of the exchange rate.

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UNCERTAINTY NO 3: THE GRID

Antiquated and congested, the national grid is in the same sort of state as Auckland's road network. But it is now up to the new Electricity Commission, not the grid's owner and operator Transpower, to decide what transmission investments can be made, and when, and who pays.

Transmission bottlenecks have impeded the development of competition by creating regionalised markets.

And transmission is also vital, of course, to the ability of new renewable sources of power to reach a market.

A new and illuminating study of the electricity reforms by Professor Lew Evans of Victoria University and Richard Meade of the Institute for the Study of Competition and Regulation, calls the future of grid investment and pricing the single greatest risk to investors in the sector.

They see the establishment of the commission as part of a drift back towards central planning, despite what they argue is the success of the market-based reforms of the 1990s.

The problem is generation and transmission are interdependent.

"Where grid and generation investments are not co-ordinated through some formal/public or informal/private means, risks of stranding and costs of transactions can be so large that investment overall is inhibited and inefficient investment take place," write Evans and Meade.

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UNCERTAINTY NO 4: CLIMATE CHANGE

Nine years after a multilateral climate change treaty was negotiated at Kyoto, domestic policy in this area is a shambles.

The (relatively) broad-based carbon tax, the central plank of the 2002 policy package, has been scrapped but a carbon tax just for large emitters, including thermal power stations, remains on the cards. Or maybe not. We will have to wait and see.

The less crude option of a domestic trading regime for rights to emit greenhouse gases seems to be stuck in the too-hard basket.

All this leaves potential investors in generation uncertain about what carbon price they or their competitors will face, if any.

Other elements of the policy environment are also a source of uncertainty and risk.

For example, resource consents to use water are granted for a finite term, which is fair enough, but they are also at risk of ad hoc political intervention, like the Waitaki Water Allocation Board affair which came close to confiscating rights Meridian has to that river's water, with potentially dire consequences for security of supply.

Overarching all these man-made imponderables lies the biggest unknown of all: How much rain and snow will fall in the catchment areas of the hydro lakes which we still rely on for the lion's share of our electricity.

In the context of a changing climate, how reliable a guide can the past be to the future? In light of this concatenation of uncertainties, how sure can we consumers be that timely and efficient investment will occur and the lights stay on?

Can the market model cope?

Given a chance, yes, say Evans and Meade.

"That new generation in the 1990s was at a level commensurate with that of the preceding two pre-reform decades should offer reassurance that the market has not, in fact, failed but delivered much in the face of great challenges."

True, there is no one party responsible for ensuring demand is met when supply is scarce. But why should there be? Should all demand be met when supply is scarce?

Demand for electricity is not all equally critical or valuable to the consumer, they argue.

The only reason voluntary savings campaigns are needed during dry-year winter crises is that many consumers, including residential ones, are insulated from wholesale prices by fixed-price contracts. If those prices don't move to ration a scarce resource, other means are required.

Power crises were not unknown before the reforms and typically required involuntary measures like blackouts to deal with them. Since the reforms, blackouts have been avoided as impending shortages have been signalled months in advance through rising wholesale prices, giving those most exposed fair warning and an incentive to seek supply contracts that reflect their tolerance for supply and price risk.

The greater danger, Evans and Meade argue, lies in the prevailing trend towards recentralisation of the sector and a retreat from reliance on market mechanisms.

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