The Operation and Performance of the New Zealand Electricity Market

Economic and physical environment matters for: operation, outcomes and evaluation of outcomes

Lewis EvansVictoria University of Wellington

12 December 2013

ConferenceApplied and Theoretical Economics

Competition Policy Issues: Theory Meets PracticeMassey University Albany

Outline

1. The Market

2. Forms of risk and implications for1.Market performance2.Modelling market performance

3. One approach: or how the spot market allocates water (and gas)

4. Comment on performance

NZ Electricity Market 2013 Energy only Market, no taxpayer-as-taxpayer- funded investment,

risks assigned to those best able to manage themHouseholds produce the peaks

Distribution

Generation

Transmission

Customers

Oligopoly: 5 large firms + fringe competition: workable competition.

1/3 households and 1/3 commercial firms & 1/3 large industrials

(Retail) (National HV Grid) Natural monopoly SOE (investment/prices regulated by the Commerce Commission)

(Local LV Grid) Natural monopoly (cooperatives/regulation Commerce Commission)

Buyers & Sellers

• 14 retailers (4 not gentailers: 22 brands)

• Generation – Greater than 1MW: there are 140 plant owned by 36

separate companies (operated by 19)– Less than 1MW: small (at least 80, micro plant embedded in

networks)

• Traders spot: 32 distinct buyers or sellers

• Traders Futures (ASX): 12 distinct traders: 5 of which are not market participants

Source EA June 2013

Managing Volatility and Its Implications

The Future

The Present

Supply cost of generation plant/fuel, Demand, Climate and events

Spot PricesInflows, Storage

Short term demandsupply and transmission events

Forward Prices

AnticipatedSpot pricecharacteristics

The wholesale market: spot, forward and capacity

Capacity Investment

Volatility Indicator Vector North Gas Pipeline: Daily Gas Throughput

Volatility (thermal generation: water/temperature): across years/seasons/weeks

( source Concept Consulting)

NZ-specific characteristic

60% is hydro generation with limited storage and very volatile water supplies

Regional Water Flow Characteristics

Implications: I

1. The risky economic environment enhances competition in the spot and hedge markets: different firms have different cost structures (water and other) that vary unpredictably over time rendering cooperation more difficult

2. Hedging will be an integral part of the wholesale market:1. Across time2. Across space3. In competition with capacity investment (in generation

and storage)

More on: Spot and Hedge PricesThe spot electricity price => value of unit of stored water

Spot market is a nationwide water market valuing use

in electricity

• Transactions occur largely at the fixed hedge price• Generators are short of water in dry years: which can

be very costly • The high price episodes do not imply market power or

rent to generators

A $50 hedge (for some quantity) and spot prices

We observe no dry-year generator cash profit humps

Generators and Buyers can each win and lose with dry weather

Implications: II

1. Spot market-measured profit distribution outcomes in general do not translate into actual profit distribution outcomes in the long or short run

2. Modelling the spot market should 1. explicitly recognise uncertainty2. recognise that decisions by generators will be taken in trading periods based on information that includes

* amount of stored water, * inflows and * forecastability of inflows (at least days – or many

trading periods – ahead)

ApplicationA(nother) model of the spot market

in continuous time

Model: behaviour• Competitive behaviour equivalent to social planner choice

• For any trading period choose on- and off-peak hydro and gas generation to maximise the expected present value of total surplus:

- looking forward to the indefinite future

- given the model’s structure, the distribution forecastibility of inflows, levels of current inflow and storage

- given a defined opportunity cost of gas, & ignoring competing uses for water

• Planner’s choice produces gas and hydro generation policies

Model: generation policiesin each trading period

•The combined cost of hydro and gas generation is minimised and consumer price equals marginal cost (typically) of water and gas

•The spot market valuation of water is the price of the last unit of stored water that renders generators indifferent between generating today or waiting:

ie value of use today equals

- the expected present value of use in some future period, and

- the value of the option to use in the future

Model: Value of Water Model calibrated to 2007

Outcomes from 200 years of simulated daily (full trading) periods

• is the proportion of storage to capacity• The upper curve relates to very low inflows • The lower curve relates to very high inflows

Model: Generation Policies: Dry Year: all gas used before hydro

Price

Demand 1 Demand 2

Marginal cost

Gas

Water Given storage

Demand predictable

Model: Generation Policies: Normal Year gas then hydro then gas

Price

Demand 1 Demand 2

Marginal cost

Gas

Water Given storage

Demand predictable

Implications: III

Where there is significant volatility in water (gas) supplies and storage

1. a rational expectations spot market has no exogenous supply curve: the level of demand affects storage and the position of the supply curve (no matter how competitive the market)

2. studies of particular outcomes have limitations in that decisions are forward looking in the context of variance & risk: improvable realised outcomes do not of themselves indicate choices were inefficient.

Model: Intra Day Spot Market Water Allocation light-shade without reservoir || dark-shade with reservoir

Outcomes from simulations

Model: Seasonal Water Allocationlight-shade without reservoir || dark-shade with reservoir

Outcomes from simulations:

Implications: IV The spot market has a socially useful role

1. Complements hedges providing transactions in unders/overs

2. Prices water in electricity production in almost real time across regions

3. Allocates water (relative to gas) over time in electricity

The model described has uses based on a presumption of efficient decisions: could be tested ondistribution of outcomes.

Comment on Performance

The Hedge/Contract Market

Evidence is a) that hedge price closely approximates next cheapest generation option: as it should in a stable/growing market. b) Capacity investment has matched supply to demand,

The NZ Cost of Electricity

Comparisons across Countries [EA March 2013]

Are fraught with issues a) definitional what is the price paying for?b) exchange rate issues: why vary them over time? (adjusting for the change in the TWI since 1999 NZ has the same ranking in 2012 as in 1999)

c) domestic fuel supply conditions

Factors Affecting Residential prices 1990-2013

Harker 2013

• Better reflect cost of electricity delivery• Corporatisation changing the subsidy->price

• Peakiness requiring capacity• Open ended contracts (insurance)• Competition in retail and the wider market

Final Comments

•Present arrangements: the electricity market has technological change in prospect that creates risk and the prospect of beneficial outcomes

•Regulatory Risk: the subsidy-single buyer model has two strands: a subsidy for electricity, and return to government management of the market. It has deleterious effects on economic performance and the environment. It is most unlikely to foster beneficial outcomes of technological advance.

Bibliography

Concept Consulting Group, Gas Supply and Demand Scenarios, 2012 – 2017, 2012, 122p.

Evans Lewis, Graeme Guthrie and Angela Lu, “The Role of Storage in a Competitive Electricity Market and the Effects of Climate Change”, Energy Economics, 36, 2013, 405-418. ----, Seamus Hogan and Peter Jackson, “A Critique of Wolak’s evaluation of the NZ electricity market: introduction and overview”, New Zealand Economic Papers, 46(1), 2012, 1-11. Introduction to a symposium of several papers on Frank Wolak’s Commerce Commission consulting report.

---- and Graeme Guthrie, "How Options Provided by Storage Affect Electricity Prices”, Southern Economic Journal, 75(3), 2009, 681-702.

-----, The Economic Effects of the Price-Discriminating Single Buyer : Presentation to the Victoria University Institute of Policy Studies, (www.iscr.org.nz), July, 2013.

Grimm Veronika, and Gregor Zoettl, Investment Incentives and Electricity Spot Market Competition, Journal of Economics and Management Strategy, 22(4) 2013.

Harker, Bruce, Address to Trustpower AGM, July 2013 (www.nzx.com/companies/TPW/announcements/239025)

Philpott, Andy and Ziming Guan, “Models for Estimating the performance of electricity markets with hydro-electric Reservoir Storage”, mimeo, EPOC, Auckland University, 2013, 44p.