Power companies' argument for higher prices no longer holds water

PATTRICK SMELLIE
Last updated 05:00 14/02/2013

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OPINION: Why aren't power prices falling?

From the "history always repeats" department come recent breathless reports that allegedly "lift the lid" on over-charging for electricity over the last 25 years.

Actually, there's nothing new about this claim. It's just that a new generation of journalists has caught up with it.

The argument is this: electricity companies have continually revalued their assets upwards and raised their tariffs accordingly, to reflect reasonable rates of return on capital.

As evidence of a jack-up, it's a disarmingly simple argument. But it doesn't stack up.

The revaluations were prompted by the fact that every new power station produces electricity at greater cost than the last one. Power prices have been rising to reflect the cost of the next unit of supply.

Of course, many see this as a self-interested scam in a vertically integrated industry that faces no competition from offshore and comparatively little onshore, in what looks like the same cosy arrangements as are alleged of banks and petrol stations.

This version of reality says if everyone's charging the same price, they must be colluding. The trouble is, the opposite is true of commodities like mortgages, petrol and electricity.

That's why the Electricity Authority's hugely successful "What's My Number?" campaign seeks "price convergence", where every power company charges much the same because price gougers lose customers.

Some critics believe power companies should base their prices on what their assets cost to build - another flawed argument, since no other industry operates that way. They price on the basis of supply and demand and hope to make a margin.

The reality for most of the last 27 years, since the New Zealand Electricity Department stopped being a government department and started being a business, is that demand for electricity has risen.

That meant new power stations were needed, and unless power companies can be sure they will earn a return on new plant, they simply won't build such capital-intensive long-lived assets.

Each new power station has got to the front of the queue simply by being the next cheapest option available.

In the late 1990s and early 2000s, natural gas won that race. More latterly, wind and geothermal options have been the next cheapest options at costs of about $85 to $100 a megawatt hour.

However, for the last five years, the key element that kept power prices rising has disappeared. There has been virtually no growth in demand.

While a rash of new wind and geothermal developments have occurred in that time, no major generator plans to build new capacity any time soon, and tumbleweed now blows down the corridors where, just a couple of years ago, bands of engineers worked on the next big project.

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Moreover, consumption may weaken before it grows again as industrial electricity users contract or turn to gas and coal. Norske Skog has closed a newsprint plant at its Kawerau facility, while the majority owner of the Bluff aluminium smelter, Rio Tinto, is strong-arming for a lower price on its contracts, which account for about a seventh of total electricity consumption.

It's unlikely the smelter will close, but even reduced production could produce slack in the system for some time to come.

Meanwhile, over the past six to 12 months, wholesale electricity prices have been weak, consistently below the $85 to $100 per MWh "long run marginal price" used to justify new geothermal and wind projects.

In other words, the wholesale market at present isn't delivering the prices on which the power company valuations are based and, for the first time in a long time, the electricity industry looks like a price-taker rather than a price-maker.

So why aren't electricity prices falling yet?

The power companies argue, with some justification, that the huge cost of upgrading the national grid, run by the state-owned monopoly Transpower, has to be passed through to consumers, along with rising costs of local distribution.

They also argue, with some justification, that fixed tariffs protect consumers from the sometimes wild swings in the wholesale electricity spot market. With only six weeks of hydro storage, it only takes a prolonged dry spell to push wholesale prices up.

Today, however, those fixed tariffs might be argued to be "protecting" consumers from persistently low wholesale prices. If those price trends are sustained, then the case for higher energy charges is weak.

The Electricity Authority is watching all this closely. At a briefing last week, its chief executive, Carl Hansen, cited both "massive changes in view about weakness of demand" and evidence from the futures market of a "very stable wholesale price outlook".

Futures prices for 2015 had dropped an average 26 per cent in recent months from $120 per megawatt hour to $90 per MWh and there was "no way" price rises could be justified in that environment.

Of course, when the economic and electricity demand growth resume, that downward pressure will ease.

In the meantime, it looks as if the reasons power companies have always given for raising prices are now available to use against them.

Disclosure: Pattrick Smellie worked for Contact Energy between 2002 and 2008.

- BusinessDay.co.nz

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