Consumers could be paying too much for electricity

Tuesday 30 March 2004

Lack of robust hedge market means consumers could be paying too much for electricity

New Zealand’s underdeveloped electricity hedge market could be contributing to retail consumers paying too much for electricity, according to Carl Hansen, Chief Economist at Mco.

In his speech at today’s National Power Conference in Auckland, Mr Hansen said “retail consumers may be paying higher electricity prices because current arrangements make it risky for independent retailers to enter the market. Because all the major generators own retailers, independents are forced to buy hedges from their competitors. This wouldn’t be a problem if there were many generator-retailers in the main energy regions, but in most cases there are only two or three."

Mr Hansen added that the lack of a robust hedge market gives large consumers little confidence they are paying competitive prices for their hedges.

“As a result, many large consumers are failing to buy sufficient hedge cover, which means the market does not send appropriate price signals about the value consumers place on reducing the risk of supply shortages during dry years. This leaves generators with weak incentives to invest in capacity ahead of time to meet growing consumer needs, especially during dry years."

Mr Hansen identified three key factors contributing to the lack of a deep hedge market in New Zealand – the lack of independent retailers, a scarcity of market makers, and market power concerns.

“Market makers play a critical role in developing liquid hedge markets, because they stand in the market ready to buy and sell contracts at posted prices. The few market makers active in the mid to late 1990s largely disappeared when ECNZ’s hedge auctions made secondary market trading of contracts difficult. The 1998 reforms, which required separation of retailing from lines businesses, were the final nail in the coffin for market makers."

The Marketplace Company Limited Level 2, 10 Brandon St, Wellington, New Zealand Phone + 64 (0)4 473 5240 Home Page http://www.m-co.co.nz Email info@m-co.co.nz He added, “Market power concerns haven’t helped. It appears that consumer groups take the view that the Government can’t stand back from high spot prices during dry years, because electricity is an essential commodity. Why buy hedge market protection against high spot prices when the chances are the Government will cap prices for you anyway, or initiate a national conservation campaign to reduce electricity consumption to reduce spot prices?"

Mr Hansen applauded the Electricity Commission for publicly identifying the development of a transparent and liquid hedge market as a top priority for the coming year. He said the key to achieving this goal will be developing a solution that provides a ‘level playing field’ for independent retailers to compete with generator-retailers. Forced separation of generation and retail is not likely to be the answer.

“One option is to facilitate the development of blind hedge markets, where buyers and sellers transact through a third party such as an exchange or through brokers. Standard insider trader policies should be imposed on generator-retailers to prohibit their generation businesses feeding information to their retailing arms before informing the rest of the market."

Mr Hansen also said there could be a case for encouraging market makers back to the hedge market.

“Developing a liquid market requires market makers to offer thin margins between bid and offer prices, to achieve large trading volumes. But market makers may not be willing to bear those risks if competitors can subsequently enter the market and erode their margins where they haven’t contributed to the costs of developing the market. The Commission may wish to consider developing policies that give original market makers greater confidence their investments will not be eroded by ‘free riding’ competitors."

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