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Discussion Paper: Reserve Generation


Discussion Paper: Reserve Generation

Introduction

This statement sets out the government’s preferred approach to improving New Zealand’s security of electricity supply. It should be read in the context of the government’s announcements on electricity made on 20 May 2003.

New Zealand relies heavily on hydro lakes for electricity generation. Well over half of our electricity comes from hydro power. This power source has historically made our electricity amongst the cheapest in the developed world. However, our hydro lakes store a relatively small volume of water storage compared to some other countries. National hydro lake capacity (when lakes are full) is sufficient to power our total electricity consumption for about six weeks. This makes hydro generation dependent on regular rainfall and snow melt in hydro catchment areas. When lake levels are low, we become more heavily dependent on other forms of electricity generation; in particular gas fired generation and to a lesser extent geothermal, coal and wind.

There has been a growing concern that current wholesale electricity market arrangements are not delivering sufficient security of supply – particularly in very dry years. In 1992, 2001 and again this year, nation-wide electricity conservation campaigns have been launched to encourage the public to save electricity during extended dry periods. The lack of certainty about supply poses a significant risk to New Zealand’s sustainable economic growth.

In response, the government has announced a range of new policy measures designed to improve security of supply. An Electricity Commission will be formed and directed to ensure that the industry operates to a “1 in 60” dry year security standard. The Commission will have the powers of an Electricity Governance Board (EGB) outlined in the Electricity Amendment Act 2001 and will be given an additional “toolbox” of powers to deliver on its security objective.

A key power will be to contract for reserve generation and set terms and conditions for its use. This paper outlines how this mechanism would work and provides answers to some basic questions.

The government would welcome comments on the design details of this preferred approach. Comments should be sent (preferably e-mailed) by 30 June 2003 to:

Andrew Jefferies
Energy Markets Policy Group
Ministry of Economic Development
PO Box 1473
Wellington
E-mail: andrew.jefferies@med.govt.nz
Tel: (04) 470 2314
Fax: (04) 473 7010

Preferred Approach: Commission to contract ring-fenced reserves

Summary

The Electricity Commission will contract by tender for a quantity of new and/or existing generation as a “security reserve” to be set aside or ring-fenced from the market. The Commission will determine the prices and quantities offered into the market by the ring-fenced capacity. Payments from the Commission under the ring-fencing contracts will cover the capital and maintenance costs of the plant and the cost of fuel. The Commission will receive the spot price when the ring-fenced capacity is dispatched by the system operator. The Commission’s net costs will be recovered through a levy on market participants.

Further comment and a graphical overview of the proposed scheme is attached as appendix one.

The Contracts

The Commission will call tenders on a regular basis to provide reserve generation for the New Zealand market. Contracts are expected to cover the fixed (capital) costs of plant, operating and maintenance costs, fuel holding costs, and fuel usage costs if and when the capacity is required.

It is envisaged that some of the Commission’s contracts may be of a sufficiently long-term duration to be capable of backing the construction of new “hydro-firming” plant. Contracts with existing generation capacity are likely to be shorter but may still cover multiple years. The contract terms will require that sufficient fuel is available (e.g. stockpiled coal) so that contracted capacity can deliver security of supply without the need for a nation-wide conservation campaign, even in a “1 in 60” dry year scenario. The Commission will be expected to hold a mixed portfolio with capacity at different locations and with different fuel types in order to manage the impact of contingencies such as disruptions to fuel supplies. However the Commission will not be expected to deliver certainty over every possible contingency – this would be very expensive.

The Commission will control the prices and quantities offered into the spot market by the reserve capacity. This is discussed further below. The Commission would receive the income from selling reserve generation at the spot price. This revenue would be used in part to pay the fuel-usage costs of running the plant as specified in the Commission’s contract with the reserve plant. Any additional revenue earned by the Commission would be used to offset the fixed costs of the contract (such as capital and maintenance costs and fuel availability) meaning that less costs will need to be recovered through a levy on market participants.

It is expected that existing generators and potential new entrants will compete for these contracts ensuring that the Commission pays the lowest possible price for the service provided. The long-term nature of the contracts will encourage a competitive outcome. In addition, competition will be encouraged through the proposed amendment to the Electricity Industry Reform Act 1998 whereby owners of electricity lines businesses will be able to invest in reserve generation without limit as to quantity. The competitive bidding process is expected to ensure that the owners of ring-fenced capacity do not earn profits above or below their risk-adjusted cost of capital.

Contracts for reserve capacity are expected to include provision for regular audits by the Commission concerning plant and fuel availability, and severe penalties for breaches of contract.

Comments are sought on the most appropriate length of the contracts and how often the Commission should let tenders.

Quantity of the Reserve

The Commission’s contracts will ensure that the ring-fenced capacity is well-maintained and has stockpiles or firm supply contracts for fuel. The quantity of ring-fenced capacity needs to be high enough to ensure that supply remains secure even in a “1 in 60” dry year. This will take into account (among other things) the estimated volume (in GWh) of hydro shortfall in a dry year, the likely behaviour of non-ring-fenced thermal generation in a dry year, and the distribution of the shortfall over the year.

The “1 in 60” dry year target means that the Commission will ensure that supply should be available to meet demand without the need for nation-wide conservation campaigns even with the very low inflows expected to occur only once every sixty years on average.

Some of the ring-fenced capacity will be new, but some is expected to come from contracts with existing plants. Although contracts with existing plants will not add directly to generation capacity, the control of these plants by the Commission will allow them to be operated specifically to provide security of supply (for example, by keeping them well maintained and ensuring fuel availability) and to ensure that existing capacity remains in the system for as long as necessary to meet the security of supply objective.

Comments are sought on the quantity of ring-fenced capacity required and the balance between new and existing generation in that portfolio.

Offer Price of Reserve Generation

The Commission will control the prices and quantities offered into the spot market by the ring-fenced capacity. The Commission’s control of a significant quantity of reserve capacity is expected to effectively set a cap on spot prices except under very extreme circumstances.

There are some important considerations relating to the Commission’s offer price into the spot market for reserve generation. If the generation is offered at too low a price, this may reduce the commercial incentives to build new high load-factor plant or invest in demand-side management, as an effective cap would be established at a low price. However, if the reserve is offered into the market at a price significantly above its short run marginal cost, the reserve capacity will be used less frequently (even though it may be efficient to operate it more frequently), and spot prices will be higher than necessary.

A further option may be to offer the generation in tranches at different prices. An initial tranche of the ring-fenced reserve generation might operate relatively frequently (for example, when inflows were below mean and/or lake levels were relatively low for that time of year). Subsequent units of ring-fenced generation would have a progressively lower load factor. The last units of ring-fenced generation would run very rarely.

The Commission might also have discretion as to whether to maintain a standing offer price into the spot market, or whether it may vary the offer price on the basis of its assessment of the risks of supply shortages.

The first option (a transparent standing offer price) provides more certainty for investors in new ordinary (non-reserve) generation, while the second option (a variable offer price) may improve security of supply within a particular year. The second option may also assist the Commission counter gaming behaviour by generators.

As a general comment, a high premium should be put on certainty and transparency of the Commission’s operations to maintain incentives for investment in ordinary generation.

Note that ring-fenced reserve capacity could not be used by generators to back long-term financial contracts, because the capacity will be under the control of the Commission, not the generator. The ring-fenced capacity will be fully committed, providing an effective cap on the spot price to the whole market (with the costs met by a levy on all market participants).

Comments are sought on the appropriate price(s) and conditions under which reserve generation should be offered to the system operator for dispatch.

Commission’s Toolbox of Powers

As outlined in the Government’s announcements, the Commission will have additional powers in its “toolbox” for delivering on the security of supply objective. These powers will be available as a backstop to help the Commission ensure that the market operates as efficiently as possible.

The toolbox includes power to set minimum requirements on generators to hold dry year reserves and long term financial contracts. The Commission will also be able to set minimum requirements on retailers and major users to hold long term financial contracts and/or maintain programmes for reducing demand when spot prices rise.

The Commission will be required to follow good process in exercising all its powers. The Electricity Amendment Act 2001 requires it to consult with affected parties and to have regard to a set of objectives specified in the Act before recommending rules or regulations to the Minister. The Commission is also obliged to deliver objectives set out in Government Policy Statements, and the Minister has specified powers to direct the Commission.

Levy to Recover Commission’s Security Costs

The revenue the Commission receives from selling reserve generation at the spot price is unlikely to be sufficient to pay all the Commission’s costs associated with contracting for reserve generation. The Commission will recover this shortfall through a levy on all market participants; for example, as an addition to the wholesale electricity price.

Comment are sought on whether a levy on wholesale electricity prices is fair and efficient, or whether some other form of cost recovery would be better.

Summary of particular matters on which comments are sought:

What is the most appropriate length of the contracts and how often should the Commission let tenders?

What quantity of ring-fenced capacity would be best and what is the best balance between new and existing generation in that portfolio?

What are the optimal price(s) and conditions under which reserve generation should be offered into the market for dispatch by the system operator?

Is a levy on wholesale electricity prices to recover the Commission’s costs for reserve generation fair and efficient, or would some other form of cost recovery be better?

Appendix One: Illustration of Proposed Scheme in Practice

The chart above shows how the demand for thermal generation varies with the level of rainfall (and hence of hydro generation). Demand for thermal generation can increase significantly in years of low rainfall.

The chart is illustrative only, and shows that some thermal plant will be required regardless of the level of hydro inflows. This plant (sometimes described as baseload or high load factor plant) will typically have relatively high capital costs, high energy conversion efficiencies and low variable costs per unit of output. Other thermal plant will run less frequently, in fact very infrequently in some instances. This type of plant (sometimes described as hydro-firming/peaking or low load factor plant) will typically have lower capital cost, lower energy conversion efficiency and higher variable cost per unit of output.

Our challenge is to ensure that the risk imposed by very dry years is managed by having adequate reserves of thermal generation capacity, recognising that the capacity needed for a very dry year might not be used for many years.

Recent experience has shown that the market will not necessarily deliver sufficient capacity to provide the level of security that the government believes is appropriate for New Zealand, taking into account the cost of additional security as compared to the potential for extreme prices and for disruptions to supply if the level of security is too low. Commercial players may not invest in capacity that might not be required for many years at a time, nor might they maintain ageing existing plant.


The chart below illustrates the Government’s proposed dry year reserve scheme.


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