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Michael Cullen Address to Energy Trusts of NZ

Michael Cullen Address to Energy Trusts of New Zealand

Thank you for your invitation to lunch today. Given the recent events in California, the north east of the North American continent and in London, you could not have timed this conference better.

It is important that we learn the lessons from those dramatic incidents, but it is just as important that we do not take the wrong lessons from them. It is important that we review our approaches to electricity supply in the light of new global experiences, but it is just as important that we do not panic in response to new experiences. It is important that we take the opportunities available to us, but it is just as important that we recognise and reject opportunism in those who seek to make gain from the misfortunes of others.

There are probably four high level lessons that we should learn from recent global experiences with electricity systems.

Firstly, they are complex, and it is very difficult to get the regulatory system right. In California, the complexity of the situation is such that the voters are thinking about electing a time-travelling cyborg to manage what some may see as being beyond the ken of mere mortals.

Second, there are very large and inescapable trade-offs lurking within that complex system. At a very general level, the system can spend a lot of money well in advance of it being needed, to increase generating and transmission capacity, and in general that will tend to increase security of supply. It will also tend to increase costs. It is not at all clear how those costs are recovered within a competitive market. Consumers tend to want low prices, and only with hindsight demand that the extra costs should have been incurred.

Third, electricity systems are tested under extreme conditions. Installing capacity and operating systems that are sufficient to meet the extremes, means that they will generally be over-engineered for most of the time. Those costs must be met somehow.

Finally, demand for electricity grows gradually, and pressure on systems builds relentlessly, but big supply side responses are slow, so there is always a risk of demand and capability being out of step.

I might add a fifth lesson, but this is more a political lesson than a systemic one. The lesson is that we have seen problems with electricity systems and regulatory regimes in the richest and most technologically sophisticated market economies in the world. I hope we can bury once and for all this misguided nonsense that if any electricity system malfunctions it is a third world system. We are talking here about an ongoing struggle to get to grips with a difficult infrastructure management issue for sophisticated and technologically advanced communities.

I think that these are close to the limits of what we can learn from recent global experiences. Our problems have very New Zealand origins and features. For a start, we are an island economy, and cannot import electricity from a wider supply source. There are extra pressures on our system to be self contained.

Second, we have adequate generating capacity. Our problem is with the cost, availability and environmental sustainability of the fuel sources needed to drive that generating capacity at different times of the day and year, and at different times in the hydrographical cycle – in other words when it doesn’t rain as much as usual.

We have particularly difficult technological and regulatory problems to deal with given our geography, and where electricity users live in relation to where the power stations are located. I will give one small example of this. We need the Cook Straight cable to get power from hydro generators in the South Island to electricity consumers in the north – and at times to get thermal generation flowing the other way. How do we price that?

I could argue that without the cable, northern consumers wouldn’t have the power, so the total cost should be recovered from a levy on North Island consumers. I could also argue that without the cable, lines companies like yours would struggle, so could suggest that the bill be left on the table at a conference like this and you sort it out. I can also argue that without the cable, southern hydro stations would be selling into a buyers market, so they should pay for the cable. Finally, I might say that the cable is simply a part of the transmission network and because from time to time power flows the other way, all consumers, or all lines companies, or all generators should cover the cost.

Anything between zero and one hundred percent of the cost can be loaded anywhere between the generator and the final consumer and there is a logic available to defend that cost apportionment. Where is Solomon now that we need him?

Finally, we have the legacy problem to deal with. Our electricity system was broken up and deregulated and placed in a profit driven market mechanism at a time and circumstance that was enormously beneficial to consumer interests.

The vast Maui field had been discovered and developed, the dams had been built, and the transmission grid had been laid. There was a vast sunk cost with very low operating expense required to run off it. I have said before that one industry expert has described that cost structure as akin to the costs of running a nuclear powered system but without decommissioning expense. It was a cost structure that was a fortunate coincidence of history. It probably never existed in such happy coincidence ever before and will never exist in that form ever again.

The effect of deregulating into that world was that electricity prices here were driven by low marginal costs. Not only were they close to the lowest in the world, but they were not high enough to stimulate and encourage investment in reserve generating capacity. They encouraged generators to match capacity with customer. Our natural exposure to problems with fuelling the system to meet peak demand in dry years was accentuated.

In the meantime, demand for electricity kept rising as the economy grew and that growth took on an energy intensive form: higher immigration, conversion of dry stock farms into dairying and so on. Maui was always going to run out, but it ran out a few years earlier than expected.

We are now in transition from that unusual state of a lot of capacity and abundant cheap fuel, to one where we need to stimulate and reward investment in extra capacity and the expansion of our fuel stocks in whatever form that may take. The absolutely inescapable result of that is that prices will rise. The issue is the extent and pace of such rises, the capacity of users to adapt to the price structure that emerges, and the role of any regulatory system in shaping the transition.

The government has not taken the view that this is simply a market matter and the chips will fall where they fall. A lesson from the last few months is that we underestimate our dependence on electricity in the modern age at our peril. It is just too important and – let us face this fact – too much under the control of natural and partial monopoly operations to leave scarcity as the mechanism that drives an increase in supply.

What we have tried to do is to avoid the extremes: avoid saying that security of supply has to be guaranteed at any price or that we must guarantee cheap power. Security of supply is relative, not an absolute. There will be times that in order to maintain overall security of the electricity system, some uses are scaled back temporarily.

So what, then, is our policy? First, the objective. The overall objective is to ensure that electricity is generated in an efficient, fair, reliable and environmentally sustainable manner to all classes of consumer. There are trade-offs within this objective. Something that may be efficient from a cost point of view may not be environmentally sustainable. Something that is reliable, like power from coal, may not be efficient in an energy conversion sense. Something that is not efficient in either a cost or energy conversion sense may become so as a result of technological improvement.

Next, the mechanism. We did not favour some heavy handed central authority making these trade-offs and second guessing the path of best technological advance. We favour industry solutions where possible, but are prepared to use regulatory solutions where necessary. Neither should be seen as being set in concrete. Industry agreements can start to unravel and require a regulatory stitch. Regulatory solutions may be overtaken by improved industry self regulation and become redundant.

In making judgements about how each is working, the government will apply some basic benchmark standards. One is that we seek to reduce cross-subsidies distorting generation and distribution decisions. The full cost of producing and transporting each additional unit of electricity should be signalled so that investors and consumers can make decisions consistent with getting the most value from electricity. I stress that it is both investors and consumers that are seen to be beneficiaries from the fact that electricity is an economic good with inherent value.

The government sees the need to encourage and recognise the role of the investor in this industry. Somebody has to invest if the lights are going to stay on, and the costs of that investment have to be recovered from somewhere. There is no point in pretending that we have either a free lunch or a captive provider that we can exploit.

If I can be very specific, I can say that the current proposal to Parliament is that the Electricity Industry Reform Act be amended to allow lines companies more scope to invest in thermal and conventional renewables like hydro and geothermal plants. Current restrictions are to the greater of 5Megawatts or 2 per cent of line company maximum demand. The proposal is to multiply both limits by five. Lines companies will be able to invest in new renewables energy generation without limit, as is the case now.

A key reason for the original restriction on lines companies investing in generation was to minimise the risk of cross-subsidy from the captive customers of lines companies to the competitive generation sector. Now, the scope for lines companies to take monopoly profits has been limited by the thresholds price control regime implemented by the Commerce Commission.

In addition, the government proposes that lines companies be permitted to own any generation without restriction where that generation is contracted to the Electricity Commission as reserve capacity. This will provide for greater competition with existing generators for tenders let by the Commission for dry year reserve, which will help to keep the costs of reserve capacity down.

The flip side of the recognition of investor interest is a recognition of the consumer interest. This is an industry where natural monopoly, practicalities of cost and size of the market, and temporary shortage can create opportunities for taking more from the consumer than is consistent with long run national interests and a stable industry structure.

We will promote enhanced competition where possible, and where it is not will seek outcomes that mirror as far as possible those that would apply in competitive markets. That is easy to say and not so easy to do, because with timing delays and lumpy investment, alongside highly variable demand and unpredictable fuelstocks, what would apply in a competitive market is itself very subjective and speculative.

We are on a journey. The deregulated and competitive market has delivered some very good efficiencies and lower prices, but it has not been seamless and painless. Industry self-regulation has proved elusive. If you want to explore this episode in more detail, the Cabinet paper on the attempt to get it up and running is posted on the MED website. There is a wonderfully understated three-word sentence in that paper. “Positions are entrenched”.

I don’t think that entrenched positions need to stay entrenched forever, but for now they are a reality that the government has to recognise and respond to. The response is the Electricity Commission, which is forming. The Commission is a reflection of our need to use regulatory solutions where necessary.

This is the next stage of our journey, and we will wait and watch in positive anticipation of a good result.

I must say, though, that by and large we have managed very well. When you think that our electricity system is a sealed unit, supplying a small market spread out across an extended and challenging terrain, and dependant on a somewhat fickle source of fuel, the mix of price and reliability of supply that has been achieved in practice, not just in theory, is world class.

If we look at the experiences of other countries in grappling with deregulated electricity markets and growing demand, our results stack up. They stack up, in my view, for two main reasons. One is that we haven’t taken a rigid ideological position, but have been prepared to watch and learn and adjust in response to what needs to happen. We have fine tuned the machine. We haven’t tried to fix it where it isn’t broken and we haven’t pretended that the broken bits will work in theory even if they don’t work in practice.

The other reason that our system has worked is that there has been a remarkable expression of national unity of purpose in adjusting to and managing through periodic difficulties that we all accept are beyond direct and material control. New Zealanders have not expected the government to make rain. It is that national unity of purpose and the expression of community that gives me confidence that we will continue to match and beat the rest of the world in managing this complex area of policy in an increasingly complex technological world.

This is probably where my theme meets your purpose. You are community energy trusts. My theme is that while we use a mix of market and regulation to supply this essential product in an efficient, fair, reliable and environmentally sustainable way, at the end of the day this is a community project.

If we try and do it without community involvement and community support, we will simply compound the problems of managing this complex problem. That, at the end of the day is the lesson we learned from the excessive deregulation of the 1990s, and that was repeated with the response of New Yorkers to their crisis: you simply can’t buy or beat community spirit.

My best wishes to you as you work through a very full and challenging agenda.

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