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$5.4 billion in “excess profits” for energy generators

$5.4 billion in “excess profits” for energy generators over seven years - economist
A new report by a University of Auckland economist has found that in the seven years from 2010 to 2016, power generators pocketed an extra $5.4 billion in profits over and above what they would have if the wholesale electricity market was truly competitive – equating to 36 percent of revenue.

Dr Stephen Poletti, a senior lecturer in energy economics at the University of Auckland Business School, used computer modelling to simulate how energy traders in generator firms behave in the wholesale market, and compared it to how they would behave if the market was competitive – that is, if generators were forced to always sell power at cost. The simulation also factored in hydro dam water level data.

He demonstrated that the model was reliable and robust by checking simulated prices against actual prices. The model showed that ‘market power rents’ – the excess profits that generators are able to make – are “substantial” – totalling $5.4 billion over seven years or 36 percent of revenue, which is similar to or higher than those found by Stanford economist Professor Frank Wolak in 2009.

“It’s excessive, and we also know from the Electricity Price Review and other work that energy retailers are making excessive profits, too,” says Dr Poletti. “We should redesign the electricity market so that the profits are less and people pay less for electricity.”

(The independent price review found that New Zealand households are paying 79 percent more for power than they were in 1990 when adjusted for inflation.)

Currently, traders in Aotearoa New Zealand’s five generator companies ‘bid’ on supplying certain amounts of power into the wholesale market. This bidding operates a little like a deadline sale in real estate, except the drive is towards higher not lower prices: each bidder is blind to other bids, so the trick is to set the bid as high as possible but not so high that you are undercut by other bidders.

Instead, Dr Poletti prefers a system like the one used in PJM, a firm that coordinates the movement of wholesale electricity in Pennsylvania, Jersey and Maryland. “In the PJM system, generators have to bid in at cost of production,” he says. “This would lower prices for consumers. If prices are too low for new investment to meet future demand growth, long-term contracts for new generation could be auctioned off.”

Other options include a price cap or a ‘single buyer’ that would negotiate long term contracts for different types of generation reflecting their cost structure, he says. In particular, the capital costs for hydro dams paid for by tax-payers decades ago have long since been recovered. “The running costs for hydro are close to zero, which would be reflected in the low contract price offered by the single buyer.”

Dr Poletti also observed that the lowest bids (close to zero) across all generators are consistently close to the level of demand, however the price is set by higher price bids for the last few megawatts of demand. He says he would next like to investigate whether there is “tacit collusion” between generators such that, taken together, they avoid offering too much low cost supply whatever the state of demand.

Dr Poletti’s report, partly funded by Vector and published this week on the University of Auckland Energy Centre’s website, is called “Market Power in the NZ wholesale market 2010-2016”.
It notes that the New Zealand electricity market is one of the least regulated markets in the world. “The extent of market power in the…wholesale market is clearly a controversial topic….it is timely to re-examine this issue.”

The prevailing view in New Zealand is that excess profits are needed to recover investment costs in generator plants is “one that we haven’t seen expressed by regulators in other electricity markets”, the report says.

“The argument can of course be turned on its head. Market power rents…may have encouraged excessive investment that has led to an oversupply of capacity.”

Says Dr Poletti: “The hydro plants were built and paid for by taxpayers years ago – they don’t need to make any extra money to cover building costs, and maintenance costs are very low at around $5-10 per megawatt hour, compared to the average market wholesale price for hydropower of $70.”

Wolak’s report, done for the Commerce Commission, was criticised at the time by academics and policy-makers for the way it assigned value to the water used in hydro dams, among other things. Poletti’s report describes many of the criticisms as “tenuous [and] used to justify the prevailing market arrangements”. His modelling factors in water values robustly, he says.

“It is true that wholesale prices have stabilised or gone down a bit in the past few years – partly because of a lot of low-cost supply coming in like geothermal. But they’ve stabilised at a high level, and they’re much higher than they should be if the market was competitive,” he says.

Read Dr Poletti’s full report on the Energy Centre website.

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