Electricity Prices and Retail Competition - Report

Electricity Prices and Retail Competition

File: RN 2/6/3/1

23 January 2004

Minister of Energy

Electricity Prices and Retail Competition

Purpose of Report

1 To report on electricity prices and retail competition.

Analysis

Retail Charges

2 Figure 1 shows movements in retail charges since 1990 (all prices are nominal and GST exclusive).

Figure 1: National Average Retail Charge (Nominal) to August 2003

3 Figure 2 shows the same data as Figure 1 expressed in real terms (September 2003 dollars).

Figure 2: National Average Retail Charge (Real) to August 2003

4 From Figures 1 and 2 it can be seen that:

- Though nominal prices have increased steadily in recent years for all consumer classes, all consumers experienced a check in increases or a reduction in real prices coinciding with the commissioning of significant new generation capacity (Taranaki (1998) and Otahuhu (1999) combined cycle plants), and the introduction of increased competition in April 1999. More recently prices have been rising.

- Domestic prices have risen more rapidly than for other groups as cross-subsidies between domestic and commercial consumers were removed. Commercial consumers are still paying a premium price over an equivalent sized domestic consumer, but this could reflect their consumption at periods of high demand and high price (weekday, daytime).

- Smaller consumers in any particular class have experienced greater increases than larger consumers.

- Industrial retail charges were relatively static in real terms up to 1999 when a real reduction was experienced.

5 A more detailed breakdown of prices offered by competing retailers since 1998 is shown in Figure 3.

Figure 3: National Average Retail Charge (Nominal) for an 8000 kWh/year Domestic Consumer

6 Figure 4 shows the same data as Figure 3 expressed in real terms using the All-group CPI deflator.

Figure 4: National Average Retail Charge (Real) for an 8000 kWh/year Domestic Consumer

7 From Figures 3 and 4 it can be seen that:

- Since 1998 a range of prices have been available wherever there is competition. Typically this spread averages around 1-1.5c/kWh i.e. about 10% of the bill, indicating the potential savings for consumers prepared to switch to a competitor from the incumbent retailer.

- Nominal prices increased (for the incumbent retailer) by about 0.5c/kWh immediately after purchase of retail operations from the line companies. Given that most line companies sold customer meters to retailers, and line companies on average did not reduce their charges after the sale, the initial increase in retail price can be attributed to this transfer of metering costs to the retailers.

- Domestic prices are now increasing both in nominal and real terms, although consumers who have selected the cheapest tariffs are generally paying a similar amount in real terms as they were paying 5 years ago.

Line Charges

8 Figure 5 shows recent movements in line charges (all prices are nominal and GST exclusive) with the equivalent figures in real terms in Figure 6.

Figure 5: National Average Line Charge (Nominal) to August 2003

Figure 6: National Average Line Charge (Real) to August 2003

9 From Figures 5 and 6 it can be seen that:

- Domestic line charges for medium and large consumers have risen over the period in both nominal and real terms; those for small consumers have fallen.

- In nominal terms, commercial line charges have been static, or have fallen for smaller commercial consumers. However, commercial consumers with the same consumption as domestic consumers (e.g. small domestic and small commercial users who consume 6,000kWh/a, large domestic and medium commercial users who consume 18,000kWh/a) still pay a premium greater than 0.5c/kWh.

- In real terms, commercial line charges have decreased.

- Overall, commercial and domestic line charges have moved closer to each other as cross-subsidies have been removed.

- Industrial line charges have been static or have decreased marginally in both nominal and real terms.

10 A feature of Figures 5 and 6 is that there is no step decrease in line charges through the 1998/99 period. Line companies on average effectively retained a benefit with the sale of metering to retailers, at the time of the split between line and retail functions. This cost (equivalent to about 15c/day/customer or 0.7c/kWh for an 8,000kWh/year customer) was passed on to the retailer, and eventually to the consumer. Lines companies are now subject to the thresholds price control regime administered by the Commerce Commission.

Wholesale Price

11 Calculating wholesale prices is difficult given the differing mix of spot and contract prices in wholesale buyer's portfolios, lag effects with longer term contracts, volatility in spot prices, differing prices in various regions and so forth. However, the Ministry has made a range of assumptions to develop a modelled wholesale price for indicative purposes.

12 Figure 7 shows the modelled wholesale price over the last 10 years, along with the mean spot price and the New Zealand Tariff & Fuels price index .

13 Figure 7 also shows the long run costs of combined cycle gas turbine (CCGT) plant and, more recently the long run cost of geothermal energy and wind.

Figure 7: Movement in Wholesale Electricity Price (Nominal)

14 Our explanation for Figure 7 is that:

- Prior to 1998, fixed price contracts (and therefore wholesale prices) moved roughly in line with the long run cost of new generation (combined cycle gas turbines supplied by Maui gas under the Maui contract) (a comparison of grey and red lines with the solid black line).

- The commissioning of combined cycle plants at Taranaki and Otahuhu in 1998 and 1999 led to temporary oversupply in generation. This, combined with efficiency gains and downward pressure on prices from increased competition, caused fixed price contracts to drop towards the short run cost of CCGT plant.

- The 2001 winter shortage led to a reversion of fixed price contracts to the long run cost of CCGT plant again as it became clear that further new generation was required (a comparison of the grey and black lines).

- The shortage at the beginning of 2003, coupled with rapid decline in availability of Maui gas and the absence of significant additional gas for new generation led to a reassessment of price to that of the next generation alternative: geothermal energy and wind. Price setting generation stations might be expected on average to price up to the long run cost of new generation (a comparison of the grey and green lines).

- Although there has been some significant spot market price volatility since the 1999 ECNZ split, its influence on the average wholesale has been limited. This is largely because the generator-retailers are highly hedged such that their average price is dominated by the value of fixed price contracts (a comparison of the blue line with the red line).

Future Price Drivers

15 The Ministry's view, explained in the Energy Outlook report, is that the wholesale price is likely to be in the 6.5 - 8c/kWh range for the next 10 years under a range of scenarios, but there is a wide range of contingencies. Note that fixed price contracts have recently been at around the 7c/kWh level.

16 Factors that could have an upward influence on wholesale prices include delays in construction of significant new generation, retirement of major power stations, commissioning of LNG import facilities or limits on the availability of some generation options such as wind, geothermal and hydro. In the latter event, prices could lift to that of CCGT with premium-priced gas, or to the price of a South Island coal-fired station. The following new entry prices have been suggested in the latest MED Energy Outlook to 2025 for potential generation options. Charges to implement Government policies to improve environmental outcomes and security of electricity supply will also affect costs.

Generation Option Unit Price (c/kWh)

Project Aqua 4.5

Other Hydro 7.0-8.5

Geothermal 6.2-8.5

Wind 6.2-8.5

Gas (CCGT plant - based on indigenous gas) 5.7-7.7 (+0.8 for Carbon Charge)

SI Coal 6.1-7.1 (+1.5 for Carbon Charge)

NI Coal 8.3-9.4 (+1.5 for Carbon Charge)

Gas (CCGT plant - based on LNG) 8.5-10.6 (+1.0 for Carbon Charge)

17 Factors that could have a downwards influence on wholesale price include construction of major new low cost generation facilities e.g. Project Aqua (any major new station would suppress prices in the short term), new gas discoveries, broad efficiency improvements or reduced demand from some major electricity users.

18 In terms of delivered energy prices, major upgrades in the transmission grid required over the next decade may put upward pressure on transmission prices. At the same time, there will be downward pressure on line prices generally through the threshold price control regime.

Retail/Wholesale Margin

19 Figure 8 below shows a mean retail "energy" price (delivered energy less line costs) , the modelled wholesale price and long run marginal generation costs.

Figure 8: "Energy" Charges, Wholesale Prices and Generation Costs

20 Figure 9 shows the retail/wholesale margin in nominal and real terms (after deduction of meter charges which transferred from lines to retail)

Figure 9: Estimated Movement in Retail/Wholesale Margin (excluding meter charge)

21 From Figure 9, the retail/wholesale margin (after deduction of meter charges) clearly has been more volatile since 1998/9. There was an increasing trend from 1995 through to 2000, but this trend has now been broken. There is an indication that the margin may be on a lower path now, but given the instability it is too early to be sure.

22 The average retail/wholesale margin (after deduction of line and meter costs, but still leaving in other customer service costs e.g. call centre, billing, etc) is about 1 c/kWh i.e. approximately the same as in 1998.

23 An alternative and more recent set of data (Figure 10) tells a similar story.

Figure 10: Recent Movement in Domestic "Energy" Charge when Compared with the NZTF Industrial Index

24 From Figure 10 it can be seen that:

- The margin between the incumbent "energy" charge (for the average domestic consumer) and new fixed price contracts increased after the initial reforms. (Note however that most retailers would have been paying higher prices in long term contracts).

- Margins were squeezed by the increase in new contract prices after winter 2001.

- By the beginning of 2003 the gross margin (including costs for meter and meter reading, billing and customer services) for domestic customers was up to about 2.5c/kWh, but has again been squeezed by the latest increase in contract prices.

25 Recent price increases appear to be moving towards the levels seen in the period around 1998.

Retail Competition

26 Retailers have taken time to increase the areas in which they compete. Only Contact, Empower (owned by Contact), Meridian and TrustPower could be considered as nation-wide retailers, at least at domestic/commercial levels, while other companies tend to be focussed on the North Island. Mighty River Power, for example operates largely in the North Island although it does market to some South Island industrial customers, and also nationally through a specialist farm-based retailing arrangement.

27 While tariffs may be made available, there is rarely active marketing of these. For Time-of-Use industrial/commercial customers, there are frequent reports of the retailers having to be chased to get any firm offers.

28 The following graph shows the increase in number of competitors over time.

Figure 11: Increase in retailer competition for domestic consumers (showing number of retailers in each line company area)

29 Information supplied by M-co indicates that 78% of customers as at 30 June 2003 were supplied by the incumbent retailer.

30 Also, disclosures by line companies indicate that around 55% of electricity by volume is still sold by the incumbent retailer.

Conclusions

31 After 5 years, there is still insufficient data to definitively state whether the retail/wholesale margin has changed significantly since 1998/9. This is because:

- It is now difficult to determine the true mean wholesale price (including the impact of all financial instruments), and

- There have been major fluctuations in the components of the wholesale price which have dwarfed changes in margins (e.g. the surplus generation following construction of CCGTs in the late 1990s, the dry hydro years in 2001 and 2003, and the early depletion of Maui).

However, there is no clear evidence of a step change in margin policy. Evidence points to maintenance of a similar margins before and after the reforms.

32 Recent increases in retail price can be related to the increased cost of new generation (and a shift in generation type). The margin between mean retail prices and the costs of new generation appears to have kept reasonably constant following the reforms, though possibly having increased slightly over the last two years.

33 Typically the customer service costs are now allocated on a cost per customer rather than a cost per kWh basis. As a result, the retail charges (when expressed on a unit basis) for smaller consumers have tended to increase relative to those for larger consumers in the same class.

34 There is evidence that competition is slowly increasing with a slow migration of consumers away from incumbent retailers.

Recommended Action

This report is for noting.

Brian White

Senior Advisor

Electricity Group

Resources and Networks Branch

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