Friday, 9 November 2001 Media Statement

Electricity: Post-winter Review - Summary of Submissions

Acting Energy Minister Paul Swain says the Government’s review of the way New Zealand’s electricity system functioned over the winter is progressing well and to schedule.

“The period for making submissions and cross-submissions has now ended,” Paul Swain said.

“A comprehensive summary of submissions has been prepared and today was posted on the review website, www.winterreview.govt.nz.”

“The points made in the summary are those of the submitters. Forty-seven submissions were received in the first round and twelve cross-submissions were received. The submissions have come from a good cross section of industry and users and provide valuable insights into the issues surrounding the winter supply period.

“Cabinet will be considering policy proposals to address the issues arising from the review in December and Government decisions will be announced before Christmas.” Paul Swain said.

In September the Minister of Energy announced the review in response to concerns among electricity consumers and industry participants about whether the market worked properly under dry-year conditions. The purpose of the review is to identify whether further changes are required to electricity market arrangements

A summary of key points made by submitters is attached.

Technical information contact Ross Milner - Team Leader - Energy Markets Policy - MED ross.milner@med.govt.nz / 04 474 2904

Summary of submissions www.winterreview.govt.nz

ENDS

POST-WINTER REVIEW OF ELECTRICITY SYSTEM:

Key Points from Post- Winter review summary of submissions.

1 What factors contributed to wholesale electricity market developments in the 2001 Winter?

- The causes of the developments were drought combined with unusually high demand for electricity. A wide range of other factors exacerbated the situation.

2 How effective were existing market arrangements in responding?

2.1 Overview

- Opinion was divided on whether the market had responded effectively to the events of winter 2001. Those that thought it had said prices had risen in response to supply limitations and increased demand, sending signals about the need to reduce consumption.

- Those that thought it had not pointed out that Government intervention, appealing to the public goodwill, had been necessary to achieve savings.

- Some suggested that wholesale spot prices had over-reacted to the situation and reached unreasonably high levels.

- Industrial consumers exposed to the spot market considered they had been unfairly disadvantaged relative to customers protected by hedges and retail contracts.

- Some said that favourable market and environmental conditions during the preceding few years had made some electricity purchasers complacent, leading to a low level of risk preparedness.

2.2 Supply side

- New Zealand is heavily reliant on hydro-electricity and this inevitably means that New Zealand is exposed to dry year risk.

- Concerns were raised over the timing of fully activating thermal plant during 2001. Delays were said to have contributed to excessively high spot prices. Others considered that thermal generation responded appropriately to price signals.

- Concern was expressed about the management of hydro resources by generators.

- Many said that New Zealand has inadequate reserve capacity and that existing market arrangements failed to adequately reward generators for providing reserve plant.

- Barriers to the development of new renewable and distributed generation were noted.

2.3 Demand side

- Wholesale price signals were not passed on to many consumers who are shielded by fixed price contracts. This limits demand side responsiveness to market signals.

- It was suggested that the ability of consumers to respond to price signals, particularly short term price spikes, is limited.

- Several submitters said the current market arrangements present barriers to demand side management, particularly in terms of access to information, lack of real time prices and the 2 hour bid rule.

2.4 Transmission

- Transmission constraints were widely regarded as a barrier to effective competition and market efficiency. Constraints exacerbated supply problems during winter 2001.

- Recent grid investment was considered inadequate. There are inadequate incentives for transmission investment.

- Transpower’s focus on maintaining system security was seen to conflict with the need to relieve grid constraints. Transpower, however, explained that a grid entirely free of constraints would be economically inefficient.

- Transmission losses represent a significant waste of energy.

- Lines companies have different approaches to dealing with transmission rentals. This was seen as inequitable for consumers.

2.5 Risk management instruments

- Submitters had widely varying perceptions of whether adequate hedges were available during 2001.

- Some (principally consumers) argued that hedges were in short supply.

- Generators argued that hedges were available, but at prices higher than buyers were prepared to pay. High prices reflected the risk faced by suppliers during a dry winter.

- Some said that favourable market and environmental conditions during the preceding few years had led to a low level of risk preparedness.

- It was pointed out that no effective tools currently exist to hedge against transmission loss and constraint risks.

2.6 Retail competition / market power / vertical integration issues

- The vertical integration of generator/retailers was seen by many to limit market competition and restrict the availability of hedges. Vertical integration was regarded as a barrier to entry to the retail market.

- Many submitters argued that the market is dominated by a relatively small number of generators, with limited opportunity for demand side influence. Some suggested the high spot prices of winter 2001 may have reflected the market power of generators.

- NZEM disagreed that market power had been demonstrated. M-co said that if they did, then this was a matter for the Commerce Commission to deal with.

2.7 Other market arrangement / design issues

- A wide range of submissions said market efficiency is hampered by the inability of participants to make informed decisions because of limited access to key information.

- The system of rewarding cleared bids at the marginal clearing price was criticised as inefficient. Others disagreed, and said the alternative, "pay as bid" pricing, would result in higher prices overall and out-of-merit order generation.

- It was suggested that current nodal pricing (including the use of marginal losses and constraints to determine prices) limits market efficiency. Other submissions explained that using marginal losses was the most efficient option.

2.8 Ownership issues

- Several submitters were concerned that the Government’s involvement in the industry exposed the public to unnecessary market risk, and created market inefficiencies.

3 What changes should be made to market arrangements?

3.1 Overview

- Suggested solutions ranged from relatively small adjustments (such as improving access to information) through to radical redesign of the market or doing away with market arrangements altogether.

- A key debate was over the need for greater or lesser regulation of the market in the public interest.

- A number of submitters opposed greater regulation and argued that the market provides the best means of managing risk and sending signals to suppliers and consumers.

3.2 Supply side

- Various approaches were suggested to increasing the supply of reserve generation, including creating market incentives for generators, establishing various insurance schemes and imposing legislative requirements on generators. The importance of ensuring the market provides genuine incentives was noted.

- The need for incentives to facilitate investment in new renewables (particularly geothermal) and distributed generation (and to remove market barriers) was noted.

- The further break-up of generating companies to increase competition was suggested.

3.3 Demand side

- Many submissions recommended that all end consumers be exposed to some degree to wholesale price volatility in order to improve demand side response. Others cautioned that domestic consumers were not well-placed to respond to short term price rises and would prefer price certainty over volatility.

- Some support was expressed for real time pricing as a means of facilitating demand side management. Others said the effectiveness of a real time market would be limited by consumers' limited ability to respond.

- It was suggested that significant advances in demand side management would be made possible by updating local distribution technology and better management of load through local lines networks.

3.4 Transmission

- Many submitters recommended upgrading the national grid to remove constraints and improve security.

- It was suggested that better incentives are needed for transmission investment and a long-term strategic approach to investment should be taken.

- Transpower recommended developing contingency plans to cope with constraints in times of supply shortage, and also noted that a constraint-free grid was not a realistic proposition.

- A review of the treatment of transmission rentals by lines companies was recommended.

3.5 Risk management instruments

- Many submissions advocated greater liquidity in the hedge market and greater availability of hedges.

- The mandatory offer of hedges was suggested by some to improve retail competition.

- Opponents of mandatory hedges said that denying companies the full benefit of internal hedging would lead to increases in spot prices and less overall system security.

- Support was expressed for the development of financial transmission rights (FTRs) as a means of hedging against transmission loss and constraint risks.

- A number of reservations were expressed regarding the introduction of FTRs, particularly in terms of their potential to exacerbate generators’ market power. Market competition issues should be addressed before FTRs are introduced.

3.6 Retail competition / market power / vertical integration issues

- A large number of submissions recommended the separation of the generation and retail arms of vertically integrated companies, to improve competition and liquidity in the hedge market.

- Generators and M-co argued that vertical integration was a legitimate risk management tool, allowing companies to internalise market risk, provide greater price stability to customers, and enhance backing for new generation investment.

3.7 Other market arrangement / design issues

- A comprehensive review of the NZEM rules and/or the structure of the market was recommended. The importance of taking an holistic approach rather than dealing with specific problems in an ad-hoc manner was stressed.

- Others argued against significant reform at this early stage of the market’s existence, and said urgent matters such as the development of new generation capacity should take priority.

- A review of the marginal clearing price system was recommended.

- Replacement of the ex-post wholesale market with an ex-ante market was recommended.

- Some suggested imposing price caps to reduce consumer price volatility. Others strongly opposed this on the grounds that price signals would be retarded.

- A range of changes were recommended to the Electricity Governance Board and proposed rule book to ensure the market is able to deliver the outcomes required by the Government Policy Statement.

- Submitters identified a wide range of market information which, if more readily available to market participants and the general public, could improve market efficiency, demand side management and generator bidding behaviour.

3.8 Ownership Issues

- Two suggestions regarding Crown involvement in the industry were made:

ƒ{ the Government should divest its retail and generation interests; and

ƒ{ SOE generators should be converted into Crown Owned Companies.

3.9 Contingency Planning

- There is a need to develop contingency plans for dealing with extreme circumstances. This would speed up the response of suppliers and consumers.

4 What changes to the Energy Efficiency and Conservation campaign should be considered?

- Analysis of the 2001 campaign and its results to identify where effort should be directed in future was recommended.

- Improve access to demand information for consumers and those charged with encouraging conservation.

- Problems with the measurement of savings need to be addressed.

- A range of specific energy-saving measures were suggested.

- There is a need to focus on achieving long-term energy consumption savings.

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