The Commerce Commission on electricity markets: part 2

I posted earlier on The Commerce Commission on electricity markets arguing that I had problems with the use of a perfectly competitive benchmark to arrive at the well publicised "$4.3b ripoff" figure.

Well it now looks like I'm not the only one with problems to do with the use of a competitive benchmark and with the way the results of the study have been interpreted and reported-note the quote from Colin Espiner I included as Update 2 in my previous posting.

There is a critique from Energy Link Ltd. Unfortunately this report is available only as a pdf file. Their report states,

But measuring the degree of “unhealthy” market power solely against the textbook perfectly competitive market is not appropriate given the over-riding need to preserve security of supply and the realities of electricity supply which diverge from the perfect market assumptions. The market‟s problems must be assessed through analysis based on realistic assumptions, and addressed in the context of an imperfect market which can and should be able to function in a way in which the imperfections can be managed, mitigated or otherwise controlled.

Also at interest.co.nz they quote a statement from the Energy Centre in the University of Auckland Economics Department and the Electric Power Optimization Centre in the Department of Engineering Science.

In part the statement reads

However, we disagree with Professor Wolak’s assumptions in calculating market rents in dry years. In his report, Professor Wolak has chosen competitive benchmarks in which either hydro‐electricity dispatches are fixed, or the opportunity cost of water is set equal to the marginal cost of the highest cost thermal generator.

Drawing on an analysis of the California electricity market in the American Economic Review, he claims that these models of hydro‐electricity costs overestimate the true opportunity costs. However, in the New Zealand setting, we believe this is incorrect, because it ignores New Zealand’s likelihood and resulting costs of running out of water. Whereas California always has the option to import electricity from other states, New Zealand faces rolling blackouts and considerable economic losses if hydro lakes run out of storage. In the face of shortages, the (risk‐neutral) opportunity cost of using water today must account for the probability of a blackout in the future and the economic cost of that blackout (often named the Value of Lost Load).

The California paper Wolak cites does not make any estimate of shortage costs, yet these shortage costs are likely to be higher than the marginal cost of thermal generation. As water levels fall, the probability of incurring these costs will rise to a point where the expected opportunity cost of water will exceed the most expensive thermal plant. If this is correct, then the Wolak report overstates the amount of market rents during dry years.

We also take issue with the interpretation of the Wolak report’s estimate of NZ$4.3 billion in market rents. The media has claimed that this represents a transfer of wealth of NZ$4.3 billion from consumers to generators. This is a misinterpretation of the results of the analysis.

Wolak himself, on p173 note 313, cautions that these figures relate only to the wholesale market. Market rents are a measure of the difference between spot prices and generator costs. Most consumers do not pay these spot prices. During dry years, the actual retail price consumers pay is well under the spot price. In theory, the retailer will turn around and pay the generator the spot price, but since they are vertically integrated, this amounts to an internal transfer of funds between different arms of the same company, with zero net effect. Generators will typically have other fixed price contracts in addition to retail load, so in practice they will only receive market rents as actual earnings for some fraction of their generation.

Thus the true transfer of wealth from generators to consumers during periods of high wholesale prices is likely to be much lower than Wolak’s estimate of market rents, even ignoring the way he estimates hydro costs. It may be the case, as Professor Wolak speculates, that high spot prices during dry years will be passed onto consumers in the form of higher retail prices in the future, but this has not been established conclusively by his report.

Likewise caution is warranted when claiming that recent retail price rises (residential as well as commercial/industrial) are attributable to these market rents. As underlying input prices have risen significantly over the last decade (e.g. gas from NZ$ 3.14/GJ in 2000 to NZ$ 6.3/GJ in 2007), even in a perfectly competitive market, wholesale and retail electricity prices would have risen significantly.

Thus I think it is far to be sceptical as to whether or not anyone has been ripped-off and if someone has, the size of that rip-off.

One good thing to say about the Commission's actions is that they are taking no action. Their media release says,

This behaviour does not meet the criteria of ‘taking advantage’ of market power for a proscribed purpose, namely the hindering or deterring of competitors, under section 36 of the Act, and is therefore not a breach.

So they at least seem to have done the right thing, nothing. Albeit for the wrong reasons.