It's fairly easy to see why consumers don't trust the electricity industry?

The electricity industry has a habit of getting very concerned about giving customers 'correct' price signals. Obviously you know when you are in monopoly when you have this discussion because in a competitive market you price to the market. All the economic 'correctness' in the world doesn't matter a jot if customers won't buy.

In my last post I suggested it is the absence of property rights for customers (which then flow back to suppliers by having to meet the contracts with customers) that is causing all the retail market problems. I can understand if this might seem like just another attempt to 'beat' the customer with economic 'correctness' but I think that property rights would actually improve things for customers. While property rights would limit the 'all you can eat' electricity tariffs that New Zealand has traditionally enjoyed, it would also allow customers to start negotiating for different service terms rather than just getting 'correct' economic signals. This would add a significant extra dimension to electricity retailing; and more dimensions means more differentiation between retailers.

The problem with how the industry operates currently is that power system engineers decide how demand will be met under an 'all you can eat world' and then customers have to pay. However, as engineers and economists are frightfully concerned that 'all you can eat' is wasteful and costly they then start designing (as only monopolies can do) 'correct' price signals. And let's be clear, in the absence of property rights to trade off, or trade up, and good information then 'correct' price signals are really only penalty fees. Which is why electricity consumers generally feel like they are being beaten upon because electricity pricing in New Zealand is, effectively, sunk cost recovery with penalties for 'bad behaviour', with no meaningful guidance on how to behave 'better'.

The belief that smart metering will help is slightly misguided as well. Smart meters will provide better information but smart meters don't actually create proerty rights. They could help enable property rights but this isn't the role that is being anticipated for them. All they will do is 'help' people to behave the way that some engineer and/or economist and/or politician thinks they should.

Introducing property rights into the current electricity industry is problematic I admit. However, until each customer can choose to elect for bulk power deals, volume limits, top up payments, prepayment, and even local reliability and voltage levels then the engineers, economists and the politicians will always have their favourite playpen. And, maybe, just maybe, this is why there has never been a proper review or study on New Zealand's retail market design - too many control freaks want control.

A new view on electricity market reforms

I recently went through a thought exercise on how the electricity market might look like if it had:

• been developed under a more commercial framework for customers,
• achieved sensible commercial terms despite aspects of natural monopoly,
• due to the different dynamic imperatives created above developed new technology.

My conclusion from this experiment is it is the retail electricity market that is badly broken, but this causes significant problems upstream particularly with lines businesses (including Transpower). In fact all problems with all aspects of the market stem from a key primary problem - property rights (or rather absence of).

My contentious starting point is that the early mid twentieth century's preoccupation with socialising everything is the source of a great deal of current woe when it comes to infrastructure generally, and particularly electricity. Now for the avoidance of doubt I see absolutely no problem with the cooperative model for developing local electricity supply. This is how electricity reticulation started and I believe a co-op was the only way that this could have begun.

The co-op wasn't the problem, the problem was these co-ops were given local authority state monopoly status, which immediately made the management of them extremely attractive to politicians, control freaks and meddlers. Rather than granting these statutory monopolies for misguided reasons of efficiency they should have had to compete with rival networks. The regulatory effort should have gone into mediating the disputes between rivals to ensure that economic terms were met for connection and interconnection. I must admit it is here that my thought experiment is a bit idealistic. I am assuming that economic terms for connection and interconnection would, ultimately, have been reached if the regulatory effort had been directed at preventing monopoly barriers and pricing.

The key thing that I think should have been different is that the connection of a new customer should have been a negotiation. The new customer should have been allowed to negotiate for terms. Even if the new customer chose the vanilla offerings then this should have been established by contract that specified capacity, volume, price, reliability and quality. If these property rights had been established from the outset then we would not have the mess we now have.

Immediately the argument usually comes back that this is too complex for consumers but this is clearly self-aggrandising b-grade ollux. It is obvious that consumers are easily able to come to terms with capacity limits, pricing plans for off-peak minutes, prepayment options that variablise everything at a higher rate, differentiated service for capacity (base capacity or excess) and different quality options. They are just as clearly (in aggregate) able to optimise their own values and preferences when given the chance (we've only being doing it for 5,000 years).

Some engineers will often tell you that the technology doesn't exist to do such things but this is not true, and a failure of imagination and innovation. Load control (for example) is a form of differentiated capacity service with differentiated reliability standards. If property rights had been established and respected from the outset then all the useful technology would already exist.

Here, then, is my thoughts on what needs to happen to properly reform electricity markets (notwithstanding that I don't believe that this would ever happen):

1. Make the customer's retailer the agent for all aspects of their electricity supply, including capacity, energy, price, reliability and quality (and guarantees and warranties).
2. Establish the implied contracts with existing customers and establish their existing property rights (this includes standard contracts that all parties must accept).
3. Allow customers (through their chosen retailer to negotiate new terms - ie, capacity, quality, reliability); but the retailer and the customer must establish the technology to enforce the new terms.
4. Completely redesign the registry to provide a central record of these property rights for lines service and energy service.
5. Transition to the point where a retailer can negotiate with any potential provider of energy or lines service where the incumbent lines company can only require that reasonable standards are met for connection and interconnection.
6. Establish methods to aggregate the consumer contracts to establish the bulk energy and capacity requirements of the retailers.
7. Require the retailers to establish that they have sufficient access to capacity and energy to meet their obligations (remember this is back to back with contractual limits on customers).
8. As part of 7 require Transpower to make available the implied capacity rights for the grid and define the standards of reliability and quality.
9. Only allow Transpower to recover revenue through negotiated contracts for capacity, reliability and quality (yes, they must take risk).
10. Allow any alternative provider of transmission service to connect to Transpower's network subject to meeting reasonable standards for connection and interconnection (but they must also contract to meet service specifications)
11. Redesign the wholesale electricity market (including hedging platforms) to ensure purchasers can meet and manage their obligations to their customers.
12. Otherwise leave the wholesale market to optimise efficient generation dispatch.

I know this is hard to do and would require significant transition planning. And great care would be needed to ensure that customers aren't immediately disadvantaged (although customers would have to accept that the established property rights are also obligations on them).

Despite this being hard I am firmly of the view that until customers are enabled to make their own trade-offs and select their own preferences for service, volume and price rather than being at the whim of central planners, control freaks, politicians, vested interests and meddlers then electricity will always be a mess.

I think some people believe smart metering is the answer but, unless property rights are first established, then smart metering will be just like all the other reforms so far. Overlaying economic incentives on a badly designed retail electricity market (actually never designed retail electricity market) is like tying a horse's legs together and then whipping it until it goes faster. The whip may be a good incentive to go fast but the biggest gain is achieved simply by untying the horses legs. The problem is, of course, the horse is going to be very angry as you try to let him go.

Electricity Prices - cause or effect?

It is not uncommon to see regular commentary on how low electricity prices are necessary for productivity and economic growth. Now obviously everybody wants what they want to be cheap (well actually they probably want it to be free but most people recognise that anything worth having will have a cost). When it comes to electricity prices, though, it would seem that they are more of an indicator of wealth than a causal input.

There are certainly many energy intensive industries where the cost of electricity (or other energy forms) is a major factor in their viability. Some of these businesses can be quite large and so their total economic contribution can be significant. Nevertheless, their value add to the economy (sales in excess of costs) is relatively small. In other words if your economy relied entirely on these industries you wouldn't be very rich (someone would be, of course, but not many people).

For most businesses (and most economies) energy costs are a relatively small cost in the economy; and most of this cost is transport. Electricity (and with most other utilities added in) will usually be well less than about 3% of an economy's input costs. This tends to mean that economic growth is not significantly effected by the price of electricity. However, most businesses rely heavily upon the electric energy service.

There are a signifcant number of factors that affect the relative electricity costs between nations but, all things being equal, low electricity prices tell you two things. First, demand is relatively low and, second, (prima facie) so is the willingness to pay. Another way of looking at this is that such a nation isn't doing very much and isn't making a lot from not doing it. Alternatively a nation with high electricity prices (certus paribus - everything else being equal) has high demand and high willingness to pay, ie doing much and earning much.

Now I am not trying to say that a nation is better off with high electricity prices - obviously the same service for less cost is always better - the point is that electricity prices are a better indicator of wealth than they are a causer of wealth. If you have low electricity prices (certus paribus) then you probably aren't very wealthy; and if you desperately want them to be lower then your wealth prospects aren't good.

Here is the truism; infrastructure does not trigger growth by itself (it can impede growth but it can't trigger it). New Zealand does not have poor economic growth because of low investment in infrastructure, New Zealand has low investment in infrastructure because it has poor economic growth. When an economy is booming and infrastructure is impeding growth then infrastructure gets built very quickly. When infrastructure is built slowly the implication is clear. You're worried about whether you can afford it; and if this is the reality then you should be concerned about whether you can afford it (and whether your children and grandchildren can afford it).

We should hope and aspire for many things. The highest academic and skills based achievement of our children, plentiful resources, technological leadership, cultural harmony, law and order. I wouldn't spend too much effort hoping for low electricity prices, we just might get them.

Energy Revolution?

Recently I have come across a term "energy revolution". This is one of those terms that regularly contorts my face into a quizzicle frown. If I'm not feeling quite so over-dramatic then at least a dignified Mr Spock like eyebrow raise.

In one way I can accept the term. If a drive shaft exercises a moment and rotates 2pi radians then that is an energy revolution. Not a particularly useful term but neither is it very offensive. Unfortunately I don't think that is what is meant when the term is used by those that believe (at least by implication) in perpetual motion (after all it's only the fuel companies keeping the technology from us).

My 1987 edition Collins Dictionary and Thesaurus describes revolution (the one I think the wistful mean) as

1. the overthrow or repudiation of a regime or political system by the governed
2. (in Marxist theory) the inevitable, violent transition from one system of production to the next
3. a far-reaching and drastic change, es. in ideas, methods, etc

The term "energy revolution" then is of the class ollux and b-grade at that; what I like to call b-ollux.

Here's the thing, work (or energy) will be expended when a force is applied to something that moves before the 'revolution' and will be expended when a force is applied to something that moves after the 'revolution' (strangely enough this works for both definitions of revolution - spooky).

Here are other realities that will transcend the revolution:

• the useful energy will be a fraction of the energy expended - let's be clear on this point by putting it another way. The energy out will not exceed (and will be less than) the energy available.
• something big and heavy (at least in aggregate - probably aluminium, copper, steel and/or concrete) will be needed to make use of the energy - and it will cost something
• it will use natural resources in some way - at least by taking up space - but also the energy must come from somewhere, an energy system must be 'robbed' of the energy
• no matter how hard you try someone will be annoyed about whatever you do because people like being annoyed.

My great fear is those wistful 'energy revolutionaries' seem to have transcended even the perpetual motion machine. Now they don't even want the machine. They just want energy to appear in a puff of smoke (which, admittedly, is probably how energy would appear if it was going to be spontaneously energetic), but again I don't think this is what the wistful want.

Now let us move forward in perfect clarity. We can either have an energy non-revolution (conservation) or we can exercise a moment on a driveshaft (in a large machine - or a large number of machines) for 2pi radians (many times) by using the earth's resources. There are no other options. Oh, and it won't be free either way.

Oil Strategy

New Zealand has now adopted a strategy around oil exploration. This is a good thing, a positive first step in utilising natural resources for wealth growth. However, there is more to the value proposition from oil than just exploration and the export of crude oil. Rich countries make most money out of value adding and leveraging not just the raw commodity but industry around that resource.

While a strategy around exploration and extraction is a good start, the strategy needs to continue to the refinement of the raw resources in to high tech products. Oil is certainly a valuable commodity. Countries that produce oil still tend to be near the upper half of the GDP per capita rankings but, if history can be relied on to repeat, previously valuable commodities fall down the relative value stakes as they become more and more commoditised.

A strategic goal of exporting, in the order of, $60 billion of oil over the 15 or so years is a big economic boost to new Zealand. However, this is nothing like the increase that could be created by moving steadily into refined petroleum products, petrochemicals, plastics & material manufacturing and high-tech products.

Now, this is not easy, but it is a truism that nothing worth having ever is. It is also easy to believe that little New Zealand can't compete in the high tech space. This is possibly true but not trying is tantamount to saying that we wish to, effectively, drop out of the OECD; certainly in terms of GDP (and income) per capita.

New Zealand seems to be able to perform at least 'at its weight' in terms of technical capability. With our historical association with agriculture we seem to hold our own in high tech food processing. We also seem to do quite well in terms of machinery manufacturing, especially when we don't have a wealth of mineral resources to leverage off (compared to Australia, for example). Not having the natural commodities doesn't have to mean that you can't develop technical dominance (a la Japan) but, generally, having the resource creates the opportunity to leverage technical expertise around that resource.

We actually already have creative businesses in the high tech space; they're just quite small at the moment. If New Zealand can now expand its oil and gas strategy to derive technically excellent products from it (which will also have energy policy implications) and connect with an already innovative, but small, local entrepreneurial base then maybe we will see some impressive gains in productivity. This would also provide a far more positive incentive to not spend money on property, although playing around with taxes is probably easier than a transformational strategy.

The sawtooth of energy development: scarce resources vs technology

There are two very significant influences on the cost of energy. The first is the scarcity of resources and the second is technology. Actually these two influences affect many industries but they are particularly prevalent in energy.

Energy has always been one of civilisation's key inputs, technically being part of resources in the trinity of manufacturing (resources, labour and capital). Prior to civilisation there was also energy requirements but in those days energy was part of labour - manpower was it.

The advances of technology allowed man to use energy resources rather than doing it all himself, which meant doing more faster. In the earliest days moving energy was still organic, first oxen, mules and ponies and then eventually horsepower; but man soon learned how to harness the power of wind and water. Heat and light for a very long time had to come from burning stuff.

In the early days burning stuff was easy. There was plenty of organic material that burned well and it was all very handy. However, human populations didn't have to get very big before the readily available material started to be harder to find. In real terms this meant more time had to be spent find energy resources, which meant it cost increasingly more. This is one of the main influences of the scarcity resources. The more you need the harder it is to find and the more expensive it gets.

But scarcity of resources also affects technology. When wood becomes too expensive and everyone wants it then people will start to do two things:

1. Try and work out how to get more heat from the same wood, and
2. Try and work out what else can be burned.

The first thing helps reduce the cost of energy by making it more efficient. The second can make energy more expensive but far more available. For example, all other things being equal it is harder (and therefore more expensive) to mine coal than chop trees but you can get a lot more energy from coal (especially if you use your new energy efficiency techniques). In fact, while new energy efficiency techniques and sources of energy tend to reduce the per unit cost of energy they tend to increase the total energy bill. Rather than reduce energy consumption people usually find that they can do far more and so they do. Then the new fuel sources start becoming scarce (locally) and people have to explore for it further afield.

This sawtooth function is the way in which energy helps economies grow. At first energy is cheap and relatively plentiful and people make stuff for all they're worth. Then the energy starts to run out locally and they have to search and get energy from further and further away. As the energy gets more and more expensive then technology takes off and someone works out how to make the existing energy go futher. Rather than use less, though, as it's effectively cheaper, people use more. Then someone works out how to use another energy source that has high power and people flock to the easy sources of that fuel. Again the extra power from the technically advanced new fuel spurs greater consumption and then more expensive sources have to be found.

The energy leverage is not used to reduce costs it is used to increase benefit. More often than not when a household invests in a technically efficient energy device (such as air conditioning) their energy bill does not go down. Previously they spent what they were willing to on energy and put up with being a bit chillier or warmer than they would like. With the new technology the tend to be prepared to spend the same amount of money but be far more comfortable.

A similar thing occurs when one looks at household energy consumption. It's been pretty much the same for the last 20 years despite the efficiency of household appliances having increased significantly. Where 20 years ago people used a large amount of energy to be warm and have light and a few hours of television now people use a large amount of energy to be warmer, have more light, watch more television, use computers, bread makers, dishwashers, can openers, mixers, electric toothbrushes, games consoles, all kinds of musical devices, etc, etc. Rather than use technology to reduce energy consumption we get more from it; but there is increasingly more people and so energy demand goes up steadily draining the easy to get resources.

Technology has reduced the cost of energy in a relative sense, that is to say that energy would now be crippling expensive without it, but energy doesn't get cheaper because rather than slowly consume the easy to get resources we use the technology gains to do more and more.

This is the reality of any physical resource (which energy fundamentally is even if you can't see it). Technology keeps it accessible but the more you use the more you pay. The cost of energy will continue to increase, but it will do more and more for us all the time.

What is meant by obscene profits?

There is a tendency to describe New Zealand's hydro systems as 'rorts' and mechanisms to make obscene profits due to their costs being largely sunk and spent a long time ago. Such arguments might be valid if the supply of money was infinite (of course money would then also be worthless). But, money isn't infinite. Fundamentally governments (and individuals) must decide how they are going to allocate their finite capital and they cannot do everything that would be considered 'good'.

This need to ration capital leads to what economists describe as the opportunity cost of capital. Now this discussion can quickly move to the arcane discussion of asset and equity betas, risk free rates, market risk premiums, debt margins, debt:equity ratios and the weighted average cost of capital, but all these mechanisms are trying to do is come up with an objective method of comparing assets and businesses for the purpose of allocating capital.

Governments must do the same thing. Ultimately governments should decide what the minimum return is that the government should make to act in the public interest. This is an important point. Unless the government is achieving a sufficient level of public good then it shouldn't take money from the public. Only if the government can do more valuable things with the money through forced cooperation than people can achieve by themselves should the government use the money. This requires a more thorough analysis than just the opportunity cost of capital but whether the government should spend the money at all is the first decision in capital rationing in the public good.

In this context there is the frequent argument that electricity is a public good, with the implication that therefore it must be government guaranteed. However, just because something is of high public value doens't mean that it is a public good (in the sense that the government must provide). The sole purpose of government is to force cooperation to achieve benefits (greater than the commensurate costs) that would otherwise be unachievable. This is the fundamental question of whether a good or service should be fully or partially taxpayer funded against fully commercially funded.

This is where many people argue that the requirement for electricity to be commercially funded leads to higher prices. Yes, that is the point. If it isn't fully commercially funded then it is, at least, partially tax payer funded. Those that argue for less than commercial rates for electricity are arguing (at least implicitly) for electricity to be partially paid for from the general tax base (ie a redistribution of wealth). If you don't think this is true then lets explore the opportunity cost of capital in this case.

Let's consider an example where someone has a Faberge egg (for lack of a better example), an appreciating asset. Let's say that person paid $10,000 for the egg in 1900. In 2009, let's say that someone would be willing to buy the egg for $10,000,000. Should the person who owns the egg (who wants to sell) sell the egg for the original cost of $10,000 or for $10,000,000. The point of this example is that an asset has a current commercial value that can be completely disconnected from the original cost. If the seller in this example sells the egg for less than $10,000,000 then the seller is subsidising the buyer.

This, so far, probably isn't that controversial. The response to this might be that we shouldn't sell the 'strategic assets' then. But what is the opportunity cost? If we swap the mythical Faberge egg above for a mythical power station and make the seller the government then the options (for the government) are to hold on to an asset only making small returns on historical costs, sell the assets to access $10,000,000 or to require the asset to make a commercial return (also releasing, over a longer time, the $10,000,000). The decision for the government becomes should it provide cheap power, should it return the $10,000,000 to the people (through reduced taxes) or should it use the $10,000,000 to provide more valuable services (such as education, health, law and order, etc - which then reduces the tax take required to provide these services). Not requiring the commercial asset to make a commercial return (either through a sale or an explicit requirement) is a cost to the taxpayer. It is not an obscene profit.

The fundamental debate for the electricity system is whether New Zealand society is better served by increased forced cooperation (or central coordination) at a cost to the tax payer, or is it best served by a more commercial system at a cost to the electricity consumer. The 'obscene profit' discussion is a vexatious sideshow.