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.

Response from Bryan Leyland

Following the post http://www.energycomment.co.nz/2009/11/different-viewpoint.html
Mr Leyland has asked that he could have a full response published.

The following comes from Mr Leyland unedited (although the formatting didn't copy properly and so I have tried to correct that only). The following material does not represent the opinion of the Headitor.


He describes the single buyer option as being considered lower risk (and therefore better?).
Not me. According to the then Secretary of Energy, WEMDG was told it was lower risk cf the alternative. As the Vickery auction was venturing into unknown territory, this could/should have been taken into account.

It is important to note here that low risk was compared to what was deemed to be the current practice.
NO! It was compared to the alternative they were offered.

The single buyer model allows the network to be centrally planned by engineers who take all care but no responsibility, and either taxpayers or electricity purchasers would pay for their mistakes. Which is exactly what happens with the current market. (Except that the engineers are replaced by energy traders out to make a quick buck.) The electricity purchasers pay. The ex ECNZ hydro and geothermal stations make obscene profits.

The bid based auction model that was implemented was designed entirely so that it would be private capital that took the risk. Might have been designed that way, but it didn't happen.

No doubt Mr Leyland would argue that the centrally planned network was better. I was never a supporter of the MoW/NZED monopoly.

If one looks back through history it will be found that energy rationing was very common under central planning.
Yes, in spite of the NZED/MoW going flat out building new stations. But political interference was a major factor - and it still is. Read the GPS!

Under central planning New Zealand also had a history of building bad projects. Most went over time and over budget and many had significant engineering problems.
Yes. Mostly political. Clyde is a classic example. Otahuhu and TCC stations have not been trouble free and are still a major risk because the boilers are seriously dodgy. They got exactly what they paid for - a cheap station not designed to work reliably in the NZ system.

I would challenge Mr Leyland to argue that projects under the electricity market have been as poorly managed as occurred previously. See above. I AM NOT suggesting a return to the politically dominated NZED style central planning.

Mr Leyland would no doubt point out that potential shortages over the 2000s indicate how badly the market performs.
Yes. Especially the 2008 shortage when the lakes were very low in the late summer. This major factor was conveniently ignored by the "review". See my submission on it.

Looking forward from today, each generator has many potential generation projects.
What are they? How many will get built? We now know that wind power is very expensive indeed and contributes least when it is needed most. Many of the new projects are wind. According to my information, there is one geothermal station of about 130 MW coming on line next year. For the next two years after that, there might be one of 60 MW windfarm which will make very little difference. There is a lot of talk about more generation, but no commitment. Time is running short.

Now that the development pipelines have been filled security of supply looks like less and less of an issue (although hydro dependency will always mean some risk).
We will see. Quite soon, I suspect!

Mr Leyland's comments on the Vickery auction make it sound like this is a mechanism designed to rip people off.
Yes. Try reading Mcdiarmid. (It is on my website) "A Modest Proposal: Revoke the Nobel Prize? Recognize the Limitations of Theory? Or Grant a License to Steal?" Using a California-style second-price auction structure in a highly volatile market with a limited number of bidders is close to a license to steal when the market approaches a peak and concerted action is highly rewarded.

In fact the auction methods used to overlay on industries where there traditionally haven't been markets are designed to replicate exactly how people behave in markets.
Fine. But, sadly, kWh is not a market commodity in terms that Adam Smith would understand. Little price elasticity and no alternative good.

… the industry can get carried away with its abstractions, and sometimes forgets the fundamentals, but this also happens under central planning. I am not talking about central planning as it was under the NZED. Central coordination is a better description of a single buyer. The single buyer goes to competitive tender for generating capacity. He does not decide which specific power stations must be built. This is a very important difference!

The justification usually given under central planning for errors of judgement is that people should have behaved the way that they should have done. Aren't the current set of fiddles to the market justified on exactly that basis? A pious hope that if the deck chairs are re-arranged, the ship won't continue to sink?

Essentially Mr Leyland's arguments are that you could design a pricing methodology for electricity that would make it much cheaper now. In this he is right but this is not what the electricity market is designed for. You can put a ring around that!

The electricity market is designed for what is known as dynamic efficiency. This means that the intention of the electricity market design is to enable the most efficient investment in electricity generation and transmission, ie for the lowest electricity prices over time. Which it has signally failed to deliver!

In other words the electricity market has a highest current price design based on generation projects that are relatively inexpensive and delivered on time, on spec and on budget.
??? Otahuhu B was late and has inherent boiler problems (Google "P91 steel HRSG"), Te Apiti has had major gearbox problems, Makara is VERY expensive, the new Taranaki open cycle GT is rumored to have problems and so on. But now, it is all "commercially sensitive" so we don't hear about it.

Mr Leyland's suggestion is, history suggests, priced 'fairly' (fairness will also be determined by the central planner) to allocate the cost of projects of impressive feats of costly engineering delivered over time, over budget, and usually with significant problems. No. By making this statement the writer demonstrates that he he doesn't understand the difference between a single buyer and the MoW/NZED + political interference.

His suggestion sounds attractive but actually costs everyone a lot more. Prove it! If we continued to get 60% of our power from low cost, fully depreciated hydro stations that the consumer paid 40% of the cost of, even fabulously expensive new stations would not jack the prices up to what we have seen - and will continue to see.

The reason that electricity costs keep rising is because we keep using more. As any country consumes more and more energy it gets harder and harder to supply. In this context harder means costlier. We have literally burned through one of our greatest energy resources (the Maui gas field) quite rapidly (we exported about a third of it) and now it gets harder and more expensive. I don't agree. In fact, in real terms, I suspect it gets cheaper. Simply using modern roller compacted concrete instead of mass concrete for a hydro dam knocks about 40% off the total cost. A modern CCGT is far cheaper and far more efficient than gas fired steam. Geothermnal is getting cheaper as drilling technology advances and wet steam turbines get to be more efficient. Our power is more expensive because the market rewards generators for keeping us on the edge of a shortage and provides windfall profits to existing generators. Confirmed by Barrett and Turner in their farewell speeches.

If Brownlee's electricity reforms deliver any net public benefits it will be good luck not good management!

Nothing can be more damning of the Cabinet's 'actions in the public interest' than the Adequacy Statement in the Regulatory Impact Statement on the Ministerial Review of the Electricity Market. This statement, made on Page 2 of the Regulatory Impact Statement and presented to Cabinet, is repeated here in full.

"ADEQUACY STATEMENT

The Regulatory Impact Analysis Team has reviewed this Regulatory Impact Statement and considers it partially adequate, with the following qualifications:

• The RIS should have included a more comprehensive discussion of the risks associated with proposed options.
• The RIS should provide a better idea of the magnitude of costs and benefits of the options discussed in comparison to the problem they are trying to address.
• The RIS should have better reflected the range of views received during consultation.
• There should be a discussion of whether or not the options proposed have been tried overseas and, if so, what their impact was.

The Ministry of Economic Development notes that many of the policies that are proposed in this Regulatory Impact Statement are intended for subsequent implementation by the Electricity Market Authority. It will be the responsibility of that agency to undertake an adequate assessment of the risks and costs and benefits of these proposals in due course."

This response from MED might seem reasonable if the proposed EMA is allowed to consider not implementing any of the proposed recommendations. But this is not the case. The Cabinet action is to put in place legislation requiring the recommendations to be given effect to. This means that the EMA will have to put in place potentially poorly considered decisions on the basis that they can review the quality of the decisions; but do nothing about it except do what they are told. In other words bypass the Regulatory Impact Analysis Test completely.

I regard this as deeply immoral behaviour by the MED; and I can't see how this doesn't constitute a breach of their most fundamental statutory duty, which is to act in the public interest. But the real agency failure here is with Cabinet, and Brownlee in particular.

Cabinet have again bypassed New Zealand's already very poor and weak constitutional protections. In a technique perfected by Labour and learned very well by National they have:

• Made political capital out of meaningless rhetoric in response to public concerns.
• Tried to create legitimacy for their own preferences (while distancing themselves from the process and any negative publicity) by having an 'independent' review.
• Set a review scope far too tight to achieve a meaningful outcome with a timeline so fast that nothing meaningful can be done anyway.
• Appointed 'independent' consultant advisors sympathetic to their own philosophies; and who have linkages to the groups that are the squeakiest wheels.
• Bypassed already weak consititutional protections by claiming that another group will work out whether this should be done although Cabinet has, for all pratical purposes, already made the decisions.
• Are pretending to have a new independant body but are requiring them to put in place specific solutions rather than require them to achieve good public policy objectives (ie no independance).
• And last, but by no means least important, ensure that their are no good public policy objectives, nor anything remotely measurable, less the Government can be held to account for its choices.

And to point out just how damning the RIS Adequacy Statement is lets looks at the shortcomings identified by the RIAT.

The MED hasn't:

• "... better reflected the range of views received during consultation." The implication here is that the consultation was only given superficial consideration.
• "... included a more comprehensive discussion of the risks associated with proposed options." Which suggests that Cabinet hasn't been fully appraised on what detrimental effects might occur; but they have still made a decision.
• included "... a discussion of whether or not the options proposed have been tried overseas and, if so, what their impact was." This is more damning than it looks as this didn't require the Ministerial Inquiry to explain why they are making recommendations that continue to make New Zealand's market design unique in the world (for example, as far as I am aware, New Zealand is the only significant electricity market in the world that doesn't have at least the option of zonal prices for loads - but the MI summarily dismisses zonal prices based on nothing but idealogical dogma). This also means that they have been allowed to ignore the large volume of international (and local for that matter) literature on these very problems in favour of their own preferences.
• provided "... a better idea of the magnitude of costs and benefits of the options discussed in comparison to the problem they are trying to address." There are two implications here. The first is relatively obvious. No meaningful cost-benefit analysis, hence the phrase in the title. If it works (whatever that means) it will be good luck. The second implication is more subtle but every bit as important. The reason that the MI is unable to do a cost-benefit against the problem that they are trying to solve is because they never properly worked out what the problems are. Instead they have generalised the problems, created unmeasurable aspirational goals, and used an extensive degree of correlation to imply causation.

This last point is very important. The consequence of the absence of a proper problem definition based on good public policy objectives is then there are no measurable objectives. It is easy to argue that the absence of any measurable objectives (or stated public policy) means that the politicians and public servants cannot be held accountable. In fact any debate on the success or otherwise of the Government's proposed legislation can only be compared to a theoretical (and substantially fictional) counterfactual (an assessment of what would have happened if their changes hadn't occurred).

The structure of the proposal looks suspicious to me as well (and possibly shows that National has learned a lot from Labour). The way that the legislation is proposed to be structured is that the industry must give effect to the Government's mandated solutions or else get regulated. Therefore, if there is still public concern over the electricity industry by the end of 2010 then the Government may be able to say "I warned you" and appear to come to the rescue. The cynic in me suggests that this will be well timed to try to avoid electricity being an election issue in 2011. A technique that Labour used in 2002.

In my view, however, the Cabinet has just set us on a path that may not mean unavoidable doom for the public good; but will certainly not mean unavoidable success. Let's hope we're lucky.

To transmit or not to transmit?

Once again the electrcity industry is struggling with the role of transmission in the power system. It is coming under the particular problem of transmission pricing and the role of locational signals for both generation and transmission.

Without getting into the details of locational pricing (which gets very complex very quickly) the fundamental question with transmission is whether one would rather have a local power station and no transmission or a remote power station with transmission. All the locational pricing is trying to do is to signal the preference between these two basic choices.

Local generation has its attraction. It means that you don't need expensive transmission. Potentially it can be smaller and less obtrusive. However, remote generation has significant benefits. A remote power station can be located to a large fuel source. The best renewable fuel sources are only rarely located in perfectly convenient locations. Remote power stations tend to be relatively large (which means it can be an advantage for them to be located remotely) but then require large transmission (which causes its own problems for those it passes). The costs of easements and access are making transmission more and more expensive.

Larger power stations located on good fuel sources have significant economies of scale, though. It gets proportionally cheaper to build something larger. Transmission has very large economies of scale. Once you have decided on the need for a transmission line it does not cost significantly more to make it larger. If you are supplying a small number of people then economies of scale don't matter much. If you are supplying large numbers, on the other hand, then the effective cost of the large power station and transmission line becomes very attractive. Currently large remote power stations with transmission still easily beat most local options on a per unit cost basis.

But there is more to transmission than just transport. I think that it is implicitly assumed that once the economics of a local generator outweigh the remote generator then transmission and remote generation will become redundant. This isn't as clear as it seems. One of the other benefits of a geographically distributed electricity network is that it contains many generating units of many different type of technology and many transmission lines criss-crossing between them. The larger the network the less susceptible it is to the failure of any single piece of generation or transmission. A single local generator is much less reliable, a single failure on a local generator completely disrupts supply.

One of the problems that we might find is that, at the point when we think we have rendered the remote power stations and transmission network redundant (thanks to cheap local generation), may be the point that find we need them more than ever. The technology required to give the local generator the same level of reliability and quality as a large electricity network is expensive. And reliability in our electricity supply is clearly something that we want.

The discussion about locational signals transmission has made the claim that transmission networks tend to be overbuilt. If one only considers the comparison between local and remote generation for energy supply this view looks attractive; but transmission upgrades are justified on the basis of reliability not energy supply. Some experts would claim that energy markets inherently price reliability and this may be true to an extent. My question, though, is this - are we so sure that we have priced all the benefits of a large electricity network? If we all have our local generators would we actually be willing to disconnect from the reliable supply?

A policy of no policy

In this post

• The Project Hayes windfarm has been turned down
• It is not clear whether this decision is correct or not
• This lack of clarity is a national energy policy failing
• The Minister of Energy and the Government are not accepting their accountability for setting energy policy
• Such a policy will not be popular with everyone as it must determine and make clear the trade offs between energy security and environmental purity
• It is time to move past the purely aspirational and make the national policy decisions
• Perfect outcomes with no compromises are for Walt Disney movies - not for real world energy policy

The recent news that the Project Hayes windfarm has been turned down makes quite obvious the energy policy failings in New Zealand. For the avoidance of doubt I am making no comment about whether the Project Hayes decision was correct or not. What I am observing is that the Hayes decision is not clear and how the Commissioners have found themselves in a ridiculous predicament.

New Zealand does not have any meaningful energy policy. Neither does it have any meaningful environmental policy despite a great deal of rhetoric to the contrary. This has been a significant policy failure of the previous government but the current government is doing little more than the purely superficial.

The Project Hayes example highlights this well. In a project such as Hayes the fundamental issue of the project's contribution to the country's energy supply versus the local and global environmental impacts must be a national policy issue. This doesn't mean that such a project should be considered at a national level (as this would merely promote the global above the local) but it should be considered within a very clear and unambiguous national policy and assessment framework.

The Commissioners in the Project Hayes case found themselves making self admitted subjective assessments (guesses in effect). All of the Commissioners found themselves in this predicament even the Commissioner with the dissenting minority report. All of them found that the evidence (the scope and content of which was entirely at the discretion of the proponent of the project) was inadequate for balancing all of the benefits and costs. This is unsurprising as the Commissioners have, unwittingly, found themeselves in the role of national energy policy makers where this is clearly not supposed to be their role.

Fundamentally, the level of contribution of renewable energy to New Zealand's increasing energy demands (and how important that is relative to various benefits of the local and global environment) is a national issue. These energy and environmental objectives of New Zealand need to be clearly presented in a national energy policy. No doubt the previous and current Minister of Energy would claim that we do have such policies. However, making the aspirational statements we want entirely renewable energy without any environmental impacts is as useful to energy policy as the anti-smacking legislation is to the genuine welfare of children. There are critical and unavoidable trade offs between energy supply and the environment and it is time for the Minister of Energy and the Government to accept this accountability. OK, so it will not be universally popular but that is the job and not doing it is unacceptable.

Part and parcel of this policy should be an assessment framework that guides the assessment of projects against the energy policy. This would not only ensure that the Commissioners deciding such projects were doing their jobs (rather than also doing the politicians job) but would also make it very clear to project proponents what standard they are to meet; and how they will meet them.

Some might argue that the call-in process facilitates the national policy objectives but I cannot agree with this proposition. The call-in process allows for political expediency rather than enforcing a clear statement of energy policy and an accountability to that policy. I think it is entirely appropriate that decisions for such project authorisations are made locally provided that there is clear and unavoidable guidance in how to balance the local with the global.

The Project Hayes decision makes these policy problems obvious but every wind project so far has suffered from the same problem (including the ones that have been accepted). One can argue indefinitely whether any decision is correct or wrong because it comes down, fundamentally, to the trade offs that we want to make as a society to have a balance between energy security and environmental purity. It is the Governments job to make this unpopular choice between the national benefit and cost and the local benefit and cost. If we prioritise the local environment then we will have to compromise on our renewable objectives. If we prioritise renewable energy then we will have to compromise some local environments. Perfect outcomes with no compromises are for Walt Disney movies - not for real world energy policy.

Different viewpoint

Brian Leyland has long been seen as the independent commentator of the electricity industry. Mr Leyland often has quite different views to most in the industry and gets some traction from his seeming common sense. To an extent Mr Leyland does bring a common sense alternative view. To an extent, however, his comments can overlook some inconvenient realities.

The most recent example of Mr Leyland's views that I have read is available on

http://www.nzcpr.com/guest170.htm

There are a few problems with the view given by Mr Leyland in this opinion piece. The piece is described as shedding light on the rising cost of power but some of the light being shone is pretty dim. As such it is worth shedding a bit more light on Mr Leyland's own commentary.

Mr Leyland selectively uses aspects of the original decision process about the New Zealand Electricity Market to suggest that a single buyer option would have been better. He describes the single buyer option as being considered lower risk (and therefore better?). It is important to note here that low risk was compared to what was deemed to be the current practice. In this context it is easy to see why a single buyer model might have been considered low risk. The status quo was a centrally planned network where engineers took all care but no responsibility, and either taxpayers or electricity purchasers pay for their mistakes. The single buyer model allows the network to be centrally planned by engineers who take all care but no responsibility, and either taxpayers or electricity purchasers would pay for their mistakes. Pretty low risk; for the engineers.

The bid based auction model that was implemented was designed entirely so that it would be private capital that took the risk. Arguably this has been watered down by maintaining much of the generating assets under government ownership but this doesn't seem to be the case. Even under the SOE model it is clear who is responsible for the use of money.

No doubt Mr Leyland would argue that the centrally planned network was better. The evidence is not kind to this point of view, however. While the dry years of the 2000s are in recent memory (and there had been a great deal of publicity and calls for voluntary savings) the country didn't run out of energy. If one looks back through history it will be found that energy rationing was very common under central planning, although the economy was very different then as well.

Under central planning New Zealand also had a history of building bad projects. Most went over time and over budget and many had significant engineering problems. I would challenge Mr Leyland to argue that projects under the electricity market have been as poorly managed as occurred previously. Mr Leyland would no doubt point out that potential shortages over the 2000s indicate how badly the market performs. I could easily make a strong argument that it was regulatory uncertainty during the 1990s that lead to the outcome that none of the restructured industry players of 1999 had workeable projects in the pipeline (which coincided with far longer development timetables than central planners ever had). Looking forward from today, each generator has many potential generation projects. Now that the development pipelines have been filled security of supply looks like less and less of an issue (although hydro dependency will always mean some risk).

Mr Leyland's comments on the Vickery auction make it sound like this is a mechanism designed to rip people off. In fact the auction methods used to overlay on industries where there traditionally haven't been markets are designed to replicate exactly how people behave in markets. They are abstractions, but they are intended to mimic how people trade not replace these methods. Now, I will agree with Mr Leyland, to an extent, that the industry can get carried away with its abstractions, and sometimes forgets the fundamentals, but this also happens under central planning. The justification usually given under central planning for errors of judgement is that people should have behaved the way that they should have done.

At the end of the day, though, the arguments that Mr Leyland uses for pricing problems are all static. Essentially Mr Leyland's arguments are that you could design a pricing methodology for electricity that would make it much cheaper now. In this he is right but this is not what the electricity market is designed for. The electricity market is designed for what is known as dynamic efficiency. This means that the intention of the electricity market design is to enable the most efficient investment in electricity generation and transmission, ie for the lowest electricity prices over time.

In other words the electricity market has a highest current price design based on generation projects that are relatively inexpensive and delivered on time, on spec and on budget. Mr Leyland's suggestion is, history suggests, priced 'fairly' (fairness will also be determined by the central planner) to allocate the cost of projects of impressive feats of costly engineering delivered over time, over budget, and usually with significant problems. His suggestion sounds attractive but actually costs everyone a lot more.

Now, let's be very clear. The reason that electricity costs keep rising is because we keep using more. As any country consumes more and more energy it gets harder and harder to supply. In this context harder means costlier. We have literally burned through one of our greatest energy resources (the Maui gas field) quite rapidly (we exported about a third of it) and now it gets harder and more expensive.

Is there a free rider problem in New Zealand's retail electricity market?

I think there are problems in New Zealand's retail electricity market but the focus is always on the wholesale market. (see http://www.energycomment.co.nz/2009/10/what-is-problem-with-retail-competition.html) Obviously many people are upset at the significant increases in retail prices over recent years. The Electricity Commission's own analysis shows the issue quite well (see Chapter 2 of http://www.electricitycommission.govt.nz/pdfs/opdev/wholesale/market-design/Market-Design-Review.pdf) Although, unfortunately, the analysis doesn't go as far as to compare industrial, commercial and retail margins, only prices, therefore there is a degree of comparing apples and oranges. This is compounded because prices include both energy costs and lines costs. Nevertheless, it is clear that industrial prices have been quite flat (in real terms), commercial prices have dropped markedly and retail prices have gone up markedly. Interestingly the national average end use purchaser price has also remained relatively flat.

For most of New Zealand's history there have been significant cross-subsidies in the retail prices. Traditionally residential prices were arbitrarily low and commercial prices were arbitrarily high. Industrial prices have always been, effectively, wholesale prices. The reason for the historical cross subsidy from commercial to residential is easily explained. This occurred because electricity was delivered by monopolies with elected governors, and businesses don't vote. A simple case of responding to the incentives of the day.

It is clear that these historical cross subsidies have been removed and this is one reason why residential electricity prices have increased in excess of inflation. Now, though, the situation seems to have reversed with residential prices being significantly higher than commercial, but this may not be a cross subsidy. It may just be economic reality.

And what of industrial prices. To a degree the industrial price is lower because it is generally a wholesale price. But is there a degree of cross subsidisation here? There isn't really enough analysis to be able to conclude much at all. Let's instead consider a 'first principles' debate around allocative efficiency.

Allocative efficiency is that economic principle that says that resources should be allocated to their most valuable use. This roughly translates to - those that are willing to pay more should get all they want and people who are willing to pay the least should get less. It can also be translated into saying that those that get the most should pay the most and the those that get the least should pay the least. If we hold off for a moment on the distinction between commercial and residential (and treat them as one retail customer bloc) then let's compare them (together) to the industrial segment.

It looks to me that allocative efficiency is working properly here. Notwithstanding that industrial prices are generally wholesale prices they seem to pay the least. Industry is also the segment most likely to shut down when there is an energy shortage. As wholesale prices increase more then more industrials shut down. Prima facie this is what you would expect. Having said that the industrials (in general) have the same mantra during any energy shortage - why do we have to bear the brunt of energy shortages? Why don't retail customers bear the burden as well? Well, the easy economic answer is because industrial loads are willing to pay less than retail customers and, therefore, industrial loads should be the first off. In complaining that they shouldn't be shutting down, and that this is doing New Zealand economic damage, then there are two implicit sides to this potential debate:

1. Allocative efficiency is working well and industrials are just engaging in political manouvering (a strong possibility), or
2. Allocative efficiency is not working and industrial loads should not be first off (but, of course, this also means that they should pay more, ie there is currently a cross subsidy from industrial customers to retail customers)

The situation seems more clear when it comes to commercial and residential comparisons. Neither responds strongly to price signals and yet each pays significantly different prices. A cross subsidy seems most likely here.

So why might cross subsidies exist? Prevailing opinion would probably suggest that it is the evil retailers that are price gouging, but this does not make sense. As mentioned the national average end user purchase price is relatively constant over time in real terms. There is no obvious price gouging in end user prices. Maybe one could argue that retailers (or lines companies) are forcing cross subsidies - but why would they? There is no obvious financial benefit to a power company in forcing an unbalanced price structure. It is more likely that power companies (as with previous cross subsidies) are just responding to the incentives that they have.

There are two reasons I can currently think of why these incentives might exist. Both are a form of free rider problem. One potentially explains why there might exist a cross subsidy from retail customers to industry.

E Grant Read in his 2009 paper (http://www.mightyriverpower.co.nz/content/1798/Electricity%20Market%20Economics-%2090302.pdf) explains the relationship between contract prices and wholesale prices in electricity markets. Over time electricity generators must recover their fixed costs (costs that are incurred irrespective of how much they generate - plant costs, most labour, infrastructure, capital, etc) and variable costs (costs that are incurred when they generate - fuel, some maintenance, opportunity costs, etc), otherwise they would not invest. In the absence of any contracts then usually (during normal times and especially during times of surplus) the generators will only get variable costs paid out of the market. Only during times of shortage will generators be able to get a contribution to fixed costs. An unhedged electricity market should be highly volatile and have a high total price (high enough to cover all fixed and variable costs). If generators are highly hedged at the total price of generation then the electricity market should be far less volatile and have a lower price (equal to the average of variable costs only as settlements to hedge contracts will pay the fixed costs).

This is where a cross subsidy may, unwittingly, occur. If a retail market design problem meant that retail consumers are making a large contribution to fixed costs then those retail contracts would help stabilise the wholesale price and tend to clear a lower wholesale price. This would enable industrial customers to free ride in the sense that they could take the lower volatility and lower price in the wholesale market and, potentially, avoid some contribution to the fixed costs of generation. Although they would continue to be able to complain about the wholesale price and volatility.

If we look at the relationship between residential and commercial customers then another free riding problem may exist. I suspect that the commercial electricity price is dominated (by volume) by national scale business. These businesses tend to tender for their (relatively large) electricity supply whereas retail customers tend to either be approached or infrequently consider their suppliers (for relatively small load on an individual basis). This means that the larger businesses tend to offer retailers a single shot bid on a lucrative volume (large commercial businesses also tend to be low engagement and good payers). This design is likely to inherently mean that commercial (and possibly industrial) customers are likely to get offered average prices while residential customers will tend to get marginal prices (the full cost of continuing to supply energy at that time at that level). In fact residential customers may pay in excess of the marginal cost, to the extent that commercial (and industrial) customers might avoid fixed costs. Pure allocative efficiency suggests that everyone should face the marginal price.

Some people have argued that the problems with the retail electricity market are structural (relating to the number and type of competitors) and, often, that it is a problem with the wholesale market. I don't think that either proposition is correct. I think that the problem is fundamentally one of retail electricity market design; and let's face it the retail electricity market was never designed - it coalesced over time. Fixing the retail market design may have implications for both the electricity market structure and the wholesale electricity market but these outcomes shouldn't be the objective of fixing the retail market.

Obviously the arguments above are purely anecdotal . The analysis required to properly assess the efficacy and efficiency of the retail electricity market is complex and requires information not readily available; and, perhaps, this is part of the problem. Nevertheless, I don't believe that the electricity market in New Zealand (or any alternative) is ever going to work properly unless every part of it is considered as a policy whole. At the moment the retail component is a significant missing link in the policy debate in anything other than an anecdotal discussion.

The problem with correct information out of context

Deborah Coddington is an honest woman. She admits in her column
http://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=10606549&pnum=2
that she, with the Martinborough community, are "not opposed to wind farms per se" but that she, like the Martinborough community, don't want them anywhere near her. Fair enough. This is a real problem with renewable energy that New Zealanders will have to get their heads around. see http://www.energycomment.co.nz/2009/10/wind-energy-doctor-jekyll-and-mr-hide.html

Ms Coddington reported that a recent Martinborough community meeting was addressed by a Mr Rob Morrison. Mr Morrison is, according to Coddington, a co-founder of the Copenhagen Climate Council (I don't doubt this I just haven't checked it); and an architect of the arrangements that may replace the Kyoto accord. Unfortunately I think the statements attributed to him in the column are generally out of context, misleading and somewhat disingenuous.

The points attributed to Mr Morrison are:

• generating energy from wind costs twice as much as the price received
• you can't store wind energy (yet)
• it won't help with winter peaks in demand
• it won't replace coal
• it won't mean cheaper power and it means more expensive bills
• New Zealand already has numerous choices to build generation capacity to meet future electricity demand

Well two out of six is... pretty bad actually.

Lets look at these assertions. "Generating energy from wind costs twice as much as the price received" - not necessarily true. I assume Mr Morrison is using information about many European wind projects where the very high "feed-in tariff" subsidies have lead to many uneconomic developments. New Zealand has no such subsidies but does have windfarms that are close to the money. New Zealand has some very good wind sites, with good average wind speeds, but not everywhere.

"You can't store wind energy (yet)" and "it won't help with winter peaks in demand" - both of these statements are true.

"It won't replace coal" - false. Mr Morrison may mean here that coal power stations will still be required to ensure security of supply under most renewable energy scenarios. If this is the statement that he is making then I agree (see http://www.energycomment.co.nz/2009/10/what-now-for-huntly.html) but I still think the statement is misleading. Even under the scenario where the Huntly coal power station is retained for security of supply then all wind energy that can be delivered to demand (transmission can be an issue) will offset the marginal generator, which will normally be Huntly coal. Wind energy will be maximised and coal energy minimised. This is wind energy replacing coal energy even if the coal station is still required for energy security.

It is in Mr Morrisons assertions that "it won't mean cheaper power and it means more expensive bills" that I cannot but feel that Mr Morrison is being highly disingenuous. Contrary to popular opinion generators are unable to force any price they like in the wholesale electricity market. If a generator builds an uneconomic power station then they will lose money. But the best windfarms in New Zealand will be economic because there will be a device that significantly increases the cost of power and will mean more expensive bills. And that device is Mr Morrison's own Copenhagen Climate Change response. New Zealand's best windfarms will become economic because of a deemed cost of carbon (deemed by a market mechanism far more arbitrary than any electricity market) that will increase everyone's power bills.

And finally "New Zealand already has numerous choices to build generation capacity to meet future electricity demand" - false. New Zealand is in an energy crunch. We don't have significant proven energy reserves in gas, although the gas is probably there. Major hydro schemes are a no no, and there is limited further developments in any case. Geothermal is all go but is fundamentally limited. Solar and marine are possible future choices but are many years away from being commercial. Small distributed generation is mostly too expensive (there are significant economies of scale in electricity - although technology continually improves this). Wind is definitely a current part of New Zealand's energy future (but only those sites that have the consistently high wind speeds).

Mr Morrison suggests we use less and put the effort into energy efficiency. This I can also agree with. There is a lot of potential in energy efficiency. However, I believe everyone continues to underestimate the true opportunity costs in energy efficiency, which I believe is why there continues to be little take up. We don't yet understand these opportunity costs properly and, therefore, we don't yet have the correct policy levers to encourage energy efficiency. I agree that this should be properly focused on.

Mr Morrison reputedly calls on power companies to stop being sneaky, and this may be good advice. However, probably accidentally, there is a degree of sneakiness in Mr Morrison's own reported comments.

The final comment in Ms Coddington's article is "build your farms far away from people." I'm sorry. It's just not that simple.

What now for Huntly?

There is some media attention on the recent financial performance of Genesis Energy and the write down of the Huntly Power Station in particular. There are a few issues that arise from this.

First, don't get carried away with accounting jiggery pokery. The Huntly write down is not a real cost. All the write down means is that one inaccurate estimate of Huntly's value has been replaced by another inaccurate estimate of Huntly's value; and the estimates are different.

Second, and far more importantly is the debate about the ongoing role of Huntly in the future. Genesis have a problem. They know, as do most reasonable people in the industry, that Huntly is a major contributor to security of energy supply in New Zealand. The problem is that there isn't a current mechanism by which the costs of keeping Huntly running will, necessarily, be recovered over time. This doesn't mean that Huntly isn't economic, it just means that the owner of Huntly may have to swallow signficant costs for those rare times that the station can earn large amounts of money (such as when hydro systems are experiencing severe droughts). For an owner of such an asset it is attractive to try to socialise at least some of the costs to keep the power station running. So, to an extent, it looks like Genesis may be playing a political game in its latest annual report and media release.

Nevertheless, it is worth considering whether there is a common good role for plant such as Huntly; and, therefore, whether there should be another mechanism for earning revenue. Somewhat ironically Huntly may have a major role to play in enabling renewables.

Renewable energy in significant quantities, in the foreseeable future, is likely to come from geothermal and wind. Geothermal has a limited beneficial contribution to the security of energy supply. When it is first commissioned geothermal almost certainly allows for more surplus of hydro-electricity but, on average, will be substantially matched to demand growth. This means that generally we will still have exposure to dry year risk as geothermal power stations will not be able to produce more (as they generally operate at maximum output) during these times.

Wind makes things worse (from an energy security basis) because it can only operate when the wind blows which may not always be when it is needed. Many proponents of wind suggest that wind and hydro are complimentary. Generally this is probably true but not at the extremes. Unfortunately you cannot guarantee that the wind will blow when you are in the middle of a drought. Indeed this was a problem during the drought of 2008. If New Zealand aspires to significant quantities of wind energy (with the associated economic and environmental benefits) then we will also need a large source of entirely discretionary generation on standby. This is an almost perfect description of the old Huntly power station - a large source of entirely discretionary generation on standby.

I'm not sure if Genesis are playing a political game or not but, regardless of the merits of such an approach, the ongoing role of Huntly needs to be elevated in the energy policy debate. And, ironically, it should be the greens that champion the old girl.

Businesses operate in the real world

I have quite a problem with the latest press release from EECA.

http://www.eeca.govt.nz/node/7702

For the avoidance of doubt I am not criticising EECA's objectives, intent nor the value of what they are trying to achieve. My problem is that idealogical arguments are not, in and of themselves, useful in isolation of all the real world complexity of running a business.

The EECA media release implies that energy consumption does not constitute a supply in the same way as other supplies. Even more bizarre is the way that they conducted the survey behind the media release. Energy management was added as a category in its own right compared to such categories as customer and supplier relationships, competitiveness and profitability. Energy management is a component of these major categories not a category in its own right. Telecommunications management would be a legitimate major category under this system. No-one can be surprised that Energy Management scored the lowest of all of these categories as it is a subset of some of them. No subset can be more important than the superset it is from. Actually, Energy Management scored extremely high in this context.

EECA go on to make a vexatious argument, based on the global benefits of energy saving, that each business should pursue energy efficiency. The global benefits for energy saving may be very large but clearly, at the level of each business, the benefits are small. Such is the nature of a tragedy of the commons [1], although its not actually that clear that such a tragedy exists in this case. It seems to me that EECA are implying that businesses are not acting in their own best interests. This will not be true. Business, in aggregate, will be responding correctly to their incentives.

To be fair to EECA they face an unenviable task. They are tasked with very challenging targets for energy efficiency with little in the way of real resources or policy levers. Nevertheless, ideology, by itself, will usually be ineffective. If ideology is effective, in isolation, it can also be very dangerous. There are always externalities and practicalities that must be taken account of.

Notes [1] a tragedy of the commons exists when all individuals would benefit from cooperating in saving a resource but only if everyone cooperates. Usually, without a coordinating body or external interference, there is no cooperation because an individual can benefit from consuming first and fast.

Is energy important?

I have just realised that I may be under a misconception. Judging from the occasional flurry of debate on power projects, and my own personal biases, I thought that the energy subject was an important one. But, maybe I am wrong.

I try to review the press in New Zealand to understand what the energy issues might be. This sometimes proves to be very difficult. Most times nobody seems to be very interested in energy. My recollection is that energy used to be its own subject area in newspapers but is no longer. I know there used to be a Ministry of Energy (now there is a Minister but no Ministry).

It seems that the debate about energy has become the more sophisticated debate about the environment. I find that a little surprising. I don't find it surprising that the environment would be a special subject of interest but that it replaces energy as a subject. To my mind the debate about energy and the environment is fundamentally about physical reality. The rules around the provision are inherently physical. Both the influences and the reality of environmental impacts are also inherently physical. A balanced debate about energy and the environment must surely be a discussion about physical reality and well considered trade offs between both.

I have already made posts on this blog to the effect that some of the debate around energy is ignoring physical realitites (let alone economic ones). Interestingly enough, in my opinion, the environmental debate also seems to be highly abstracted from reality. To an extent this is because the major concern in global environmental terms is highly complex and sufficiently indirect to be, for all practical purposes, abstract. Much of the solution infrastructure, global greenhouse gas markets, is also highly complex and abstract.

All of this belies the underlying reality that the problem is essentially physical and that there is no perfect solution. Ultimately, as well, there are no global solutions and that it is at the local level that each carefully considered trade off needs to be made. And, it is at the local level that the global abstractions become the most acute. In my previous post I posited that most people want windpower but most people would also rather that it isn't built near them.

My primary concern with the abstraction of the arguments is that these global abstractions do ignore the reality. That each solution must be both physically practical with acceptable physical effects at the local level. Unless these physical realities are well understood at the local level then the globally abstracted debate is meaningless.

What forum, is my question, is the local reality discussed in a policy sense? The RMA discusses local isssues but this is always from a purely local perspective. National's proposed EPA may achieve this purpose but if New Zealand's EPA becomes anything like Australia's then it will not reconcile local reality to global abstraction. It will only make the gap more layered in inaccessible bureaucracy.

Wind Energy - Doctor Jekyll and Mr Hide

Wind energy's fortunes in New Zealand continue to be mixed. Most people's attitude to wind tends to be similar. Most people would say that wind power is a good thing but most would also say "don't build one anywhere near me!"

One of winds problems is that there tends to be a belief that a windfarm can be built just anywhere and that energy companies are just being difficult in wanting to build them where locals don't want them. The problem is that windfarms need to be built where it is windy. Of course lots of places are windy but being occasionally windy isn't good enough. A place has to be fairly constantly windy and this isn't as common as most people think.

New Zealand has such windy places. Places where it blows strongly regularly. New Zealand is a good place to build windfarms but not just anywhere. For example, very few windfarms look feasible in the upper North Island. Locations that can be very windy, such as round the Kaipara and Manakau harbours, don't tend to be consistently windy and no windfarm in this region yet looks economic.

Alternatively the Manawatu region blows not just a lot but often. In fact the problem in some of the Manawatu ranges is almost that it is too windy. Wind turbines are mechanical devices and can be overloaded. Most Manawatu windfarms require the highest specification turbines available to withstand the mechanical stresses. However, this adds relatively little cost (or input energy) to sites that can produce a lot of wind energy.

A big issue in the Manawatu ranges is not that windfarms here have been blocked but that there are now so many of them. Local residents have a reasonable point to make in that adding more and more windfarms to the skyline does make a difference. And, as more of the remote sites are developed, the newest project proposals must, necesarily, be closer to existing residents and amenities. The residents of Palmerston North and its environs might feel somewhat aggrieved that they are bearing considerable brunt for the development of New Zealand's energy future. They aren't alone, however, the Waikato, Waitaki and Clutha Rivers have been irrevocably altered and give more energy each than the Manawatu yet does. The Bay of Plenty region is also being heavily developed, although with geothermal plant which has less obvious local impact. Manawatu's main issue isn't that development hasn't been concentrated in a region before but that windfarm developments are so obvious.

Many might argue that small scale generation is the future and they could be right. However, there are currently three significant barriers to this:

1. There are economies of scale
2. Small scale generation still needs to be built where the resources are significant (a small wind generator in a place where it isn't windy may never recover the energy it took to manufacture and construct)
3. The electrical networks have significant technical challenges before signficant small scale distributed generation can be safely and economically exported.

What are we to do? In the absence of fossil fuel use (which would currently need to be imported unless New Zealand makes a big commitment to coal) then the major development opportunities for large scale energy use are wind and geothermal. Both are practically limited relying on technology to deliver more developable areas. If wind is a major component of New Zealand's energy future, which makes sense, then someone has to put up with them. And if we are to make the most of the resource with the smallest overall disruption and least input resources then they need to be built where it is windy, consistently windy.

Ask a question about energy in New Zealand

What do you want to know about energy in New Zealand? Ask a question through the comment link below.

What is the problem with retail competition in electricity?

I don't think anyone really knows.

There have been a number of studies into the electricity industry in New Zealand but none that I am aware of have really analysed the retail market. There have been a few that have purported to, such as Wolak, but his study was really a wholesale market study (with flaws). The linkages he made to the retail market were somewhat nebulous and completely about correlation without any attempt to discuss causation.

The most comprehensive study that I have seen about the retail market in New Zealand was done by the Electricity Commission in their Market Design Review.
http://www.electricitycommission.govt.nz/pdfs/opdev/wholesale/market-design/Market-Design-Review.pdf

This review did some interesting analysis around the retail market. While this was some of the most in depth analysis that had been done on the retail market it actually lead to asking more questions than it answered. Particularly interesting of the ECs analysis was Figure 27 of chapter 2 page 28. These four charts demonstrate something quite strange. When it comes to large or high density networks (which New Zealand doesn't have many of) there appears to be a correlation between size and low retail margins (which is what you would expect with economies of scale). However, in small networks retail margin is random. Small networks can have very low retail margins, very high retail margins and everything in between. The reason for this is not clear.

Much public debate has been made of location and transmission constraints in preventing retail competition but, again, the evidence is correlation only (with no empirical analysis on causation) and is inconsistent. While generator-retailer operations do tend to be distributed around geographic areas, which can be explained by locationally restricted competition but can also be explained by the starting position of the generator-retailers and relatively low effective rates of switching. In other words correlation does not necessarily mean causation. More interestingly the concentration of generation does not line up with the margin uplift. Areas where there is significant regional generation (and therefore low location risk such as the central North Island) have networks with relatively high margins. Correspondingly, many of the small networks with low retail margins are remote from significant generation and should be expensive (if location risk is the real problem).

I don't know what the answer is but I do know that just about every review that has been done looks almost exclusively at the wholesale market. The wholesale market has been done to death, the New Zealand wholesale electricity market has been constantly reviewed and there is mountains of international literature on wholesale electricity markets. It is the retail market that needs a proper empirical review. The retail market is not an adjunct to the wholesale market. The retail market relies on the wholesale market for its input prices but in every other respect it is a different market with a different design and structure. It needs its own focus.

Why nodal pricing matters for generation and transmission?

This is another follow up post to Brian Fallow's articale in the New Zealand Herald on asset swaps. One of the things he suggests in the article is that nodal pricing doesn't matter for generation. This is not true. Arguments about the relevance of nodal pricing to the demand side are quite valid.

Nodal pricing in fact is highly relevant to efficient generation and transmission outcomes both in operational terms and investment efficiency. The locational issue relevant to generation is the fundamental question, (at its simplest) are we better to have a local generator only or a remote generator with transmission? If you don't have a locational signal in your pricing then you run the risk of using a remote generator every time and having an increasingly expensive transmission network. This is true of operating the electricity system as well. Sending power through transmission lines heats those lines up, which represents a loss of energy to the system. Without a nodal pricing system for dispatch then you could easily use a far away generator to meet demand even though it uses proportionally more energy (through losses) than the difference in cost of the local generator. Choosing which plant should run to meet the energy needs at least cost overall is a process called economic dispatch.

Brian Fallow makes a reasonable point in suggesting that nodal prices are meaningless because renewables are the first cab off the rank for investment and they have to be built where there is a resource. This oversimplifies the issue, however, because there are lots of renewable projects and they are distributed all over the country. The question isn't so much where should a project be built (it must be built where fuel is available - this is even true of thermals) but which projects should be built. Given that the main logistic challenge of the power system is getting power to Auckland from all over the country (but with significant other loads at very different places - such as 12% of the country's demand at the very bottom of the South Island) then deciding the least cost way of moving this energy around is a complex problem. The SPD model is the piece of technical magic that performs this task. Then, managing to signal to potential investors where they should invest (nodal pricing) is a neat trick that falls out of the New Zealand's electricity market pricing model (SPD - which is in fact an economic dispatch model).

Even under the heading of renewables you can choose hydro in the South Island (and other places), geothermal in the central North Island or wind (predominantly around the lower North and upper South Island). Each choice has a markedly different impact on how much the grid will cost to dispatch and how much transmission capacity will need to be built; and this can be very different at different times depending on weather (hydro and wind), outages and fossil fuel stockpiles. The pricing model for generation and transmission is, necessarily, complex.

Most of the solutions proposed to increase simplicity tend to be quite static. This is to say that they might work well if the electricity system didn't change much. The problems with electricity supply, however, are either very short term (I have to meet demand now) or very long term (which 40 year investment decision is best). Neither of these suits static solutions. The electricity system is very dynamic and dynamic means complex.

This does contribute complexity to the buying side of electricity and it is here that pure nodal pricing and economic dispatch has far less relevance. Here some form of simplification might make sense.

Mr Fallow has made some sensible observations but he does need to be aware of one of Albert Einstein's most useful quotes: "Everything should be made as simple as possible, but not simpler."

Does electricity have to be complicated?

Brian Fallow wrote a fairly good article in the NZ Herald yesterday.
http://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=10600480&pnum=3

In it he drew on the problems of asset swaps and some of the reasons why they might not work. He also wondered whether the complexity of the electricity market might be part of the problem; and, therefore, simplification could be part of the solution.

To an extent he has a point and there is some merit in pursuing some of his ideas. However, the reason that the electricity market is complicated is because electricity is complicated. While we should try to make things as simple as we reasonably can over-simplifying things that are genuinely complex can lead to a new set of problems.

But why is electricity so complicated?
Mr Fallow wonders whether things have been made complicated by engineers and economists. Again, to an extent, he has a point. The nodal market not only has nodal pricing but is also marginally priced including marginal transmission losses (and this is only the start of the gobbledegook). On the whole though the electricity system is more complicated than people realise and there are two good reasons for this.

First, electricity has its own branch of physics and much of the electricity system is constrained by pure physics. Electrical physics, in practice, probably isn't much more difficult than say the physics of flowing water, but is much less intuitively obvious. Most people, without necessarily understanding the underlying mathematical models can nevertheless understand that water falls down hill and will go anywhere lower than it is now if it isn't held back. A water system is fairly intuitive; and so too is a mechanical system. Electricity, though, does not behave in an intuitive way because it cannot be directly observed (for all practical purposes). For many people it is a mystery and it does have its peculiarities.

Second, electricity cannot be stored in large commercial quantities and must therefore be produced, transported and consumed at exactly the same time. This doesn't sound like a complicating factor but it is. If anyone has tried their hand at logistics, perhaps an example even as simple as buying, wrapping and posting Christmas presents so that they arrive at their destinations at the correct time, will know that logistics can be difficult at the best of times. Now imagine that the complexity of the problem is more like trying to coordinate traffic on all of Auckland's roads so that everything runs smoothly every second of every minute of every day of every year. The electricity system effectively does this and is does it in such a way that, generally, renewable resources are maximised and thermal fuel is called on as necessary. It also caters well for most emergencies of which there are many. And, it does so in such a way that new investment in the system does not need to be subsidised by the taxpayer.

Can the electricity market be simplified? Yes. Can it be simple? No, it cannot.

MED's new New Zealand's Energy Outlook

The Ministry of Economic Development have recently released their 2009 Energy Outlook and they have done a good job.



They have, sensibly, released a reference scenario which is a deliberately static analysis. This scenario uses the best trend information to extrapolate out a future scenario. It does not purport to be a forecast because it is not dynamic. However, it is every bit as useful as a forecast because it is the dynamic elements that forecasters rarely get right.



The MED then does a number of sensitivity scenarios around the reference, which helps give a feel for how things could go. These sensitivity scenarios are more useful than a necessarily opinionated dynamic forecast.



On the whole I think MED has done a good job of taking current trends and projecting them forward, especially as the economic recession has introduced a lot of uncertainty in how various aspects of the economy and energy demand might progress in future. They may have erred, slightly, to the politically acceptable in some areas where they had scope to flex the range of their forecasts. On the whole though, given that their reference scenario is also a statement on where current government policy will take us (all other things remaining static), been refreshingly honest.



My primary bugbear is with the categorisation of transport, although to be fair to MED they are using the accepted conventions. For some strange reason the world continues to view transport as an energy category in its own right. This is a pesonal gripe of mine. To me this would be like presenting the electrical losses of the national grid as an energy category in its own right. It implies that transport is an objective in its own right rather than being a derived demand based on residential, commercial or industrial imperatives.



The major misleading problem this casues in when we look at the energy usage categorisation around residential, commercial and industrial. Treating transport as a separate category makes residential enrgy use look like a small proportion of total demand, but most of the transport demand (the largest energy category) is residential demand. It also significantly increases the commercial category.



Generally, though, good job MED. The full report is available at http://www.med.govt.nz/templates/MultipageDocumentTOC____41969.aspx

Energy Economics

The debate around meeting energy demand is always a controversial subject as there is always some form of trade-off between local effects, consuming scarce resources and economic growth. Many people hope for perfect solutions where there are no local effects, no consumption of scarce resources and plenty of energy. Many are so hopeful of such a nirvana that, believing the barriers to such outcomes are purely economic, they make suggestions that can look sensible. Most of the time, however, the barriers aren't purely economic but are physical. While some might say that if a project doesn't meet economic standards then this is just a cost that has to be worn for social or environmental benefits. However, there is 'energy economics' that must also be satisfied or else we will simply consume more to meet the energy demand than we otherwise would have done.

In other words, we should generally use the most energy efficient ways to make energy available for human use to lessen primary energy consumption. The fact is that everything uses energy to make to a greater or lesser extent. Even things that 'make' energy are made with energy; some of them use a lot of energy to make. A minimum requirement for the bulk supply of any countries energy needs is that (over the lifetime of each project) the energy supplied should exceed the energy consumed to create the supply. Overall preference should also be given to those supplies that 'payback' the fastest. That is to say the energy supply that most quickly repays the energy it took to build.

In the real world projects must make economic sense more broadly but clearly the 'energy economics' case must be met. The problem with many suggestions around particularly small scale and distributed generation is that the energy paybacks tend to be quite poor. This is why energy can get very complicated.

There are economies of scale in energy production. This economy of scale generally applies on a pure energy basis as well. In other words large energy production facilities use less energy to build per unit of output than smaller facilities. And, some technologies are less energy intense than others. Photovoltaics, for example, are very energy intensive to make and so is the support technology it takes to make PV cells practically useful. While it's true that PV panels use free energy to make electricity this is not necessarily true of their production.

It can seem sensible that a large gas turbine is more polluting than the equivalent number of PV panels but the reality is not that simple. The PV panels required to produce the same as a large gas turbine take an enormous amount of energy to make (which is why they are still relatively expensive). As the energy to make the PV panels is generally produced overseas (with the accompanying emissions) then the PV panels look good. On a total lifecycle basis, however, including the total energy to manufacture, utilise and dispose/recycle the case for PV panels is far less clear.

I'm not trying to say that PV panels might have their place or that they do not stack up. What I am saying is that the issue is rarely as simple as if first looks. When it comes to producing energy there is always a piper to be paid.