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.