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LECG Limited

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Economics and the electricity sector – the significance of basic principles 16

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November 2006 Simon Hope (B.Appl.Econ Hons - Massey)

Disclaimer: the views and ideas expressed in this presentation are those of the author and not of LECG Limited

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Background

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NBHS Completed a Bachelor of Applied Economics with Honours in 1999 Worked as a Senior Analyst in Forecasting and Modelling Unit at MSD Moved to NZIER, worked primarily in energy sector Currently a Senior Managing Economist at LECG, working primarily in the energy sector LECG work covers regulation, competition analysis, modelling, contract analysis, market design

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In one ear and out the other…

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Not always easy to make economics ‘sexy’ Theory can be overwhelming Difference in application of theory to reality – varies by course, subject 6 th /7 th form and 1 st year university economics the key years for picking up fundamental concepts Concepts built on throughout university

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The eternal question: when am I ever going to need to know this?

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Need to emphasise real world application of these key economic concepts Helps reinforce their importance and makes learning easier We all remember examples Practical examples make economic theory and concepts a reality Digging out old text-books

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Outline – significance of basic economic principles in the electricity sector

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Introduce NZ electricity sector Discuss the role of basic economic principles Identify and discuss use of these principles Parting thoughts Questions

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The New Zealand Electricity Sector

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New Zealand’s electricity sector has four main components:

    generation (electricity production stations) transmission (the high voltage network known as the national grid) distribution (local lines companies) retail (electricity retail companies compete to buy wholesale electricity and compete to retail it to consumers)

Huge industry in terms of assets (lines companies alone have assets in the order of $5 billion, govt. owned generation assets approx. $7.5 billion), employment and impact on consumers (residential, commercial and industrial) Use of basic (and complex) economics is pervasive in the industry, even if many don’t realise it…

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The role of basic economic principles

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Economics is about allocating scarce resources Applies perfectly to electricity sector – water, gas, coal etc. all relatively scarce (some more than others) Basic principles influence:

   Prices in the market Regulation in the market Incentives on market participants  The role of the energy sector in the wider economy

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Prices in the market

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Key economic concepts in this area:

   Supply and Demand Elasticity of demand Marginal cost   Opportunity cost Economies of scale

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Prices in the market (II)

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Spot/wholesale price determined by supply and demand in the market Wholesale price forms part of overall retail price Consumers purchase electricity in different ways:

 Residential and small commercial consumers effectively purchase via a retailer (who buys from the market or has own generation)  Large industrials may generate some of their own, or purchase straight from the market (or a mixture)  Non-residential consumers tend to have a portfolio i.e. some contracts, some spot purchases

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Prices in the market (III)

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NZEM introduced in 1996 Majority of wholesale trading in electricity for immediate delivery occurs through NZEM Wholesale/spot market prices determined by:

  Generator ‘offers’ into the pool Buyer ‘bids’ for take from the pool

Intersection of Demand (bids) and Supply (offers) effectively determine spot prices Half hourly spot prices derived for nearly 250 nodes Differences in price at nodes reflect transmission constraints, losses and cost of electricity

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Prices in the market (IV)

Schematic of price derivation for a half hour Price

Total demand Supply ‘stack’

P* Q* Demand

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Prices in the market (V)

Schematic of price derivation for a half hour Price D S 1 S S 2 P 1 P* P 2 Q* Demand

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Prices in the market (VI)

Electricity Price Index, seven day rolling average

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Prices in the market (VII)

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Key points to note:

   ‘Lumpy’ supply stack reflects nature of generation plant Demand and supply both shift for each ½ hour period Supply stack can shift left/right/up/down/stretch. Demand shifts left or right    Weather, strategy, fuel supply, new technology all important Demand is effectively assumed inelastic at each point in time  ALL GENERATORS required to generate to meet demand get marginal price of the last plant required to meet demand – ‘marginal cost pricing’ e.g if last plant required to meet demand ‘offers’ at 10c/kWh, then all dispatched generators receive 10c/kWh

Prices have huge incentive effect for potential/existing generators

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Prices in the market (VIII)

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Opportunity cost plays an important role in offer strategies of generators

  e.g. stored water ‘used’ today is not available tomorrow Opportunity cost of fuel changes depending on weather conditions, fuel supply etc.

 End of supply stack is very steep (potential effect on price) 

Economies of scale

 Larger generators able to spread fixed costs over higher level of output  Some economies of scale depending on generation, investment is ‘lumpy’

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Regulation

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Key economic concepts in this area:

     Opportunity cost Vertical integration Producer/consumer surplus Types of competition: monopoly  perfect competition Encouraging efficiency – productive, allocative, dynamic

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Regulation (II)

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Opportunity cost

 The way the industry is regulated will affect the relative returns of being involved e.g. intrusive regulation could stifle incentives as opportunity cost of investing elsewhere increases  Important consideration in cases where prices/revenues are regulated (e.g. lines companies)

Vertical integration

 Vertical integration provides an internal hedge   Historic issue (lines company/generation split) Important for competition considerations

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Regulation (III)

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Producer/consumer surplus

   Key issue for competition cases involving mergers/acquisitions Tests of PS and CS help determine outcomes of transactions Calculations often relatively simple (interpretation difficult)

Types of competition

 Concentrated large generation  28 lines company    1 transmission service provider Limited retailers (linked with generators) Current review of wholesale/retail competition. Huge issue in the industry, with very divergent views  Important to consider size and characteristics of NZ market

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Regulation (IV)

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Encouraging efficiency

 Key economic concept used frequently in assessing options in the electricity industry   Can use provision of efficiency as criteria for evaluation Common use in government policy as a goal/objective   Quantitative as well as qualitative evaluation tool Information limitations make qualitative evaluation difficult in many cases

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Incentives on participants

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Price signals vital for investment Level of regulation important signal Affected by level in supply chain, type of generation, ownership (e.g. Govt./private) Type of generation important – fixed/variable costs Sector covered by variety of rules, regulations, Act’s so complex and involved to be in

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Incentives on participants (II)

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Fixed/variable cost example

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Role of electricity sector in wider economy

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Costs of regulation passed through to consumers (e.g. HVDC, Electricity Commission levy, CO 2 tax) Electricity key input to industry – affects cost of production (and hence cost of consumer products) Electricity cost affects international competitiveness e.g. Comalco Retail prices affect consumer purchasing power (e.g. via electricity bills and CPI) Efficiency of market influences overseas investment

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Parting thoughts

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Electricity sector a good example of economics in action Constantly evolving industry, important to wider economy Often the most basic concepts that turn out to be the most commonly used Practical application of economic theory can make learning economics more interesting Make use of examples of practical economics (e.g. Reserve Bank, Treasury, MED, NZIER)

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Questions

[email protected]