Thursday, 2 May 2013

Information and thoughts on NZ's electricity market

Summary and key points

The electricity market is already different to what people think and will likely undergo radical changes in the next 1-2 decades or earlier.

Electricity consumption is not increasing as commonly thought, this impacts planning and assumptions people have about continued increases in capacity.

1.1 Solar power has become much cheaper lately and has already had a major impact on utility profits in Australia, meaning they may never recover some of their investments.

1.2 Batteries that could allow you to cheaply store nighttime electricity for use during peak hours are past the prototype stage in at least one case. This will also have a massive impact on electricity pricing.

Secondly, how has the present system performed, how would you expect it to perform given how it is set up, and what other options are there given the present and future uncertainties?

2.1  The market where electricity is priced at or above the most expensive generation cost rather than the average is not the only way things can be done. Healthcare and education of course don't work that way, neither does electricity in many different markets around the world with a range of political systems (even in some parts of the USA).

2.2 The objection that a given policy will destroy the value of power companies is not a valid argument. You need to look at NZ as a whole.

2.3 Efficiency and insulation are the most cost effective ways to ensure sufficient supply, wind is perfectly capable of supplying more if necessary with negligible risk to build. Centralized wind is cheaper than distributed solar, but because of the way the market is set up, that is not what will happen. Residential investors will install solar and save themselves some money, but not as much as they would have saved if the market was structured so that they could get full advantage of cheaper wind. If solar is built, this new distributed capacity will very likely still crash the wholesale electricity price meaning the "destruction of value" that people say they are worried about is unavoidable anyway.

1.1 Electricity consumption is hardly increasing unlike what is commonly assumed

Here is NZ electricity consumption recently:

It is no longer rising, and like many developed countries could fall.

This is widely not put down to recessions etc, but a permanent shift in trends. It is not surprising either that such a thing happens. Our electricity needs are not changing that much, and with insulation/efficiency improvements the electricity required to meet them reduces. Just like I don't eat exponentially more food each year, I don't use more and more electricity.

(A similar thing happens with petrol. My need for that is not continually increasing with time, if I was given free petrol for  my car I wouldn't use that much if any more than I already do)
So we can quite likely expect the electricity requirements to be pretty stagnant now, and the assumption of a steadily increasing need, and that being met by continuing centralized investment can not be assumed at all.

1.2. Distributed generation, that is rooftop solar power is having a massive impact already.

In fact it is happening in Australia where already about 10% of people live under a roof with some solar panels. In spite of us paying lots of attention to Australia, as far as I am aware, this hasn't even been given a single mention anywhere. Do you know anyone who is aware of this?

Look at the massive drop in price of solar panels recently
and the corresponding increase in production:

This kind of steady exponential increase in production and decrease in price is like what happened for silicon chips/digital cameras/flat screen TV's etc. Any technology that has seen this kind of continual increase in production and decrease in price has gone mainstream with devastating effects on the incumbents e.g. analog cameras, old CRT TV's etc. If it continues, profit margins for existing electricity generators will pretty much disappear.

So what will this trend do when it comes to little old NZ? well look whats already happening in other countries:

NZ doesn't have as much sun as Aus, so the panels need to get a bit cheaper before it becomes worthwhile.

The utilities are in some kind of death grid spiral where they cannot recover their investments. A few years ago, in Aus they made a decision to upgrade the grid to handle more centralized power that is now not needed. The power demand is not going up as predicted, and to make it worse for the utilities, the supply from distributed is going up quickly from solar. Now because of the way the market works, they were guaranteed a return on their investment from higher power prices. However if power usage drops then per KWh they need to charge more to make their money back. As a result of that price increase people use less, either conservation or solar, so they then need to charge even more per KWh to make the same return, which of course makes even more people install solar because it is an ever better investment. This was completely unexpected by the industry (but perhaps not technologists) such an issues has never happened in the electricity market, with 50+ years of data. What this should tell you is that what would have been a safe assumption 20 years ago is very much not the case now.

1.3. Daily electricity storage with batteries further changes things

It gets worse, because there is another technology coming which will also shake up assumptions unchallenged for as long as power lines have existed, that is that you cannot cheaply store much electricity. As you know there can be over a 10c difference between nighttime and daytime electricity with even more variation on the spot market. This is how generators make much of their profit. They generate for say 5c, and sell for 10-15. Users bid against each other, raising the price. However if you could store electricity cheaply then this wouldn't happen. There is a massive rush to make batteries capable of doing this, as there is such a huge gain if successful.

Here is a company that can deliver on energy storage: $160 per KWh, with 10,000 cycles.
Sure it isn't on sale yet, but they have a lot more than just a prototype, and as I said there are many other contenders. They may be currently focused on commercial, but there is nothing stopping them from making residential size batteries as far as I can see also.
What does $160 per KWH, with 10,000 cycles mean? Well, that's 27 years where you can buy at night and use during the day. The cost per cycle is 1.6c. That is compared to 10c. Now because of interest/installation costs etc it won't be quite that but you can see it is enough to destroy the 10+c extra the generators and grid operators are used to making for peak electricity.
If residential users do this in combination with solar panels and the traditional generation/profit model is quite undermined. Our house (and of course many others) receives enough sunlight on average for us to supply our electricity needs that way. (Even though the average is high enough, we would still need the grid in winter until solar panels become more efficient) Users would just use the grid for backup, literally on a rainy day not under normal operation. This is guaranteed to produce fights about who should pay what and when, which isn't helped when some peoples savings benefit by people paying too much for power.

So as you can see, the situation over the next 20 years is very different to what many people think. In 5 years, solar could be starting to make a large impact on electricity supply/wholesale price if power prices continue to be high and within 5-10 years because of battery tech things could be very different indeed. These trends need to be taken into account when considering future options.

2.1. How does the current system work and what to expect

The current system works on an auction where price is determined more by supply constraints than production cost, and everyone gets the same price no matter what it costs to produce the electricity.

Price range from 5-30c per kWh averaging about 9-12c or so lately. Hydro costs anything from about 2-4 cents to run depending on how you price things. So if there is a glut, then prices can drop to somewhere near the low cost of producing power from hydro, but if there is a shortage, and another power source is needed, (e.g. gas) then the power price will settle above the cost of that source so the operator can make a profit. The upshot of this is that if there is say a demand of 9, with 10 units of hydro available, then the price could be 3c per KWh, however if there is a demand of 11 with 10 units of hydro available then the price will shoot up to over 10c/KWh. In terms of profit from the hydro operators point of view, you can see that they could make 5-10* more profit per kWh when there is a shortage, as their fixed costs are always the same. You can quite quickly see that a hydro operator benefits massively when there is not enough cheap electricity to meet demand.

2.2 To understand how things work, follow the incentives (yes its money in this case)

It is a pretty well known rule that if you want to understand a system, or organization, look at the incentives of the players in it. Now in this case if it is a power company then of course it is incentivized to make a profit. It has a legal obligation to make a profit, that is its #1 directive. A stable cheap-ish economically beneficial power price is not its incentive.  It is also directed to make dividends, MRP gives 90-110% dividend from memory I think. So what will this obviously do? Well it will have two very good reasons not to invest in new capacity. Firstly of course new capacity will reduce future profitability, and secondly it is directed to pay dividends anyway. Even if the power company is only say 15% of the market, with the massive profit increases that under capacity gives, if its investment causes this under-capacity to be reduced then its profit will be substantially reduced. It doesn't require the power companies to collaborate or a power company to control over 50% of the market, because hydro under-capacity can cause such a massive profit increase.

Say a power company was considering a large new project that would generate more income because of the increased electricity production. It would always have to factor in the fact that same project would reduce the times when electricity spiked to over 20c/KWh and hence greatly reduce its profit margin. You can see that what would be best for the power company would not be best for the country at a whole. Average NZers and power companies therefore will have different ideas on what is the optimum generating capacity, with power companies favoring less capacity with the potential for massive profits on a dry year. This obviously isn't optimal for NZ however as such massive price increases are distressing to low income families and damaging for business.

2.3 What are the options

The most simple option is some way of ensuring that capacity is chosen not to optimize the profits of the power companies (this would be them getting together and spilling most of their water out of their dams to always get the >20c per KWh prices) but calculating how much capacity NZ needs from a cost/benefit perspective. This is going to be a higher number than the power companies choose. Now because electricity usage is hardly increasing, this will likely be a small amount of extra capacity that will last 20+ years, but will have the benefit of hugely reducing the massive price increases we are forced to put up with in a dry year.

How can this be built?

Wind is a good hedge to hyrdo and can be built quickly and risk free. The benefit of building extra wind is that as soon as it is built you are saving on natural gas costs, and those natural gas power stations are still there to be used if needed in a really dry year. There is also no cost uncertainty going forward as there is no fuel needed. These projects are very low risk and easy to do, but if you really are worried of course, the govt can just open a tender to build sufficient capacity of wind and it will be filled on budget and on time by an international company. This is very common internationally and can be depended on.

New wind costs between $78 and $105 per megawatt in NZ

and it can cost less in other locations:

However because of efficiency often being cheaper than new construction it may not be necessary to build much if any more capacity, as mentioned later

2.4. Will adding new capacity “Destroy value” of the power companies?

Yes! Of course it will “destroy the value” of the power companies, mathematically this is unavoidable. It will reduce the massive profits that are beneficial to them in dry years but far more damaging to NZ as a whole.

The way to economic prosperity is not to have companies that supply essential services make massive profits at the expense of everyone else. If it was, then why not just charge everyone $100 per week to use NZ’s roads, $10,000 per year for water etc and sell the rights to charge these prices to a private company? That sure would quickly create a very valuable company, (and yes people could buy shares in it too!) but of course would be disastrous to NZ as a whole.

Also, if someone invented some semi-magical device to produce electricity for 1c/KWh then introducing that into NZ would completely “destroy value” for the power companies also, but of course be MUCH better for the NZ economy as a whole. Arguments relating just to the value of the power companies are not valid at all, in this case it would lead to the banning of importing such a device into NZ. It is the whole NZ economy that we are trying to make work. However once peoples personal life savings are involved, this argument will have political weight in spite of not being a good one, leading to bad decisions all round.

2.5. What is the most cost effective way to make sure there is sufficient capacity?

I mentioned wind/solar as ways to increase electricity supply, however they are probably not in fact the best and most efficient ways to start with. Energy efficiency and insulation schemes have the same effect, and usually for a cheaper price with added benefits. There is overwhelming evidence worldwide that energy efficiency investments are often “cheaper than free”. That is they pay for themselves quite quickly are give a good return on investment. This is because of well documented “market failures”. For example in a renting situation landlords will often not spend money on efficient heating/lights or insulation because they won’t get their money back even though objectively the investment could make very good sense for both parties. The tenant won’t pay extra in rent even though it may make financial sense to do so. Incentives to avoid these market failures save everyone money and make the country more prosperous.

Also from a social welfare perspective this is a very effective way to spend money. Given that we already have social welfare for poor families you can ask what is the most effective way to spend it. Giving money to spend on heating (or other not so useful stuff) or spending it on insulation to save money. There are also well documented health benefits for low income families that have a $ amount many times greater than the initial cost (Asthma attacks requiring expensive hospital stays avoided etc). Spending money this way multiplies its beneficial effect and helps to give a stable dependable power price for us all.

Cheap energy efficiency and insulation alternatives should be exhausted before additional capacity is built, where such efficiency is cheaper than building new capacity.

2.6 What to expect if there are chronic high prices

As has been noted, the price of power is often much in excess of the price to generate it. This means that things like rooftop solar which would not be competitive with the average price of power will be competitive for homeowners.  Therefore sooner or later the extra capacity will be built anyway, but if it is rooftop solar instead of wind/efficiency, then it will be several years later, and it will be more expensive. Homeowners will buy the capacity instead of power companies; however overall NZ will end up paying more as solar is more expensive than large wind or efficiency measures. It is better to have additional capacity built sooner so cost drops sooner and the overall cost is less. However with the current market, we will get the higher prices for longer and have the more expensive rooftop solar being built. This is not the optimum solution.

2.7 What will the sale do?

This deal has been sold as a way for the government to raise some money, as a way for New Zealanders to invest in their future, to encourage them to start investing in the share market etc. Many of them will do this, however they have many false ideas about what is going on, and have little idea of the risks involved and what to actually expect from the power market. Information like whether power usage is increasing, not to mention all the other technological trends are things people should know when making investment decisions, however I have met almost no-one who knows even about these issues. Those mum and dad investors are being sold something that is completely different to the reality of the situation, and it is only going to end badly for someone. The power industry is going through a transition and it doesn't  make sense to make it even more difficult by polarizing the population and potential national and international investors by giving them shares in a difficult situation. If there are personal finances at stake that there is political pressure to protect, that is just going to complicate things, and cause bad choices to be made to protect interests.

You are supposed to do homework before investing, but how does the general public even get information on this?

What hasn't been made clear is that investing in a power company now is an incredibly risky long term investment, rather than the solid one it once was.  Because of the combination of political and technological uncertainty you are essentially making a wild guess rather than a stable long term investment. That is about the worst way to get people into the share market and away from just investing in housing.
 So I see two possibilities:
1. Investors get screwed because of issues above, and lose confidence in the whole share market business.
2 NZ including all businesses and residential power users get screwed because of bad decisions taken to protect the “value” of the shares owned by say 10% of New Zealanders, meaning needlessly high power prices.

Other information:
Distributed generation is only given one sentence in the risks section in the MRP share offer document as far as I can see, and battery storage is not mentioned at all. I think this is misleading as it stands.

Vector CEO thinks Labour-Green plan could work:
Mr Parker says the single buyer will offer the wholesalers a reasonable price instead of an inflated one.
"Each generator will be paid a fair return for their actual costs. The fair return will be calculated by NZ Power on the basis of their historic capital costs, possibly adjusted by inflation, plus operating costs like fuel, depreciation and maintenance."
Many states in the US use similar models, he says.

Battery storage:

Germany exports more than it imports: