Lessons from the winter 2001 electricity shortage. (Annex III).
Spot prices increased, as could be expected. But did they go too high? On balance, the evidence suggests they did not, given what happened to demand. The supply curve is steep once hydro generation has been exhausted because the next cheapest option -- thermal generation -- is relatively expensive to bring on line. Prices remained within the cost range of each successive generation option (Figure A1). In addition, there was still interruptible (variable) demand that was not switched off, but could have been if prices had gone higher.
Having said that, retail prices did not move so initially there were no direct financial incentives for households or smaller commercial enterprises to economise. However, towards the end of the winter, buy-backs and reward schemes for decreased power usage began to operate. One private-sector retailer, who had not hedged its exposure to the spot market, tried to raise its prices to avoid bankruptcy but backed off when the other retailers, including the state-owned ones, held prices fixed. Its retail arm essentially went bust, and it was forced to sell its retail customer base to its competitors. While some degree of price smoothing is economically efficient, and large firms are often in a better position than others to manage their demand, stable retail prices or sluggish changes in household demand may have pushed all the burden of adjustment onto large industrial users.
These rigid retail prices raise the question of whether there is inadequate retail competition, though the answer is far from clear. All five major retailers are vertically integrated with generation businesses, four are regionally based, and three are government-owned. Each of these three features has generated comment. First, some players have called for generation to be separated from retailing. It is not clear whether this would improve efficiency. It has the advantage that it may encourage new entrants, who currently may be put off by the need to buy hedges from generators who are also their competitors in the retail market. On the other hand, a retail network is a natural hedge for a generation business, so vertical integration may be a cheap way to manage the most significant risk in the business. Second, the regionalisation of the industry is partly caused by bottlenecks in the transmission grid, which can lead to large differences and high volatility of prices across regions, which in turn reflects insufficient investment in the grid over the past decade. This occurs partly because no investment can take place unless all affected parties agree to share the cost, so the framework has a free-rider problem. At present, this bottleneck risk is difficult to hedge against, although the development of new financial instruments (Financial Transmission Rights) should help. In addition, the government should also consider whether the grid owner, Transpower, has adequate incentives to invest in extra capacity where it is economically efficient to do so. Its incentives to lower the safety margin in the system temporarily during shortages, in order to boost the capacity of the system, may also need to be reassessed. Finally, there may be a perception by other retailers that the SOEs will be less willing to raise retail prices during a power shortage. Selling the SOEs would remove any such perception.
The spike in spot prices put some large consumers under considerable financial pressure, largely because they did not take out hedges before the winter. To some extent that may have been a gamble that did not pay off: three good years with low wholesale prices may have lulled some firms into a false sense of security. It may also reflect insufficient transparency in the futures market. This could be partly overcome by mandatory publication of hedge prices and contract terms or compulsory hedge tendering ("market making") by generators. The first option has been a government requirement of the industry since the government's Policy Statement of December 2000, although the industry has dragged its feet in implementing this and other requirements; the second is being investigated by government, and it should ensure that a decision is made before the winter of 2002.
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