1. 1 LECG Limited

2. 2 Economics and the electricity sector – the significance of basic principles 16 th 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

3. 3 Background  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

4. 4 In one ear and out the other…  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

5. 5 The eternal question: when am I ever going to need to know this?  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

6. 6 Outline – significance of basic economic principles in the electricity sector  Introduce NZ electricity sector  Discuss the role of basic economic principles  Identify and discuss use of these principles  Parting thoughts  Questions

7. 7 The New Zealand Electricity Sector  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…

8. 8 The role of basic economic principles  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

9. 9 Prices in the market  Key economic concepts in this area:  Supply and Demand  Elasticity of demand  Marginal cost  Opportunity cost  Economies of scale

10. 10 Prices in the market (II)  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

11. 11 Prices in the market (III)  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

12. 12 Prices in the market (IV) Schematic of price derivation for a half hour Total demandPrice Demand Supply ‘stack’ P* Q*

13. 13 Prices in the market (V) Schematic of price derivation for a half hour D Price Demand S P* Q* S2S2 S1S1 P1P1 P2P2

14. 14 Prices in the market (VI) Electricity Price Index, seven day rolling average

15. 15 Prices in the market (VII)  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

16. 16 Prices in the market (VIII)  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’

17. 17 Regulation  Key economic concepts in this area:  Opportunity cost  Vertical integration  Producer/consumer surplus  Types of competition: monopoly  perfect competition  Encouraging efficiency – productive, allocative, dynamic

18. 18 Regulation (II)  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

19. 19 Regulation (III)  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

20. 20 Regulation (IV)  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

21. 21 Incentives on participants  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

22. 22 Incentives on participants (II)  Fixed/variable cost example

23. 23 Role of electricity sector in wider economy  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

24. 24 Parting thoughts  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)

25. 25 Questions shope@lecg.com