1. The Operation of the Electricity Markets Brent Layton Talk at EMA Central Electricity Forum 6 th April 2006

2. 2 Outline of Questions Is the electricity market working? Do current prices reflect marginal cost? Why have prices been rising? How do NZ electricity prices rate internationally? How closely is demand for electricity tied to economic growth? Where to next for electricity?

3. 3 Is the “electricity market” working? (1) Market Design Report – See www.electricitycommission.govt.nz Two questions: –What do we mean by “working”? –Is there more than one electricity market and, if so, what are they? Working means? –Producing efficient outcomes in terms of: Productive efficiency – minimizing cost of supply Allocative efficiency – providing right signals in terms of use Dynamic efficiency – providing right investment signals

4. 4 Is the “electricity market” working? (2) Wholesale spot market Retail market –Competition and barriers to entry from vertical integration? –Lack of contracts that allow demand-side participation to manage dry-year risk Forward or hedge markets for electricity –Transparent robust forward price curve –Ability to contract forward by potential new entrants to generation and retailing

5. 5 Is the “electricity market” working? (3) Ancillary services markets –Reserves Regulation or frequency keeping Instantaneous reserves Over frequency reserves –Voltage support –Black start

6. 6 Is the “electricity market” working? (4) Other electricity markets –System operator – contestability would be a good idea –Market administrator –Pricing manager –Clearing manager –Reconciliation manager –Registry

7. 7 Is the “electricity market” working? (5) Transport –Transmission Lack of transmission hedges significant issue Ensuring efficient investment – Part F –Distribution Summary of key issues: –How to get a transparent robust forward price curve –How to get parties access to contracts based off forward price curve –How to get demand side participation from consumers to help manage dry-year risk and constrain any uncompetitive market outcomes –How to provide access to effective transmission hedges

8. 8 Do prices reflect marginal cost? (1) Wholesale spot –Market design is such that, if there is enough players competing, then each is incentivised to offer at its short run marginal cost of generation –Market price is the marginal cost of the last plant needed to be dispatched to meet demand –Question is whether there is enough competition – ComCom investigating –Price spikes to very high levels not necessarily evidence of uncompetitive prices or prices above marginal cost because of “spring washer” effect

9. 9 Do prices reflect marginal cost? (2) Forward prices –Forward prices tend to be higher than spot –This tends to lead to accusations prices “too high” –Dry-year risk justifies some premium – but how much? –See NZIER website –www.nzier.org.nz - for paper on factors to consider when contemplating forward contracts

10. 10 Why have prices been rising? Two factors: –Longer term: Generating capacity constraints are starting to loom larger more of the time Prices have been trending up towards long-run marginal costs of electricity –Shorter term Fuel costs of water rising as dry-year conditions have developed Fuel costs of hydrocarbons high reflecting world prices Market forces at work as they are intended to work

11. 11 How do NZ electricity prices rate internationally?

12. 12 How closely is the demand for electricity tied to economic growth? (1)

13. 13 How closely is the demand for electricity tied to economic growth? (2) Until early 1990s, electricity consumption grew faster than real GDP Since early 1990s, electricity consumption has grown significantly slower than real GDP –Rise of service sectors –Prices reflecting economic costs and not political decisions

14. 14 Where to next for electricity? Market development –Transparent robust forward price curve –Demand-side participation in dealing with dry-year risk –Effective transmission hedges Longer-term –Removal of government involvement Make EC independent of Minister like CC Privatize SOE retailing and generation activities –Government involvement a key factor why market will struggle to reach full potential