GREY POWER SUBMISSION
On The
ELECTRICITY SECURITY OF SUPPLY
POLICY REVIEW
Consultation Paper
For the
Electricity Commission
Dated March 2007
Greypower Federation Energy Committee
Contact: John Noble, e-mail: [email protected]
April 2007
SUMMARY: SALIENT POINTS
1. We agree that the economically efficient level of unserved energy should be
calculated and from that the required energy margin established.
2. We consider that there are factors that have not been taken into account in Castalia’s
calculations. These factors are noted in section 4
3. We consider that the concept of ring fenced reserve energy should be discarded, and
that the energy margin should be provided from within the market. The means of
doing this is considered in section 3
4. We consider that the concept of an energy margin should be complemented with a
means of predicting shortages (including high spot prices in the run up to shortages)
in order to allow the early dispatch of thermal plant (while managing the risk of fuel
wastage). This would result in a reduced energy margin. A suggested method is
described in section 2.
1:
GENERAL:
We congratulate Castalia on producing a reasoned and well analysed consultation paper.
However, we believe that the prescription for the review in the Government Policy Statement
(paragraphs 35-67) has perhaps inhibited Castalia from taking a more fundamental view of
the present arrangements.
The paper sets out to examine the status quo system, ask if there is a market failure, and if so,
decide what’s the least cost “intervention”. It doesn’t appear to acknowledge that the status
quo is not a market system at all, but is an intervention in its own right, Asking “where is the
market failure” seems a little strange…
We prefer an approach that asks what’s the most sensible way in a market system to ensure
sufficient energy is available in a dry year. Our suggestion is not very different from the
ECNZ system, but that system can be much improved through the availability today of much
better information and modelling systems.
We also note the government’s ambition to reduce the proportion of thermal generation, and
eventually phase it out completely. At present, security of supply in dry years is provided by
thermal backup to NZ’s hydro generation. How security of supply can be ensured in the
future, in a system with a high proportion of renewables (some, like wind, with intermittent
and highly variable outputs) and a low or negligible thermal proportion, is extremely difficult
to assess. This is, of course, outside the terms of reference for the present review, but needs
to be borne in mind in forming policy.
1.1:
Systematic Market Failure
The Cause of the Market Failure
PA Management Consultants has pointed out in a report to the Electricity Commission’s
Security Advisory Group that historically there has been more than enough thermal capacity,
had it been run to its operational limit, to avoid shortages in dry years. The problem is that in
the early stages of a prospective dry year there is no way of knowing how dry it will become
or when inflows will pick up; and therefore of knowing whether running thermal generation
at a very early stage is a necessary precaution or a waste of fuel. The prudent approach
involves an energy margin, the cost of which can be balanced against the potential wastage of
fuel.
The need to define a class of “reserve energy” which is subsidised by a levy and is ring
fenced in ways that limit its use, is basically an admission that the “ordinary” market is
expected to fail to supply adequate electricity in dry years. We thus disagree with the
Castalia comment (p, 12) “If the market failure turns out to be sustained and systematic—
unlikely as it is [emphasis added]—this will become obvious due to frequency and scale of
intervention needed…”
We consider the failure to be systematic, noting that it results from:
a) A shortage of capacity, and/or
b) The imprudent deployment of capacity.
With regard to a), we contend that the market is set up in such a way that there is a
disincentive for adding new capacity, in that the prospect of electricity shortages raises spot
prices towards rationing levels (ie, above the cost of the most expensive generation in use).
This results in windfall profits derived from consumers with spot price exposure, and
provides an opportunity for generators and retailers to raise prices to other consumers. These
increased prices are observed to stay high after the shortage is over.
The following chart (from data supplied by NZ Tariff and Fuel Consultants and from the
centralised data set and data from Comitfree) demonstrates this for large retail contracts. In
August 2001 the price increased from about 3.3 to 5.2c/kWh because of the 2001 shortage,
and did not fall back significantly. In June 2003 it rose again to about 7c (2003 shortage), and
did not fall back. From October 2005 it ramped up and steadied at about 8c/kWh. (2005-6
scare).
NZTF contracts compared to spot price haywards,
averaged monthy and yearly
25
2006
1997
5
Oct-06
Oct-05
Apr-06
Oct-04
Apr-05
Oct-03
Apr-04
Oct-02
Apr-03
Oct-01
Apr-02
Oct-00
Apr-01
-15
Oct-99
0
Apr-00
-10
Oct-98
5
Apr-99
-5
Oct-97
10
Apr-98
0
Apr-97
15
Oct-96
c/kWh, monthly
20
10
c/kWh, yearly
NZTF index
spot prices
NZTFyearly
spot price yearly
Thus shortages are profitable for generators, especially in comparison with adding new
capacity which would both increase their capital investment and tend to reduce prices.
However, the threat of regulation causes the generators to limit the severity of the shortages;
they tread a fine line between maximising their profits, and suffering regulation. Put another
way, it is the threat of regulation more than the balance between demand and supply that has
driven market decisions during and following low-hydro episodes. This is, by definition, a
market failure.
Recent Shortages
Similarly, with regard to b), the early deployment of thermal capacity to conserve hydro
storage in prospective shortages tends to reduce prices and also requires increased fuel
stockpiles. A partial cause of the 2001 shortage was the late entry of thermal generation.
Fortunately, sufficient natural gas was available to run the thermal generation, when it did
enter the market, at a high load factor. In 2003 much less natural gas was available, and it
was low coal (and oil, for New Plymouth) stockpiles that contributed to the severity of the
shortage. In 2005-6 the thermal generation did start early. The threat of regulation (and, as we
understand it, direct political intervention with the generators) ensured that coal had been
stockpiled and available for generation. Yet spot prices rose far above the marginal cost of
coal generation – leading to several months of high spot prices. Even though the spot price
fell in May, well before winter began, the spot price averaged over the calendar year 2006
was the highest ever.
1.2:
Disadvantages of a Reserve Energy Approach
Thus we consider the market’s unwillingness to provide adequate supply during dry years is a
product of the way the market was designed, that is, a systematic failure. The solution to this
is to overcome this design flaw, not to provide additional but circumscribed capacity external
to the market, which inevitably causes an economic distortion. By Castalia’s analysis the
distortion on investment in generating capacity is small. We argue that there are other
distortions.
Reserve Energy and the Ring Fence
We contend that the selection of a particular type of “reserve energy” (low capital high
running cost), the ring fence around it, and the insistence on not deploying it until the last
moment for fear of distorting the operation of the “ordinary” market inhibits more flexible
and economically efficient solutions. In fact, the requirement for (subsidised) low capital cost
high running cost plant to ensure security of supply is a product of the ring fenced reserve
energy policy, because the ring fencing and prohibition on it not operating until the last
moment means that it cannot earn an adequate return. This policy also means that a relatively
high MW reserve capacity is required, because it has to compensate for the hydro shortfall
over a short period of time. For example, Castalia has calculated that a 15% energy marginabout 6000GWh- will result in the economically efficient level of unserved energy, with a
security standard of 1:20. The 1:20 year hydro shortfall is about 3000GWh. Their assumption
is that the compensation will have to take place over a period of three months, and therefore,
allowing for the economic level of unserved energy, a yearly margin of 6000GWh is
required.
2:
A PREDICTIVE APPROACH TO SECURITY
Early Dispatch of Thermal Generation
We agree with Castalia’s attempt to establish the economically efficient level of supply
security (chapter 4) although we have some reservations about the outcome. We consider that
this needs to be complemented by developing a means to dispatch thermal generation in a
prudent manner in the early stages of a prospective shortage. As we noted above, this
happened in the 2005-06 hydro scare, because of the threat of regulation and, as we
understand it, direct intervention with the generators by the government. While it worked that
time, we do not consider this to be a satisfactory long term solution.
The Value of Hydro Storage
Thermal generation needs to be dispatched to conserve hydro storage when the probable cost
of an impending shortage equals the probable cost of the fuel (and possibly additional
generating capacity) required to avoid it. A possible method of evaluating these factors is
through the calculation of the opportunity value of the hydro storage. New Zealand at the
moment needs both hydro and thermal generation to meet its annual consumption; the
thermal generation is needed both to supply a proportion of the energy, and to help meet the
peak demand. In this situation any usage or shortfall of hydro storage potentially commits
compensating thermal generation in the future. The water can thus be valued at the cost of the
thermal generation that would be committed by such a shorfall. This, essentially, was the
method used by NZE to give hydro a value that could be incorporated in the generation merit
order.
Calculation and Trigger Point
Of course, the inflow and consumption probabilities have to be factored into this assessment.
But, in general terms, the data is available to develop scenarios based on the economically
efficient merit orders associated with the inflow and consumption probabilities at a particular
time and storage level. From this, the probability of an impending shortage, its cost and the
cost of avoiding it, can all be estimated- and thus, the prudent timing and quantity of thermal
generation dispatch.
These calculations could be triggered by hydro storage falling to a level, as an example,
where the 10th percentile low inflow probability and the expected consumption produce a
shortage before the end of September in a particular year. The objective of the calculation is
to bring thermal generation on line to conserve hydro storage while managing the risk that the
fuel will be wasted, with the aim of reducing the energy margin required. Note that in the
NZE days, this was done by human judgement, not by a formal assessment of probabilities.
3:
PRACTICAL IMPLEMENTATION
Trigger Point and Critical Period
As Castalia have noted, the energy margin is expected to remain above 15% until 2015. We
argue that by the pre-emptive but prudent dispatch of thermal generation, this margin can be
reduced. Castalia’s figure of a 15% energy margin is based on a three month critical period;
if this could be doubled, the margin could be halved. Until 2015, then, there is no need to set
a specific energy margin; by then there should be enough experience to estimate what the
trigger point for the calculations should be, and over a critical period of what length the
energy margin needs to be deployed.
Energy Margin
We agree with Castalia’s methodology for determining the energy margin in general (but see
section 4 for our reservations regarding the calculations).
The energy margin should be calculated, and the generators encouraged to maintain it.
Castalia considers that if the margin is eroded to a level below that required, the Commission
should contract reserve generation to compensate. We see no difficulty in estimating the
energy margin for several years in the future (as Castalia have already done). If the margin
falls below the required level, we suggest that the Commission should issue a Request for
Proposals for additional generation to both existing generators and possible new entrants.
This could take the form of additional capacity in an already planned conventional plant
(geothermal, for example), embedded generation (running on biofuel?), fuel substitution, as
was done by Southpower in 1991 and 1992, or any other available form of generation or
conservation. Embedded capacity could help reduce transmission and distribution investment
as well as contribute to the energy margin. The Commission should then decide on the most
suitable proposal, and arrange for it to be implemented. This would include protecting it from
gaming, for example by arranging for it to receive a pro rata share of existing hedges. We
note that the Rules would have to be changed to make this possible.
Trigger Point
A trigger point for the predictive process will be estimated before 2015 (or when the energy
margin is predicted to fall to the required level), based on past experience at that time. The
trigger point may, for example, correspond to a particular storage level (analogous to the
NZE rule of thumb that the lakes should be full by April each year) possibly in combination
with an inflow probability as suggested above. The objective of the trigger point is to provide
an early signal of a possible shortage.
Predictive Process
When the trigger point has been passed, scenarios based on the merit orders associated with
various probabilities of inflow should be produced and updated. If or when some of the
scenarios indicate a possible shortage (or even that hydro is moving up the merit order,
indicating that spot prices are liable to increase to the point that production from the
electricity intensive industries will be reduced) the probability weighted estimated cost of the
unserved energy can be compared to the cost of fuel required to avoid the consumption
restraint. This calculation should be made publicly available, to give thermal generators and
demand-side participants the impetus to correct the situation.
Energy Conservation Should be Part of the Strategy
It is possible to assign a value to the electricity saved by various types of conservation
campaign in terms of the cost of the non-supply. Castalia have calculated a cost which ramps
up from the nominal residential electricity price of 18c/kWh at a rate of 20c/kWh for every
percentage point of restraint. Thus conservation campaigns can also be inserted in the merit
order. We consider this to be a sensible move, as it will both conserve storage and also reduce
the extreme spot price volatility that occurs during the run up to a shortage. Demand-side
alternatives include dual-fuel space or water heating systems, running on natural gas or LPG
(the latter was used by Southpower), or firewood or pellets. Dairy farms generally use
electric water heating, and their rapid expansion suggests an opportunity for dual-fuel
systems able to switch in dry years.
4:
CRITQUE OF ENERGY MARGIN CALCULATIONS
While we agree with Castalia’s energy margin methodology in general, we have reservations
about some details of the calculation (apart from assuming a three month critical period
mentioned above).
“Natural” Market Security Standard
We note that the pre-emptive dispatch of thermal generation happens naturally within the
market. The current limitation of contracting no more than 1200GWh of reserve energy is, as
we understand it, based on the difference between the “natural” security standard afforded by
the market (thought to be about 1:15) and the desired standard of 1:60. Castalia have
calculated the energy margin required to produce an economic level of unserved energy in
dry years. They have not allowed for the market’s “natural” security standard. Our aim is to
extend the natural security standard by means of a predictive system for dispatching thermal
generation.
Double Counting
Castalia’s advice seems to be that the energy margin should be calculated as the supply
capability allowing for maintenance, average contingency outages, load factor effects and
consumption uncertainties minus the expected consumption. We believe there is an element
of double counting here, because it is unlikely that all the adverse effects will happen in the
same year. We would suggest that each margin is calculated separately, and the required
margin should be the root mean square of these.
Reductions in Production Caused by High Spot Prices
We would argue that the cost of shortages is not just the cost of residential unserved energy,
but also the cost to the economy of reduced production caused by high spot prices in the run
up to the shortage. The GDP loss caused by the 1992 shortage was estimated at $500M; in
2001, $200M; in 2003, $100M. But the rise in spot prices caused by shortage scares, as in
2005-6, also damages the economy in three ways: first by the direct loss of production by the
electricity intensive industries, which seems to occur at spot prices well below $200/MWh
(which might be called the cost of unserved industrial energy); second by the knock on effect
on their suppliers; and third because of the effect of supply and cost uncertainties on
businesses. These effects are included in the GDP losses quoted above. There are of course
many more shortage scares than actual shortages, and the scares tend to last longer. However,
it is very difficult to estimate their cost. Production cuts might cost about $150/MWh on
average. Assuming the reduction in consumption of the major industries to be, say, 17GWh
per week in the pre-shortage period the reduction in GDP could be $2.5M/wk or more. These
very preliminary assumptions suggest the costs could be about the same as for domestic
consumers, but they occur much more frequently than conservation campaigns leading to
domestic consumer consumption restraints.
Lowest Capital Cost Generation Option
We disagree that the “lowest capital cost generation option” of diesel fuelled open cycle gas
turbine generators (Castalia, sect 4.3) is necessarily the correct one. It is, only if reserve
energy is considered to be separate from the market. None of the large thermal plants run at
their maximum annual outputs in hydrologically normal years. The least cost source of
additional electricity is to increase their outputs (zero fixed cost, low variable cost). However,
they will tend to run at full output during actual shortages, so their outputs can only be
increased outside these periods. That is why a means of predicting impending shortages is
required. We also point out that the use of diesel fuelled generation is not consistent with the
government’s energy strategy,
Marginal Cost of Increasing Security of Supply
We believe that both the variable and fixed costs of diesel fuelled open cycle gas turbine
generation have been underestimated in sect. 4.3. The variable cost should include both the
fuel cost and the variable maintenance cost. We estimate the fuel cost at present oil prices to
be around 25c/kWh and rising, with an additional 1c/kWh for the variable cost of
maintenance. In sect. 4.3, Castalia have calculated the fixed cost of a diesel fuelled gas
turbine generator running in the reserve energy mode as 4c/kWh. This is based on the plant
running continuously during the critical three month period. However, if this happened at all,
it would only happen once in 20 years, with perhaps some shorter periods of operation in
between. Because of this, we would expect the fixed cost to be considerably higher.
Calculation of Energy Margin
.Having taken these factors into account, an economically efficient level of unserved energy
can be calculated (including both domestic and industrial restraint) and from that, the
appropriate energy margin.
5. CONCLUSION
Today’s system for contracting for reserve energy aims for an extremely high “security”
level. “Conservation campaigns” are planned to be needed when hydro flows are less than 1
year in 60. This was an arbitrary figure, chosen after the 1992 hydro shortage, and has never
been contested by consumers’ willingness to pay the very high cost of maintaining that
standard.
Today spot prices have increased, in each of the three years of low hydro flows, for
progressively longer periods. As a result, high-price years have seen average prices over the
whole year, typically twice the average prices in medium or wet years.
Contract prices have increased each time the spot prices rose, but have not fallen when spot
prices fell. Domestic consumer prices have followed a similar trend, leading to an average
increase of consumer prices in real terms of 5.5% per year from 2000 to 2005. (The trend is
reported to have been similar, in 2006,)
Domestic price rises are causing increasing fuel poverty, with more and more consumers
unable to afford to heat their houses to healthy temperatures, Some consumers, who have
alternative space heating options, could well be invited to contract for reserve energy as dry
years approach, and some generators could also be contracted for dry year energy. If these
true market solutions for the “dry year problem” were called on by the Commission, the
recent high spot price events might be avoided,
The key is to put objective information into the market that would guide the tendering to meet
the energy margin. This would put this concept back into the market, and allow it to be
provided by lower-cost means than the remote, diesel fired Whirinaki gas turbine or other
“reserve” generation.
This would reduce the cost of dry-year energy to the benefit of all consumers.