Wind and water are complements

Wind power can make sense if you also have a lot of hydroelectric power generation. Wind is of course highly variable and somewhat unpredictable, and the grid requires realtime constant matching of demand and supply to maintain stability. It's much easier to open or close the sluices a bit depending on wind than it is to ramp up or down a thermal plant.

If you don't have the flexibility of a hydroelectric system...well, here's some evidence from Europe, from Motl:

Every year, a huge excess of wind-generated electricity from Northern Germany causes problems to the grids in Czechia, Poland, Austria, Slovenia, the Netherlands, Belgium, and Switzerland.

A year ago, the wind was really strong and the first problems occurred. So they established a warning system. The problems are repeating in 2009, too. For example, it was planned for the last week that there would be a total of 130 MW of electricity flowing from Czechia to Germany. However, the actual budget was 1300 MW in the opposite direction. The balance was almost 1500 MW different than planned.

Mr Petr Zeman, the CEO of the Czech Power Grid (ČEPS), explained that they have survived so far. In his opinion, the problems are caused by the uncoordinated development of the wind turbines in Germany. They have stated that 20% of the electricity should come from renewable sources but these slovens no longer care what it does with the grids.

It is clear to Mr Zeman that if Germany were not connected to the rest of Europe, it wouldn't be able to survive these moments. The grids could be built to sustain such irregularities. However, it takes something like 10 years to build new power lines (which includes 7 years of the hugely complex EU paperwork).

The blackouts are being avoided by rather ad hoc methods of turning individual stations on and off in an internationally semi-coordinated and semi-predicted fashion. However, the chaotic description makes it likely that the system may collapse at some moment. The tasks for the regulation will be increasingly difficult as Germany wants to inflate the current 25 GW of pinwheels to 50 GW of pinwheels.

A commenter at Motl's blog notes that coal and oil thermal plants that have to stand down because of wind have to be put into "hot standby": they're still burning fuel to keep the plant's temperature up, but they're not generating electricity.

Sounds like a great deal: pay for wind turbines, keep paying for fuel for the oil and coal plants, and get the added bonus of grid instability.

Should Meridian be made to swap hydro for thermal generation?

I was pretty lukewarm about the proposed asset swap in which Meridian would be made to sell some of its South Island hydro generation capacity to Genesis and Genesis to sell some of its North Island thermal generation to Meridian, but then I saw this story:

Meridian Energy faces a fight to preserve its green branding following recommendations that it be made to own a North Island natural gas-fired power station.

Of course, a straight swap of assets will do nothing to change the total carbon emissions from electricity generation in New Zealand. What might change, however, is the ability for Meridian to suggest that consumers can reduce their own carbon footprint by buying their electricity from Meridian.

ETAG Report and Wholesale Competition

As I noted yesterday, the ETAG report has some recommendations to improve the wholesale market. Their main recommendation is to require some asset swaps between Meridian and Genesis so that Meridian would own some thermal generation units in the North Island and Genesis some hydro units in the South Island.

Over at Progressive Turmoil, this is seen as

an implicit admission that the contracts market doesn’t work properly. In principle, these two firms should have been able to (and should have wanted to) contract for exactly the same outcomes as will be delivered by the asset swap.

I am not so sure. The ETAG is a bit equivocal in its treatment of wholesale market power. I suspect that the members of the group were unable to reach a consensus. The recommended asset swap may simply be a case of a policy that would increase competition if there were market power and do no damage if there is not, and so can be recommended even without an admission that the “contracts market doesn’t work properly”. I can also imagine a story in which decision making under uncertainty in the allocation of scarce hydro resources would work better if each hydro-owning generator were able to substitute to its own thermal capacity.

In any event, there is another reason why a swap of some of Meridian’s South Island hydro capacity with some of Genesis’ North Island thermal capacity is an attractive policy suggestion. More on this later….

Did electricity companies really overcharge by $4.3b? Part 3

I am still reading the report by the Electricity Technical Adviosry Group, released yesterday, but it looks like they have rejected the conclusions of the Wolak report and instead focused their attention on other areas.

I'll blog on that when I have digested the report. In the meantime, a final post on the Wolak report:

Previously, I blogged here and here on why I don’t believe the figure of $4.3b from the Wolak report on how much electricity companies ostensibly have overcharged themselves through the exercise of market power. The calculation of the $4.3b figure, however, was just one part of the empirical analysis in the report. A significant earlier part of the report is devoted to calculating estimates of the ability and incentive of firms to exercise market power, and showing that it correlates very highly with price.

Now correlation does not imply causality. While the results in that part of the report are consistent with firms having exercised market power, they are also consistent with perfect competition, since the very conditions that lead to a high ability of firms to exercise market power (firms running up against capacity constraints) are the very conditions that would lead to high prices in competitive markets. The details here become somewhat technical, but I want to make one general point: Sometimes empirical results can be too good to be believable. Consider the following graph from the Wolak report:

The red lines shows average prices across the day between 2001 and 2007, and the blue line shows the average estimated ability of firms to exercise market power. One can see just by eyeballing the graph that one could explain close to 100% of the within-day variation in prices by the within-day ability to exercise market power. There are two conclusions one can draw from this: Either the exercise of market power is the only factor influencing price variation; or, the measure of the ability to exercise market power is highly correlated with other determinants of price.

It is pretty hard to believe that market power is the only determinant of within-day variation in price: for instance, there are fixed costs to starting and shutting down thermal power stations, so once a thermal station is started in order to supply power during the peak hours, the marginal cost of continuing it running during low-demand hours is relatively low.

If, on the other hand, the ability to exercise market power is highly correlated with other determinants of price, we cannot infer from the high correlation between it and price that it was the cause of any of the price variation.

The bottom line here is that we should be very very wary of drawing any conclusions from the correlations presented in this section of the report.

Did electricity companies really overcharge by $4.3b? Part 2

In a number of places, the Wolak report assumes that the demand for electricity in New Zealand is not sensitive to the spot price. This is certainly reasonable as a short-run assumption. In New Zealand, wholesale prices are set every 30 minutes. If something unexpected happens to supply (say a failure in a piece of the transmission network) causing prices to spike up, then there is no capacity for buyers to respond to that price spike within the half-hour to reduce the pressure on prices.

But over the course of a dry winter, when prices remain high for long periods, demand can and does adjust. This happens in various ways. First, a few large buyers who buy directly on the spot market reduce their demand to lower their exposure to high prices; second, other large institutional buyers who purchase in advance on forward contracts find it profitable to reduce their electricity use and sell those contracts back into the market at the spot price; finally, retail companies, who are buying at the spot price and selling to customers at a pre-set fixed price, offer financial incentives to their customers for reducing usage below normal levels.

What this means is that, even if, contrary to what I argued in my previous post, there were genuine excess capacity in the system in the dry years due to generation companies exercising market power, prices could not have been reduced right down to normal-year levels without generating excess demand and market failure.

The implicit assumption in the Wolak report is that there is so much excess capacity in our system that, even in dry years, we could meet all the country’s electricity demand without a significant increase in price, and without the need for public “conserve power” campaigns. Furthermore, it assumes that at price equal to the marginal cost of the most expensive thermal unit, generators would be able to earn a sufficient return to cover the investment costs of creating capacity that would only be used for a few months 1-2 times a decade. I simply don’t find this plausible.

Did electricity companies really overcharge by $4.3b? Part 1

I finally have a bit of spare time from my day job to post my thoughts on why I don’t believe the Wolak report’s claim of overcharging by $4.3b over 7 years. The way that the overcharging figure was calculated is a bit involved, but it essentially boils down to an assumption that it would have been possible to supply the country’s electricity needs, even in periods of low hydro reserves, if all generators (hydro or thermal) had charged the marginal operating cost of the most expensive thermal plant. This is shown in the following graph taken from the Wolak report which compares the actual wholesale price to that theoretical benchmark.

The counterfactual prices (in red) rise a bit in the winter months, as marginal costs are higher at thermal plants when they operate close to full capacity, but not by as much as actual prices (in blue), particularly in the dry years of 2001 and 2003.

There are underlying assumptions here that I question. The first is that the marginal operating cost rather than capacity constraints would have been the key determinant of prices in a competitive market. The report assumes that since plants were operating below full capacity during the dry years, the high prices were not due to capacity constraints, but this ignores that fact that plants are required to maintain capacity in reserve so that the system does not collapse if there is a failure at some point in the transmission grid (so called ancillary reserves), and also that hydro generators in particular, need to conserve the limited amount of water in their reservoirs at the start of the winter months not only for later use at the time when, in retrospect, it has the highest value (the report’s assumption), but also as insurance against continuing low inflows. That is, even if in retrospect at the end of a winter it transpires that not all the available water was used, that does not mean that reserves were being strategically withheld to manipulate price; it is consistent with the need to maintain security of supply for all but the worst-case contingencies.

The second underlying (and implicit) assumption in the report is that the electricity demand is fully inelastic (i.e. unresponsive to price). More on that in the next post.

Electricity Report: Who Paid the $4.3b?

The slides from my talk at the Institute for the Study of Competition and Regulation (ISCR) on the Wolak report into the electricity industry are now posted on ISCR’s website.
This is the study that produced newspaper reports like the following:

Power companies face public outrage after a Commerce Commission report said they had overcharged customers $4.3 billion.

I will blog a bit over the next few days on why I think the $4.3b is heavily overstated, but first it would be useful to correct a misunderstanding in the way that the study has been reported in the press.

In New Zealand, wholesale electricity prices are determined every 30 minutes in an auction market in which electricity generators submit offers for how much electricity they would be willing to supply at different prices at different injection points on the national grid, while buyers submit bids to buy electricity at the exit points on the grid. The computer-based market maker then sets the prices to equate supply and demand taking into account energy loss along the transmission network. In principle, generators can submit offer curves that are higher than their true willingness to supply (essentially pretend to be willing to supply less than they actually would like to) in order to push up the price. In the retail market, electricity retailers buy electricity from this wholesale market to sell to final consumers, usually at a price that is fixed for 12 months or more.

The Wolak study looks at the wholesale market, not the retail market. The $4.3b is an estimate of how much electricity generators have overcharged wholesale buyers. But who are those buyers. A small percentage are large industrial final users who purchase directly from the wholesale market at spot prices. But the overwhelming majority of purchases are by retail companies, who are mostly also the big generators. That is, the unfortunate purchasers that Wolak estimates have been overcharged $4.3b by the four large generator companies—Meridian, Genesis, Mighty River Power, and Contact—are, in fact, none other than Meridian, Genesis, Mighty River Power, and Contact!

A full study of the retail industry might reveal that there is pass through from wholesale overcharging to retail prices, but such a study has not been conducted, and it is by no means clear theoretically that such pass through would be profit maximising behaviour in a vertically integrated industry.