Monday 21 November 2011

A Justification for Partial Asset Sales

Like most economists, I think, I have been critical of National’s policy to sell off non-controlling stakes in some SOEs. The argument, which I would adhere to in most circumstances, is that either there is a justification for public ownership or there is not—partial sales that allows some private ownership but without injecting the discipline of a threat of take-over would achieve nothing.
In the case of the three state-owned electricity companies, however, there might be a case. The argument is as follows: Vertical integration between the wholesale and retail sides of the electricity market essentially nullifies the market power that in principle would exist in the wholesale market with only four major generators. The close-to-balanced positions that have emerged in New Zealand, with the major gentailers each having roughly the same market share on the demand side as the supply side of the wholesale market removes the incentive for suppliers to restrict supply to inflate the wholesale-market price.

At the same time, however, vertical integration makes the retail market less contestable. If competition between retailers is not as intense as we would like, it is difficult for a new entrant to come into the market, as it would be highly exposed being a buyer and not a seller on the wholesale market, particularly in periods when low rainfall or transmission constraints gave a seller some temporary monopoly power.

Now imagine, however, that a new entrant in the retail market could simultaneously buy shares in the company that was the dominant generator in the region the entrant wanted to sell in. This would be a risk management strategy that would enable it to price to the retail market based on normal wholesale prices, knowing that losses in the event of a high wholesale price would be offset by the return on its shareholdings. Now further imagine that there are strong political reasons why the government would want to retain a controlling stake in the main electricity gentailers. In this case, these two arguments together suggest that maybe sale of a non-controlling stake is the optimal policy.

I’m not sure what I think about this, but I can’t reject the argument out of hand.


  1. A new entrant would have to buy up a fair bit of equity as an effective hedge, but I suppose could do it across a set of generators.

  2. Let's test this idea against what happened in the dry year in 2008.

    Genesis Energy's earnings were boosted by the high prices caused by the dry year. Its EBITDAF in 2008 was 90% higher than 2007 and 65% higher than in 2009. What's the impact on a company's share price of a one-year boost in EBITDAF of up to 90%? I'm guessing not a huge amount.

    What's the impact of a dry year on an otherwise unhedged retailer? Let's make up some rough numbers: in a normal year the retailer buys electricity at say $80/MWh and targets a gross margin of says $20/MWh, i.e. it sells to its customers at $100/MWh (plus local lines charges). The retailer's net profit is $20/MWh less whatever its costs are.

    In a dry year like 2008 wholesale prices can easily go as high as $300/MWh for an extended period. So that $20/MWh gross margin suddenly becomes minus $200/MWh, and the retailer is burning through its cash at a fairly rapid rate.

    For every MWh of electricity that the retailer was selling, what percentage of Genesis Energy would it need to own to be able to survive this?

    Second problem - let's say the retailer wants to compete in Christchurch. The dominant generator in the region is Meridian, as it has 6 out of the 8 hydro stations on the Waitaki river. By your criteria it is the correct company for the retailer to buy shares in.

    What happened to Meridian in 2008? The output from its hydro stations went down because it was a dry year. Meridian became a net purchaser of electricity, at very high spot prices, and so it made significant losses. If Meridian had been partially listed, its share price would have gone down. So it would not have been a very effective hedge.

  3. Anonymous

    All retail companies, be they gentailers or retail-only, need to price retail to take into account the high opportunity cost in dry years, so $100 / MWh seems a bit low. What they need to insure against is heightened market power that can arise in some circumstances.

    That will depend on what the likely source is. In your example, a ChCh retailer wanting to insure against market power from a failure on the HVDC would need to be buying shares in Meridian (mitigated perhaps since the asset swap so that Meridian is not a South Island monopoly), but if they wanted to insure against dry South Isalnd lakes, would need to be buying power in North Island thermal. Maybe if both risks are likely, risk management through share ownership wouldn't be feasilbe, but it might be a useful option.

    And yes, my story was predicated on the SOEs paying out all earnings as dividends so that a retail partial owner would see bad-year cashflow insurance rather than looking for a capital gain on the share value.

    Still not saying I'm convinced; just think it's a possibility that might have value.

  4. Seamus

    The numbers were illustrative only. You can put in whatever number you think is reasonable for a normal year, the point is that in a dry year whatever profit and cashflow margin you were expecting can suddenly become massively negative unless you are hedged. Buying shares in a competing company and relying on either capital gains or dividend payouts is not a realistic way of dealing with this.

    Company dividends are typically paid twice yearly. In a bad year an otherwise unhedged retailer could become insolvent in a few months, unless it has a very strong balance sheet or a large parent company willing to support it. So waiting for a dividend payment from your SOE shares to save you is not a good strategy.

    A much better strategy for a retailer would be to buy a hedge directly from one of the generators, or more likely anonymously via the ASX hedge market.

  5. @ Anonymous:

    I don't disagree with anything you say here. Retail-only companies should be hedged, preferably via a market; owning shares in generating companies would be a marginal risk management strategy.