Thursday, December 8, 2011

Reserve Generation

Labour Energy Spokesman, David Parker, is quoted in the paper today defending the Labour government’s decision in 2004 to commission the reserve-generation plant at Whirinaki. Parker says that
there was a need to do something in the short term to get over the problem [of thin generation margins].
The idea of “reserve generation” has always seemed crazy. Electricity generation typically implies relatively high capital costs relative to operating costs, so the idea of commissioning a plant with the express purpose of having it lie idle except in the event of a one-in-sixty-year drought seems extraordinary. Add to that Parker’s view that it was only needed to get over a problem in the short term, then the period over which that capital cost can be amortised is also short.

Let’s do some back of the envelope calculations. According to the article, Whirinaki cost $150m and has been sold 7 years later for $33m, so depreciation costs are approximately 11%. Add in a very conservative 5% opportunity cost on the $150m (nominal interest rate since the purchase and sale prices are nominal), and to get a 16% opportunity cost of capital which equates to $24m per year. Again using the figures from the article, it has operated less than 4% of the time, which is roughly 350 hours per year. Whirinaki has a capacity of 155 MW, so if (another heroic assumption that understates the costs), it was running at full capacity for each of the 350 hours, it would have produced a bit over 54,000 MWh. To cover the capital costs, therefore, this would have required a price of around $450 per MWh in excess of operating costs. The Wolak report estimated that the marginal operating cost for other thermal plants at full capacity to be around $50/MWh, but it is acknowledged that Whirinaki was more expensive than this, so we would need a price of in excess of $500/MWh to enable Whirinaki to cover its costs. And this is without considering maintenance costs and general staffing throughout the year. There is no way that wholesale prices were consistently that high during the period Whirinaki was operating. Of course, this is hardly surprising since no private companies were clamouring to build it based on market prices, and funding had to be through a compulsory levy.

The other statement by Parker that caught my eye was this:

The real criticism that should be levelled here is what was wrong with the so-called “market solution” that left New Zealand short of generation capacity.
There are two quick responses here. First, as above, if New Zealand was genuinely short of generation capacity, why could the government not successfully enter the market and run Whirinaki at a profit rather than through a compulsory levy? Second, if you want to make the criticism that the problem with the New Zealand market in the early years of the century was that we were short of generation capacity, then you must also emphatically reject the conclusions of the Wolak report that claimed $4.3b of market-power overcharging based on an analysis that depends totally for its numbers on an assumption of excess generation capacity in New Zealand. In other words, you can’t say this
“The Commerce Commission report (22 May 2009), based on an in-depth study by Professor Wolak of Stanford University, a world authority, found NZ$4.8b (sic) of overcharging by electricity companies, equivalent to 18 per cent overcharging”, David Parker said.
(For more on why I think the Wolak report is wrong, see Working Papers 11/08, 11/09, and 11/10  here.)

6 comments:

  1. Are you sure you meant to say that the Wolak report was "not wrong"?

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  2. @Anonymous:

    That was a typo: Now fixed.

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  3. Relevance to the row, I mean full and frank discussion, that we've been having elsewhere in these pages - at root here is the inability of politicians and the public to think rationally about risk and to factor it into cost benefit analysis.

    From the UK experience, it seems that, as in other markets, the supply side in an electricity market will deliver the level of security (ie excess capacity, which determines the probability of supply shortfall) that the demand side is willing to pay for - but that politicians want us to have and pay for a higher level of security than that. Many a cup of tea fuelled debate in Whitehall's corridors of power over whether security of electricity supply constitutes a public good, and on what grounds.

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  4. Was there really risk of system collapse absent spare capacity? I'd thought that wholesale prices just spiked up and a bunch of price-sensitive demanders cut back usage.

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  5. @ Eric

    I don't think we have actually ever been in threat of blackouts from lack of capacity (as opposed to transmission issues) since the market was introduced. Rather, the pain of low rain is felt in high prices by those price-sensitive demanders, who like to encourage talk of blackouts in order to have the government invoke the spirit of Dunkirk to induce fixed-price consumers to cut back and spare the flex-price consumers some of the pain. That is, the degree of public hand-ringing is not necessarily a good measure of the true threat to security of supply.

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  6. That's what I figured. You could build a model then on public stupidity leading to political pressure for excess reserve capacity, but I'm not sure why it's easier for those price-sensitive demanders to make that case than it is for the other side to say "Screw the smelter".

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