Power Games: the Electricity Crisis Is the Result Of Bad Economics

Listener 31 May, 2003.

Keywords: Regulation & Taxation;

The enthusiasts who reformed the electricity system in the 1990s gave little indication of the possibility of the power shortages the nation now faces. Their premise was that the introduction of market forces would generating efficiency improvements without generating problems. Faced with repeated failures, they have been conspicuously silent, although their reforms were not quite concluded because they favoured privatisation. Almost 60 percent of electricity production is still generated by three government owned companies (Meridian, Genesis, and Might River Power).

Even so, the commercialised solution would still be flawed. With four major producers (the three plus privately owned Contact), the electricity market is oligopolistic rather than a purely competitive. Consequentially the companies will ‘game’, introducing complicated strategic plays to unsettle competitors, which have little public benefit, but transfer profits to the successful gamer. Because of the diverse production structures of the contestants – the different balances of hydro, thermal, geothermal and wind generation – the industry probably needs a dozen significant players to be properly competitive. That such firms may be technically too small suggests an effective competitive market solution may not be practical.

A further weakness is that many consumers are shielded from price fluctuations. Wholesale prices reaching 70 cents a unit, as they did recently, should have induced householders to conserve power. But because of their power suppliers even-out incoming prices, most consumers did not respond to the shortage, and the burden of adjusting was carried by a few businesses, some of which laid off workers.

While these ‘imperfections’ affect the short term, they do not explain the medium term crisis New Zealand faces from a lack of capacity in a dry year, when the hydro-lakes get insufficient water. The reformers seemed to be unaware that markets do not function very well when they are ‘incomplete’.

A market is incomplete if it fails to provide a good or service, even though the cost of providing it is less than what economic agents are willing to pay. There are many reasons for incompleteness. A familiar one is that people may want environmental sustainability, but the pure market is oriented for depletion. So the government steps in. An even bigger category of incomplete markets involve decisions through time when, in effect, people are unable to insure themselves for a risk.

Consider the risk of a dry year, and the inconvenience to a household or business that a power shortage means. In a complete market each could get insurance (at a price) to cover themselves against this possibility. Initially the insurance contracts would be paper deals – transactions between those who would be willing to pay to prevent the consequences to them of shortage, and those willing to take on the risk. But eventually someone would collect enough revenue from the insurance contracts to put in the additional non-hydro capacity to meet the insured’s requirements. This is an idealisation, of course, but in practice today there is no near approximation to this insurance solution. So we turn to the government.

Because it is not always obvious how to ‘complete’ a market: the government is groping for solution. My guess is that it will establish something like a central insurance agency, perhaps levying consumers to put in more capacity to provide a larger security margin of surplus production than the market currently does in a normal year. The agency itself could be the provider of this additional margin (as occurred under the state electricity monopoly), but it may commission (and subsidise) existing producers instead. That will involve projecting electricity supply and demand. Planning? Perish the thought, except that dealing with incomplete markets is what market planning is about.

It may even be necessary to re-amalgamate the existing suppliers. Oligopolistic gamers are not necessarily better than a monopoly. But as it takes time to put in the required electricity generation capacity, the ineptitude of the market reformers cannot be unwound overnight. We are going to be stuck with power shortages in dry years for the next three or so years.

Each solution to market incompleteness depends upon a lot of complex technical decisions depending on situational particularities, so the precise outcome is not obvious. For instance, the labour market is also incomplete, but an agency analogous to the proposed electricity one would be inappropriate (although there is a case for better centralised coordination).

My preference would be for a rigorous analysis which seeks pseudo-market solutions but which is not fearful of centralised institutions where the market patently fails and there is no practical alternative. Hopefully the government wont rely for advice on those who cocked up last time. It is easiest, of course, to ignore the complexity and incompleteness, as some will do so even as they warm their bath water with candles.