Competitive Advantage

Carefully designed changes to the electricity-generation industry could make it work better.

 

Listener: 25 May, 2013

 

Keywords: Business & Finance; Regulation & Taxation;

 

Discussions on what to do about electricity have been so political and self-interested that almost all the public economic analysis has been puerile. So let’s begin with some basics.

 

Economics shows that a perfectly competitive market has many desirable properties. However, perfect competition cannot exist: it requires perfect foresight and strict assumptions about supply conditions and how consumers function. Practically, economic policy often settles for “workable competition”, where market conditions are close enough to perfect competition that there is no better way of organising it. Sometimes a bit of tweaking is required to get the market workable.

 

There are few general rules for assessing workable competition. We do not regulate corner dairies to make them more competitive, because they are easy to start up. Yet we have only two supermarket chains, which we leave to compete with each other.

 

Telecommunications is different. During the height of Rogernomics ideology, we privatised the Telecom monopoly. For over 20 years, we thrashed around trying to restrain its dominance. Subject to the complexity of technological change, we have probably got as close to workable competition as we can by the recent separation of the firm into two businesses: Chorus, which provides the lines and is under tight regulation, and Telecom, which competes with other businesses to provide services. (That Telecom is now struggling indicates it was protected in the past by its privileged access to the line business.)

 

The electricity-generating market has a different structure. There are five major generating companies, which would normally be almost enough for workable competition. However, each produces electricity in different ways – for instance, only Genesis Energy has a huge thermal power station – and although there are strong economies of scale, investment tends to be lumpy. Plus prices to household customers don’t vary with changing conditions.

 

The heterogeneity has led to considerable intervention in the electricity market, including making it easier for households to compare suppliers and ordering Meridian Energy to sell the Tekapo A and B power stations to Genesis. (Illustrative of the political nature of the debate, some commentators said that they were “shocked” because the Labour-Greens’ proposal of NZ Power would introduce “regulatory risk” to investors in the industry, so their investment return could be influenced by changes in the regulation of the industry. Excuse me – there has always been regulation of the electricity sector.)

 

The sector may not have the outcomes you’d expect under workable competition. Modelling suggests market prices to electricity consumers are higher than might be expected from an efficient market, although subsequent changes in the market since the simulations might moderate the conclusions. Economist Geoff Bertram has made an impressive case that pricing arrangements tend to increase electricity prices and profits at the expense of households and businesses. That companies “game” one another – using short-term tactics to make profits at other firms’ expense – is an indicator that the market is not competitive in the economists’ sense.

 

So there is considerable debate among economists over whether the current light-handed regulation regime results in workable competition. Because there is room for judgment, good economists may come to different conclusions.

 

Labour and the Greens seem to think we don’t have workable competition, proposing NZ Power, which would buy all the electricity from the generators and on-sell it. It would have considerable influence over the prices of electricity (they say they will fall) and on industry investment.

 

My judgment is that we don’t have workable competition in the electricity-generating industry and that carefully designed changes could make it work better. The superimposition of NZ Power might be such a change. (It certainly would, if the smelter at Tiwai Point closes down; ordinary competition is not very effective in a contracting industry with lumpy investments.) But even if the Labour-Green proposal is never implemented, and whichever party forms the government, further changes are likely. Continuing regulatory risk is integral to such an imperfectly competitive sector.