Summary
Electricity prices for residential consumers in New Zealand rose 20%, adjusted for inflation, between 1996 and 2004 (Ministry of Economic Development 2005).[1] Given these price increases, it is not surprising that the New Zealand electricity market has come under increased scrutiny. Some observers question the operation of the wholesale market, where a generator that announces willingness to produce electricity for a relatively low price is nevertheless reimbursed with the market price. This paper attempts to shed light on pricing in wholesale electricity markets, in New Zealand and around the world.
There are four main points:
- All major competitive electricity markets, including New Zealand’s, are designed according to the principle that, in order to achieve an efficient allocation of resources, the market price should be determined by the marginal cost of production.
- When wholesale markets are competitive, the gap between market price and marginal cost that is enjoyed by some generators typically represents “scarcity rents”, which compensate for fixed costs, and possibly also short-term “economic profits”. These scarcity rents and economic profits play an important role in mobilising new investment and spurring efficiency. There may be some valid questions about distributional issues – in particular, about whether any economic profits could be better shared with consumers. However, it is difficult to think of a workable policy to redistribute these profits to consumers without distorting generators’ incentives to operate and invest efficiently.
- International experience with electricity wholesale markets shows that it can be difficult to maintain an adequate level of competition: generators may sometimes be able to exercise “market power” and withhold capacity in order to intermittently earn excess “monopoly profits”. We don’t have any evidence that suggests this is currently a problem in New Zealand, but it is worth being aware of lessons learned overseas. A number of features can help promote competition, including adequate transmission capacity, low barriers to entry for new generators, ample scope for hedging and demand-side responsiveness.
- There is little reason to believe the alternative “pay-as-bid” mechanism for wholesale market pricing would improve market outcomes in New Zealand.
Notes
- [1]This figure excludes GST. Although residential electricity prices increased over this period, real prices paid by industrial users remained fairly stable (on an annual average basis, which masks shorter-term fluctuations). Commercial users experienced real price declines.
