False prophets of market power

Article from the Sunday Star Times, entitled Power Market Claims Shocking

The recent spate of high electricity prices led energy consultant Bryan Leyland to claim in this newspaper last Sunday that generators are exercising market power, and to call for some kind of central authority to make decisions about generation investment.

I won't defend generators and their pricing strategies in the spot market because that’s their job. If generators are exercising market power then that would be a scourge on what is otherwise a world-class market, and shouldn’t be tolerated. My point is that dubious and irrelevant statistics should not be used to rekindle interest in central planning ideas that died long ago and should stay dead.

In particular, Bryan Leyland calculated that generators have earned $7 billion of surplus profits over the last 10 years – compelling evidence he claims of generator market power.

As strange as it may sound, surplus profits – that is profits over and above a firm’s cost of capital – are not necessarily a sign of market power, especially in electricity markets for which the cost of new generation has been increasing over the period of Mr Leyland's study. The incumbent generators in those markets may well earn surplus profits but the market is still competitive if they are unable to raise prices consistently above the cost of new generation. And more often than not, surplus profits turn into losses when changes in technology drive down market prices. That is what happens in markets.

A good example of this is the housing market, where house owners over the last five years have experienced large gains in the capital value of their homes because the cost of acquiring new sites and building new homes has increased rapidly. No-one would argue that the housing market isn't competitive, even though a lot of people have made large capital gains in the market. Inevitably there comes a time when fortunes are reversed, and prices decline in real terms, as many New Zealanders are currently experiencing.

The cost of new electricity generation has increased markedly over the last five years. There have been large increases in construction costs, coal prices have increased by a third and gas prices have more than doubled. It would indeed be surprising if generators hadn’t earned surplus profits with existing plant that did not face these cost increases.

Annual average spot prices vary greatly across locations, and from year to year due to variable hydro conditions. Depending on the averages used, the spot price at Haywards (in Wellington) has increased in the range of 45 – 80%.

Despite these price increases there is very little empirical analysis of generator market power. An Electricity Commission study in 2007 found little evidence of electricity prices consistently exceeding the cost of new generation. In fact, that analysis showed that since 2004 electricity prices have been lower than the cost of new generation. The Commerce Commission has also been investigating the issue since 2005 but it hasn’t yet released any findings on the matter.

Of course this doesn't prove generators are acting competitively in the spot market. My point is simply that alleging market power is all too easy, and consumers suffering from high electricity prices are often all too ready to believe it. I don't blame consumers for that, but in my view accusers should provide robust evidence of market power, and to test their analysis with experts before going public with them.

Finally, electricity generation isn't a natural monopoly business – market power can only persist in the presence of barriers to entry to generation. If there is robust evidence of generator market power then I would have thought the obvious first step would be to reduce barriers to entry to generation, rather than to return to the past and centrally plan generation investment.

Carl Hansen is Chief Executive of M-co New Zealand and leads M-co's consulting practice.

DDI: +64 4 473 5240
E: carl.hansen@m-co.co.nz