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LECG Limited

LECG Limited. Economics and the electricity sector – the significance of basic principles 16 th November 2006 Simon Hope (B.Appl.Econ Hons - Massey). Disclaimer: the views and ideas expressed in this presentation are those of the author and not of LECG Limited. Background. NBHS

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LECG Limited

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  1. LECG Limited

  2. Economics and the electricity sector – the significance of basic principles16th November 2006Simon Hope (B.Appl.Econ Hons - Massey) Disclaimer: the views and ideas expressed in this presentation are those of the author and not of LECG Limited

  3. Background • NBHS • Completed a Bachelor of Applied Economics with Honours in 1999 • Worked as a Senior Analyst in Forecasting and Modelling Unit at MSD • Moved to NZIER, worked primarily in energy sector • Currently a Senior Managing Economist at LECG, working primarily in the energy sector • LECG work covers regulation, competition analysis, modelling, contract analysis, market design

  4. In one ear and out the other… • Not always easy to make economics ‘sexy’ • Theory can be overwhelming • Difference in application of theory to reality – varies by course, subject • 6th/7th form and 1st year university economics the key years for picking up fundamental concepts • Concepts built on throughout university

  5. The eternal question: when am I ever going to need to know this? • Need to emphasise real world application of these key economic concepts • Helps reinforce their importance and makes learning easier • We all remember examples • Practical examples make economic theory and concepts a reality • Digging out old text-books

  6. Outline – significance of basic economic principles in the electricity sector • Introduce NZ electricity sector • Discuss the role of basic economic principles • Identify and discuss use of these principles • Parting thoughts • Questions

  7. The New Zealand Electricity Sector • New Zealand’s electricity sector has four main components: • generation (electricity production stations) • transmission (the high voltage network known as the national grid) • distribution (local lines companies) • retail (electricity retail companies compete to buy wholesale electricity and compete to retail it to consumers) • Huge industry in terms of assets (lines companies alone have assets in the order of $5 billion, govt. owned generation assets approx. $7.5 billion), employment and impact on consumers (residential, commercial and industrial) • Use of basic (and complex) economics is pervasive in the industry, even if many don’t realise it…

  8. The role of basic economic principles • Economics is about allocating scarce resources • Applies perfectly to electricity sector – water, gas, coal etc. all relatively scarce (some more than others) • Basic principles influence: • Prices in the market • Regulation in the market • Incentives on market participants • The role of the energy sector in the wider economy

  9. Prices in the market • Key economic concepts in this area: • Supply and Demand • Elasticity of demand • Marginal cost • Opportunity cost • Economies of scale

  10. Prices in the market (II) • Spot/wholesale price determined by supply and demand in the market • Wholesale price forms part of overall retail price • Consumers purchase electricity in different ways: • Residential and small commercial consumers effectively purchase via a retailer (who buys from the market or has own generation) • Large industrials may generate some of their own, or purchase straight from the market (or a mixture) • Non-residential consumers tend to have a portfolio i.e. some contracts, some spot purchases

  11. Prices in the market (III) • NZEM introduced in 1996 • Majority of wholesale trading in electricity for immediate delivery occurs through NZEM • Wholesale/spot market prices determined by: • Generator ‘offers’ into the pool • Buyer ‘bids’ for take from the pool • Intersection of Demand (bids) and Supply (offers) effectively determine spot prices • Half hourly spot prices derived for nearly 250 nodes • Differences in price at nodes reflect transmission constraints, losses and cost of electricity

  12. Prices in the market (IV)Schematic of price derivation for a half hour Supply ‘stack’ Price Total demand P* Q* Demand

  13. Prices in the market (V)Schematic of price derivation for a half hour D Price S1 S S2 P1 P* P2 Q* Demand

  14. Prices in the market (VI)Electricity Price Index, seven day rolling average

  15. Prices in the market (VII) • Key points to note: • ‘Lumpy’ supply stack reflects nature of generation plant • Demand and supply both shift for each ½ hour period • Supply stack can shift left/right/up/down/stretch. Demand shifts left or right • Weather, strategy, fuel supply, new technology all important • Demand is effectively assumed inelastic at each point in time • ALL GENERATORS required to generate to meet demand get marginal price of the last plant required to meet demand – ‘marginal cost pricing’ • e.g if last plant required to meet demand ‘offers’ at 10c/kWh, then all dispatched generators receive 10c/kWh • Prices have huge incentive effect for potential/existing generators

  16. Prices in the market (VIII) • Opportunity cost plays an important role in offer strategies of generators • e.g. stored water ‘used’ today is not available tomorrow • Opportunity cost of fuel changes depending on weather conditions, fuel supply etc. • End of supply stack is very steep (potential effect on price) • Economies of scale • Larger generators able to spread fixed costs over higher level of output • Some economies of scale depending on generation, investment is ‘lumpy’

  17. Regulation • Key economic concepts in this area: • Opportunity cost • Vertical integration • Producer/consumer surplus • Types of competition: monopoly  perfect competition • Encouraging efficiency – productive, allocative, dynamic

  18. Regulation (II) • Opportunity cost • The way the industry is regulated will affect the relative returns of being involved e.g. intrusive regulation could stifle incentives as opportunity cost of investing elsewhere increases • Important consideration in cases where prices/revenues are regulated (e.g. lines companies) • Vertical integration • Vertical integration provides an internal hedge • Historic issue (lines company/generation split) • Important for competition considerations

  19. Regulation (III) • Producer/consumer surplus • Key issue for competition cases involving mergers/acquisitions • Tests of PS and CS help determine outcomes of transactions • Calculations often relatively simple (interpretation difficult) • Types of competition • Concentrated large generation • 28 lines company • 1 transmission service provider • Limited retailers (linked with generators) • Current review of wholesale/retail competition. Huge issue in the industry, with very divergent views • Important to consider size and characteristics of NZ market

  20. Regulation (IV) • Encouraging efficiency • Key economic concept used frequently in assessing options in the electricity industry • Can use provision of efficiency as criteria for evaluation • Common use in government policy as a goal/objective • Quantitative as well as qualitative evaluation tool • Information limitations make qualitative evaluation difficult in many cases

  21. Incentives on participants • Price signals vital for investment • Level of regulation important signal • Affected by level in supply chain, type of generation, ownership (e.g. Govt./private) • Type of generation important – fixed/variable costs • Sector covered by variety of rules, regulations, Act’s so complex and involved to be in

  22. Incentives on participants (II) • Fixed/variable cost example

  23. Role of electricity sector in wider economy • Costs of regulation passed through to consumers (e.g. HVDC, Electricity Commission levy, CO2 tax) • Electricity key input to industry – affects cost of production (and hence cost of consumer products) • Electricity cost affects international competitiveness e.g. Comalco • Retail prices affect consumer purchasing power (e.g. via electricity bills and CPI) • Efficiency of market influences overseas investment

  24. Parting thoughts • Electricity sector a good example of economics in action • Constantly evolving industry, important to wider economy • Often the most basic concepts that turn out to be the most commonly used • Practical application of economic theory can make learning economics more interesting • Make use of examples of practical economics (e.g. Reserve Bank, Treasury, MED, NZIER)

  25. Questions shope@lecg.com

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