Wholesale electricity customers 'couldn't have been expected to hedge against Genesis' Big Saturday'

By Gareth Vaughan 

Conditions in the wholesale electricity market have been ripe for a long time for Genesis Energy's so-called 'Big Saturday' on March 26 when prices spiked to levels more than 200 times above normal, says Deloitte's Paul Callow, but the other electricity retailers and companies complaining to the regulator about Genesis' actions couldn't have been expected to have had hedging in place to cover such unprecedented prices.

In a Double Shot interview Callow, Deloitte corporate finance partner and energy and infrastructure sector leader, told interest.co.nz the six to seven hour price spike on a Saturday in late March was caused by capacity being taken out of the system, meaning local load had to be met from local generation because power couldn’t be imported from elsewhere in the country.

"And that was influenced by the bidding behaviour of the generators who were in that (Auckland and upper North Island) area," Callow said. "It is certainly an unprecedented event. Nothing like this has happened in the market in New Zealand (before)."

The surge in prices, to levels of between NZ$19,000 and NZ$20,000 mega watts per hour (MWh) from normal prices of about NZ$100 MWh, took place while Transpower was undertaking planned maintenance between Auckland and the Waikato, which significantly reduced the transmission capacity from the Waikato region to Auckland. A total of 25 companies including ASB, Westpac the New Zealand Refining Company, Air New Zealand, Telecom and Vodafone, have lodged complaints (see full details here) with regulator the Electricity Authority, saying the price spike - if allowed to stand - will cost them tens of millions of dollars.

The Electricity Authority is investigating whether an Undesirable Trading Situation (UTS) occurred, and on top of this, has launched a separate market performance investigation.

Summing up the line taken by many complainants, Meridian Energy says Genesis Energy's Huntly power station was required to support load in the upper North Island during the Transpower maintenance and Genesis could "effectively name its price."

Callow said the price spike, in a market which has no ceiling set for prices, caught everyone by surprise but had been brewing for some time.

"In some respects it has been not so much an accident waiting to happen, but certainly the conditions have been ripe for this kind of event," said Callow.

"What has happened is people have got used to prices within a particular band. So they have tended not to hedge and tended not to look for price security over the long-term. So when you get a big (jump in prices) like this because of an unusual set of circumstances, even though they were well telegraphed, then that catches everyone by surprise and catches them unhedged."

'Why would you hedge against an event which has never happened before?'

Meridian and Mighty River Power who were both buying from fellow SOE Genesis to serve their customers during the maintenance, say the price spike - if allowed to stand - will hit their combined earnings by up to NZ$40 million. For its part Genesis denies it acted unreasonably during the "well-signalled" transmission outage. Genesis notes it offered customers the opportunity to hedge their risk, says it wasn't Genesis’ role to cover and pay for the spot market risk some market participants chose to take, and it has high operating costs and "will recover those costs when the opportunity arises."

However, Callow said the hedging market was very illiquid.

"Genesis is saying they should have hedged. Yes, well with retrospect it’s an easy thing to say, but why would you hedge against an event which has never happened before?" Said Callow.

"If you’ve never seen hedges that high before you’re not going to go out and pay very high prices for a hedge for that particular period. That’s why I say it caught people by surprise."

If this type of price spike happened, say every Friday evening during winter, then companies would hedge to cover themselves during that period.

"But this was very much a surprise."

The Electricity Authority, an independent Crown entity responsible for the efficient operation of the New Zealand electricity market that succeeded the Electricity Commission last November, has the power to reset prices as part of its UTS investigation if it believes they were too high.

Here's the regulator's definition of a UTS:

a) undesirable trading situation means any contingency or event—

(i) that threatens, or may threaten, trading on the wholesale market for electricity and that would, or would be likely to, preclude the maintenance of orderly trading or proper settlement of trades; and
(ii) that, in the reasonable opinion of the Authority, cannot satisfactorily be resolved by any other mechanism available; and
(b) includes, without limitation—
(i) manipulative or attempted manipulative trading activity;
(ii) conduct in relation to trading that is misleading or deceptive, or is likely to mislead or deceive;
(iii) unwarranted speculation or an undesirable practice;
(iv) material breach of any law; and
(v) any exceptional or unforeseen circumstance that is at variance with, or that threatens or may threaten, generally accepted principles of trading or the public interest.

If the price is left to stand, Callow said the question was what market behaviour that might drive in the future.

"Are people going to behave differently? And if they choose not to let it stand and choose to regulate down, what behaviours will that drive?"

'Reforms won't prevent a repeat'

The Electricity Authority says the scope of its market performance investigation includes both the spot and hedge markets. It says it already has a "comprehensive" set of reforms underway to "substantially" improve market performance, in both the spot and hedge markets.

"A key reform initiative relevant to recent events is the proposed introduction of a financial transmission rights (FTR) market. If an FTR market had been in place prior to last Saturday (March 26) then FTR-holders could have been substantially protected from the price spikes at Otahuhu relative to Benmore, and participants would have been likely to have had a wider range of choices for hedging their risks arising from scheduled transmission outages. The Authority is on track to decide Code amendments by 1 November 2011 and have the FTR market operating in 2012."

Callow said, however, these moves aimed at driving a deeper hedge market, and the government's Ministerial Review of Electricity Market Performance designed to improve the electricity market's performance which includes Genesis' NZ$821 million purchase of two Tekapo power stations from Meridian,were unlikely to necessarily prevent a repeat of March 26.

"Those reforms are aimed at providing participants with the means of managing price risk and they’re also aimed at increasing retail competition," said Callow. "So they’re not aimed specifically at preventing this and on the face of it they wouldn’t prevent an event like this if you had similar conditions in the transition market again and similar behaviour from the market participants."

How do you reward generators for holding capacity in reserve?

He said the wholesale market had changed a lot since its inception in 1995-96, in terms of the nature of the participants, the nature of competition, and the degree of vertical integration. Add to this a series of "dry year events" creating a need for large amounts of stand-by electricity capacity behind hydro and renewable electricity sources when climatic conditions - such as a lack of rain - reduce the amount of generation.

"The problem that you’ve got is how do you reward market participants for holding that capacity in reserve? And I’m not talking about reserve just if a plant drops off, I’m talking about long-term firm capacity to support climate dependent generation and that’s really the question that you’re asking yourself," Callow said.

"And if this is effectively the market working the way it’s allowed to at the moment, what happens is the providers of that capacity try to recover their full fixed costs over very short-term events. Other ways of doing that are effectively to build the cost of that capacity into the price of electricity over the longer-term so you don’t get these big spikes," added Callow.

"Effectively what you do is you build the cost of reserve capacity into the price of electricity paid for by participants who have potentially got climate dependent generation."