Energy companies don’t see sufficient profit in preparing for dry year risks and are leaving the Crown to pick up the tab instead

At the heart of Wednesday’s energy announcements was an admission that market forces were failing to provide a secure electricity supply that can manage years with low rainfall.

It is true, this problem was exacerbated by the Labour Government's ban on oil and gas exploration (which has now been lifted) but it isn’t the only cause.

Frontier Economics found a fundamental market failure was limiting the incentive for electricity companies to build power plants that provided supply during dry years. 

“The key problem is that, given the size of the New Zealand electricity market, under the current market design, investors struggle to capture sufficient returns for investment in assets to address dry year risk and, to a lesser extent, firming,” it wrote in its report. 

“This is because competitors, and industrial customers, can free-ride on the investment made by someone else that has the effect of suppressing prices.”

Added on-demand capacity reduces risk of scarcity and therefore prices for all energy users across the board. Those who do not make the investment benefit alongside those who do.

“This creates an underinvestment problem, as private entities have little incentive to build assets that may be rarely used, and so have limited revenue opportunities, but are essential during periods of high supply risk,” Frontier said.

The report said the main obstacles were shareholders’ reluctance to fund new fossil-fuel plants and the risk that climate policies could wipe out their value. But both problems are intensified by freeriders and a shortage of fuel supplies.

Investors don’t want to pay for an asset that's expensive to run and could end up sitting mostly idle as the grid bathes in cheap (or legally required) renewable power. Oil drilling firms are unlikely to start a new field just to supply a little spurt of gas in occasional dry years.

It is a problem that needs solving. The Ministry of Business, Innovation & Employment said the risk of high prices in a dry year added $30 to $50 per megawatt hour to electricity futures contracts, equivalent to about $200 or $300 a year on the average household bill.

With the market unwilling to take action, it falls to the taxpayer to fix it. So the Crown has promised to use a chunk of its limited capital allowance to provide energy security.

Literal national giveaways (LNG)

On Wednesday, the Coalition announced it would look at building a liquified natural gas (LNG) import facility and told state-owned electricity companies it would fund a capital raise for energy security projects.

Imported LNG would help to solve the fuel scarcity problem. It could take the form of a billion-dollar offshore terminal, or a smaller onshore option for a few hundred million dollars.

The latter would only cover some of the dry-year energy needs but it could complement the coal boiler in Huntly and whatever domestic natural gas supply was available. 

But it would be expensive energy and only economical to use in moments of tight supply. 

A year ago, the Coalition asked the energy industry to organise its own LNG terminal with some regulatory help but it was unable to make it stack up commercially. 

MBIE will also put out a broader request to the industry for other investment options which could provide energy security in dry years.

Labour had planned to build a pumped-hydro scheme (essentially a water-based battery) but opponents argued it would be too expensive and also discourage private sector investment. 

The Coalition scrapped further planning of the scheme, which was estimated to cost up to $15 billion, but some private investors have reportedly been looking at reviving the project. 

Another option might be to build more solar and wind, allowing existing hydro dams to save more water for dry winters. But lake storage is limited and heavy rain is often spilled in the wet months.

Whatever gets built, someone has to cover the cost. While the Crown is prepared to underwrite an LNG import terminal, it would prefer the electricity sector to invest itself.

Capital raises allowed

To this end, Finance Minister Nicola Willis has offered to inject capital into state-owned electricity firms if they use it on projects which support energy security.

Frontier Economics said in its report these firms had avoided raising equity capital because they believed the Crown would refuse to take part, effectively vetoing any attempt.

Instead, they have used corporate bonds to finance developments. Bonds are usually cheaper for short-term funding, but equity is better for long-term projects where returns are uncertain or a long way off.

Shares in Meridian Energy jumped 4.7% following the announcement, adding $685 million to its market valuation, suggesting investors saw the energy policies as good news. 

Chief executive Mike Roan said having the Crown willing to support a capital raise would help to bring forward investment in new flexible electricity generation.

“This is bold. It’s the biggest change to our capital investment settings since we were listed in 2013,” he said in a statement.

“This will add even greater momentum to our development pipeline, and building new generation is the best way to improve energy security and affordability.”

Genesis Energy shares rose 2.1% and Mercury Energy climbed 1.4%, while privately owned Contact Energy gained just 0.9% on Wednesday. 

Low risk til ‘26

Greg Smith, an investment specialist at Generate, said the market was prepared for an interventionist policy but “ultimately it was a damp squib”. 

“If the government manages to follow through on introducing an LNG import terminal, that would reduce dry year risk on hydro operators, of which Meridian is the largest, and allow them to conserve water in dry years, thus achieving higher prices,” he said.

While Meridian shares saw the biggest bounce, Forsyth Barr analysts said Genesis stood to benefit most given it has limited capital and was already focused on backup generation.

In a note to clients, Forsyth Barr analysts Andrew Harvey-Green and Hugh Lockwood said the announcements removed the risk of structural change until after the 2026 election.

“It is notable that NZ First deputy leader and Associate Energy Minister Shane Jones was absent from the government’s announcement,” they warned.

“In recent weeks, he has proposed vertical separation, re-nationalisation of the generators, and compulsory capacity procurement, while expressing his ambition to become Energy Minister.”

Just nationalise it

The NZ Council of Trade Unions (CTU) and the Green Party have also advocated for renationalising the power companies, although their version wouldn’t directly harm investors as they suggest buying shares back at market price.

A report written by the CTU argued the electricity companies had manufactured energy scarcity by paying out dividends instead of investing new capacity. It wants the government to use that stream of dividends to purchase outstanding shares. 

“The faster that the gentailers distribute dividends, the faster those firms will come back into public hands. Should those firms instead decide to use those dividends to deliver new generation, this will bring down the cost of electricity  and provide New Zealanders greater energy security,” it said. 

As of Wednesday, the 49% of shares owned by the market were worth about $12.2 billion but the process of bidding to buy them would likely drive the price higher.