Anyone who normally books hotels through on-line agencies like needitnow.com, would have observed the price oscillations in hotel room rates. The cheapest rooms at premium hotels during Melbourne's Grand Prix were four times the price commonly on offer. Airline seats see similar price swings.
These prices act to choke off demand by persuading people with greater discretionary needs to forego or defer the use of the rooms or travel when pressure is on supply. Setting prices in the face of volatile demand clearly involves considerable judgement to avoid foregoing profits, while filling the rooms or seats.
Like airline seats and hotel rooms, electricity supply has a low marginal cost, and is non-storable. However, unlike other commodities, electricity cannot experience a selective shortage. It is either available to all those who turn on the switch or unavailable to a great many.
Moreover, electricity has a very minor market response to short run price changes. Few people are able or willing to fine-tune their electricity consumption. They seldom have the metering information to do so, and in many cases it would take a massive temporary price hike for consumers to respond. After all, someone who invested thousands of dollars in air conditioning would want to use it in the dozen hours per year when it is especially hot and humid -- the precise times when spot wholesale prices are high. And a manufacturer would tolerate very high temporary prices to prevent stop-start work disruption to avoid a short price peak if electricity represents only five per cent of costs. This means suppliers must provide virtually all the adjustment.
Very high price peaks are required in order to attract plant that will run only occasionally and otherwise lie unused but ready for action. In Australia, a peak of up to $10,000 per megawatt hour may be reached -- three thousand times its normal price. While such prices are reflected in consumers' bills, they are not explicit because they are incorporated within retailers' smoothed tariffs. Retailers themselves largely avoid these peak prices by writing forward contracts.
In Australia therefore, a single price signals both long term and short term market scarcities. An alternative approach is to lower maximum prices but to pay firms for capacity. This is rather like having a levy on everyone who may use airlines or hotel rooms and using it to ensure there is some spare capacity to meet the peaks.
Capacity charges mean regulators determining what the right capacity is, who has capacity and how much they should be paid for it. In practice its main use is to provide a signal some years into the future to allow new plant to be installed but designing this is especially difficult.
In Australia we have shown that an energy only market allows capacity to be created without such interventions and supply and, as illustrated below, demand has been fairly well synchronised over the past six or seven years. Peak Demand and Capacity in the NEM
The National Electricity Market has proven to be highly resilient. It has brought adequate margins of supply and low prices for the fifth year in succession. It is not and should not be engineered to withstand all contingencies.
But there is no room for complacency. Electricity supply remains vulnerable to government interventions that might undermine the commercial principles on which stable supply has been ensured.
Its government induced vulnerabilities include:
- Retail price caps being kept below market levels in NSW and Queensland, which seriously restricts competition.
- Low cost recovery allowed on monopoly electricity lines -- this was one cause of last year's Queensland outages, though it did not contribute to the loss of the Victoria/ SA link that triggered this week's outages in SA, where the issue is why reserve power was not immediately available.
- Government subsidised investments that undermine the incentives for new private capacity. New Queensland government owned plant may fall within this category.
The green power measures introduced by some state governments and the Commonwealth can also suppress incentives for efficient new plant as can the environmental barriers put in the way of the most efficient new generators (those fuelled by coal) in NSW and Victoria.
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