The Tiwai Point Subsidy

Matt and Paul have both covered the subsidy to Rio Tinto that facilitated a new contract between RT and Meridian Power. There is not a lot to say about the actual policy; Matt's "Urg" pretty much sums it up. But a few points about the politics of this are worth noting. 

1. There was nothing inherently wrong about the a long-term contract between Meridian and Rio Tinto at favourable rates. I believe that in the past transmission constraints meant that the opportunity cost of power delivered to Rio Tinto was not necessarily the wholesale price elsewhere on the grid. And I also understand that the smelter was drawing power fairly evenly throughout the day rather than mostly at times of peak demand. I stand to be corrected on both those points, and maybe Meridian negotiated poorly in the past, but, absent government subsidies in the past, these were normal commercial transactions that should not colour our opinion about the subsidy announced yesterday. That subsidy should be criticised on its own merits. 
2. It is hard to believe that the decision was not affected by the political capital the government has tied up in its asset sales programme. Again, however, that should not colour our opinions about the policy. The policy would not be any better if it were motivated by different objectives. 
3. Labour are totally on the right side on this one, but it is notable that Clatyon Cosgrove's reaction reported in this Stuff article, framed things entirely in terms of it using taxpayer's money to facilitate the partial sale of Meridian. It would be good to hear a clear statement from Labour that they are opposed to corporate welfare of any kind, and, if it were them, they would have just let Rio Tinto close down the smelter. As it stands, they might be saying that National paid a subsidy for the wrong reasons, but they would have done the same in order to protect jobs in Southland. I haven't seen the news coverage. Has anyone seen if a journalist has put this question to Labour? 

Increasing consumer surplus through price increases

As I noted last year, the University of Canterbury administration has this year increased the price of an annual parking permit threefold from (roughly) $100 to $300. This raises the price from what was a subsidised rate to something they calculate as being approximately marginal cost. Needless to say, this is something that the Economics department had been advising for a long time, given our propensity to value efficiency even at the expense of our own direct wellbeing. After a few months of experience with the new policy, it has become clear, though, that it is not only efficiency enhancing, but it has also increased consumer surplus even without consideration of what use the university makes of the increased revenue.

How can that be? It is an application of how the deadweight loss triangle in a standard S&D diagram understates the cost of a price floor or ceiling. Previously a parking permit at Canterbury did not confer a right to park; it conferred the right to hunt for a park. Many of us wasted a lot of time searching for a park before giving up and parking on the street several blocks away. The problem was particularly acute on wet days. Some of those who successfully found parks had a low willingness to pay, others who missed out valued the parks much more highly. How do we know this? Well this year, as a result of a trivial price change from next-to-nothing to three times next-to-nothing, the carparks are never full.* Even on the wettest days, one can come in late and always be guaranteed a park. Those cluttering up the parks last year but not this clearly didn’t value the parks highly; this year, it is only those put a high value on parking who get the parks. And how high can that value be. Well we don’t know for sure, but I am sure this story could be replicated here.

So there we have it. The price went up, and so did consumer surplus. Could the same happen in reverse. Well imagine if you were to impose average cost pricing in the retail electricity market despite it being an industry with sharply increasing marginal cost. Everyone would get a lower price for power, but with no guarantee that the lights would come on on demand. Consumer surplus might well go down. And that is without even considering the lost government revenue from publicly owned power companies….

* I find it difficult to comprehend the size of the demand response; think of the Slutzky equation: there is a huge shortage of on-street parking around the university, so there are no close substitutes for on-campus parking; $300/annum is hardly a large fraction of anyone’s expenditure, student or lecturer. Can the income elasticity really be that high? 

The morality of corporate takings

In the comments on my post containing the open-letter to the Labour Party’s two Davids a couple of weeks ago, John Small and I got into a discussion about the morality of a government policy that would wipe value from a private company (in this case, suggested changes to the electricity market that would reduce the profits of privately owned electricity companies). John wasn’t sure why I raised the issue of morality; this is worth post on its own.

It is inevitable that changes in government policy will result in both winners and losers, just as changes in the non-governmental actions will. One of the starting points I argue in my Honours class in welfare economics is that, in terms of practical policy (as distinct from the conceptual benchmark of a mythical social planner) the world is, always has been, and always will be Pareto efficient, and so a rule that policy changes cannot impose costs on anyone is tantamount to a rule that policy changes can never occur. But I think we can suggest some guidelines for when government-imposed costs are justified. The key issues are whether the policy is imposing costs on individuals or corporate bodies, whether the policy is a direct appropriation of property or one the imposed costs are indirect, and whether the policy is designed to improve efficiency or serve some social objective. Let’s take each in turn.  

• Is the cost imposed directly on individuals or on corporations? Takings from individuals require a higher threshold of benefit than takings from corporations. I don’t here mean to that corporations are somehow separate from the individuals who own them, or that their owners have lesser rights than other citizens; this is simply recognising the fact that company owners have the opportunity to diversify risk in their shareholdings, and hence to diversify the implications of government policy changes. A policy that forced lower electricity prices might wipe value from electricity companies, but add value to electricity buying companies as well as final consumers. If such a policy were efficiency increasing, there is no reason for it to impose significant costs on any diversified shareholder.
• Is the policy one that appropriates resources directly or one that changes the value of current assets? A direct takings, such as when the government uses compulsory purchase to acquire land for a highway, is a more serious use of government power than one that imposes costs indirectly through revaluations of assets, simply because a direct takings has the potential to impose far greater costs to an individual if their personal valuation of the asset is greatly in excess of its market value.

Based on these two criteria, I have no problem on morality grounds with, say, the government’s forcing Telecom to give other companies access to its copper wire network, with the anti-trust actions against Microsoft, or with changes to patent law that would stop Apple from suing Samsung. In each case, the question for me would be simply whether such policies would promote long-run efficiency or not. (In the case of these three examples, I suspect the answer would be No, No, and Yes, but that is an empirical question.)  The issue becomes more when the policy is put in place to achieve social objectives.

• Is the policy one that is designed to improve efficiency or to bring about social redistribution? In my view, the hurdle has to set very high before one can justify a direct or indirect takings to fund redistribution. This is not to say that social redistribution is not warranted, but rather the moral case for redistribution should be grounded in a transparent and honest policy that seeks to share the burden broadly rather than hiding the costs. Financing redistribution through indirect takings smacks too much of offering the other kid’s bat for my taste.

This is the key question in the case of Labour’s proposed electricity reforms. If their proposal were based on a view that market power was keeping price above marginal cost so that reducing price would be efficiency enhancing, then the issue would be the technical one of whether there is market power and whether eliminating that market power through a single payer would cause more problems than it would solve. But the proposed policy is explicitly to set price below marginal cost in order to equate price to average cost. John argued from a utilitarian perspective that the redistributive benefit would likely exceed the efficiency cost. We can debate about how large the efficiency cost would be, and whether, if you had revenue available for redistribution, subsidising electricity prices would be the best way of using it. But if we want to have more redistribution, either with an electricity subsidy or with direct transfers, then we should finance that directly with broad-based tax increases. Let’s not get into the game of arguing for a policy to transfer resources from corporate owners to electricity consumers on the basis of “they must have known that regulation is very very common in this industry” and hence that the costs are ethically inconsequential.

An Open Letter to David Shearer and David Parker

Dear David and David,

I have read with interest the policy document you released yesterday: New Zealand Power, Energising New Zealand. I wonder if you could clarify a few points for me.

1. In the document and the associated speeches, you quote the Wolak report's figure of $4.3b of, in your words, "super profits". Have either of your read the report, or any of the trenchant criticisms of that report? (A bit egotistically, I can suggest work that I was involved in, here, here, and here, but there are others.) 
2. You say that "prices are rising faster than in many of our major competitor countries", and show a graph comparing the price trend in a number of countries since 1986. Let's leave aside the question of what is meant by "competitor country". Is it your position that prices were correct in New Zealand in 1986? Elsewhere you say that your new agency, New Zealand Power, will set prices based on operating costs and a fair return on capital. Is it your position that prices were generating a fair return on capital in 1986?
3. You say that the faster rate of price growth in New Zealand "undermines the competitiveness of our economy". But one of your graphs shows that real industrial prices have remained about constant since 1986 and commercial prices have fallen. What exactly do you mean by "competitiveness"? 
4. Your graph shows that the faster increase of prices relative to other countries has been fairly steady since 1986 albeit with an acceleration around 2000. Since your explanation for this price trend is a lack of competition in the market and the use of marginal-cost rather than average-cost pricing, is it your position that these factors have been changing steadily over the past 25 years, accelerating during the period of the last Labour government? Is it possible that the trend might be attributable to steady increases in demand over time and regulatory obstacles to power companies building new capacity? 
5. You say that selling assets will "push up power prices even more as foreign and corporate investors look to maximise profits". Is it your position that the state-owned electricity companies are not currently looking to maximise profit, even though that is their fiduciary duty under the State-Owned Enterprises Act? 
6. You state that the Wolak report found that the four big generators made "super profits of $4.3b at the expense of consumers". You also state that hydro generators earn "super profits" by using free water to generate electricity that is sold at the same price as generators using more expensive methods. Do you think this is what Wolak meant when he calculated the excess profits earned? Have you read the Wolak report? 
7. As I noted earlier, you state that price will be set based on operating costs and a fair return to capital. But the Wolak report assumed that there was excess capacity in New Zealand so that a competitive market would have produced prices based only on operating costs. Are you stating that Wolak's $4.3b figure is overstated? Have you read the Wolak report? 
8.  Drawing on a report you have commissioned from BERL, you state that your policy will create 5,000 jobs and boost the economy by $450 million per annum. In their report, BERL state that they are assuming an economy with deficient demand so that unemployed resources are avaialbe to the industrial and commercial sector with no opportunity cost. In citing that figure as an on-going per annum benefit, are you stating that it is your view that the economy will remain in a state of deficient aggregate demand forever, and that your government would take no other action to increase demand? 
9. And if you have time, could you ask BERL whether it is not an oxymorn to have a computable general equilibrium model, and then state that "the model's calculation of the impacts on the government accounts exclude the direct loss of revenue from lower generator dividends and lower tax receipts from the generator's reduced profits". 
10. By the way, did you know that one of the implicit assumptions Wolak used in his report implied that there was no efficiency loss from the putative overcharging, just a transfer from users to taxpayers? If you accept this report, wouldn't it be easier just to use the tax and benefit system to transfer money back to poorer consumers? Have you read the Wolak report?

Kindest Regards....

Electric experiments

Electricity demand is less elastic than I'd thought.

ISCR's Competition & Regulation Times reports (pdf) on an experiment run by New Zealand power company Mercury Energy. Four hundred households were randomly assigned to four different treatment groups. One group received information about how to reduce electricity usage. The other three groups received the information plus a time-of-day price differential of on- and off-peak power use on weekdays: 4 cents, 10 cents or 20 cents: the experiment added half the differential to the household's existing on-peak price and subtracted half the differential from the off-peak price.

Results? There was no change in power use in summer, autumn and spring. In winter, the group experiencing the largest price differential shifted some power use to off-peak times: the 50% price premium on on-peak use resulted in a 6% decrease in on-peak usage and a 4.5% increase in off-peak use.

I was pretty surprised that demand was this inelastic. The article notes that Mercury didn't use time-of-use pricing with any of its customers prior to the experiment. When we moved to New Zealand, we signed up with Meridian Energy and took its Night-and-Day rate plan; we then shifted our laundry, dishwasher, and hot water heating to the lower night-rate. Current daytime power prices with Meridian on the DayNight plan are just about three times the night rate: $0.3072 per kWh daytime and $0.1180 per kWh at night. After the kids showed up, we stopped turning the hot water cylinder off during the daytime.

We're now with PowerShop which, while not charging an explicit time-of-day price, conditions your average price on your day/night/weekend usage patterns; we've kept our "shift to the evening" strategy. PowerShop's underlying daytime power rate, when I'd enquired back in May, was about double the price of their night-time rate.

The Mercury experiment suggests that larger roll-out of time-of-use dependent pricing can shave some peaks off peak power use, and knocking back those peaks can be pretty important. But I had expected time-of-day power usage to be more price sensitive.

Green growth

There's a new 'Green Growth' report out. The Science Media Centre asked me for comment; here's what I gave them, along with a few additional comments below.

“There’s much to like in the [Green growth] report. It rightly recommends that New Zealand move toward more efficient pricing and trading of water resources. Similarly, they recognize the opportunity for New Zealand to make a global difference by directing research and development resources towards lower-emission pastoral systems – so much the more so if New Zealand were to release the developed technologies under Creative Commons license as our contribution towards reducing global warming. Streamlining regulations to let entrepreneurs take advantage of New Zealand’s natural potential comparative advantages in aquaculture also is well worthwhile.

“I worry that some of the identified opportunities may impose cost well in excess of potential benefit.

“While more energy-efficient buildings would be very nice to have, regulatory mandates in the area often have perverse effects. For example, mandates that homes undergoing renovations also be brought up to higher energy efficiency standards can encourage people to avoid renovating their homes. Financing programmes assisting those already undertaking renovations for earthquake-strengthening to improve energy efficiency at the same time would be more effective; by contrast, EQC in Canterbury has been barring homeowners from undertaking any energy-efficiency improvements while repairing earthquake damage.

“Imposing carbon dioxide emission standards on New Zealand vehicles, when we do not make vehicles, mostly shifts to other countries those used cars we would have bought. We already have seen evidence of reduced used car availability and higher prices consequent to the government’s recent regulatory measures that effectively barred Japanese imports produced prior to 2005. Further, shifting towards greater use of electric cars because of New Zealand’s low electricity emissions-intensity would only work if we were able substantially to expand our base of hydroelectric or geothermal generation.

“I was somewhat surprised to see no recommendations around allowing well-regulated hydraulic fracturing technology for natural gas extraction. Wave and tidal power are worth investigating, but remain rather too uncertain to bank on. Greater use of natural gas powered thermal electricity generation is likely New Zealand’s best bet for lower emissions intensity power generation in the absence of substantial breakthroughs in other energy sources.”

I'll add a bit here.

As best I understand things, coal is now part of our baseload generation capacity. Huntly runs all the time, their gas turbines are easier to fire up and scale down for peaking than are their coal units, and our hydroelectric stations are obviously better as peaking units. Adding electric cars adds to baseload demand, so we need more baseload capacity. That's ideally hydro, which is banned by the environmentalists / water spirits people. Wind can be part of our baseload because it can be partnered with hydro: when the wind blows, we can dial back the hydro plants and save the water there for times when the wind is calmer. But, that means they need to service the same demand points as our hydroelectric stations. And hydroelectric plus lots of wind means the Canterbury High Country. And the environmentalists / scenery people have banned our putting wind power there too because it would make a tiny percentage of that scenery look different. So that's out too.

Fracking can be done safely - from my read of the literature, whatever problems there have been in some cases with water contamination can be avoided by techniques that only slightly increase the cost of extraction. Getting more access to cheap natural gas in New Zealand can displace what coalfire generation we are running and gives us room to expand generation capacity at lowest environmental cost given the existing political constraints. But the Greens have pushed to ban that too, and have succeeded in getting a pile of Councils to ban it within their catchments.

What's left? Maybe more geothermal.  Tidal remains a bit of a pipe dream - I hope we can get there someday, but I'd sure want it on-stream and running before pushing everybody into electric cars. Solar faces some of the same constraints as wind - it's a great complement to hydroelectric and lets us store electricity in the form of lakes-not-yet-run-through-turbines when the sun shines. And maybe it'll be low enough cost sometime soon that we'll be able to use it. And I wonder whether the same "Oh but I hate everything that changes anything" people will work to ban solar plants near our hydroelectric stations in the same way that they're putting wind into the "too hard" basket.

Pushing more demand onto the grid, without getting more capacity on the grid, is a bit scary. I like the stuff in the report about getting more active demand management systems. That will help smooth out some of our peaking issues. But we need more baseload if we want electric cars sometime down the track. It's not obvious how we get there from here.

Bill Kaye-Blake also provides useful comment:

Bottom line: the report seems to be a re-tread of well-known issues with a recommendation to spend more public money to help private businesses. When it comes to really difficult issues — what trade-offs are we willing to make? how do consumers symbolise environmental values through economic transactions? — it seem to fall silent. Maybe somewhere in those 300 pages they grapple with the hard stuff. If so, Pure Advantage will have gotten its money’s worth.

The benefits of solar water heating

The parliamentary commissioner for the environment, Jan Wright, had a perfectly sensible article in yesterday’s Herald on the value of solar water heating. In a nutshell, her point is that a large chunk of the economic cost of producing electricity including the environmental cost comes from the need to build and use peaking plant to satisfy peak demand, typically in the winter months. Solar water heating is at its most effective in the summer, and so does little to reduce the demand for peaking plant. Notice that this is not saying that there is no value to solar water heating in the summer (not all of the cost of electricity is the cost of building peaking plant), nor that solar water heating couldn’t help reduce demand during peak periods to some extent. The commissioner was merely pointing out that the benefits of solar heating will not be as high as one might think from a naïve calculation of how much overall reduction in electricity usage you can get from solar.

Russel Norman then posted on facebook a letter he received from a constituent extolling the virtues of solar heating. (HT James Meanwell.) The essence of this letter is that the correspondent installed solar heating, paid for in part by a government subsidy, and this in combination with a wetback heater and other energy saving devices is contributing to very low power bills in his/her 400 square metre house. The correspondent then says:

My reason for writing is to tell you that Jan Wright has got it wrong when she says that solar water heating has little impact on domestic power savings. I have no financial or any other interest in the solar industry for that matter but I’m at a loss to know where she is coming from with her comments deriding solar water heating. Based on my own experience within our own house set-up, I believe her comments are without foundation and harmful to what should be our goal of greater energy efficiency.

Now, in a normal market, an anecdote of this kind conveys useful information: if some capital equipment saves you more money than it costs to install, there is clear evidence of some economic benefit. But we can’t conclude anything from this anecdote. First, by his or her own admission, solar is not the only electricity saving measure—the wetback in particular is probably much more effective in the winter months. Second, there is no question about solar heating reducing the cost of producing electricity; the interesting question is whether the savings outweigh the capital cost of the solar panels and installation. If that is paid for in part by the government, we know nothing about the overall value. But the main problem is that the letter doesn’t engage with the commissioner’s issue about managing peak load at all. And this points to the final reason that the individual savings are not a good measure of the social benefit.

Specifically, the wholesale electricity market in New Zealand is an energy-only market. That is, generators get paid only for the electricity they sell. The cost of constructing peaking plant therefore has to be covered by the price that electricity is sold for on those rare occasions when peaking plant is used. That is why the wholesale price has to rise in the winter, particularly in dry years. Retail customers, on the other hand, are typically only on fixed-price contracts in which the retailer company charges a prices that will on average cover the costs of purchasing power at the wholesale market. That is, customers face a price in excess of marginal cost during off-peak times and a price below marginal cost in peak periods. Any time customers finds a means of reducing consumption during off peak times, they are simply creating a need to increase the overall average price. That is, the savings to them are mostly just a transfer from other consumers, not a net gain in economic efficiency.

Green politics can be about a genuine attempt to address environmental externalities, but there is always a risk that they can end up as middle-class capture. It is surprising, therefore, to see Russel Norman publishing this letter from the owner of a 400 square house, which appears to be a poster child for the latter interpretation!