A generator’s nightmare: low prices, less demand

With the press coverage focused on retail price rises and the impact of the carbon tax, a breaking news story in the electricity game has slipped through to the keeper. Demand for electricity traded on the National Electricity Market – or the NEM – declined in 2011 for the 3rd consecutive year and is now down 3% since 2008.

With industry analysts predicting 2-3% annual growth rates over the period, demand is down almost 10% on expectations.

Partly we are seeing the impact of energy efficiency measures, such as pink batts, and distributed generation like rooftop photovoltaics. We are probably also seeing some price sensitivity entering the market.

While the good news is the decoupling of GDP growth from energy intensity, it is deeply worrying for our electricity generators. Not only is their market is shrinking, but also the structure of NEM – which runs a wholesale spot market – is causing their revenue to plummet.

Spot prices are sensitive to the proportion of surplus generating capacity. When surplus capacity is around 15% energy spot markets work well in balancing the needs of consumers in checking wholesale prices and in providing reliable supply, while also providing enough price incentive for generators to make new investment. On spot markets, too little surplus and prices rise, while too much surplus and prices fall.

Declining demand increases the surplus which, according to some estimates, is already well above optimum at around 25% on the NEM.

At an average of 5.7 gigawatts, 2011 demand in Victoria was down 2% from 2010 levels and almost 4% from 2008. Similar scenarios played out in NSW where demand is down some 2.7% since 2008, and Queensland where demand has softened by 3% since 2009.

And the value of electricity traded on the market is showing it. In Victoria, the 2011 wholesale price averaged 3.1 cents per kilowatt hour, down 20% from 2010, and less than half 2007 prices. Adjusted for inflation, Victorian 2011 wholesale prices were the equal lowest with 2003 since the NEM started in late 1998.

High wholesale prices of 2007 tell a story. Drought conditions constrained both coal and hydro generation across the NEM, effectively reducing surplus and allowing higher cost peaking-plants to set the wholesale price more of the time.

Weather is crucial in the electricity game. Demand peaks as temperatures soar in heat waves. On January 29, 2009, temperatures in Melbourne reached 43 degrees and demand peaked at over 10 gigawatts. The Basslink inter-connecter between Tasmania and Victoria failed, and the wholesale price hit $10000 a megawatt hour. The traded value of electricity on the Victorian market that day was around $530 million. At 20% of the market value for the year, it contributed more than 1 cent to the annual average wholesale price.

In 2011 wholesale prices remained low in part because declining demand effectively boosted surplus capacity, but also because a strong La Nina weather pattern resulted in cooler than expected temperatures, with few extreme heat events.

With 2011 wholesale prices down why are we experienced double-digit percentage rises in retail prices, already at around 20 cents per kilowatt hour?

For one thing, much of the generation is forward contracted so the wholesale market doesn’t actually dictate the price paid by retailers. In 2011 retailers undoubtedly paid more than the wholesale price, partly hedging against the potential of extreme heat events that didn’t occur.

But it’s the distribution, not generation, that accounts for the spiralling costs in our electricity bills.

While average demand is falling, peak demand continues at near record levels. So distributors are required to provide an infrastructure that carries fewer electrons on average, while capable of serving ever more electrons for the few hours of peak demand each year. The ratio of average to peak demand is falling steadily across the NEM from 73% in 2006 to 66% in 2011. In Victoria it has declined from 71% in 2004 to 60% in 2011.

In effect our grid is becoming less productive at the alarming rate of about 1 percent each year. It is putting huge pressures on the distributors, who have the additional problems of maintaining an ageing infrastructure as well as accommodating new demands such as the feed-in from domestic photovoltaic.

This declining ratio of average to peak demand is an elephant in the room as far as national productivity is concerned and it’s only likely to get worse.

With multiple pressures facing generators and distributors, and the added need to reduce the emission intensity of our electricity supply, it may well be time to rethink our market incentives.

For example, incentivizing distributors to accommodate rooftop photovoltaic and retailers to implement demand management, would seem a straightforward way to help shave peak loads and reverse the declining productivity of the grid. It’s likely to have to happen anyway when grid parity for rooftop photovoltaics arrives in a few years time.

These are challenging issues for the business of electricity, worrying for government, business and consumers alike. But in helping decouple GDP growth from energy intensity, they also provide a great opportunity if we can get our policy settings right – and then stick to them.

Prof Mike Sandiford is director, Melbourne Energy Institute, University of Melbourne.