“Electricity prices are high at present. Gas prices are also high. Who’s setting these prices?" 

By Greg Sise, 10 th May 2021  

Prices in the electricity spot market are currently consistently high relative to historical prices.  We also know from the Energy Link Index that the prices charged to large consumers when they re-contract electricity made a step change upward since last year.  In fact, the last months of the index are the two highest values since August 1996. 

Prices in the gas spot market are also high, and we’re hearing that large gas consumers face large price increases when they re-contract gas. 

As far as we’re concerned, the underlying cause is the fall in gas production at the Pohokura gas field (have a look at the 3rd chart in our post on 29th March, which shows the decline in production in blue). 

But we’ve heard a few comments that electricity generators are behind the high prices for electricity and for gas:  is this correct? 

As so often is the case with energy markets, the answer is a little complicated, but I’ll try to keep it simple.  First off, electricity generation is ‘dispatched’ in a competitive process in which all generators make offers to the market:  the offers include a price at which a generator is prepared to generate, and the amount of power they are prepared to generate at that price.  In simple terms, the market then dispatches the cheapest offers first, working through progressively more expensive offers until there is enough generation dispatched to meet demand from consumers.  The last, and highest offer sets the spot price. 

We need to be clear that in the longer term, once the ebbs and flows of dry and wet periods are averaged out, electricity prices are driven by the cost of fossil-fuelled thermal generation (‘thermal’), gas-fired in particular.  There is an apparent paradox here, because about 55% of generation comes from hydro generators, while thermal generators provide about 17% of generation on average.  But the mechanism here is not that complex:  if hydro generators consistently offer to generate at a price lower than the cost of thermal generation, then it will be dispatched before thermal, the lakes will run down and empty out, and we’ll have shortages. 

If hydro generators offer at prices higher than the cost of thermal generation, then the lakes will fill up and we’ll have constant spill. 

Both of these scenarios are suboptimal (dreadful actually). 

To get the balance right, hydro generators “shadow” the cost of thermal generation. So, if the cost of gas rises, then the price of electricity will go up, and vice versa. 

Normally, gas is in plentiful supply, and 95% of it is sold under medium and long-term contracts.  But some of these contracts allow the amount of gas to be reduced if the gas can’t be delivered.  For example, Contact Energy’s contracted quantities from the owner of the Pohokura gas field, OMV, are currently reduced because Pohokura cannot deliver.  This leaves Contact short of gas for thermal generation, so it’s hard to go shopping for more gas to run its large thermal power stations.  Sadly, Briscoes didn’t have gas in their sale this week, so Contact did a deal with Nova Energy. 

In the normal situation, there is also enough gas for large industrial gas consumers.  If these large gas users are currently under contract, then they may not face any price increases at all.  But if they happen to be in the process of re-contracting, or if their contract allows the supplier to reduce supply if their gas field can’t deliver, then they may also be looking for more gas. 

What happens when large gas users are all looking for more gas, at the same time as electricity generators, just when gas is unexpectedly in short supply? 

Simple answer: exactly what happens in any market when supply reduces, the consumer that is prepared to pay the highest price gets the widgets. 

If the large gas users were prepared to pay more for gas than electricity generators, then they’d get the gas, and they would set the price for gas in the current market.  But the reality is that the public can get very grumpy when electricity supply is rationed, for example, through voluntary or forced curtailment of electricity supply.  This in turn makes the Government very grumpy, not to mention the Opposition, and the minor parties.  Electricity generators know this, and the Electricity Authority knows this, and they all have estimates of the economic value that the public puts on electricity supply:  needless to say, it is a very high value.  When the cost of gas drives a generator’s costs, then the price the generator is prepared to pay will trump the value that large gas users put on gas in most cases. 

So right now, the electricity generators probably are setting the price of gas, on the public’s behalf, at least in the timeframe over which the Pohokura field is likely to be operating below par (does anyone know how long that’s going to be?  If so, please tell us, because we have only the scantest information coming from the gas market on this point!!) 

But the underlying cause of this is the gas shortage. And when the rain comes back and the lakes fill up, the electricity spot prices will come down, but not as much as they otherwise would: not until gas becomes plentiful again. 

So, there you have it. I got it off my chest. I hope it makes sense. 

One thing to add:  the electricity market’s been around since October 1996, and along the way there were inquiries after periods of sustained high prices, to find out why. Maybe it’s time for another inquiry after this event (maybe it should start now) to find out how we got into this situation, where key infrastructure is seriously impaired over a sustained period.  I’m certainly not suggesting anyone’s done anything wrong, or been careless; I'm not even hinting at it.  But we (the collective energy industry) need to learn from the experience to see if we can do better in future.  The Gas Industry Company (the sort-of gas industry regulator) is doing some good work in this area, but it is focussed on the future, and doesn’t appear to address the details of how Pohokura came to be so impaired so quickly.