04 March 2014

ASEC Disagrees with Electricity Authority Proposals

Andrew Shelley Economic Consulting Ltd (ASEC) has submitted on its own behalf to the Electricity Authority's ("the Authority's") consultation on the use of the "loss and constraints excess" (LCE) to offset transmission charges.*

The Authority issued its working paper, Transmission pricing methodology: Use of LCE to offset transmission charges, on 21 January 2014. ASEC made this submission because the Authority's working paper lacked the intellectual rigour that should reasonably be expected from professional economists. In a letter to the Authority, Andrew Shelley states that "it is important to distinguish between conjectures that seem logical and robust demonstrations of fact."

Mr Shelley's letter demonstrates that the LCE should be returned to the party paying for transmission. If this is not done then locational marginal pricing creates a distortion in favour of market participants owning transmission assets (and thereby keeping them out of the wholesale electricity market). Mr Shelley also argues that the resulting “muting” of the marginal price signal is not a concern from an economic perspective, with a price equal to marginal cost only being optimal in a narrow set of circumstances such as perfect competition.

It has been claimed that payment of LCE to parties that pay for transmission could introduce a risk that generators would "game" the LCE. Mr Shelley examines this claim and concludes that it is unlikely that generators will have such an incentive, with an increase in LCE normally being associated with a decrease in generation and decrease in profitability.

ASEC's letter to the Authority can be downloaded here.

Note: The LCE arises from the pricing system used in the wholesale electricity market. Locational marginal prices are set based on the marginal cost of electrical losses and constraints, whereas the average cost of losses is the cost actually incurred. A fundamental characteristic of the physics of electricity is that electrical losses are proportional to the square of current, which means that marginal losses are greater than average losses. In the wholesale electricity market this means that more money is collected from customers than is paid to generators, and the difference is termed the "loss and constraints excess". This does not represent a super-profit, but is instead currently returned to consumers by way of a reduction in lines charges.