Report Title

A review of the draft Waitaki Catchment plan

Report to Major Electricity Users’ Group

April 2005

Preface NZIER is a specialist consulting firm that uses applied economic research and analysis to provide a wide range of strategic advice to clients in the public and private sectors, throughout New Zealand and Australia, and further afield.

NZIER is also known for its long-established Quarterly Survey of Business Opinion and Quarterly Predictions.

Our aim is to be the premier centre of applied economic research in New Zealand. We pride ourselves on our reputation for independence and delivering quality analysis in the right form, and at the right time, for our clients. We ensure quality through teamwork on individual projects, critical review at internal seminars, and by peer review at various stages through a project by a senior staff member otherwise not involved in the project.

NZIER was established in 1958.

Authorship This report has been prepared at NZIER by Vhari McWha. The assistance of Brent Layton, Peter Clough and Simon Hope is gratefully acknowledged.

8 Halswell St, Thorndon P O Box 3479, Wellington Tel: +64 4 472 1880 Fax: +64 4 472 1211 [email protected] www.nzier.org.nz

NZIER’s standard terms of engagement for contract research can be found at www.nzier.org.nz.

While NZIER will use all reasonable endeavours in undertaking contract research and producing reports to ensure the information is as accurate as practicable, the Institute, its contributors, employees, and Board shall not be liable (whether in contract, tort (including negligence), equity or on any other basis) for any loss or damage sustained by any person relying on such work whatever the cause of such loss or damage.

Executive Summary

The Major Electricity Users’ Group has commissioned this report to highlight the key effects of the draft Waitaki Catchment Water Allocation Regional Plan on electricity generation and the wider economy.

We have reviewed the plan in the context of economic efficiency, considering:

• The impact of the draft plan on electricity generation, price and cost. • The impact of the draft plan on the wider electricity industry, principally in relation to security of supply. • (Briefly) the environmental justification for the draft plan. • The broader effects of the draft plan on the economy. • At a high level, what alternatives are available to the WAB.

Key issues identified There are some key issues around the draft objectives of the plan. In particular, there is no protection of existing users or recognition of their rights. In the context of the Resource Management Act and ensuring investment incentives, this principle is fundamental.

Second, the efficiency objectives are unnecessarily narrow and focused on technical efficiency (i.e. using the least input to achieve a specific output), rather than allocative and dynamic efficiency (i.e. choosing the highest value use over time). It is well established that dynamic efficiency goals are to be preferred over other types of efficiency (including static efficiency).

Finally, in terms of the objectives, they are not measurable. Hence it is not possible to know whether the plan achieves them.

In terms of the rules, there is some uncertainty about how some of the plan would be implemented. We have identified three key changes to the environmental flow and levels regime that would affect the electricity market and the economy more widely. These are:

• A minimum flow of 3 cumecs down the Tekapo River. There is currently no minimum flow. • An increase in the minimum level of Lake Tekapo from 702.1m (above mean sea level) to 704.1m. • An increase in minimum flows downstream of the Waitaki Dam from 120 cumecs year round, to 200 cumecs in winter and 230 cumecs in summer.

NZIER – A review of the draft Waitaki Catchment plan i

We consider the impact of these changes using examples and estimating where possible the quantitative effect.

• Electricity production from the Waitaki system will be 75GWh lower each year as a result of the minimum flow down the Tekapo River. • The profile of generation will be flatter due to minimum flow requirements. Generation in summer will be higher one third of the time on average than it otherwise would be. In winter storage will be dedicated to meeting river requirements. As a result electricity will not be available as flexibly to meet peak demand. • Generation will be redistributed from winter to summer as a result of lower storage. The likely longer-term impact of the WAB’s proposed regime would be to force investment in mid-merit or peaking capacity that would not be made if hydro-flexibility was maintained. If hydro-flexibility can be retained then new investment is more likely to be in higher efficiency baseload plant with lower short-run marginal cost (and higher capital cost).

Prices are likely to rise. In the short term, prices are likely to rise more than in the longer term, as the market adjusts. In the longer term though, the use of more hydro in summer and less in winter will see average prices pushed up, as winter peaks are increasingly met from more expensive thermal plant.

Another economic cost relates to higher levels of spill. Spill is a result of inflows exceeding outflows when lakes are full (i.e. no storage is available). With an increasing need for storage buffers to ensure the proposed inflows can be met, it is more likely that spill will occur. This is contrary to the Government Policy Statement on Electricity Governance which set an objective of using fuel resources efficiently, including minimising spill.

A further detrimental effect is the loss of hydro-firming for wind generation. Wind and hydro generation are synergistic, because the short-term stability of hydro capacity can be used to off-set the short-term intermittent nature of wind. A corollary of this is that if the WAB’s draft recommendations are implemented, less hydro storage will be available as wind-firming capacity. This may in turn restrict the development of New Zealand’s wind resource. This would mean that other (presumably non-renewable) generation would be required to replace potential wind capacity.

Security of supply will deteriorate. It is more likely that the level of the storage in the lakes will be insufficient to meet demand even with all thermal capacity operating. This means that existing reserve plant will be relied on more often, and additional reserve plant may be required. The restricted capability of the HVDC to transfer energy south exposes the South Island to significant risk if hydro assets are not optimised and reliance is placed on the provision of energy from the North Island.

NZIER – A review of the draft Waitaki Catchment plan ii

It is clear that the WAB draft rules will result in an increase in the cost of electricity generation and a greater risk to security of supply. The grounds, relating to adverse environmental impacts, for making these changes are not demonstrated in the plan. In Part V of the RMA there is an obligation to set out the principal reasons for objectives and policies in a regional plan, and to state the environmental results expected. Given the scale of the changes, and lack of any apparent justification for them, we recommend continuing the existing regime.

Recommended amendments The key modifications we recommend to the draft plan are:

NZIER – A review of the draft Waitaki Catchment plan iii

Contents

1. Introduction ...... 1 2. Key terms...... 1 3. Approach ...... 2 4. The draft plan ...... 2 4.1 Objectives ...... 2 4.2 Rules...... 4 5. Electricity generation...... 5 5.1 Lake Tekapo storage ...... 5 5.2 Tekapo River flow ...... 6 5.3 Minimum flows ...... 6 5.3.1 Interpretation ...... 6 5.3.2 Illustrating the effect of the minimum flow regime...... 7 5.3.3 Dry year flow management – storage...... 8 5.3.4 Conclusion on effect of minimum flows ...... 10 5.4 Overview – effect of WAB draft plan on electricity generation...... 11 6. Electricity prices and costs...... 12 6.1 Costs of proposed regime...... 12 6.1.1 Generation investment costs...... 12 6.1.2 Wind farms ...... 13 6.1.3 Spill ...... 13 6.2 Prices in a thermally flexible market...... 14 7. Security of supply ...... 15 8. Environmental basis ...... 16 9. Wider economic effects ...... 17 10. Alternative options ...... 18

NZIER – A review of the draft Waitaki Catchment plan iv

Figures

Figure 1 Distribution of excess flows below Waitaki Dam...... 7 Figure 2 Total inflows upstream of Waitaki Dam ...... 8 Figure 3 Daily inflows and WAB minimum flow...... 9 Figure 4 Single year cumulative storage...... 10 Figure 5 Supply and demand: winter and summer ...... 14

NZIER – A review of the draft Waitaki Catchment plan v

1. Introduction

In February 2005 the Waitaki Catchment Water Allocation Board (WAB) released its draft Waitaki Catchment Water Allocation Regional Plan (the draft plan). The WAB was established by the Resource Management (Waitaki Catchment) Amendment Act 2004 (the Waitaki Act) specifically to develop a regional plan for the allocation of water in the Waitaki Catchment.

The original impetus for the Waitaki Act was the lack of a regional plan in the face of Meridian Energy’s (Meridian) proposed Project Aqua and other demands for water. Project Aqua contemplated the development of six hydro stations downstream of Waitaki Dam. The scheme would have generated around 3,000GWh of electricity annually. Project Aqua was cancelled by Meridian in March 2004. Despite this, the WAB process continued.

The WAB has sought submissions on its draft plan. This report was commissioned by the Major Electricity Users’ Group (MEUG) to illuminate the effect of proposed changes to environmental flow and level requirements in the system.

2. Key terms

While we have endeavoured to ensure our report is easily understood, some technical language is inevitable. The key terms with which readers may be unfamiliar are:

MW megawatts – a measure of capacity; the rate of energy consumed or produced. One watt is one joule/second. MWh megawatt hours – a measure of consumption or production of electricity over time. One megawatt hour is the amount of electricity consumed or produced when one megawatt is used for one hour. cumecs a measure of the rate of flow of liquid; 1 cumec is 1m3/second CMD cumec day – a measure of the flow of liquid over time; 1 CMD is the volume of water that is ‘used’ when 1 cumec flows for 1 day. amsl above mean sea level, the base for measures of lake level. summer November to April, as defined by the WAB. winter May to October, as defined by the WAB.

NZIER – A review of the draft Waitaki Catchment plan 1

3. Approach

Time and resource constraints mean that we have not built a sophisticated model to show the impact of proposed changes to minimum flows and other hydrological conditions in the Waitaki Valley. We have used examples and approximations to illustrate the likely effect of various proposals. Where possible we provide estimates of the quantitative impact.

We have addressed five issues in this report:

The draft plan contemplates 24 rules to give effect to 45 policies. The 45 policies have been derived from five objectives.

4.1 Objectives

The five draft objectives are:

1. To protect the qualities of the environment of the Waitaki River and associated beds, banks, margins, tributaries, islands, lakes, wetlands and aquifers by: a. Recognising the importance of maintaining the integrity of the mauri in meeting the specific spiritual and cultural needs of the tangata whenua, and by recognising the interconnected nature of the river.

b. Safeguarding the life supporting capacity of the river and its ecosystems. c. Maintaining and enhancing people’s appreciation and enjoyment of the water bodies within the Waitaki catchment. d. Safeguarding the integrity of the large braided river systems. e. Providing for individuals’ reasonable domestic water needs. f. Providing for individuals’ reasonable needs for their animals’ drinking water. g. Providing for fire-fighting water needs.

NZIER – A review of the draft Waitaki Catchment plan 2

2. To enable, subject to Objective 1, people and communities to provide for their social, economic and cultural wellbeing and their health and safety, by providing for water for: a. Town and community water supplies. b. Hydro-electricity generation. c. Agriculture and horticulture. d. Industrial and commercial. e. Tourism and recreation facilities. f. Future unknown activities.

3. In allocating water, to recognise beneficial and adverse effects on the environment and both the national and local costs and benefits (environmental, social, cultural and economic). 4. To promote the achievement of a high level of technical efficiency in the use of water. 5. To provide for a practical and fair sharing of water during times of low water availability. These objectives are deficient in a number of respects. Most significantly, there is no objective relating to protecting existing users, or recognising the rights of existing resource consent holders. It was established by the High Court in Aoraki Water Trust and Ors v Meridian Energy that existing consent holders’ rights may not be derogated by later decisions.

It is an overriding principle that a regional plan cannot reallocate (to other users) a water resource that is already allocated. Secure property rights are vital to maintaining investment incentives and ensuring efficient behaviour.

In addition, the objectives are not measurable; hence it will be impossible to know if the plan achieves them.

If a proposal supports one objective but detracts from another it is not clear how a trade-off may be made. For example, the minimum flow regime proposed in the draft plan is arguably aimed at objective 1(c) and may erode the values objectified in 1(b): a trade-off has implicitly been made.

The relationship between objectives 1 and 2 is inappropriate in terms of the implementation of the Resource Management Act. The RMA does not elevate in-river values above other values. From an economic perspective, appropriate, balanced valuation of the activities contemplated in both objectives will result in the socially optimal outcome. In addition, parts e and f and arguably g of objective 1 do not relate to the quality of the environment and do not logically form part of this objective.

NZIER – A review of the draft Waitaki Catchment plan 3

Objective 2 part f suggests that the typical RMA first-in-first-served process will be abandoned for the Waitaki Catchment. Some proportion of water will be kept aside for “future unknown activities”. This is neither practical nor efficient. How the amount of water to be kept aside will be determined and how the “future unknown activities” will be recognised when they eventuate is arbitrary. In addition, it is not clear what the position will be if it transpires that the future activities, once they become known, are not as valuable a use of water as existing, known uses. This means that the framework involves unnecessary uncertainty, and will not necessarily balance the costs and benefits of not allocating water immediately.

The intent of objective 3 seems appropriate but it could be clarified and made more specific. Presumably, the purpose of this objective is to recognise that water should be allocated to its highest value use. Objective 3 refers to “recognising” costs and benefits. It is not clear what is intended once they have been recognised. For example, should allocations be made only to those where benefits outweigh costs, should some costs result in veto of projects, should costs and benefits of different projects be weighed against each other? This objective implies a static allocation of water that cannot adjust in future to provide for new activities as they become known and are proved to be valuable. It is well accepted that dynamic efficiency is a preferable goal to static efficiency. A dynamic allocation structure would allow for transferability to new uses as they arise (at the discretion of the existing user).

The intent of objective 4 seems admirable: to use the least volume of water to achieve a particular outcome. But it is not an appropriate objective for an allocation plan. The policies that relate to this goal are grouped under the heading “policies on efficient and effective use”. From an economic perspective, efficient, effective use of a resource implies allocative and dynamic efficiency goals. In other words, resources should be allocated in such a way that no one can be made better off without making someone else worse off, where short-term and long-term concerns are considered and balanced. Technical efficiency in comparison is a very narrow objective that requires the minimisation of waste.

It is our view that objectives 3 and 4 should be replaced by a single objective that implements a long-lived allocation mechanism that will deliver dynamic efficiency.

4.2 Rules

Rules 1-5 relate to setting environmental baselines in the catchment in terms of flows and levels.

The key changes in the environmental flows and levels in the Waitaki Catchment are:

NZIER – A review of the draft Waitaki Catchment plan 4

The application of sections 68, 128 and 132 of the Resource Management Act mean that these rules apply to existing consents. The process for applying the new rules to existing consents could take some time. The length of time that it will take for any appeal of the plan to be worked through and then the resource consent review process to be completed is unknown. For the purposes of our discussion here, we have assumed that the plan is effective with minimal delay.

5. Electricity generation

5.1 Lake Tekapo storage

The increase in the minimum level of Lake Tekapo has the effect of reducing the storage available to Meridian for hydro electricity generation purposes. In the very short-term this could mean that some of the inflow into Tekapo has to be used to fill up the Lake. Once the Lake has reached its new minimum the ongoing effect is to reduce the flexibility of the system.

Currently, Meridian is able to store over 900GWh of potential energy in Lake Tekapo.1 This allows Meridian to bank current inflows to use later, or to use storage to generate electricity when inflows are low. Typically storage is built up over the summer (when inflows are at their highest) and used over the winter (when electricity demand is at its highest). We can think of the loss of storage therefore as shifting generation from winter to summer.

This is a problem from an economic perspective because electricity is more valuable in winter than in summer. This is simply a result of the higher demand for electricity in the winter (relative to a static capacity for supply). This manifests most obviously in a higher price in the winter than the summer. The loss of storage means that inflows must be used as they are received rather than being able to set them aside for use in winter. We explore in more detail in section 6.2 what the impact on price is of a shift from winter to summer production.

1 This is simply the amount of electricity that would be generated in all eight Waitaki hydro stations by the total volume of water between the maximum and minimum control levels.

NZIER – A review of the draft Waitaki Catchment plan 5

The loss of 2m of storage is approximately 23% of the current potential storage. This equates to around 200GWh. An additional 200GWh of generation may be required in winter as a result of the increase in the minimum level of Lake Tekapo.

5.2 Tekapo River flow

There is currently no requirement in Meridian’s consent to maintain a flow down the Tekapo River.2 The WAB has proposed changing this to a constant minimum of 3 cumecs.

The effect of this will be to reduce the flow down the canals (Tekapo, Pukaki and Ohau) and therefore the potential electricity generated at Tekapo A and B and the three Ohau Stations. The potential generation between Lakes Tekapo and Benmore is approximately 68GWh/1000 CMD.

The loss of 3 cumecs through the Tekapo and Ohau Stations is approximately equivalent to 75GWh of potential generation annually.

An additional second order effect of requiring a flow down the Tekapo River is to raise the operating range of Lake Tekapo. Effectively a storage buffer above the minimum lake level is required to ensure that there is sufficient water to meet both the minimum lake level and the Tekapo River flow.

5.3 Minimum flows

5.3.1 Interpretation For the purposes of analysing the minimum flow regime, we have interpreted the rules as intending that Meridian is responsible for ensuring that there is sufficient downstream flow for other users. This is similar to the status quo. In winter this means that 4 cumecs must be available for drinking and stock water, and fire-fighting. In summer, an additional 80 cumecs must be available for irrigation. Finally, Meridian has advised that it currently operates a 20 cumec buffer on the minimum flow; we assume that this continues. The total flows we have assumed at Waitaki Dam are therefore 224 cumecs in the winter, and 334 in the summer. Summer Winter Minimum flow (draft rule 2) 230 200 Drinking water etc 4 4 Irrigation 80 - Operating buffer 20 20 Total 334 224

2 Meridian’s consents allow it to release water down the river during flood events, but do not require a flow.

NZIER – A review of the draft Waitaki Catchment plan 6

It has been suggested that it is possible to interpret rule 2 as requiring Meridian to release only 230 and 200 cumecs at Waitaki Dam in summer and winter respectively. If the rule is interpreted in this way it follows that downstream abstractive use would have to progressively decrease when the flow fell below 304 cumecs in summer (204 in winter). Below this level the requirement for “a minimum flow of 230 cumecs from Waitaki Dam to the sea” (emphasis added) could not be guaranteed. This implies a heavy cost to the agriculture sector precisely when it is in most need of irrigation. If this interpretation is contemplated, many questions remain unanswered; not least what would be the regime to progressively reduce irrigation takes. We do not believe that this is the interpretation the WAB intended, and have not considered it further.

5.3.2 Illustrating the effect of the minimum flow regime The effect of changes to minimum flows is less easily illustrated than the other proposed changes. Figure 1 shows the flow downstream of the Waitaki Dam. The data is for 1984-2004. We have subtracted the minimum flow that would be required under the draft plan.

Figure 1 Distribution of excess flows below Waitaki Dam Cumec days, 1984-2004

2500.0

2000.0 Summer

1500.0 Winter

1000.0

500.0

0.0

-500.0 0.00.10.20.30.40.50.60.70.80.91.0

Source: NIWA

The chart shows that in summer months between 1984 and 2004, the flow below the dam was less than would be required under the draft plan nearly one third of the time. In winter over the same period, the flow was less than would be required under the draft plan slightly more than 10% of the time. This indicates that in order to maintain the minimum flows proposed in the draft plan, on 60 days over the summer period (November to April) Meridian would have to use more water than is optimal (from the perspective of maximising the annual return from generation).

NZIER – A review of the draft Waitaki Catchment plan 7

We have already seen that the proposed change in the minimum control level at Lake Tekapo will mean that less flexibility is available, in terms of moving potential generation from the summer to the winter. In addition, storage will be required in the winter specifically to manage the probability that there will be insufficient inflow to meet (contemporaneous) minimum downstream flow requirements.

5.3.3 Dry year flow management – storage Figure 2 shows the daily inflows to the Waitaki Catchment upstream of the Waitaki Dam. The figure illustrates the variability in day-to-day inflows. It also demonstrates that a dry sequence is not necessarily related to a year. For example it is apparent that mid-2001 was a period of very low inflows. However, late 2001 saw a period of relatively high inflows.

Figure 2 Total inflows upstream of Waitaki Dam Cumecs per day

3,500

3,000

2,500

2,000

1,500

1,000

500

0 1997 1998 1999 2000 2001 2002 2003

Source: Meridian Energy (Project Aqua data)

Figure 2 is useful to illustrate the variability in inflows. However to understand the implications of the draft plan given this variability we need to consider a shorter period.

In 2001, as we have mentioned, inflows were relatively low for a large portion of the year. The average daily inflow upstream of the Waitaki Dam over the period 1927-2003 was 361 cumecs per day (CMD). In 2001, between May and October (the period described as winter by the WAB) the average daily inflow upstream of the Waitaki Dam was 191.6 CMD. This is insufficient to meet the WAB minimum flow below the Dam.

NZIER – A review of the draft Waitaki Catchment plan 8

Figure 3 Daily inflows and WAB minimum flow CMD, 1997-2003

3,500

Daily inflow 3,000 WAB minimum flow

2,500

2,000

1,500

1,000

500

0 1997 1998 1999 2000 2001 2002 2003

Source: Meridian Energy (Project Aqua data)

Figure 3 shows daily inflows upstream of the Waitaki Dam and the WAB minimum (out)flow downstream of the Dam. Clearly when the inflow is less than the outflow storage must be used to make up the difference. Put differently, every time the required outflow is higher than that day’s inflow water must be taken out of earlier inflows ‘banked’ under Meridian’s existing consents. Although Figure 3 shows a number of spikes where daily inflow was very high, in fact 47% of the time from 1997 to 2003 the WAB required minimum outflow exceeded the day’s inflow. This suggests that a storage buffer is required specifically to meet WAB requirements. This water would not be available to the market at the optimal time in terms of demand, as Meridian would have no discretion over when to use the water. This water would be required to ensure that Meridian could meet the WAB requirements under the worst possible inflow sequence.

Meridian has indicated that the amount of buffer that would be required is around 600GWh of storage. A simple way to understand why additional storage is required is to consider an example.

In 2001, there was a dry sequence that resulted in high spot prices and concern over security of supply. Figure 4 shows two cumulative ‘storage’ sequences. In both sequences we assume that the Waitaki system runs at the minimum flow rate (so any ‘extra’ water is stored). In addition we make the simplifying assumption that the year must stand alone (in other words, we assumed that there is no storage held over from the previous year).

We have chosen a November to October year on the basis that inflows predominantly arrive over the summer months (defined by WAB as November-April).

NZIER – A review of the draft Waitaki Catchment plan 9

Figure 4 Single year cumulative storage CMD, 2000-01

50,000 Cumulative storage: WAB Cumulative storage: status quo 40,000

30,000

20,000

10,000

-10,000 Nov-00 Jan-01 Apr-01 Jul-01 Oct-01

Source: Meridian Energy (Project Aqua data)

The status quo sequence illustrates the flexibility that was available in the Waitaki system over the 2000/01 dry sequence. There is water available above the minimum flow to generate electricity in a way that would enhance system security.

The WAB minimum flow sequence illustrates that if no water is held over from the previous year then it is impossible to meet minimum flows. A buffer of around 4300 CMD is required to ensure that cumulative storage never falls below zero. This is approximately equal to 300GWh of generation if we assume that most of the storage is held in Lake Pukaki. This water is held for river purposes – not the purposes of generating electricity when it is most valuable.

Another key point illustrated by Figure 4 is that a dry spring is a crucial contingency. Consider the ‘closing’ level of storage at the end of October 2001. If another spring inflow sequence like the one illustrated for 2000/2001 occurred, the shortage would be exacerbated.

It is important to realise that because the minimum flow is higher under the WAB proposal than it is currently, more electricity is generated if the system runs at the minimum flow rate. However, under the WAB requirements the flow is constant, so the ability to match the timing of generation to the timing of demand is eroded. It is this loss of flexibility that is a crucial implication of the WAB draft plan.

5.3.4 Conclusion on effect of minimum flows Overall, the profile of generation will be much flatter around the minimum flow levels. For an average of 60 days each summer, Meridian will use more

NZIER – A review of the draft Waitaki Catchment plan 10

water than it (and society) would consider optimal. Storage capacity will be lower and there will be less flexibility around the timing of storage use, as storage will be kept aside specifically to manage low flows rather than to match demand peaks.

Without a sophisticated model we cannot predict accurately the impact of this on the overall generation profile. However, we know that the profile will be flatter; we also know that in the extreme the profile would follow the minimum flows proposed in the draft plan.

We have estimated the change in the summer/winter profile of generation based on:

• The average distribution of inflows at Tekapo, Pukaki, Ohau, Benmore and Aviemore; • The potential generation downstream of each of these points; and • The average flows downstream of the Waitaki Dam in summer and winter. This suggests that Meridian currently produces slightly more electricity in the summer than winter (55:45). The WAB profile increases this bias to 60:40.

If we assume that current average annual generation in the Waitaki system continues, this amounts to a transfer of around 380GWh from winter production to summer production. This is equivalent to 100-125MW of mid- merit or peaking capacity (depending on the assumed availability factor).

5.4 Overview – effect of WAB draft plan on electricity generation

Electricity production from the Waitaki system will decline by 75GWh if 3 cumecs is required to flow down the Tekapo River.

Changes to the minimum flow downstream of the Waitaki Dam, and a reduction in the availability of storage in Lake Tekapo will reduce the flexibility of electricity supply.

In particular, the profile of generation will be flatter (particularly in summer) due to the minimum flow requirements. Higher winter minimum flows will mean that storage is dedicated to ensuring sufficient water is available to meet minimum flows. This electricity will not be available at peak times in winter (at least 300GWh and as much as 600GWh).

Lower storage availability will redistribute generation from winter to summer (in the order of 380GWh).

NZIER – A review of the draft Waitaki Catchment plan 11

6. Electricity prices and costs

The impact of the WAB draft plan on the cost of electricity generation and prices is difficult to predict. It is apparent that the short-term and long-term impacts could be quite different. For example, in the short-term there is likely to be a price spike as the market adjusts and new plant is built, either in the form of new investment brought forward or different investments substituted for planned plant.

In the longer-term the level of prices may well settle. It is certain though that there will be a real permanent cost as a result of the loss of relatively cheap hydro flexibility.

6.1 Costs of proposed regime

6.1.1 Generation investment costs Some additional generation capacity will be required year-round as a result of the loss of 75GWh of production to a flow down the Tekapo River. The larger impact though is the loss of winter capacity due to lower storage availability and the minimum flow regime.

For a peaking plant, the choice is usually an open cycle gas turbine (OCGT). This type of plant is lightweight, has a high power output, low ancillary plant requirements and liquid fuel that can be stored in a relatively small area or transported relatively quickly and easily. Whirinaki is a 155MW OCGT, it was commissioned in 2004 and cost $150m to build. In general, an OCGT costs less than $1000/kW to build but between $100/MWh and $200/MWh to run on diesel.3

A peaker has a very short start-up time and is typically used for short periods only. Another option would be to build a hydro-firmer. These, typically thermal, plants run for longer periods, up to several months, to “make up” the generation needed when hydro capacity is constrained. Taranaki and Huntly are generally used as hydro-firming capacity. These are also sometimes called “mid-merit” plants because of their place in the merit order or “stack” of generation.

For a mid-merit hydro-firming plant short-run cost competitiveness is more of an issue than it is for peaking plant. This means that coal and gas are more likely options. Options are a small combined cycle gas turbine (CCGT), similar to Southdown in Auckland, at a cost of around $1500/kW and around $70/MWh to run, or a coal station. A coal station is more costly to build (around $2000/kW) but has a slightly lower short run marginal cost (around $60/MWh, although a carbon tax will change this relationship).

3 Whirinaki’s offer strategy indicates that its short-run marginal cost is less than or equal to $200/MWh.

NZIER – A review of the draft Waitaki Catchment plan 12

Market provision of mid-merit (and peaking) plants has proved problematic. The incentive for market participants is to have their plant dispatched as often as possible (as long as the price is above marginal cost) to improve the investment return (by spreading fixed costs over more units of production).

The likely longer-term impact of the WAB’s proposed regime would be to force investment in mid-merit or peaking capacity that would not be made if hydro flexibility was maintained. If hydro-flexibility can be retained then new investment is more likely to be in higher efficiency plant with lower short-run marginal cost (higher capital cost).

6.1.2 Wind farms There is considerable, recognised, synergy between wind and hydro plant (with storage). Wind has a high level of short-term (daily/weekly) variability, but it is relatively stable in a seasonal to annual timescale. Hydro has the reverse properties: aside from relatively rare major events (floods) the short-term variability is low. Seasonal and annual variability, though, tends to be high, especially when snowmelt is a key component of inflows.

The simple explanation for this is that hydro storage can be used to firm wind generation. In other words, the short-term stability of hydro capacity can be used to off-set the short-term intermittent nature of wind.

A corollary of this is that if the WAB’s draft recommendations are implemented, less hydro storage will be available as wind-firming capacity. This may in turn restrict the development of New Zealand’s wind resource. This would mean that other (presumably non-renewable) generation would be required to replace potential wind capacity.

6.1.3 Spill Another significant cost associated with lower storage flexibility is higher spill. Spill occurs as a result of inflows exceeding outflows at a time when all storage is taken up (i.e. lakes are full). Spill is necessary to ensure that the level of water does not exceed the design safety of dams.

Spill is not excess water. It results from the unpredictability and variability of inflows, the resource consent and other safety constraints on the hydraulic system and the number of factors that have to be considered and balanced in making the complex decision about using water.

Higher minimum lake levels and the need for buffers to ensure the imposed minimum flow will reduce Meridian’s capacity to bank high inflows. Spill will increase. Anecdotally, estimates of the increase in hydro spill are around 200-300GWh in a mean inflow year, and up to 1000GWh in a wet year. This may not affect security of supply, but it will certainly affect the cost of meeting demand as other generation capacity will have to meet this loss.

NZIER – A review of the draft Waitaki Catchment plan 13

In addition, spill at Manapouri is likely to increase. Manapouri is a relatively controlled system and has little storage capacity. Typically, Meridian stores water in the Waitaki system to balance the inflows at Manapouri. With Waitaki storage constrained, it seems intuitive that when inflows at Manapouri are high, spill will increase.

This is contrary to the Government Policy Statement on Electricity Governance, which charges the Electricity Commission with “minimising unnecessary hydro spill” (para 2).

6.2 Prices in a thermally flexible market

Figure 5 Supply and demand: winter and summer

SupplyWAB Price Average winter demand (c/kWh) Supplywinter

PWAB

Pwinter

Quantity (GWh)

Supplysummer Price Average summer (c/kWh) demand SupplyWAB

Psummer

PWAB

Quantity (GWh) Source: NZIER

New Zealand electricity prices are typically relatively low and stable. This is largely a result of the dominance of hydro generation and the capacity for hydro storage to meet demand fluctuations. A decrease in the flexibility of hydro capacity and consequent increasing reliance on thermal peaking

NZIER – A review of the draft Waitaki Catchment plan 14

capacity will tend to push up both the average level and the peakiness of prices.

To illustrate why the average level of price will rise we need to consider the effect of the draft plan on summer and winter supply separately. Figure 5 illustrates the effect of the draft plan on summer and winter supply. The top chart shows winter.

The transfer of generation from winter to summer means that less cheap winter generation is available so the supply curve moves left and up; prices rise. In summer, in contrast, more generation is available in the low cost part of the stack, so the supply curve moves down and right; prices fall.

The crucial feature to note on the two graphs is the position of demand relative to the steepness of the supply curve.

We can be reasonably sure that the effect in winter will be larger than the offsetting summer effect for two reasons. First, the decrease in available winter capacity may be larger than the increase in summer capacity. This would be true if the storage held specifically to manage low flows is not used to generate electricity (i.e. spill increases). Second, the supply curve is steeper at the top end, i.e. as demand increases the compensating increase in price grows. This means that a loss of generation in winter pushes prices up more than the same size gain in generation in summer.

We have already noted that peakers tend to have very high marginal costs, relative to most of the existing plant in New Zealand. This suggests that relying on thermal peakers is likely to see not only higher average prices, but more volatile prices.

Again, there is a difference between short-term and long-term effects. A short-term price spike as market adjustment takes place will likely diminish. But prices will permanently remain at a higher average level than they otherwise would, because cheap hydro flexibility is replaced by more expensive thermal flexibility. Given the current composition of the market, investment in baseload plant may occur. The loss of hydro-peaking capacity will result in a shift in investment to mid-merit plant.

7. Security of supply

As we have described in some detail above, the effect of the draft plan on electricity generation, price and cost will be to reduce the level of hydro generation and increase costs and most likely average prices. Meridian will have no alternative but to operate conservatively, increasing its storage buffer and using water to provide smooth flows down the lower Waitaki, rather than to meet demand peaks. It is critical to understand that more water due to storage buffers does not necessarily mean an increase in the

NZIER – A review of the draft Waitaki Catchment plan 15

security of supply. Crucially, Meridian is not able to use that storage at its discretion to generate electricity. The water must be used for river purposes.

New Zealand, and in particular South Island, security of supply will deteriorate.

• Meridian will have less ability to allow storage to fluctuate because it faces higher minimum flows requiring it to conserve storage to meet these. As a result, hydro generation capacity could be constrained at any time of the year (not just in winter). • Total available storage will be lower, reducing the availability of hydro generation to meet peaks. • There is a limit of around 500MW on southward flow on the Cook Strait cable (HVDC link). The lack of capability of the HVDC to transfer energy south exposes the South Island to significant risk if hydro assets are not optimised and reliance is placed on the provision of energy from the North Island. As a result, the Electricity Commission will need to revisit its assessment of reserve energy requirements. A lower availability of storage to meet peaks means that the minzone will be higher than has been indicated to date. The minzone is a concept that indicates the level of storage required when all thermal plant is generating to maintain security of supply if the worst inflow sequence occurred. A higher minzone implies that existing reserve plant (Whirinaki) will be relied on more as the probability of entering the minzone is higher. Additional reserve plant may also be required. This would be a peaker, as outlined as one possible option in section 6.1.1, most likely in the South Island.

8. Environmental basis

NZIER is not an expert in environmental science. Our comments are therefore brief and based almost exclusively on NIWA’s assessment of the effects of Project Aqua on the environment.

From an economic perspective the test is whether the costs of a change outweigh the benefits. In terms of the environment, we assume that the ideal outcome would be the natural state of the river.

Our reading of the NIWA assessment of Project Aqua suggests that the natural state of the river is more similar to the current flows, than it would be to the draft plan. For example, NIWA have indicated that “regular flushing flows will be needed to scour fine sediments and periphyton from the bed of the river. It is recommended that flushing flows of 450 cumecs be released for one day every 5-6 weeks during December to April.” The analysis above indicated that the requirement to maintain at least 334 cumecs through summer will mean that flow rates are less variable. In other

NZIER – A review of the draft Waitaki Catchment plan 16

words, it may be difficult to achieve these flushing flow rates. Our understanding is that this would be detrimental to maintaining the braided river form of the Waitaki.

The natural mean annual 7-day low flow has been estimated at around 127 cumecs. The draft WAB minimum flow requirements are set well above this level. It is not clear to us what the environmental harm is that justifies a change of the scale considered given the clear costs to the security of electricity supply and the apparent environmental concerns raised by the increase in minimum flows.

9. Wider economic effects

The key economy-wide effects measured in the national and regional cost- benefit analyses of the Waitaki Catchment, undertaken for the Ministry of Economic Development and Ministry for the Environment respectively, relate to the change in electricity demand that will result from a change in price.

In terms of the direct effect on electricity consumption, we have already seen that summer electricity prices will fall and winter prices will rise. Sinclair Knight Merz indicates in their national cost-benefit analysis that the long-term elasticity of demand for electricity is around -0.26. That is to say a sustained 1% increase in electricity prices will eventually induce a 0.26% decline in demand.

A short-term change in prices would have a much more subdued effect on demand. SKM estimates a short-term elasticity of -0.07. The difference between these two numbers reflects the fact that in the short-term there is only limited capability to reduce electricity consumption. In the longer term processes can be modified and businesses evolve in the face of a higher price.

We noted that the short-term effect on price is likely to be more significant than the longer-term impact. This suggests that there will be a temporary depression in demand.

Large industrial customers tend to be more price sensitive than other consumers. Large industrials are likely to be disproportionately affected as a result. Consumers who are able to shape their demand to meet the availability of cheap supply (i.e. increase demand in summer and reduce it in winter) may be made better off by the proposal. All other consumers (including residential consumers) will be detrimentally affected.

Although the direct price effect should not be ignored, the more significant economic impacts will result from the precedent effect. In particular, investment incentives will be impaired. A risk premium associated with

NZIER – A review of the draft Waitaki Catchment plan 17

regulatory uncertainty will be applied to New Zealand investments where resource consent is required. In order to enable investment in infrastructure, investors must be assured that they will be able to use a certain volume of water over a certain period. If there is precedent for regional councils to arbitrarily clawback rights to the use of water then existing investment will be undermined and further or new investment will not proceed. An investor will only make an investment where they can be sure that they will receive the benefit of the investment.

In addition, the allocation of water is unlikely to be efficient. Considering only the setting aside of water for “future unknown uses”, we know that this will mean that the value of using the water in the present will be lost. Furthermore, if new uses arise and prove more valuable than existing uses, water rights should be able to be transferred (without the need for draconian measures).

10. Alternative options

The Waitaki Act is fairly specific in detailing what must be included in the Regional Plan: s.13 Regional plan for allocation of water In carrying out its function under section 6, the Board must include objectives, policies, and methods (including rules, if appropriate) in the regional plan, to provide for

(a) water that is or may be taken from, or used in, the Waitaki catchment in accordance with section 14(3)(b) and (e) of the principal Act; and

(b) water to sustain the intrinsic values and amenity values that the Board identifies and determines should be sustained in the Waitaki River and associated beds, banks, margins, tributaries, islands, lakes, wetlands, and aquifers; and

(d) the management of allocated water, including methods that provide for dealing with periods of time or seasons when the level or flow of water is low.

The WAB is charged with developing a regional plan for the Waitaki Catchment by the end of September 2005. The only appeals are to the High Court on points of law. Once operative, the plan cannot be revised for two years. It is our view that, given this context, the draft plan should be modified to improve economic efficiency, while preserving environmental values.

NZIER – A review of the draft Waitaki Catchment plan 18

The key modifications we recommend are:

• Including the recognition of existing users’ rights as an objective of the plan. • Developing, or providing for the development of, a regime that would allow transferability of rights using a market mechanism to ensure dynamic efficiency. • Amending the objectives so that they are measurable. • Maintaining the existing environmental flows and levels regime. It is our view that under s.13(c) of the Waitaki Act the ‘appropriate’ allocation of water to activities should include the protection of existing rights. It must be recognised that in order to ensure that efficient investment is enabled consent holders must have certainty around the operation of their consents. Consents must be expressed in a way that assures investors that they will have the right to use a specified volume of water for a certain period of time. Indeed it could be argued that consent-holders should be entitled to the expectation that their consent will take priority at renewal particularly where there are long-lived assets involved.

An environmental flow and level regime is clearly envisaged by the Waitaki Act. However, the relationship between the rules specified in the draft plan and the achievement of the relevant provision of the Act or indeed the objective outlined by the WAB is not clear. In Part V of the RMA there is an obligation to set out the principal reasons for objectives and policies in a regional plan, and to state the environmental results expected. Given that the existing plan does not set out these reasons, we consider that the test has not been met. In fact, the current regime better reflects natural flows, and there is no evidence of environmental damage resulting from it. Therefore the plan should, in the absence of a demonstrated environmental need for such a change, retain the existing environmental flow and levels regime.

The plan should also either outline a regime that would allow transferability of rights between uses or provide for one to be developed as part of the implementation of the plan. The WAB has identified an objective and series of policies aimed at ensuring that water is used in a technically efficient, i.e. non-wasteful, way. This should not be the key consideration; allocative and dynamic efficiency are preferable objectives. Ensuring that allocations can move to their highest value use across time is critical to achieving efficient outcomes.

The mechanisms for allocating water to activities and managing those allocations need to recognise the economic fact that the highest value use of water will change over time as technology advances and the economy evolves. The most efficient way to do this is to allow new investors with more valuable uses for the water to buy out existing users. This would also remove the need to set aside water for ‘future unknown activities’; setting

NZIER – A review of the draft Waitaki Catchment plan 19

aside water essentially wastes today’s resources. Nor would there be a need for onerous clawback provisions that would undermine investment incentives.

NZIER – A review of the draft Waitaki Catchment plan 20