Another year, another electricity price rise -- as I wrote in this newspaper a year ago. This time it's 10 per cent, last year it was 15% (although that was after a two-year freeze).

Transmission and distribution costs make up about 40% of the current domestic tariff, and these costs will remain the same. That means that what Meridian takes out (the energy component) will, in fact, rise by about 16%.

Between April 1999 and May 2004, transmission and distribution costs in Christchurch fell by 9%, while Meridian's energy price increased by 25%. Including the latest rise, this makes the increase in Meridian's cut about 40% over five years.

Meridian implied that last year's price rise was necessary to finance Project Aqua. Now that Project Aqua has been abandoned, what's the excuse (and, incidentally, what's happened to the money they accumulated to build it)?

Meridian says wholesale electricity prices are rising, future supply is uncertain, and it needs to be able to buy on the (very expensive) spot market in times of shortage. To do that, it needs to raise its prices to build up a reserve.

That's quite logical, given the state of the market and the requirement on Meridian to operate as a successful business. So there is no point in blaming Meridian -- that's just shooting the messenger.

The real question is, why does it need more money to operate as a successful business? Why do electricity generators need an increase in revenue of 40% over five years, when distributors, or for that matter car dealers, baked bean manufacturers and other businesses, don't? There are two fundamental causes.

As Meridian correctly says, future electricity supply is uncertain. Maui gas, which fuelled about a quarter of our generation (and up to 40% in dry years), is running out and it's not clear what will replace it. This puts an upward pressure on prices. Competition is supposed to apply a compensating downward pressure, and keep prices in control. It doesn't because there is no effective competition in the generation market. The generators pretend, and the Government and its advisers (notably including the generators themselves) hold as an article of faith that there is -- but there is not.

The Minister of Energy, Pete Hodgson, has boasted about "New Zealand's tradition of constructing new generation capacity at the last minute". Historically, that was true. But last-minute generation additions and competition can't co- exist; there must always be an excess to compete with.

The Minister's contention that "electricity prices must rise to meet the cost of new generation" shows the same lack of understanding.

Earlier this year, his ministry hired consultants who showed that since 1993 wholesale electricity contract prices have tracked the "cost of new generation", except in 1998 and 1999 when there was a "temporary oversupply of generation". This was intended to show, among other things, that the Minister's contention was correct. What it actually showed was that when there were last-minute additions, and hence no oversupply, prices were high; when an oversupply allowed some competition, prices fell.

Prices cannot reach the "cost of new generation" if there is effective competition.

It's a catch-22 situation: in our competitive electricity market, new capacity will be built only if there's no competition. Of course, there are other competitive markets where new capacity is routinely built. The flaw, then, must be in the structure of the electricity market.

One problem is that there aren't enough generating companies for effective competition. The two largest, at least, are each capable of cornering the market. Also, the companies have markedly different cost structures: hydro generation has a much lower variable cost than fossil-fuelled generation, but less control over when and how much can be generated. Thus the companies, with their different types of generation, tend to complement each other (as they were originally designed to do) rather than to compete head-on. The result is a lack of effective competition.

As well, there is no incentive to develop an oversupply of generation. That raises the companies' costs and lowers their prices. No wonder they maintain the tradition of last-minute additions.

The market was set up (and tinkered with) by governments past and present, and change to it would need authorisation from the Government (the Electricity Commission is responsible for the market rules, but can only act through the Minister, not independently). However, the State (in practical terms, the Government) owns about two- thirds of the electricity industry, including most of the very lucrative hydro generation, and receives around $1 billion each year from it. It has a vested interest in not disturbing its cash cow by fiddling with the market environment.

The outcome, then, is that we have a market in which prices are supposed to be controlled by competition; but competition doesn't work because there's no excess generation to compete with. And even though this has allowed prices to rise high enough to pay for it, there's no incentive to build more.

The Minister, by his various pronouncements, has demonstrated that he does not (or will not) understand how competitive markets operate. He seems satisfied with (uncompetitive) prices at "the cost of new generation" -- probably out of fear that no generation will be built if the price falls. By this logic, "just-in-time" generation will meet demand in normal years; problems with exorbitant prices will occur only when there's a hydro shortage.

He has moved to solve this by his "ring-fenced reserve generation policy", under which capacity to overcome the shortage in dry years is built up, but not allowed to go on the market. It can be used only when the shortage occurs. The reason for this ring-fencing is that it is paid for by a levy on consumers, and could therefore compete unfairly with normal generation.

The first and only part so far of this reserve generation, the Whirinaki power station, has been installed. Outside the Government, there are doubts about whether it can be adequately fuelled where it is, about how much of its output can be transmitted to the rest of New Zealand, and in fact whether it's needed at all.

The work the Electricity Commission had done on the need for reserve generation in 2005 indicates that if the conventional stations, like Huntly and New Plymouth, were fully fuelled, nothing more would be needed -- and neither would Whirinaki.

This demonstrates that the Minister also doesn't understand how the system was designed to operate -- with its thermal power stations backing up hydro in such a way that shortages are avoided at a minimum cost in all types of years. His reserve generation plan is to wait until a shortage happens, and then release expensive generation to fill in the hole.

Meridian, and the other generators, are operating as the Government requires them to -- as successful profit-maximising businesses. They are able to take advantage of flaws in the market structure to raise their prices to reduce their risks.

The problem is the way the market has been set up, and that there are strong incentives for both the Government and the industry to keep it as it is. Consumers were not and are not consulted; they have no voice on policy matters.

There's an economic cost to the nation because of the supply uncertainty and the price rises, but the Government is so economically illiterate that it doesn't consider the national interest.

I think we're stuck with unwarranted price rises until something (a disastrous shortage?) forces the government of the day to overhaul the market.

John Noble is an energy commentator and consultant.

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