Brook: New Zealand Electrical Utilities

By Stefan Stevanovic, Investment Analyst

The Mighty River Power IPO process, part of the Government’s ‘Mixed Ownership Model’, is now underway. It is anticipated that two other gentailers (a term coined for vertically integrated electricity utilities, which generate electricity and sell it on the retail market), Meridian and Genesis, will also follow suit and New Zealand investors will be placed at the front of the queue to acquire majority stake ownership. Assets like these are normally considered as stable and defensive investments; however, the New Zealand electricity market is unique, exposing investors to risks not necessarily inherent in other electrical utility sectors.

Globally electric utilities are usually perceived as defensive assets due to their low earnings volatility, inelastic demand, high dividend yield and having high barriers to entry due to their natural complexity and capital intensive infrastructure. Electric utilities fall in the low risk low reward category and in general tend to outperform in bear markets and underperform in bull markets. They supply essential services and exhibit natural monopolistic characteristics. In order to prevent them from exploiting this position, they tend to be heavily regulated by local authorities. It is this regulation that gives electric utilities some of their defensive qualities as it restricts them from making abnormal profits for their shareholders and eliminates competitive pressures which are a prominent tenet of a free unregulated market.

In New Zealand, electrical utilities are not regulated to supply power at a cost to serve or a capped rate of return basis. They compete against one another in the wholesale electricity spot market where they make supply offers in 52 different grid injection points across New Zealand every half an hour, 24 hours a day. So far this is nothing unusual, but what differentiates New Zealand’s electricity market from the rest of the world is its bias towards hydro as a fuel supply, the risks associated with hydro and the continued widening of imbalance between consumption and generation.
The pre-eminent fuel for electricity in New Zealand is water (hydro), which accounts for approximately 55% of total capacity. Of that total hydro capacity, two thirds is generated in the South Island catchments, making the region a significant supplier of base load electricity. In comparison, most of thermal peaking generation (i.e. coal/gas) is generated in the North Island. Such large regional dependence on water exposes the gentailers to adverse hydrological conditions and this is further magnified by the fact that the catchments have extremely low storage capacity. For example, if you were to decommission all plants and rely solely on hydro you would have approximately 1.5 months of generation to meet normal demand levels, while Brazil has a multi-year storage capacity period. This risk is further amplified by the current transmission constraints of the High Voltage Direct Current (HVDC) network, which links North and South Islands via Benmore and Hayward substations. Simply, the HVDC is physically constrained in how much power can be delivered from north to south. The HVDC constraint mixed in with dry/wet risk can cause significant volatility in wholesale prices and can disconnect the pricing between the North and South Island by as much as 80MW/h, exposing the gentailers to earnings volatility.