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Efficient price discrimination in the wholesale electricity market

Sapere was asked by Meridian Energy to review the discussion paper ‘Inefficient Price Discrimination in the wholesale electricity market – issues and options’, issued by the Electricity Authority (Authority) as part of its Wholesale Market Review.
The Authority claims that the price discrimination implicit in the ‘Tiwai contracts’ between Meridian Energy, Contact Energy and New Zealand Aluminium Smelters (NZAS) raises the possibility that electricity may not have been allocated efficiently, and results in potential inefficiency costs of around $57 million to $117 million per year.

According to the Authority, the Tiwai contracts provide a potential illustration of how price discrimination may, in some cases, not be in the longer-term interests of consumers. That is, the Authority considers the Tiwai contracts to be an example of inefficient price discrimination.

Kieran Murray and Vladimir Bulatovic demonstrate that the tests applied by the Authority, for distinguishing efficient and inefficient price discrimination, are at odds with the established literature on price discrimination, and that the Authority has wrongly characterised the Tiwai contracts as an example of inefficient price discrimination. Their report also demonstrates that rather than an efficiency loss of $57 million to $117 million as arrived at by the Authority, the better measure of the total efficiency gains from the Tiwai contracts (relative to a scenario in which the smelter ceased production) is around $40 million to $120 million per year, applying the Authority’s assumptions consistently.

The report shows the Authority has wrongly interpreted its own analysis, and provides an example of welfare enhancing price discrimination, not inefficient price discrimination as the Authority concludes.