The winner’s curse, power station edition

Ian Verrender in the Sydney Morning Herald recently wrote of Victoria’s two oldest power stations that they were bought by their owners “when the issue of climate change was well known”.  Though he made that remark in the middle of a longer article focused on different issues, the point is important. The winners of Australia’s power station privatisation auctions all knew they might someday face a carbon price. And the losers knew it too. It’s one of the reasons they lost.

Since some appear to doubt this – for instance, commenter Patrick in this Ken Parish post – it should be made clear.

Patrick argued: “Anyone in 1996 who seriously envisaged carbon trading/caps/etc would have been considered delusional. Can you remember how long ago 1996 was?”

In fact, 1996 was not that long ago in the climate change debate, which is more than 30 years old. Dr Sinclair was teaching my Year 10 science class about the greenhouse effect back in 1979; the first substantial federal political discussion of a carbon tax occurred in 1990. The prospect of a carbon tax or trading scheme was very real by the time the Victorian electricity assets came up for sale in the mid-1990s. And the prospect of a carbon tax was particularly real for the community of people trying to figure out what a brown coal power station was worth. The conversations I had with keen potential buyers (or more often, their investment bankers) at the time could be summed up like this: “Carbon pricing will come. One day. But there’s plenty of money to be made before that happens.”

Now step back a bit and take a careful look at the potential buyers who made it to the final stages of the Victorian power auction. They were by definition the biggest optimists about the industry’s prospects. They could see the greatest opportunities, and had the greatest myopia about the risks. Fifteen years later, what I remember most is their intense optimism. In contrast, people who were worried about carbon pricing couldn’t justify the sort of prices that were being talked about, kept their wallets in their pockets, and didn’t even bother flying to Melbourne.

The Victorian power station buyers were delusional. I don’t mean that in a bad way. Successful asset buyers have to be delusional: you bet billions of dollars that the bad stuff won’t happen and the good stuff will. It takes nerve. The uncertainties of betting that much of people’s superannuation money would turn most people into a nervous wreck.

Anyway, one of the Victorian power station buyers’ delusions was that carbon pricing would not arrive – or at least, not until after they’d made plenty of money.

(A bigger delusion was that the $40/MWh electricity price forecast in a McKinsey study paid for by the assets’ seller would turn out to be correct. If McKinsey had been right, the original buyers really could have made a nice profit on the deal by now. Whoops.)

The huge challenge that asset buyers confront is called the winner’s curse. It’s a known issue in auctions with incomplete information. The curse is often a problem in utility privatisations, because the profits of utilities are politically sensitive and government policies change. The same curse pops up all the time in business, though often the incomplete information is about a question like “does this oil field I bought from that nice multinational oil giant actually have any economically extractable oil in it?” If you’re particularly foolish, like that Perth bloke who bought the late Kerry Packer’s TV stations, the winner’s curse will send you broke.

I’m pretty sure I wrote something in The Age in the mid-1990s noting that if and when carbon pricing did come in, the Victorian power station purchasers would scream their heads off. I think I also noted that paying any attention to their screaming would be unfair to the losers of the Victorian asset sales process. That still seems a fair observation today.

The real problem for Australia is that we need a smooth transition to a carbon price, and power stations are lumpy assets. Ross Garnaut is trying to solve this, but it’s not easy.

The not-real problem is that power station owners need to be compensated for all the losses in the value of their assets. They don’t. The buyers were grown-ups, and they knew what they were getting into. They knew about carbon pricing and the winner’s curse and they hoped like hell they had guessed right. Bad luck, fellas.

About David Walker

David Walker runs editorial consultancy Shorewalker DMS (shorewalker.net), editing and advising business and government on reports and other editorial content. David has previously edited Acuity magazine and the award-winning INTHEBLACK business magazine, been chief operating officer of online publisher WorkDay Media, held policy and communications roles at the Committee for Economic Development of Australia and the Business Council of Australia and run the website for online finance start-up eChoice. He has qualifications in law and corporate finance. He has written on economics, business and public policy from Melbourne, Adelaide and the Canberra Press Gallery.
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Nicholas Gruen
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Nicholas Gruen(@nicholas-gruen)
10 years ago

Great post. Amazes me how credulous people are. Even our friend Patrick seems to want to hand vast sums to people who took a calculated risk.

On the winner’s curse, if it’s seen as a psychological phenomenon I guess imperfect information is part of the recipe, but more generally when you win an auction you’re facing the spectre of the winners curse. After all, in winning the auction you just proved that you valued the asset more highly than anyone else in the world! Good luck with that! Especially if you want to sell it again ;)

Incurious and Unread (aka Dave)
Incurious and Unread (aka Dave)
10 years ago

David,

It is worth pointing out that only one of the original buyers of the Victorian brown coal power stations still owns them. The other later sold them, as follows:

Hazelwood: bought 1996 by International Power, who still owns it
Yallourn: bought 1996 by PowerGen, who sold it to China Light and Power 2000
Loy Yang A: bought 1996 by NRG consortium, who sold it to AGL consortium 2004
Loy Yang B: bought 1997 by Edison Mission, who sold it to International Power consortium 2004

Anyone who wasn’t expecting future carbon pricing by 2004 really was delusional. However, the purchasers’ thinking was more likely to be that they could argue successfully for compensation. They may be right.

aidan
aidan
10 years ago

I can’t understand the mad rush to sell off the NSW power assets. Surely they’d get a shitty price because of the almost certain introduction of a price on carbon?

Who better to absorb the “loss” turn them into backup/load-following generation and gradually shut the things down than a Government?

Surely even Keating can see the playing field has changed from the 1980s?

John B
John B
10 years ago

Aidan,

The NSW power stations already follow the loads, ie track the daily swings and the weekend trough. It is normal for them to cycle between loads of 40% and 90% or even 105% of nameplate rating, which they are designed to do. The notion that coal fired power cannot follow load has always been incorrect.

Regarding backup operation, that has always been done. It’s called spinning reserve, and the national market is managed in such a way as to ensure that sufficient reserve is immediately available at all times to prevent system collapse if one or two of the largest units unexpectedly fail.

In extreme overseas cases, some coal fired stations have been “two shifted”, ie turned right off at night and re-started for the morning peak. This is a silly option when reducing load on in-service units is able to provide the same service without all of the metallurgical stresses and increased operational costs which are part and parcel of heating and cooling such massive lumps of metal and having to use oil or gas during the morning re-start.

As to whether a government or private industry is better situated to absorb business losses through ownership of stranded assets, your comment identifies you as supporting the privation of profits and socialisation of losses. I do not.

Very well done, David Walker. The world needs more clear thinkers like you.

Pedro
Pedro
10 years ago

“(A bigger delusion was that the $40/MWh electricity price forecast in a McKinsey study paid for by the assets’ seller would turn out to be correct. If McKinsey had been right, the original buyers really could have made a nice profit on the deal by now. Whoops.)”

Thank goodness they have not made the same mistake on the NBN forecasts!

doctorpat
doctorpat
10 years ago

I’m pretty sure I wrote something in The Age in the mid-1990s noting that if and when carbon pricing did come in, the Victorian power station purchasers would scream their heads off. I think I also noted that paying any attention to their screaming would be unfair to the losers of the Victorian asset sales process.

I’m not sure that follows. If the high bidders should have been able to predict the likelihood of a future push towards carbon pricing, then it is equally true that the low bidders should have been able to predict that the future owners would scream their heads off, AND that it would be on the cards that governments would listen to them.

Everyone involved had to balance out the likely fight between interest group politics, and had to choose the the eventual final path that reality would follow. Neither one side nor the other suffers any unfairness.

wilful
wilful
10 years ago

Australia is a signatory to the United Nations Framework Convention on Climate Change. We signed it on 12 June 1992, it came into force in 1994. This is a binding commitment of the Australian Government, like any similar international treaty. Here is it’s entire text: http://unfccc.int/resource/docs/convkp/conveng.pdf

Anybody who says that anybody deserves any compensation after this date is a fool or a charlatan.