Buyers with market power can reverse the logic of price discrimination

The Tiwai Point aluminium smelter has been in the news again this week, as reported by the New Zealand Herald on Thursday:

The Electricity Authority (EA) has changed market rules to ensure that consumers are not affected by very large power contracts after last year's Tiwai Point deal highlighted the potential for price discrimination.

The independent statutory body said consumers would be protected from potentially paying more than they should due to the impact of very large electricity contracts on wholesale prices under urgent changes announced today...

The arrangement announced in January 2021 to extend operations by the NZ Aluminium Smelters (NZAS) at Tiwai was used to highlight the potential issue of inefficient price discrimination.

In a separate statement, the Consumer Advocacy Council said current negotiations for a new electricity supply contract for the smelter - which consumes about 13 per cent of New Zealand's generation - must not disadvantage New Zealand consumers.

Meridian and Contact are currently negotiating a new contract to supply the smelter from the end of 2024.

"We are pleased that the authority is protecting consumers with urgency given new contract negotiations for Tiwai Point are under way," council chair Deborah Hart said.

"We accept that an operation consuming so much power, 24/7, should get a discounted rate, but that rate must be fair and reasonable for all consumers and not repeat the mistakes of the past."

Last year, the EA estimated the impact of the Tiwai contract could potentially lead to households paying up to $200 extra on their electricity bills each year. 

As I noted in yesterday's post, price discrimination occurs when a firm charges different buyers a different price for the same good or service. In this case, the Tiwai Point aluminium smelter has previously been charged a lower price for electricity than household consumers, to such an extent that it appears that electricity sold to Tiwai Point was being sold at a loss.

That's where things get interesting. Tiwai Point must have very inelastic demand for electricity. There are few substitutes for the electricity it gets under contract from Meridian and Contact. It isn't simple to start and stop producing aluminium, with large costs and lots of waste involved. So, even if the price was higher, Tiwai Point would still demand roughly the same quantity of electricity.

As I noted yesterday, when a firm price discriminates, it should apply a higher mark-up (and a higher price) to buyers who have less elastic demand (less price sensitive demand) for the good or service. That suggests that Tiwai Point should be paying a higher price, not a lower price, than household consumers. But the reverse is true. What is going on?

Meridian and Contact supply a huge amount of electricity to Tiwai Point. As noted in the quote above, it amounts to 13 percent of New Zealand's total electricity generation. If that electricity wasn't going to Tiwai Point, it would drop into the rest of the market. That would greatly increase supply in the non-Tiwai-Point electricity sub-market, decreasing the price of electricity. Electricity consumers would benefit from this, of course. But because household (and industry) demand for electricity is quite inelastic, lowering the price of electricity decreases total revenue for the firm. So, Meridian and Contact would likely be made worse off. Alternatively, Meridian and Contact could withhold that additional supply from the market, leaving them with some stranded hydroelectric assets (which doesn't make much sense, because hydro power has a fairly low marginal cost of generation).

So, since Meridian and Contact really don't want to be left with the choice of stranding assets or dumping electricity into the rest of the market, that gives Rio Tinto (the owners of the Tiwai Point smelter) some market power. Rio Tinto uses that market power (on top of using the threat of job losses) to negotiate a preferential deal for electricity at a lower price. And that is what reverses the logic of price discrimination.