Finishing the job of energy market reform

By Anita George and Tim Nelson

In early August 2012, Australia’s Prime Minister called for major reform in the energy sector in the wake of significant increases in average electricity bills over the past four years.

The Prime Minister called for greater efficiency in investment in electricity networks, particularly in states where electricity networks are publicly owned, and for greater empowerment of customers to be able to manage their electricity consumption and expenditure.

The Prime Minister referred specifically to the current inefficient handling of peak power demands – stating: one sixth of our national electricity networks, $11 billion in infrastructure, has been built for events that last for less than four days per year; and that more than $500 a year for a typical family is spent to meet the costs of peak events that last for less than two days each year(1).

Efficient network capital expenditure and appropriate reforms to the regulatory arrangements under which networks operate need to be considered. However, a necessary and complementary mechanism to manage peak demand, enhance competition, and maximise the efficiency of generation investment in the NEM, is retail price deregulation where markets are competitive, along with critical peak pricing (CPP) and time-of-use (TOU) tariffs.

Retail prices should be deregulated in competitive markets like the NEM.

There is no rational economic or public policy explanation for the existence of price regulation in a competitive market. In fact, price regulation in competitive markets inhibits the exercise of customer choice and competitive market forces – stifling innovation and new product development.

Retail electricity markets within the NEM are workably competitive. The NEM has the highest customer-switching rate when compared with other industries such as telephony, pay television and banking. For example, churn rates in NSW are currently around 17 per cent, and around 50 per cent of customers are benefitting from being on market contracts rather than retailers’ default tariffs(2).

Further, statistics on comparative residential churn rates by state between 2004 and 2012 indicate that switching rates are highest in states in which there is no evidence of regulatory intervention (e.g. in Victoria, where the Essential Services Commission monitors, as opposed to sets or approves, retail prices). These figures also show that over-regulation and sub-economic decision-making (as occurred in NSW between 2004 and 2006) result in significantly diminished competition and switching rates (switching rates in NSW were as low as 5 per cent then).

Cost reflective prices will reduce peak demand and end the “energy market death spiral”.

Enabling retailers the flexibility to develop innovative products with genuinely cost-reflective tariffs such as TOU pricing and CPP would not only provide the opportunity for enhanced competition through greater customer choice, it would reduce peak power demand and the associated expenditure currently being incurred. This in turn would curb the incidence of the “energy market death spiral”(3) that the use of ‘flat’ or average tariffs currently promotes. Such a situation occurs where higher capital expenditure is required for rising peak demand but this capital expenditure is spread across the same output resulting in higher ‘flat’ tariffs. In response to higher ‘flat’ tariffs, consumers reduce expenditure at times other than peak demand times, necessitating even higher ‘flat’ tariffs. TOU pricing and CPP alleviates this problem by ensuring customers are incentivised to reduce demand at times of peak demand.

Where prices are regulated, LRMC as floor must be maintained

Where price regulation is retained despite the existence of effective competition, then the wholesale energy cost component of regulated default tariffs must be set at an estimated premium to the long run marginal (or sustainable) cost of supply (known as the LRMC), as distinct from being based upon short run market costs, for a number of key reasons.

Firstly, a short run dynamic approach to the setting of default tariffs will be market distorting, and will not result in an efficient price being set. Such an approach requires regulators to take an exceedingly narrow view of the market and to define as efficient only short-term instruments spanning one-to-three years. This is incorrect given the wide array of wholesale pricing instruments available and the many combinations of hedging arrangements used by retailers, and is incompatible with the way the industry currently operates.

Further, in the specific case of NSW where the next retail price path is due to be set shortly, pricing with LRMC as the floor price would avoid acute volatility in pricing and in particular a sharp price increase that would otherwise occur from 2014 onwards when the next price determination process will commence and prices would readjust from the sub-economic pricing levels that setting a regulated tariff below LRMC now would constitute.

Where regulated prices are below long run sustainable costs, retailers will be unable to compete. This would potentially have a significant impact on investment and threaten security of supply, as credit-rated retailers would be unable to write Power Purchase Agreements (PPAs) with generators as there would be no way for retailers to obtain an economic return in the short term.

This would stifle the entry of new plant in the NEM, as current economic conditions dictate that new entrant plant requires long-dated PPAs to be entered into. If this was to become a systemic issue in the NEM, then the stability of the NEM itself would be threatened, as integrated entities would lose their investment-grade credit ratings and they would therefore be unable to write PPAs, hence potentially requiring governments to finance new investment. It would also lead to the likelihood of inefficient investment, as new investment will more likely involve low capital cost ‘peaking’ plant regardless of whether this is the most efficient technology.

Energy market reform is critical

Australia’s NEM seems to be at a crossroads, with significant cost pressures across all components of the electricity supply chain. So far, there has been little appetite for reform in relation to electricity prices. This lethargy in policy making needs to end, and significant structural and regulatory reform needs to occur to address inefficiencies across the industry and to curb spiralling electricity prices. The decision of the Prime Minister to force this debate before Australian policy makers may be the impetus that is needed to bring about real reform.

Anita George is Manager Energy Policy and Strategy and Tim Nelson is Head of Economics, Policy and Sustainability at AGL Energy.