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Energy consumers are paying for useless, profit-boosting infrastructure

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The Conversation

Infrastructure construction – including poles, wires and substations – has far outstripped peak demand. AAP Image/Dan Himbrechts

Infrastructure construction – including poles, wires and substations – has far outstripped peak demand. AAP Image/Dan Himbrechts

The preliminary report on energy prices released last week by the Australian Competition and Consumer Commission (ACCC) suggests that the consumer watchdog is concerned about almost every aspect of Australia’s electricity industry.

It quotes customer groups who say electricity is the biggest issue in their surveys, and cites several case studies of outrageous price increases experienced by various customers.

The report is long on sympathy about the plight of Australia’s electricity users. But the true picture is even worse – in reality, the ACCC’s assessment of Australia’s energy prices compared to the rest of the world is absurdly rosy.

Australia has internationally high energy prices

The ACCC quotes studies from the Electricity Supply Association and the Australian Energy Markets Commission (AEMC) to compare electricity prices in Australia with those in other OECD countries. But the ACCC’s comparison is based on two-year-old data, and badly underestimates the actual prices consumers are paying.

The AEMC’s analysis assumes all customers are on their retailer’s cheapest available offer. This is an obviously implausible assumption, and gives a favourable impression of the price that customers are paying.

As previously pointed out on The Conversation, the Thwaites review – which looked at customers’ actual bills – found that in February 2017 Victorians were typically paying A35c per kilowatt hour (kWh) – 42% more than the AEMC’s estimate.

What’s more, we know that Victoria’s electricity prices are lower on average than those in South Australia, Queensland and New South Wales, and hence below the Australian average.

A part of this 42% gap – around 15% – is explained by the latest price increases that are not included in the ACCC’s comparison. But this still leaves a 27% gap between what the AEMC assumes and the evidence of actual prices.

This begs the question: why did the ACCC not recognise the widely known flaw in the AEMC’s analysis?

The real problem is overbuilt network infrastructure

The report estimates that rising network charges account for more of the price increase than all other factors put together. There is no doubt that network charges are a real problem at least in parts of Australia, although their significance relative to retailers’ costs is contested territory.

But why would distributors build far more network infrastructure than they need? And why have government-owned distributors built far more infrastructure than private ones, despite having no more demand?

The answer to this perplexing question is to be found in part in Australia’s “competitive neutrality” policy. This is Orwellian doublespeak for an approach that is neither neutral nor competitive.

Under this policy, government-owned distributors are regulated as if they are privately financed. This means that when setting regulated prices, the Australian Energy Regulator (AER) allows government distributors to charge their captive consumers for a return on their regulated assets, at the same level as if they were privately financed. That is despite the fact that private financing is much more expensive than government funding.

It’s no surprise that when offered a rate of return that far exceeds the actual cost of finance, government distributors have a powerful incentive to expand their infrastructure for a profit. This “gold-plating” incentive is a well-known in regulatory economics.

Regulators, the industry and their associations have explained higher spending on networks in a variety of ways: higher reliability standards; flawed rules; flawed forecasting of demand growth; and the need to make up for historic underinvestment.

But was there ever historic underinvestment? A 1995 article co-authored by the current AEMC chair concluded that distribution networks had been significantly overbuilt. That was more than two decades ago, government distributor regulated assets are at least three times bigger per customer now.

The chart below – based on data from the AER’s website – examines how the 12 large distributors that cover New South Wales, Victoria, Queensland and South Australia spent their money on infrastructure between 2006 and 2013.

This period covers the last five-year price controls established by the state regulators, and the first control established by the AER. It was during this time that expenditure ballooned. The monetary amounts in this chart are normalised by the number of customers per distributor.

Distributor spending on infrastructure between 2006 and 2013. Author provided

The first five distributors from left to right (and Aurora) were owned by state governments and the others are privately owned. A clear pattern emerges: the government distributors typically built much more infrastructure than the private distributors.

And the government distributors focused their spending on substations, which are much easier to build (or expand or replace) than new distribution lines or cables.

We also know that the distributors’ spending on substations far outstripped the increases in the peak demand on their networks. The figure below compares the change in the government and private distributors’ substation capacity (the blue bars) with demand (the red bars) over the period that most of the expenditure occurred. Again, the amounts have been normalised by number of customers.

Substation capacity versus peak demand between 2006 and 2013. Author provided

The gap in spending between government and private distributors is stark. It is also obvious that in all cases, but particularly for the government distributors, the expansion of substation capacity greatly exceeded demand growth – which hardly changed over this period (and is even lower now, per connection).

To put it in more tangible terms, as an average across the industry, peak demand between 2006 to 2013 increased by the equivalent of the power used by one old-fashioned incandescent light bulb, per customer. But government distributors expanded their substation capacity by more than one 100 light bulbs, per customer.

The private distributors did relatively better, but still increased the capacity of their substations by the equivalent of about 30 light bulbs per customer.

My PhD thesis included econometric analysis that shows government ownership in Australia is associated with regulated asset values that are 56% higher than private distributors, and regulated revenues that are 24% higher, leaving all other factors the same.

To some, this evidence supports a “government bad, private good” conclusion. Indeed it was this line of argument that the Baird government in New South Wales used to justify its partial privatisation of two network service providers.

But in international comparisons of government and private distributors in the United States, Europe and New Zealand, no such stark differences are to be found. The huge disparity between government and private distributors is a peculiarly Australian phenomenon.

How we got here

This Australian exception originates in chronic policy and regulatory failure. As far back as 2011, the Australian Energy Market Commission (AEMC) heard a proposal that government distributors should earn a return closer to their actual cost of financing – a suggestion that would have reduced prices significantly and removed the incentive to gold plate.

In response, the AEMC said the regulations were consistent with the “competitive neutrality” policy. But this is not true: in the policy’s own words, it was designed to stop government businesses from crowding out competitors. Distributors are protected monopolies; they do not have competitors.

The AEMC also argued, somewhat bizarrely, that it was good economics for a regulator to assume that government distributors are privately financed.

This represents the triumph of an idealistic “normative” regulatory model in which regulators act on the basis of how the regulated entity should behave rather than how they actually behave.

But it would wrong to blame the AEMC alone for this failure. All of Australia’s key institutions and governments have agreed that government distributors should be regulated as if they are privately financed. For governments that own their distributors, this has been a wonderfully profitable fiction.

Therein lies much of the explanation for what is effectively, if I may call a spade a spade, a racket.

It is an indictment of Australia’s polity and so many of its economists that the 2011 Garnaut Climate Change Review stands alone, in a library of reviews, as stating this problem clearly. In fact, if you review last week’s report from the ACCC, you will not find a single distinction between the impact of government and private distributors.

And if you thought this was yesterday’s war, you would be wrong. Despite the mass of evidence, our regulators persist in the fiction that ownership and regulation should be independent of one another.

It is difficult not to lapse into despair about Australia’s energy policy morass. Despite the valiant attempts by many, a deeply entrenched culture of half-truths, vested interests, ideology and wishful thinking still characterises all too much of what emanates from the political and administrative leadership of this industry.

Some energy consumers – Prime Minister Malcolm Turnbull among them – will buy their way out of this problem through solar panels and batteries. But the poorest households and many business customers will increasingly be left carrying the can.

The ConversationAustralians are angry about electricity. Not unreasonably.

 

Source: The Conversation. Reproduced with permission.  

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  • trackdaze

    So we have the network operators running the show of the proposed NEG. doesn’t bode well for prices into the future.

    Get solar and storage. I’ll bring the champagne for the “cut the cord” party.

  • cres

    Great insight Bruce… though I would have expected peak demand to have risen more between 2006 and 2013 as the tail end of the air-con roll out in Australia was in play, which was a significant event with respect to network peak demand.

    My main gripe around the ‘competitive neutrality’ provisions is not so much that government owned network operators receive private finance returns… but that if they do, then they should expect to take on the risks that privately financed investments take. Network operators, in my opinion, take little or no risk in their investments. The main objective of regulating monopoly asset owners is to incentivise them to act as if in competition with other service providers, which being a natural monopoly prevents. As any private generator or large load looking to connect to the grid would attest to, this competitive attitude to service delivery is seldom the case.

    Additionally, private investors bear the impacts of misjudged investments (think Rio with Alcan, BHP with shale gas), often leading to significant asset write downs. Regulated monopoly network operators, now faced with disappearing demand behind the meter, should similarly face asset write downs. They have been paid a premium regulated return for bearing this market-based risk, as a prudent operator would within a competitive environment. Instead, consumer’s are faced with increased network charges to shore up declining revenue.

    • Coley

      And those “customers” are increasingly going to be the ‘captive poor’ those who can’t escape by opting for solar.

  • David leitch

    Excellent points well made, although no surprise. Network Revenue per customer compared to consumption per customer is another metric to show the same thing. Once again the finger is firmly pointed at the AEMC for being in charge of the process.

    However the more important point is that its very hard to correct the over build. The only way to get network prices down is either to significantly cut the return on the existing regulated asset base, or to cut the size of the asset base itself.

    Both will be difficult.

    Another point is that because grid delivered consumption growth is expected to be very slow because of energy efficiency and competition from behind the meter this will tend to perpetuate and even exacerbate the role of high network charges.

    More thinking about answers is required. I think most smart people now understand the problems.

    • Andy Saunders

      Or to get the deemed WACC reduced…

    • bruce mountain

      Thanks David. Not too sure that I agree that most smart people now understand the origin of the problem, or accept the answer that arises from this i.e. don’t regulate govermment-owned distributors. All our governments, ACCC, AER, AEMC, Productivity Commission, Treasury, Harper Review support ownership-invariant regulation. Ross Garnaut and George Yarrow (with Michael Egan) stand alone amongst our luminaries in accepting this stuff, publicly at least.

    • RobertO

      Hi David, It a very good article by Bruce, so how do we change the networks?
      Audit networks with someone (company of) whom understands substations and their relationship with both tranmission and customers. If the auditor finds that substation not required (ie gold plating) or should not have been built remove that assett from network (network unable to claim revenue or costs associated with asset even if it is used). Aduit of transmission will show if that was built on the assumption of more power supply or more asset useage of gold plated substations then remove transmission from networks. In all cases when Networks can prove asset is required then and only then may asset be re add to asset base. The auditors need to be electrical engineers with forsenic accounting back ground, possibly some company the like’s of say ABB from overseas
      One rumour I have heard is that there is a substation on the Central Coast of NSW that has been built and that there was no connections (Transmission or Customer) for some (and no requirements) for some 3 years after it was completed (which is why forsenic auditing by electrical engineers is part of the idea).