Networks: Bad news for consumers is good news for renewables

There is about $40 billion of debt sitting against the electricity distribution regulated asset base (RAB) spread across the entire National Electricity Market (NEM).

Every 1% change in the interest rate the regulated industry is allowed to charge for is thus an extra $400 million of industry revenue/consumer cost.  We estimate there is about a 2% difference between the rate the Australian Energy Regulator wanted to allow and what some businesses can now recover after this week’s Federal Court ruling.

We expect that difference to decline each year, but to average about 1% over the next ten years.

In a typical way that the world works, NSW consumers will probably be the least impacted because of the guarantees the NSW Government obtained from purchasers of the Ausgrid and Endeavour networks. Over time there will be more impact on Queensland consumers and then South Australian and Victorians.

Meantime, the move to decarbonisation will benefit from the rising price of  fossil fueled, grid delivered electricity because higher prices will encourage investment in efficiency and lower consumption ,and incentivise alternatives such as distributed renewables.

Background

As reported here at Reneweconomy the Federal Court has dismissed the appeal by the AER [Australian Energy Regulator]  from a decision by the ACT [Australian Competition Tribunal] that the AER remake various elements of its revenue determination for the NSW electricity distributors.

The two major areas of the AER’s original decision that were disallowed by the ACT were  (1) the way in which the AER used benchmarking to cut the amount of opex [operating expenses] it allowed the NSW distributors to recover and (ii) the way in which the AER calculated the cost of debt in allowed the NSW distributors to recover.

The opex issue is one that applies mainly to the NSW distributors as their opex is much higher comparatively than anyone elses.

Most people in the industry think, that no matter what the law is, that the NSW distributors have been demonstrably inefficient. However, consumers are somewhat covered in the case of Ausgrid and Endeavour by assurances given by the purchasers of 51% of the equity from the NSW Govt that prices in 2019 will be lower than 2014.

It’s the issue of the theoretical amount of interest factored into the regulated revenue that will have the broadest impact across the whole of the NEM, not just in NSW.

Move to 10 year trailing average

Historically, the AER used to allow for a cost of debt for a forward looking five year period by taking one “overnight” estimate of the company’s cost of debt, broken down between the risk free 5 year bond rate and a debt margin.

This did not reflect the actual way in which companies managed their debt. The companies generally reset their risk free rate to coincide with the decision but had a portfolio of  margin hedges and swaps that spread their refinancing risk over time.

About four years ago as part of its move to “better regulation” the AER with the agreement of the industry decided to move to a “ten year trailing average” for estimating debt costs.

The issue was the transition from one method to another. The industry wanted to use its existing 10 year trailing average but the AER proposed a 10 year transition where in year 1 the allowed cost of debt would be 100% of the rate prevailing  in year 1.

In year 2 it would 90% at the rate in year 1 and 10% at the rate in year 2. In year 3 80% of the rate in year 1, 10% at the rate in year 2 and 10% at the rate in year 3.

This meant in practice that for the next 10 years for any regulated entity the interest rate in the first year of the decision would have a major impact on the entity’s allowed interest rate for the next 10 years.

Interest rates have been falling

This matters because interest rates in general have been falling. For instance we can see the Australian Govt. 5 year bond rate below:

Figure 1: Australian 5 year Govt. bond rate. Source: Factset

We don’t have data to show the debt margins but in general they are correlated with the bond rate itself. Ie high base rate higher margin. The 10 year monthly average of this series from 2007 is 3.8% whereas over the past 12 months its been 2%..

Broadly speaking, across the NEM from regulatory perspective there is about $40 bn of debt in electricity distribution alone (this ruling will apply to gas distribution and electricity transmission  as well ). Actually that’s a 2015 number and it will be higher by now.

Figure :2 Electricity distribution business in the NEM. Source: CSIRO/ENA, ITK

We get the $40 bn by taking 60% of the RAB which is what the regulator allows.

So for every 100 bps (basis points) of interest rates allowed the industry in total can recover $406 m  of regulated interest revenue per year. So if we said the difference between the industry’s approach, as upheld by the ACT and the Federal Court, is correct that’s broadly speaking about $0.8 bn per year in electricity distribution alone in the first year and perhaps half that as the average per year over 10 years .

Not quite as bad as that

For one thing the NSW distributors as stated above have committed to lower prices, for another the starting year in each State is different.

After ten years the two methods will coincide as the AER’s preferred transition becomes the actual 10 year trailing average.

Indeed, even after five years the difference between the two methods will diminish..

State Govt. ownership of networks is a reform blocker

Fig 2 shows that five largest networks retain some degree of State Govt. ownership. As the State Govt’s each get a vote up at COAG it would be silly to assume they don’t support maximizing the value of the networks.

Frankly that’s why its been so hard to get reform of network pricing. The appeals process to the ACT could have been substantially modified years ago had COAG been so minded.

That said the network businesses like all business in Australia are entitled to the protection of the law. It’s the laws themselves (and here we look at the AEMC) that can perhaps be criticized.

The outcome is a bad one for consumers but it’s the law that is an ass not necessarily the lawyers.

In any case there’s an argument that high network prices provide a renewables and efficiency incentive

Electricity is an essential service/good. Higher costs of electricity can be difficult to deal with for some parts of society and hard to pass on for business when inflation and wage growth are low.

Still, we think the bigger picture is that as the grid delivered price of electricity rises, both from network costs and from the presently higher generation price it has two very positive effects.

1. It incentivizes investment in energy efficiency;
2. It encourages consumers to search for substitutes. In this case the substitute is distributed electricity. Expect those rooftop PV and battery sales to keep going.

David Leitch is principal of ITK. He was formerly a Utility Analyst for leading investment banks over the past 30 years. The views expressed are his own. Please note our new section, Energy Markets, which will include analysis from Leitch on the energy markets and broader energy issues. And also note our live generation widget, and the APVI solar contribution.