Prime minister Malcolm Turnbull should be talking to Paula Conboy and John Pierce, the head of the AER and the AEMC respectively as well as network owners Singapore Power, China State Grid, CKI, an Aussie Super, as well as the gentailers he plans to talk to about energy prices this week.
In the end under-supply of generation leading to high prices in the wholesale markets will fix itself. The fix may be painful but if generation prices are high enough for long enough there will be new supply. Nothing is more certain. But network prices, the biggest driver of higher electricity bills, are unlikely to ever fix themselves.
The regulatory system guarantees the network business a return on capital for the next 100-200 years, no matter how much volume falls networks get a fixed amount of revenue. Like the NBN, this is not an easy problem to fix. Until it is fixed though expected to continue paying over the odds for electricity if it comes from the grid.
Electricity distribution in the NEM – one of the world’s best businesses
The electricity network distribution business (excluding transmission) in the NEM have a regulated asset base [RAB] of around $70 billion and their market value is around $100 billion. So long as the distribution businesses are valued by the market at 30-50% more than the regulator values, then it’s prima facie evidence that returns in the sector are too high
However, more than that, it’s very difficult to see consumption per point of presence going back to the levels of 10 years ago and at the same time the RAB grows 1-4% a year. This means consumers pay “more for less”. We can see this with two examples.
One is in Victoria where we use United Energy.
The data we show is for the household sector, but the medium and even large volume consumer sectors in this distribution franchise show similar trends. Remember, this is just the distribution cost, and it doesn’t include transmission, let alone all the generation and retail factors.
But we are focusing on distribution because it’s our view that, as they are legally entitled to do, owners of these businesses are making risk-free profits paid for by consumers and we can’t see under the current rules how this will ever change.
That’s enough of a worry, but what happens when you get to Sydney – and the Augrid network – where there is more unit development (more energy efficient), much more solar PV, and much higher utility costs passed through to consumers>
Volumes per house are down a staggering 22 per cent, so a gold star for Sydney-siders: but, their reward has been a 127 per cent increase in the unit cost of electricity.
Note that we have adjusted 2016 to be flat with 2015. That’s our estimate following the recent Federal Court Case comprehensively won by the networks.
The regulatory system requires higher prices when volumes fall
Each regulated asset entity is allowed to recover a fixed amount of revenue each year. If volumes fall then prices rise. If volumes rise then prices fall.
This system works, more or less to everyone’s satisfaction when volumes are rising. The airline industry is an example, or the computer industry or many others. It brings nothing but misery when volumes fall.
Message 1: Trends that have delivered the fall in consumption per household are likely to continue.
At least for a while. These trends are:
- Higher prices. Consumers naturally react to higher prices by consuming less.
- Energy efficiency. Fridges, swimming pool pumps, double glazing, insulation, LED lightbulbs. We are only part way through that process.
- More behind the meter PV and batteries.
- Household sizes are getting smaller.
Under the present system if consumption per house continues to fall prices have to go up.
Message 2. The system provides no explicit signal to the regulated companies to stop investing. It’s true that these businesses are run by extremely sensible people who will act appropriately, more or less. There is clear evidence in numbers below of a decline in augmentation capex. Still, there is a financial incentive to invest.
Every $1 invested in RAB is valued by the market at $1.30-$1.60. Since $0.75 of that $1 invested is financed by debt the equity owner invests $0.25 and its valued $0.55 -$0.85
Note that EV = Enterprise value = Market value of equity (adjusted for minorities) + value of debt = The total cost of buying the business
The licenses these network businesses have are for 100 to 200 years.
Is it time for a fresh estimate of RAB?
The only way that prices can decline is if volumes pick up, returns on capital fall or the capital base is cut. Things like cutting opex just wont do it other than in NSW.
We simply note here that when the electricity sector was “created” following the Hilmer reforms of the early 1990s and the Initital Capital Base [ICB] of the wires and poles had to be considered. This was calculated using DORCs (surely invented for the engineering fraternity) = Depreciated Optimised Replacement Cost.
In other words an engineer went out and worked out what it would cost to replace the network in its depreciated state. This was of course a fairly wooly estimate and the various State Goverments then went around making arbitrary adjustments to suit their own purposes. The ICBs were then written into law but nevertheless perhaps its time for a fresh look.
Where the money goes
We put together a small data base of the electricity distributions businesses across the NEM. The sources for the data were firstly the CSIRO/ENA technical modelling report
And then the AER’s “final decision” reports not all of which are fully adjusted for appeals but are arguably still fit for this purpose. For the NSW distributors we basically used their “revised final proposals” which involved skimming through 100s of pages to find a few tables.
As an aside we note that Paula Conboy recently said that in 2014 or 2015 there were about 100,000 pages of regulatory submissions!!! No wonder you need new glasses!
From this data we have complied a NEM wide aggregate annual revenue and capital expenditure view. That is we added up the revenues and capital expenditure forecasts/allowances of each regulated entity in the model. Annual revenue is about $11 bn, of % is return on capital, 11% depreciation, 30% opex and 1% other.
What we see is that most of the revenue is going to the capital providers and most of the capex is going on maintenance. Maintenance way exceeds depreciation as calculated in this table.
Note that these numbers could have errors. The supporting tables are below but this sort of work benefits from a team approach.
Other data shows that non coincident max demand is basically flat. We expect the new connection capital expenditure to actually decline once the housing boom comes off, and it will. One day…
Still we think that there is arguably still room to cut the return on capital further. Alternatively the RAB needs to be rebased.
$67 billion of electricity distribution assets in the NEM
The following table shows the electricity distribution assets in the NEM.
These assets deliver about 78% of NEM wide generation to about 9.6 m customers of whom 8.5 m or 89% are residential.
The residential customer base in the NEM consumes about 48 TWh or 34% of total consumption at a daily average (grid delivered) 15.5 KWh. The Jemena area households in Victoria are the thriftiest and Tasmanians consume the most on a per household basis.
Over the current regulatory period for this 14 networks they will recover $51 bn of revenue of which 51% is return on capital and 12% is depreciation. Note that our total numbers here have no real meaning as Tas Networks and SA Power don’t have five year time frames. Some years start in July and some in January.
However we have left the numbers in this form as they are those reported by the AER. The exception is the NSW distributors, Ausgrid, Endeavour and Essential where the AER is required to remake substantial parts of the decision and so we have used the network “final proposal” numbers.
We could ballpark that of the 51% of revenue allocated to return on capital about 60% represents debt funding and about 40% equity funding.
Now let’s look at the capital expenditure. What we find is that “only” about 20% of allowed capex is going on new customers and augmentation. By definition then about 80% of capex is going on maintenance and other purposes. But mostly maintenance.
In coming to that conclusion we have assumed that customer contributions are essentially for new connections and so they can be subtracted from the new connections capex as allowed by the AER.
Once again we use the NSW distributor final proposal for their capex.
Capital contributions are reported as revenue, profit and capex under Australian accounting standards but essentially paid up front by the connecting business at cost and don’t go into the RAB. In our view all new connections should be treated the same way but that’s a different part of the story.
As any analysis will show there are a number of factors that are responsible for the high electricity prices paid by households and businesses in Australia. In no particular order these include:
- High gas prices and gas is the price setter in some key markets;
- Low consumption per $ of invested RAB.
- Supply demand balance that favours supply;
- Increasing costs of new generation relative to old generation
- Poor market structure (too much vertical and horizontal integration)
Most of these factors are to an extent self-correcting. Other forms of generation will substitute for gas if the gas cost doesn’t come down and left to itself enough new supply will be brought. However even the market based solutions won’t work properly because of the market structure (the more the structure resembles a monopoly the more likely it is to be undersupplied).
More to the point of this article there is no real answer to the problem that consumption per $ of RAB is low. Essentially that means it costs plenty to get electricity delivered from a central generating unit to its point of consumption.
Many argue, and no doubt with some truth, that there has been gold plating of the networks, but it’s also worth bearing in mind that for maybe 20 years prior to the gold plating period there was significant under investment.
Again we can argue about consumer reliability required standards but there is no doubt that the public in general wants the electricity supply to be reliable. Who after all would want electricity to work like the NBN?
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.
David Leitch is a regular contributor to Renew Economy. He is principal at ITK, specialising in analysis of electricity, gas and decarbonisation drawn from 33 years experience in stockbroking research & analysis for UBS, JPMorgan and predecessor firms.