Too much power: The real crisis in Australia’s energy markets

“Go into the London Stock Exchange – a more respectable place than many a court – and you will see representatives from all nations gathered together for the utility of men. Here Jew, Mohammedan and Christian deal with each other as though they were all of the same faith, and only apply the word infidel to people who go bankrupt” – Voltaire.

In Brief

• The thermal generation market is becoming increasingly concentrated with two players accounting for over 50% market share in every State. This process has been aided and abetted by the Australian Competition Tribunal, the Queensland Government and the closure of various “independent” power stations.
• The market is also becoming vertically integrated outside of QLD with AGL and Origin (ORG) having more than half the generation, electricity mass market retail and gas mass market retail in the combined Victorian, NSW, South Australian market. They would also have a strong hold on gas transmission contracted capacity in the same markets.
• Despite that emerging oligopoly, it’s yet to show up in an excess return on capital. Still, post the closure of Hazelwood, remaining producer market power (no pun intended) will increase. Perhaps substantially.

Symptoms of a crisis

This note forms part of a series identifying the varied problems in the National Elecricity Market.  The symptom of the problems is that there is a significant risk that there will be a crisis in the NEM next Summer, or it could even happen in Winter. All it would take is a couple of the old generators to break down, another flood at Yallourn, a trip at Bayswater, Gladstone giving up, a transmission failure and there would be big problems.  Sky high prices and or blackouts.  Every electricity consumer big and small should be taking risk mitigation strategy over the next 11 months in our view.

Two players more than half the market in every State

The following figure shows that in 2016 in every State no more than 2 players account for more than 50% of generation market share. The figures are not precise because of State imports and exports but to our mind the general picture is clear. You don’t get a competitive market when there are too few players. The figure doesn’t show all the generators for the sake of simplicity.

Figure 1 Generation market shares Cal 2016. Source: NEM Review

It gets worse once Hazelwood closes

Hazelwood’s closure removes 10 TWh from the market. In addition “The Australian” has reported that Engie has put LYB up for sale. LYB produced 8 TWh in 2016. We don’t think that ORG will buy LYB but its not beyond the realm of possibility. Its hard to see in the above list who would buy it. Still that’s for another day.

If we assume that 1/3 of Hazelwood output is replaced by each of AGL and ORG.  AGL by an expansion of  Liddell and possibly another 1 TWh from LYA and ORG from Eraring then we can recast the table as.

Figure 2 Generation market shares post Hazelwood. Source derived from NEM Review

The picture hasn’t changed that much but clearly concentration has increased. If we were to consider the QLD Govt owned entities Stanwell and CS Energy as one then their combined market share of 43 TWh with AGL’s 51 TWh is almost 50% of the NEM.

Not just an oligopoly, but vertically integrated

We can keep cutting the market in a number of ways but perhaps the most useful maybe is to look at Victoria, NSW, SA as one market. We put QLD to one side mostly because its difficult for NSW generation to get into QLD and because the Government controls the generation.

The data shows that post the Hazelwood closure we model the big two to have 55-60% of the market.

Figure 3: AGL, ORG market postiion Source: NEM Review, AER, ESC

Although these two companies do have less than 50% of the upstream gas supply if we were to measure their market power by looking at their share of the gas transmission contracted capacity we would see it is very strong. I.e. it’s not APA that’s the problem, it’s really the fact that most of the pipeline capacity in the East Coast is rented out to AGL and ORG.

Other players but are they diminishing?

In QLD the Govt effective third force, and in NSW/Vic/SA Energy Australia also has a good position. Snowy is a significant mass market retailer and easy number 4 and ERM is the number 4 retailer if measured by volume. Still neither Energy Australia or Snowy are anywhere in gas, Snowy couldn’t even get Colongra to run in the recent high demand event and ERM is a very small company in market cap. terms.

What Fig 3 confirms is that the NEM has become both more horizontally and vertically integrated. As a result the “market” is becoming less and less useful.

Some things to worry about

A general problem that results when markets become less competitive is for prices to be higher and supply to be less. This is the “Producer surplus”

Figure 4 Producer surplus Source: Adapted from Economics text

Don’t forget that in the current system 50% of the consumer final price is a regulated monopoly, that’s the wires and poles. Now we see that the rest of the market has evolved into what we regard as a less competitive state.

On top of that vertical integration may reduces the need for retailers who own peak shavers to use them to their full extent.

Not yet much evidence of excessive returns to  AGL and ORG

AGL and ORG’s combined strong share in the overall market is relatively recent. Neither has really made an excessive return to date out of being “gentailers”.  In our view that’s largely because of two related factors. (i) Consumption fell meaning fixed costs had to be spread over greater volumes and (ii) there was an oversupply of generation.

AGL and ORG have both historically made large investments to attain their current position. From the point of view of the past five years several of these investments seemed over priced making it difficult to earn WACC.

A summary of the two companies for the Dec half is below. As ORG does not report invested capital in its utility business (“Energy markets”) we have used ebit to total assets rather than return on equity.  AGL’s 12 month trailing return on equity is 8.9%. Both companies have written assets up and down more than a bride’s nighty still we think the numbers are indicative.

Figure 5 AGL(consol) & ORG “energy markets” 6 month P&L. Source Company

ORG’s gross profit half yearly history, although it misses the expense improvement below the gross profit line gives a picture of how things are going.

Figure 6 ORG half yearly gas and electricity gross profit. Source: Company

By way of background

A combination of  factors have undermined the design of the National Electricity Markt [NEM] to the point where increasing calls are heard for a full makeover.

Although there are a number of issues with market the one we focus on today is concentration (oligopoly) and its close cousin vertical integration.

Under the original Hilmer Reforms that lead to the current market design in about 1995 the idea was to break up the vertically integrated State owned electricity monopolies such as the NSW Electricity Commission and State Electricity Commission of Victoria.

The State organizations were broken up both horizontally and vertically. Initially the retail business were put with the network.

As part of the reforms interstate trade was encouraged and the National (excluding West Australia and the Northern Territory and initially Tasmania) market formed. Another part of the reform was that customers were allowed to choose their electricity retailer.

From the start the networks were regarded as monopolies and were regulated. Initially the regulation was from the State Regulatory bodies but in time the powers were devolved to the Australian Energy Regulator [AER].

The initial outcome was positive. Electricity prices fell. The reason was not so much improvements in efficiency but basically it was because each of Victoria, NSW and QLD had their own reserve margin. From a national perspective putting the three States together meant that a smaller overall reserve margin was needed. Victoria and NSW competed for generation market share. Victorian generators with lower variable costs ended up winning the battle but lost the war as one or two of them nearly went broke.

The value lost by generators was partly transferred to consumers but it was also partly transferred to the retailers because final prices didn’t fall as much as generations prices.

Meanwhile Victoria and South Australia privatised their businesses. Investment banks saw that the steady monopoly cash flows from networks were very well matched to superannuation funds liability patterns. As such they carved out the retail operations and sold off the networks separately.

Economies of scale encourage consolidation

Each of the three sectors now saw that there economies of scale to be had. Retailers saw three areas of economies: IT spend, marketing, and being a volume buyer from the generators. In addition big retailers could afford their own peaking generators.

Networks although monopoly regulated saw that there were economies in merging. In theory they had to be given back eventually but this could take years and perhaps new economies could be found. Both private and Govt network owners went about consolidating.

Generators were slower to consolidate and initially it was more about vertical integration.  More recently though the generation sector has also partly by accident and partly by design become more consolidated.

Mergers, sales and closures reduce competitors

In the past five years we have seen:

AGL buy both LYA in Victoria and Macquarie Generation in NSW. Subsequent to those purchases AGL’s market share and market power in Victoria has increased as a result of the Hazelwood closure. Its market power in NSW has increased because the major competitor in NSW, Delta Electricity has been broken up with one of its generators Wallerawang closing and another Eraring operating at lower capacity factors. Further in NSW available coal to competing generators has reduced.

In QLD the QLD Govt merged Tarong Energy into Stanwell Corporation meaning that there are just two main generation companies in QLD, Stanwell and CS Energy, both being owned by the State Govt.

In South Australia the vast majority of gas generation is controlled by AGL and ORG. AGL also has a significant share of the wind market, although since wind generates as available ownership seems to matter much less.

Pointing the finger at the Australian Competition Tribunal

In recent years it  can look as if when an electricity business has a problem it just goes off to the ACT to get something rubber stamped. Certainly that’s the way it often looked in the regulated network space. More recently AGL seemed to have cottoned on to the same idea. When the ACCC complained about the reduction in competition it saw from AGL’s bid for Macquarie Generation it was to the ACT they turned rather than to some of the other legal options that may have been open. And the ACT obliged handing AGL a thumping victory.

This put AGL in a strong position in NSW as Macquarie’s main competitor Delta had been broken up partly sold to EnergyAustralia, partly to Origin and the leftovers (Vales Point and Colongra) given away.

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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.