Albanese’s risky power play

The Albanese government walked into a nasty energy price bombshell that blew up when the Treasurer revealed advice that electricity and gas prices would rise by more than 40 per cent over two years. This is not a market failure. The energy market works with merciless efficiency, and Australia’s abundant resources are in high demand overseas, mostly courtesy of the Ukraine war. The domestic consequence looked to be horrible, and Treasury agreed.

The government had no choice but to intervene, and none of the possible interventions was without big consequences. Energy consumers have been pleading for relief, while energy producers threatened the direst of outcomes if their windfall profits were affected. Just to be helpful, the Queensland Premier was outraged that her government-owned generators might also lose windfall gains, and joined with the NSW Premier to suggest they may deserve compensation for the loss of associated royalties.

Over the past few weeks, it became clear that both gas and coal needed to be considered, and some form of price caps would be the least bad solution. The caps should apply only to domestic supply and preferably without affecting current contracts.

In addition to threatening a form of investment strike, the gas industry argued that the coal sector was the culprit, while the Minerals Council, representing the coal producers, protested that most coal is sold under contracts and high spot prices wouldn’t have much impact. This argument ignored the way the electricity market works such that the marginal supplier, the most expensive to meet demand at any time, sets the price for all suppliers for that period.

Most importantly, the industry seemed to suggest that the price increases were an acceptable consequence of a functioning market. In a normal market, they would be correct in that high prices would trigger new supply to bring prices to an acceptable level. However, new gas or coal supply takes a long time to deliver, and new supply would probably not be big enough to move the high, war-driven international price.

On Friday, the Prime Minister announced he had reached agreement with the states to introduce temporary caps on the wholesale price of gas and coal of $12 per gigajoule and $125 per tonne respectively. The federal government will act on gas while Queensland and NSW will act on coal. These state governments will accept the resulting loss of windfall gains.

The caps will not apply to export contracts and will not restrict the companies’ capacity to benefit from the high international prices. Presumably on the coal side there will need to be agreement to ensure supply to the domestic market, like what the federal government can deliver through the Australian Domestic Gas Security Mechanism.

In the case of both coal and gas, the proposed price caps are at levels consistent with market prices that should deliver acceptable profits to the producers and not impede future investment. They will apply to a very small proportion of total supply, less than 4 per cent of production in the case of LNG. In NSW, the domestic coal market is about one-tenth of production, and most of that supply is via long-term contracts at prices lower than the international price and probably no higher than the proposed cap. The detail will be important as the government works through the implementation and some concessions may be required.

Before Friday’s National Cabinet meeting, there was an expectation that the gas price cap would be based on the price that would apply outside a war premium. This could have been determined and reviewed transparently by the ACCC, which has been tracking LNG netback parity pricing since 2017. The initially announced $12 cap seemed consistent with that approach.

However, late on Friday, the government announced that a longer-term reasonable price would “reflect the cost of domestic gas production, allowing for a reasonable return on capital”.

Presumably, this definition of reasonable price will not change the announced $12 figure. Yet, even if used for ongoing price caps or for new sources of gas, such a level of cost-based price control seems unnecessary and has raised alarm from industry analysts and the gas industry.

The alarmists may be overreacting, and some clarification may provide a sensible resolution. Let’s hope the government hasn’t snatched a messy defeat from the jaws of a major victory.