Electricity price reform a shock we need

by Tony Wood

Published by The Australian, Wednesday 18 December 2013

For the first time in at least 50 years, electricity use in Australia is falling. This unprecedented shift brings some unpleasant consequences and governments must respond to them. From the 1960s to the end of the 20th century, electricity consumption increased at an average annual rate of 6 per cent. But from the early 90s, the electricity intensity of the Australian economy began a structural decline.

Since 2009, electricity consumption in the eastern states has fallen and in Western Australia growth has plateaued since 2011. Unfortunately, investment in the networks has not followed the downward trend.

The Grattan Institute’s new report, Shock to the system: Dealing with falling electricity demand, analyses the consequences of falling consumption and the related problem of poorly constructed network tariffs.

In conventional markets, a fall in demand usually leads to a fall in price. But since 2006 the average household has reduced power consumption by more than 7 per cent. Over the same period, the average household power bill has increased by more than 85 per cent: from $890 to $1660 a year.

A central reason is that Australians are funding billions of dollars of infrastructure that falling consumption has made redundant. If this trend continues, as seems likely, a nasty correction will be needed to pay for all this surplus infrastructure. But who pays: power companies, governments or, once again, consumers?

Falling consumption has several causes. Manufacturing is in long-term decline. Consumers are responding to high electricity prices by reducing use or switching to a new breed of more energy-efficient appliances.

But these changes are not leading to lower prices because of the nature of Australia’s energy market. Electricity generators operate in a free market: when consumption falls they must produce power at a lower price to sell it, or reduce production.

But network businesses – which carry power from the generator to the business or home, and which take about 45c of every consumer dollar – are regulated monopolies not subject to market forces.

Instead, the independent Australian Energy Regulator determines the revenue they can collect to cover their operating costs and provide a return on the capital they invested in the past and projected future capital needs.

Over time, the regulator has allowed these companies to earn excessive profits by setting tariffs that are too high, given the low risk they face as monopolies. Some states have also allowed the companies to over-invest in infrastructure.

In this system, where the businesses are not faced with commercial market risks, falling consumption means that the price of each unit of electricity must increase to maintain the regulated revenue. When a business closes, for example, the profit that would have been earned by delivering electricity to that business is still generated, but from all other customers on the network. The result is even more price increases.

This problem was less apparent when demand was rising and higher costs were spread across more electricity users. But when demand falls, the high cost of the network is spread across a smaller volume of electricity use, and customers pay more.

If prices keep rising long enough, customers could start to disconnect from the network and source alternative power. Enough disconnections would trigger what insiders call “the death spiral”.

To prevent this happening, governments must ensure that network companies make future investments that better match future power needs. This requires companies and the AER to more accurately forecast power needs, and for the AER to review these forecasts more often than the current five-year period. It may also be valuable to shift the balance of risk and return for these businesses, to ensure their returns better reflect their costs.

They must begin the hard task of reforming network tariffs so that the prices companies charge reflect the costs they incur. A move to network tariffs based on demand, rather than mostly on consumption, is likely to be the best approach.

And they must review the value of the networks’ assets to decide whether any loss of value of the networks should be crystallised sooner rather than later.

If so, governments will need to decide who should pay for the writedown.