How to avoid the electricity death spiral

by Tony Wood

Published by Business Spectator, Wednesday 11 December 2013

Australia’s electricity transmission and distribution network businesses are facing some unprecedented challenges and the answers are neither obvious nor painless. A history of poor regulation is going to make life more difficult for what were supposed to be low-risk and low-return, regulated monopoly businesses.

One of their biggest problems is that virtually for the first time in 50 years, electricity consumption is falling. Grattan Institute’s new report, Shock to the system: dealing with falling electricity demand, analyses the consequences of this extraordinary trend and concludes that a big and nasty correction is coming.

For most of the last half of the 20th century, Australia’s electricity use grew at a steady rate of 6 per cent a year, on average. But in the early 1990s things began to change. The economy became less reliant on electricity as it moved away from electricity-intensive manufacturing. Nevertheless, the growing economy still drove growth in total electricity consumption.

But around 2006 even a growing economy was not enough. Growth in electricity consumption in the eastern states first flattened and then consumption levels began to fall. In Western Australia the same trend is emerging. In neither place does it show any sign of going away.

In most sectors of the economy, a fall in demand for a product or service usually triggers a fall in price, as supply and demand find a new equilibrium. If the trend continues, assets used to produce the goods or services become surplus to requirements and are written off. Businesses may even close. There are clear signs this trend has begun in the electricity generation sector, with low wholesale prices and claims that more than 15 per cent of the current generation capacity could already be surplus to the needs of consumers. In this case, the market is working.

But the business model for the electricity transmission and distribution network companies that deliver electricity from the generators to our homes and businesses is very different. Falling demand is not followed by lower prices. Rather, prices are increasing and consumers are paying more.

The answer to the conundrum lies in the nature of the networks. They are natural monopolies. In the generation and retail sectors, the companies compete for business. They take on commercial volume and price risks and this competitive dynamic ensures that customers are not ripped off.

But when it comes to distribution, it doesn’t make sense to have more than one company installing electricity networks across the landscape. Therefore, in exchange for being granted a monopoly position, an independent agency, the Australian Energy Regulator, sets the revenue that the companies can collect to cover both the capital cost of the infrastructure they build and the cost of operating and maintaining that infrastructure.

While electricity consumption was steadily increasing, the businesses invested to meet this growth and their revenue increased accordingly. In recent years evidence has emerged of two problems with this model: one, the AER has allowed the businesses to earn profits higher than can be justified by the low risks they face, and two, some state governments have allowed their government-owned network businesses to spend too much on infrastructure. Recently the AER has begun to address at least some of these issues.

However, falling demand has exposed a new problem. Electricity customers have unknowingly been carrying what is called “volume risk” in the network sector. This means that if demand falls below a projected volume, the network businesses can simply increase their unit prices to continue to collect the approved total revenue. When businesses close or disconnect completely from the network, costs are spread across all remaining customers, who pay more.

This scenario was never anticipated by those who designed the system. It is certainly a nasty surprise for consumers. A little imagination reveals that the arrangements could spiral out of control as costs are spread over an increasingly smaller number of consumers. Analysts at AGL have called this scenario the “death spiral”.

It is in the interests of consumers, the network businesses and policymakers need to deal with the consequences of falling demand long before the risk of a death spiral becomes real. Policy reforms in three areas would begin to address the problem.

To reduce electricity costs, the AER needs to set rates of return for network businesses that are consistent with the low risks of a natural monopoly. It should also implement more regular capital forecast reviews to ensure the businesses are spending an appropriate amount on infrastructure. The businesses may have to take on more of the risk of falling volumes of power consumption. If so, then there would need to be an explicit change in the risk/reward balance to allow the businesses a higher return in proportion to the higher risk.

The second reform would be to move towards network tariffs that reflect the costs that consumers place on the network. Since it is peak demand, rather than consumption, that is the major driver of those costs, a move towards peak demand tariffs would be sensible.

Such a move would not please consumers who have installed large air conditioners or solar PV systems, since demand-based tariffs would expose the extent to which such investments are effectively free-loading on the rest of the network’s consumers. But it would be a move in the right direction. It would also require new and smarter electricity meters.

The third, and most difficult, action would be to explicitly review the value of the network infrastructure already installed and paid for by consumers. Falling demand means that network users no longer need all the infrastructure and would not want to keep paying for it.

If consumers continue to pay, and bills continue to increase while demand falls, the result will become politically unacceptable. A government decision to write down the assets of over-valued networks on the companies’ balance sheets would be painful for taxpayers where the businesses are government-owned. A forced write-down for privately-owned businesses would almost certainly trigger cries of sovereign risk. The remaining alternative is that governments pay for the writedown – another very unattractive proposition in times of tight budgets.

Grattan will explore these alternatives in future research with a view to making clear policy recommendations. There is no easy or painless way to deal with the consequences of falling demand. But one way or another, it must be done.