Who will pay for the cost of falling electricity demand?

by Tony Wood

Published by The Australian Financial Review, Page 43, Wednesday 25 September 2013

For decades, steadily rising electricity demand had been a feature of Australia’s economic landscape. But since 2009, national demand has fallen by 7 per cent. As a result, there is over-investment and underuse of assets across the supply chain. A big and nasty correction is on the way, and the question is, who will pay?

Until about 2007, industrial and population growth provided the basis for investment in power generation plants, and the transmission and distribution networks that deliver the power to our homes and businesses.

In the competitive generation sector, investors were adding about a thousand megawatts – the equivalent of a new large power plant – every year.

In the monopoly distribution business, regulators used forecasts of rising demand to approve capital expenditure and allowed distributors to pass on these costs to consumers.

All was steady and predictable. Even responses to climate change included the assumption that this demand-growth paradigm would continue. But the paradigm has changed, and the consequences are yet to be fully grasped.

In about 2007, the steady growth in electricity demand slowed significantly. Yet the industry and its key agencies, notably the Australian Energy Market Operator, continued to project steady growth and maintained investment. It was only in 2010 and 2011 that a new reality began to dawn. Annual demand for electricity at the wholesale level was falling. The 2013 data shows the fall is continuing.

There are several reasons for the unprecedented change. Industrial output has reduced with the slowing economy and unfavourable exchange rates. The big Kurri Kurri aluminium smelter in the Hunter Valley closed last year. High power prices have affected consumer demand, and solar panels, driven largely by generous subsidies, are on a million roofs.

Clearly some of these factors may not be permanent, but equally demand is unlikely to stop falling anytime soon.

Falling demand for electricity has also influenced the debate over climate change. It is thought to be responsible for about half of the 7 per cent drop in emissions in the past financial year. If that pattern were to continue, it would indeed help the new government achieve its target of a 5 per cent reduction in emissions below 2000 levels by 2020. Yet it is unclear how demand will be affected if the carbon price is scrapped and a falling dollar revives manufacturing.

For power generators, falling demand has been exacerbated by the Renewable Energy Target that forces them to compete with new supply from renewable sources. The resulting oversupply has led to very low wholesale prices and the mothballing of some coal-based generators.

Some in the industry estimate that well over 4000 megawatts of capacity is now superfluous, and there have been calls for governments to financially support the orderly closure of such plants. This would be an alarming and unnecessary intervention in the market that would hurt taxpayers. Asset write-downs, as much as they will hurt shareholders, seem inevitable.

For power distributors, the asset base has grown even as demand has fallen. This rising capitalisation is most to blame for the annual double-digit price increases that have hit consumers over the last five years. Grattan Institute’s 2012 report, Putting the customer back in front: How to make electricity prices cheaper, argues that the regulatory process has failed to produce investment planning that is sensitive to changes in market demand. The report also shows that regulators have allowed monopoly power distributors to make unduly high profits, given the relatively low risks they face. There is evidence the Australian Energy Regulator is moving to fix this anomaly.

But distribution assets remain over-capitalised. Like generators, the owners of distribution assets could be forced to write down the value of their assets. The pain this would cause would be financial and – for the state governments that own some of these businesses – political. Again, shareholders would pay.

But the position is more complicated than for the generators. Distributor revenues are set not by the market, but by regulation and based on capital forecasts approved by the Australian Energy Regulator.

The regulator could allow the businesses to charge customers a fixed annual connection fee to maintain revenue in line with the regulated rate-of-return for the assets employed. In that case, consumers would pay.

The solution is far from obvious. The businesses will argue for re-pricing to safeguard their revenue to maintain the low risk that goes with their low returns. Fixed fees would also better reflect their costs, thereby sending better pricing signals to customers.

Advocates for asset write-downs say the businesses should pay for over-capitalisation since they are responsible for the poor forecasts of demand provided to the regulator. It can also be argued fixed connection fees blunt the incentive for actions to improve energy efficiency.

Whoever wins the argument, the financial, political and consumer pain will be large and loudly proclaimed.

An upcoming Grattan Institute report will describe and further define this looming problem and possible solutions. When the piper calls, who will pay?