Rules distort energy market
The recent Council of Australian Governments meeting called for policies to promote greater competition in electricity, a coded call for retail price deregulation.
Competition already drives the wholesale generation component of electricity supply. More than 30 separate generation businesses supply the National Electricity Market, the largest one only having a 14 per cent market share.
Generation accounts for about half of the costs of electricity supply. The other major cost component comprises the monopoly, distribution and transmission poles and wires.
Retailing services comprise most of the remaining electricity costs. Across the interlinked grid (which excludes Western Australia) there are three leading retailers AGL, Tru and Origin and about two dozen smaller or niche retailers.
Competition is fierce indeed: a major customer complaint is about the often intrusive nature of suppliers' marketing activities.
Only Victoria, however, confines its electricity supply price regulation to the monopoly poles and wires services. Other states also regulate retail prices to smaller customers, though in South Australia there is "headroom" - the maximum price is considerably above what suppliers might wish to charge.
Recent reviews by the regulators in NSW and Queensland foreshadow new maximum retail prices for smaller customers and the Queensland government has frozen the standard domestic tariff for next year.
The retailers have protested that the regulators' recommended prices are too low. Though it might be argued that "they would say that wouldn't they?", the point is establishing a market price for electricity at the retail level is extraordinarily complex.
There is massive variation in demand, hence wholesale prices fluctuate between $12 and minus 20c per kilowatt hour.
Moreover, the cost also varies depending on when the electricity is contracted.
Even more than other retailers, those in electricity need a secure supply chain. Having customers buying at a fixed price but facing extremely volatile wholesale prices can transform a healthy firm to bankruptcy in a matter of weeks.
The one business that failed in Australia, Jack Green, did so because of inadequate contract cover. Other retailers had to pick up its customers, in some cases at a loss.
Australian regulators have been criticised for setting excessive prices for the monopoly distribution and transmission supply components, especially for the inefficient government-owned businesses.
A conservative approach is understandable since prices set too low would starve investment (as has arguably happened in the past), causing blackouts and brownouts. But if regulators also set retail prices, they are compounding the risks of regulatory failure because not only are they making educated guesses about costs for the monopoly poles and wires components, but they are also overriding market-determined costs that emerge from competition between generators and retailers themselves.
If maximum prices are set too low, retailers are stuck with losses and could be bankrupted. Ten years ago the Californian market collapsed as a result of retail price controls in the face of surging wholesale costs stemming from regulatory constraints on new generators and exacerbated by Enron's market manipulation. The outcome was the bankruptcy of the entire system and lawsuits that resulted in Californian taxpayers footing the bill. Less dramatically, several years of government-mandated underpricing of electricity in WA led to the state's dominant (government-owned) retailer incurring sustained losses that have required taxpayers to re-capitalise the business.
Profitless markets also deter entry by rival retailers, thereby reducing attention to consumer needs and diminishing incentives for forward contracting. As was the case with the monopoly state-based suppliers in the eastern states before deregulation and privatisation, this brings about a misalignment between new investment and consumer-demand characteristics. In the state-based systems in eastern Australia the upshot was over-investment in baseload plant and inflexible production due to underinvestment in fast-start peaking plant.
In the period since the late-1990s, Australia's competitive wholesale National Electricity Market has meant a better alignment between demand and supply. This is notwithstanding the additional new market distortions of carbon taxes and renewable energy requirements.
Increased costs induced by greenhouse measures and, perhaps, a legacy of underinvestment in distribution networks are bringing pressures on governments and regulators to hold down prices. If this is extended to the competitive aspects of electricity supply generation and retailing, it will distort the balance of supply and demand in the near term and deter investment in new generation.
Queensland's retail price regulation could seriously damage the market, all the more so if it is extended to business tariffs. Contrary to this approach, governments should fully deregulate retail prices, as Victoria has already done, leaving regulation to the areas of natural monopoly where market disciplines are inadequate.