by Tony Wood, Energy Program Director, Grattan Institute
Grattan Institute Energy Program Director Tony Wood weighs in on the electricity and gas market ‘death spiral’ debate, and shares his thoughts on the impact regulating these markets could potentially have.
Charging for electricity by measured consumption rather than the number of light bulbs per consumer was introduced in the first decade of the 20th century. Around the same time, the idea of electricity supply as a natural monopoly and setting monopoly prices by a government agency became the standard model and it has survived, with some evolution, ever since. The most significant evolution was the separation of competitive markets for production and retailing of electricity and gas from the remaining natural monopolies, the transmissions and distribution networks. Recent developments may challenge whether this structure will evolve to meet new challenges or be confined to the dustbin of history.
Over the last five years, retail electricity prices have increased by more than 60 per cent in real terms and gas prices by more than 35 per cent. Electricity consumption has been falling for several years and there are signs that gas consumption is doing the same, if nothing else, proving that price works. A common cause for both trends has been big increases in the prices set by the Australian Energy Regulator (AER) for the cost of connecting homes and businesses to large, centralised electricity and gas suppliers.
A 2013 Grattan Institute Report, ‘Putting the customer back in front: How to make electricity cheaper’, highlighted fundamental flaws that had arisen with the regulatory model and its outcomes. The good news is that there are signs that network price increases will at least be strongly curtailed as the next five-year price paths are negotiated between the businesses and the AER.
Yet more fundamental challenges to the model and the businesses themselves are emerging. Although far from uniform across Australia, overall falling electricity consumption, driven by causes including pressure on manufacturing and the adoption of more energy-efficient appliances and rooftop solar PV shows little sign of abating. Failure to adapt tariff settings to this new paradigm means that we almost certainly have built more network assets that we now want or need.
The current network tariff structures served us reasonably well when consumption was rising steadily and consumers generally had similar consumption profiles. These underlying factors no longer apply. The result is that, in addition to being too high, current tariffs have led to unfair cross-subsidies between consumers. Reform of electricity network tariffs is a high priority and should sit at the top of the agenda of the COAG Energy Council. We made specific proposals for such reform in our July 2014 report, ‘Fair pricing for power’.
More cost-reflective tariffs, whereby charges are based on the load that consumers put on the network, will make tariffs immediately fairer and lower in the long term by providing better pricing signals to drive consumer choices. Ongoing falling consumption and solar PV adoption could create the circumstances for the dramatically described death spiral for electricity networks. Proponents of this scenario also embrace the prospect of cheap battery storage that could lead to widespread network disconnection within a decade. The consequences for the underlying model of a regulated natural monopoly are hard to envisage, but clearly serious.
If that wasn’t enough, we are now seeing the prospect of very big increases in wholesale gas prices, driven by the exposure of the domestic east coast gas market to the global market. The most recent Grattan Institute report, ‘Gas at the crossroads: Australia’s hard choice’, documents the potential impact on gas consuming homes and businesses. Households, particularly in Victoria where gas is extensively used for winter heating, could see annual bill increases of more than $300 per year. Small and large businesses that use gas as a source of heat or chemical feedstock are confronted with big cost increases that will be difficult to recover from their customers.
These electricity and gas trends and their consequences are not disconnected. Gas consumers will be faced with complex choices, including whether to shift to electricity, particularly when the cost of replacing expensive appliances is considered. This choice is complicated even more by the current tariff structure. In general, gas tariffs follow a declining block structure, so that a reduction in consumption avoids the cheapest tranche of gas. If this energy is replaced with electricity, current electricity tariffs will most likely mean the additional electricity is at the average unit price. However, if electricity tariffs are reformed as described above, the marginal price of electricity could be much lower and this would make a shift from gas to electricity much more attractive.
Some businesses have already recognised that gas network prices could go up again if other businesses on the same network move away from gas to other energy sources or even close down. And so we see the prospect of a death spiral for gas networks, with possibly even fewer mourners. Such a prospect may be initially slow if it happens, and is not inevitable, but we would be wise to be alert to the possibility.
A double death helix of collapsing electricity and gas networks may also be thwarted since a shift of gas to electricity would restore some electricity consumption, at least in areas where the gas price impact is greatest.
So, the questions clearly are: is this bad? And if so, should governments do anything?
As with all changes in consumption of goods and services, government intervention to resist market forces usually doesn’t work and makes things worse in the long term. This does not mean no action. Critically important roles for government are: to address market failures and barriers to efficient market operation; to ensure that policies and regulations made for different times and circumstances remain effective and efficient; and to provide protection for the vulnerable in our society.
The immediate priorities should be to drive electricity network tariff reform and to ensure that the gas market is operating effectively, including bringing on new supply and opening up the wholesale market. With highly uncertain longer-term prospects, it is harder to be prescriptive. Instead the COAG Energy Council could take a lead in ensuring that the sort of scenarios identified by the CSIRO’s Future Grid work are more widely communicated and explored and, where necessary, options are developed so that policy and regulation of the market and natural monopolies can rise to the challenge. This will not be easy, but it is