Striking a balance on energy market reform

As Julia Gillard's electricity reform proposals descend into a state-versus-federal political debate it has to be said that on at least one issue the prime minister has touched on a core issue: that of the "gold plating" of electricity distribution networks.

While there are good arguments to be made for privatisation of state-owned networks and more flexible pricing, the key issue, and one identified by the Grattan Institute's Tony Wood in a timely piece of research on the issue, is that the regulatory process is flawed and consumers are footing the bill for its imperfections.

The Grattan Institute research started from a premise that was borne out by the research – and by the experience of Victoria in the regulatory re-set periods that followed the industry's deregulation by Jeff Kennett and Alan Stockdale. Its hypothesis was that recent and pending increases in electricity distribution costs were higher than they would be under efficient ownership and regulatory arrangements.

That was – and the learnings from the Victorian experience tend to reinforce the conclusions – due to a number of factors.

Victoria's privatisation of its energy sector was motivated by a view that government ownership and integrated monopolies generated over-investment – gold plating – and inefficiency and that strong regulation and competition by comparison could generate consumer benefit by getting a better balance between reliability and prices.

Grattan's view is that distribution businesses have been earning excessive rates of return relative to the risks they face; that government ownership leads to excessive capital investment and other inefficiencies; that reliability standards are higher than the benefits justify and that a regulatory process that provides undue incentives for capital investment leads to excessive investment.

It believes that fixing the flaws in the regulatory process could save consumers about $2.2 billion a year, which may be overly conservative.

At the most basic level, whether privatised or not, under the existing approach to regulating distribution companies there are significant incentives for them to "game" the regulator, the Australian Energy Regulator, into allowing excessive capital spending and operating costs.

Regulators use "building block" approaches to determining the rates of return they allow on regulated services, which means they allow companies to earn sufficient revenue on their asset bases to cover the reasonable costs of their debt and equity.

That means they have to make a number of assumptions about the cost of that capital, which ought to be low relative to most other companies because of the natural monopoly characteristics of companies operating poles and wire businesses.

Grattan concludes that the regulator's decisions have over-compensated the distribution companies by over-estimating the real cost of their capital. That issue, which is quite technical and theoretical, generated fierce debate and collisions between the regulator and the regulated during the early phases of Victoria's reforms.

For the regulator, and for state-owned businesses in particular, there is also a natural tension between consumer prices and the system's reliability. No one, least of all politicians, wants "brown-outs".

Over-investment to deal with a day or two of estimated peak demand within a framework of the worst possible conditions, however, does have a cost which has been exacerbated by the reality, not built into industry forecasts or regulatory decisions, that demand has actually fallen significantly.

For the government-owned distributors, there is also mutual interest for the companies and their governments to inflate spending and the cost of government-supplied funding in order to drive excessive returns that in turn deliver inflated financial flows to generally cash-strapped treasuries. The political dimension also deters operating and maintenance efficiencies because of the implications for jobs.

The regulatory re-set periods of five years are another issue. While they give the companies some certainty as to the returns they can generate, the time between re-sets means that there can be considerable differences between the assumptions made at the start of the period (on demand, or the cost of debt or equity, or the actual costs and investment incurred) and what actually transpires.

Grattan advocates the continuing use of five-year forecasts but says they should be updated annually to take account of material changes and that the regulator should be able to subject all over-expenditure to a "robust" cost-benefit analysis after the fact.

It also says that where state governments' have retail ownership of distribution businesses they should clearly separate their roles as shareholder and financier and put in place strong governance structures free of political interference.

There is no reason in theory why properly structured state-owned entities can't be as efficient as private sector organisations but in practice that is rarely the case. Grattan said its analysis had shown that on average government-owned entities had spent more on their assets and grew their asset bases faster than their private sector counterparts.

Consumers in those jurisdictions consequently paid more for electricity distribution – about 40 per cent of the retail price – that in regions where the distribution companies were privately owned.

The costs and benefits of smart meters and time-of-use pricing for retail customers, consumer "challenge panels" and demand management can be debated but it is obvious from the Grattan report and other studies of the sector that the most significant focus of reform ought to be the approach to regulation and a re-balancing of the emphasis on reliability versus prices.

One of the perverse outcomes of the initial regulatory reviews in Victoria in the post-privatisation period was that, even as the regulation brought capital spending plans and the returns it would allow for them under closer scrutiny and pressure, reliability actually improved as the investment became more efficient. It helped that the penalties for reliability lapses were increased.

Creating a regulatory system that places more emphasis on the outcomes for consumers, that has more flexibility to respond to changing energy demand without delivering windfall gains for either distribution companies or their customers, that provides disincentives for over-investment and that distances political influences from the operation of the sector, has the potential to break the trend of soaring electricity costs even as demand has fallen.

As the Grattan report makes clear, the potential benefits to consumers and the economy are too large, and the consequences of not addressing the escalating prices too great, not to do something to arrest the trend and to do so with some urgency.