The state government power price gouge

Attempts by state government electricity network businesses to justify gold-plating just don't add up.

Until recently, electricity prices in Australia ranked near the middle of electricity prices in member countries of the Organisation for Economic Development and Cooperation. However, since 2007, electricity prices have risen between 70 per cent and more than 100 per cent in different parts of the National Electricity Market.

Average household electricity prices in the NEM, even at Purchasing Power Parity rates of exchange, are now amongst the highest in the world. Although publicly available price indices for commercial and industrial users are not available to prove it, the outcome for industrial and commercial energy users are likely to be no better.

While electricity prices (and the industry’s expenditure) has risen steeply, the industry’s output has risen only slightly. As a result there have been significant declines in the productivity of the electricity industry in absolute terms and even more so relative to productivity improvements in the wider Australian economy.

From the mid-1990s, the electricity industry was radically restructured from what were previously vertically integrated state-government owned electricity commissions. The reform was motivated by evidence that the industry was inefficient, and that through privatisation and the introduction of competition wherever possible, costs would reduce and services improve.

Outcomes in the competitive generation market in the NEM since this reform was implemented seem broadly positive. Risks associated with the development and operation of generators now rest with competing, often privately-owned producers, rather than consumers. Services have been reliable and average production prices are lower than when the reforms were adopted.

In the reform program it was recognised that much of the natural monopoly network service provider activities would still need to be regulated, and it was decided to implement regulatory designs that applied explicit efficiency incentives. The chosen approach largely copied the form of regulation that had been implemented for privatised networks in Britain, and which had already demonstrated some success in raising efficiency.

Outcomes delivered by the privatised network service providers in Victoria, while they were subject to regulation by the Essential Services Commission of Victoria, were encouraging with high levels of reliability and declining costs and prices.

Government owned service providers have not had the same success. Their capital expenditures have grown considerably while demand for their services has not. A large gap has grown in the size of the regulated asset base, so that by 2013 state-government owned network businesses will be employing almost three times as much capital, per connection, to provide distribution services as are their privately owned peers.

The justifications from network businesses don’t add up

By international standards, the level of capital expenditure by government-owned network service providers in the NEM is remarkable. The capex allowed by the AER to government-owned distributors in NSW (in the current regulatory period) is around six times higher (per connection) than the average capex per connection in Great Britain. In 2011 the total transmission and distribution capex that the AER allowed network businesses to recover through regulated charges, per MWh delivered, is more than seven times higher in the NEM than in the United States of America.

The networks that distribute electricity in the NEM are reasonably long, per connection. This is often cited as a reason for higher costs (and higher expenditure) on networks in Australia than in other countries. However a significant part of the NEM network (22 per cent by length at the end of 2010) is inexpensive single wire earth return, serving a few distant rural users. This adds to the network length but makes little difference to the total cost. By comparison this inexpensive technology is not common in countries with more compact networks.

In addition the proportion of the network in the NEM that is more expensive underground cables (rather than overhead lines) is just 14 per cent - compared to around 60 per cent in Great Britain. In considering the expenditure on the development and maintenance of a network, the use of cables rather than overhead lines is likely to be a more significant factor than the length of the network.

Furthermore, between 2004 and 2011 (during which the aggregate asset base of Network businesses in the NEM has expanded by 91 per cent, the total length of the NEM network increased by just 3 per cent and most of this increase has been in reticulation voltage cables which are likely to have been funded mostly by newly connecting customers (and hence are not recovered through regulated charges).

Differences in demand growth do not explain differences in capital expenditure between government and private distributors. Demand has grown more strongly in Victoria and South Australia (where the networks are privately owned), yet capital expenditure to meet that demand growth in those states has been significantly lower than in New South Wales, Queensland and Tasmania.

There is also a big disparity in the level of capital expenditure between government and private service providers on the replacement of ageing assets. This is not explained by differences in asset age – the assets of the privately-owned service providers are generally older than those of the government-owned service providers.

While government-owned service providers in NSW and Queensland have been required to invest to meet higher reliability standards, there is no evidence that there was a systematic problem with network reliability to justify this expenditure, or that consumers were willing to pay the resulting higher prices, or indeed that the additional expenditure has had any measurable impact on the reliability of supply.

The source of the problem

The main reasons for higher capex do not lie with external factors but rather that they can be attributed to state ownership, and the adoption of a form of regulation that has failed to provide incentives for government-owned service providers to reduce expenditure.

State governments that own their network businesses have obtained extra-ordinary income from the provision of network services. This is attributable to their receipt of their service providers’ profits as well as the income tax on those profits (where they own the network businesses) and what are euphemistically called 'competitive neutrality' fees that are levied on the debt provided to the network service providers by their government owners.

In 2010 for example, the NSW Government received $596 million in income tax equivalents and competitive neutrality fees from its distribution and transmission service providers and retailers. By comparison, dividends of $575 million were paid in that year from these utilities.

Network service providers have been able to deliver higher financial rewards to their government owners, by expanding the regulated assets from which these proceeds are funded. Government-owned network service providers have delivered the unusual combination of higher profits through higher capital expenditures. This is the phenomenon known colloquially as “gold plating”.

The disproportionate rewards that governments have derived as a result of the form of regulation that has been adopted, is an important reason for the increase in capital expenditure and hence prices.

The problem, in other words, is the combination of flaws in regulatory design and conduct, and government ownership, not either alone.

Bruce Mountain is a Director of Carbon Market Economics, a specialist energy and climate change economics consultancy.

This is an edited extract of a submission made by Bruce Mountain to the Senate Inquiry into Electricity Prices. Republished with permission.