Where will power prices be in 2020?

Power prices remain a major community concern, but looking out to 2020, it's easy to see prices moderating in real terms... provided the right policy settings are in force.

Last week the Committee for Economic Development of Australia (CEDA) released the 2013 Economic and Political Outlook.

Chapter three of the document is titled ‘The outlook for electricity prices in 2020’ and was authored by Professor Paul Simshauser and myself. It says something about the interest in energy policy that the topic of electricity prices was included in the annual CEDA outlook. You would expect me to say this, but I think the publication is useful for two reasons: it provides a useful summary of energy policy settings in the past; and it provides a concise roadmap for future reforms.

The past

Figure 1 shows real electricity prices (line series) and nominal electricity prices (bar series) for NSW and Queensland residential customers from 1955 to 2008.

Two periods of sustained real price reductions are discernible: the period between 1955 and 1979; and the period between 1985 and 2008.

The first period (between 1955 and 1979) was characterised by the development of large coal-fired power stations and networks that utilised economies of scale to drive down costs. The second period (between 1985 and 2008) was a period of significant supply-side reform.

In this second period (between 1985 and 2008), policymakers turned their attention to the management of the supply system, and later began a process of disaggregation, greater interconnection between regions, the introduction of competition and privatisation.

Vertically-integrated, state-owned monopoly electricity commissions were exchanged for competitive wholesale and retail trading markets. The result was a significant improvement in the capital utilisation of the industry (see Figure 2) and a reduction in real prices.

The present

However, the reforms of the 1990s, which led to the creation of the National Electricity Market, stalled in the 2000s. Importantly, demand side reforms were largely ignored. Prices remained regulated, network businesses continued to have a monopoly on metering services and retail electricity pricing was based upon ‘average costs’ rather than marginal costs.  

Between 2008 and 2013, electricity prices have increased significantly. Figure 3 shows how residential tariffs have increased in Sydney – primarily driven by increased spending on distribution networks.

There has been a large increase in capital expenditure on electricity networks over the past five years. For example, between 2001–05, aggregate capital expenditure on electricity networks in NSW and Queensland totalled just $7 billion. In the period between 2010–14, capital expenditure is expected to reach almost $30 billion.

Much has been written on whether the capital invested and the subsequent price increases are justified. In our article we do not offer a definitive explanation, but a material component was driven by two factors: network augmentation to meet forecast rising peak demand at the network element level; and replacement of aged assets.

The AEMC concurred with this assessment stating that higher network tariffs are largely due to “peak demand, higher commodity prices, replacing ageing assets and higher costs of capital due to the Global Financial Crisis.”

Peak demand growth in the Australian electricity industry has (until recently) outstripped growth in underlying energy demand.

Figure 4 shows how the maximum summer demand in each mainland NEM jurisdiction increased by 20–38 per cent between 2001–12. During the same period, underlying energy demand increased by only 15 per cent.

This divergence in demand growth is problematic due to the heavy fixed cost nature of the electricity industry. The addition of capacity results in disproportionately higher average costs if it has a poor utilisation rate. Unfortunately, the manifestation of the divergence between peak and underlying demand growth has been a rapid decline in capacity utilisation. This is shown in Figure 4 (which extends the time period captured in Figure 2).

The future

There are, understandably, a variety of views in relation to whether electricity prices will continue to increase. In the very short-term, prices are likely to rise modestly as a result of the completion of the current investment cycle. However, the interest of our article in the CEDA publication is in considering the longer-term and what prices might look like in 2020.

In our analysis, we constructed a model of electricity prices which effectively replicated the analysis we completed for the Boomerang Paradox papers. We considered wholesale energy costs; network costs and green schemes. Importantly, though we made two key assumptions regarding public policy settings:

-- Retail electricity prices are deregulated; and

-- Competition is introduced for all metering services. By introducing competition in metering services, the introduction of smart metering and time-of-use pricing becomes a point of product differentiation rather than a ‘mandated roll out’. Based upon AGL research, we would expect such policy settings to improve load factors by around eight percentage points.

The results of our modelling are presented in Figure 5. In nominal terms, prices are forecast to increase slightly. However, in real terms our modelling indicates that prices may fall by 10 per cent by 2020 relative to 2013. Such forecasts should be treated with caution – we have assumed significant demand side policy reform. However, the results provide policymakers with two key conclusions in our view:

-- The Large-Scale Renewable Energy Target can be achieved at the same time retail electricity prices may fall; and

-- Demand side reforms are critical to achieving better utilisation of the installed capacity of the industry.

Tim Nelson is the Head of Economics, Policy and Sustainability at AGL Energy.

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