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How electricity prices are determined and why it's important

August 01, 2021
Owen Evans
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Key Findings

If one wishes to impact the price of electricity, the greatest leverage lies in grid transmission and distribution.

The level and volatility of wholesale electricity prices are far from the prime determinant of pricing. The key drivers of pricing include interest rates, inflation, and the equity risk premium.

In order to give companies some certainty, the Australian Energy Regulator issues pricing determinations that cover 5-6 years.

Executive Summary

Electricity prices in Australia’s national electricity market (NEM), excluding West Australia which has its own market, are made up of the following components:

  • Around 50% of the electricity price is the cost of grid transmission and distribution (T&D). These are legislated monopoly industries which are heavily regulated by the Australian Energy Regulator (AER), a department of the Commonwealth government. Pricing is determined by a formula that depends primarily on the cost of debt and equity and the value of the asset base. The formula is agnostic with respect to ownership. Distribution in South Australia is owned by a Hong Kong-based billionaire In Brisbane it is owned by the state government. They both get the same deal.
  • About 33% is the cost of wholesale power. Generation assets are generally privately owned, and this is a largely competitive market thanks to the increased competition of distributed rooftop solar and new utility scale wind and solar entrants. The interstate market is operated by the Commonwealth-owned Australian Energy Market Operator (AEMO). Regulation revolves around safety, security of supply, and access to market to ensure a free and fair market rather than pricing.
  • About 10% of the cost is the retailer. Retail has historically been regulated by the states, with the retailer putting together the power, transmission, distribution, meter reading and billing, while taking the counter-party risk. Some states have chosen to deregulate retail entirely making it relatively easy for new entrants.
  • About 7% relates to Commonwealth government imposts. This includes fees to run AEMO, green taxes and the like. These regulatory structures have been in place for nearly a quarter of a century, having initially been designed by the Keating government (1991 - 1996) and honed during the Howard and Costello years (1996 - 2007). Once policy makers understand the basics of how they work sensible policies can be implemented. Ignoring these basics results in wasteful policies that do not achieve their aims.

These regulatory structures have been in place for nearly a quarter of a century, having initially been designed by the Keating government (1991 - 1996) and honed during the Howard and Costello years (1996 - 2007). Once policy makers understand the basics of how they work sensible policies can be implemented. Ignoring these basics results in wasteful policies that do not achieve their aims.

Over the past decade retail prices in Australia have risen by less than inflation. The components have not moved in sync. Wholesale prices have risen by 1.66% pa while transmission, distribution and other charges have risen by 1.25% pa. In total prices have risen by 1.33% pa.

The Commonwealth government for some time has been behaving as though prices in Australia are too high, which may well be the case however stable and high are not mutually exclusive. As a consequence, it has committed billions to new gas-fired power stations and associated peaking power. Typically, this has been done inefficiently. The trophy project in this is Snowy Hydro 2.0.

Over the past decade retail prices in Australia have risen by less than inflation.

Initially planned to be online by 2021 to prevent a perceived imminent collapse of the electricity system, at a cost of $2.1bn Snowy 2.0 is now progressing at a leisurely pace with a 2027 scheduled opening. It has an uncertain price tag (more than $5bn but less than $10bn) plus a requirement to build transmission lines at $2bn to Sydney. 

To make matters worse, the Commonwealth has committed publicly-owned Snowy Hydro to spend a further $1bn on a 600 megawatt (MW) peaking plant at Kurri Kurri in New South Wales that will likely run once a month or so with the primary fuel being diesel for the first six months.

If one believes that prices are too high in Australia, and the Commonwealth government clearly does, the component to attack is the cost of T&D, which it has done nothing about.

T&D is the largest single cost and it is the area where the Commonwealth has the greatest power.

Decisions like Snowy 2.0 should not take a decade to implement and mistakes made here are unlikely to cause chaos by shutting out private capital spending, as is happening in the generation sector.

In addition, there are levers in place that can be pulled.

The AER, which regulates assets, does so by use of a relatively rigid formula applied to all assets. It estimates an acceptable return (WACC), multiplies this by the regulated asset base (RAB) adds agreed costs and out falls allowable revenue. Divide by units and a unit price is determined. These determinations have a five year term to allow sensible capex decisions to be taken.

All recent determinations, which cover $58bn of assets, result in a decline in nominal pricing driven by the impact of lower interest rates and inflation on the WACC and RAB. They continue, however, to allow for a very high equity risk premium component to the WACC. This does not appear consistent with market valuations of infrastructure assets. This is an area where the Commonwealth at the very least could offer an opinion during the public submissions process.

All recent government determinations, covering $58bn of assets, continue to allow for a very high equity risk premium component.

The impact on prices of lower allowable returns would be greater than the claimed impact of Commonwealth investment in new firming power capacity. The cost would be the writing of a letter rather than $10bn. The impact would be immediate rather than in the never never.

As is often the case, it is easier to get somewhere if you have a map and a plan when you begin. It is time for the Commonwealth to buy a map.

Press release: Surging energy prices accelerating pace of wind, solar and battery adoption

Please view full report PDF for references and sources.

Owen Evans

Guest contributor Owen Evans spent 25 years as a financial analyst in investment banking in Australia, mainly at UBS where he was a Managing Director and Head of Emerging Companies Research. Since 2010 he has served as a Director for small financial companies and Not for Profits.

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