Why do Australians pay the highest power prices in the world?

This is the second in a series of three posts looking at the hot topic of Australian power prices:

1. Do Australians really pay the highest power prices in the world?
2. An explanation for the high power prices in Australia – this post
3. A look at what can be done about the high power prices in Australia

In Part 1 we established that – while there are a few different ways to compare the data – Australia does have pretty much the most expensive electricity in the world. The price increases in the last decade have been significant, more than doubling according to the Consumer Price Index.

The question now is why prices have risen so much, when Australia is blessed with vast coal and gas reserves and huge renewable energy potential?

First, we need to look at the components of a typical residential electricity bill, illustrated in the graph below which refers to the following elements:

• Wholesale – effectively the cost to generate electricity.
• Network – the charges for delivery of energy via the poles and wires from the point of generation (power stations) to the point of consumption (homes and businesses).
• Retail – charges levied by the consumer’s chosen retailer for selling electricity.
• Federal environment – this includes items such as the large scale renewable energy target and subsidies for feed in tariffs.
• Metering – these charges only apply in Victoria to fund the state-mandated roll out of smart meters.

Source: CME, via Australian Financial Review

These components have all contributed different amounts to the rising energy prices. A September 2017 report by the Australian Competition and Consumer Commission (ACCC) identified and ranked the source components of power bill increases over the last decade by how much they had each contributed:

1. Network charges (41%)
2. Retail costs and margins (24%)
3. Wholesale costs (19%)
4. Green schemes (16%)

Let’s now look at these one by one in more detail as well as the effects of renewable energy.

1. Network charges

Investment in the electricity network has been the primary driver in power bill increases for some time. 

The way the network companies make their money is by earning a certain rate of return on their asset base. As the size of the asset base increases, so do revenues. A revenue cap is set by the regulator every five years, dictating how much the (natural monopoly) networks can spend on building and maintenance. The end consumers foot the bill for this, even if the spend wasn’t needed. This has turned out to be the case in Australia. 

Investment decisions were based on forecasts projecting that demand for electricity would continue to rise. The forecasts were wrong – demand has flatlined and declined since about 2009, mainly due to increased rooftop solar and energy efficiency improvements in household appliances. Consumers may also have reacted to higher energy prices. (As a side note – demand may increase again if there is widespread adoption of electric vehicles in Australia.) 

A 2015 Senate enquiry found that there had been significant overinvestment in networks far beyond what was required, especially in the government-owned companies in NSW and QLD. This has been termed network “gold plating”. 

2. Retail costs and margins

Retail costs have also risen. This is the part of a power bill that several investigations have found is the hardest to monitor, and the least transparent to consumers. 

There are a few different reasons for the increases in retail costs.

Finding the best offer

The market is characterised by very wide price dispersion, meaning a consumer can save hundreds of dollars by moving from the worst to the best offer. It is also complex, making it hard to compare rates and find the best offers. Private comparison websites do not include all market offers, while the websites offered by the Australian Energy Regulator and the Victorian government do not provide the tools customers need to differentiate between offers. A Grattan Institute study in March 2017 found the system was so complicated that many consumers did not understand what savings they could make and just gave up. 

The bars in the chart below illustrate the vast gap between the best retail market offers and the ‘standing offers’ in New South Wales. 

Source: Carbon + Energy Markets, 2016 IPart submission, via Australian Financial Review

The Thwaites review in August 2017 found Victorian households are paying on average 21% more for their electricity than the cheapest market offer available. Nearly a quarter of customers could save $500 or more by switching to the best available offer.  

Punishing loyal customers

Consumers are often attracted by the deep discounts of a retailer’s initial offer, only to slip unknowingly onto a much smaller discount or a costly standing offer a year or two later. AGL Energy chief executive Andy Vesey admitted last year that big power companies were guilty of punishing their most loyal customers in this way, but said subsequently AGL was abandoning the practice. 

Retailer profit margins

Profit margins have also been in the spotlight recently, with a Grattan Institute study finding retailers’ profit margins in Victoria were around 13% – higher than in other retail sectors, and more than double the margin that regulators considered fair when they set retail electricity prices. The study concluded that Victorians would save about $250 million a year if the profit margin of electricity retailers fell to match that of other retail businesses. The companies rejected this, saying they have been forced to spend more on marketing due to increased competition.

Failure of competition

Competition in electricity retailing hasn’t delivered what was promised: lower prices for consumers. The failure appears to be worst in Victoria, the state with the most retailers and the longest experience of deregulation. 

The market is highly concentrated. Despite there being 25 energy retailers in Victoria, three players (Origin, AGL and Energy Australia) command a market share of over 70%. The next two largest players, taking the total market share to around 90%, are vertically integrated, making it difficult for others to compete.

3. Wholesale charges

Network charges may have been the primary driver of power bill increases over the last decade, but they have now levelled off. More recently, it is the cost of electricity generation that has been the biggest contributor to rising electricity prices. In the past year or so some states have seen increases of over 100%. 

There are two main reasons for the increases in wholesale costs: generator bidding behaviour and the soaring price of gas. 

Generator power

With the recent closures of the Northern and Hazelwood coal plants in the last year, the gap between supply and demand at peak times has tightened. The market is therefore now far more susceptible to wholesale price surges if a generator breaks down (not uncommon, given Australia’s ageing fleet of coal generators) or an operator decides to withhold their electrons from the market until demand rises. In each state, the two or three principal generators command a market share of 70% or more, giving them enough clout to swing the market. 

Indeed, generator market power was clearly seen in Queensland recently with two generators having two thirds of capacity and prices spiking. When the Queensland Government directed its generators to tone down their bidding, prices immediately reduced significantly.

The rise of gas

The second reason for the sudden increase in wholesale costs is much higher gas prices. As supply has tightened, natural gas fired power plants are increasingly being called upon to meet demand. As illustrated in the diagram below, prices are set in five-minute intervals, determined by the price of the most expensive generator required. At 4:25 this was $38, set by Generator 5. Settlement is done in half hour blocks and the spot price for the half hour is determined as the average of the prices for the six five-minute intervals.

Source: AEMC Fact sheet: How the spot market works

As the most expensive fuel that we rely on to create electricity to meet our needs, gas is increasingly determining the wholesale price that generators are paid. Gas generation now sets the wholesale price around a third of the time in South Australia. The correlation is clearly visible on the graph below of spot price data from the Australian Energy Regulator's wholesale statistics. 

Why is gas going up?

The reason for the rising gas prices is more mysterious. Australia has a lot of gas, so much in fact that it is expected to become the world’s largest exporter by 2020. Yet it is cheaper to buy Australian gas in Japan than it is in Australia and AEMO is already forecasting a shortfall in domestic gas supply. 

ACCC chairman Rod Sims noted “International prices are at all-time lows; Australian gas prices are at all-time highs.” High local prices appear to be the result of so-far inexplicable behaviour by exporters, selling gas at lower prices on the export spot market than they could achieve by selling the gas locally. Australians are effectively subsidising loss-making exports. Or it could be down to a cartel controlling Australian gas.

An ACCC inquiry into the east coast gas market identified three causes:

1. The introduction of the export LNG projects changed gas flows and domestic prices.
2. Oil prices fell faster and further than some thought possible, curtailing investment in gas exploration and development. 
3. Regulatory uncertainty and exploration moratoria have significantly limited or delayed the potential for new gas supply.

4. Green schemes

Responsible for about one sixth of the electricity price rises in the last decade, green schemes include:

• The bipartisan renewable energy target
• Solar feed-in tariffs that pay consumers for power sent into the grid.
• Some programs designed to boost energy efficiency, mostly through the use of better light bulbs and appliances.

The cost of green schemes is not transparent: it is smeared over all electricity consumers and can appear costless to some. But they do cost consumers, often inequitably as those with solar panels are being subsidised by those who do not have them.

Is renewable energy to blame? 

No. Well, maybe partly. 

Renewable energy has increased significantly over the last decade and now provides around one fifth of Australia’s energy needs. It is an easy target and often blamed in sweeping statements as the sole reason for power price rises without an appreciation of the finer details explained above. 

The Renewable Energy Target has helped reduce power bills and will continue to do so, according to the government’s own modelling as well as analysis by energy market experts ROAM Consulting, who found that Australian households would pay over half a billion dollars more for power in 2020 without the Renewable Energy Target in place (equivalent to more than $50 per household).

The ACT has the lowest bills in the country and is on track to reach its goal of 100% renewable energy. Indeed, a recent report by the Australian National University showed that electricity price increases from 2006-2016 were highest in the states with the least renewable energy. 

Source: Australian National University

But on the other hand...

Wind and solar generate intermittently and at zero marginal cost – their operating costs are far lower than coal and gas generators. This means that when wind and solar are generating, prices will be lower.

However, over the medium term, lower wholesale prices could contribute to early retirement decisions for existing coal generators, and push prices higher due to increased reliance on more costly gas plants.

Intermittent generation can also increase spot price volatility and this puts upward pressure on electricity prices as well as making new investment decisions more difficult. 

Now we understand the many reasons why Australian power prices have risen so much, we next need to look at what can be done about it. Stay tuned for Part 3!