Rising Energy Prices, More Than Meets The Eye

Over the past two days I have attended the annual Energy Users Association of Australia conference, in which I have heard a number of speakers from various walks of life talk about issues that are relevant to large energy users.  This was the first annual EUAA conference that I have personally attended, though earlier this year I went to the EUAA Climate Change briefing in Sydney.

NSW Electricity Privatisation

One of the first speakers was Joe Tripodi MP, who is the NSW Minister for Finance, Infrastructure, Regulatory Reform and Ports and Waterways.  He was at the conference primarily to spruik the NSW government’s plan to sell off NSW energy retailers, including Integral Energy and Country Energy among others.  The difference between this and the two previous privatisation attempts of the NSW electricity assets is that this time the government is only selling the retailers and not the physical assets.

There were two other interesting pieces of information that Joe said.  The first was that NSW has consistently had the cheapest energy prices in the NEM.  He attributed this to the central location of NSW between QLD and VIC.  According to the AEMO website, NSW has had the cheapest price (not including the Snowy region) in three financial years – 98/99, 00/01 and 07/08.  This compares well to QLD (2 fin years), VIC (5 fin years), Tas (2 fin years) and SA (which has never been the cheapest region in a financial year). Certainly though NSW has not had consistently lower prices than other regions.  Joe also made mention that at a federal level there was some talk of moving the NEM to zonal pricing.

Climate Change

Compared to the previous EUAA conference I attended the mood here was discernibly different concerning climate change legislation.  The previous conference was rather pessimistic, not only on the socio-political aspects of the debate, but on the negative effects on businesses of the legalities and technicalities of the legislation.  This time around the speakers seemed much more reserved and more focussed on mitigation of the impacts of the legislation on their businesses.

The aspect of these discussions that concerns me the most is the havoc that the MRET is causing on the industry.  Without the MRET, but with the CPRS, the majority of new generation would be combined cycle gas plants.  With the MRET in place the amount of gas plant investment is halved, and the total capital costs to meet Australia’s energy needs increases substantially.

The problem is one of confusion.  What is the goal of the government?  If the goal is to reduce greenhouse gas emissions, then new baseload combined cycle gas turbines are the most cost effective and efficient solution in the medium term.  The mandatory renewable energy target will artificially interfere with this by forcing wind farms and other renewables to be built instead of gas plants.  This means higher capital costs and less new baseload generation.  The implication is that less new baseload generation means that the CO2 intensive brown coal generators will have to run for longer.

A lot of the climate change discussions centered around the pass through costs of the CPRS.  There were a number of differing views by the panelists as to the best way of calculating how much of the carbon price should be passed through to energy users.  There were some comparisons to the GST, though the point was made that the GST was much less complex as it was simply a fixed percentage.  The price of carbon will be variable which therefore makes the carbon portion of energy costs quite difficult to calculate.

The various parties that were represented were suggesting different methods for companies to mitigate the risk associated with the uncertainty surrounding the CPRS.  Dean Price, CEO of d-cypha Trade suggested, on numerous occasions, that the futures market was a very good way to hedge risk going forward.  Others suggested Over the Counter (OTC) contracts.  OTCs have numerous advantages and disadvantages, but most importantly the uncertainty around the CPRS was making them difficult to price.  Historically over the last two years OTCs have been extremely variable in pricing, primarily due to government announcements about the timing of the CPRS.

Ultimately the CPRS is now viewed by most as a future certainty, as much as that is possible.  The real questions remaining are when, how and how much will it cost.  Each energy user will have to determine the best way forward for their business.  For some that will be OTCs, for others that will be on the futures market and for others it will be by purchasing straight from the pool and using deSide to watch the energy market and curtail their load while price is high.

Financing and Capital Markets

Paul Simshauser was the second last presenter on day one of the conference.  He is the chief economist at AGL and made a presentation that I personally found incredibly fascinating on world capital markets and their effect on Australia and electricity investment worldwide.  During the 90s and 00s a number of western nations worldwide liberalised their energy markets, which caused massive gains in efficiency.  Most markets worldwide were oversupplied and have for some time now been relying on “closing the gap” between the available generation and peak demand (that is, lowering reserve plant margins) to meet energy growth requirements.  Australia has pretty much reached the point at which efficiency gains in the reserve plant margin can no longer meet the growth in peak demand.  To address this issue more power plants need to be built.  Capital for new investment is required.  Unfortunately a little event called the “Global Financial Crisis” has dropped capital investment worldwide by a significant amount.

Australia has the highest share market participation per capita in the world and yet very few people invest in the bond market.  This has lead to Australia with a structural dependence on foreign capital, which makes up around 55% (or $150bn) of capital investments in Australia.  With the collapse of world financial markets this has lead to much less capital investment around the world, including in Australia.  This means that the Weighted Average Cost of Capital has increased dramatically, which ultimately affects the energy price.  In a perfectly efficient market, Paul explained, the increase in the WACC that has occurred since the beginning of the GFC should have the effect of raising energy prices from $45/MWh to $60/MWh.  Similar modeling suggested that VOLL needs to be over $20k NEM-wide to send the correct signals for investment to the market (note that he was not advocating this and neither am I).  In addition to this, a significant portion of capital investment in energy markets is now being spent on renewables, which worldwide in 2008 was worth $150bn out of a total of $333bn.  Over the next five years it is estimated that Australia will need $107bn in capital, just for refinancing of current assets and $32bn in new generation.

In summary, there are significant costs emerging which are more significant since the advent of the GFC.  Required capital investment will likely place upwards pressure on energy prices in Australia.

The 800 Pound Gorilla Riding Atop the Elephant In the Room – Distribution Costs

By far the biggest issue for most energy users who attended the conference was the issue of distribution costs.  I do not fully understand the detail of the arguments that were presented, but this is what I have pieced together from the talks.  Earlier this year the Australian Energy Regulator approved for changes in the billing structure for distribution costs for the next five years.  This has angered many energy users for a number of reasons.  Primarily the problem is that many energy users feel that the cost increases are too high.  There are several reasons for why these costs have increased so drastically.  Many electricity assets that were due to be replaced in the 80s and 90s were not, leading to an aging distribution network that needs significant capital investment for maintanance.  Secondly, the distribution networks in many areas need significant upgrades to handle the recent growth in peak demand.  It was estimated that 15% of network capacity was needed for 1% of the year.  Thirdly, it was felt by many energy users and the EUAA that the AER had not fulfilled their requirements for benchmarking under the rules set by the AEMC.  It should be noted that the representative from the AER disputed these claims.  As a company we are in no position to ascertain either way the validity of the claims made by either party.  It is clear though that this is currently a very contentious topic.

Distribution networks are a natural monopoly and as such a competitive market does not exist for distribution.  To try and provide energy users with the equivalent of a competitive market, the AER is required to perform benchmarking (that is, a comparison of costs between distributors) to assist in determining the prices that the distributors are allowed to charge.  It was felt by the EUAA that the benchmarking performed by the AER was either inadequate or nonexistent and that outside expertise should have been used in the benchmarking process.  What further exacerbated the problem for many large energy users was that their distributors were allowed to change their pricing model from charging on a maximum demand basis to a time-of-day basis.  Given that the load profile of many large energy users coincides with the peak times of the day this even further pushed up prices for these users.  Retailers appeared to be the most upset by this particular change.  Finally, to compound the problem for energy users even further, the distribution price rises were announced two days before the end of financial year, which played havoc with budgets.

It seems to me that there is a number of components to these price rises (the rest of this paragraph is my opinion only and not that of global-roam or anyone at the conference).  The aging network, the strong growth of peak demand, increases in the cost of capital and possibly inadequate benchmarking have all lead to this sudden increase in pricing.  It is fair that large energy users pay for their fair share of the aging network and the cost of capital, but in my mind (ignoring the technical debate about benchmarking) the real issue that I have with the price rise is that it is sending the wrong signals to the market.  Most of the energy users have a relatively static load, while peak growth is being primarily caused by the vast uptake of air conditioners by homeowners.  So by changing to time of day pricing instead of demand pricing, the energy users are paying for the bulk of the growth caused by residential users.  It is the peak demand growth component of distribution pricing that should be passed on elsewhere rather than to large energy users.  One way of helping ameliorate this problem would be by charging a “capacity tax” on air conditioner units and other high power use items at retail level.  This payment would go directly to the distributors in the areas where these units were purchased.  If the tax was fairly priced it would provide a much more accurately targeted price signal.

Conclusion

Plenty more was discussed at the EUAA Annual Conference and overall I found the entire event was very valuable, both for the information presented and the opportunities to speak to energy users and other interested parties. The biggest concern on energy users lips at the moment is not the CPRS but the distribution price rises, which have only hit NSW so far.  The food was great too.