The sorry state of WA’s electricity market reform

Unnecessarily over-funded electricity networks leave WA consumers to foot the bill. visualdensity

It should have led to lower electricity prices; that was the theory at least. But the 2006 disaggregation of Western Australia’s vertically-integrated electricity utility, Western Power Corporation, into four separate state-owned entities – Verve Energy (generation), Western Power (networks), Synergy (retail sales) and Horizon Power (the state’s regional power supply entity) – has not met the expectations of the policy pundits who pushed for the reform.

The disaggregation of Western Power was expected to lead to increased efficiency due to the introduction of competition, which would in turn bring about lower electricity prices. However this has not transpired. Rather, between 2008 and 2012, retail electricity prices for households connected to the Western Power Network in the south west of the state rose by 48%, and this does not even include the comparatively small (and mostly compensated for) impact of the carbon tax.

On the surface, it was almost a direct application of text-book economics: full disaggregation, creation of an independent regulator and a Ministerial Direction which put a 3000 MW cap on the generation capacity of Verve Energy.

So why have electricity prices risen so dramatically in Western Australia since this reform? In answering this question, it helps to focus on the main contributor to the retail electricity price: the capacity cost of meeting system-peak demand. It’s mainly a network cost but also includes the cost of peak generation capacity.

This cost has not been adequately constrained? Why? The short version of the story is one of poor policy implementation due to the conflict of interest that arises when state government bureaucracy regulates state government enterprise.

One doesn’t need to have too cynical a view of government in Western Australia to see your electricity tariff as being part service delivery payment and part state tax. Electricity network regulation in Western Australia is essentially cost-plus. This means that all costs incurred in building Western Power’s network capacity are recovered, along with a juicy monopoly profit, from electricity consumers.

This profit is risk-free for the monopolist and is delivered from the consumer to the state treasury via Western Power as its surrogate tax collector. In 2011, $84 million of the State’s $484 million surplus was delivered by the dividend that Western Power paid to the government.

Every dollar that Western Power spends on expanding its network capacity, whether it is needed or not, provides a return to the state government. Therefore, there is a tendency for the government owned network business to over-invest in capacity. This leads to a phenomenon known in the field of regulatory economics as “gold plating”.

Under the current regulatory system in Western Australia, gold plating results in higher electricity tariffs than those that would occur if Western Power was not rewarded for its over-investment. It is in this way that government revenues derived from gold plating of the network are equivalent to a state tax; a state tax with an extremely high cost of administration.

Since 2006, Western Power’s expenditure and its guaranteed risk-free profit have been approved by the Economic Regulation Authority under regulatory rules approved by the Minister for Energy. Recently the CEO of the ERA’s secretariat denied any gold plating of the Western Power Network, stating, “our view is that there has certainly not been gold plating overall of Western Power’s network. Indeed, we saw a period of significant catch-up expenditure needed to meet the service standards.”

A similar, perhaps more cautious, denial came from the Deputy Director General of the government’s principle energy policy agency, the Public Utilities Office, who said, “the view of government here is that … [gold plating] is probably not the case for the Western Australian network businesses.”

These views are not consistent with the available evidence. Take the most recent financial year as an example. A total of 5,493 MW of generation capacity was assigned to the South West Interconnected System in 2011-12. However, the peak generation for 2011-12 which occurred on Australia Day was only 3,868 MW.

Data: Independent Market Operator

The South West Interconnected System is regulated as an “unconstrained network”. This means that in 2011-12 the regulatory framework required sufficient investment in substations, high voltage transmission lines and low voltage distribution systems to deliver 5,493 MW to consumers. This regardless of the fact that system-peak demand was only 3,868 MW.

By building more capacity than is required to meet system-peak demand, in 2011-12 the South West Interconnected System was gold plated by about 42%. The estimated value of this over-investment in Western Australia’s major electricity system was $3.85 billion in 2011-12.

Under the Western Australian system, all of this $3.85 billion, plus profit, must be recovered from wholesale consumers of electricity. These include major retailer Synergy and the publicly owned Water Corporation, who are then put under pressure to recover the associated cost increases from their retail customers.

The fact is that this approach to network regulation places all of the investment risk on consumers, but no financial risk is placed on the network business paid to augment the network.

What is needed is a network tariff system that shifts the financial risk away from consumers and back onto the network operators.

A solution would be to replace the current system of network tariffs, which are spread across the year as energy consumption charges, by a system of network tariffs based on actual system-peak power demand. Under this system a network business would be automatically penalised for their gold plating of the network.

Denial of gold plating by the government agencies responsible for Western Australia’s regulatory framework does not inspire much faith in them devising a solution to the problem. It appears that the Western Australian Government is quite happy to maintain the status-quo, despite a looming election in which electricity prices are likely to be a hot topic of political debate.