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Select Committee on Electricity Prices
27/09/2012
Electricity price increases in Australia

PATTAS, Mr Chris, General Manager, Network Operations and Development Branch, Australian Energy Regulator

PROUDFOOT, Ms Sarah, General Manager, Retail Markets Branch, Australian Energy Regulator

REEVES, Mr Andrew, Chairman, Australian Energy Regulator

WILLETT, Mr Edward, Board Member, Australian Energy Regulator

Committee met at 08:43

CHAIR ( Senator Thistlethwaite ): I open this public meeting of the Senate Select Committee on Electricity Prices. The committee proceedings today will follow the program as circulated. These are public proceedings. The committee may also agree to a request to have evidence heard in camera or may determine that certain evidence should be heard in camera. I remind all witnesses that, in giving evidence to the committee, they are protected by parliamentary privilege. It is unlawful for anyone to threaten or disadvantage a witness on account of evidence given to a committee and such action may be treated by the Senate as a contempt. It is also a contempt to give false or misleading evidence to the committee. If a witness objects to answering a question, the witness should state the ground upon which the objection is being taken and the committee will determine whether it will insist on an answer having regard to the ground which is claimed. If the committee determines to insist on an answer, a witness may request that the answer be given in camera. Such a request may also be made at any other time.

The committee has authorised the recording, broadcasting and rebroadcasting of its public proceedings in accordance with the rules contained in the order of the Senate concerning the broadcasting of committee proceedings, including by electronic means. Media outlets may record the public proceedings subject to following conditions: the committee or witnesses can object to being recorded at any time and the committee can require that recording cease at any time; recording must not occur from behind the committee or between the committee and witnesses and must not otherwise interfere with the committee proceedings; computer screens and documents belonging to senators must not be recorded; and flashes must not be used.

I welcome representatives of the Australian Energy Regulator. Do you have any comments on the capacity in which you appear?

Mr Reeves : Thank you, Chair—just that Mr Willett is also a commissioner of the ACCC.

CHAIR: Do you wish to make an opening statement?

Mr Reeves : Yes. Thanks for the opportunity to address the committee today. The AER is Australia's national energy market regulator and an independent statutory authority. We are responsible for setting the prices charged for using electricity networks—that is, the poles and wires—to transport electricity to customers. We also monitor the wholesale electricity market to ensure generators comply with the market rules, and we take enforcement action in this regard where necessary. From 1 July this year we have also taken on responsibility for regulating retail energy markets in some jurisdictions under the National Energy Retail Law. While our retail roles are wide ranging, our responsibilities do not extend to setting household electricity prices. In all states except Victoria, those prices are set by jurisdictional regulators.

The committee's review is taking place in an environment of unprecedented interest in electricity market issues. As highlighted in our submission, electricity prices have risen significantly, particularly since 2007, and, as numerous submissions to the committee have highlighted, these prices are causing considerable distress to consumers. There have been a range of reasons for recent price increases—rising generation costs, rising retail costs and the costs of meeting green schemes have all played a part. But the rising costs of the electricity network have been the main contributor to price increases in all states. There are a range of factors driving these increased network costs. The need to replace ageing equipment and meter peak demand has driven significant network investment across the market. However, our submission emphasises that, while much of this investment was necessary, weaknesses in the regulatory framework—that is, the rules that set out how the AER must regulate prices—have led to price increases beyond what has been necessary for a safe and reliable supply.

We completed most of a full round of electricity transmission and distribution determinations under the current rules in 2011, and from our experience under the rules our concerns were such that in September last year we submitted proposals to the Australian Energy Market Commission—that is, the rule-making body—to try to fix the regulatory framework. In a draft decision released last month in a response to our proposal, the AEMC outlined significant improvements to the rules for setting prices for energy network businesses. In particular, the draft decision proposed changes to the approach for setting expenditure allowances which would provide the AER with greater scope to scrutinise investment spending by the businesses and reject excessive forecasts. Secondly, changes to the incentive arrangements would allow the AER to prevent businesses from receiving a return on inefficient over-investment.

Thirdly, changes to the approach for setting rates of return would allow the AER to set rates that better reflect actual financing practices. Finally, changes to the consultation arrangements would promote more effective consumer engagement, in particular by requiring network businesses to consult with users in the development of their spending proposals. The AER considers that these changes would promote the interests of electricity consumers. While network businesses will continue to be rewarded for undertaking efficient and necessary investment, consumers would not be required to foot the bill for inefficient overinvestment in the network.

Our submission also highlighted the impact of appeals of AER decisions on electricity prices. The outcomes of these appeals, heard by the Australian Competition Tribunal, have increased revenues to network businesses by some $3 billion out of some $58 billion over the current five-year obligatory period. A review of that appeals mechanism is currently underway.

Another major focus in our submission is on initiatives to engage and empower consumers. I should note that there has been some reporting of our submission to this review which may be interpreted as saying that we are not supportive of electricity retail market competition, and that is simply not the case. We are strong advocates for effective retail competition. We believe that effective competition provides strong incentives for suppliers to operate efficiently and to be price competitive. This can deliver significant benefits to consumers, both in more competitive prices and in more innovation in what retailers can offer to consumers.

Effective competition does, however, rely on informed consumers actively seeking out the best deal and finding the best prices. To do this, they may need easily accessible and good-quality information about the products and services they are buying and the behaviour of the seller to be able to make an informed choice. Our submission highlighted some of the issues and challenges that are currently occurring in the retail energy market.

Alongside this, we also sought to highlight the opportunities to improve consumer engagement and to make the retail energy market work better for consumers. I will touch on two of these matters. First, we believe there is a compelling case for establishing a well-resourced, national, independent consumer advocacy body. The establishment of such a body would ensure that the views of all customer segments can be represented effectively and a new regulatory environment and the impacts upon consumer groups could be appropriately considered and reflected in decision making.

We also believe the uniform adoption of the National Energy Customer Framework would provide real benefits to Australian electricity consumers. This framework is designed to equip customers with the tools to compare price offers on an apples-to-apples basis when looking at the retailers' energy offers. It seeks to address some of the issues that consumers may experience when they are searching out energy offers. The retail energy market is complex and the structure and proliferation of energy offers can be confusing to consumers.

Of particular importance in informing and empowering consumers is the AER's price comparison website, called Energy Made Easy. This website was launched on 1 July to provide consumers in those jurisdictions where the retail law has commenced with independent, objective and free comparisons of energy offers to help customers work out which is the best energy deal for them.

To sum up, while there have been significant price rises, there are a range of initiatives currently being considered to address problems in the electricity market and its regulation. The network regulation and retail market reforms highlighted in our submission have the potential to deliver significant benefits to consumers now and into the future.

CHAIR: You were reported in the Sydney Morning Herald on 9 August 2012 as saying:

Consumers are paying more than necessary for a reliable supply…

We are constrained in our ability to reject excessive demands from businesses.

Are they the weaknesses in the system that you were referring to earlier, or is there anything else that is contributing to that? What is the primary factor?

Mr Reeves : First I should say that there are fundamental reasons for some increases in prices. Some of the investment in the network has been necessary to replace ageing assets. We have also seen a significant increase in peak demand. We have also seen investment to deal with new residential housing and the like. We have also seen rising costs of funds, particularly post GFC. So there are reasons for price increases. That said, the rules under which the regulator operates have been set such that there is a principle to promote efficient investment, but our concern is that when the rules were made they had the emphasis on promotion and less emphasis on the efficiency. We were, firstly, constrained by the current rules in our ability to reject excessive forecasts by the businesses and, secondly, constrained in the way we were required to assess the cost of capital—that is, the financing costs of the business. So, while acknowledging the fundamental reasons for price increases, we do consider that customers have been required and are required to pay more than necessary for their reliable supply.

CHAIR: So is it your view that the current rule changes that are proposed will alleviate some of those pressures and deal with some of those problems?

Mr Reeves : The draft report that the AEMC has produced, if that carries through to the final, would address the issues that we have raised. There are restrictions in our capacity to reject excessive forecasts. That has been addressed. The draft report also acknowledges that there have been difficulties in assessing the costs of funds, and the proposal there would send it back to the regulator to come up with methods of assessing costs of funds in consultation with the industry and with consumers.

CHAIR: The network businesses are also required to provide demand forecasts to you. To what extent are you able to test those demand forecasts, and is that dealt with in these proposed rule changes?

Mr Reeves : It is not dealt with explicitly. We do receive demand forecasts from the business. We challenge those. I think it would be unusual for us to accept the demand forecasts that have been put in front of us, and there have been a range of reasons for that. So that power currently exists, and we would continue to examine those demand forecasts and also to look to external advice for confirmation of an appropriate demand forecast.

Senator MILNE: This is a follow-on from that question. From what you said, Mr Reeves, you have obviously often been given what you regard as excessive demand forecasts, and you can interrogate those and obviously feed back to it, but what powers do you have to just say, 'No, our independent advice is that that is way excessive and therefore we are only going to accept X'? Do you have any powers to actually do anything about it? Also, given that there has been this demand fall right across the system and everybody is saying, 'Oh, it's a surprise; it's more than anything that was modelled,' can you just comment on that aspect of it? The first one was: what power do you have to actually do anything about it when you identify that there has been an excessive forecast?

Mr Reeves : In regard to the first, first of all, the businesses do have the incentive to submit to us conservative demand forecasts—that is, forecasts which would support higher levels of network investment. We challenge each of those. I cannot think of a circumstance where we would have accepted the raw forecast put in front of us. We do have the power to examine and to substitute our own forecasts. That then has implications for the amount of capital that we allow. On many occasions we have considered that the proposals put in front of us could be deferred to later periods, because our view of demand forecasts is less than that put forward by the business.

The second matter that you have raised was noting that the rates of growth in demand have slowed markedly in the recent past. The current pricing period represents decisions that were made over the last, say, three years. The proposals that we were dealing with were formulated some 12 months to two years in advance of that, so the current pricing period reflects the thinking at the time even pre GFC. That was coming off the back of very strong growth in the Australian economy. It was also in a period of high temperature, and we saw then our considerable growth in air-conditioning penetration in residential, and the manufacturing sector was quite strong. Since that time, as I think has been reflected in the most recent forecasts—and I see that the committee will be speaking to AEMO, the market operator, later this morning, who will go into more detail, I am sure, on those demand forecasts. But the current pricing period was set off the back of forecasts that were made some time ago, with much more aggressive prospects for the Australian economy.

Mr Willett : We probably ought to recognise that there are two categories of demand forecast, and it is important to recognise the distinction. One is peak demand, and it is peak demand that drives investment. The other is aggregate demand, and aggregate demand is important for recovering costs, because you recover over the total demand, and that determines prices.

CHAIR: Many of the submissions that the committee has received indicate that it is the view of submitters that we are not doing enough as an economy to encourage demand-side participation. Do you have a view on that? If that is the case, what could be done to a greater extent to encourage credit demand-side participation?

Mr Reeves : That has been a concern of wide bodies of people. It is currently being considered and addressed by the AEMC, the Australian Energy Market Commission, through their power of choice review. That review, which was released in the last month, has come up with a range of matters which could be adopted to incentivise the businesses to be more aggressive in their consideration of alternatives to simply building more assets to meet growing demand. It has also identified things such as changes to tariff structures, such that consumers are given more incentives and are rewarded for managing their demand.

Senator EDWARDS: Mr Reeves, you are on the record as welcoming the new rules. In fact, you said they would provide 'greater scope to reject excessive proposals and to scrutinise investment'. We heard from Mr McIntyre a couple of days ago in Sydney at our inquiry there. How do you respond to comments from Grid Australia, who stated that the long-term development of the grid could be at risk under the AEMC proposals?

Mr Reeves : Firstly, the work that we do and the work that the AEMC as the rule-maker does is done under the national electricity law. Sitting within the law is the national electricity objective, which is set out to promote efficient investment in and efficient operation of electricity services for the long-term interests of consumers. That means that, in coming up with the rules and in our decisions, we have to take into account the long-term interests of consumers. One interpretation of that objective is that efficient investment is in the long-term interests of consumers in that it ensures consumers are provided with a reliable and safe supply. Secondly, the law contains the revenue and pricing principles which also direct how wedo our work. One of the key principles is that we are to provide the businesses with a reasonable opportunity to recover at least efficient cost. That means that we cannot wind back the allowance to the point where the business does not have the incentive to invest efficiently to receive a commercial rate of return. They are really the assurances that sits within the law. They guide both the rule-maker and the regulator in what he does.

Senator EDWARDS: You also stated that these changes may lead to an increased risk of power blackouts. Do you agree with that? Your answer there would say that this is all encompassing, it is a fix-all, it will cover all, but he is asserting that, because of these new proposals, the reliability that you talk about in your answer is not going to be present. Do you agree?

Mr Reeves : No. There are a range of matters that deal with there. The networks are built to meet certain levels of reliability standards. First, the AEMC has examined the way in which those standards have been set, and there are a range of approaches to that. Ultimately, that assessment of reliability standards is done by an economic analysis of the value of reliability to consumers and the cost of the investment so that balance is there. We then take those standards into account in dealing with our proposals for the network businesses. Again, there is a recognition within the framework that customers put a high value on reliability of supply. That is really the assurance. Most of the assurances come through the standards, but there are further economic tests that are carried out both by the businesses in putting forward their proposals and in our analysis to ensure that those levels of reliability are met.

One of the key things in the distribution networks, which is not the area that Grid Australia was dealing with and which has recently been examined by AEMC at the request of governments, and in particular the New South Wales government, is that the reliability settings for the distribution in New South Wales have been set above the levels that consumers would value. That has been the view of AEMC and they have recently come out with a report suggesting that consumers may find better value with some relaxation of those standards, and those matters would now be considered by government. They would then feed into our next round of determinations.

Senator EDWARDS: Referring to Mr McIntyre's statement, he said:

We have argued that the AER has always had the power but not necessarily the skills to undertake its important task.

He argued quite strongly several days ago that you do not always get things right, and that he feels you do not have the resources or the skills to adequately do your job. What do you say to that?

Mr Reeves : We appreciate his views that the business—

Senator EDWARDS: It seems like a love-hate relationship that he has with you. He gives you a smack and then—

Senator MILNE: There are 50 per cent more resources—

Senator EDWARDS: Of course. I did ask him what particular skills he thought you lacked.

Mr Reeves : First of all, our practice has been to engage engineering consultants to inform the regulator. We will continue with that but we are also moving on from that to bring more skills in-house. We acknowledge the concerns of the business. One of the positions put to us has been that the regulator is being given more discretion and it is important that the regulator exercise that discretion with the confidence of the community. We are addressing some of those factors that have been raised by bringing some of the additional technical skills in-house.

Further, there is a developing role for AEMO as the market operator and the national planner in giving us advice to assist us with our work. Another study being carried out by the AEMC, called the Transmissions frameworks review, is examining the role of the national planner. One of the points this has raised is that the national planner could better assist the regulator in its examination of the proposals so that, while AEMO is doing the high-level planning of the national grid and the transmission network service provider is coming down a layer, AEMO's advice to the regulator would help us in our appraisal of the proposals put forward by the business.

Senator EDWARDS: Why is it that South Australia and Tasmania suffer the highest electricity prices on the National Electricity Market?

Mr Reeves : I will deal with South Australia first. South Australia has always had comparatively high prices. The primary reason for that has been the costs of generation in South Australia. Unlike the major east-coast states, which have large brown coal generation or significant black coal generation, South Australia has not had access to that. Its generation has predominantly been gas fired and by import from Victoria. More recently, South Australia has had an explosion in wind generation, and what we now see in the spot market is wind generation starting to suppress the price.

There are issues, too, with the costs of the network, but in broad terms South Australia's prices are largely represented by the costs of generation being higher than in other states. The allowances—the retail prices that may be charged by retailers in South Australia—are capped by decisions of the independent regulator in South Australia, who takes account of the costs of generation, the costs of networks and the costs of other certificates and the like in coming to his approach.

As we know, Tasmania has been through a period of drought, and has substantial import of energy from the mainland. Again, the prices there are assessed by an independent regulator who takes account of those costs of generation in making his decision on retail tariffs for residential customers.

Senator MILNE: I note what you just said about the reliability standards, and I understand Queensland has adjusted its reliability standards and this has made a big difference. I will be interested to see where that all comes out in the report. The question I wanted to go to was something that was identified in the Garnaut review and by a lot of people; that is, the reason for the overinvestment by the networks is that publicly owned networks can borrow finance at rates of four or five per cent whilst the regulated returns are based on corporate debt costs. In other words, they make money out of it. I note from the draft determination that has come out from the economic regulation rule change that it gives you greater flexibility but, unfortunately, in my view, there was a rejection of a proposal that the return on debt be set differently for state owned networks than for privately owned networks.

I just wanted to ask your view on this and also the adequacy of the proposed rule change which gives you greater flexibility but does not go as far as to be able to change that debt ratio. Can you just give me an understanding of what difference you think it has made from the fact that they can make money on the cost of borrowing as opposed to what they get in return? What does flexibility means since they have rejected that rule change?

Mr Reeves : Sure. You have raised a number of points. First, the proposal that the government owned businesses be rewarded with a lower cost of debt than privately owned businesses came from the major energy users rather than from us. We did not support that proposal and neither has AEMC. The reason for that is we consider that the benchmark that we use for provision of these services should be the efficient private sector provider. That would mean that the price outcome should be the same, whether the network is in government ownership or private ownership. That means that government owned businesses would be entitled to receive private sector rates of return.

Importantly though, going hand-in-hand with that, government owned businesses should only be rewarded for levels of efficiency that the private sector may attain. That was another important part of our rule change proposal which has been recognised by the AEMC. It is that we can take benchmarks and applied benchmarks of the efficient service provider to apply to any business, government or privately owned.

In regard to the Garnaut proposition that the allowance of higher rates of return than the actual costs of funds leads to incentives to overinvest, without going into the detail of that, if we look at the solution to that being addressed by AEMC, we support that. The issue there is the threat of curtailing or not giving a return on inefficient overinvestment. The AEMC's draft rule change proposal would give the regulator an obligation to examine the overspends—that is expenditure in excess of the allowance—and for us to reject inefficient overexpenditure. That threat of rejection of the inefficient overexpenditure would act as a disincentive on any business, government or private, to spend more than the forecast.

Senator MILNE: So you are happy that the flexibility that you have now been given, or that has been enabled as result of the proposed rule change, will be enough for you to deal with that?

Mr Reeves : It goes a long way towards that. It gives us the capacity to examine and a capacity to reject. That is one of the important factors that would then reduce the incentives for overinvestment. Other bodies are also examining the application of benchmarks. Further down the track we will be in a better position to look at the comparative efficiencies of government owned businesses and privately owned businesses to ensure that the initial allowances are appropriate and then, as you have observed, have an ability to reject inefficient expenditure in excess of those allowances.

Senator MILNE: I guess we will have to wait and see.

Mr Willett : The regulatory design is basically a benchmarking design whereby we model the costs of an efficient service provider, give them the money we think they need for five years. They go away and do it as best they can. To start looking at the actual debt costs of a particular service provider moves away quite substantially from that broad regulatory approach and we believe that the regulatory approach, in broad terms, is right. We just need more in terms of the ability to benchmark and the ability to make assessments about what is efficient.

Senator MILNE: The other thing is that the AEMC made some recommendations in its recent Power of choice draft report that would impact on the activities of the regulator. Can you just comment on those?

Mr Reeves : One of the features of that report was a suggestion that we examine the incentives on the businesses for demand management as against the expenditure. At the moment we have a framework where there are incentives on the businesses for reducing their operating expenditure. We do not have the same balance of incentive to deal with capital expenditure, and that should be examined. It has been our proposal to examine this for some time, but we have been waiting for the Power of choice review to get the context for that work to be done. That is an important part of examining incentives for these businesses.

There is a further aspect: in regard to significant expenditure, the businesses are required to put their proposals through a regulatory investment test. That obligation exists currently on distributors and the scope of that is being extended. As part of that test, the businesses are required to demonstrate that they have considered both network alternatives as well as demand management and local generation. We have examined a number of these tests carried out by the transmission business and we have not really been satisfied that that work has been adequate. Part of our work plan is to improve the oversight of those tests to see that they are carried out appropriately and that alternatives to network investment are not ruled out too early in the process.

Senator THORP: We have raised quite a few issues in the last half an hour, and given the terms of reference as they currently stand, what do you think would be the most significant and most important recommendation—a single recommendation—that could come from our work?

Mr Reeves : The most significant in the medium term would be the work of AEMC with the rule changes. The ability for the regulator to scrutinise and to reject proposals for excessive expenditure and to do a determination of cost of capital that is a better reflection of the financing practices of the businesses is an important step—that is, in the medium term. In the longer term, the Power of choice review is a really significant body of work. That really has the potential to change how consumers engage with electricity services. What we are seeing is developments in the industry in the wave of reforms in Australia. Australia is a world leader in the reforms in the energy market—that is, in the generation sector.

We are now entering an era where the next wave of reforms is at the customer end. We are seeing there—and this is acknowledged through power of choice—that at the customer end customers will make the choice of local generation—that is, solar or other domestic generation—of demand management, of storage as we see in the future electric vehicles coming on to the scene and of grid services. That is a recognition of very significant changes in the electricity market over the medium and longer term.

Senator EDWARDS: I have a supplementary question on where we finished up. Do you think that South Australian electricity consumers are being prejudiced by the explosion of wind farms? We now have over 53 per cent of the nation's wind farms in South Australia by virtue of planning regulations which allow for them. Have you looked at that? Do you think they are being prejudiced with the purchase of renewable energy certificates, for the lack of an interconnector?

Mr Reeves : The assessment of the standing offers is done by the South Australian Independent Industry Regulator. His construction of the costs feeding into that are in his report, so that would be the best source of information as to what makes up the standing offers. A further thing—and you may want to take this up with AEMO—is that the capacity of interconnection between South Australia and Victoria has been a very important issue. We have recognised that South Australia has an unusual market in terms of the concentration of generation with one provider. That is an important factor. A larger interconnector would assist in a number of ways. First, it would improve competition in the generation market in South Australia, such that South Australian generators would be exposed to competition from Victoria. Further, it would add to the stability of the South Australian system in that there would more capacity to get more wind out of South Australia into the other markets at a time of high-wind generation. That work is currently being examined under some joint studies between ElectraNet, the South Australian network service provider, and AEMO and their work is examining the upgrade of the interconnect, and the market benefits and security benefits that would arise from that.

CHAIR: I thank representatives from the Australian Energy Regulator.