Some thoughts about energy pricing

Electricity prices have risen significantly over the past few years. Unfortunately, a lot of the commentary about why prices have risen is often incomplete or erroneous. I thought it might be useful to put down a few thoughts on why prices have increased and how the Finkel Review’s recommendations may assist reduce pricing pressures in the future.

The final price paid for electricity is generally comprised of: network charges; wholesale energy and retailer costs; and government scheme costs (such as the Renewable Energy Target). A high level overview of the proportion of each was provided by the Australian Energy Market Commission last year and is reproduced below for NSW.

Networks

Transmission and distribution networks transmit the power generated to our homes and businesses. Networks are regulated monopolies. The Australian Energy Regulator regulates the prices charged by networks. There has been a significant increase in network charges over the past ten years. This has been driven by forecasts of increased peak demand; increased reliability standards; and replacement of ageing infrastructure. There are strong arguments for examining whether network asset bases may need to be reviewed in the future as more consumers install embedded generation (such as solar PV and batteries) and use of the network declines. You can read more about my thoughts on these issues in a paper I had published in Economic Papers.

Wholesale energy and retailer costs

The other major component of the energy supply chain is the production and retailing of electricity. In the wholesale electricity market, generators bid the quantity of electricity they are willing to supply and the price they want to receive for each dispatch interval (each interval is five minutes in length). Generators are dispatched by the Australian Energy Market Operator (AEMO) in price order from lowest to highest up to the level required to match demand. All dispatched generators receive the market-clearing price in their region, which is the price of the final dispatched generator. The specific bids made by each generator are a combination of several factors including their short-run operating costs and plant technology. The suitability of different technologies for different types of demand is discussed in an earlier blog post.

The wholesale market can be very volatile. Prices can increase rapidly from around $50-100 per megawatt-hour (MWh) to $14,000 per MWh in half an hour. As a result of this price volatility, a prudent retailer will enter into  forward contracts with generators to ensure their customers can be offered a stable price. Essentially, retailers and generators seek to reduce their exposure to price volatility by entering into these financial contracts.

For most of the National Electricity Market’s operation, prices in the wholesale market were below the cost of building a new power station. Eventually, prices were going to need to increase to ensure the cost of building a new power station could be recovered. Otherwise, the existing coal and gas power generation fleet (more than 75% is beyond its original design life) would never be replaced and reliability would be compromised.

However, wholesale prices have now risen substantially. The graph below shows forward Victorian prices for several years into the future over the past few years to early 2017.

The Australian Energy Market Commission has stated that prices have increased because of factors including:

  • A lack of investment due to the uncertainty created by a lack of integration between current energy and emissions reduction policy mechanisms.
  • The retirement of Hazelwood in March 2017, which supplied capacity of 1600 MW equivalent to around 20 per cent of Victoria’s electricity consumption. This came on top of the retirement of the Northern Power Station in May 2016, which supplied 546 MW of capacity.
  • Increases in gas prices, partially due to high demand.

But that does this mean in simple terms? Well, having written on these issues extensively, it comes down to two basic points in my personal view:

  • As more renewable energy generation entered the market, it placed downward pressure on wholesale prices. Eventually, with more supply than was required, surplus ageing power stations found it uneconomic to continue operating and retired from the market. However, because of the significant scale of individual power stations, this resulted in a substantial tightening of the supply/demand balance and not enough notice was provided to ensure replacement capacity was constructed. It is important to note that renewables provide energy but complementary investment in capacity is needed for times when the wind isn’t blowing and the sun isn’t shining. You can read more about these issues in this paper from Economic Analysis and Policy.
  • As coal generation has been retired, gas-fired generation has been required to produce more energy. The market for gas is very tight due to a near tripling of gas demand (associated with the development of a new LNG export industry at Gladstone in Queensland) and various moratoria exist preventing some new gas supplies being brought to market.

The Finkel Review identified many of these issues and proposed a number of very important policy measures which will assist in reducing pricing pressures while still ensuring Australia can meet its international obligations to reduce emissions. These include:

  • The introduction of a Clean Energy Target (CET) which will provide clear investment signals to bring more low-emissions energy into the market. Put simply, more supply puts downward pressure on prices.
  • A requirement for power generators to provide several years notice before they close.
  • A requirement for renewables to become ‘dispatchable’ through a Generator Reliability Mechanism.

 The importance of retail competition

A final observation about energy prices is to emphasise the importance of retail pricing competition. South-East Australia has a highly competitive retail electricity market. The Australian Energy Market Commission recently noted there are 22 retail electricity businesses in New South Wales and that consumers who shop around can save around 21 per cent or $309 per annum on their electricity bills. The Energy Made Easy website is a great way of comparing offers in the market. There are significant benefits available through a deregulated market.

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