Grattan report as broken as energy market

There is a problem with think tanks. It is that they come from old money. This ensures that they operate within the bounds of the excepted political thinking. And yes, this does rather undermine their only reason for being.

A great example is a new report form the Grattan Institute on energy. It’s sheer lack of imagination condemns it to a series of conservative conclusions that are both factually wrong and destructive to the Aussie economy. Hardly a great output on one of the great policy challenges of our time.

Wholesale electricity prices rose across Australia’s National Electricity Market (NEM) by 130 per cent between 2015 and 2017. The value of electricity traded in the NEM more than doubled, from about $8 billion to $18 billion. Household bills increased by up to 20 per cent in 2017 alone. Consumers are not happy, and politicians are under pressure to fix the problem. But fixes are either non-existent or complicated.

Three issues caused the price increases. First, two big, old, coal-fired power stations closed (Northern in South Australia in 2016 and Hazelwood in Victoria in 2017). Although they were low-cost to operate, they faced big maintenance bills that weren’t worth paying given low market prices as a result of historic oversupply. Their closure reduced supply and pushed prices up. This accounts for about 60 per cent, or $6 billion, of the increase in the value of electricity traded annually in the NEM between 2015 and 2017.

Second, the price of key inputs, especially gas and black coal, rose just when the plants they fuel were needed more often. This accounts for up to 40 per cent of the price increase between 2015 and 2017.

Both these issues are largely beyond the control of governments. In both cases, the market responded efficiently to the changing circumstances. Prices have increased to levels that are expected in the long run, closer to the long-run marginal costs of generation including construction and maintenance costs. But prices have not gone so high as to attract much additional investment in the system, beyond the additional supply from subsidised renewables schemes.

The third issue is that generators ‘game’ the system: they use their power in concentrated markets to create artificial scarcity of supply and so force prices up. Supply in all NEM states (Queensland, NSW, Victoria, South Australia and Tasmania) is concentrated, so a single outage, plant closure or transmission constraint can lead to a supplier having a high level of transient market power. In these circumstances, generators can temporarily force prices up.

Gaming has occurred in Queensland and South Australia, there are signs of it in Victoria since the closure of Hazelwood, and it could appear in NSW as supply tightens with the scheduled closure of the Liddell coal-fired power station in 2022. Gaming has been a part of the market for years and appears to be permitted by the current market rules. It is notoriously hard to identify, but it may add as much as $800 million to the price paid for electricity traded in the NEM in some years.

We draw three conclusions from this analysis. First, wholesale prices are very unlikely to return to previous levels of around $50 per megawatt hour. Over-supply, as a result of historic over-building, is disappearing, and gas prices will stay higher than they were in the past. And new generators, using any technology, including coal, cost more. Additional, subsidised renewable supply could put some downward pressure on prices, but this will be transitory because the ‘intermittency’ of wind and solar energy will ultimately have to be paid for. This is not good news, but politicians should be honest with consumers about the harsh truth: higher wholesale electricity prices are the new normal.

Second, governments and the market operator should consider additional changes to the bidding rules to reduce gaming. But more drastic actions, such as lowering the cap on wholesale prices or intervening in the market to break up private energy companies, should be rejected because they are likely to create bigger problems.

And third, governments must provide stable energy and climate-change policy so there are clear incentives to invest when supply tightens and prices rise. Australian households and businesses could then get low-cost, high-reliability, and low-emissions electricity.

Recommendation 1: Facilitate investment by providing stable policy The federal Government – with the states – should provide bipartisan, credible energy and climate-change policy to underpin new investment in the NEM. The National Energy Guarantee would help, and should be endorsed. Government intervention in the market, actual or threatened, should be unnecessary.

Recommendation 2: Ease input cost pressures State governments should fully implement the recommendations of the ACCC’s East Coast Gas Inquiry from 2016. These include lifting the current moratoria on gas exploration and instead considering gas development projects on a case-by-case basis.

Recommendation 3: Be honest with consumers about prices Federal and state politicians should be honest about the likelihood that higher wholesale prices are the new normal, and that intervention to keep ageing legacy assets is a poor long-term solution. Instead governments should keep pressure on other parts of the electricity bill – such as retail and networks.

Recommendation 4: Stop price gaming The Australian Energy Market Commission (AEMC) should change market rules to address ‘gaming’ that results in artificial price spikes. AEMC should reconsider a gate-closure mechanism to eliminate inefficient late rebidding.

Recommendation 5: Monitor market concentration The ACCC should use its existing powers to continue monitoring the impact of vertical and horizontal integration on electricity market outcomes. The federal Government should not introduce legislation to give the ACCC powers to break up private generation companies and should not reduce the cap on wholesale prices. The AEMC should continue to investigate more fundamental changes to the NEM – such as a pivotal supplier rule, a day-ahead market, and demand-response mechanisms – to ensure reliable, low-cost and low-emissions supply into the future.

This is really poor analysis. Australia always had an energy transformation plan. It was to let base load coal be substituted by gas while renewable plus storage caught up. The only thing that went wrong is that the price of gas went through the roof. Coal plant closures made this one basic problem worse but they did not cause it. Bizarrely, Grattan itself explains why:

The increase in input costs has two impacts on wholesale electricity prices.

Gas generators set their electricity prices higher to cover their higher input costs in response to an increase in the price of gas. But because of the way the NEM is designed, all generators benefit if the spot price of electricity goes up.

In the NEM, generators bid the electricity they propose to deliver into the market at different price levels. The Australian Energy Market Operator ranks all bids in order from cheapest to most expensive and dispatches the cheapest set of bids that meets the needs of the system. The market price is set by the last generator needed to meet demand, and all generators that dispatched electricity also get paid this price. (Box 1 on the following page explains in more detail how electricity is priced in the NEM).

The incentive is for generators to bid at their marginal cost – the cost of producing an extra unit of electricity. If they bid a higher price they risk not being dispatched and therefore not receiving any revenue. If they bid a lower price they lose money on the electricity they produce.

When a generator with high marginal costs sets the price, all other generators benefit from additional revenue. So, in 2015 when a gas generator was setting the price, all generators were getting about $50 a megawatt hour. But in 2017, after gas costs had increased, when a gas generator was setting the price, all generators were receiving about $100 a megawatt hour even if their own costs had not increased (see Figure 2.2 on the preceding page).

So increasing black coal and gas prices means that, whenever coal or gas power stations are the price-setting generator, the revenue of all generators goes up.

This is the market working as it should. Generators have an incentive to bid at their marginal cost. But if the price they received was only equivalent to their bid (that is, their marginal cost), they would not earn sufficient revenue to recover the fixed costs. If generators are to be financially viable, the market needs to provide periods when they can earn above their marginal cost.

As the marginal price setter for power, all that is needed to fix everything in the east coast energy market is to lower the price of gas. Everything else flows from this. If the gas price halved then electricity would go straight back to $50. And decarboniation would march on. An impossibility according to Grattan.

Why didn’t Grattan look at this in more detail? The recommendation that we need more gas supply is fine. But that’s just parroting Federal policy. It won’t fix the issue because all the cheap supply is locked up in the gas export cartel.

Why didn’t Grattan examine the cartel? Why didn’t it examine what every other energy producer on earth does with policy to prevent over-exporting from denuding yourself of an energy advantage? They all use domestic reservation. Is this “beyond government control?”

All we got was this:

Gas prices have fallen to between $8 and $10 a gigajoule, from a high of $20 a gigajoule.112 But these prices are still way above the $3 to $4 a gigajoule paid before the domestic market was opened up for export. International gas prices have historically been higher than domestic gas prices. Opening up the gas market for export means domestic customers must now compete with international customers. Through the ACCC monitoring role, export parity pricing should be the appropriate price benchmark.

Export net back is not the appropriate benchmark. No other energy supplier aims for export net back. They aim for production plus margin. Even in WA where gas is $5Gj. On the east coast it is the same, not $8-10Gj.

Perhaps the answer lies in Grattan funding:

Grattan began with a $15 million endowment from each of the Federal and Victorian Governments. BHP Billiton provided $4 million and the National Australia Bank $1 million. In order to safeguard our independence, Grattan Institute’s board controls the endowment. The funds are invested and Grattan uses the income to pursue its activities.

Independence from what? BHP is a card-carrying member of the east coast gas cartel and one of its largest beneficiaries. Indeed, the ACCC singled out its Gippsland JV with Exxon for its aggressive gouging:

In what a number of users described as a new practice, EOI processes or ‘auctions’ have been conducted in which prospective users need to put in a bid for their gas demand and price. This is in stark contrast to the usual practice of users seeking offers from suppliers. One of these EOI processes has been conducted by the Gippsland Basin Joint Venture (GBJV) for 2018 and 2019 supply and it is reported to have received keen interest.88 A user is reported as describing the terms as ‘not very customer friendly’.

The east coast energy market is not “mostly working”, it is a text book market failure rife with discriminatory pricing. It requires deep government intervention to fix it. Simply force enough gas to stay here, via fixed price quotas if necessary. Sure, the cartel will take some losses. Good. They misallocated capital.

All that is needed to fix the entire east coast energy failure is an IQ above seventy, cojonies, and domestic gas reservation.