June 2017
With the release of Dr Alan Finkel’s review into the electricity grid and various state-based energy policies emerging promising lower electricity prices. Will the price of electricity from the grid drop in future?
To answer this question it is worth understanding how the existing electricity grid works.
How does the electricity grid work?
Basically, the grid consists of Generators, which generate electricity. This electricity is supplied to transmission companies who distribute via transmission towers to distribution companies who distribute electricity to end electricity consumers (homes and businesses who use electricity). Electricity retailers simply handle the financial arrangements with the consumer.
Figure 1: The key components of the Australian electricity grid
The generators consist predominantly of large-scale coal-fired power stations; gas and hydro to meet peaks in demand, and a small amount of wind, solar farms and biomass.
Figure 2: Electricity generation mix in the NEM, 2015-2016
Power stations compete in supplying electricity into the grid via a market-based mechanism called the National Electricity Market (NEM), which is managed by the Australian Energy Market Operator (AEMO).
Electricity transmission and distribution companies are regulated by the Australian Energy Regulator (AER). The transmission and distribution section of the grid is regulated for practical reasons, in that; it is impractical to have more than one set of power lines.
The AER sets the revenue which transmission and distribution companies are allowed to collect for their distribution services.
Electricity retailers operate in a competitive market place. Consumers can purchase from a variety of electricity retailers even though there is only one set of wires supplying electricity to their property.
In summary, there is a competitive market for the large power stations feeding into the grid, the pole and wires are regulated with guaranteed revenues and retail is a competitive market.
History of the grid
Prior to the electricity grid, communities and individual electricity consumers generated electricity with community-based or individual generators. These were predominantly diesel generators.
It was found that building large-scale coal-fired power stations and distributing energy via an electricity grid was lower cost than local generators. This approach to supplying electricity has led to what the grid is today. As costs to supply electricity via the grid system increased over the years electricity prices were simply increased to cover these costs. In the past, people would easily accept these price rises because electricity from the grid was significantly cheaper than local diesel generators. In addition to this, the cost of electricity was low compared to other household and business costs so people did little to reduce electricity usage and hence the revenue for utilities would increase proportionally when prices were raised. While electricity price rises were not entirely predictable the rate of change was well controlled and rises would usually only occur on an annual basis and rarely much above CPI. This provided large businesses with confidence that future electricity price rises was not a major business risk.
However, over the past 10 years electricity prices have risen dramatically and have been very unpredictable. The price of electricity during this period has risen by approximately 150%. This rate of increase has resulted in electricity costs being a major expense in many cases, which has forced people to focus on using less electricity to maintain reasonable electricity costs or generate their own electricity. As a result, price rises no longer increased revenue for electricity utilities proportionally. To cover costs utilities have to increase prices further and hence customers use less. A cycle that continues to place upwards pressure on prices.
What makes up the price of electricity?
All of the states connected to the grid have slightly differing arrangements for distribution and retail. Lets look at Queensland as an example to better understand what makes up the price of electricity.
The price Queenslanders pay for electricity is made up of the following costs:
- generation costs: creating electricity at a power station
- transmission costs: to build and maintain the state’s network of high voltage powerline infrastructure
- distribution costs: to build and maintain the network of low-voltage poles and wires that deliver electricity to homes and businesses
- retail costs: connecting customers, billing customers and managing their accounts
- green scheme costs: costs associated with the Commonwealth Government’s Renewable Energy Target.
- metering costs: costs associated with your metering equipment, including maintenance and meter reading.
Figure 3: Breakdown of typical Tariff 11 bill costs in 2016-17 (Queensland)
Source: Queensland Department of Energy and Water Supply – 13 September 2016
Wholesale generation costs
The wholesale generation costs account for only 25% of the price of electricity. Any reduction in wholesale electricity costs will have minimal influence on the price of electricity. For example, if the wholesale cost of electricity is reduced by 20%, which is significant, the electricity price for consumers would only drop by 5%.
Even if transmission utilities could miraculously access FREE electricity from generators, electricity prices would only drop by 25%. So the current focus on the wholesale generation market seems unlikely to drive down electricity prices to world competitive levels.
Another interesting aspect is that grid-connected power stations need to produce electricity at approximately 25% of the price of local generation to be comparable in costs at the point of supply to the consumer. In practical terms, a large-scale solar array supplying the grid needs to produce electricity for less than a quarter of the price of electricity from a solar system installed on the consumer’s roof. Large scale grid connected power stations also have to generate additional energy to cover transmission and distribution losses between the power station and the consumer. Losses can be significant in regional and remote locations.
Wholesale generation component of electricity costs have reduced from 49.2% in 2007 to 25% in 2017 and electricity prices have increased by 150% during this period.
Network (Poles and wires) costs
Network costs are the largest contributor to both the price of electricity and rises in electricity prices in the last 10 years. In 2007 Network costs contributed to 42.8% of the cost of electricity and today is 48%.
This is largely due to the method in which network utilities are regulated. Distribution utilities receive a guaranteed return on assets and poor incentives to reduce network costs. It’s safe to say, that the regulatory framework is clearly not contributing to lower electricity prices.
The Finkel report cites Demand Management as a key strategy for distribution utilities to reduce costs. Poles and wires assets are designed to meet the projected maximum demand of electricity over the life of the asset so if the demand can be reduced this would offset the need to upgrade power lines and improve asset utilisation saving costs. While this principle is sound, in practice utilities have been implementing demand management strategies for more than a decade now. For example, demand related tariffs have been in place for many years’ incentivising consumers to use off-peak electricity. Various demand management programs have also been trialed over the years. Demand management strategies implemented by utilities to date have not delivered a reduction in electricity costs.
In addition to this, demand on the grid is reducing as a result of increasing electricity prices. Consumers are purchasing less electricity from the grid because of energy efficiency measures and electricity from rooftop solar and storage. Therefore, the demand on the grid is dropping and likely to drop in future. The opportunity for future demand management strategies to achieve savings clearly does not exist if demand on the grid is reducing.
What about changing the structure of poles and wires businesses, will this deliver cost savings? Over the years there have been a variety of attempts to change the business model of poles and wires businesses to deliver efficiencies. Combining utilities to form larger businesses, privatizing and also attempting to enter new markets to supplement revenues. These strategies have clearly not delivered lower prices for consumers.
Without significant changes to the regulatory framework and ‘customer focussed’ performance improvements by utilities, it is unlikely that there will be any savings achieved in Network costs anytime soon.
Retail costs
In 2007, the retail component of electricity prices was 8% of the price of electricity. In that year ‘full retail contestability’ was introduced into Queensland allowing consumers to purchase electricity from their preferred retailer. In 2017 the retail component of electricity prices is now at 21%.
Origin Energy’s electricity tariff for residential customers in South Australia rose by 16.1% from 1 July 2017, while the tariff for small businesses increased by 18%.
Electricity tariffs for both business and residential customers in New South Wales increased by more than 15%.
In Queensland, residential customers are paying an additional 3.3% from 1 July 2017. This increase would have been 7.1% if the Queensland Government did not subsidize utilities by $770M.
It is safe to say that retail competition is not delivering lower electricity prices. The retail market consists of a number of companies who make money for shareholders through retailing electricity (buying and selling electricity). The idea of retail competition is that customers can move to another retailer who offers a better deal. This movement encourages retailers to continually offer better solutions which can include better pricing. The problem with the existing retail market is that customers find electricity plans and contracts very confusing and difficult to compare so they tend to stay with the existing arrangement. This lack of movement means that retailers are not pressured to compete and hence provide improved solutions to keep customers. It also means that retailers are profiting most from their most loyal customers.
Prior to the introduction of retail competition, the retail function simply consisted of metering and billing activities. There was very little sales and marketing costs involved in retail function. Now, with retail competition, there are significant sales and marketing costs involved as companies try to attract new customers (ie advertising costs, sales staff, marketing staff etc). These costs need to be absorbed in the pricing across the board.
In theory, customers can benefit from a truly competitive market. However, the retail electricity market is clearly not an effective competitive market and hence delivering lower costs for customers.
The market
There is a lot of talk about the ‘electricity market’ of late. This talk is focussed on the NEM (National Electricity Market), which is the market where large-scale generators compete to supply electricity into the grid. This is the wholesale generation cost, which accounts for only 25% of electricity prices.
The ‘real’ electricity market is the electricity consumer – the end user of the electricity. Homes and businesses that purchase electricity from the grid.
Today’s electricity consumers have options other than to simply buy electricity from the grid. For example, they can make electricity themselves at lower cost by simply installing solar on their roof. They can also install energy storage to store excess solar energy for use at night.
The grid system now has to compete with suppliers of new technologies, which generate electricity locally, at consumer’s premises. Local generation can be individual houses, small groups of houses, individual businesses or small groups of businesses.
The pre-grid concept of local electricity generation is re-emerging as competition to the grid because of new lower cost technologies.
The key challenge for the grid
The key challenge for the various companies and regulators that make up the grid is to provide lower priced electricity than new and emerging local generation technologies.
Unlike telecommunications, which requires a grid to provide communications from one place to another, the electricity grid is not an essential aspect of electricity supply. The grid was only developed because it was lower cost than local generation at the time. As the cost of local generation continues to fall it will be challenging for the grid to follow given it has large asset values with long payback periods.
Lower cost local generation technologies are now available such as roof top solar and energy storage. There are also significant technological developments for local generation in the pipeline which will provide more reliable electricity at lower cost. It is unlikely that the traditional grid approach can supply the lowest priced electricity in future.
The regulatory and market framework around the grid has proven to be ineffective at delivering efficiencies over the last decade, and any substantial change to this framework is almost impossible given the variety of stakeholders involved with often competing interests. Federal and state governments, industry groups, unions, publicly listed companies, regulators, and other related stakeholders.
Initially, the management of the grid was quite straightforward. The generators, transmission and distribution networks were owned and operated by government and the retail section simply part of the distribution business. Controlling electricity prices on the grid was relatively simple compared with today. The government would set the prices after submissions from utilities and provide drivers for savings.
Over the years competitive markets have been introduced into the generation and retail sections of the grid to deliver lower prices. These markets are populated by a variety of companies trying to make as much money as they can for their shareholders. In the retail market, companies have developed large teams of people in sales and marketing to attract electricity consumers to buy electricity from them rather than other competing retailers. These are additional overheads that did not exist in the supply chain when electricity was treated as an essential service. Hence lower prices for electricity consumers has not been the result since the introduction of retail competition.
Our verdict
The grid and the market mechanisms associated with the various components of the grid remain largely the same. Whilst adjustments to these may result in some minor savings the key drivers for price increases, which have occurred over the past decade, remain.
We believe it is highly unlikely that electricity prices from the grid will drop in the near future
What can consumers of electricity do to keep electricity costs down for their homes and businesses?
Basically, they can generate their own electricity by installing rooftop solar. The fuel, sunlight, is free and the only cost is the solar equipment. Rooftop solar provides set electricity prices for the life of the solar system of 20+ years. A good quality rooftop solar system can produce electricity at significantly lower cost than electricity from the grid.
Energy storage can also be added to store any excess solar energy for use at night.
By installing solar and energy storage, an electricity consumer can take control of their electricity costs and reduce their reliance and exposure to the uncertainty of electricity prices from the grid. They can also sleep well at night knowing they are using renewable energy that produces no harmful emissions.
Figure 4: 100kW solar system supplying electricity for one of Bunnings stores.
The solar system provides electricity at lower cost than purchasing from the grid and reduces the businesses exposure to future electricity price uncertainty.