Bottoms up: Can the new DMO overcome false precision?

The Australian Energy Regulator (AER) recently released its Draft Determination of the Default Market Offer for 2022-23 (DMO 4). The regulator intends to switch from the currently used indexation methodology to a cost build-up methodology - a significant move that will influence how the final DMO price is set, which will have implications for retailers and customers.

Here we take a look at what is likely to change under DMO 4.

Background

Prior to the release of the Draft Determination, the AER’s Options Paper invited stakeholder views on which methodology best supports the DMO’s objectives to protect customers from unjustifiably high standing offer prices, while continuing to encourage competition and innovation in the retail market.

The AER’s Chair, Clare Savage, aptly described the DMO as a “safety net” to protect disengaged customers, but not something customers should actively look to be on as there are cheaper offers available in the market.

When the DMO was introduced in 2019, the AER set the price at the 50^th percentile between the median market offer and the median standing offer. This intentionally imprecise model was based on an indication by the ACCC when recommending the reform, as part of its Retail Electricity Pricing Inquiry, that there would be risks to competition if the price was set too low. ‘Indexation’ refers to the AER’s approach in subsequent years, which sought to retain the status quo on the positioning of the DMO in the market, but to shift the price up or down based on changes in estimated retailer costs. A cost build-up (or bottom up) approach is more commonly used in regulated price setting, where a regulator seeks to identify efficient costs of supply to determine an appropriate retail price as a means of acting as a proxy to competition.

Responses to the Options Paper mostly favoured staying with the indexation approach, with these stakeholders arguing that it was meeting the DMO’s objectives and there was no obvious reason to shift methodologies. Consumer representatives and two retailers were open to a cost build-up approach, believing it would provide greater transparency and accuracy over retail costs and margins.

The AER agreed with the latter and announced its preference for a cost build-up approach, noting the importance of transparency on cost drivers in the energy market given the pace of the transition underway.

Retail costs

How to incorporate retail costs into the DMO has been a point of contention since its commencement. All stakeholders, for different reasons, have pushed for greater transparency and accuracy on how retail costs are calculated.

According to consumer groups, more transparency will reveal that retailer margins are too high, while for retailers, more transparency will reveal how high retail costs actually are. The AER is hopeful that a cost build-up approach will provide a level of precision that resolves these tensions.

To do this, the AER has proposed to rely on ACCC data to determine retail costs - data that retailers submit to the ACCC every two years as part of its market monitoring functions. While this sounds simple, there are concerns that the different purposes (ACCC data is for market monitoring, while the DMO is for price setting) means this data is imprecise and unsuitable. For example, the data contained in the ACCC’s November 2021 report – which the AER intends to rely on – was submitted by retailers two years prior. It is difficult to understate how much societal change has occurred since the end of 2019, and it seems unlikely that pre-COVID data accurately reflects the costs retailers face today.

The ACCC’s function of collecting retail data also expires in 2025. The AER has noted this and said the next DMO review will align to account for it. One floated alternative is for retailers to directly report their costs to the AER via a template. This would provide the precision the AER is searching for and ensure smaller retailers receive visibility over their costs compared to larger retailers. This alternative has received mixed support among stakeholders with some worried about administrative burden and others fearing their exclusion from the consultation process.

Regardless of the approach taken, tensions over whether the final calculation truly captures retail costs is unlikely to go away.

Wholesale costs

A core service retailers provide to customers is protection from fluctuations in the wholesale price. To do this, retailers develop a hedging strategy where they enter into wholesale contracts ahead of time at a fixed price. The DMO accounts for this by modelling a range of potential outcomes. To set the wholesale price from these modelled scenarios, the regulator must determine which of these modelled outcomes should be recoverable by the retailer to best meet the DMO’s objectives.

ACIL Allen, the consultant responsible for forecasting wholesale and environmental costs (WEC) under the DMO, favours using a 95^th percentile scenario because this minimises the risks of retailers underestimating the value of the WEC and recognises that price uncertainty varies across regions and load profiles.

Yet the AER has instructed ACIL Allen for this Draft Determination to adopt a lower percentile of 75. This is necessary, the AER says, because a 95^th percentile is “overly risk averse” and the DMO does not need to account for extreme wholesale fluctuations since retailers are almost entirely hedged. In effect, the Draft Determination would mean the DMO would not allow retailers to recover their efficient wholesale costs in 1 out of every four years.  

For retailers, this may prove unsettling given there was little support among stakeholders to change the percentile. Recent events arguably favour taking a risk adverse approach, with Minister Taylor expressing concern that the earlier closure of Eraring Power Station may trigger volatility in the wholesale market, and the geopolitical tensions in Europe significantly impacting global energy supply chains - implications that are already being felt in Australia.

Retail allowances

In separating retailer costs from the DMO, there is an obligation on the AER to identify a retail allowance or margin that it considers best delivers upon the DMO’s objectives. The DMO is not intended to be an efficient retail price akin to the Victorian Default Offer, and most stakeholders believe that the ‘safety net’ approach of the DMO somewhat diminishes the risks to competition seen in traditional price setting processes.

Under the indexation methodology, retailer costs and their allowance were less visible and presented as the ‘residual’ (the difference between a retailer’s costs and the DMO price). While actual costs are not identified in an indexation approach, the AER has sought to ‘construct’ retailer costs and their allowance using publicly available information for listed and government owned retailers. This process identified a vast discrepancy between retailer allowances in each regulated jurisdiction.

In South Australia, for residential customers the constructed allowance in DMO 3 was in the range of 1 per cent to 4 per cent. At the other end of the scale, for small business customers in NSW, the allowance was more like 20 per cent.

To resolve this disparity, the AER has opted to impose a single retail allowance of 10 per cent for residential customers, and 15 per cent for small business customers across all regulated jurisdictions. In South Australia that will see the allowance increase significantly, albeit in a stepped manner across the next three regulatory periods. In NSW, the allowance will decrease for small business customers.

Of concern is the impact this change might have on the DMO and on its ability to meet its objectives. The AER itself states that the DMO is currently meeting its objectives despite these significant disparities in retail allowances.

Conclusion

No matter how the DMO is calculated, it is important that the DMO’s messaging remains the same. It is a safety net, not a competitive offer. Customers who remain on the DMO are paying too much and can save money by engaging in the market, either by talking to their retailer or using the AER’s Energy Made Easy website. Changing the DMO’s methodology won’t change this fact.