Default Prices: A fine balancing act

There has been much attention on the Default Market Offer (DMO) and Victorian Default Offer (VDO) in an environment where cost-of-living pressures continue to bite. The process of setting a regulated price tries to cater for industry and consumer needs but it is not a simple case of giving more to one sector while giving less to the other. The best-case scenario of a regulated price will see competition dampened. But in the worst scenario, retailers will go out of business, as was seen this week with two more retailer failures impacting more than 12,000 customers. In this EnergyInsider we consider the latest decisions, and what the market indicators are saying about the effectiveness of the policies overall.

Default Objectives

Consumers gain from a competitive market where retailers can adequately cover their costs – this delicate relationship plays out in the different objectives of the default offers. In setting the DMO, the Australian Energy Regulator (AER) has to balance the following objectives:

• protect consumers from too high prices
• allow retailers to recover the efficient costs of providing services
• maintain incentives for competition, innovation and investment.

In contrast, the objective of the VDO is focussed on simplicity, trust and a “reasonably” priced electricity option.

These different objectives may help explain the different outcomes in the two default offer regions. According to the Essential Services Commission (ESC), 15 per cent of Victorian households are now on the VDO, a dramatic increase since the regulated tariff was introduced in 2019. The Australian Energy Market Commission (AEMC) reported in 2020 that only 5 per cent of Victorian households were on standing offers[i] just prior to the introduction of the VDO. 

Given the VDO isn’t the cheapest energy deal on the market, with an increasing number of consumers preferring the regulated tariff over market offers, anecdotally more households are likely to be on higher tariffs than necessary. The VDO effectively acts like a cap which market offers are priced against. Victoria has an estimated 2.9 million residential electricity customers, which equates to 435,000 households now on the regulated tariff.  In 2020-21 there were 2.85 million residential electricity customers in Victoria, so around 142,000 households would have been on standing offers in the initial phase of the VDO.  While we don’t know who has moved from market offers to the VDO nor their reasons, it is no doubt a symptom of a market where the incentives to engage have been reduced.

The number of customers on the default offers is considered a good measure of engagement in the market. The risk that there could be a fall in the number of consumers actively engaging with the market as a result of the VDO was previously flagged by the Australian Energy Council (AEC). In a 2021 submission, the AEC noted that the VDO had dampened price signals in the market, and limited incentives for consumers to shop around and seek out the cheapest energy deals.

In December 2018, the AEMC advised the then-COAG Energy Council that the introduction of a default offer in the short term may result in a decrease in price dispersion in the market which could lead to a reduced incentive for consumers to engage in the market and decreased switching. It also noted that changes in consumer behaviour could result in decreased competition. At approximately the same time, the AEC published advice from Oakley Greenwood that sought to assess the impact of customers currently on the Standing Offers opting not to seek out a cheaper market deal due to the presence of a default offer marketed as ‘fair’.  Oakley Greenwood found that the benefits that would accrue to consumers under a ‘do nothing’ scenario that saw customers continuing to move from standing offers to market offers at the same rate as they were currently shifting would see benefits of $658 million, as compared to the benefits of introducing the default offers of $610 million. It is not unreasonable to assume that had Oakley Greenwood modelled the impacts of increasing numbers of standing offer customers, that lost benefit would have been materially higher.

At least on the face of it, this appears to be a concerning trend for Victorian energy consumers.  

In contrast to Victoria’s experience the number of residential customers on the DMO have dropped since its introduction (around 10 per cent are on a standing offer). There could be a variety of factors that explain this trend but one factor to consider is the state of competition in the DMO regions compared to Victoria.

Changing the Rules of the Game

Another notable development with the VDO was that in setting the 2023-24 rate, the ESC changed two significant components between the Draft and Final Decision – wholesale electricity costs and the retail operating margin. 

The ESC’s wholesale electricity costs changes revolved around an assessment of the types of contracts which are being traded, with the ESC judging that peak swaps are rarely traded and therefore removing them from the overall assessment. There are at least two major problems with the ESC Final Decision in this regard – they made a major change on this assessment between Draft and Final without any industry consultation. Second, while they removed one type of contract from their assessment (peak swaps), they did not consider the contracts retailers have entered into to replace the peak swaps. 

The Australian Competition and Consumer Commission’s (ACCC) November 2022 Inquiry into the National Electricity Market report indicates the significant impact of recent and current market conditions on the ability of retailers to manage their risk. Increases in ASX margin requirements have led to clearing participants reducing their engagement with the ASX and, as the ACCC reports, the proportion of contract volumes traded over-the-counter (OTC) has increased. The ACCC notes “that the readily available ASX pricing information does not currently act as an accurate proxy for market-wide contract pricing”. This points to the need for a form of OTC headroom allowance in determining wholesale electricity costs.

The other significant aspect of the May VDO decision was the change to the retail operating margin from 5.7 per cent to 5.3 per cent. The decrease was made following a comparison of the retail operating margins used by Tasmanian, Queensland and ACT regulators, despite these jurisdictions operating largely with monopoly retailers and Government ownership. The ESC noted that there is some circularity in using other regulators decisions to set margins and that it will consult on potential alternative approaches in its next review. Unfortunately, the decision to lower the retail operating margin does not reflect the higher costs of operating in Victoria compared to other jurisdictions. 

The VDO announced in May will hamper the ability of retailers to offer competitive market deals enjoyed by the majority of their customers. The ACCC’s November 2022 report assesses, correctly, that retailers are operating under significant financial pressures. In that report, the ACCC advised regulators to take great care to ensure retailers were able to cover rising hedging costs. It stated that regulated offers should be set to preserve competition in retail markets noting that it “is the best way to deliver benefits to households and businesses over the longer term”. The ESC decision appears at odds with this advice.

[i] At the time of the introduction of the VDO customers on standing offers were transferred to this new tariff.