Electricity retailing: The squeeze is on

The high profile of energy prices has continued into 2023 with the cost to households and small businesses set to attract further attention when the Australian Energy Regulator’s next default market offer is released in the coming months.

The setting of the DMO will pose challenges despite the Federal Government’s intervention to cap prices at the end of last year. Getting it right and ensuring retailers are not further squeezed, while meeting political expectations of taking the sting out of prices, will be difficult.

Some of the challenges were outlined in the most recent National Electricity Market inquiry report released by the Australian Competition and Consumer Commission (ACCC) just before Christmas[i]. While it did not attract much attention it did flag some emerging concerns for retailers and overall competition. The report considered the impact of the June 2022 electricity crisis on market conditions, competition and consumers. We take a closer look.

The Emerging Challenge

While consumers are finding that cost of living pressures continue to mount, the report highlights that retailers too are under extreme pressure. The ACCC has flagged the need for the default market offers to be set to preserve competition noting that “competition in retail markets is the best way to deliver benefits to households and businesses over the longer term”.

The ACCC writes that what we saw last year was that it was becoming harder for retailers to manage their exposure to volatile spot market prices, increasing “the likelihood of retailer failure, declining competition, and higher bills for consumers”.

With the concerns about cost-of-living pressures on households there was increased pressure for a political response which led the Federal Government to intervene to cap gas and coal prices. The ACCC report added a note of caution by stating that “even where short term interventions are warranted, it is still crucial to preserve the conditions for future retail competition”.

Retailers provide electricity to their customers at an agreed price. That price has to be met regardless of any volatility on the spot market, which can see prices shift up and down significantly.

To manage any risk, retailers purchase a range of hedging products that guarantee the price they pay for the electricity they offer customers.  Generators also enter hedge contracts to manage their exposure to any price or volume risks, to avoid being exposed if wholesale prices fall. Exchange-traded and over-the-counter hedging contracts are typically used to manage these risk. Based on the ACCC’s analysis that has become harder for retailers.

The ACCC says: “during periods of temporary price volatility, it is essential that market participants can appropriately manage financial risks. Our analysis indicates that retailers are finding it increasingly difficult to manage their exposure to prices in a volatile spot market. This, in turn, increases the likelihood of retailer failure.”

Since May 2022, six retailers have exited the market, triggering the Retailer of Last Resort ROLR) scheme which sees customers immediately transferred to the incumbent retailer, while a number of other retailers have actively encouraged their customers to switch to another retailer. Additionally, several retailers are no longer seeking new market offer customers.

This has led to consumers moving from small and very small retailers towards bigger retailers with the ACCC concerned that it is increasing market concentration.

Thinning Margins

Retail competition has seen retail margins come down from their peak in 2016-2017 and in the past 12 months they fell 4 per cent (from 2020-21 to 2021-22) and now represent just 2 per cent of the average cost stack.

The total average costs per residential consumer for 2021–22 were:

• 49 per cent network costs
• 28 per cent wholesale costs
• 11 per cent environmental costs
• 10 per cent retail and other costs
• 2 per cent retail margins.

The average retail margin across the National Electricity Market dropped to just $35 for each residential customer, down 33 per cent in real terms from the previous financial year (see figure 1).

Figure 1: Average retail margin change

As margins have come down, the range of offers in the market have also reduced. At the same time the price caps from default market offers has limited retailers' ability to increase prices while their underlying costs have increased. This is putting added financial pressure on retailers. While retail prices have increased - they commonly do so annually - meaning retailers have limited ability to pass through increased costs in the short term, increasing their liquidity risk.

Unsurprisingly, given this situation, market offers have moved closer to the default market offer, one of the risks the Australian Energy Council identified at the time of the introduction of the retail price caps – that it could limit the scope for ongoing competition and discourage engagement with the market. Other consequences include decreased innovation, degradedcustomer experience and ultimately higher energy prices.

The ACCC report sets out the challenges for regulators in setting a price cap and has thrown its support behind the idea of allowing the DMO and its Victorian equivalent to be adjusted outside of the annual price review to deal with market disruptions. Such a change could counter one of the issues the AEC identified with a regulated price – that it requires a regulator to forecast costs that have not been incurred, so they have to make projections to identify upper and lower price thresholds. Last year’s energy crisis underscored how prices can become extremely volatile for unexpected reasons, in many instances entirely outside the control of retailers.

The ACCC has argued that the Australian Energy Regulator (AER) should be able to reduce price caps when costs significantly decrease and to increase them when the reverse is the case and costs jump significantly “allowing retailers to better manage cash flow, costs, and revenue”.

The ACCC also comments that it is important regulated pricing reflects the actual costs of operating in the market, which includes the costs of managing price risk. Given steps taken by the regulator in recent decisions to decrease risk thresholds within the regulated price, this recommendation is telling.

Limited Contracts

As a result of the dramatic shifts in the wholesale market last year, the availability of Australian Stock Exchange (ASX) traded contracts decreased as some clearing participants reduced their exposure by closing out existing positions or not taking on new clients, according to the ACCC.

As a result, was that a number of smaller retailers had to rely on over-the-counter hedging contracts to manage risk and “are more likely to be exposed to high and volatile wholesale electricity spot prices”. There was a 16 per cent increase in over-the-counter purchases in 2022 (excluding load following swaps) which was even more dramatic in the second quarter of last year with OTC purchasing jumping 33 per cent compared to the same quarter in 2021 (see figure 2).

Figure 2: Fall in % of ASX Contracts

Source: ACCC

High spot and contract market prices also increased the credit requirements for all market participants imposing costs on contract parties and limiting the amount of trading they could financially manage with implications for large and small retailers.

The ACCC noted that for larger generators and gentailers “the increase in margining requirements pushed many up against internal risk limits and presented an exposure some sought to address with reduced ASX traded volumes.”

For retailers there was an added challenge: “Retailers are required to meet prudential requirements set by AEMO to participate in the market, such as posting collateral and providing credit support. While not immediately related to the hedging contracts market, prudential requirements are an additional potential source of financial pressure for retailers, as they require access to capital (cash, bank guarantees) and incur costs to service this capital.”

The shift in contracting from ASX to OTC for some retailers and generators “has likely increased the cost of hedging for some retailers” with the warning from the ACCC that if the shift is sustained its influence on hedging costs could become more pronounced.

The ACCC argues it is important that regulated retail pricing (DMO and the Victorian Default Offer, VDO) accurately reflect the costs of operating in the market, including the costs of hedging spot price risk. The ACCC suggests this is important because:

“Regulated retail pricing protects consumers from unreasonable prices, but also influences the ability of retailers to recover their costs and remain active participants in the market. Regulated pricing which reflects actual costs is also important to giving other participants in the market, such as brokers and clearing participants, confidence that retailers have the capacity to recover their costs and remain viable, making them less risky contract counterparties.”

It flags concerns that the big increases in spot and hedging contract prices might not have been fully reflected in default offer prices set for the current financial year. “This means the standing offer price caps could be a major factor pushing down retail margins in 2022–23.”

Another Blip on the Horizon

 Future compensation payments as a result of generators being directed into the market and the administered price cap at the height of the energy crisis are likely to add to retailers’ costs. These costs cannot be hedged and could impact retailers’ cash flow.

While the ACCC comments that some retailers may seek to ‘pass through’ these costs directly to large business customers “for most customers the retailer will be forced to absorb the increased cost or increase market offer prices until standing offer prices are reset”.

Given the DMO and VDO will not be updated until May 2023, with new prices taking effect on 1 July 2023, “the timing of spot and hedging contract price spikes mean that retailers will have experienced 13 months of elevated costs by the time standing offers are reset on 1 July 2023. Retailers have indicated that this long delay will limit their ability to pass on cost increases to consumers in the form of price rises during this time, further impacting their cash flow”.

It looks like another challenging year ahead for the retail market.