New Year, new regulated pricing approaches?

Consultations are underway for the setting of the default market offers in 2024. Both the Australian Energy Regulator (AER) and the Essential Services Commission (ESC) in Victoria and have released early papers outlining their key areas of focus. In comparing the two approaches, the AER appears to be undergoing a more detailed review, whereas the ESC seems to be more settled in its methodology overall. We take a look at the approaches being undertaken.

DMO 6

The most significant change that the AER is considering in the latest iteration of its default market offer (DMO) is to the retail allowance.  Various options are under the AER’s consideration to set the retail allowance, which include:

• percentage of the final DMO price.

• fixed dollar amount.

• a percentage-based efficient margin component and a fixed competition allowance component.

The Australian Energy Council (AEC) notes that DMO 4 (2022) set the target rate for the retail allowance to reflect the market-wide aggregate retail allowance available in the previous three DMOs of 10 per cent for residential customers and 15 per cent for small business customers. Given where the margins were sitting prior to the 2022 DMO, the AER opted to implement a glide path towards 10 per cent and 15 per cent over a three-year period.

Last year, with wholesale prices escalating, the AER decided to deviate from their glide path decision from 12 months earlier and stick with the previous year’s margin. New South Wales was artificially deflated to 9.3 per cent and the AER decided to maintain the south-east Queensland and South Australian residential retail allowances at the DMO 4 values of 8.4 per cent and 6 per cent respectively.

The AEC is concerned that there may be calls to reduce the retail allowance in the next DMO due to concerns about overall cost-of-living pressures. It is worth noting that the DMO regulations and objectives make the DMO different from other regulated prices. The DMO’s key twin objectives to incentivise retailer investment, innovation and competition in the market and give customers the ability to engage in the market mean that the DMO has additional objectives when compared to other regulated prices.

The retail allowance includes compensation to retailers for their costs to serve, the costs involved in acquiring and retaining customers, the costs of advanced meters, allowance for bad and doubtful debt plus depreciation and amortisation. Domestic, international and weather-related events, alongside regulatory interventions, have given rise to heightened uncertainty, and hence risk, for retail market participants in recent periods. These risks are not expected to subside for retailers in the near future. Given this, it is important the retailers are given confidence that these factors are covered by the retail allowance, which then allows them to invest in innovation and product development initiatives, often with long lead times which ultimately benefit customers. Chopping and changing year to year on the methodology does little to deliver such confidence.

To account for this the retail allowance should continue to be expressed as a percentage of the final DMO price. Retailers point to increased risk, potential bad and doubtful debt increases, working capital costs and impacts to competition could arise if the AER lowers the retail allowance percentage. The continuation of the current approach of calculating the retail allowance as a percentage of the DMO price also ensures consistency, simplicity and regulatory certainty for retailers.

In terms of wholesale costs, the AER is interested in stakeholder views about what approach they should we take towards estimating load profiles. The AEC has recommended that the AER utilise the interval meter data alongside the Net System Load Profile (NSLP) in calculating the wholesale electricity costs (WEC) allowance for all future determinations, given the growing proportion of customer load settled under interval meter data (in response to market trends and the flagging of targets by the AEMC). The AEC proposed this approach for DMO5 as we then noted and agreed with ACIL Allen's assessment for the DMO 5 Draft Determination':

"The use of interval meter data improves the estimation of the costs of supplying energy to small customers because the interval meter data in addition to the NSLP better reflects the shape of small customers' load."

"...that it is better to commence using the interval meter data in combination with the NSLP data sooner rather than later as it removes the risk of a step change in WEC estimate."^[1]

The AER has asked stakeholders what other methodologies it could investigate to determine the wholesale cost in South Australia in the absence of sufficient exchange traded South Australian contract data. While there is an issue of more limited market liquidity in South Australia utilising the ASX data remains the best available option. The AEC has recommended that the AER consider supplementing ASX data with the use of broker curves, which take into account over-the-counter activity and inter-regionals and indicate their view of the fair value of contracts at the end of each trading day.

The AEC notes that the AER has continued with its DMO 4 approach determining a WEC which covered the 75th percentile of modelled outcomes, as opposed to using the previously adopted 95th percentile. This method change derives a WEC which is both inadequate and inconsistent. This is  particularly pertinent during a period of high price volatility as seen over the past 2 years.

VDO 2024

The ESC is proposing to use generally the same methodologies as in past reviews and is considering whether changes need to be made to the setting of the benchmark for the WEC and the retail operating margin.

In terms of the WEC, the ESC notes that in their final decision on the 2023-24 Victorian Default Offer (VDO), they did not include peak swap contracts in the estimation of our wholesale electricity cost benchmark. The AEC accepts that peak swap wholesale electricity futures contracts are now rarely traded and has proposedthat the ESC seek over-the-counter contract (OTC) prices from brokers and incorporate these into the modelling to estimate wholesale electricity costs.

For the 2023–24 VDO  the ESC set the retail margin at 5.3 per cent based on benchmarks set by other regulators and having regard to the expected returns model. The AEC proposes that the ESC make explicit its assumptions in determining the 5.3 per cent, so that there is more transparency about what earnings before interest, taxes, depreciation, and amortization (EBITDA) the ESC is targeting and how it makes its selection within the range of observed variables. With respect to the other regulators (Independent Competition and Regulatory Commission, Office of the Tasmanian Economic Regulator and Queensland Competition Authority) that the ESC uses as a comparison point, the AEC does not believe they are comparable market environments given each is regulating a market with a dominant incumbent retailer and limited competition.

Summary

Retailers have been competing in a highly volatile and challenging environment as the below graph from the ACCC shows:^[2]

There is a fine balance regulators need to find when setting the default market offer price, between protecting customers from unreasonably high prices and ensuring investors are compensated for the capital they provide retailers. The AEC considers that in recent years the retail market is becoming increasingly unattractive for equity investment. There has been a record level of Retailer of Last Resort (RoLR) events over the last 18 months and that as the AER noted in its State of the Energy Market Report 2023, the market remains vulnerable to supply or demand shocks:

While wholesale prices have subsided since a peak in 2022, the market remains vulnerable to supply or demand shocks. Reliability issues with coal-fired generation assets and managing the increasingly peaky shape of customer demand could also put upward pressure on wholesale costs.^[3]

In this environment it will be critical for both the ESC and AER to ensure that 2024 default market offers adequately supports the ongoing strength of the retail market.

[1] ACIL Allen (2023) Report to Australian Energy Regulator - Default Market Offer 2023-24, Wholesale energy and environment cost estimates for DMO 5 Draft Determination, February 2023, p16.

[2] ACCC (2022) Inquiry into the National Electricity Market – November 2022 Report at https://www.accc.gov.au/about-us/publications/serial-publications/inquiry-into-the-national-electricity-market-2018-25/inquiry-into-the-national-electricity-market-november-2022-report p.73

[3] AER (2023) State of the Energy Market at https://www.aer.gov.au/publications/state-of-the-energy-market-reports/state-of-the-energy-market-2023 p.230