Submission to the Electricity Market Review September 2014

Transcription

1 Submission to the Electricity Market Review September

2 About CCI... 2 Executive summary... 3 Electricity market context... 4 Encouraging competition in wholesale and retail markets... 5 Restructuring Synergy is essential... 5 Introduce full retail contestability... 7 Introduce independent retail price regulation... 9 Reform the application of the Tariff Adjustment Payment Fund the Horizon Power subsidy from consolidated revenue Improving incentives for efficient investment in networks Privatise Western Power Addressing fuel cost pressures Improve gas market transparency and investment signals Reverse government policies that limit coal production Market mechanisms and institutional arrangements Improve demand forecasting Elevate the role of markets in securing resource adequacy Carefully manage the transition

3 About CCI The Chamber of Commerce and Industry of Western Australia (CCI) is the peak organisation representing business in Western Australia. It is the second largest organisation of its kind in Australia, with a membership of over 9,000 businesses across all sectors of the economy. CCI aims to build a competitive and productive business environment in Western Australia by promoting free enterprise through advocacy and essential services that make it easier to do business. CCI s vision is for Western Australia to be a world leading place to live and do business. 2

4 Executive summary CCI has consistently argued that the best way to achieve a secure and affordable supply of electricity in Western Australia is by increasing the openness, transparency and competitiveness of the electricity market. The Electricity Market Review should seek to ensure that the electricity market in the South West Interconnected System (SWIS) is transparent and appropriately regulated, barriers to entry are minimised, and energy supply chains have competitive ownership structures. CCI advocates the following key reforms: structurally separate and privatise Synergy, the dominant State-owned vertically integrated generator/retailer, to create additional competition in the wholesale and retail markets and improve the efficiency of the provision of these services; introduce full retail contestability (FRC), to permit competition in the retail market for small electricity customers, enable the pass through of savings in the wholesale electricity market and network services, and improve product offerings; privatise Western Power, the monopoly network service provider, to improve the efficiency of the provision of network services; and elevate the role of markets in securing resource adequacy, to ensure an efficient level of generation capacity is secured. The structural separation of Synergy and the introduction of FRC are likely to result in the biggest efficiency gains and savings to electricity customers, but the benefits from privatising Synergy and elevating the role of markets in achieving resource adequacy will also have significant benefits. Other related reforms that should be progressed include the following: appoint an independent regulator to determine electricity tariffs, to depoliticise the setting of regulated tariffs as an interim measure until effective retail competition develops; amend the Tariff Adjustment Payment (TAP) subsidy such that it is paid to customers through reductions in Western Power s network tariffs or directly through their chosen electricity retailer, and phase out the subsidy over time; should the government retain tariff equalisation as a policy, the Tariff Equalisation Contribution should be funded from consolidated revenue; and reverse State government policies that limit coal production in Western Australia, to increase the supply of coal available for electricity production. 3

5 Electricity market context Electricity Market reform in the SWIS to date has benefitted many large customers through increased competition and lower-priced electricity, however, reform progress has stalled and the majority of customers who are small have not benefitted to the same extent. The primary objective of the electricity market is to promote the economically efficient, safe and reliable supply of electricity related services in the SWIS. 1 The electricity market in the SWIS is currently failing this objective for many customers. 2 Synergy s cost of supplying electricity is higher than in most other parts of Australia and average costs are expected to rise by up to 20 per cent over the next four years. To keep prices below Synergy s cost of supply, the electricity subsidy from Western Australian taxpayers is currently over $600 million per year and projected to total $2.4 billion over the next four years. 3 This places a considerable burden on taxpayers and diverts funding from essential Government services such as health and education. A lack of competition in the wholesale electricity market, due to its high level of market concentration, results in much higher wholesale electricity costs than those in the National Electricity Market (NEM). There is significant excess generation capacity in the SWIS which increases electricity costs for customers through excess capacity payments. In , generation capacity in the SWIS was equivalent to per cent of that required to satisfy the reserve capacity requirement. State-owned enterprises continue to dominate all sectors of the electricity market (generation, networks, transmission, and retail), and taxpayers bear the majority of the financial and risk burden of electricity supply. Greater private sector participation would improve the Government s balance sheet and improve the efficiency of electricity supply. Household and small business customers are not able to choose their electricity retailer and do not benefit from the savings that retail contestability has delivered for medium to large businesses. A lack of retail competition limits the range of product offerings available to customers, such as innovative tariff structures and information services. There is significant uncertainty as to the future direction of energy policy, and particularly the role of government in the sector. Uncertainty decreases the responsiveness of investment to changes in demand and increases prices for consumers. The case for reform of the electricity market in the SWIS is now overwhelming and cannot be ignored. Doing nothing is not an option. To do so would consign Western Australia to increasing relative electricity costs and ultimately reduce the competitiveness of Western Australia as a place to do business and the standard of living of its citizens. 1 As in the Electricity Industry Act Electricity Market Review Steering Committee 2014, Electricity Market Review Discussion Paper, July. 3 Western Australian Government 2014, State Budget , Perth. 4

6 Encouraging competition in wholesale and retail markets Discussion Paper questions addressed in this section In developing competitive electricity markets how important is the structural separation of Synergy into several generators and retailers? Do you see the structural separation of Synergy as important for achieving a competitive market? Do you see regulating Synergy to mitigate its market power as a superior or inferior option to structural separation into two or three sets of assets? Should the retail electricity market be opened to FRC and should all retailers also be able to retail gas? In moving to a market that can accommodate FRC, how should the TAP and TEC be handled? Should the TEC continue to be funded from SWIS distribution tariffs, or instead be funded from consolidated revenue? The Electricity Market Review Steering Committee (the Steering Committee) has identified a continuing lack of competition as a key reason for the high cost of electricity supply in the SWIS. The Steering Committee has stated: In considering the current industry structure, we identify the dominance of state-owned enterprises and the absence of full retail contestability (FRC) as potentially constraining competition that would drive efficiencies and place downward pressure on costs. 4 CCI agrees with this assessment and considers the facilitation of competition in wholesale and retail markets as the principal opportunity to reduce costs. Both the structural separation of Synergy and the introduction of FRC would have net benefits for the community. Restructuring Synergy is essential In January 2014, Synergy produced 55 per cent of the electricity generated in the SWIS. The Steering Committee has identified the weak competition amongst generators, in addition to relatively low transparency around forward prices, as significant contributors to the high costs of wholesale electricity in the SWIS. As outlined in the Discussion Paper, the Steering Committee has found that that the portfolio generation cost for Synergy is about $180 per MWh although CCI understands that the average portfolio cost for other market participants market may be lower than this. In comparison to the high levels of market concentration in the SWIS, the most concentrated market in a NEM region is South Australia, where the largest generator holds a 35 per cent market share (figure 1). South Australia is also the NEM region with the highest average wholesale electricity cost of about $100 per MWh. In Queensland, the largest generator 4 Electricity Market Review Steering Committee 2014, Electricity Market Review Discussion Paper, July, p. iv. 5

7 Market share holds 33 per cent market share, in New South Wales 27 per cent and in Victoria 25 per cent. Average wholesale electricity costs in these regions are lower at about $60 80 per MWh. 5 In 2013, the Australian Energy Market Commission (AEMC) assessed whether there was substantial market power in any of the four largest NEM regions (News South Wales, Victoria, Queensland and South Australia). The AEMC found that market outcomes do not support a conclusion that there is substantial market power in each of the regions. 6 The NEM is a different market to the SWIS, and competition there may be enhanced by the more transparent functioning of the NEM gross pool market. However, market concentration in the NEM may still provide a useful benchmark with which to assess the industry structure that would be conducive to effective wholesale competition in the SWIS. Figure 1 Generation market share in the SWIS and NEM regions 7 100% 90% 80% 70% 60% Other 5.8% Collgar 4.1% Alinta 8.7% Newgen 10.2% Bluewaters 15.8% 50% 40% 30% 20% Synergy, 55.4% 10% 0% SWIS Qld NSW Victoria SA Notes: For the SWIS, market share is proportion of electricity generated in January For Queensland, New South Wales, Victoria and South Australia, it is based on installed capacity in January The high level of market concentration in the wholesale electricity market in the SWIS is unlikely to change in the next ten years without concerted action. Synergy s market share fell progressively from over 85 per cent in to about 55 per cent in but has been stable since then. 8 In part, the decline in Synergy s market share was the result of a ministerial direction capping Synergy s generation portfolio at 3,000 MW, and incentives through the capacity market that have resulted in excess but diversely owned generation capacity. The most recent demand forecasts for the SWIS project that no new capacity will 5 Electricity Market Review Steering Committee 2014, Electricity Market Review Discussion Paper, July. 6 Australian Energy Market Commission 2013, Potential Generator Market Power in the NEM Final Rule Determination, 26 April 2013, Sydney. 7 Independent Market Operator 2014, Explore the Market, (accessed 8 September 2014); Australian Energy Regulator 2013, State of the Energy Market 2013, December. 8 Independent Market Operator 2014, Explore the Market, (accessed 8 September 2014). 6

8 be required in the SWIS until and, as a consequence, Synergy s market share is likely to remain stable for this period. Given the high cost of wholesale electricity and continuing high market concentration in the SWIS, CCI supports the structural separation of Synergy as the most effective option to increase the level of competition. There are few other feasible alternatives to structural separation of Synergy. Divesting Synergy of individual generation plant would reduce Synergy s market share but if the plant is purchased by incumbent operators then the existing high level of market concentration would be rebalanced rather than reduced. There may also be additional complications with this approach due to the need to reallocate Synergy s existing fuel contracts. Another option is price regulation, which could require Synergy or other market participants to price their services at long-run marginal cost, or cap revenues at an appropriate level. However, price regulation would have the following significant costs for Synergy, the regulator, and the broader market: 10 costs of administering and complying with a price regulation or monitoring regime, including the cost of making regulatory proposals and responding to proposals, and monitoring compliance with regulated prices; the cost of regulatory errors such as those that may be caused by asymmetric information between the regulated entity and the regulator and the requirement of the regulator to make decisions based on imperfect information; lobbying costs and rent seeking if regulated entities invest resources into maximising its revenue from price determinations, or make ambit claims to increase prices; and investment distortions due to regulatory risk stemming from price determinations or delays if investment is reliant upon price determinations. Unlike a transitional retail price regulatory regime that might operate following the introduction of FRC, price regulation of the wholesale electricity market would likely be enduring. Price regulation would also be futile if Synergy s cost structure is itself inefficient, and this is only likely to be determined conclusively through comparison of costs in a competitive market. Introduce full retail contestability There is retail competition in the SWIS for customers consuming more than 50 MWh of electricity per year (approximately $11,000). However, the vast majority of small businesses and households are not able to choose their electricity supplier and must purchase their electricity from Synergy. Western Australia is now the only jurisdiction in Australia not to have implemented FRC for electricity customers. 11,12 9 Independent Market Operator 2014, SWIS Electricity Demand Outlook, June. 10 Productivity Commission 2012, Australia s Urban Water Sector, Melbourne. 11 Australian Energy Market Commission 2013, Advice on best practice retail price methodology, September. 12 FRC was introduced in the Northern Territory in 2009 and Tasmania in 2014, however, there is currently a single retailer for households in each state. 7

9 If FRC was introduced in the SWIS, competition would be likely to develop quickly in the market for small business and household customers. In each of the NEM states, there are a minimum of six electricity retailers, and customer switching rates of between 13 and 30 per cent per year. 13 Perth Energy, an independent retailer operating in the contestable market in the SWIS, has publicly stated that it would enter the household retail market if FRC was introduced even if existing subsidies to Synergy are retained. 14 In the contestable market, independent retailers have won significant market share from Synergy and now supply over 50 per cent of demand from contestable customers. 15 In the gas market in Western Australia, the introduction of FRC has resulted in the development of retail competition. After several years of the household and small business gas market being served by a single retailer, Wesfarmers entered the household and small business market in Wesfarmers entry into the market has been despite the existence of regulated tariff caps, and demonstrates the benefits that can be delivered through competition Wesfarmers is currently advertising discounts of 10 per cent on regulated gas tariff caps for two years. Expanded retail contestability would have a number of benefits for newly contestable small business and household customers, as well as existing contestable customers. Competition between retailers would result in lower retail margins, improved services, and innovative products. Retail competition would ensure that the full value of any savings in the wholesale electricity market and networks are passed on to newly contestable customers. A larger contestable market may result in greater economies of scale for existing retailers, benefitting existing contestable customers. Greater retail competition would increase incentives for retailers to seek savings in the supply chain, potentially driving efficiency gains in the wholesale electricity market. FRC combined with time-of-use metering could result in tariff structures that more accurately reflect the cost of using electricity at different times of the day, reducing peak demand, network and generation costs. In addition to benefits to electricity customers, it is likely that FRC would also benefit gas customers as retailers are likely to bundle gas and electricity offers and pass the savings from economies of scale on to customers. Although FRC is likely to have significant benefits, it will also have costs. Introducing FRC would require systems and infrastructure to be developed to enable the transfer of customers and data between retailers. The development of these systems may require significant initial set-up costs and operational costs to maintain. For example, the systems required to introduce FRC in gas in Western Australia were estimated to require one-off 13 Australian Energy Regulator 2013, State of the Energy Market 2013, December. 14 Kerr, P. 2012, We can sell cheaper power to householders', The West Australian, 12 July. 15 Electricity Market Review Steering Committee 2014, Electricity Market Review Discussion Paper, July, Figure 6. 8

10 capital costs of $12 million and non-capital costs of $1.3 million per year. 16 There is limited publicly available information on the benefits and costs of introducing electricity FRC in other comparable jurisdictions. However, a benefit-cost analysis of electricity FRC in the SWIS by the Retail Energy Market Company (REMCo) found that a conservative 2.5 per cent saving over cost-reflective regulated tariffs would result in benefits exceeding costs. 17 The ultimate aim of FRC is to develop effective competition in the retail market, such that the offers presented to customers reflect the efficient cost of supply including a profit margin for retailers. However, in the initial period following the introduction of contestability, there is likely to be an interim period in which competition will be developing and customers become aware of competing retail options. In some jurisdictions, retail price regulation has been maintained as a safety net for customers until competition has been deemed to be effective, and a similar approach could be taken in Western Australia. Introduce independent retail price regulation The introduction of FRC would be assisted by, but is not dependent upon, the introduction of cost reflectivity of electricity retail tariffs (discussed below). In the SWIS, the State Government still determines the price of electricity for residential and small business customers and is only one of two State or Territory governments to do so. 18 The State Government currently sets electricity prices below Synergy s cost of generating, distributing and supplying electricity. Successive Western Australian governments have been unwilling to pass on even small cost increases to electricity customers reflecting inflation. Electricity prices were frozen for a number of years up to 2009, leading to an expansion in the TAP. In recent years, the Western Australian Government has recognised the need to move towards cost reflectivity and has increased tariffs. Despite the increases implemented, it has been estimated that there is a 30 per cent gap between regulated residential tariffs and Synergy s cost of supply. 19 The subsidisation of electricity prevents price signals from influencing consumption, meaning the incentives to moderate electricity use, such as through behavioural change (switching off lights and appliances when not needed) and the purchase of more efficient appliances, are dulled. By making Synergy s tariffs fully cost reflective, these price signals would be improved, and there would be savings over the long term through more efficient use of, and investment in, the electricity system. As an interim measure until effective retail competition develops, it is recommended the Government appoint an independent regulator to determine electricity tariffs to depoliticise 16 Office of Gas Access Regulation 2003, Final Decision Recovery of Costs Associated with the Introduction of Full Retail Contestability in the Mid-West and South-West Gas Distribution Networks. 17 REMCo 2014, Electricity Full Retail Contestability in Western Australia Detailed Report, July. 18 In the Northern Territory retail electricity tariffs and charges are regulated by the Territory Government. 19 Nahan, M. 2014, Questions on Notice Supplementary Information, B9EE16C2FE904FE748257C6F0013D8D0/$file/ef.aar aqon.001.Synergy.pdf (accessed 8 September 2014). 9

11 the setting of regulated tariffs. As noted above, price regulation is costly, but independent price regulation would be an improvement over the current arrangements where the State Government sets electricity tariffs. Under FRC, price regulation could be removed once retail competition was deemed to be effective as was the case in Victoria and South Australia. 20 Reform the application of the Tariff Adjustment Payment Although cost-reflective pricing would assist in the development of retail competition, it is not absolutely necessary for retail competition to develop. As noted by the Steering Committee, the subsidy paid by the Western Australian Government to keep electricity costs below Synergy s cost of supply does not need to be paid directly to Synergy. Instead, the subsidy should be provided to customers through reductions in Western Power s network tariffs or directly to customers through their chosen electricity retailer. 21 The subsidy could then be phased out over time as cost reductions in the electricity system resulting from reforms are realised. Providing the subsidy through a reduction in Western Power s network charges is likely to be the least administratively expensive of the two options as the subsidy could be paid as one lump sum to Western Power, whereas providing the subsidy through retailers may require apportionment based on the number of customers and/or their usage. If the subsidy policy is amended, the chosen allocation mechanism and design of the subsidy should include consideration of its effect on economic efficiency. Where a subsidy is applied to variable charges on an electricity customer s bill, it can undermine pricing signals and result in wasteful consumption. A more efficient way of apportioning the subsidy may be as a fixed credit to customers bills. However, CCI understands that the relationship between variable/fixed costs and variable/fixed charges is already weak in the electricity sector and so it is not clear that applying a fixed credit to customers bills would actually improve efficiency. A more complicated issue will be determining the size of the appropriate subsidy to provide to customers through either Western Power or their retailer. At present, the relationship between Synergy s costs and the efficient cost of supply is not clear. If Synergy s costs are higher than efficient costs, then a lower level of subsidy could be provided to the current level of the TAP while keeping prices at a comparable level. The remainder of the existing TAP could then be used to offset Synergy s losses as it improves its efficiency in a competitive market. An independent regulator would be best placed to determine the efficient cost of supply in the SWIS, as part of a transitional price regulation regime. Fund the Horizon Power subsidy from consolidated revenue Electricity customers in the SWIS continue to be charged the Tariff Equalisation Contribution (TEC) to ensure the price of electricity in Western Australia s regions is the same as it is in Perth. Tariff equalisation is a social policy decision, and the TEC inefficiently adjusts prices for SWIS customers to subsidise those in the regions. Should the Government retain tariff 20 Australian Energy Regulator 2013, State of the Energy Market 2013, December. 21 Electricity Market Review Steering Committee 2014, Electricity Market Review Discussion Paper, July. 10

12 equalisation as a policy, it should be funded from consolidated revenue, not through a cross subsidy. Although the TAP and sub-cost-reflective retail tariffs for non-contestable electricity customers offset the distortionary effects of the TEC on these customers (while creating other distortions), contestable customers bear the full effect of the TEC in their electricity prices. Hypothecation is often used to promote public acceptance of a tax, but it introduces rigidities into Government financing and shields hypothecated expenditure from appropriate budget scrutiny. Directly funding the TEC from consolidated revenue would improve the transparency and governance of the subsidy to Horizon Power. An alternative to funding the Horizon Power subsidy from consolidated revenue is to fund it from Royalties for Regions which would also remove the price distortion of the TEC for metropolitan electricity customers while retaining the Government s social policy objective. 11

13 Improving incentives for efficient investment in networks Discussion Paper questions addressed in this section What industry changes need to be made to reduce subsidies? In the Electricity Market Review Discussion paper, the Steering Committee reported that SWIS transmission and distribution costs are lower than most [other] distribution areas, which is contrary to expectations as the SWIS is a longer and less dense network than most. 22 Based on this assessment, the focus of the Discussion Paper, including the discussion on network access, is on addressing issues in the wholesale electricity market. CCI considers there are at a few factors which, when factored into the Steering Committee s analysis, warrant further consideration of cost issues in the electricity network. Network costs in the SWIS do not reflect the full capital expenditure approved by the Economic Regulation Authority (ERA) in Western Power s third access arrangement. Western Power has stated that there is a shortfall of $1.085 billion between its approved capital expenditure and that approved by the Western Australian Government (discussed in greater detail below). 23 The Productivity Commission has found that flaws in the national regulatory regime led to inflated costs of capital and created incentives for inefficient investment. 24 As such network costs in the NEM may not be a suitable benchmark for efficient costs. Some of the difference in network cost between the SWIS and NEM reflect the lower Weighted Average Cost of Capital used by the ERA compared to that used by the Australian Energy Regulator in the NEM. 25 However, this does not reflect inherent differences in the efficiencies of operational or capital expenditure of the different networks. The differences in assessed networks costs in the NEM therefore may not provide an accurate reflection of the relative efficiency of the transmission and distribution network in the SWIS and the scope for efficiencies. Privatise Western Power CCI considers that reform of the SWIS should support the role of the private sector in all facets of the electricity market in generation, networks, transmission and retail. The sale and privatisation of government-owned businesses has been a foundation principle of Australia s successful microeconomic reform policy for the past two decades. The National Competition Policy reforms of the 1990s encouraged the corporatisation of 22 Electricity Market Review Steering Committee 2014, Electricity Market Review Discussion Paper, July. 23 Western Power 2013, Annual Report 2013, Perth. 24 Productivity Commission 2013, Electricity Network Regulatory Frameworks, Report No. 62, Canberra, p Economic Regulation Authority 2014, Final Decision on Proposed Revisions to the Access Arrangement for the Western Power Network, September. 12

14 government-owned businesses. The assumption made then that competitive pressures and private sector profit motives would result in reduced costs for consumers and improvements in community well-being still holds today. Privatisation of transmission and distribution networks is being progressively undertaken across Australia. Full privatisation of electricity networks has been undertaken in Victoria and South Australia and the network in the ACT is 50 per cent privately owned. 26 The New South Wales Government has proposed leasing 49 per cent of its electricity network and the Queensland government is reportedly considering the sale of its network. There may be significant benefits to customers from the sale of Western Power or the long-term lease of the network to the private sector. The Productivity Commission, in a study of electricity regulation in the NEM, found that privately-owned network businesses are better at efficiently meeting the long-term interests of their customers. The Productivity Commission stated: While governments have a legitimate role in owning and operating many services in Australia, the rationale for state-ownership of electricity network businesses no longer holds. This reflects the development of sophisticated incentive regulations that function best when the regulated businesses have strong cost-minimising and profit motives. 27 Comparison of the relative efficiency of government and private networks reveals that privately-owned networks tend to be more efficient. When corrected for customer density, privately-owned electricity networks typically have lower operational expenditure per kilometre of network (figure 2) and more customers per employee than government-owned networks (figure 3). The Productivity Commission found that state-owned network businesses have conflicting objectives, which reduce their efficiency and undermine the effectiveness of incentive regulation. Conflicting objectives for electricity network businesses identified by the Productivity Commission include: social and environmental obligations; requirements to procure locally; a lack of coherence of governments in their dealings with the businesses over time; employee benefits and job security for employees that exceed those in private businesses; and poor governance, including appointment of board members on a non-merit basis. Importantly, while Government influence in the operations of government-owned businesses can be explicit, such as in legislation or through ministerial directions, it can be also be tacit and this is very hard to monitor and assess. 26 Australian Energy Regulator 2013, State of the Energy Market 2013, December. 27 Productivity Commission 2013, Electricity Network Regulatory Frameworks, Report No. 62, Canberra. 13

15 Customers per employee Opex per km ($) Figure 2 Operational expenditure and customer density for government-owned and privately-owned electricity distribution networks in the NEM and SWIS 28 90,000 80,000 70,000 60,000 Government 50,000 40,000 Private 30,000 20,000 10, Customers per km Figure 3 Distribution networks in the NEM and SWIS, customers per employee Private Government Customers per km The ERA in a recent report on Microeconomic reform in Western Australia, found that there was a conflict of interest in the Western Australian Government s ownership of Western Power and setting policy objectives and legislation for the regulation of networks in the 28 Australian Energy Regulator 2013, State of the Energy Market 2013, December, Figure 2.7; Current network revenue decisions aer.gov.au, erawa.com.au; Western Power Annual Report Reproduced and expanded from Productivity Commission 2013, Electricity Network Regulatory Frameworks, Report No. 62, Canberra, Figure 6.16; Western Power 2013, Annual Report 2013, Perth; Western Power Annual Report

16 SWIS. The ERA found that with the appropriate regulation, the private sector could provide network services at a level consistent with society s interests. 30 There are a few prominent examples where Government has exercised influence over Western Power which may have negatively affected the efficiency of its operations. This includes the following two ministerial directions. In July 2012, the Government directed Western Power to double the compensation payment required by statute for households affected by a long power outage (Electricity Corporations Storms Supply Interruption Payment Direction 2012). In September 2012, the Government directed Western Power not to appeal a regulatory decision by the ERA regarding its approved revenues (Electricity Networks Corporation September 2012 Access Arrangement Review Direction). Although these directions have reduced the short-term costs for customers, or increased payments to customers, they undermine the commercial imperatives of Western Power. To the extent that the ministerial directions result in Western Power being less able to finance priority expenditure, reduced dividend payments, or contributed to additional costs for other customers (cross-subsidies), they may have reduced Western Power s efficiency. Western Power s government ownership has also proved to be a constraint on the corporation s ability to finance capital expenditure approved by its regulator. In Western Power s second access arrangement, Western Power spent less than the expenditure approved by the ERA due to government budget constraints. 31 Western Power has also reported a shortfall of $1.085 billion between the approved capital expenditure in its third access arrangement and that approved by the Government. 32 In response to the funding shortfall, Western Power has indicated it has been necessary for it to continue to prioritise asset replacement programs in areas and asset types (such as wood poles and conductors) assessed as presenting the highest risk of failure 33. The implication is that other projects, including those to improve services or the efficiency of the network have been deferred or cancelled. To illustrate the efficiency enhancing capital expenditure that may be at risk, in the third access arrangement period the ERA approved $87 million in capital and operational expenditure to install smart metering infrastructure to support the rollout of 280,000 smart meters. 34 Western Power developed a business case for the project demonstrating operational efficiencies, improved reliability and peak demand management. The estimated net benefits to the market of the smart metering infrastructure is $149 million over 20 years. 35 If this program is one of those deferred, it would represent a prime example of the types of efficiencies that would be available if Western Power was privatised. 30 Economic Regulation Authority 2014, Inquiry into Microeconomic Reform in Western Australia Final Report, June. 31 Economic Regulation Authority 2014, Inquiry into Microeconomic Reform in Western Australia Final Report, June. 32 Western Power 2013, Annual Report 2013, Perth. 33 Western Power 2013, Annual Report 2013, Perth. 34 ERA 2012, Final Decision on Proposed Revisions to the Access Arrangement for the Western Power Network, September. 35 Western Power, Smart Grid Proposal, %20D76321%20-%20Access%20Arrangement%20Information%20-%20Appendix%20R%20 %20Smart%20Grid%20Proposal.PDF (accessed 8 September 2014). 15

17 Addressing fuel cost pressures Discussion Paper questions addressed in this section Will there be sufficient gas reserves for future electricity generation needs? How can the transparency and liquidity of the local gas market be improved? How can new domestic gas supplies best be encouraged by downstream markets? Would there be material benefit in establishing a gas supply hub in Western Australia? How should it be implemented? Developments in commodity markets for gas, coal and oil have a significant effect on the electricity sector and the security of electricity supply. Growing demand for energy exports, in particular liquefied natural gas, has created pressures in the domestic gas market, driving up the price of domestic gas and electricity, and shifting investment incentives. There is uncertainty about the adequacy of future gas supplies to the domestic market. The Independent Market Operator (IMO) has forecast that supplies may not be sufficient in the period 2021 to 2023 if the North West Shelf joint venture partners, the largest supplier of gas to the domestic market, do not supply gas to the domestic market beyond the expiry of existing contracts in Future supplies by the North West Shelf joint venture partners are contingent upon negotiations with the State Government and investment decisions to access remaining undeveloped reserves and to extend the life of the ageing Karratha Gas Plant. However, increasing liquefied natural gas and gas prices, and changes to regulations, have also driven investment in domestic gas processing, including Apache s new plant at Devil Creek and BHP Billiton s Macedon Gas project, and in exploration for unconventional sources of gas. Furthermore, domestic supplies rely on export opportunities to deliver capital investment. Concerns about the impact of higher gas prices saw the previous Western Australian Government introduce a domestic gas reservation policy. Some 15 per cent of reserves are now required to be set aside for domestic use. However, it is not clear that the policy has achieved its objective of providing Western Australian gas users with certainty over supplies. The policy also has the potential to discourage exploration and distort future investment decisions in new gas fields for both domestic and export-based production. Improve gas market transparency and investment signals The IMO has characterised the gas market in Western Australia as opaque with little public information about contracted gas prices or volumes. 37 To better facilitate the availability of gas to domestic users, the State Government should continue to support reforms to improve market transparency, investment signals and ultimately to increase the liquidity in the domestic market. 36 Independent Market Operator 2014, Gas Statement of Opportunities, January. 37 Independent Market Operator 2014, Gas Statement of Opportunities, January. 16

18 Some important reforms have already been introduced. The gas bulletin board and gas statement of opportunities commenced operation in 2013 and provide the opportunity to better understand gas demand and signal investment in domestic supply. However, the gas bulletin board and statement of opportunities need time to be refined and develop into a more useful snapshot of the domestic gas market. In downstream markets, the State Government should support industry efforts to develop short-term gas and pipeline capacity trading markets in Western Australia. Private trading platforms for gas are already emerging for major domestic users, demonstrating how the private sector can respond to market signals, but it remains to be seen whether these will be able to provide the trading mechanism and market transparency required. 38 The Gas Trading platform commenced operation in 2009 and provides a platform for the sale and purchase of natural gas a month in advance, with prices and volumes published on its website. The volume and price of gas traded is published, but the market is not a short-term market. The Energy Access platform commenced operation in 2010 and provides opportunities for gas sellers and buyers to trade short to medium-term gas supply. However, the volume and price of gas traded is not published. CCI has been advised that gas pipeline capacity is traded bilaterally in Western Australia. Western Australia s Gas Advisory Board, comprising representatives of gas producers, pipeline owners, shippers and users, is currently investigating the development of a short-term trading market for gas and pipeline capacity in Western Australia. 39 A short-term trading market would likely improve transparency in the market but would also have implementation and operational costs. If a formal trading market supported by the industry can increase transparency of the price and availability of gas or pipeline capacity and in doing so reduce transaction costs, then it should be actively pursued. Reverse government policies that limit coal production Energy exploration and production in Western Australia is being hampered by Western Australian Government policies. In 2013 the Western Australian Government enacted a blanket ban on coal mining in the Margaret River region without any strategic assessment of the region. 40 The decision followed an impact assessment and appeal for one project in the region under which other existing and potential investors had no indication it would form the basis of a more wide ranging decision. CCI unsuccessfully lodged an appeal on the environmental impact assessment report, on the basis of the openness, transparency and fairness of the EPA s assessment. In making its decision, the Government effectively ignored the option of a strategic environmental assessment and with it the benefits of transparency and wide ranging consultation. 38 Australian Energy Market Operator; Retail Energy Market Company 2013, Business Case for a Short Term Trading Market in Western Australia. 39 Gas Advisory Board 2014, Agenda July Moore, N. 2012, Ministerial Media Statement No coal mining for Margaret River, Barnett&StatId=6176 (accessed 9 May 2014). 17

19 Market mechanisms and institutional arrangements Discussion Paper questions addressed in this section Could alternative capacity mechanisms work within the current industry structure? Could the capacity mechanism be carried out one year ahead rather than two years to minimise forecasting error? Are there other ways to provide the market with sufficient reserve at lower cost? Would one or more IMO auctions for capacity, in which only capacity to meet the Reserve Capacity Requirement was acquired, produce more competitive prices for capacity? Are there alternative methods for lowering capacity acquisition costs that should be considered? What do you consider the most important matters to be managed in a transition to the NEM? The wholesale electricity market in the SWIS is unique in Australia, in that it comprises both an energy market and a capacity mechanism. Under this arrangement, generators receive revenue streams for the electricity they sell to major users and retailers; and for making their capacity available throughout the year to meet forecast peak demand. The capacity mechanism in the SWIS is distinct from a capacity market. In the SWIS, the per megawatt price paid for capacity is administratively determined using a formula set out in the market rules. In a true capacity market the price of capacity is determined by the forces of supply and demand and capacity that is excess to requirement does not receive capacity payments. The Steering Committee and others (for instance, the ERA) have identified the high cost of capacity payments in the SWIS as a significant contributor to the high portfolio cost of generation in the SWIS relative to other regions of Australia. There are two issues with the capacity mechanism which have resulted in inflated costs. 1. Capacity mechanisms and markets require centralised estimates of peak demand and reserve margins (the reserve capacity requirement) in order to allocate reserve requirements among market participants and create a minimum level of demand for generation capacity. The IMO s forecasts of peak demand have exceeded actual peak demand by a wide margin, resulting in a reserve capacity requirement much higher than actually required. 2. The price for capacity determined by the market rules has been too high, encouraging more investment in generation capacity than has been required to achieve the elevated reserve capacity requirement. In , generation capacity equivalent to per cent of the reserve capacity requirement was certified. In addition to deficiencies identified with the capacity mechanism, Government policies such as the Renewable Energy Target have also contributed to excess generation capacity in the SWIS. 18

20 The Steering Committee has estimated that the cost of excess capacity including forecasting errors to be $114 million per year on average, or a total of $1.03 billion in the period to The ERA has estimated the cost of excess capacity excluding forecasting errors has been $35 million per year on average, or a total of $279 million over the period to Given the significant excess costs attributed to the capacity mechanism, there is a strong case for reform. Improve demand forecasting With regard to the forecasting errors by the IMO, there are likely to be costs to market participants due to under or over-estimation of demand regardless of the market mechanism employed. In particular, the decrease in electricity demand in the SWIS and the NEM following the global financial crisis was not expected by market participants or operators and has contributed to excess capacity in both markets. Under a capacity mechanism or market, costs from forecasting errors are socialised and paid for by electricity customers through capacity payments. In an energy-only market, the costs accrue to individual generators or retailers, but are ultimately socialised through higher prices to compensate investors for the higher demand risk. The IMO implemented a change to its forecasting approach in 2012, under which it takes a more conservative approach to the inclusion of new large loads. The following other reforms could also improve the accuracy of forecasting of the capacity requirement. Carrying out the capacity mechanism one year ahead, instead of two. Introducing a requirement for large loads to provide security to cover the costs they cause in the capacity market, similar to the security required of prospective generators to secure capacity credits, could insulate other market participants from the costs incurred if the loads do not eventuate. This was suggested by Synergy in the Market Development Rule Suggestion Log 43 and would be consistent with a user pays philosophy and encourage large loads to present accurate information to the IMO. Introducing incremental procurement under a capacity market as is practiced by PJM Interconnection. Under this arrangement, capacity is procured in stages over a number of years. For example, 50 per cent of the requirement could be acquired three years out, 35 per cent two years out and 15 per cent one year out. If the peak demand forecast has changed in the out years then the amount of capacity to be acquired can be changed to reflect this. Elevate the role of markets in securing resource adequacy An administratively-determined capacity price benefits from simplicity over market mechanisms but is unlikely to ever result in an efficient price for capacity. This is because administratively-determined prices are unable to respond dynamically to changes in the 41 Electricity Market Review Steering Committee 2014, Electricity Market Review Discussion Paper, July. 42 Economic Regulation Authority 2013, 2012 Wholesale Electricity Market Report for the Minister for Energy, April, Table Independent Market Operator ND, Market Rules Evolution Plan: , _ _final.pdf?sfvrsn=2 (accessed 8 September 2014). 19

21 supply and demand for capacity, and as such do not provide accurate signals for investment. The weaknesses of the current capacity mechanism in the SWIS include: The formula used to calculate the price paid for capacity is equal to 85 per cent of the long-run capital cost of a gas-fired peaking plant less an adjustment factor. The starting discount rate (15 per cent) is arbitrarily determined, and does not reflect market conditions. Generators can expect to earn some revenue above their short-run marginal cost in the energy market, and may be overcompensated as the capacity price is based solely on the capital costs of generation. All certified capacity receives the capacity price regardless of whether it is actually necessary. An adjustment factor reduces the price paid for capacity by one per cent for every per cent of excess capacity above the reserve capacity requirement determined by the IMO, such that the total amount paid for capacity does not change to reflect changes in demand and supply. Auctions are only held when the IMO assesses that there is insufficient capacity to satisfy the reserve capacity requirement. Because to date the market has always had excess capacity, this is yet to occur and the capacity price has never been marked to market. A review of the capacity price formula between 2012 and 2014 found that the current capacity price formula is not responsive enough to excess capacity and recommended that the slope of the offer curve be steepened to decrease the capacity price by 3.5 per cent for every one per cent of excess capacity. 44 A rule change has been proposed but the IMO has deferred making a decision pending the outcomes of the Electricity Market Review. 45 The proposed rule change would increase the responsiveness of the capacity price to changes in the supply and demand for capacity, and reduce the cost of capacity payments in the present excess capacity environment. However, it would not address the other key issues with the capacity mechanism, namely the arbitrariness of its key parameters and inability to mimic the dynamisms of a market. Markets are arguably the best mechanism with which to ensure there is an efficient level of generation capacity in the SWIS however a number of challenges will need to be overcome to implement a market. The Steering Committee has identified two broad options to reform market mechanisms in the SWIS: replacing the capacity mechanism with a capacity market; or, transitioning to the NEM gross pool market. Each of the proposed options has strengths and weaknesses and the choice of market mechanism should be informed by a robust benefit-cost analysis. The benefit-cost analysis undertaken should explicitly examine the cost of administering the alternative arrangements, the risk involved in the transition, and the efficiency of the mechanism with respect to energy and resource adequacy procurement including the ability of demand side management to participate. 44 Independent Market Operator 2014, Draft Rule Change Report Changes to the Reserve Capacity Price and the Dynamic Reserve Capacity Refunds Regime, March. 45 Independent Market Operator 2014, Rule Change Extension Notice Changes to the Reserve Capacity Price and the Dynamic Reserve Capacity Refunds Regime, May. 20