A path to success or a road to nowhere?

The Victorian Government appears committed to implementing its crowning piece of Retail Electricity Market reform on 1 July. Legislation to enable the Victorian Default Offer (largely a rebranded Basic Service Offer) has passed the Parliament, and the Essential Services Commission (ESC) has provided advice to the Government setting out its views on the price of the VDO.

Concerns were raised with the ESC’s Draft Advice (and the Terms of Reference under which it was provided) by a wide array of stakeholders. Retailers were alarmed at how low the draft VDO was, but concerns were also formally raised by the Australian Competition and Consumer Commission (which has advocated its own version of default pricing), as well as other key stakeholders about the likely impact of a poorly considered policy.  More recently, two separate reports have highlighted the risks of implementing a VDO at the level proposed in the ESC’s draft advice.

How did we get here?

The challenge facing the Government today arose out of the 2017 Independent Review into the Electricity and Gas Markets in Victoria (known as the Thwaites Review). An expert panel, albeit one absent any energy market experience, was tasked with reviewing the operation of the electricity retail markets in Victoria, and asked to make recommendations on necessary reforms to deliver better outcomes for Victorian energy consumers.

The key recommendation was to abolish the existing standing offer obligations, and replace them with an obligation to have a Basic Service Offer (BSO) in its place. The BSO was broadly lambasted by almost every industry expert as being fundamentally incompatible with the outcomes it intended to deliver. Given this resounding criticism, the Victorian Government sat on the recommendation for more than a year before announcing its support in the days leading up to the November 2018 state election, referring to the VDO as ‘one of the biggest reforms to the energy sector in a decade’.

So where are we now?

In December the ESC was tasked with providing advice to the Government outlining an appropriate price for the VDO prior to 3 May 2019. Given historical experience in other jurisdictions globally, four months is a manifestly inadequate period to complete a price setting project of this nature. The task was made more difficult given the legislation enabling the VDO only became law in March, and the rules setting out how the VDO will be implemented in practice remain undecided. It helps explain why stakeholders are concerned about the long-term impacts of this policy.

What are the experts saying?

The two recent separate expert reports highlighted the risks of implementing the proposed VDO: if you set the price too low, it can only damage competition to the detriment of consumers.  It is far less risky to consumers if you set the price slightly higher.

The contention of these reports is backed up by recent comments from the ACCC, the Grattan Institute, and even St Vincent de Paul.

Former Federal Competition Policy Minister and noted economist, Dr Craig Emerson, notes in his report “Economic consequences of the Victorian Default Offer” that customers who have engaged in the market, and found offers cheaper than the VDO can only lose from the introduction of the VDO; they cannot win. This customer outcome should be extremely concerning for a Government presiding over one of the competitive retail electricity markets in the world. So competitive that approximately 50 per cent of all generally available offers in Victoria are already cheaper than the VDO proposed in the ESC’s draft advice. Yet for the vast number of Victorians who have engaged in the market and signed up to a cheaper offer, it is highly likely they are in for a price increase in the near future.

Why is it risky to set the price too low?

It is incorrect to assume that if the VDO is set too low then the only impact will be on those retailers with significant numbers of standing offer customers. The ESC has been tasked with determining the ‘efficient’ cost of supplying electricity, but has had parameters enforced that limit normal costs incurred in any competitive market, such as the costs of marketing.  So while there will undoubtedly be a hit to the large retailers initially, ultimately it is the smaller retailers who are lacking economies of scale and other ‘efficiencies’ that will be unable to recover their costs in the longer term. In practice, smaller retailers unable to recover their costs under the VDO price cap will either be forced to stop selling, or take on the customer at a loss.  The latter seems an unlikely outcome given the retailers commercial imperatives.

This does not represent a good outcome for the competitive market or consumers. Emerson states:

“As some existing retailers exit the market and new retailers are prevented from entering it, future customers will pay higher electricity prices while existing customers on standing offers will pay less.”

Emerson’s point was reinforced by Gavin Dufty of St Vincent de Paul who noted “We may see a number of smaller retailers going broke, and that will concentrate market power and increase the price for all consumers.”

So how do you de-risk the VDO

KPMG set out eight principles of prudent regulatory practice in their report “Evaluation of ESC draft advice on the Victorian Default Offer”. These principles were compared against the 22 separate cost forecasts undertaken by the ESC in its cost stack approach. While KPMG found the ESC acted reasonably in a number of elements of the methodology, overall, “the ESC’s approach to estimating the cost stack for retailers falls short of best regulatory practice in setting regulated prices. While the time and data constraints noted by ESC are valid, the methodologies employed are not consistently transparent, replicable, well accepted or representative of efficient costs faced by retailers in Victoria.”

For example it notes that the ESC’s approach to estimating wholesale purchase costs is not consistent with retailers’ practice, while the ESC draws on wholesale prices from 2012/13 to 2016/17, a period when there was relatively minor price volatility compared to the most recent years.

KPMG sets out a number of key decisions that should be reviewed and amended prior to setting the final price. KPMG stated that the ESC should:

• Investigate the relationship and sensitivities of retailers’ different load profiles against the ESC’s estimation of wholesale purchasing costs
• Estimate a long term average of LGC purchasing costs to better align with retailers’ portfolio approach to managing their LRET obligations
• Re-examine the appropriate level for volatility allowance given expected market conditions for 2019/20
• Consider the possibility of the level of VDO being set too low through modelling the compounding impacts if actual outcomes are different from estimates across the 22 inputs
• Think through whether the VDO at the level in the draft Advice remains appropriate if there is a substantial transfer of customers on to the default tariff
• Justify that the VDO is set at a level which promotes overall market efficiency
• Change the approach for any costs which the retailer cannot control to a lagged pass through mechanism in order to better manage the risks under the VDO.

The concerns highlighted by KPMG and Emerson are not the industry’s alone. The Grattan Institute provided a stark reminder to the Australian Energy Regulator during their recent determination of the Federal Government’s default market offer price:

“Risks to competition remain from any form of price cap, however. The DMO should, if anything, err on the high side. Customers are currently moving off high standing offers to lower market offers, and so the risks of setting a DMO that is too high are, in practice, modest. The same is not true of setting the DMO too low. Damage to competition, once done, takes a long time to fix.”

A quick price drop may make for a great political announcement, but is dangerous when it is not underpinned by sound economic rationale.  In the long term, we need to be very sure that the average Victorian will be better off under this policy than they were before. There is widespread expert and stakeholder opinion that they will not.