Changing the Approach to Embedded Network Prices: Simple solutions or creating problems?

How best to regulate embedded networks to protect the customer, while getting the most from them for the end user has been high on the radar in New South Wales for some time. There have been several reviews over the past half a decade and following the most recent of these, the NSW Government released an Embedded Network Action Plan last year. That plan’s stated aims included, bringing outcomes for embedded network customers “in-line with those in traditional energy supply arrangements” and providing “more equitable consumer and price protections for embedded network customers”.

The Action Plan also led to a further review by the State’s Independent Pricing and Regulatory Tribunal (IPART) to establish the best way to set the maximum price for embedded network services and how to enforce any price protections, as well as considering whether new embedded networks for hot and chilled water should be banned in NSW.  Following the release of its recommendations IPART sought advice from Axiom Economics on the potential financial and incentive related impacts its draft recommendations on the maximum price methodologies may have on embedded network providers.  We take a look at the report and IPART approach and consider what the broader implications might be.

Efficiency, anyone?

The regulation of embedded networks needs to be proactive and sufficiently flexible to avoid inhibiting both technology innovation and the uptake of renewable energy.  NSW has ambitious renewable energy and emission reduction goals, within which embedded networks can make a significant contribution if appropriately set pricing attracts investment for sustainable energy solutions powered by both onsite and offsite renewable energy. 

The Axiom report to IPART makes it apparent that this approach is best ignored.  Axiom write that the maximum price for embedded network services should only seek to compensate an Embedded Network provider for the efficient costs associated with supplying energy, which includes the costs of:

• procuring the energy required to provide the relevant embedded network services;
• having the energy transported to the parent connection point; and
• servicing embedded network customers, which includes customer service-related costs (e.g. the costs associated with contracting, billing and collecting payments, managing enquiries and complaints etc) and the costs of complying with regulatory obligations (jointly ‘cost to serve’).

Disappointingly there appears to be nothing in there about innovation, or renewables, or emissions reductions.  And nothing at all towards meeting IPARTs objectives to:

• Incentivise customers and embedded network sellers to supply and use energy efficiently and enable the efficient use of energy, and
• Encourage sustainable energy solutions and accommodate innovation and investment in the energy sector.

It’s a curious blend of reasoning.  Professor Sherry of the Macquarie Law School submitted to the IPART consultation that house prices would not increase as a result of IPARTs recommendations. The Professor submitted that “Developers do not discount apartment sales because the developer did not pay for the infrastructure; developers charge purchasers as much as the market will bear for apartments.”  That is generally true, and it is also why owners corporations and Embedded Network operators typically want to recover the capital costs of ‘above market’ investment in infrastructure through the energy prices.  And if their investments are not considered in the cost of supply, they could be deterred from providing the current level of investment in the sustainable energy solutions sought.  Or so you might think.

Acquisition Rates

Axiom also notes that to compensate an Embedded Network provider for the efficient costs associated with supplying energy is an approach consistent with what their non-embedded network counterparts are required to pay.  And this latter statement is kind of true, kind of not.  There is no doubt that retail customers outside of embedded networks have access to choices outside of the bottom third of available offers on the Federal Government’s Energy Made Easy comparator website.  Interestingly, IPART agreed that the offers on Energy Made Easy are often introductory offers and do not reflect the true cost of supplying customers.  In fact these lower offers are often loss leaders, where retailers might acquire customers using below cost market offers for an introductory period (a common practice in any retail industry) but are not sustainable long term.  The Australian Competition and Consumer Commission (ACCC) also concluded that retailers recoup their costs over a customer’s lifetime, by setting attractively low acquisition offers and then making unilateral price increases for their existing customers over time.  So, this is not really a benchmark for an efficient cost; it’s just a discounted price.  It’s an unfortunate approach for IPART to take and one that will likely have a chilling effect on any future investments.

The Axiom report also contemplates that the site owner should be responsible for any capital costs for consumer energy resources (CER) that can no longer be recovered under IPART’s proposed embedded network price caps. The compelling logic here is that the site owner is the only one that can take the actions required to manage the costs associated with installing, operating, maintaining, upgrading or replacing the embedded network related assets. It is noted that ‘Change in Law’ provisions in embedded networks agreements can require site owners to meet these costs. 

This is an appealing simple solution for solving this problem; but it is not one without problem consequences.  IPART’s proposal would create a one-off requirement for capital contributions from owners’ corporation members, since owners’ corporations typically are unable to finance assets, as reflected in the NSW government program for financing the cost of replacing combustible cladding in NSW. 

Post Implementation Review

IPART also recommends that the NSW Government should not prohibit the establishment of new hot and chilled water embedded networks.  Whilst welcomed, when combined with IPARTs view that only operational savings can be used to offset the capital costs of the infrastructure, it is unlikely to lead to the sorts of capital investments that would see innovative, efficient or sustainable solutions. Operational savings can no doubt flow from innovation as IPART reason, because renewable generators and innovative automation are cheap to run.  But they are also costly to build, much more costly than available alternatives in new builds or retrofits, which means there must be sufficient allowance to recover the cost of capital if these sustainable energy solutions are to attract investment in embedded networks. 

Therefore, what IPART has recommended is most likely to lead to lower upfront capital solutions being installed instead, such as gas heating, gas cooktops and gas hot water systems.  In practice the whole of any building infrastructure will likely be built around gas to match with the incentives towards lower upfront costs and pricing, and any future retrofit will be uneconomic for decades probably.   This won’t encourage sustainable energy solutions and accommodate innovation and investment in the energy sector.  At least now we have the methodology that will be used to set maximum prices for electricity, gas, hot and cold chilled water supplied through embedded networks. 

Perhaps a review in two-years time might give us some indication as to how the market has responded?   In the absence (or avoidance) of a regulation impact statement, post implementation reviews are an important failsafe mechanism.  IPART recommends that it review its new price setting methodology at five-year intervals.  However, a first review at two years may be more prudent in this case, as sufficient data will be available to determine any impact on how embedded network services are being provided, and the economics of those services, and the problems and costs experienced by those owners corporation members required to make unexpected capital contributions.  Trends in the electrification of centralised hot water systems that currently use gas, and the uptake of sustainable technologies such as batteries and heat pumps are also measurable. 

Conclusion

Will IPART’s recommendations deliver the outcomes forecast?  The concern here is that IPART is not just messing about with the price, but with a whole investment mechanism that could, and clearly did, encourage sustainable energy solutions and accommodate innovation and investment in this sector in a manner consistent with both the NSW Government’s and IPART’s objectives.  Regulators routinely bemoan the perceived absence of market innovation in embedded networks; of energy as a service for example, and then make decisions like this that further suppress innovation.  So, measuring the outcomes of IPARTs recommendations early will be important, as it’s probably better to examine an important though diminished contributor after two years that has some chance of revival, than a dead one after five.