Cost Reflective Tariffs: The Disconnect Between Theory and Reality

Energy Consumers Australia (ECA) recently published its “Cost reflective tariffs aren’t very cost reflective” paper[i].  This was timely given the Australian Energy Market Commission (AEMC) is about to consider such matters in their Electricity pricing for a consumer-driven future​ review[ii].  The recent collision between the economic theory of network cost reflective tariffs and real-world customer experience was made apparent recently as the AEMC scrambled to shield customers from the direct bill effects of mandatory cost reflective network tariff assignment.  This led to the hasty development of a Directions Paper[iii], a potential short-term fix to cover the outcome of a decade of government and regulatory direction encouraging these same outcomes – that the tariffs reflect the network’s efficient costs of providing its services to the retail customer.

Do these tariffs reflect the networks efficient costs of providing its services? 

The ECA baldly concludes that they don’t[iv].  But these network tariffs do create confusion and challenges for consumers, as per widely reported customer power bill shocks[v].  And they do not address the problem of reducing peak demand.  As the ECA note, network costs are driven not by the daily cycles in energy consumption, but by the events of extreme heat or cold.  And these events may happen only once or twice a year.

This is not new.  In their advice to the Australian Energy Regulator (AER) in 2020, the Consumer Challenge Panel stated that:

A tariff that is not flat may or may not have a more cost reflective structure than a flat tariff. If it is badly designed, a complex non-flat tariff may actually be counter-cost reflective. It should not be assumed that every possible complex tariff is more cost reflective than a flat tariff. There remains an onus on any proponent of a complex tariff to demonstrate that it really is more cost reflective than a flat tariff.[vi]

This onus is met through networks’ tariff structure statement proposals, that must be submitted to the AER for approval.  The trouble is that it is based on a theoretical construct.  That theoretical construct holds out the promise of major, systemic benefits that could cut the underlying costs of power for everybody.  But that outcome is not measured.  The Australian Energy Council has responded to the AEMC Draft Terms of Reference for their Electricity Pricing Consumer Driven Future Review and argued there needs to be a better understanding and broadening of the definition of what’s effective.  In our view effective should also include a more explicit meaning, of having a measurable and material impact on the network condition that the distribution network tariff was designed to remedy.  Not just the theoretical justification.  We suspect, and the ECA analysis supports this, that the implied efficient cost outcome from these complex arrangements is rarely realised in practice.  Regulatory Impact Statements and Post Implementation Reviews are uncommon in energy, whereby the economic and social costs and benefits of regulatory proposals are examined fully pre and post implementation. 

When considering the economic and societal benefits in pricing network services, why are network tariffs such an important exception?  Many energy users create costs that are not reflected in their individual price that are unrelated to network utilisation.  For example, late payment fee bans have the practical effect of distributing the costs of late payments across all customers, including those that pay on time or early.  Hardship programs are for all practical purposes funded by retail customers collectively.  Rooftop solar tariffs such as the Premium Feed-in Tariffs have been funded by other network customers.  The concessions frameworks are a taxpayer subsidy.  All of these and more are being variously extracted from or paid for by all or other classes of consumers.  And given the raft of cross subsidy already embedded in retailing and government responsibilities, are cross subsidies such a universally bad thing?

If a purpose of cost reflective network tariffs is to unravel cross subsidies, why are network tariffs such an isolated and uncompromising pursuit?  The AEMC highlights this isolation further:

The role of the networks is to provide cost-reflective [network] pricing. The retailers’ role is to take wholesale costs, network charges and other potential energy services such as distributed generation or energy management systems, and package these up for consumers. In many ways, their (retailers) job is to be the consumers’ agent for dealing with the rest of the system… Consumers choose between fixed and variable mortgages with different terms in the financial sector; and they choose from a range of mobile phone packages in the telecommunications sector. [vii]

The role of retailers as the customer’s agent is uncontested.  But network pricing is a bargain between the regulator and the network, whereas every other component is a bargain between the retailer and their supplier.  And in this way, network pricing risk is entirely different from the other market risk that retailers manage as the customers agent.  There are no tools available for network pricing risk, beyond sharing that risk with the customer – the option that the AEMC is now hurriedly working to prevent.  A retailer cannot refuse a network tariff on any grounds, and any network tariff reassignment is entirely at the networks discretion.  And unlike the hopeful analogies of the financial sector and mobile telecommunications sectors, there are effective regulated caps on energy pricing that can prevent costs from finding their way to end users.  Frankly, would a simple fixed distribution cost for all residential customers be a fairer and more transparent way to recover the costs related to distribution, which in themselves are largely fixed?  As retailers will tell you, most customers in our experience are actually looking for a very simple and predictable energy tariff.[viii]

In the end, are the costs of facilitating the increase in demand better addressed outside of a proliferation of price signals via cost reflective network tariffs to end users.  As the ECA notes, many distribution networks have a lot of spare capacity to accommodate increases in peak demand.   They contend that distribution networks overinvested in network augmentation capex between 2009 and 2014, and peak demand has since stabilised.  And as a result, most networks have significant additional capacity to manage increases in peak demand.

There are alternatives.  There are other ways that the regulatory framework could incentivise effective utilisation of network capacity, both where over and underutilised.  The AER’s 2023 Review of the incentive schemes it applies to networks[ix] found that they both improved network efficiency and reduced costs.  Whilst some doubts remain about participants (networks) gaming of expenditure forecasting rather than efficient spending, these schemes do offer an opportunity for the more locally targeted approach identified as necessary in the ECA report and is consistent with our own views.  Efforts to lower demand via cost reflective network tariffs in lower utilisation areas will not reduce network costs. 

We’ve said it all before.  We are pleased that the ECA, in a well researched report, is saying it again.  That reducing network costs through pricing does not require all customers to be exposed to the signals, and that interested consumers can opt in to more dynamic pricing if they see a clear value proposition. That there are better alternatives.  The Australian Energy Market Commission (AEMC) upcoming review will represent an opportunity to unlock our thinking on what the necessary framework to deliver the future of electricity pricing, products, and services.  And maybe finally break free from 2014, and what seemed like a good idea at the time.

[i] https://energyconsumersaustralia.com.au/wp-content/uploads/report-cost-reflective-network-tariffs-arent-cost-reflective-5.pdf

[ii] https://www.aemc.gov.au/market-reviews-advice/electricity-pricing-consumer-driven-future

[iii] https://www.aemc.gov.au/sites/default/files/2024-08/directions_paper_-_erc0378_accelerating_smart_meter_deployment_-_ner_and_nerr.pdf

[iv] The report writes: “This paper demonstrates that ‘cost-reflective’ network tariffs do not necessarily reflect the true nature of a distribution network’s costs.”

[v] https://www.abc.net.au/news/2024-08-15/calls-to-end-power-bill-shocks-and-convoluted-prices/104113386

[vi] (Consumer Challenge Panel (CCP 17) Advice to the AER on the Victorian Electricity Distributors’ Revised (Final) Regulatory Proposals for the Regulatory Determination 2021-26)

[vii] (AEMC, Ensuring the regulatory framework facilitates competitive and efficient energy markets in a time of technological change: Address at Australian Energy Week 2016, 21 June 2016)

[viii] Mark Collette, CEO of Energy Australia https://www.abc.net.au/news/2024-08-28/energy-consumers-claims-cost-reflective-tariffs-do-not-work/104275654

[ix] https://www.aer.gov.au/industry/registers/resources/reviews/review-incentive-schemes-regulated-networks/final-decision