Power Price Pressures: Here, there and everywhere

Power prices continue to be in the news. Last week the Australian Financial Review’s Energy and Climate Summit was told that retail electricity prices could increase by as much as 35 per cent next year.

That commentary reflected the continued extreme pressure on wholesale prices in the National Electricity Market (NEM).  Recent reports have now also highlighted the impacts that the significant increase in wholesale prices is having on the energy system, not just here but also in Europe.

Key regulators such as the Australian Competition and Consumer Commission (ACCC) and NSW’s Independent Pricing and Regulatory Tribunal (IPART) have noted substantial price increases in retail tariffs.

The ACCC told the House of Representatives Standing Committee on Economics that it had seen an increase of $300 in the median bill since April this year, or around 25 per cent, and for small business the increases were in the order of $1500.  The ACCC said the increases stemmed from some “quite complex factors”, including the “weaponisation” of energy by Russia which is significantly impacting European energy prices, but had also had major knock-on effects in the Asia-Pacific region. Other factors included flooding affecting coal mines and the availability of coal-fired plants.

In its draft report into the NSW energy retail market 2021-2022, IPART found that while prices had increased 2-8 per cent for households and 2-6 per cent for small business in the year to June 2022, the steepest rises had emerged since June when the energy crisis locally was fully felt.

One outcome from higher wholesale prices has been retail offer prices in July and August 2022 that have seen the difference between median market and median standing offers narrow dramatically (as shown in figure 1 below). As a result, they are now “closer together in price than at any other time since IPART began its market monitoring role”.

Market offers show the median market discount off the residential standing offer has fallen from 15 per cent in May to less than 2 per cent in August, according to IPART.

Figure 1: Annual residential electricity bills for median offers by offer type and region in NSW compared to spot price

Source: IPART

In July 2021 residential standing offer prices initially fell by 3-6 per cent, while in July 2022 they were reset by 9-14 per cent.

Electricity and gas retailers ‘hedge’ against wholesale volatility which helps smooth the increase in gas and electricity prices. As new hedging arrangements are put in place the wholesale price changes can be expected to be reflected in those contracts. IPART says hedging was likely to be a key reason why retail gas and electricity prices did not increase markedly during the last quarter of 2021-22.  But it has reported that towards the end of that period and in July and August this year the wholesale price increases are filtering through to retail offers. In the longer-term, it expects higher wholesale prices to increase the cost of hedging instruments.

An indication of the extreme financial pressures faced by retailers and the risks of not being effectively hedged is highlighted by IPART’s finding that from May to July this year, the retailer cost of purchasing energy on the spot market would have exceeded the total customer bill.  “The spot market cost of just the electricity needed for a typical residential customer (4215kWh) exceeds the entire bill that customer would pay the retailer.”

Another critical impact seen here and overseas is the number of retailers leaving the market. IPART notes that for the first time since deregulation in NSW, there are fewer retailers in the market than the year before with retailer numbers falling from 40 to 35 in 2021-22, and dropping to 27 active retailers in August 2022, as seen in Table 1.

In part this stems from a number of Retailer of Last Resort (ROLR) events this year with the Australian Energy Regulator’s register showing six electricity retailer ROLR’s.  IPART also notes that at least three retailers responded to the price pressures by encouraging their customers to switch retailers before 1 July, while 11 stopped taking on new customers during the year.  As a result, there were fewer offers in the market in August, likely driven by the high costs of new customers and the overall market conditions.

Despite retailers leaving the market, the number of retailers in June 2022 was still higher than at any time from 2015-16 to 2019-20, which IPART says could be sign of resilience.  Australia’s loss of retailers remains small when compared to the UK’s. But IPART is concerned that if small retailer withdrawals continue it could have real implications for competition in the medium term.

Table 1: Retailers in the NSW Market

Source: IPART

In response to both higher prices and some of the retailer behaviour noted above IPART speculates that customers may increasingly switch to, or return to, larger retailers in what it dubs a “flight to safety”.  While the switching rate at around 19 per cent is similar to previous years IPART noted a spike in switching in July 2022.

Euro Pain

The stress in Australia’s energy market from high prices pales in comparison to European energy cost pressures and the expected impact on household bills. One forecast is for a 200 per cent jump in bills versus this year.

A Goldman Sachs report puts a number to the level of pain energy users may feel. At the same time it believes the market continues “to underestimate the depth, the breadth and the structural repercussions of the crisis”. At current forward prices the paper estimates energy bills will peak early next year at a staggering 500 Euros per month for the typical European family. That translates to A$765/month based on current exchange rates. That implies a 2 trillion Euros surge in bills for Europe as a whole or around 15 per cent of the EU’s GDP.

Goldman Sachs sees scope for price caps in generation, claiming it could save Europe 650Euros annually, but it would still not address the affordability issue and further argues for a “tariff deficit” to spread the spike in bills over 1 or 2 decades with utilities able to securitize the future payments.

It points to the effectiveness of Spain’s price caps on gas generators. Under that approach CCGTs are fully compensated for gas procured and the price for the electricity generated is capped at $70/MWh. The profitability of plants remains the same, but the forward price curves for Spanish generation is markedly different to that for the rest of Europe as shown in figure 2.

Figure 2: Temporary price cap on gas and decoupling of Spanish forward curve from rest of Europe

A tariff deficit would see prices smeared across several years (in fact Goldman Sachs assumes 8 per cent each year for 20 years in its example). The aim is to smooth the impact of significantly higher power prices on consumers. Its simulation of a theoretical tariff deficit approach uses an Italian example. Here a typical family spent on average nearly 100 Euros each month on gas bills in 2021. It’s estimated 2022 gas bills will reach nearly 220 Euros a month and peak in 2023 at above 300 Euros each month. Goldman Sachs expectation of an annual increase of 8 per cent out to 2040 from the 2021 average implies the same payments in gas bills over the coming couple of decades

Goldman Sachs has also proposed a new energy market design to accelerate electrification of the economy and decouple gas prices from the returns for fixed cost generation sources. It also sees electrification as the most cost-effective, permanent solution to high power bills.

It estimates that electrification of households could see a 75 per cent drop in bills. This assumes a move away from fossil fuel generation as well as the broad installation of heat pump systems for heating.

By 2023 a typical household (based on a typical Italian family) is expected to have energy bills of around 500 Euros each month based on electricity costs of 150 Euros/month with gas bills making up the other 70 per cent of energy costs (350 Euros) each month.

The reduction in bills through electrification would see savings of nearly 400 Euros each month, or nearly 5000 Euros each year. This would mostly be because the unitary cost of electricity would fall by around 55 per cent to 2030 driven by the normalisation of commodity prices with gas returning to pre-crisis levels and increased renewables and the lapsing of incentives for legacy renewable investments.

Meanwhile gas bills would be expected to fall to zero as heating is electrified through heat pumps.

Of course, electrification comes with an upfront cost, and Goldman Sachs supports energy policy in the form of subsidies for heat pumps and upgraded cabling to homes (to handle increased electricity load) with the upfront investment being nearly 5000 Euros for each household.