Thwaites Review of Retail Markets in Victoria: Reviewing the risks

Victoria’s Independent Review of the Electricity and Gas Retail Markets in Victoria was released on 13 August 2017.  Since that time the Victorian Government has indicated that it will respond to the Review before the end of the year, but has been silent as to the consultation process it will run in the meantime.  The Department held one forum (on 24 August 2017) at which industry and community stakeholders heard a presentation from the Panel, and were permitted to ask questions (although no answers were provided in relation to the issues raised).

In advance of a consultation process, we now understand that the Victorian Cabinet is likely to consider publicly announcing in principle support for all of the Review’s recommendations, including the first two, which propose a removal of the Standing Offer in Victoria and the introduction of a Basic Service Offer.  This would effectively re-regulate the Victorian market.  We are expecting that announcement to occur in the coming weeks, and possibly as early as the first week in October.

This article outlines the risks for Government of adopting Recommendations 1 and 2 of the Review, and its contents have already been provided to the Victorian Government to inform the deliberations that are currently on foot.

There are three key concerns:

1. Re-regulating retail electricity markets will represent significant risk to Government, as retail bill cost drivers such as wholesale and network costs are not under the Government’s control. It will mean the Victorian Government will be seen to be responsible for future energy price increases to Victorian consumers.

2. Re-regulating retail electricity prices in Victoria will wipe out most if not all of the smaller retailers from the market. This includes new renewables based vertically integrated disruptor businesses.

3. Competitive and open retail markets will be essential to enabling discovery of different demand response capabilities of consumers, which will be critical to enabling increased penetration of variable supply generation technologies (renewables) in Victoria.

Recommendations 1 and 2

Of the Thwaites Review’s 11 recommendations, the standout recommendation is Recommendation 1, which re-introduces price regulation for small customers. The Review Panel proposes a new offer type called a Basic Service Offer. This is proposed to be regulated via a price cap to be set by the Essential Services Commission. Importantly, the price cap cannot allow for customer acquisition and retention costs or provide for headroom. Recommendation 2 then proposes to abolish the current standing offer, apparently because the Basic Service Offer renders the standing offer irrelevant. We discuss Recommendations 1 and 2 together.

There are two categories of issues with these recommendations.

First, there are issues of interpretation. The Review Report does not explain how the Basic Service Offer would be provided, other than including high level principles of it being unconditional and part of an obligation to supply. This leaves this vital element of the Review Report open to competing views about its application, each with material effects.

We have identified two very different views, as follows:

1. The narrow view: Some people (potentially including the Review Panel) appear to see the Basic Service Offer as a ‘no frills’ option that will not be available to customers on request but provides some form of backstop for a possibly limited number of customers. It is not intended to affect the market in general. Some people further consider that ‘no frills’ means very basic retail supply, without the terms and conditions attached to the current standing offer (as found in the Retail Code), such as customer entitlements to paper bills and payment in person. It is not actually clear how any of this would work in practice or how this view sits with the principles of being unconditional or retailers having an obligation to supply.

2. The broader view: Other people interpret the Basic Service Offer as acting in place of the standing offer to guarantee supply (that is, in any circumstance when a small customer is not on a market contract) and providing the full suite of standing offer entitlements as set out in the Retail Code. This is logical given that the standing offer consumer protections need to be addressed in some way if Recommendation 2 is to be adopted. This would also be consistent with consumer advocate expectations.

It can also be expected that the Basic Service Offer will be available on request to any small customer as potentially the ‘best’ offer available. This is because the Basic Service Offer will likely be the cheapest offer given it does not allow for the usual costs of competing in the market or provide some element of headroom. 

Leading from this, the second category of issues relates to the impact of the adoption of Recommendations 1 and 2.

According to the ‘narrow view’ outlined above, the market should not be radically affected by the new Basic Service Offer, which is what retailers have been hearing from government officials.

However, an interpretation according to the ‘broader view’ is much more likely in practice, as outlined above. According to this perspective the market impact of these recommendations will be severe. The lack of allowance for acquisition/retention costs and headroom in Recommendation 1 means that retailers will be unlikely to beat the Basic Service Offer, and so competition will be stifled. It is conceivable that most or even all second tier retailers would leave the market, some by choice and others because their businesses as a whole have become unviable. 

It is also worth noting that the Basic Service Offer is unlikely to be as cheap as the cheapest offers in the market today – ie those customers currently on very cheap deals (who are often vulnerable or under financial stress) would find themselves in a worse position with a Basic Service Offer.

Industry position

Some of the Review’s criticisms of the market and of retailers’ practices are warranted, and retailers agree these should be addressed through regulatory change supported by the industry. For this reason, the AEC has communicated to the Government its in principle support for the Review’s Recommendations 3 – 11 inclusive.

However, Recommendations 1 and 2 are extremely concerning. All retailers (including those that are not members of the AEC) view the implementation of these recommendations as effectively ending energy retail competition in Victoria. Customers (including vulnerable and disadvantaged customers) will lose the price benefits they currently receive through very cheap market contracts. Reducing the energy retail environment to the three incumbent retailers (because all second tiers have left) will mean a loss of jobs and a chilling effect for the investment required to encourage the service innovation that will allow customer uptake of new technologies and demand response. It will also likely stifle private sector investment in generation.

This would be a retrograde step that would not work in the interests of Victorian consumers. It would also put the Victorian Government in charge of retail prices – a responsibility that most State governments have been keen to shed because they cannot control the key generation and network input costs recovered through retail prices.  Research conducted by AGL in 2012 demonstrated that media attention on energy price rises in regulated markets was more sustained and critical of the Government, compared to jurisdictions where prices had been de-regulated.[1]

If the Government is committed to re-regulation, Recommendations 1 and 2 must be subjected to a rigorous assessment of costs and benefits before any commitment to that framework is announced.  These recommendations may not present the best framework in which to deliver re-regulation.

The AEC also notes that the Thwaites Review did not provide any analysis of alternatives, or a cost-benefit assessment (and it did not profess to have done this). The AEC released this week an independent report by Oakley Greenwood, which examined the analysis provided by Carbon and Energy Markets (CME) of the gross margins that are likely being achieved.  The CME analysis, which found retail margins in Victoria to be in excess of $400 per customer, was heavily relied upon by the Thwaites Panel, which used those figures to justify its view that competition has failed Victorian consumers and so re-regulation is the only option.

The Oakley Greenwood report suggests the CME analysis of retail margins of in excess of $400 per customer in Victoria over-estimates gross margins by at least 30% because of:

• Questionable choices in the methodological approach used;
• Factual errors in its calculations; and,
• A preference to ignore publicly available data and rely instead on analytical assumptions.

These errors and incorrect assumptions have the result of materially over-estimating retailer costs relative to the rest of the bill.

The AEC and its members continue to seek formal consultations with the Victorian Government on the material unintended consequences of any implementation of Recommendations 1 and 2.  This is not a decision to rush, and we note that the Victorian Government has already made a public commitment to publishing its response before the end of the year, and that timeframe would seem appropriate to enable a proper consideration to be undertaken.

[1] Simshauser, P & Laochumnanvanit, K 2012; ‘ The political economy of regulating retail electricity price caps in a rising cost environment’ pp 14-15