Background briefing: How coal and gas prices impact retail electricity bills

The Federal Government is considering price caps on generator fuel costs – gas and black coal – in an attempt to minimise the forecast increases in power prices for end users.

How electricity prices are set

In the National Electricity Market electricity prices are set through a gross pool, or spot market, which generators must sell through. Supply and demand are matched through a central dispatch process controlled by the Australian Energy Market Operator (AEMO). The type of generators that are supplying at any one time will depend on the level of demand and the availability of different plant (wind, solar, black and brown coal, gas and hydro). Like all markets, the price is set at the intersection of supply and demand. This means it clears at the price of the last generator dispatched by AEMO.

Generators will offer to supply the market with specified amounts of electricity at specified prices for set time periods. Generator bids will depend on their available capacity at any time, as well as factors like fuel cost, contract positions or availability of their fuel.

Gas peaking generators tend to be dispatched into the market by AEMO when demand is high or when other plant is not available. They are quick start plants and tend to be relatively high-cost producers of electricity. As a result, gas-fired generation can be the price setter, but only for some periods and this will vary by NEM region.

Historically, gas has tended to only set the wholesale market price during peak demand periods. A much lower gas price could potentially lead to an increase in gas generation, but this will also depend on gas supply availability.

In the third quarter this year gas set the price 10 per cent of the time in Queensland and New South Wales, 11 per cent in Victoria and 20 per cent in South Australia and 6 per cent of the time in Tasmania. In comparison black coal generators set the price 44 per cent of the time in Queensland and 41 per cent in NSW. Comparatively hydro set the price most frequently in the third quarter, according to the market operator and coal’s price setting reduced.

Price setting by generation type and state Q3 2022

Source: AEMO Quarterly Energy Dynamics Q3 2022

Impact of Fuel Costs on Retail Prices

• The market is designed to meet electricity demand in a cost-effective way with higher cost generators being dispatched into the market only when demand increases and more capacity is needed.
• The effectiveness of caps on the supply price of gas and coal and the timing of any flow through benefits to retail prices will be impacted by a range of factors, including:
• Existing contractual arrangements:
  • Much coal for generation is bought through contracts, not spot prices. According to the Australian Energy Regulator (AER), in NSW international prices can shape prices for short-term supply contracts and influence long-term contracts when they are renegotiated.
  • The terms of existing retail hedge contracts (see below for more details on hedging).
  • Most energy deals between retailers and small consumers are based on annually set tariffs. The AER’s Default Market Offer (the regulated price) has already been set through to 30 June next year.
  • Given the outlook for 2023 over most of this year has been for much higher prices, retailers, who purchase hedging contracts ahead of time to manage their exposure risk, will have already locked in higher costs.
• The expected mix and type of generation to meet forecast demand, ie how often capped fuel price coal and gas generators are setting the price in the market.

The effectiveness of the reduction in fuel costs for one form of generation in limiting wholesale prices will depend on its contribution to meeting expected electricity demand (how much electricity is bid into the market and at what price by generators using the fuel.

Theoretically, the more electricity that is generated by the price capped fuel source, the greater the impact on wholesale prices).

For larger commercial and industrial users, a reduction in the forward price can have an immediate impact, but will depend on the timing of their individual contractual agreements and energy procurement approach.

The following tables illustrate the volume of electricity generated by each fuel type in the NEM.

NEM share of generation output by fuel types (1 Jan -5 Dec 2022)

Source: AEC analysis, NEOexpress

Share of generation output by fuel types (1 Jan -5 Dec 2022) – includes rooftop PV

Source: AEC analysis, NEOexpress

How much does the cost of generation impact a customer’s bill?

Generation costs make up around a third of the electricity bill for households and small businesses, so reduced generator input costs will only influence this portion of the customer’s retail bill.

Source: ACCC

Forward Contract Prices

Forward contract prices are set on expectations of what capacity and demand are expected to be.

Both retailers and generators are exposed to volume risks due to demand fluctuations, which generally correlate to weather and time of day, while price risks are based on supply availability combined with demand.

Forward contracts play an important role in managing the risks of price fluctuations for retailers and generators. These financial contracts lock in a firm price for electricity that will be produced or consumed at a given time in the future. Forward prices are set based on expectations of average future spot prices – reflecting expectations of plant availability, fuel costs and demand.

While retailers can buy on the spot market, it exposes them to extreme financial uncertainty and risk. The risk to retailers can stem from increasing spot prices, high consumption from end users on an agreed tariff, or uncontracted loads (eg, additional customers whose consumption has not been accounted for or anticipated).

To reduce the risks of dramatic changes in prices (price volatility), retailers will hedge by entering contracts to lock in supply at a firm price. Generators can be exposed to financial risk if the spot market price is too low and they cannot recover their costs, or if there is a price spike and the generator cannot meet any contracted supply because of factors like planned or unplanned outages. If the generator is not able to meet the contracted volume, it will have to purchase the additional power on the spot market.

How the DMO (the regulated price) is set

Generation costs have historically made up approximately a third of a retail customer’s bill. This remains the case with the regulated price, which also comprises network costs, environmental costs, retail costs, and a regulated margin.

In order to reduce price volatility for customers, the AER will consider how an efficient retailer would have purchased hedging contracts when setting the DMO. This approach increases price certainty for consumers by smoothing out volatility in the wholesale market.

The AER’s approach assumes a retailer will purchase these hedges over a three-year period. As such, any reductions in the wholesale electricity price as a result of interventions in the cost of gas and coal will take some time to flow through to the DMO, as the lower wholesale prices will only affect about six months of the DMO calculation period.

The DMO is set annually, commencing on 1 July each year. The current DMO was set on May 26 of this year, meaning that for most customers, the current high wholesale prices have not yet affected their retail bill. While the Budget assumed a 20% increase in 2022, and a 30% increase in 2023[1], these increases are from a base price prior to the change of the DMO in May this year.

Given the DMO methodology, customers should not expect price decreases when the AER releases its final determination in May 2024. If the Government’s interventions are successful, they would merely reduce the quantum of any increases.

[1] The announced 56% increase is made up by compounding the 20% price rise projected in CY2022 into the 30% price rise projected in CY2023.