Rational Gold-Plating

Much has been written and spoken about electricity prices, particularly the role of network prices in driving up household bills. I’ll admit I haven’t listened to this Background Briefing, but there is one point I have wanted to discuss for a while:

Federal Treasury estimates that 51 per cent of an average household bill is spent on network costs. Most of that is going towards paying off the $45 billion network companies have spent on updating our poles and wires over the last five years.

The definitive work on electricity pricing is the Australian Energy Market Commission’s 2013 Electricity Price TrendsFrom page ii onwards gives a good summary of the biggest price drivers in the last 12 to 24 months. Yes the various ‘green’ schemes have an impact, making up 17% of the average bill. These include legacy solar feed-in-tariffs, which look incredibly generous in hindsight. I think there are some houses in the ACT and Queensland still getting 60c/kWh, where at the moment about 20c/kWh will give you a 10-year payback. The carbon price contributed about 10%, the RET a bit less, and then the state efficiency schemes even less.

The real action is in network prices, making up almost exactly half of the average residential bill. This has risen in the order of 40% in the last few years, driven by the network investments. The question for today then is “Are network operators trying to rip us off?”

I have heard in a number of places now the charge that network companies are cynically using the network investment return rules; that when they build new networks they can claim a 10% return on investment through power prices. Network businesses are state owned or regulated, so the amount they can charge is regulated by a central agency, like IPART in NSW. The allegation at the centre of the Gold Plating charge is that knowing these rules and wanting to make money, the networks built unnecessarily large infrastructure. The Background Briefing cited above claims this is demonstrated by unused or oversized infrastructure, like substations that aren’t being used. This doesn’t look great, but I argue this isn’t as sinister as it appears and that network companies are making rational business decisions. Two things drive this; the time it takes to make investment and infrastructure decisions and the fixed costs associated with upgrades.

In 2006-7 I was working for Sydney Water, a massive electricity user in NSW. About 1% of state demand, or 2% if the desalination plant is running. During this time I was in meetings with the network provider about upgrades to the Sydney ring main. The ring main is the circuit of wires under Sydney that powers everything. It’s all underground, under roads and under buildings. Upgrading it is a big job, and it was going to happen one day. Wires can only carry so much current, and at some stage they must be upgraded as demand in the city grows. That time was coming and planning was well underway. So these meetings were going from about 2005 until the project finished in around 2012, about 7-years worth of planning. The result is a $400m or so project that greatly increased the capacity of the main and improved its reliability. If you’re interested I’m pretty sure the solid grey building near the light rail and Bellevue park near Central is the new substation associated with this project. Planning electricity upgrades takes a long time because it is a massive job.

So in 2006 they were nearing capacity of the network and wondering what to do about it. This conversation was being had all over the network; the initial build outs of the 70s and 80s were reaching capacity and needed to be replaced.

Considering the Sydney example again, how are the costs apportioned in a big job like this? I don’t know the specifics, but in smaller projects I’ve worked on, getting staff to site, foundation work, meetings and the big one, closing roads to do the work, can take up as much as 80% of the total cost. These are the fixed costs. It doesn’t matter what capacity you install, these costs are the same. The network infrastructure is 20%. Since it’s such a massive job just showing up, you might as well put the biggest cable you can in the hole. Even if you double the carrying capacity of the infrastructure, that only increases the project cost by 20%. This means there is a very strong technical incentive to oversize the infrastructure as it avoids those fixed costs.

Compounding this, how do you decide how big to make a network anyway? Residents don’t call the network provider and tell them they’re thinking of doubling their load with a new air conditioner and to some degree neither do industrial customers. The rational thing is to observe trends and make a guess. And the trends in electricity use in the National Electricity Market have side swiped virtually everyone.

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This graph from The Conversation tells the story. If you were making electricity decisions in 2007 the data says electricity use grows every year, for almost the last 30 years (this trend goes back a long time). I did not see anyone, anywhere, predict the decline in electricity use that happened from 2009. Even two years into the decline the market operator was forecasting growth in the following years. Now though we have just finished the 4th straight year of declining electricity use.

Put all this together; it is a massive job upgrading electricity infrastructure, requiring disruption to supply, holes under roads and co-ordination of dozens of stakeholders. Of the cost of upgrading, a small component is impacted by deciding to go large, so network companies upgrade based on a 20-year forecast. The previous 20 years showed unrelenting growth and no one predicted the slide. What would you do? Exactly what the network companies did. Mitigate fixed costs by upgrading massively when you have to and assume the trend of the last 20 years is going to continue. The greatest risk then is an oversized network and increased cost; the greatest risk of an undersized network is blackouts, political tension and increased costs as the fixes are done urgently.

So I argue; network businesses made rational decisions with the information available to them. I agree there is an incentive to oversize based on the infrastructure return-on-investment rules, but this is dwarfed by the incentive to build big networks when you have to. Given the networks are state regulated there is good argument to reign in those investment rules, but I don’t think it would make much difference. Network businesses are large, unwieldy and rightly conservative organisations. As a result, we have some of the best electricity supply certainty in the world.

What can a consumer do about rising network prices? Leave the network. And the more people leave the greater the incentive for those remaining to go as network costs fall to a smaller customer base. This is something I am *very* interested in at the moment and can’t wait to see what happens.

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About evcricket

Extreme gardener, engineer and bird nerd. View all posts by evcricket

7 responses to “Rational Gold-Plating

  • Jane Bryony Rawson

    Very clear, and good to hear another perspective on this: thanks! As someone interested in the electricity ‘death spiral’, I’m guessing you already read this: https://theconversation.com/were-headed-for-an-electricity-war-heres-how-to-stop-it-16582

  • Zvyozdochka (@Zvyozdochka)

    This is a great addition to the conversation and very useful explanation that helps understand the Gold Plating charge better.

    The Background Briefing program is definitely worth a full listen when you get a chance however.

  • David

    My impression of the main thrust of the Background Briefing piece was not that network operators were acting irrationally or in an underhand way with their investment decisions and “ripping us off”. Rather, the policy structures and business model that had worked so well while demand was growing, was under serious threat. If they were acting badly it was in blaming RET for their troubles rather than examining the suitability of their own business models in the new environment.
    As you say “the trends in electricity use in the National Electricity Market have side swiped virtually everyone”

  • Malcolm Scott

    I’m surprised that the electricity companies in the supply chain have not put more effort into increasing electricity demand for more efficient and productive outcomes, ie, do more to support the EV market and be more vocal in support of a high speed train project.
    1,000,000 EVs recharging 10 kWh over say 6 hours approaches 2 GW generation required. This is not an insignificant amount. Such numbers could be a stretch target for EV sales over a 10 year period now that we don’t need policies to protect legacy local car manufacturing.
    If we can’t have local vehicle manufacture, we can at least have the fuel locally made, renewable, and displacing imported fuel that we are increasingly dependant on.
    For most EV owners charging will be at the home and at night. For the foreseeable future this requires grid connect and thus a sticky customer. QED.
    Deregulating the distribution network to allow local virtual grids between local distributed small generators and consumers would also enhance the community benefit from the grid and thus usage – which is sort of back to the old days when councils owned local electricity networks, and as per recent developments in Germany with municipality (ies?) buyback of the grid. Compare what Maroochydore council wants to do with a 10kW solar PV project on old cane fields where the one size fits all distribution cost probably makes a mess of the business case, where the ACT can make it work.

  • Malcolm Scott

    At a recent electricity supply workshop an ACCC commissioner commented that the increase in distribution costs was not caused by just over investing for demand that did not occur, but the financing costs at the time of these projects (just post GFC) also had significant additional cost impact. Recent refinancing at low interest rates might now have improved things. I hope.

  • cityslicker72

    Good post.
    I’d also note the observation made by the Productivity Commission in their 2013 inquiry into network regulation (http://goo.gl/YWBIIe), highlighting the problem of the AER using past information to set future targets as this “reduces the incentives of a firm to lower costs since it knows that it will decrease its revenue in the future”.
    Rational gold-plating, as you say.

  • jufemaiz

    Another thought on this is around high penetration of distributed energy resources. With such “gold plating” claims, there should be lower capacity (pun intentional) for networks to refuse increases in distributed energy resources. If not, perhaps the “gold plating” isn’t quite gold, but perhaps silver?

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