If the retail energy market is competitive then is Lara Bingle a Russian cosmonaut?
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as at 17.08 on 22 June
If the retail energy market is competitive
then is Lara Bingle a Russian cosmonaut?
Dr Ron Ben-David*
Chairperson
Essential Services Commission
ron.ben-david@esc.vic.gov.au
* The opinions expressed in this presentation are those of the author alone. They do not represent the views of the Essential
Services Commission, its staff or the Victorian Government. The author takes full responsibility for any errors, omissions or
conjectures made herein.
1ABSTRACT
For the last decade, a set of criteria have been applied when testing for the competitiveness
of a retail energy market. These criteria consist of market characteristics such as: customer
switching rates, barriers to entry, independent rivalry and product differentiation. This paper
finds that these criteria can lead to ambiguous, and even contrary, conclusions about the
competitiveness of the market. At best, they support a tentative conclusion about the
existence of competition but they provide little (if any) insight into the vitality of that
competition. The weakness of these tests is found in their logic and in their economics. With
the assistance of Lara Bingle, the paper demonstrates the inferential weakness of these
criteria. The economic weakness of the criteria is due to their focus on the ‘means’ rather
than the ‘ends’. That is, competition is only ever a means for achieving the policy objective
of market efficiency. Analysis ought to focus on whether the objective has been satisfied.
Therefore, three alternative criteria are proposed which seek to assess the efficiency of
market outcomes. These include: retailer margins, price shocks and tariff structures. The
paper’s findings suggest that competition in the retail energy market does not appear to be
sufficiently vital in terms of the outcomes it is producing.
The essential nature of energy is defined by consumers’ inability to switch to substitute
products or to exit the market. These features distinguish the retail energy market from
most other consumer markets. The paper contends that energy retailers are sheltered from
the disciplines of genuine competition because their customers are ‘trapped’ in the market.
This muted level of competition may explain how ‘signs’ of competition can be observed
despite the lack of competitive and efficient outcomes. Has the regulatory community
therefore fallen victim to a confirmation bias? That is, having accepted the signs of
competition as conclusive, the regulatory community may have unwittingly blinded itself to
possible limitations in the effectiveness of that competition.
The immediate response to concerns about sheltered competition should not be to ‘protect’
consumers. Instead, regulators should seek to enhance competition to the greatest extent
possible — noting that this could require more regulation rather than less. While such an
approach may jar with prevailing views about competition policy, the regulatory community
should not abjure from asking difficult questions about how it might seek to promote
greater competition in the retail energy market.
Looking further into the future, the paper suggests the advent of new technologies will
enable innovators and disruptors to break the old model. They will give customers real
choice and real power; the power to leave the market as we know it. Innovators will liberate
consumers and, in doing so, they will also liberate regulators. Regulators must ensure that
they do not inadvertently inhibit the emergence of these new and disruptive business
models.
This paper informed a presentation to the NEM Future Forum 2015 (25 June 2015)
2“Retail competition has been very good for retailers.
I’m not so sure about customers.”
― former chief executive of a sizeable energy retailer
3TABLE OF CONTENTS
1.0 INTRODUCTION
2.0 AN ELUSIVE DEFINITION
2.1 CHURN RATES
2.2 NUMBER OF RETAILERS
2.3 PRODUCT DIFFERENTIATION
2.4 RETAIL MARGINS
2.5 BUT ARE WE ASKING THE RIGHT QUESTIONS?
3.0 ENTER LARA BINGLE
4.0 A MATTER OF ECONOMICS
4.1 RETAIL MARGINS REDUX
4.2 WHERE HAVE ALL THE PRICE SHOCKS GONE?
4.3 THE MYSTERY OF TWO PART TARIFFS
5.0 COMPETITION AND EFFICIENCY DECOUPLED
5.1 ESSTENTIAL AND SHELTERED
5.2 HAVE RETAILERS KICKED AN OWN GOAL?
6.0 WE MUST OVERCOME
6.1 AND LET’S NOT BLAME CUSTOMERS
7.0 THE DAY MAY BE COMING, BUT UNTIL THEN…
APPENDIX A: A BRIEF REGULATORY HISTORY OF THE VICTORIAN RETAIL ENERGY INDUSTRY
41.0 INTRODUCTION
Thank you to Keith Orchison and the conference organisers for inviting me to present today
about the challenges of being a regulator in a market that is evolving very rapidly. Keith is
right to ask the question: How do we regulate markets that are evolving rapidly? I would like
to suggest the question be rephrased slightly: How do we regulate for the future rather than
the past?
Of course, this NEM Future Forum 2015 is all about asking ourselves: What will that future
look like?
I can well imagine that one hundred years ago the Horse and Carriage Association of
Australia held a conference (probably not far from here) and asked what will the future look
like? I’ll bet you that no-one at that conference would have had the faintest inkling about
the impact that Henry Ford and his Model-T would soon have on the horse and carriage
industry. I can also imagine how forty years ago the Typewriters Manufacturing Federation,
gathering at their annual Typewriters Future Forum, devoted many hours to discussing the
exciting future that awaited typewriting. I’ll bet you that no-one at that conference foresaw
the impact that Steve Jobs and the personal computer would soon have on that industry.
And, it is no stretch of the imagination whatsoever to picture a gathering of industry
heavyweights at the Australian Taxi Association’s annual conference three years ago where
no-one would have been able to even comprehend what Travis Kalanick and Garrett Camp
were about to do to the taxi market with the world-wide roll-out of Uber.
Is the energy market next? Is the energy industry next to be ‘Ubered’ ?
We already know that Elon Musk and his Powerwall and PowerPack are out there.1 But who
else is out there: lurking; waiting to pounce? What business model destroying ideas are
being dreamt-up by 19 year olds in their bedrooms and garages — hidden away in suburbia,
out of sight of all the incumbent players and vested interests (owners, operators and
regulators)?
Like you, I have no idea about what is about to happen next or when. It is probably an axiom
of disruptive innovation that incumbents cannot foresee the things that will upend their
business models. I am an economic regulator not a business entrepreneur, so I am not even
going to attempt to predict the future.
1
http://fortune.com/2015/05/06/elon-musk-tesla-home-battery/
5Rather, I will try to answer the question put to me by the conference organisers by asserting
that to know how we regulate the future we must understand how we have regulated to
date and what we have achieved as a result. We should recognise the successes of our
regulatory models and we must accept, honestly and openly, their shortcomings. As they
say, “Those who fail to learn from history are doomed to repeat it.”2
So answering a question about how we regulate for the future rather than past, demands we
examine what our regulatory efforts have achieved so far.
When it comes to being a regulator, I consider myself to be an economic regulator rather
than an industry regulator. In brief, I describe the difference as: Industry regulation is part of
a broader category of social regulation which focusses on allaying harm or the risk of harm
on behalf of the community.3 In contrast, economic regulation focuses on the pursuit of
economic efficiency — typically defined in terms of consumer outcomes such as service mix,
quality, and price; and upholding competitive (or competitive-like) outcomes wherever
possible.
Therefore, in reflecting on the outcomes achieved under the regulatory framework to date
— and given the competitive model of service delivery already established in the retail
energy market (at least in Victoria) — it is only natural that I begin my reflection with a look
at the state of competition in that market.
2
The philosopher, essayist, poet and novelist George Santayana (1863–1952) wrote, “Those who cannot remember
the past are condemned to repeat it.” This famous statement has produced many paraphrases and variants.
3
For a more detailed discussion of economic regulation, see: Essential Services Commission (2014), Annual Report
2013-14. What is Economic Regulation? p.13 (September)
62.0 AN ELUSIVE DEFINITION
But what does “competition” mean? And more specifically, what does it mean in the
context of the retail energy market?
Reading through the source policy documents unfortunately, does not provide straight
forward answers to these questions. In fact, and curiously, competition is never defined and
references to competition are almost always qualified so that only “effective competition” is
ever mentioned. This term can be traced back to 2004 and the original Australian Energy
Market Agreement (AEMA) entered into by the State, Territory and Commonwealth
governments. However, the AEMA does not offer a definition. It only provides a set of
principles to guide the future development of criteria for assessing the effectiveness of
competition in individual markets.4
By 2007, these principles guide the work of the Australian Energy Market Commission
(AEMC) ― the rule-making body of the national regulatory framework ― as it undertakes its
assessment of the Victorian retail energy market.5 The AEMC’s review of ‘effective
competition’ in the Victorian market comprised six broad tests. These included:
(i) independent rivalry within the market
(ii) the ability of suppliers to enter the market
(iii) the exercise of market choice by customers
(vi) customer switching behaviour
(v) price and profit margins
(iv) differentiated products and services
Based on these tests, the AEMC found the market now displayed the attributes of ‘effective
competition’ and, therefore, there was no longer any need for price regulation in that
market. This led to the removal in Victoria of all remaining price controls from 1 January
2009 (see Appendix A). Similar reviews with similar findings were subsequently conducted by
the AEMC into energy retail competition in South Australian, NSW and Queensland.
4
See Notice of Amendment to the Australian Energy Market Agreement signed by the Chief Ministers of the States,
Territories and Commonwealth Governments on 2 July 2009 (see page 26 and Annexure 3).
5
AEMC (2008), Review of the Effectiveness of Competition in Electricity and Gas Retail Markets in Victoria. Second
Final Report, 29 February 2008, Sydney.
7In August 2014, the AEMC reiterated6 its satisfaction that, “Competition is effective for small
customers in the Victorian retail electricity and gas markets.” In this latter analysis, the
AEMC stated, “We have drawn on [the earlier] criteria and refined them to focus on whether
retailer markets in NEM jurisdictions are providing outcomes that are consistent with
effective competition.” Again, the term “effective competition” was adopted without
further elaboration. The AEMC’s five refined criteria were:
1. the level of customer activity in the market
2. barriers to retailer entering, expanding or exiting the market
3. the degree of independent rivalry
4. customer outcomes; and
5. retailer outcomes.
The AEMC found that the Victorian market continued to rate favourably against all these
criteria, though the finding in relation to the fifth criteria was somewhat qualified. In
summary, the AEMC found:
Most customers were on market offers having actively investigated the option; with very
high customer switching rates (28 per cent in 2013).
Retailers considered the barriers to entry, expansion or exit to be few ― observing,
“Retailers identified Victoria as the preferred jurisdiction to enter the retail energy
market in Australia.” This was despite retailers also noting that the current customer
protection framework in Victoria was the “most onerous and costly in the NEM”.
There was a high level of retailer product differentiation and marketing activity, noting,
“Retailers are offering different tariff structures, discounts and a broad range of non-
price incentives.”
Most customers surveyed were satisfied with the level of choice, the quality of service
and the value provided by retailers.
Retailer margins were found to be higher in Victoria than elsewhere but the AEMC
cautioned that this could be due to under-estimation of wholesale costs and higher
“operational/regulatory costs faced by retailers in Victoria.”
6
AEMC (2014), 2014 Retail Competition Review, Final Report, 22 August 2014, Sydney.
8Based on its updated analysis, the AEMC reaffirmed its earlier conclusion about the
effectiveness of competition in the Victorian retail energy market.
Nonetheless, a working definition of competition in the retail energy market remains elusive.
Perhaps the authors of the AEMA considered that providing such a definition was either
unnecessary or too difficult. Instead, they adopted an inferential approach — if ‘signs’ of
competition could be observed, then competition could be inferred to exist. The remainder
of this section tests the veracity of this inferential approach by examining the AEMC’s
findings and the conclusions that they might support about retail competitiveness.
92.1 CHURN RATES
Victoria’s high churn rates are widely cited as evidence of the competitiveness of Victoria’s
energy markets.7 In 2013, the ESC undertook some analysis of the electricity transfer figures
from the Australian Energy Market Operator (AEMO) that are usually cited for customer
churn rates.8 The ESC sought to correct for situation where one customer moves out of a
premises and another moves in as well as meter installations associated with new dwellings.
This resulted in the churn rate for 2011-12 reducing from 26 per cent to 17 per cent.
Presumably, similar corrections to churn rates in other States would have similar
consequences so this analysis probably does not alter the claim that Victoria has the highest
churn rate. It does, however, significantly reduce the rate at which consumers can be
claimed to be exercising ‘choice by choice’ ― that is, consumers who are entering the
market for no other reason than to exercise choice.
By implication then, if the ESC’s 26 per cent or the AEMC’s 28 per cent rates of churn are
upheld as admirable and demonstrative of competition, a true rate of 17 per cent is
presumably less admirable and demonstrative of less competition.
None of this, however, explains how we ought to interpret particular rates of churn. What
level of churn (however it is measured) is an indicator of a competitive market? There is no
self-evident reason why 20 per cent is better than 10 per cent or even 5 per cent. In a
competitive market where providers have been responding to customer preferences for 15
years by delivering high (or improving) quality of services to their customers, we might
reasonably hypothesise that churn rates should be low or at least reducing.
It is also worth noting that in more recent times, a number of retailers (including the three
large incumbents) have ceased their door-to-door marketing. Moreover, in my discussions
with them, retailers have reported that they have been rebalancing their marketing
strategies away from pure growth towards customer retention. In these circumstances, it is
reasonable to expect that churn rates will fall. Would these lower churn rates mean the
market has become less competitive? Does it mean that by shifting their marketing efforts
from growth to retention, energy retailers are engaging in anti-competitive practices? Of
course not.
7
Energy Retailers Association of Australia (2012) Global report shows Australian energy markets are leading the
world (media release).
8
Essential Services Commission, Progress of electricity retail competition in Victoria, May 2013.
10The only insight that high customer churn rates provides is that customers can move
between retailers with relative ease if they so choose. While this is a valuable insight in its
own right, it cannot be interpreted as telling us anything more substantial about the level or
nature of competition in the market. Churn rates tell us nothing about the effect of that
churn.
112.2 NUMBER OF RETAILERS
The AEMC, amongst others, has pointed to the number of retailers operating and entering
the Victorian energy retail market, noting in its 2014 report the “strong rivalry” between
these retailers.
It is certainly true that there are many licensed retailers in Victoria. Looking just at
electricity, in 2013-14 there were about 35 licensed electricity retailers in Victoria. Of these,
24 were active in the market place insofar as they had customers. Of these, 18 were
supplying electricity to household customers. Five of these retailers were very small, having
just over 10,000 customers between them. Without doubt, small operators can be highly
competitive and contribute to the ‘independent rivalry’ sought by the AMEC, but their lack
of scale probably suggests it is too early in their life-cycle for them to pose a serious threat to
other retailers or the market equilibrium that exists between those other retailers.
Among the remaining retailers, there are numerous related-party relationships due to
acquisition and mergers in recent years. Taking account of common ownership leaves 96 per
cent of the household retail electricity market is in the hands of six truly independent retail
groups.
To be clear, this analysis is not suggesting that six providers is not a sufficient number for
independent rivalry. Six independent providers can drive competitive outcomes. But six is
obviously a lot less than the headline figure we often hear about. While six providers may
still be a significant source of independent rivalry and competitive tension, it is surely less
significant than often claimed.
But whether the number is 6 or 16 or 3, is not particularly insightful. It is just a small piece of
information that tells us nothing about how those providers interact with customers or each
other.
122.3 PRODUCT DIFFERENTIATION
In assessing independent rivalry, the AEMC also identified that there was a high degree of
product differentiation ― mostly in the form of alternative tariff structures.
It is certainly true that there are many hundreds of offers available in Victoria at any one
time. When this is broken-down by distribution zone, meter type and contract type (standing
and market offers) it is likely that most individual customers would probably face a choice of
a dozen or fewer different market offers.
The AEMC review in 2014 found that only 13 per cent of Victorian residential customers
were currently looking for a better deal; 46 per cent were interested but not currently
engaged; and 37 per cent were just not interested. Of those currently not engaging with the
market, around one quarter of customers did not investigate options for switching their
retailer because it was either too difficult (“too much hassle”), too confusing or that choice
was not perceived to be genuine (“they’re all the same’). A slightly smaller proportion rated
themselves “too busy” to bother looking for a better option suggesting they did not believe
the value-for-effort proposition warranted the required investment of their time. In other
words, a significant proportion of customers appear to have little interest in the market or
what it has to offer.9
This weak customer interest in choice is a curious finding — particularly in light of the
unavoidability of the purchase. Choice or ‘product differentiation’ is generally viewed as a
hallmark of a (dynamically) efficient market responding to customers’ many and varied
preferences. While at one level there appears to be a reasonable degree of choice for
customers, that choice does not seem to be particularly appealing to customers. Despite
findings of extensive ‘product differentiation’ in the energy retail market, might these be the
wrong products as far as customers are concerned?
Almost all of the ‘product differentiation’ identified by the AEMC related to the design of
tariff structures (and similar claims have been made by the ESC in its annual pricing reports).
In December 2013, the AMEC found that, “Retailers are offering a wide range of tariff
products.”10 The reference to “tariff products” is very interesting.
In most markets, products are differentiated by their attributes and the prices charged by
suppliers reflect the different attributes of the differentiated goods and services. The
9
Note, one quarter of customers were “Happy with current arrangements” and the remaining customers surveyed
had varied other reasons for not engaging with the market.
10
AEMC, 2013 Residential Electricity Price Trends report, 13 December 2013, Sydney. (p. xiv)
13product and the price are distinct and separate features of the same object. The AEMC’s
reference to “tariff products” would suggest that pricing ― that is, tariff structure ― is
integral to, rather than separate from, the product being offered by retailers.
For the moment, most of that choice between “tariff products” is expressed in terms of:
(i) the balance between fixed and variable charges; (ii) the blocks at which different variable
charges apply; or (iii) the time at which different variable charges applied. One sample of
this choice of “tariff products” is highlighted in Figure 1. This analysis comes from a paper I
presented two years ago.11 The diagram shows how different retailers offered different
combinations of fixed and variable charges to customers like me. Clearly, there is some
dispersion of offers in the market.
Figure 1: Market offers – Usage and Supply charges12
(single rate tariffs, after discounts in United Energy distribution zone
as at February 2013)
120.00
110.00
Supply charge (c/day)
100.00
90.00
80.00
70.00
60.00
20.00 22.00 24.00 26.00 28.00 30.00 32.00
Usage charge (c/kWh)
Importantly, these different tariff products have no bearing whatsoever on the physical
product being delivered to the customer ― in this case, electrons (elsewhere, it will be gas
molecules). The only effect of these different tariffs is to offer customers a different
opportunity to limit their financial exposure. That is, for an expected level of consumption
and the customer’s expected probability of under- or overshooting that level of
consumption, the customer can make an assessment of the tariff structure that is likely to
result in the lowest expected electricity bill.
11
Ben-David, Ron (2013), Pursuing competitive accountability in retail energy markets.
12
Note, the diagram only shows one offer from each of the available retailers. Some retailers may have had multiple
tariff products on offer but these are not shown.
14In other words, a “tariff product” is a structure that reflects an assignment of financial risk
between the counterparties. It has nothing to do with electrons or molecules. Electrons or
molecules are effectively thrown in for free. Indeed, electrons or molecules can be
characterised as the free steak knives of the energy retail market. The true value customers
are buying comes from a financial instrument to help them manage their demand risk.13 If
that is the case, then the so-called “energy retail market” is really a market for financial
services rather than a market for physical delivery.
Could it be that energy retailers are not competitively selling electricity or gas, as is
commonly held? It might be argued that the primary basis on which they differentiate
themselves in the market place, and the primary basis on which they compete, is in offering
a financial service to customers. They differ only in terms of the financial services they
provide because they all throw in exactly the same electrons or gas molecules.14
This is quite an astonishing conclusion.
But there is one final implication that is possibly even more disquieting.
If energy retailers are really in the business of providing financial services rather than
physical services, then ought they to be regulated as such? Should we stop regulating this
industry as though it were an essential service and start regulating it as though it were a
financial service?
The advent of new technologies might render this question moot.
13
In more recent times, conditional discounts (for example, discounts for bills paid on time) add additional
dimensions to the risk management profile of tariff products.
14
It is acknowledged that there may be some refinement of this argument to account for any ‘green’ electrons
voluntarily purchased by customers. This is a marginal consideration and does not alter the line of reasoning.
152.4 RETAIL MARGINS
In May 2013, the Essential Services Commission released its findings on the potential growth
of retail margins in Victoria.15 In general terms, our findings were consistent with those
reported by the AEMC in 2011 and reaffirmed later in 2013.16,17 Victoria’s retail energy
market was displaying retail margins that were inexplicably high ― on a time-trend basis and
also when compared to other states.
The retail industry sought to wave away these findings; sometimes politely and in the spirit
of positive engagement, sometimes less so.18
In addition to criticising the methodology, the industry has argued that findings of excessive
margins in Victoria is not evidence of economic rents being extracted by retailers but is the
consequence of two external factors: (1) higher operating costs in Victoria due to the State’s
more onerous regulatory obligations; and (2) the more competitive nature of the Victorian
market imposing its own higher operating costs. Despite requests to do so, no evidence has
been put forward in support of these claims. It is therefore somewhat disappointing that the
AEMC gives credence to at least the first of these concerns by reflecting it in its 2014 report
without any further testing.19,20 Meanwhile, the latter claim is usually given short shrift by
the regulatory community. Competition being the source of higher prices does not fit with
our notions of competition, market efficiency and rational profit maximising firms. But
maybe, we have been too hasty in dismissing this claim by the retailers. Indeed, perhaps it
provides us with a very valuable insight into the true nature of the retail energy market.
Section 5.2 returns to these claims and provides an alternative view about the competitive
structure of the retail energy market ― one that might support retailers’ claims of an arms
race as well as the higher retail margins observed by the ESC and the AEMC.
Despite not examining the retailers’ claims of higher operating costs due to greater
regulation and competition in Victoria, the AEMC still set aside its (and the ESC’s) findings of
inexplicable retail margins, stating:
15
Essential Services Commission (2013) Retailer Margins in Victoria’s Electricity Market — Discussion Paper, May
16
Australian Energy Market Commission (2011) Possible Future Retail Electricity Price Movements: 1 July 2011 to 30
June 2014. 25 November 2011. Sydney.
17
Australian Energy Market Commission (2013) 2013 Residential Electricity Price Trends report, 13 December 2013,
Sydney.
18
For an example of the latter see: http://www.esaa.com.au/policy/so_competition_doesnt_work_1_1_1_1_2_1_1_1
19
AEMC (2014) ibid.
20
The AEMC also also highlighted that there may be methodological problems in modelling retailers’ wholesale
energy costs in the current environment (p.147 and pp. 174-180).
16“While such estimates can be informative, particularly when compared over a long
time series, they cannot be considered as ‘evidence’ alone of a systemic issue in the
market.” (2014, p.173)
This led the AEMC to conclude:
“We have concluded that competition is effective in Victoria’s electricity market. The
market has the right conditions to promote competition between retailers and we
have not identified issues to warrant policy interventions to alter retailer behaviour.”
(p.174)
It is unclear why the AEMC attaches less weight to its findings of retail margins than its other
findings. Indeed, it seems that its conclusion that the market is competitive precedes
consideration of its findings on retail margins (leaving those findings stranded outside its
assessment).21
It is also difficult to understand the AEMC’s reasoning when it suggests that the only
recourse in light of such findings would be “policy interventions to alter retailer behaviour”.
Of course, an alternative response might have been to acknowledge that such finds are
concerning and warrant further detailed analysis.
I will return to the matter of retail margins shortly.
21
Such approaches are discussed further in section 6.0.
172.5 BUT ARE WE ASKING THE RIGHT QUESTIONS?
Where does this leave us in our quest to understand the nature and extent of competition in
the Victorian retail energy market?
There is no doubt that the tests applied by the AEMC, in keeping with the original Australian
Energy Market Agreement, are dealing with various attributes of competitive markets. As
demonstrated in the preceding sections of this paper, the findings from applying each of
these tests do not leave us any the wiser about the true nature of competition. These tests
reveal signs of competition, not proof of it.
As such, the AEMC’s conclusion that:
“Intervening in a competitive market based on inconclusive evidence can lead to
unintended outcomes and reduce the effectiveness of competition.” (p.180)
is not in dispute. What remains to be tested however, is whether the market is indeed
sufficiently competitive and, as such, whether it warrants the AEMC’s warning that
intervention may reduce the level of competition.
This paper contends that the AEMC’s warning is not supported by its analysis of the market.
We do not yet know, based on the AEMC’s analysis, whether the Victorian retail energy
market is indeed sufficiently competitive as to warrant a warning that intervening will only
damage that level of competition. This contention is based on both matters of logic and
economics.
This is where Lara Bingle enters the discussion about the competitiveness of energy retail
markets.
183.0 ENTER LARA BINGLE
The Australian Energy Market Agreement laid out the features of a competitive retail energy
market that should be assessed before States move to deregulate their markets. These
features have formed the basis of the tests applied by the AEMC and discussed above. In
general terms, these tests ― or economic descriptors of competitive markets ― reflect
standard economic thinking about such markets. There may be a problem, however, in how
these tests have been applied in order to infer a conclusion.
For ease of exposition, I will use just one of the five descriptors used by the AEMC ― though
any of the other (or indeed, all) of the AEMC’s tests can be substituted into the following
analysis without altering the outcome. I begin with the test regarding entry to the market
and present it as a straightforward premise.
Premise 1: Competitive markets have low barriers to entry.
There is nothing remarkable with this statement. It is supported by every undergraduate
micro-economic textbook in circulation. In logic, this statement is known as a major premise.
Based on its research into the Victorian regulatory framework and feedback from market
participants, the AEMC then states:
Premise 2: The retail energy market has low barriers to entry.
Again, this statement is not contentious and is supported empirically. This second statement
is known as the minor premise. When combined with the first premise, it supports the
AEMC’s conclusion about the Victorian market.
Premise 1: Competitive markets have low barriers to entry.
Premise 2: The retail energy market has low barriers to entry.
Therefore:
Conclusion: The retail energy market is a competitive market.
While this is obviously a simplified representation of the AEMC’s analysis of the Victorian
energy market (which uses five tests), it is sufficiently representative of the inferential
analysis that has been applied.
19This form of reasoning is known as a syllogism. It is perfectly legitimate and has been used to
support arguments and conclusions since the time of Aristotle. Syllogisms are incredibly
useful devices. Let me show you why.
The two premises include a characteristic regarding ‘low barriers to entry’. This can be
replaced with a characteristic concerning ‘arms and legs’. The syllogism now reads:
Premise 1: Competitive markets have arms and legs.
Premise 2: The retail energy market has arms and legs.
Conclusion: The retail energy market is a competitive market.
While the two premises now look like nonsense, funnily enough, these changes do not
undermine the robustness of the conclusion. The conclusion still follows from the two
premises even though the two premises are nonsensical.
It is now possible to change the subject of the second premise. Enter Lara Bingle.
Premise 1: Competitive markets have arms and legs.
Premise 2: Lara Bingle has arms and legs.
Conclusion: Lara Bingle is a competitive market.
This supports a new and somewhat odd conclusion about Ms Bingle; but again, the
conclusion follows perfectly from the two premises.
Finally, we can change the subject of the first premises so that it is about Russian
cosmonauts rather than competitive markets. This necessitates a change to the conclusion
as well:
Premise 1: Russian cosmonauts have arms and legs.
Premise 2: Lara Bingle has arms and legs.
Conclusion: Lara Bingle is a Russian cosmonaut.
We now have a completely different syllogism from the one we started. This new syllogism is
just as robust as the one with which we started. The two new premises are true and not in
dispute, and the new conclusion logically follows from the two premises. But…
20Despite the accuracy of the new premises and the legitimacy of the logic, the new conclusion
is clearly nonsense.
So we have two identical and perfectly legitimate conclusions: one about the retail energy
market and one about Ms Bingle. The two syllogisms are identical in terms of their
construction and in terms of the logic upon which they rely.
Syllogism 1: Syllogism 2:
Competitive markets have low barriers to entry. Russian cosmonauts have arms and legs.
The retail energy market has low barriers to entry. Lara Bingle has arms and legs.
Therefore: Therefore:
The retail energy market is a competitive market. Lara Bingle is a Russian cosmonaut.
How can it be possible that two otherwise identically constructed arguments simultaneously
lead to both true and false conclusions about the real world? How and why are we prepared
to accept the first conclusion as proven and true, while we know with certainty that the
second is nonsense and false?
Please be assured that there is no sleight of hand at work here. I have not played any tricks
in morphing the first syllogism into the second. The two arguments are identical and equally
legitimate in their construction and in the conclusions they reach.
The problem with the second example is that it suffers from a phenomenon known as the
‘syllogism fallacy’ whereby two perfectly true premises lead to an unquestionably false
conclusion. But if that is true for the second example, and in its construction it is identical to
the first argument, then we ought to be very concerned about whether that first conclusion
is indeed true. Why are we so willing to accept the first conclusion? Why are we so willing
to accept that the retail energy market is really competitive when we have no doubt that
Lara Bingle is not really a Russian cosmonaut?
Have we accepted the first conclusion so readily because we want to believe it is true? Are
we just rationalising a conclusion that we want to believe to be true? Might we have fallen
21prey to that old saying that, “Believing is seeing”?22 We see only that which we already
believe to be true.23
Let me suggest, that such conclusions should not be left as matters of belief. Belief has no
place in determining whether a retail energy market is competitive or not.
22
“I wouldn't have seen it if I hadn't believed it” — Marshall McLuhan, philosopher and intellectual.
23
See section 6.0 for a further discussion of confirmation biases.
224.0 A MATTER OF ECONOMICS
There is a solution to the syllogism fallacy discussed in the previous section, but rather than
becoming overly distracted with arcane matters of logical construction, the following
discussion returns to the more familiar terrain of economics.
While I contend that the AEMC has not proven that the Victorian retail energy market is
competitive, I am certainly not contending that I have proven that it is not competitive.
But, does it even matter? Are we actually asking ourselves the right question?
Let me put it more provocatively: Who cares if the market is competitive or not?
I can almost hear a gasp of disbelief from those seated in the room. An economic regulator
asking such a question must surely border on the heretical. “Off with his head,” you may be
thinking. “Off with his head.”
But before I am led away to the chopping block, handcuffed and hooded, let me suggest that
the reason for the question’s apparent heresy is a precise demonstration that the modern
policy paradigm surrounding retail energy markets has become distracted ― distracted by
an article of faith pertaining to the primacy of something labelled “competition”.
Nowhere other than in that policy paradigm is competition anything other than a means to
an end. The end is always efficiency: the efficient allocation and use of society’s resources
such that suppliers’ production decisions align with the preferences exercised by consumers,
now and into the future ― without deadweight losses or economic rents. Efficiency is, and
must be, the outcome we seek. But competition is not synonymous with efficiency.
Competition is a means. Efficiency is the end. Testing for signs of competition is not
axiomatically equivalent to testing for efficiency.
Testing for, and finding signs of competition and declaring “mission accomplished” is
equivalent to declaring a cake will be delectable just because we observe the required
ingredients laid out on the kitchen counter. The causal relationship is insufficiently complete.
In the cake example, we know nothing about the competence of the baker, the suitability of
the baking tray or the consistency of the oven’s heat. In the case of competition, we learn
little (and maybe nothing) about efficient market outcomes from observations about
switching rates, retailer rivalry or product differentiation. Just as with the baking example,
there are many other factors that need to be considered, such as: the nature of the product,
the structure of the market and the behaviours of customers and retailers. However, even if
23all these additional factors are satisfied — whether regarding the baking of a cake or the
competitiveness of the market — we can still never be fully certain about the outcome. It
may be true that the more factors that we can satisfy ex ante the more confident we can be
with our inferences about the cake or the market, but there are better options than
inference.
The following sections highlight that we can do better than relying on inference if we focus
our attention on competitive outcomes rather than just signs of competition per se. The
three alternative tests pursued below include: the significance of retail margins (again); the
transmission of industry-wide supply shocks; and the persistence of particular tariff
structures.
Unless we apply the right tests, we can be no more confident about the outcomes produced
by the energy retail market than we can be about Lara Bingle’s ability to navigate her way to
the International Space Station.
244.1 RETAIL MARGINS REDUX
I now briefly return to the topic of retail margins.
I have already referred to the analysis undertaken by the AEMC (2011, 2013) and the ESC
(2013) which suggested the possible existence of economic rents in the Victorian retail
energy industry. Since then, others have sought to undertake their own analyses, including
St Vincent de Paul (2014),24 CME Australia (2014)25 and Brotherhood of St Laurence
(forthcoming). Figure 2 reproduces as faithfully as possible the findings by CME.
All these studies have reached the same broad conclusion ― namely, that despite Victoria
having lower generation and network costs than other States, our retail prices are not lower
than these lower input costs would suggest. In other words, Victorian retail prices are
inexplicably high.
Figure 2: Breakdown of average price for an average consumption household
35
30
(cents per kilowatt hour)
25
20
Non-network
15 charges
10
5
0
SA VIC QLD NSW TAS
(Australian Jurisdiction)
Without doubt, each of these analyses has its methodological strengths and weaknesses.
And yes, there is a probability that each study might be completely wrong in its findings. But
surely, after so many analyses and differing methodological approaches all pointing in the
same general direction, the regulatory community ought to be shifting its starting position
from doubt and disinterest to one of suspicion and concern.
24
Dufty, Gavin (St Vincent de Paul Society) and Mauseth Johnston, May (Alviss Consulting) (2014) The National
Energy Market – Wrong Way, Go Back? Observations from the Vinnies’ Tariff Tracking Project. Melbourne,
September 2014.
25
The Australian Financial Review on 21 November 2014 (Ben Potter, Govt aiming for power shift, p.11) published
analysis undertaken by CME Australia on the contribution network costs make to the average cost of energy for
typical residential customers. While the focus of the analysis was on network charges, it also showed that the
non-network contribution to energy prices in Victoria was broadly double that observed in other NEM States.
25And lest you think all of this talk of excess margins is just a pursuit of folly by the usual
suspects, let me suggest that it is not just me (and some of those other organisations just
mentioned) who suspect conditions in the retail energy market might support the
persistence of excess margins.
Let me share with you some analysis that was shared with me last year. It comes from well-
outside the usual cohort of culprits. Indeed, it comes from a very large, global investment
bank; one with a balance sheet the size of a national economy. This global player concluded
the following in an industry briefing note on the local retail energy market (see Box 1):
“When all market participants have similar pricing strategies, it’s not hard to
understand why profitability can be maintained despite the large number of retailers
competing for customers.”
At some point we should think about heeding the old saying, “If it looks like a duck, swims
like a duck, and quacks like a duck…”26
Box 1: Extracts from Investment bank’s assessment of the energy retail industry
“We acknowledge that there is further upside based on our understanding that annual Victoria
margins are $100/customer higher vs. NSW.”
“Victorian electricity retailers have moved their standing tariffs in the same direction every year
since deregulation in 2009, which in part explains why the state continues to be the most
profitable despite the high 25% customer churn.”
“Our analysis of the Victorian market suggests that [X] and [Y] are capturing gross margins of
$50-100/MWh. This compares to the $40/MWh allowed under the current NSW regulatory
regime.”
“Vic may have higher churn and therefore retail opex, but it also has the lowest cost electricity
in the NEM, meaning a large component goes straight to margins.”
“It’s almost counter-intuitive that the state (Vic) with the highest churn is also the state that
retailers enjoy operating in.”
“…all retailers have moved their standing offers in the same direction since tariff deregulation.
When all market participants have similar pricing strategies, it’s not hard to understand why
profitability can be maintained despite the large number of retailers competing for customers.”
(April 2014)
26
“…then it probably is a duck.”
264.2 WHERE HAVE ALL THE PRICE SHOCKS GONE?
In competitive and efficient markets, we would expect that industry-wide input price shocks
will be rapidly transmitted by producers through to consumers. We have seen this
mechanism at work each year as network prices have been increased. The introduction of
the carbon pricing regime in July 2013 represented another industry-wide price shock. As we
all know, energy prices increased accordingly very soon thereafter. No surprises on that
front.
The repeal of the carbon pricing regime was another industry-wide price shock, however.
Interestingly, despite the assumed competitiveness of the energy retail market, the federal
government still directed the Australian Competition and Consumer Commission (ACCC) to
monitor and ensure that this input cost reduction flowed through to retail customers.
Despite its confidence in, and commitment to, competitive markets, I suppose the federal
government thought it better to be safe than sorry.27
In light of the role given to the ACCC, the Victorian regulator chose not to monitor the
impact of the repeal. Fortunately, St Vincent de Paul did. It used its well-developed price
monitoring systems and skills to track the impact of the repeal on retail energy prices and it
reported its findings in November 2014.28 Reading the report on its release, I was struck by a
finding on which no commentary was provided.
It was reported that, in Victoria, the average annualised reduction off a standing offer was
around $175 for the benchmark household using 6000 KWh per year. This represented a
saving of around 8-9 per cent per year. This was in keeping with the federal government’s
estimated savings from the repeal of the carbon price.29 Looking at market offers for a
household using the same amount of electricity, Vinnies found that the saving following
repeal was notably lower ― averaging $95 or 5 per cent per year.
The discrepancy is odd. After all, customers on standing offers and market offers differ only
in terms of the retail prices they pay. The energy they consume is no different and comes
from the same source; uses the same network; and has the same carbon intensity. That
being the case, we might have expected that the dollar savings following the repeal should
27
For example, see: Commonwealth of Australia 2015. 2015 Energy White Paper. Canberra. April.
28
Johnston, May Mauseth (Alviss Consulting)(2014) Tax on, Tax off: Electricity prices before and after the repeal of
the carbon tax. A report prepared for St Vincent de Paul Society. Canberra. 17 February 2014.
29
For example, in a media release on 3 April 2014 (Consumers to benefit from lower energy prices when carbon tax
repealed) the Ministers for Small Business and Environment stated, “Power bills are forecast to be around 9 per cent
lower and gas prices would be around 7 per cent lower than they otherwise would be.”
27have been the same for the households modelled by Vinnies. But they were far from the
same: $95 seems like a lot less than $175.
Given the role of the ACCC, I turned to its report to see if it could shed any light on what had
happened in Victoria.30 Unfortunately, the ACCC report does not provide a clear discussion
about the different types of contracts, with only a few passing references. Nevertheless, the
numbers in Annexure 2 are not too different from those reported under Standing Offers in
the Vinnies’ report. In other words, it appears that the ACCC focussed its attention on the
impact of repeal on the more readily observable Standing Offers ― leaving it to the market,
rather than regulators, to ensure the savings were passed through to customers on market
offers.
Might the retailers have anticipated that this would be the case and therefore focussed on
delivering the savings where they thought the most scrutiny would be applied by regulators?
When I asked retailers about this apparent discrepancy in the savings returned to customers,
the only explanation I could garner was something to do with smoothing impacts across
different customer categories. I am still not sure what that really means.
So what happened to the savings for the 75 per cent of household customers who were on
market offers? How can it be that a negative industry-wide price shock failed to be
transmitted in full to those customers? What does this tell us about the competitiveness
and efficiency of the market?
(And, what does it tell us about the likely transmission of future negative price shocks such
as lower network charges?)
30
Australian Competition and Consumer Commission (2014) Monitoring of prices, costs and profits to assess the
general effect of the carbon tax scheme in Australia. October 2014.
284.3 THE MYSTERY OF TWO PART TARIFFS
Tariff structures in retail electricity still predominantly consist of a fixed charge and one-or-
more variable components. Customers pay a supply charge to the retailer irrespective of
how much energy they use and then they pay a usage charge reflecting the actual electricity
consumed. Typically, this tariff arrangement is explained as reflecting the cost structure of
the industry. After all, the energy sector is a capital-intensive or fixed cost industry. All those
poles, wires and power plants don’t go away if we use them less. Someone needs to pay for
all those fixed assets.
Today is not the time to go into the history and theory of network tariff regulation. While
there is no universal agreement on methodology, there is widespread acceptance of the
economic case for two part tariffs. Indeed, the network tariffs set by my colleagues at the
Australian Energy Regulator (AER) consist of fixed and variable charges.
If, indeed, it is the capital intensive nature of the industry that explains retailers’ fixed
charges, then we might expect a reasonably close relationship between the network’s
regulated fixed charges and those charged by unregulated retailers operating in a
competitive environment. Figure 3 highlights just how misplaced such an expectation would
be in Victoria.
Figure 3: Average retailer supply charges31 vs Distributor supply charge - Electricity32
( household customer, by distribution zone, $ per year for 2013-14)
450.00
400.00
350.00
300.00
250.00 Average Retailer supply
200.00 charge ($/year)
150.00 Distributor supply charge
($/year)
100.00
50.00
0.00
CitiPower Jemena Powercor SP AusNet United
Energy
31
Based on market offers pre-discounts (as reported annually by the ESC).
32
Retailers typically discount their usage charges rather than their supply charges but even if discounts were applied
to usage charges, the overall implications of Figure 3 remain unaffected.
29On average, in 2013-14, retailers’ market-determined fixed charges were over nine times
higher than the networks’ regulated fixed charges. As shown in Figure 4, this ratio has
fluctuated over the last six years between a multiple of 9 and 14 times, averaging at a
multiple of about 12.
Figure 4: Retailer supply charges as a multiple of the Distributor supply charge - Electricity
( 2008-09 to 2013-14 )
16.0
14.0
12.0
10.0
8.0
6.0
4.0
2.0
0.0
2008-09 2009-10 2010-11 2011-12 2012-13 2013-14
There is clearly a very substantial and persistent disparity between networks’ fixed charges
and those faced by customers in the bills they receive from their electricity retailers.
Moreover, the impact on customers of retailers’ fixed charge has been steadily increasing, as
shown in Figure 5.
Figure 5: Annual retailer supply charge as a proportion of total household bill - Electricity
(based on 4000 kWH per year for the five Victorian distribution zones, standing offers)
0.31
0.29
Annual supply as proportion of total
0.27
0.25 Supply Powercor
0.23 Supply SP Ausnet
bill
0.21 Supply Jemena
0.19 Supply United Energy
0.17 Supply Citipower
0.15
2008 2009 2010 2011 2012 2013 2014
Year
30For smaller households all the lines would shift up (that is, fixed charges would represent a
higher proportion of household bills) and they would move down for larger households ―
but the exact position of these lines is not particularly important. Likewise, the lines would
move around a little for customers on market offers, but the upward trend would remain.
While it is not obvious why these lines should be sloping upwards, it is not their upward
slope —that is most concerning. The most curious aspect of lines shown in Figure 5 is that
they exist at all.
Let me put it this way: Competitive markets don’t do two-part tariffs.
Think about it like this: Where else do customers making purchases in a competitive
environment confront prices that consist of fixed and variable components?
The answer to that question has nothing to do with large, fixed input costs. There are plenty
of businesses in other markets with high fixed (or almost fixed) costs. Those firms do not
charge their customers a fixed price before delivering them any goods or services. Myer does
not sell tickets to enter its stores. Its customers just pay for the goods they acquire. Petrol
customers are not required to purchase an ‘access right’ to the bowser, they just pay for the
petrol. Iron ore companies (one of the most capital intensive industries of all) do not charge
their customers a ‘negotiation fee’. Their customers just pay for the iron ore delivered.33
Suppliers in competitive markets cannot (and do not) extract fixed and variable charges for
the services they provide. Yet, somehow, energy retail companies can do precisely this.
They ubiquitously demand that their customers purchase a ‘right to be supplied’ before the
first kilowatt or mega joule is even delivered. It is called a “supply charge” and as shown in
Figure 5, retailers are imposing this charge on customers in increasing quantum and
proportion.
There may be some examples from other competitive sectors where fixed and variable
charges are observed. I would posit, however, that in those cases the fixed charges reflect
some form of additional or exclusive benefit; or they are negligible relative to the value of
the overall purchase price (for example, representing an administration fee); or they are a
pass through of external costs.34 Of course, we observe two part tariffs in price regulated
33
Even in the wholesale electricity market, fixed charges (i.e. capacity charges) have been rejected — as discussed
by the CEO of the AEMC in a recent speech. See: Smith, Paul (2015) Australia’s work to encourage demand side
participation and the implementation of the Power of Choice review. 28 May 2015.
34
In some sectors we observe split tariff structures. For example, there are mobile phone plans whereby a customer
pays a fixed charge and receives in return a fixed volume of calls, text messages and downloads. The customer then
pays a variable charge when that usage is exceeded. This differs significantly from energy retailers’ two part tariffs
where the fixed and variable charges both apply from the first unit consumed.
31sectors. Clearly, regulated networks charge their customers —the retailers — two part
tariffs.
But retailers are not networks and the forces determining retailers’ price structures are very
different from the forces determining networks’ prices. Whereas a boffin with a textbook
and spreadsheet will determine the structure of network tariffs, we should expect
unregulated retailer tariff structures to be moulded into their most efficient form by the
rough and tumble of competitive forces. To the best of my knowledge, there is nothing in
micro-economic theory that supports producers or service providers in highly competitive
markets charging prices with fixed and variable components (that are non-trivial and which
apply from the first unit consumed).
Two part tariffs are very unusual — one might say, even unnatural.
So how is it possible that the forces of nature — or in this case, the forces of competition —
can be suspended in this market when they are not suspended in any other market? Sure.
Network charges are a large input into a retailer’s cost base. But fixed-cost inputs are not
unique to energy retailers. How is it possible that the oft-described “highly competitive
retail [energy] sector”35 can charge its customers for the privilege of being supplied whereas
Myer, Shell and BHP cannot charge their customers likewise?
I can offer only one explanation for this phenomenon.
At the time of privatisation, retail licences were stapled to distribution licences. Before too
long, the market uncoupled the licences. Thereafter, networks became just one input into
retailers’ cost structures. In those early days, retail energy prices were set by my regulatory
forebears at the Office of the Regulator-General. In effect, they applied network tariff
theories (with their emphasis on fixed and marginal cost) to the setting of retail tariffs. In
hindsight, perhaps they should not have done so.
Some time later, regulatory controls on retail prices began were eased in the expectation
that competition would drive efficiency in pricing. By 2009, all price controls had been
removed. Yet, despite the unimpeded opportunity for competition to mould retail tariff
structures and the passage of many years, retailers have somehow been able to sustain their
old utility-like tariff structures. Somehow, fifteen years of competition has not seen supply
charges bid away to zero (or near zero) as we might expect from competition and as seen in
every other market. Not only are supply charges not zero or trending toward zero but as
35
For example, see: Pierce, John (2015) Towards smart regulation: Efficient market outcomes in periods of
transition. Speech by Chairman [of Australian Energy Market Commission] at the World Forum on Energy
Regulation. 28 May 2015.
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