IAN MCAULEY. Electricity discounts for some, price rises for others

If we follow the government’s suggestion that we should  hunt around for cheaper electricity there will be no net benefits, just a re-shuffling of who cross-subsidises whom in the market. We have been brought to this absurd situation by a blind faith in privatisation and “competition”.

Imagine if a state government, in response to morning traffic congestion, were to urge all businesses, government departments and schools to open at 6 am, on the basis that there is less traffic in the early morning.

It’s easy to see the absurdity of such a proposition. The absurdity is known formally as the “fallacy of composition”: what may be valid for one or a small number of people (if my workplace alone started at 6 am I would indeed avoid congestion) does not necessarily hold for the whole group.

Yet that is the fallacy in the Commonwealth’s suggestion that to ease the burden of electricity bills we should all be active consumers in the market, seeking the best bargain by shopping around.

If we follow that advice the likely consequence is that while some people would indeed benefit from switching – from their present plan or from their present retailer – others would almost certainly be paying more.

Some years ago I was working with a multinational team of public servants and academics in an OECD project on consumer behaviour, considering the effects of competition in utility markets – water, electricity and telecommunications.

The experience of countries that had gone down the track of privatisation and enforced competition was that these measures simply shuffled consumers around, with most paying more and a few paying less for their utilities.

We identified two dimensions of consumer behaviour.

First was a distinction between those who had plenty of time to go through suppliers’ offerings – the “time rich” – and those who were too pressed to shop around – the “time-poor” – usually busy people who had other things to do.

Second was a distinction between those who had computational skills, who had the arithmetical ability to compare offerings, and those who lacked such skills.

That led to three observed patterns of behaviour:

  • the time-rich with computational skills generally benefited from switching;
  • the time-poor, with and without computational skill tended to go along with whatever was on offer. They stuck with their suppliers and plans, not out of loyalty, but because they couldn’t be bothered searching. (Some who did switch actually switched to higher-priced services.)
  • the time-rich without computational skills, a group that included many older retirees, knew they were paying too much, but felt they could do nothing about it.

So the first group benefited a little, while the other three groups cross-subsidised them. And there were new costs in the system associated with the breakup of once seamless vertically-integrated state-owned monopolies (transaction costs in the language of economists). Competition isn’t cost-free.

The same goes for Australia. Because of the way our electricity industry is structured, lower prices for one group of consumers almost always have to result in higher prices for other groups.

That’s because the generation, transmission and distribution companies, whose costs comprise 70 to 80 per cent of one’s bill, are big firms with largely fixed costs over the medium term. In fact the generation and transmission companies, being regulated (and largely privatised) monopolies are guaranteed a generous return on capital under the rules of the National Electricity Market. There may be some market competition at the generation end, but only over the long term. in the medium term if some customers pay less, the companies make it up by charging others more in order to maintain their revenue.

At the retail end is there some potential for competition, in theory at least, but so far little if any benefit has been seen by consumers. Where the old state-owned utilities enjoyed the economies of a single universal customer base, the “retailers” (in reality commission agents who cream off 25 to 35 percent of our bill in return for smoothing out spot prices) spend huge amounts in promotion and associated costs of competition. Switching retailers may benefit the individual, but someone has to pick up the costs of closing old accounts and opening new ones.

It gets worse, however, because if some customers react to higher prices not by switching but by reducing consumption or going off-grid, the industry as a whole has a smaller customer base over which to absorb its costs, resulting in higher prices all around.

The government is well aware of this dynamic, and if it were really concerned about reducing emissions and preserving enough capacity for hot summer afternoons, it would be pressing for home and business owners to adopt conservation measures, and pushing for landlords to improve their properties’ energy efficiency. But that would be too much like Labor’s much-maligned home-insulation program (aka “pink batts”), and they probably want to ensure that there is enough demand to justify construction of a new coal-fired station.

The so-called National Electricity Market is a dud. It looks good in the abstract world of undergraduate economics, where under certain assumed conditions markets work to bring consumer benefits, but while competition works in many markets it doesn’t in the electricity market.

Anyone who knows even a little about engineering and consumer behaviour knows that electricity does not fit the textbook model. For example, the mathematics of the simplified standard economic model show that when demand falls prices fall, but the electricity market is so different from that model that over the short to medium term prices rise when demand falls.

For most people the benefits of competition are about standards of customer service, innovative products, and more reliable products. But electricity is a basic commodity, and every domestic consumer wants it delivered at 50 cycles, 240 volts, with a power factor close to 1.0. All the so-called “retailers” supply exactly the same product. Not an identical product, but the same product. All that’s left is the possibility of price competition, which, as demonstrated above, has only limited applicability in this industry.

Also, anyone familiar with the economics of the industry knows that privatisation carries perverse incentives that can be avoided in state-owned utilities with a public interest charter.

The most notable perverse incentive results from the commercial tendency for retailers to increase the fixed connection prices more than they have increased the price per kWh.

This results in an inequitable price structure, because for almost all consumers an electricity connection is a “must have” item (in economists’ terms the price elasticity is close to zero). And while we are so dependent on fossil fuels for generation it also results in unnecessarily high consumption and therefore greenhouse gas emission. It would be a far better allocation of resources to have cheaper or free connection fees, and low prices for the first few kWh per day, with a steeply rising tariff for high users – those who want to heat the swimming pool or air condition the dog kennel. But commercial pricing (known as Ramsay pricing) dictates that the highest prices should be charged to those whose needs are greatest, and the lowest prices should be charged to those whose consumption is discretionary.

A public utility, by contrast, can be directed to have a tariff (known as an inclining black tariff) that serves equity and environmental objectives, while covering costs.

Perhaps, at the government’s urging, a few retired engineers, economists and accountants will take the hint, and after devoting a chunk of their lives to poring over websites and constructing Excel models will save a few dollars on their bills (or maybe go off-grid). I doubt if they will show gratitude at the ballot box, however. After all, if the utilities had remained in public hands they would never have had to waste their time on such nonsense.

 

Ian McAuley is an adjunct lecturer at the University of Canberra and a fellow of the Centre for Policy Development.

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Peter Lynch

Thank you Ian for your most informative article. The operation of the NEM is clearly more complicated than it would seem at first glance and can fairly be described as, what you call it, “a dud”. The NEM becomes even more compromised when the government enters the fray. I would be interested to hear your views on how Mr Turnbull’s Snowy Hydro 2 is going to work in an otherwise privatised power market and what it can contribute to solving our power supply, emissions and cost problems. We generally think of hydro-power coming from natural water sources or being attached… Read more »

Don Macrae

It is clear that in moving from State based centrally controlled grids with concentrated coal fired generators to a national grid with multiple generators, some intermittent, and no national responsible authority, the ball has been dropped. Finkel’s recommendation for a new committee reporting to CoAg amounts to nothing more than tinkering, and does not address the core problem: there is no body with the resources and authority fix the obvious problems. While I agree with Ian McAuley that the NEM as currently operating is a dud, my feeling is the best way of ensuring that we and the planet benefit… Read more »

Gerard Yates

I agree, with this bargain hunting among competing suppliers there can be no real winners.
However we are in an area where the chance to even participate in this farce is denied. We have one supplier and that’s all!

Dog's breakfast

Thank you Ian.

Not just electricity, the gas market also, telecommunications, the health industry, railways, public transport generally, a host of services that are essential in the regions as well as the big cities.

Market economics has no place in these industries, and in Australia even less.

John Thompson

I find it interesting when I read reasoned posts like Ian McAuley’s and John Quiggin’s on the failed privatisation of the electricity industry that there is a deathly silence from the industry itself. No response. No countervailing argument. No rebuttal despite the formidable resources available to the industry. And not just on this website. (It is similar to the lack of response to arguments presented on the wasteful inefficiencies of the private health insurance system that we maintain. The private health insurers are similarly silent. Though Tony Abbott did claim that support for private health insurance was “in the DNA”… Read more »