Why electricity prices are high and going higher

It's never my policy to feel sorry for any politician, so let's just say I wouldn't like to be in Malcolm Turnbull's shoes when he meets the electricity retailers he's summoned to Canberra on Wednesday.

His hope is to persuade them to do more to help their customers find the best prices on offer, so that any savings customers make reduce, to some extent, the further big price rises that are on the way.

Trouble is, it's long been the practice of many big businesses – telcos, internet service providers, electricity retailers – to make it as hard as possible for their household customers to find the "plan" that meets their needs most economically, and also to take advantage of any trusting customer on a more expensive plan than they need.

So, whatever noises they make after their meeting with the Prime Minister, I can't see the likes of Energy Australia, Origin Energy and AGL – which between them have about 70 per cent of the retail market – volunteering to help their customers pay less.

Turnbull seemed to begin the year hoping to shift the blame for high electricity prices to Labor – which, federal and state, certainly has contributed to the problem – but it finally seems to have dawned on him that, if further big price rises are coming through right now, voters are likely to lay most of the blame on whoever happens to be prime minister at the time.

And, after all, it was Tony Abbott who sought election in 2013 on the claim that the big rise in power prices was caused almost solely by Ju-liar Gillard's price on carbon, and that abolishing the tax would fix things.

In truth, the story of why retail electricity prices have risen so far – doubling over the past decade, even after allowing for inflation – is long. But let me summarise.


About the first 30 per cent of the retail price is accounted for by the wholesale price – the cost of generating the power.

This component didn't contribute greatly to the price doubling of the past decade, but is now the chief source of the recent price rises of 15 to 20 per cent in some states, with more to come.

About the next 40 per cent of the retail price comes from network distribution costs – the cost of taking electricity from the power stations and transmitting it, first, through the high-voltage power lines and then through the poles and wires that distribute it to our homes.

It's this component that explains the great bulk of the doubling in the real retail price.

Because the distribution network is a natural monopoly, the prices the privatised or still government-owned distribution companies are allowed to charge are controlled by the Australian Energy Regulator, using a cost-plus formula.

Trouble is, with connivance by the NSW and Queensland governments, which retained government-owned distributors, the companies soon found ways to game the formula.

They claimed they needed to spend big on strengthening their networks to ensure that the spike in demand for power on just a few hot afternoons each year could be met without blackouts.

There were much cheaper ways to reduce the risk of blackouts – such as by rewarding some users for cutting back on those few days of peak demand – but these wouldn't have been as lucrative for the companies.

After years of big price rises to pay for this "gold-plating" of the network, the regulator finally woke up and tried to wind back some of the increase.

The NSW Coalition government, anxious to maximise the sale price of the poles-and-wires companies it was about to partially sell off, took the regulator to court and got the price roll back stopped in its state.

This brings us to the final 30 per cent or so of the retail price accounted for by the electricity retailers' margin.

Price control over these margins was lifted some years ago in the belief that competition between retailers would keep their margins in check, but it hasn't really worked.

This is partly because the companies try to avoid competing on price, and partly because not enough people use the government website, energymadeeasy.gov.auhttps://www.energymadeeasy.gov.au, to check every few years that their existing supplier isn't taking advantage of them.

But now the formerly stable wholesale generation part of the market has begun producing big price increases, with more to come.

This is partly because very old power stations are being closed and not sufficiently replaced by new generators, thanks to uncertainty about how the transition from fossil fuels to renewable energy is to be managed.

Having abolished Labor's carbon tax, the Coalition has so far failed to replace it with any other mechanism because of opposition from its climate-change deniers.

But also partly because miscalculations by one of the three gas companies permitted by the previous Labor government to build big gas export facilities in Queensland has pushed gas prices way above even the higher export-parity price.

Apart from crippling some industries, this has greatly reduced the ability to use gas-fired power stations to cover the "intermittency" of wind and solar power, pending the arrival of adequate storage technology.

Turnbull has threatened to use the feds' export powers to reserve sufficient gas for domestic use, but we're yet to see this have its effect. Much potential price pain lies ahead.

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Cost-of-living talk provokes bulldust

I read that the Turnbull government has decided to make the cost of living its focus for the year. Oh dear. In that case, brace yourself for a year of con jobs and flying bulldust.

There's a long history of politicians professing to be terribly concerned about "the cost of living" and nothing good ever comes of it. It's always about saying things to keep or win your vote and rarely about doing anything real – let alone sensible – about prices.

Politicians start "focusing" on the cost of living when the spin doctors running their party's focus groups report that the cost of living keeps coming up in the things the punters are saying.

But this is a strange time for the cost of living to be high on people's list of complaints. The rate of inflation has been below the 2 per cent bottom of the Reserve Bank's target range for two years.

My theory is that the cost of living is what you complain about when you've got no bigger worries. Say, that unemployment is shooting up and you're worried about losing your job.

Politicians' professed concern about the cost of living invariably leads to bulldusting because, where prices are set by private businesses operating in the market, pollies have neither the ability nor the desire to do anything about them.

Any price you have to pay is a price some business receives. And it'd be very lacking in generosity should any government want to lower that price.

That's why so often pollies limit themselves merely to continually repeating "I feel your pain".

It seems, however, that Malcolm Turnbull's spinners are using "the cost of living" as a catch-all for "focusing" on three prices in particular: for energy, childcare and housing.

Particularly in the case of childcare, these are prices heavily influenced by government policy. The government has never wanted to talk about housing affordability, so the focus groups must be telling it to do something.

As for childcare and energy, my guess is the government has thought of these itself, believing them to offer it an edge against Labor in the eternal blame game.

If the government's latest omnibus bill passes through the Senate, it will be able to trumpet the late arrival of the big cuts in the cost of childcare first promised in the budget of May 2015.

If the omnibus doesn't make it through, the government will be loud in blaming the high cost of childcare on Labor.

There's no industry more heavily government regulated than energy. Indeed, the "national energy market" was artificially created by federal and state governments in the late 1990s. It's governed by a rule book of more than 1000 pages.

The government has three goals in energy, with plenty of room for conflict between them: to keep energy flowing without blackouts, meet our Paris commitment to reduce carbon emissions, and keep price rises to a minimum.

The industry is going through huge disruption as renewables replace fossil fuels, and the government hasn't yet come up with a policy to achieve its conflicting goals, but that's not the point.

It believes it has more credibility with voters on energy prices than Labor has, so it will have little trouble shifting the blame for price rises and blackouts to Labor. That's especially so since responsibility for energy is shared with the states, and most of the premiers are Labor.

Focusing on energy prices will also divert attention from a topic where the Coalition's credibility with voters is much less than Labor's: climate change.

Do you buy "energy"? People I know buy electricity and maybe gas as well. The pollies have switched to talking about "energy" because they don't want to mention that three-letter word "gas".

That's because the big price hikes in recent times have been for gas. It's gone from being a third of the price of gas in America 10 years ago, to three times the American price today.

When the boss of BlueScope Steel warns of a looming "energy catastrophe", that's what he's referring to. Our manufacturers now face hugely higher prices for the gas they use.

Politicians on neither side want to talk about gas prices. Why? Because federal governments of both colours were responsible for letting it happen. They allowed the development of a liquefied natural gas export industry in Queensland.

Now, all the gas produced in eastern Australia can be exported to Japan or China for much higher prices. If we want some, we have to pay the "export parity" price.

This has given a huge windfall gain to our gas producers. But it's also disrupted the electricity market by making our gas-fired power stations uneconomic.

But please don't think about that. The real problem, we're told, is too much renewable energy which, though it's been encouraged by the renewable energy target begun by John Howard and continued by Tony Abbott, is all Labor's fault.

It appals me the way first, climate change, and now energy policy have been turned into partisan, salute-the-flag issues. If you vote Liberal you're expected to be dubious about climate change and have a grudge against renewable energy, particularly wind turbines; if you vote Labor it's compulsory to love both.

There'll be a lot of game playing on energy this year, but much less effort put into fixing the problems while minimising price increases.

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Our new comparative advantage: renewables

The old joke says the questions in economics exams don't change from year to year, but the answers do. Welcome to the economics of energy and climate change, which has changed a lot without many people noticing - including Malcolm Turnbull and his climate-change denying mates.

They've missed that the economics has shifted decisively in favour of renewable energy, as Professor Ross Garnaut​, of the University of Melbourne, pointed out at an energy summit in Adelaide last October.

Garnaut is chairman of Zen Energy, a supplier of solar and battery storage systems. But there aren't many economists who know more about the energy industry and climate change than Garnaut, who's conducted two federal inquiries into the subject.

He says that, since his second review in 2011, there have been four big changes in the cost of renewable energy relative to the cost of energy from coal or gas.

First, the cost of renewable energy generation and energy storage equipment has fallen "massively".

The modelling conducted for his inquiry assumed the cost of photovoltaic solar generation would fall by a few per cent a year. In practice, costs have fallen by about five-sixths since that assumption was made.

"Similarly large reductions have occurred in the cost of lithium ion batteries and related systems for storing energy," he says.

There have been less dramatic but substantial reductions in costs of equipment for electricity from wind and other renewables.

The cost reductions come from economies of scale in the hugely increased production by China and others, plus savings through "learning by doing". Advances in technology will keep prices falling after scale economies have been exhausted.

Second, there have been "transformational improvements" in battery storage technology, used at the level of the electricity grid, to ensure balance between supply and demand despite renewables generators' "intermittency​" (inability to operate when the sun's not shining or the wind's not blowing).

Third, there's been a dramatic reduction in the cost of borrowing the money needed to cover the capital cost of generation equipment.

Real interest rates on 10-year bonds are below or near zero in all developed countries, including Australia.

"These exceptionally low costs of capital are driven by fundamental changes in underlying economic conditions and are with us for a long time," Garnaut says.

Low interest rates reduce the cost of producing, storing and transporting renewable energy more than they reduce the cost of fossil-fuel energy because renewable costs are overwhelmingly capital (sun and wind cost nothing), whereas fossil fuel costs are mainly recurrent (digging more coal out of the ground).

Fourth, there's been a dramatic increase in the cost of gas - and thus gas-fired electricity.

Ten years ago Australia had the developed world's cheapest natural gas - about a third of prices in the US. Today, our prices are about three times higher than in the US.

Why? Because the development of a liquid natural gas export industry in Queensland has raised the gas prices paid in eastern Australia to "export parity" level - the much higher price producers could get by selling their gas to Japan or China (less the cost of liquefaction and freight).

It's worse than that. Because foreign investors were allowed to install far too much capacity for LNG exports - meaning none of them is likely to recover their cost of capital - they've been so desperate for throughput they've sometimes bid gas prices well above export parity.

Apart from making gas-fired power more expensive relative to renewables, this has implications for how we handle the transition from "base-load" coal-fired power (once you turn a generator on, it runs continuously) to intermittent solar and wind production.

It had been assumed that gas-fired power would bridge the gap because it was cheap, far less emissions-intensive than coal, and able to be turned on and off quickly and easily to counter the intermittency of renewables.

Now, however, without successive federal governments quite realising what they'd done, gas has been largely priced out of the electricity market, with various not-very-old gas-fired power stations close to being stranded assets.

What now? We thank our lucky stars the cost of energy storage is coming down and we get serious about storage - both local and at grid level - using batteries and such things as "pumped hydro storage" (when electricity production exceeds immediate needs, you use it to pump water up to a dam then, when production is inadequate, you let the water flow down through a hydro turbine to a lower dam).

In other words, the solution is to get innovative and agile. Who was it who said that?

Turnbull's party seem to be pro coal and anti renewables partly because they know we have a comparative advantage in coal.

We can produce it cheaply and we've still got loads in the ground. The rest of the world is turning away from coal and the environmental damage it does, but let's keep opening big new mines and pumping it out, even though this pushes the prices our existing producers get even lower.

If the banks are reluctant to finance new coal mines at this late stage, prop them up with government subsidies. Join the international moratorium on new mines? That would be unAustralian.

But get this: Garnaut says we also have a comparative advantage in the new world of renewables.

"Nowhere in the developed world are solar and wind resources together so abundant as in the west-facing coasts and peninsulas of southern Australia. South Australian resources are particularly rich...

"Play our cards right, and Australia's exceptionally rich endowment per person in renewable energy resources makes us a low-cost location for energy supply in a low-carbon world economy.

"That would make us the economically rational location within the developed world of a high proportion of energy-intensive processing and manufacturing activity.

"Play our cards right, and Australia is a superpower of the low-carbon world economy."

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