Energy market disruption - the implications for a regulator

In a speech at the 2015 Energy Networks Association Regulation Seminar in Brisbane, AER Chair Paula Conboy discussed energy market disruption.

Check against delivery

Introduction

Good afternoon and thanks to the ENA for the invitation to speak with you today.

I understand that it’s become a bit of a tradition for the ENA to hold this forum before the ACCC/AER Regulatory Conference across town later in the week. I also understand that it’s a bit of a tradition for this forum to look at the ‘big picture, longer term’ challenges that the Australian energy sector will face in coming years.

The topic I have been asked to address today very much fits into this ‘big picture, forward looking’ requirement.

There has been a great deal of commentary recently on ‘energy market disruption’ and how it may shape the future direction of energy markets and energy regulation.

Some of this discussion on ‘energy market disruption’ can tend to be somewhat esoteric. Sometimes the discussion infers that we are seeing shifts to markets that have previously been in some sort of static equilibrium.

But we have always seen our energy markets evolve. In the past, our markets have had to respond to changes in government policies, consumer preferences and to a lesser extent technologies.

We are seeing a range of developments that have the potential to impact the operation of the industry. As highlighted in a range of reports, including the recent Electricity Network Transformation Roadmap work by the ENA and CSIRO, we are seeing a shift from a centralised electricity supply model to one where consumers will have greater potential to control how their electricity is delivered and consumed. New products and services are emerging, including distributed generation and storage options, demand management services such as direct load control, and new business models for selling energy.

In the past, our regulatory frameworks have generally been able to accommodate or adapt to changes in market conditions. Will this remain the case going forward?

My presentation today focuses on the features of the current regulatory framework – features that enable the framework to deal with an evolving energy market and adapt to market changes. I also will note the modifications that are being made to some of these features to ensure that the regulatory framework remains capable of supporting this energy market change.

Incentive regulation

Perhaps the most significant feature of the current regulatory framework that supports efficient market evolution is that it is forward looking and incentive based. We shouldn’t overlook the importance that incentive regulation can play in flexibly responding to changes in energy markets.

The aim of incentive regulation is to encourage regulated businesses to make efficient expenditure and investment decisions – whether they are network or non-network solutions.

Under the incentive based approach to regulation, if a business can provide required services at lower costs than the revenue allowance we set, the business can ‘keep the difference’ for a period of time. This approach encourages businesses to flexibly adapt to a changing environment. Businesses have incentives to continually look for innovative ways to deliver energy services and make savings. The tools we use to improve incentive properties include the Efficiency Benefit Sharing Scheme, the Capital Expenditure Sharing Scheme and the Service Target Performance Incentive Scheme.

In addition, and subject to a given threshold, networks have an explicit obligation to conduct a regulatory investment test assessment to consider whether demand management and embedded generation are more efficient ways of providing services than augmenting networks.

But this does not mean that changes to the existing incentive regulation framework are not required to deal with energy market changes. Notably, the AEMC recently issued the Demand Management Incentive Scheme draft rules. These reforms, if implemented, will provide a framework to guide the AER in developing and applying a demand management incentive scheme and innovation allowance mechanism which would help to balance the incentives on distribution businesses to make efficient expenditure decisions.

We are participating in this rule change process and will amend guidelines to assist in the implementation of any rule the AEMC develops.

We have recently signalled that the regulatory investment test should be amended to include replacement capital. This will supplement the regulatory framework’s focus on only allowing efficient investment and requiring the most cost efficient options to be used.

Service classification

Not only is it important for us to ensure that the incentive framework remains sufficiently flexible and robust, but changes in the market are affecting where the line should be drawn between what needs to be regulated and what does not.

Currently, while there continues to be a need to regulate the core network service of transporting energy through the 'poles and wires', the regulatory framework allows for services which may be provided through competition to be treated differently.

Before a network business submits a regulatory proposal to us, we undertake a ‘framework and approach’ process that clearly and transparently sets out how we will apply aspects of the regulatory framework. The process provides an opportunity for the businesses, community and other interested parties to have a say on which services should be regulated, and how prices for those regulated services are determined. Levels of regulation for services are determined in accordance with 'degrees of competition'.

A service can be defined as part of the core services of the common network and its costs included in the revenue allowance for network services. Alternatively they could be classified as an individual service used by only some customers and a price set for that service. Or they may be negotiable and a negotiating framework is set up. Where there are options for competition, regulation may be limited or removed altogether.

This is a robust framework that is capable of being adapted to the more challenging questions around service classification that we are likely to face with the introduction of new technologies and services into the market.

The new products and services that are developing to meet consumer demands should be provided through contestable markets unless there is likely market failure that means that consumers need to be protected through regulation. Contestable markets are more likely to be innovative, to allocate risk to those best able to manage it and to meet consumer expectations.

We are beginning to see this competition emerge in the provision of some services such as metering. The AEMC has signalled that investment in metering and related services should not be driven by regulated monopolies but rather be driven by consumers able to choose products and services enabled by the technology that they value at a price they are willing to pay.

An approach to service classification and decisions about the form of regulation that are based on assessments of monopoly power, market failure and potential for competition should be able to deal with both the introduction of competition into services that have traditionally been provided by network businesses as a regulated service – such as metering, connections and public lighting – and with competition in the provision of new services.
This is not to suggest that these issues are straightforward. It requires us to consider what these new services might look like, which new services can be provided by competition and which may still need to be provided as a regulated service. It also requires us to consider whether more of the “network core services” will become contestable and what these services might be.

This all means that the framework and approach process assumes a greater significance than it has previously. The discussion on framework and approach in one reset may also have implications for other resets. Accordingly, our consultation and engagement processes at the framework and approach stage need to become broader.

Ring fencing

The Hilmer Report, the foundation of Australia’s successful national competition policy, identified the importance of industry structure in the development of effective competition. One of the key principles set out in Hilmer was the separation of natural monopoly and potentially competitive activities. Hilmer argued that without this separation there was a risk that monopoly returns made in the monopoly component of the market may be used to cross subsidise prices in the competitive market and drive out or disadvantage competitors. Further, a monopoly service provider may deny, or restrict access, to the monopoly service to prevent competition in the potentially competitive sector. Importantly, even if access wasn’t misused, the potential for it to happen may deter efficient new entry.

It is imperative that there is a level playing field between network businesses and other potential providers. My experience is that there is far from unanimous agreement on what constitutes a level playing field. By a level playing field, I mean participants being able to compete in the provision of services, knowing there is an appropriate framework in place to prevent the sort of harm that Hilmer’s structural reform proposals addressed. Structural separation and regulatory tools such as ring fencing guidelines form the basis of this framework in the NEM – as they do in many other regulated network sectors around the world.

Ring fencing of network businesses’ unregulated services is required to ensure that network businesses do not shift costs between regulated and unregulated activities. Ring-fencing may also set out rules for non-discrimination, limits on employee and information sharing between regulated and unregulated activities or prohibit a network business engaging in a potentially contestable activity.

The current distribution network ring fencing guidelines, inherited from the previous jurisdiction based regime, are overdue for amendment. As well as needing to shift the current guidelines into a nationally consistent framework, new guidelines will need to address the range of issues that will be presented by the introduction of new technologies and services into the market. The existing guidelines were designed largely to address the ring fencing of distribution from retail – the guidelines did not anticipate the evolving markets. Hence, there is a need to make them relevant in a changed market environment.

Ring fencing guidelines will be an important tool to support the development of effective competition in new services and it is important they be developed through broad consultation with all interested parties – network businesses, new service providers, retailers, customers and policy makers.

We anticipate getting started on consultation on these guidelines in the last quarter of this year. We note that there is already some good work out there, including from the ENA and CSIRO, to leverage off when our consultation begins.

Tariff reform

Customers are in the best position to make the right decisions about their own energy use – how they want to be supplied and what services they want. But they need clear and predictable information about the costs of the options they face. They will engage more readily and confidently with new market offerings, new sellers and new technology if they are confident about their choices. This will, in turn, lead to more competitive markets, particularly when faced with new services and sellers.

The tariff reform measures that have been introduced mean that over time, prices will be structured such that they better reflect the efficient cost of providing network services to individual consumers. This will support the information needs of consumers.

Under the new Rules, there is a more explicit requirement for tariffs to be structured efficiently and to move toward greater reflection of the underlying drivers of network costs. For example, the new pricing principles contain:

  1. an overarching objective for tariffs to reflect efficient costs of service delivery and removal of cross subsidies;
  2. a requirement for tariffs to be based on forward- looking costs - the long run marginal cost of providing services to a customer; and
  3. a requirement to structure tariffs with consideration to the time, location and varying nature of network cost drivers.

Network businesses will be expected to demonstrate how they have consulted with consumers and retailers in developing the network prices that they propose to apply from 2017. Network businesses will also be required to show how they have sought to address any relevant concerns that have arisen as a result of their engagement. Businesses will need to submit their initial tariff structure statements to the AER by late 2015.

As an aside, the Victorian distribution companies are currently in this phase of the process, which is still ongoing. As we understand it, a number have set up customer councils, pricing workshops and other forums as well as bilateral discussions with customers and retailers. These have focussed on the significance and relevance of tariff transitions in minimising customer impacts. For example, they have tested trade-offs with customers in how they should balance the pricing principles of moving towards more cost reflective tariffs but in a way that takes account of customer impacts. This feedback would be useful in informing the business on the rate of transition that is seen as appropriate.

It is very important that tariff reform is implemented well. The framework itself is robust. It gives the network businesses the ability to design appropriate, more cost reflective network tariffs in consultation with their customers, stakeholders and with the oversight of the regulator. It also provides the flexibility to move towards more cost reflective network tariffs carefully. This is important as gaining acceptance of tariff reform requires all stakeholders to be brought along the journey.

I think we have time to get this right. Our approach needs to be measured and incremental. Our objectives are clear and need to be aligned at every level and at every step of the way. Where misunderstandings occur, we need to discuss, educate and advise.

I’m confident in time that between us we can deliver the benefits of cost reflective pricing to energy consumers.

Alternative sellers

While the focus of my presentation has been on the network regulatory framework, the evolution of the market has retail market implications as well.

The AER’s retail market responsibilities provide a base upon which we support customers making informed decisions about their energy solutions. The Retail Law requires that an entity selling energy to a person for premises must hold either a retailer authorisation or an exemption (deemed, registrable or individual). At the time the law was developed, the retail market had a very simple structure, effectively comprising retailers and their customers. Today, we are applying that law to a range of new products and services that were not specifically contemplated even as recently as 2011. We have seen a lot of activity, particularly from solar power purchase agreement providers wishing to sell energy generated from solar panels installed at a customer’s home or business.

We are undertaking consultation and are seeking views from consumers, traditional industry participants, and the proponents and providers of new products and services in determining our regulatory approach in this area.

We are mindful that customers are looking for more from their energy supply than they once did. They are also looking for solutions that meet their individual needs. Customers may want to use solar pv or batteries, for example, but may not want to own or maintain that technology. These customers are better served if there are a range of potential service providers developing products and options that might suit them.

The COAG Energy Council’s Energy Working Group is also examining the regulatory implications of new products and services in the electricity market – one key question is whether it is appropriate to move away from ‘sale of energy’ as a threshold test for retail energy law application to a more targeted protection of supply of an essential service. This could leave the broader consumer law to provide additional protections for things like electric vehicles and solar panels.

It is also clear that – regardless of whether they adopt new technologies – consumers want to engage in this market, but need confidence in the information and protections available to them should they do so. The AER has very important roles in providing information, such as through our Energy Made Easy website. The consumer protection framework provides redress where consumers are misled or deceived. As a recent example, the AER (and ACCC) took action in relation to inappropriate telemarketing of energy offers by various retailers. In a time of change, adequate customer information, explicit informed consent and customer protection remain essential for consumers to confidently engage with energy markets and get the outcomes that best suit their needs.

Concluding remarks

The potential for change we are seeing in energy markets has implications for the operation of the regulatory framework. However, the idea that the framework is broken is in my view the wrong place to start. The regulatory framework has proved to be resilient and will generally be able to accommodate market change. To the extent that changes to the framework are required, the evidence suggests that existing policy and rule change processes will be able to identify and deal with any emerging issue.

Thank you for your time today. I am happy to take questions or hear your views on these important issues. I also look forward to catching up with you at the ACCC/AER Regulatory Conference over the next couple of days.