Mind the gap: Why are businesses seeing such large energy price increases?

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Ai Group has been hearing a lot from member businesses across Eastern Australia who are horrified by the enormous electricity and gas price increases they are facing. “I heard the wholesale price was doubling,” goes a common refrain, “so why is my bill going up three times or more?”

We also hear from skeptical policy makers who think industry may be exaggerating the scale of energy price rises, because the price metrics they can see are moving more slowly.

This gap between expectations and reality is a big deal; business viability and the policy priorities hang in the balance. What’s going on? This post digs in to the energy situation confronting industry, and the limitations of some available metrics. The electricity and gas situations are distinct; let’s deal with them in turn.

Electricity

The final cost of electricity is made up of wholesale energy costs, network costs, retail costs and costs for various State and Federal schemes funded by electricity suppliers. The mix of these elements in a bill and the total price paid varies dramatically for different energy users. In particular, very small users pay much higher prices that are dominated by network charges, while larger industrial users pay lower overall prices in which wholesale electricity costs are most important.

While increases in network charges were very significant from around 2010 to 2015, recent retail price pressure has been almost entirely about wholesale electricity prices. The table below shows how an illustrative wholesale electricity price increase of 1 cent per kilowatt hour (kWh) might affect the end price for an industrial and residential energy user.

 

Example starting price Price after increase Percentage increase
Household 25 cents/kWh 26 cents/kWh 4.0%
Industrial energy user 11 cents/kWh 12 cents/kWh 9.1%

 

Wholesale price increases thus tend to produce larger percentage end-price increases for industrial users. Differences in contract length can also amplify the increases that industrial users experience. Households typically contract for one or two years at a time, or rely on regulated rates or standing offers that are updated annually. Industrial customers may take short-term contracts too, but have often preferred three to five year deals.

Depending on conditions at the start and end of a longer contract (especially forward electricity prices at the time), an industrial user may see a very large change between the end of one contract and the start of another, where a household may experience a series of smaller changes.

The most visible sources of data on electricity prices are the wholesale market data published by the Australian Energy Market Operator and the futures price data available from the Australian Securities Exchange. The chart below joins together annual averages for volume weighted wholesale spot prices since the National Electricity Market was formed, with current prices for base futures contracts. Note that base futures prices are not directly comparable to historical wholesale prices. When retailers determine expected future wholesale prices, it is usual to include additional costs associated with caps (financial instruments to manage price risk). Therefore, expected future wholesale prices are likely to be higher than base futures indicate.

Figure 1 - historical annual average wholesale electricity prices (AER) and current futures prices (ASX)

Figure 1 – historical annual average wholesale electricity prices (AER) and current futures prices (ASX)

Our best explanation for the ongoing price rise is that the electricity market has greatly tightened, with more than 4 gigawatts of old coal capacity closing since 2012 and demand turning around recently after declining for many years. More demand and less supply usually means higher prices in any market, but the design of the National Electricity Market sets the price for all participants on the basis of the marginal bidder required to meet demand. In the tighter market, gas-fired generators are the marginal bidder more frequently, and the price of the gas they burn has surged at the same time as their role has grown.

The resulting price rise in the base futures market is very dramatic, roughly doubling from 2016 to 2017 in most regions, but the other factors canvassed above are making this an even more intense overall price rise for industrial users.

Many supply contracts now concluding were signed in 2014 and 2015, at a time when wholesale electricity prices were deeply depressed by strong oversupply, falling demand and the removal of the carbon price. These now-expiring contracts locked in low energy prices; we have spoken with many energy users in Victoria and New South Wales who were paying off-peak prices of 3‑4 cents/kWh and peak prices of 4-5 cents/kWh.

Businesses seeking new electricity contracts are now facing much higher prices. We have been shown quotes received by businesses in many states ranging from small to very large and covering everything from pharmaceuticals to food processing to plumbing products. There is some variation and the prices keep evolving, but the recent range of prices quoted for 2017-18 is around 10 cents per kWh off-peak and 18 cents peak.

For many that is a tripling of their off-peak price and a four-to-five-fold increase in their peak price.  For businesses with constant operations and relatively flat loads, and including all supply and policy charges, their new average price in 2017-18 may be around 10 cents/kWh higher than in their previous contract, or a nearly threefold increase.

It is important to note that base futures prices offered for 2018-19 and beyond decline from the highs of 2017-18, reflecting lower prices in the wholesale futures market and the expectation that significant new generation will enter the market as a result of the restart of mothballed gas generators and the construction of much new wind and solar generation to meet the tail end of the current Renewable Energy Target.

In Victoria, recent contract offers specify prices for 2019-20 of around 7 cents/kWh off-peak and 11 cents peak. In NSW and Queensland the decline is somewhat larger. 2017 is the year of the most intense price shock – though the situation can change rapidly and future reductions in generation capacity, such as the planned closure of the large Liddell power station in 2022, could produce new price shocks if there is no visible pipeline of new generation projects to fill the gap.

Gas

The Eastern Australian gas market is much less transparent than the electricity market and it is a great deal more difficult to observe meaningful prices. Most gas is sold through long-term and confidential bilateral contracts, not through open trading platforms. Most of the open platforms that exist are relatively new and all are largely used for balancing and dealing with transient shortfalls in demand and excesses of supply. There is no direct connection between these markets and the prices offered to retail gas customers.

Nevertheless, reported prices at the Wallumbilla Gas Supply Hub do show a substantial increase since it began operating in 2014.

Figure 2 - Wallumbilla spot prices (AEMO)

Figure 2 – Wallumbilla spot prices (AEMO)

The dip in late 2014 likely reflects the brief surge of uncontracted ‘ramp gas’ from wells coming into production to serve the not-yet-operating Queensland LNG export terminals. The spikes in July 2016 and January-February 2017 likely reflect surges in demand for gas-fired electricity when intense weather events coincided with problems for other generation sources. The larger dynamics of the market – the volumes of gas sought and made available for long-term contracting – only lightly coincide with the pressures of this short-term market.

Seeking data directly from energy users is a more promising window into the market. One obvious source is the ABS Producer Price Indexes, which include a measure of gas prices paid by businesses, including manufacturers. This index shows a gradual rise since around 2008, a short-lived price spike around the introduction and removal of the former carbon price, and only a modest uptick in the past year.

Figure 3 - producer prices for gas (ABS)

Figure 3 – producer prices for gas (ABS)

However, while the PPI is survey-based and substantial, there is a strong reason to believe that it is not a useful descriptor of the situation confronting most industrial gas users. As we understand it, the ABS includes LNG producers in their definition of manufacturers. LNG consumes vast volumes of natural gas – in Eastern Australia, LNG now uses twice as much gas as all other users combined – and much of this is produced by related entities and priced on an internal basis. The PPI is also a national index, encompassing the unconnected WA and NT markets where prices have differed greatly from the East.

As a result, we think the PPI movements reflect the increased production of LNG and its internal pricing decisions, rather than anything visible to power, industrial and residential gas users.

Our best guide to trends in gas pricing is the reports we receive from individual businesses. The story from chemicals businesses, brickmakers, dairy processors, metal treaters and more is very consistent. In south-eastern Australia, the wholesale element of industrial gas bills used to be around $3-4 per gigajoule. Contracts concluding in 2016 often had prices around $6/GJ. Like-for-like prices offered have increased rapidly and dramatically since then, with high-end offers of up to $24/GJ emerging in February 2017 and the typical offer hitting $17/GJ by July 2017.

As for electricity, network charges tend to be a much smaller proportion of the bill for industrial gas users and their overall price is lower than for residential customers. Contracts have tended to be multi-year.

As a result, it is now very common for industrial gas users to report a threefold increase in their gas prices from one contract to the next – a rise from around $6 to around $18 – or to report a four- or five-fold increase on the basis of a longer-term comparison to the prices in older contracts.

Our best explanation for the extreme rise in gas contract prices – not closely reflected in spot market outcomes – is that there is a looming and significant shortfall in uncontracted gas supply relative to the sum of pre-existing domestic demand and the new LNG industry’s requirements. Given the marginal role of the spot markets compared to bilateral contracting, it is perfectly possible for longer-term shortage to coexist with a spot market with very different dynamics. The lack of contractible gas and surge in prices is also likely to destroy demand, potentially meaning that spot market prices never match the highs of current contract prices for any sustained period.

Alternative theories of current gas contract prices may invoke market power behaviour by pipeline operators and/or gas retailers. While both transport and retail have problems worthy of reform, we do not find these convincing explanations for the current situation. The competitiveness of these segments of the gas market has not notably declined in recent years – except for the apparent inability of more than two gas retailers to secure any gas to offer to industrial customers.

It is the supply-demand balance, in a market with an unprecedented surge in demand growth and an apparently disappointing performance by new production, that seems to be the most plausible source of the current crisis.

For further details about the causes of rising energy prices, and the various energy management options available to your business, watch our recent webinar.

 

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Tennant Reed
Tennant is Principal National Adviser – Public Policy at Ai Group. He has worked heavily on climate and energy issues, advising Ai Group’s Leaders’ Group on Energy and Climate Policy and developing reports on natural gas supply, energy prices and energy efficiency. He also works on a range of issues related to manufacturing and innovation. Previously he was an adviser in the Department of Prime Minister and Cabinet, working on fiscal policy, stimulus and infrastructure.

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