AER Releases Draft Decision on 2022/23 Default Market Offer Prices
Fast Facts.
Under the Competition and Consumer (Industry Code – Electricity Retail) Regulations 2019 (the Regulations), the AER is required to set the DMO price each year for regions that have no retail price regulation – being NSW, South-East Queensland and South Australia.
The purpose of the DMO, as identified by the ACCC at its conception, is to act as a fallback for those customers who are not engaged in the market. This includes customers who have never taken up a market offer; customers who are supplied under obligation by a retailer (e.g., those with poor credit history where retailers would not otherwise supply them); or customers who have defaulted to a standard offer after a market contract has expired.
The AER is required to set DMO prices for residential customers on flat rate or TOU tariffs; residential customers with controlled load; and small business customers on flat rate tariffs. There are around 580,000 residential customers and 102,000 small business customers for which the DMO prices apply, with the majority in NSW and South-East Queensland.
The Regulations require the AER to consider a range of specific factors in determining a reasonable annual price. These include wholesale electricity, network and retail costs, costs to acquire, retain and serve customers, and the principle that a retailer should be able to make a profit.
In Ausgrid’s distribution zone, the AER has reduced all of the DMO prices. Residential without controlled load fell by 5.1% in real terms, residential with controlled load fell by 4.9% in real terms, and small business without controlled load fell by 5.9% in real terms.
In Endeavour Energy’s distribution zone, the AER also reduced all of the DMO prices. Residential without controlled load fell by 4.2% in real terms, residential with controlled load fell by 1.7% in real terms, and small business without controlled load fell by 0.2% in real terms.
In Essential Energy’s distribution zone, the AER also reduced all of the DMO prices. Residential without controlled load fell by 5.6% in real terms, residential with controlled load fell by 6.5% in real terms, and small business without controlled load fell by 2.2% in real terms.
In Energex’s distribution zone, the AER also reduced all of the DMO prices. Residential without controlled load fell by 4.2% in real terms, residential with controlled load fell by 1.7% in real terms, and small business without controlled load fell by 0.2% in real terms.
In South Australia Power Network’s (SAPN) distribution zone, the AER reduced most but not all DMO prices. Residential without controlled load fell by 0.6% in real terms, residential with controlled load rose by 1.1% in real terms, and small business without controlled load fell by 2.0% in real terms.
The AER is holding an online forum on Wednesday 9 March. Interested parties may make a submission on the draft determination by close of business 17 March 2022.
Background
Under the Competition and Consumer (Industry Code – Electricity Retail) Regulations 2019 (the Regulations), the AER is required to set the DMO price each year for regions that have no retail price regulation – being NSW, South-East Queensland and South Australia.
The purpose of the DMO, as identified by the ACCC at its conception, is to act as a fallback for those who are not engaged in the market. This includes customers who have never taken up a market offer; customers who are supplied under obligation by a retailer (e.g., those with poor credit history where retailers would not otherwise supply them); or customers who have defaulted to a standard offer after a market contract has expired).
The AER’s DMO price determination applies to small business and residential customers in South Australia (SA), New South Wales (NSW) and South-East Queensland where there is no other retail price regulation. This means it does not apply in areas which are price regulated – for example Ergon Energy’s distribution zone is price regulated by the Queensland Competition Authority.
The DMO price for each region acts as a reference price for comparing residential and small business electricity offers. When advertising or promoting an offer, retailers must show the price of the offer in comparison to the DMO. This aims to help customers more easily compare different offers.
The Regulations require that the AER must have regard to a range of factors in setting the annual DMO price. These include ensuring that retailers can recover the costs they incur to serve customers and make a reasonable profit, including having regard for the incentives inherent in the DMO prices for retailers to compete, innovate and invest. The AER’s current process of setting the DMO prices is the fourth time that it has done so – the 2022–23 DMO process is therefore referred to by the AER as ‘DMO 4’.
The methodology for setting the DMO prices has changed over time – DMO 4 is a substantial shift from precedent.
The first DMO 1 was based on retailers' observed market and standing offer prices. The AER set the DMO price at the 50th percentile (mid-way) point in the range between the median standing offer (the upper bound) and median market offer (lower bound) in each distribution region. In relation to the median standing offer, the AER took the view that given this was an indication of what the majority of standing offer customers were likely to be actually paying, and the policy objective to reduce prices for these classes of customers, DMO 1 should be below this level. This therefore established the upper bound. The AER then viewed the median market offer as a lower bound (making an assumption that retailers would not seek to commercially contract with customers on a loss making basis) and accordingly, to provide incentives to invest, the DMO price should be above this level.
In DMO 2 and DMO 3, the AER considered the base levels in DMO 1 to be efficient, and only had regard to changes in underlying assumed costs for retailers including step changes.
The DMO 4 Options Paper released in October 2021 identified the option of a cost build-up approach and a shift away from indexation. Stakeholder submissions almost universally objected to this approach. Nonetheless, the AER has selected this as the preferred option, with the Draft Decision noting that “We have considered stakeholder feedback on these options and our draft decision is to adopt a cost build-up approach for the DMO 4 determination. We expect to continue using this approach in DMO 5 (2023–24) and DMO 6 (2024–25). Our view is that, moving forward, a cost build-up approach will best support the policy objectives”.
As justification it noted that “The cost build-up approach was the preferred approach of consumer representatives and a small number of retailers. However, many retailers raised concerns about the challenges and risks in us estimating representative costs using this methodology. We have given these issues careful consideration and provided a response throughout this determination document”. [1]
Key Issues
Establishing a cost build-up requires the AER to assess the hypothetical costs of a representative retailer servicing the customers in each distribution zone. This in turn requires assumptions to be made around how the retailer accesses wholesale markets, manages risk, operates its business, and establishes its retail margin requirements. While these types of exercises have extensive regulatory precedent, they are fraught with risk in that they must assume the size, scope, risk appetite, cost, funding arrangements, and scale of a hypothetical retailer and then apply this to all retailers.
In relation to wholesale costs, the AER made a number of assumptions about how a hypothetical retailer might buy energy in the NEM. Firstly, it assumed that the retailer engages in the market and pays a wholesale price influenced by energy supply and demand forecasts, sets a strategy to manage its exposure to the spot market, and then makes a decision about the level of residual exposure it is willing to accept in relation to spot market prices. On this issue, the AER assumed that the hypothetical retailer is risk-averse, therefore that the hedging strategy would include a mix of base, peak and cap contract products that would result in a small proportion of the total retail load being exposed to the spot market.
The cost of these products was calculated as the trade-weighted average of ASX energy daily settlement prices from the time the contracts are first listed, and the AER assumed that the retailer would accumulate these contracts from 36 months before the start of the relevant period (the ‘hedge book build period’). This resulted in estimated wholesale costs ranging from $67/MWh in 2021/22 in Essential Energy’s zone (for residential controlled load customers) to $119/MWh in SAPN’s zone (for flat rate residential customers), with all wholesale prices scheduled to rise between 2021/22 and 2022/23 (the largest in Energex’s zone which was forecast to rise by 24.9% YoY for flat rate customers).
For network costs, the AER used regulated network prices for each zone, which is presently uncontroversial.
In relation to environmental costs, the AER used publicly available forecast data to determine prices ranging between $16.75/MWh in Energex’s zone, to $20.39/MWh in SAPN’s zone, with all prices decreasing between 2021/22 and 2022/22 (by between 7.5% and 15.9%).
In relation to retail costs, the AER used data from the ACCC Inquiry into the National Electricity Market reports to examine retail costs. This data did not include advanced meter costs and therefore the AER separately obtain information on advanced meter costs from retailers.
There are shortfalls in using ACCC retail cost data: they reflect the costs of scaled tier 1 retailers, not smaller retailers; they do not include the cost of writing off bad debts; and do not include corporate overheads. The AER therefore augmented the ACCC data with bad debt costs from annual reports of listed retailers, and advanced metering costs provided directly from larger retailers. The AER determined base retail operating costs at $132/customer/annum across all residential customers, and $204/customer/annum across all small business customers, with bad debt costs set at $25.71/customer/annum across both types of customers. Annual metering costs ranged from $13.21/customer/annum in Ausgrid’s zone to $22.57 in SAPN’s area. Excluding CPI, retail operating costs ranged from $170.92/customer/annum in Ausgrid’s zone to $180.28/customer/annum in SAPN’s zone. Assuming 10MWh consumption per customer/annum provides a rough estimate of $18/MWh in retailer operating costs.
In relation to retail margin, the AER determined a retail allowance which would be a reasonable amount above cost. Customer stakeholders proposed that this allowance be set at no more than 5.7% over and above assumed costs. AGL submitted that 11% was a reasonable allowance, having regard for present margins in NSW and South-East Queensland. The AER’s draft decision set a residential DMO allowance of 10% and a small business allowance of 15%.
Our Insights
It is important to recognise the competitive dynamics that lie behind this draft decision. For the larger retailers, provided that the DMO price remains above cost plus reasonable margin, it is better to have a lower DMO decision from the AER than a higher one. This is because DMO customers are off market; shocking them with higher prices incentivises them to seek market offers and opens them up to churn away to smaller retailers.
The draft decision appears to meet this objective for first tier retailers. The AER’s decision to set retail allowances at 10% for residential and 15% for small business will reduce headroom in some cases and increase it in others. This is particularly evident in Ausgrid’s zone, where the AER reports DMO3 allowances to have been between 25% and 30% of the DMO price for small business customers and around 13% for residential customers. This means that while there will be a negative cashflow impact in supplying customers at the new DMO price, this may be offset by a reduced willingness for those customers to seek market offers. For others, however, such as in SAPN’s area where the AER calculated DMO3 allowances at between 1.3% and 4.2% of the DMO price, the cashflow impact for retailers will be positive but may induce customers to engage in the market.
The AER’s decision to phase the changes in impacted areas over three years will help smooth these impacts, meaning that for first tier retailers, the signals being sent to DMO customers will be diluted. For first tier retailers, this draft decision could be interpreted as not a bad outcome overall.
For new entrant retailers, which do not supply customers for the most part under DMO prices and would instead prefer to have customers on market seeking new contracts, the incentives are reversed. Provided that disadvantaged groups can be protected, a new entrant retailer would prefer to see as high a DMO price as possible, even though the returns from these prices accrue almost completely to their larger competitors. For these retailers, the opportunities likely lie not in arguing the cost building blocks but in seeking, above all else, for those customers who are commercially attractive to become engaged in the market.
In order for this to occur, customers will need to be exposed to a price shock sufficient to induce action. This is likely achieved by a three-pronged approach: arguing for disadvantaged groups to be identified and protected; removing the transition pathways for price shocks; and arguing for public information campaigns directed at those customers.
For customer groups, the objective is to protect the marginal customer. The DSO should ideally only exist for the benefit of those customers that have no other options; the pensioner who does not engage in the market because they do not understand the offers or the process, or the individual with the bad payment record. For all other customers, the objective should remain to get these customers to market, where the power and incentive of market competition can lower their cost of living and improve service levels.
For more information, contact Simone Rennie at srennie@renniepartners.com.au
[1] AER - Default Market Offer - Draft price Determination 2022-23 - 18 February.pdf, page 1
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