The Privatisation of Electricity Assets in NSW

Today’s AFR column.

These Thai workers made their views about electricity privatisation very clearly known. Mind you, that isn’t of itself a great argument against it, just an apt photo – KP (from The Age)

Paul Keatings strength in government was his ability to make the case for government policies. There was theatre as well, but behind the drama was the compelling essence. It was a much needed skill, and its absence in NSW is a problem. The Iemma government wants to privatise its electricity generators, but it is floundering to make the case, even against weak union argument.

The union movement wants to win over the electorate, but its conflicting arguments must confuse more people than they convert. For example, unions want an electricity generating industry of world best practice. But they also worry that private owners of generators would reduce staff. Controlling costs is important to attaining best practice, and government bodies are typically over-staffed.

Unions also profess a concern that privatisation will lead to higher prices. But a properly structured, competitive electricity generating industry will lead to a reduction in electricity prices. Some efficiency improvements were achieved when the NSW generating monopoly, Pacific Power, was dismembered into contesting entities. However, continued government ownership of NSWs main generators – and weak transmission links between states – has allowed NSW Treasury to moderate competition to ensure the flow of healthy dividends into state coffers.

It is thus not surprising that the average wholesale price of electricity in NSW have been as much as 42 per cent a megawatt hour higher than Victorias. The NSW Audit Office further reported last year that, on average over the last five financial years, NSW prices were more than 20 per cent higher than Victorias. A similar but lesser difference exists between NSW and Queensland electricity prices. Costs must have had some bearing on these differences, but profit maximisation also played a part.

Because of NSWs desires for dividends, the profitability of the governments electricity industry has been markedly higher than the Australian average, and too high in absolute terms. Using Productivity Commission data, the Audit Office reported that NSW generators, transmitters and distributors collectively recorded a 15 per cent return on equity for 2006 and 2007. In the last three financial years, NSWs three electricity generating businesses recorded an average pre-tax annual return on equity of nearly 20 per cent. Earnings on assets were around 10 per cent. These are sterling returns for humdrum utility businesses.

But unions have not been the only dissemblers. When the union movement criticised privatisation because it would reduce government dividends and revenues, the NSW Treasurer, Michael Costa, said the proceeds of sale could be put in a term deposit at the local bank and earn more for the NSW taxpayers. Comparing annual dividend flows with interest earned on sale proceeds is misleading. And as the above returns indicate, the NSW government would be hard pressed to find a better investment than electricity, if revenues were the only concern.

Similarly, the government reassures voters by saying it will retain ownership of the electricity generators; it is merely leasing them. Economists, accountants, lessees and lessors know that there is little to distinguish a long-term lease from a sale. The passage of time eliminates nearly all of the differences between these divestment tools.

The Electricity Reform Implementation Group, a body established by the Council of Australian Governments, also embellished the case for privatisation when it claimed that budget pressures were limiting further government investment in the electricity sector. A large additional investment in NSWs generation and distribution sectors is pressing. But even with recent interest rate increases, needed investments can earn sufficient gross profit to service borrowings. And such borrowings, made outside of the general government sector, would not affect the governments budget. Still less would they imperil the states AAA status.

If jobs, dividends and revenue flow were the main issues, the union movement should have objected to governments selling banks, airlines, a gambling business, motor manufacturing, insurance companies, aluminium smelters, a brick factory, petrol refining, a shopping centre, a uranium mine and all the other businesses which Australian governments have sold over the last few decades. What we have seen from these sales is that governments run their businesses as monopolies, at the cost of the customer. And when they do engage in competition, it is at the cost of the taxpayer. Politics and business are bad company: each suffers when they are forced together.

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NPOV
NPOV
13 years ago

Can somebody explain how competition actually works in the electricity supply area?
As a consumer, I have no choice over which company generates my electricity.
I have no choice regarding which power lines it is transmitted through, or what substations it is transformed at. All I seem to have is a choice over the company that prints my bills. I gather it is also the company that purchases wholesale electricity from generators to supply as a retail consumerable, but as I discovered, if you don’t choose the retailer that primarily supplies the area you live in, you’re made to jump through hoops on every inquiry and/or pay higher prices.
It would at least seem that the electricity grid itself is a natural monopoly, and little can realistically be done to harness the power of competition to improve it.
But is there any reason consumers can’t be given direct choice over the wholesale provider?

Nicholas Gruen
Admin
13 years ago

Generation can be made fairly competitive NPOV and yes, reticulation is pretty much a natural monopoly. But transmission can often be reasonably competitive – for instance with interstate links.

Have a read around it – there’s lots about.

NPOV
NPOV
13 years ago

Well it was a rhetorical question more than anything.

I’ve no doubt that competing private industries should in principle be able to provide better and cheaper electricity supply to consumers, but it’s not clear to me that that’s actually occurred.

Further, how do we prevent the problem that the owners of polluting generation sources are compelled to sell as much electricity as possible, when we actually need to be reducing our usage of such electricity?

swio
swio
13 years ago

All this depends on the government getting the regulatory framework right.

We have seen with privatisations that there is a fundamental conflict of interest between the government being both the regulator and the seller. They get a higher price if the regulatory framework doesn’t produce competition. There is also the problem of different time preferences. The NSW government is almost certain to have a shorter time preference than a potential buyer so the likely outcome is that the goverment will go for the immediate reward (ie higher sale proceeds) and trade that away for a favourable regulatory environment and other things that would not become apparent until long into the future. What this all means is that for the privatisation of NSW electricity to be a net gain the NSW government has to put the interests of NSW a long way above its own incentives and conduct the negotiations with a very high level of competence to avoid NSW getting dudded by the buyer’s clever lawyers.

I don’t think the current NSW government can do that. They have already screwed up numerous PPP’s. They signed contracts with key items marked “commercial in confidence”, so if they do screw up the negotiations we won’t know until after the fact. And as for them putting the interests of NSW ahead of their own? Well I would never trust this bunch to do that. If we had Keating or Nick Greiner running the government it would be a different story. But you can’t put Morris Iemma and Michael Costa on one side of a table and Macquarie bank (with consultant ex-premier Bob Carr) on the other side and expect a good outcome.

The case for privatisations is pretty straight forward, but the case for privatisation NOW, as opposed to under some future signficantly more competent government seems pretty weak.

Nicholas Gruen
Admin
13 years ago

Good points SWIO.

SJ
SJ
13 years ago

I don’t think some bits of this piece stand up to close scrutiny. (And please don’t take any of this personally, Tony, I met with you quite a few times back in the 90s, and we were usually on the same side of the argument on all sorts of issues).

However, continued government ownership of NSWs main generators – and weak transmission links between states – has allowed NSW Treasury to moderate competition to ensure the flow of healthy dividends into state coffers.

It is thus not surprising that the average wholesale price of electricity in NSW have been as much as 42 per cent a megawatt hour higher than Victorias. The NSW Audit Office further reported last year that, on average over the last five financial years, NSW prices were more than 20 per cent higher than Victorias. A similar but lesser difference exists between NSW and Queensland electricity prices. Costs must have had some bearing on these differences, but profit maximisation also played a part.

Because of NSWs desires for dividends, the profitability of the governments electricity industry has been markedly higher than the Australian average, and too high in absolute terms. Using Productivity Commission data, the Audit Office reported that NSW generators, transmitters and distributors collectively recorded a 15 per cent return on equity for 2006 and 2007. In the last three financial years, NSWs three electricity generating businesses recorded an average pre-tax annual return on equity of nearly 20 per cent. Earnings on assets were around 10 per cent. These are sterling returns for humdrum utility businesses.

Would any of the problems you’ve highlighted here be alleviated by privatisation? No.

The weakness of the transmission links between the states has been designed into the market. It’s something that enabled SA to get higher sale prices for its generators, and it’s something that will enable NSW to get higher sale prices too. In effect, the taxpayers of NSW will benefit (temporarily) at the expense of NSW electricity consumers. The “regulatory test” that gets applied to proposed new electricity transmission assets does not consider price differentials between states as a benefit, on the basis that it represents a pure transfer from producer to consumer. The regulatory test is administered by the AER, a spin-off from the ACCC, rather than by the states, but the states had considerable input into the initial formulation of the test, and substantial ongoing ability to bring pressure for a change in the test via the COAG process. Privatisation of any or all parts of the industry in NSW will have nil impact on the interstate transmission links, and the restricted competition that results from them.

However, continued government ownership of NSWs main generators… has allowed NSW Treasury to moderate competition to ensure the flow of healthy dividends into state coffers.

I don’t think this bit is even true.

There’s limited price competition between retailers, because IPART sets maximum levels for regulated tariffs, and this forms a baseline price for competitive tariffs. It’s frequently argued (by, e.g. the BCA, IPE) that the regulated tariffs should be eliminated or increased to increase “competition”, but we can all recognise this as code to “monopoly profit extraction”. Privatising the retailers will have nil impact on this situation, unless IPART’s role is eliminated as part of the privatisation, which would have a negative impact on consumers.

There is limited competition between the generators, which is purely a function of the number of them, and not (in this particular case) a function of who owns them. Part IV of the TPA applies to the government owned generators. Collusion between them, or any kind of pricing directives from the NSW government would be investigated and prosecuted by the ACCC just as for any other businesses. The ACCC initiated an investigation in 1998, and there may well have been others since, but no prosecutions. You suggest that “profit maximisation” plays a role, and of course it does. But it’s a joint profit maximisation beteeen the generators, exactly the sort of Cournot competition you’d expect in the situation. Privatisation will not change the situation, unless the number of generating companies is reduced. The ACCC has the final say on this, but given the limited number of potential buyers, it’s a strong possibility. Needless to say, this would again have a negative impact on consumers.

The NSW government does gain a benefit from owning both retailers and generators. This arises because of the almost perfect negative correlation in profitability between generators and retailers. If wholesale prices are high, generator profits will be high but retail profits will be low, and vice versa. If you own similar sized portfolios of retail and generation, this balances out and you get a steady cash flow. The NSW govt has chosen for some reason to “cook the books a bit” using the Electricity Tarriff Equalisation Fund, which transfers profits back and forth between the generators and retailers. It has no effect on the bottom line from the government’s perspective, but it does serve to even out the cash flows of the retailers and generators, giving the illusion to, say, a prospective purchaser, that the cash flows of the generators and retailers are much less risky than would otherwise be the case.

Prospective purchasers aren’t fooled by this, they understand the desirability of vertical integration (i.e. the ownership of both generation and retail). So the big existing private retailers, like Origin and AGL, will be looking to buy up balancing portfolios of generation and retail in NSW. Note that the privatisation achieves no consumer benefit.

tony harris
tony harris
13 years ago

NPOV
Each day a government body sets out the expected demand for electricity and accepts bids from generators. It has to choose suppliers in a way that balances the grid, but otherwise it will accept the supply provided each hour by the cheapest generator(s). As I recall, the prices are set out in order from cheapest to dearest and the price of the last or dearest chosen supplier is the price paid to all accepted auppliers for that hour.
This system is presumably designed to prevent gaming, but sometimes all generators have placed a $0 cost in their submissions. This means the authority pays nothing for that hour.
The transmission and distribution are natural monoplies not under the control of gnmerators, otherwise they would foirestall competition by charging monopoly prices for electricity. But investments in the grid is a vexed issue.
Tony harris

tony harris
tony harris
13 years ago

SJ
I would have thought that the conditions do not meet Cournot competition, and I think you meant that there had to be an increase not a decrease in the number of gnerators for improved competitive bahaviour.
But my main point is that I concluded there was collusion when several years ago two NSW generators almost simultaneously closed plant (they mothballed a power station each, but I presume they are now out of service). Reducing supply was not in the interests of a single player. But it was in the interests of the group – and the owner – so that comeptitive pressures caused by excess capacity did not lead to marginmal pricing. Collusion like insider trading is difficult to prove withput witnesses, even then it seems hard.
I should have said that the high NSW prices are also the result of a narrowing of the gap between supply and demand.
The break up of Pacific Power was meant to enhance competition Certainly having four generators oughbt to be enough in the absence of collusion. There is also competition at the borders, especially from Victoria and a limited form of competition from the Snowy, when it has capacity.
But more competition will arise with new players. This will not happen under the current structure with one main owner.
The transmission and distribution remian natural monoplies and will have to be heavily regulated whoever owns them.

SJ
SJ
13 years ago

“I would have thought that the conditions do not meet Cournot competition…”

Well, they don’t exactly, in that the generators strictly speaking decide prices rather that quantities, but this is a special case because price elasticity of demand is zero (over the 5 minute timeframe involved), and the generators get to set multiple prices for blocks of their output. What you end up with is very close to Cournot, and that’s the simplest model that explains the observed behaviour. This isn’t really worth getting into a long discussion about, because you can just say “oligopolistic competition” rather that “Cournot competition”.

“…and I think you meant that there had to be an increase not a decrease in the number of gnerators for improved competitive bahaviour”

No, I was saying that I expect that the purchasers will be existing players from the other states, and that the number of players in the broader market will therefore be reduced.

I can’t remember enough about the timing of the plant closures by Delta and Macquarie to comment authoritatively on it, but I will note that there’s an alternative explantion.

In oligopolistic competition, given similar costs of production, the players maximise profits when they share equally. The plant closures by the two largest generators may have been a simple recognition of the fact. This is an oversimplification, of course, because the fixed costs of the larger ones are greater, but I’m sure you get the idea.

David
David
13 years ago

If this sell off is to create income I have one question.
Business principles are generally the same regardless of what the business is.
If you have a farm and sold off the paddocks to pay your bills. Pretty soon, wouldn’t you have no farm left?

tony harris
tony harris
13 years ago

David,
It depends on what the government does with the money.
It is true that NSW government will not have the dividends and deemed taxation that it garners from its generators. but if it reduced debt – thus saving interest payments – it might be no worse off, adjusting for risk.
It might also invest in assets which increase economic activity in NSW thus increasing employment and payroll tax and increasing property transactions and stamp duty.
But the essential question is why should governments do that which can and is elesewhere done satisfactorily by the private sector?
Tony

Chris Lloyd
Chris Lloyd
13 years ago

And yet we still get this sort of stuff published in reputable newspapers without the journalist dissenting.

Mr Goodsell said electricity sector privatisation had occurred in every other state where it was introduced as a means to enable greater government spending in health, education, and public transport.

(The government) doesn’t have the money and it is going to come out of schools, transport and other infrastructure budgets or alternatively, the state will start to go into dangerous levels of debt.”