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WA’S $2.4 billion Energy Moral Hazard

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Image: Center for Problem Gambling.

Energy is a funny industry. In most industries, when supply increases, prices should fall. It is different in the Australian energy sector, the opposite seems to happen. The State of Western Australia (WA) is a good example of this phenomenon as pointed out in this article.

The problem is that the WA government is forecast to subsidise the energy industry $2.4 billion over the next four years according to their discussion paper. This is despite increasing capacity from under 4000 MW to around 6500 MW – approximately a 60% increase in capacity. Most of the new capacity was in high cost peak load capacity such as diesel and gas generators that were added to reduce the risk of blackouts but also should theoretically reduce energy prices during periods of high demand. This increase in capacity was underwritten by the WA tax-payer in the form of the ‘Reserve Capacity Mechanism’ (RCM) which is a way for the WA government to purchase additional capacity. Despite the increase in capacity, prices paid by consumers increased 86% between the financial years 2006-07 to 2013-14. Furthermore, WA wholesale electricity prices is almost twice as expensive as other networks at $180/MWh compared to the next highest at $100/MWh. To cap it off, this additional capacity has only been used 35% of the time.

What can explain this anomaly? Is it simply a matter of regulatory capture by the dominant State-owned firm, Synergy? Or is the explanation political – can this outcome be explained by a climate change-denying government to protect fossil fuel interests? These may all have an influence but I have a different take on what causes this obviously inefficient outcome, and that has to do with incentives.

Specifically, the key incentive problem here is moral hazard. Moral hazard can be likened to gambling with Other People’s Money or OPM as Michael Lewis called it in Liar’s Poker. When you are gambling with OPM, you are more likely to take risky bets. Same with large-scale investments. The reason why moral hazard arises is because someone else is bearing the risk while you can walk away with the winnings if your bet pays off. In the case of the WA energy sector, the WA tax-payer is paying for the additional capacity. Obviously, not a great deal if you are a WA tax-payer. But the deal of a lifetime if you are a WA energy generator. To paraphrase Kerry Packer when he spoke of Alan Bond, you only get one RCM in your lifetime.

The consequences of this moral hazard are economic and environmental. I have mentioned higher energy prices and the subsidies. In addition, the WA tax-payer bears the financial and environmental risk of this excess capacity. It is an economic risk because the investment may not pay off. And it is an environmental risk because it is locked into an expensive, higher carbon-emitting energy future. This is despite WA being recognised as having high potential to produce renewable energy.

To the WA Government’s credit, they have canvassed some options in the discussion paper. These include at least reforming the RCM, moving from an administratively-administered system of energy pricing to a market-based one, and joining the National Energy Market (NEM). These would all help reduce the moral hazard inherent in the RCM and lower prices by increasing competition. But as Renew Economy points out, it underplays the role decentralised and renewable energy could play in increasing competition and reducing wholesale prices. As recent experience has shown, renewables have actually helped reduce wholesale energy prices. At the prices WA generators are charging, renewables should be able to compete if they are able to compete successfully in the NEM.

According to the WA Government’s discussion paper, the main reason why wholesale prices are much higher than other Australian networks is because of the RCM. Unlike WA, energy consumers in other networks aren’t slugged the full cost of capacity increases. In those other networks, the investors bear the cost of bad investments. However, according to Renew Economy, utilities in other States are lobbying for a similar type of mechanism to the RCM. At least the WA Government is thinking of ways to reduce the cost of the RCM given the less than satisfactory outcomes. Other Australian governments should also resist lobbying for a RCM in their jurisdictions – nothing is free in this world, especially hard-earned tax-payer’s money.