Sunday, 15 June 2014

Why electricity prices are going up as demand falls

Ross Gittins in Why electricity prices continue to shock people explains why electricity costs keep rising as demand drops, which is counter to normal economic theory:
But hang on, is this guy saying the price of electricity has gone up because demand for it has gone down? Isn't it supposed to be the other way round? Isn't a fall in demand supposed to lead to a fall in the price?
Well, assuming no change in supply, yes it is. So you're right to be to be puzzled. The relationship I've described between price and demand is, as an economist would say, ''perverse''.
But why? Because, as Garnaut explains, we've stuffed up the deregulation of the electricity market. (Moral: as we're being reminded by the plan to ''deregulate'' university fees, if you deregulate or privatise without knowing what you're doing you can make things worse rather than better.)
Before the reform process began, each state had its own, government-owned electricity monopoly, with little trade between the states. From the late 1980s it was decided to break the integrated state monopolies into their component parts - generation, transmission, distribution and retailing - and form one big eastern Australian electricity market with as much competition and as little monopoly as possible.
The power stations were separated into individual businesses - some of which were privatised, particularly in Victoria - and made to compete in a highly sophisticated ''national'' wholesale market for electricity. Garnaut says this has worked well, with competition keeping the wholesale price low in response to the reduced demand.
But transmission (high-voltage power lines) and distribution (local poles and wires to the premises) are natural monopolies. That is, it's not economic to have more than one network. So whether these businesses are publicly or privately owned, the prices they charge have to be regulated to prevent them overcharging.
Trouble is, Garnaut says, we've done this by fixing the maximum rate of return the businesses are allowed to earn on the capital they have invested. Economists have known for 60 years that this always causes problems because it's so hard to pick the right rate of return.
If it's too low it leads to underinvestment in the physical network, causing blackouts. If it's too high, however, it leads to overinvestment in the network at the expense of business and household customers.
But as well, when monopoly businesses that are guaranteed a certain rate of return suffer a loss of demand, the regulator has to allow them to restore their profitability by raising their prices.
Read the whole article.

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