Network regulation and cost-reflective pricing

Around 50 per cent of an Australian consumer’s electricity bill is made up of network costs to build poles and wires. Network regulation is important because we want investment in the grid to be efficient so people don’t pay more than necessary to upgrade, maintain and manage the system.

There are two broad parts to the regulation of network expenditure:

  • An incentive-based regulation of network revenues: This determines maximum revenues that network businesses are allowed to recover from consumers for network investment over a five year regulatory period.
  • A cost benefit analysis known as a ‘regulatory investment test’ which is carried out on specific investment proposals by network businesses so that investment is carried out at the highest net benefit for the lowest possible cost to consumers.

Why we need regulation for networks

The massive cost of extensive networks of electricity poles and wires and gas pipelines means that network services in a particular region can be most efficiently provided by a single (monopoly) supplier.

Regulation helps consumers by managing the potential risks of monopoly pricing such as overcharging or poor service in regional areas. The rules governing the economic regulation of electricity and gas enable the regulator to set the maximum revenues that electricity network businesses can charge for the services they provide.

They also enable regulation to establish prices and other terms and conditions used in negotiating access to gas pipelines. Network prices are usually set every five years. The five-year regulatory cycle was established to help encourage a stable investment environment.

Incentive-based regulation of network service providers

The incentive-based regulation sets a limit on overall revenues a network business can recover from consumers. Under this regulation, electricity transmission and distribution businesses in the national electricity market apply to the Australian Energy Regulator (AER) to assess their revenue requirements every five years.

They also provide the AER with supporting information on the costs they expect to face based on demand forecasts, and operational and regulatory requirements. The regulator determines the maximum amount of revenue that the network business can recover from consumers over the regulatory period based on estimates of the costs that an efficient network business would incur.

Regulatory investment test

Under the regulatory investment test, network businesses must assess individual investment proposals against a market based cost–benefit analysis.

The regulatory investment test encourages the businesses to plan and operate their networks to meet their reliability obligations at least cost. 

Network businesses are required to assess the efficiency of proposed investment options by estimating the benefits that would result for market participants and consumers, and comparing these to the associated costs. 

Network businesses put forward various options for the investment need, inviting consultation and explicitly inviting non-network solutions, such as generation support and demand management. The regulatory investment test ensures each individual investment proposal is evaluated on its merits.

Network service providers consult publicly under the regulatory investment test process, partly in order to test their identification of the likely costs and benefits. This provides the opportunity for interested stakeholders to be part of the decision-making process.

Incentives for non-network solutions

Following rule changes in recent years, the national electricity rules contain a number of mechanisms to incentivise efficient network investment in, and use of, distributed energy resources, including storage and embedded generation.

For example, a network business is incentivised to use battery storage or embedded generation services to help manage peak demand in a particular area facing constraints, rather than building more poles and wires, where this is a cheaper solution.

The demand management incentive scheme (DMIS) and demand management incentive allowance (DMIA), due to start later this year, provide further incentives and funding, respectively, for networks to invest in non-network solutions.

Reforming the way networks are regulated

New rules in 2012 increase the regulator’s ability to base regulation on business efficiency

In 2012 the AEMC made changes to the rules which govern the ‘incentive based’ regulatory framework.  The new rules were all about changing the basis of setting revenue allowances for regulated monopoly networks.

Network regulation is based on business efficiency. Allowed revenues for the network businesses are now set by using the most prudent, efficient operators as a benchmark. Companies have incentives to beat the benchmarks so they can keep some of their savings and pass the rest on to customers.

Changes to the rules included an amended rate of return framework that is common to electricity distribution, electricity transmission and gas. The AER has to make the best possible estimate of the rate of return at the time a regulatory determination is made, taking into account market circumstances, estimation methods, financial models and other relevant information. 

The new rules also require the AER to conduct public consultation at least every three years to develop its approach to setting the rate of return.

Benefits for consumers:

  • After the introduction of the new rules there were initial falls in regulated network prices in most national electricity market jurisdictions.
  • The AEMC’s 2016 Price Trends report noted that outcomes are now uncertain in some jurisdictions because of appeals against lower network revenue determinations made by the AER which are currently being reviewed by the Australian Competition Tribunal under the Limited Merits Review Regime.

Find out more about the Economic Regulation of Network Service Providers rule change.

New rules in 2014 put consumers in the driving seat

When prices reflect how much it costs to use different appliances at different times, consumers are able to make more informed decisions. This rule change is all about changing the way distribution networks charge consumers, to keep up with increasing diversity in the way people use energy today.

Today there is far greater diversity in the way consumers use electricity than in the past. Two households might look the same but because of the appliances they have and the different lifestyles they lead, they will consume electricity in very different ways.

Changes in technology and lifestyle mean that the amount of electricity individual households use at different times of the day can vary a lot.

Different households place very different demands on the network – and that demand flows through into network building and maintenance requirements.

Existing network prices charge too much for off-peak use of the network and too little for peak use.

It means consumers who use most of their energy at off-peak times are paying more than their share of the costs, while those using energy at peak times are paying less than it costs.

The rules have been changed so that consumers will have the option of reducing their peak demand to save money, or continuing to use electricity at those times when the value they place on that use outweighs the costs.

Benefits for consumers:

  • Research undertaken as part of the rule-making process showed that all network prices are likely to be lower in the long run with cost-reflective prices. Consumers with the flattest load profiles will receive the biggest and most immediate benefits.
  • The same research found that businesses which change their pattern of use for just 20 hours or more per year at times of high demand when networks are congested, could save up to $2,118.
  • The AEMC estimates that 70-80% of consumers will have lower network charges in the medium term:
    • Consumers with flat load profiles who use proportionately less energy at peak times of the day are most likely to have lower network prices under the new rule.
    • Consumers who use proportionately more energy at peak times are likely to have higher prices, although those consumers would also have the greatest potential for future savings if they chose to change how they use energy and move some of their peak use to off-peak times.
  • Everyone will benefit in the longer term as lower peak demand reduces the need for infrastructure investment.

The new prices will be phased in from 2017.

Find out more about new rules for cost-reflective network prices.