Reforming the economic regulation of Australia’s electricity distribution networks

The costs of building, replacing and maintaining electricity distribution network poles, wires and substations impact all households and businesses that pay their electricity bills. The combined regulatory asset base (RAB) of all distribution companies in the National Electricity Market (NEM) is currently A$82.7 billion, with distribution network charges typically representing 25-35% of electricity bills. The way distribution networks are remunerated – their economic regulation – therefore has implications for Australia’s economic productivity.

RAB per customer was AUD 5,059 in 2006. It increased dramatically by 60%, peaking at AUD 8,077 in 2015, before declining 5% to AUD 7,644 in 2022. The increase in RAB per customer coincided with a decline in the use of the distribution network from 57% in 2006 to 39% in 2015. Then this percentage stabilized at around 41%, but never returned to the level of 2006. While the trends observed since 2015 can be interpreted as positive stabilization, that between 2006 and 2022 RAB per customer increased by 34% while network utilization decreased by 15% in absolute terms. Consumers now pay significantly more for a service they use less than they did in 2006, net of RAB adjustments.

Source: IEEFA. All data in real dollars, 2022.

This analysis shows that although previous over-investment of RAI has stopped as a result of the reforms implemented in 2012-2013, economic regulations did not ensure effective costs of distribution network services.

In addition, there is a worrying risk of future over-investment comparable to the situation observed around 2006–2015, where distribution networks demanded higher capital write-offs, which will result in an increase in both the value of WRA and electricity bills. In January 2024, three distribution network service providers (DNSPs) submitted revenue proposals for 2025-2030 to the Australian Energy Regulator (AER). All of them in their regions have over 45% of households equipped with photovoltaic panels on their roofs and an increasing number with batteries. All three (SA Power Networks, Ergon and Energex) propose an increase in capital expenditure (capex) by 20-22% compared to the 2020-2025 regulatory period. Most of these increases appear to be aimed at replacing or expanding aging assets. It is unclear why the increases are so large when grid utilization is so low and the use of solar power and rooftop batteries is increasing.

Source: IEEFA based on AER data.

This report argues that, in addition to the risk of overinvestment, there is a significant opportunity to reduce network costs by reforming the economic regulation of distribution networks, especially to enable distributed energy resources (DERs) such as solar batteries and smart devices to provide network services. The network services that a DER can provide typically include congestion management, voltage control, reliability improvement, and network deferral. If DER can replace costly infrastructure upgrades or replacements – poles and wires and substation capital expenditures – it should lower bills. Based on currently conservative DER use data, Baringa estimated that A$10 billion in distribution network investments could be avoided by 2040 through effective DER integration, including the use of DERs to provide some network services.

Economic regulation of distribution networks dates back to the 1980s in Great Britain, with a few changes. This report outlines ten reasons why distribution network revenue regulation should be reformed to help Australia achieve its cost-effective 82% renewable energy target by 2030.

From the point of view of the theory of regulatory economics and for the purposes of this report, the fundamental question is whether distribution networks are still a monopoly service or whether they can be challenged. This report details examples of two use cases where DERs can compete with grids. The first is to replace remote and regional networks with autonomous power systems and microgrids. In southwestern Western Australia, Western Power has made the decision to convert over 52% of its remote and regional network serving 3% of its customers to autonomous power systems (SAPS) and microgrids. In 2004, the UK introduced the possibility of last mile challenge for new network developments on brownfield and greenfield sites, and now 80% of new residential connections are made through independent (commercial) network providers.

The second use case for DER is in the provision of network services, especially the alleviation of congestion in existing networks, in order to reduce the need to expand and replace parts of the network. There have been a number of successful Australian trials demonstrating that DER can provide network services, including the Networks Renewed, CONSORT, Edge, Edith and Symphony projects. In the UK, where around 20% of network areas are restricted, each of the six distribution networks procures ‘flexibility services’, earning DER owners in some locations up to £33/kW/year. For example, a 10kW home battery could cost up to £331 per year. Flexibility services are also procured from utilities such as water companies that have control over pumping and other uses of electricity. By August 2023, UK distribution networks have already contracted 2.4GW of flexibility services for 2023/24.

Internationally, there is progress towards reforming the economic regulation of electricity networks, with the UK being the most advanced. This report examines international case studies on network revenue reform in three areas and outlines what Australia can learn from them:

• Totex regulation (total expenditure, combining capital expenditure and operating expenditure – operational expenditure) is widespread in Europe as a way to reduce the risk of error in capital expenditure, but has not been implemented in the US.
• Purchase of network services through DER and other means. It is widely recognized that DERs can and will provide the bulk of network services. In the UK and Europe, network services provided by third-party DERs (and larger-scale assets) are called “flexibility services”, while in North America they are called wireless solutions (or wireless alternatives (NWA)). .
• Performance incentive mechanisms (PIM), including those supporting DER integration. These incentives are linked to decarbonization in many EU and US jurisdictions, but not in Australia.

Taking into account the ten issues identified in the current regulatory system and innovative overseas examples that are delivering better outcomes for customers, IEEFA recommends that the Productivity Commission review the fundamental principles of economic regulation of distribution networks in the NEM.

We recommend a review to develop a form of economic regulation of distribution networks to achieve the following results:

1. The best results for consumers in the form of the lowest possible prices.
2. Economically efficient results for our economy, including ending capital expenditure bias.
3. Rapid decarbonization, including electrification, to meet Australia’s emissions reduction targets.
4. A level playing field for infrastructure and network services provided by DER.
5. Improved climate resistance.

IEEFA recommends that the following questions should be key to such an assessment:

1. What is the nature of competition in distribution network services?
2. For what results should distribution networks be rewarded?
3. How can and should distribution networks be rewarded for accelerating decarbonization?
4. How can and should distribution networks be rewarded for innovation (including within and outside economic regulation)?
5. What processes can be used to effectively determine network revenues, and within what time frames, given the rapid nature of the energy transition?
6. How to avoid excessive profits?
7. Should monitoring of the regulatory performance of the network and the regulator be introduced and, if so, what form should this take?

The review would identify ways to ensure cost-effective distribution network services in a high-DER world. Important medium-term benefits would be lower proportionate costs for consumers and improved economic efficiency, with implications for Australia’s overall economic productivity. If consumers were compensated for providing grid services through DERs, they could see a greater return on their DER investment. Moreover, assuming DER network costs are lower than infrastructure investments, costs would be reduced for all consumers. As the UK shows, contentious procurement of network services can be supported and facilitated by distribution network companies.

High costs for electricity consumers impact the cost of living and make the Australian industry less competitive internationally. The combination of cheaper renewable energy and more efficient grid costs is expected to deliver the cheaper electricity needed for Australia’s future economic prosperity.