Risk, gold-plating and over-pricing for electricity


With the debate about electricity network prices being overtaken by asylum seekers, it is worth sitting back and analysing the issue in some more depth.

The claims seem to be:

  1. The costs of electricity distribution and transmission exceed 50% of the cost of power to households and is rising;
  2. The cause is ‘gold plating’ (i.e. excessive investment)  in the electricity network;
  3. The revenue that network companies in the eastern states can make through its charges to customers is regulated by the  Australian Energy Regulator (AER) but the AER has its ‘hands tied’;
  4. The problem is worse for state-owned network companies than for privatised network companies; and
  5. By the way, power demand is falling and so there will be less need for network investments going forward.

The first point is a fact (at least according to the government propaganda that came with my electricity bill yesterday). The second is partly an issue of ‘reliability’ versus ‘cost’. I commented on that here.   The AEMC is considering rule changes relating to the third point. But the fourth point is really interesting. Why do state-owned network companies have more gold plating than privately-owned network companies? And should the networks be privatised to avoid gold-plating?

Let’s look at the first question. After talking to a variety of people the argument appears to run as follows:

  • State-owned networks get all their ‘equity’ and ‘debt’ from the relevant state government. The government gets its money from taxes and borrowing. The government borrowing rate is much lower than the corporate borrowing rate  because the likelihood of default is low (at least here in Australia). Put simply, the taxpayers would bail the government debt-holders out.
  • Under competitive neutrality, state-owned network companies are regulated just like privately-owned companies. They effectively pay the same tax (under federal-state agreements) and the regulator sets their allowed revenue on the basis of the private costs of debt and equity. These are significantly higher than the cost of public debt.
  • State governments like to take dividends from their companies because this is a source of revenue that is ‘hidden’ compared to direct taxation revenue.
  • To raise the dividends that the government can charge its state-owned network companies, the company over-invests in its network. The cost of this capital investment to the government is the government borrowing rate. But the regulator allows the company’s revenue to rise by the higher private cost of debt. The government (or treasury) takes the difference as a dividend. So government revenue rises without an explicit tax increase.

This is not a new theory. It is really a state-owned version of a rather old theory in regulation – the Averch-Johnson effect. To see how it works, suppose the government can borrow at 2% and the private cost of capital (given an optimal debt-equity ratio – whatever that is ) is 6%. Now suppose that the state-owned network company spends $100m on completely unnecessary network assets that last forever (to make the example simple). The government borrows the $100m which costs it $2m per year (i.e. the 2% interest rate on government debt). The regulator allows the electricity network charges to rise to cover the cost of the new investment, but based on the private cost of capital which is 6%. So electricity charges go up by $6m per year. The government then charges an extra $4m per year dividend to the network company. So the government has a net increase in cash of $4m per year.

Now, this is complicated by a number of factors. The first is that regulators only approve efficient investment. So the investment is unlikely to be complete waste. The regulated firm will dress it up as reliability improvement. The regulators are awake to this game but face a difficult problem of asymmetric information (they don’t run the network), working within the regulatory rules and avoiding risk of the network ‘crashing’. Hence the state-owned network company can only ‘gold plate’ within the bounds of regulation.

The second is the underlying issue – why would the state government do this and not just raise taxes? I am going to just take the political economy bit as given. The people arguing for gold plating seem to believe that state governments are playing this game, so I will take it as my starting point.

Third, the real culprit here is the interest rate differential. Why is the state-owned enterprise allowed to get a 6% return on capital that only costs the government owners 2%? I have discussed this before here. To the degree that the interest rate differential reflects real risk of the electricity system that investors bear under private ownership and taxpayers bear under public ownership, we (may) want those risks reflected in the price of electricity. The risks are a real cost of owning and running the network. However, if the interest rate differential is due to sovereign risk (the possibility that the government will act in a way that harms the private network investors) the interest rate gap represents a risk that is ‘internal’ to the government and shouldn’t be reflected in electricity prices under government ownership.

So (like in my earlier post) let’s say that of the 4% gap (i.e. 6% less 2%), 1% is due to sovereign risk, so the ‘sovereign risk adjusted’ return to the state-owned network business should be 5%. This still exceeds the cost of government debt of 2% so it still gives the government an incentive to overbuild the state-owned electricity network.

What else could we do? It is inefficient for the government to overbuild the network just to raise revenue. Perhaps the regulator, when dealing with state-owned networks, should recognise that government ownership creates different issues to private ownership. In other words, treat the regulatory problem as a ‘taxation’ or ‘government revenue’ problem rather than an issue of mimicking the returns to a private investor.

How could that be done here? First, to remove the incentive for wasteful over-investment, the state-owned network as seen by treasury would need to have its cost of capital set at the government borrowing rate. In my example, that is 2%.

To understand how this could be done we have to consider the ‘risk element’ (the 3% between the government borrowing rate and the sovereign-risk-adjusted private rate). The easiest way to deal with this 3% is simply to let the taxpayers bear the risk as tax payers. In other words, recognise that the tax payers (who own the network and are also electricity users) would have to come up with the money to bail the network out if it ran into any trouble. The taxpayers can’t avoid the risk so, rather than putting it into electricity prices, just leave it as an (uncapitalised) risk on the governments balance sheet.

In this case, the regulator simply sets the allowed revenue for the state-owned electricity company using the government borrowing rate of 2%. This reduces network charges immediately and reduces the cost of electricity. It also removes any incentive for the government or treasury to promote over-investment in the network. The ‘gap’ that led to the Averch-Johnson-type effect has disappeared.

A problem with this solution is that there is an unfunded risk placed on taxpayers. The production and consumption of electricity creates the risk but it is not reflected in any prices. This may or may not be a bad thing – there are many ‘unfunded risks’ that are carried by the taxpayers. Every time the government provides flood relief, drought relief, bails out a manufacturer  and so on, this simply reflects that the taxpayers have taken on an implicit risk and an event has occurred that has crystalized the risk into a payout.  Anything – public or private – that is too big or too important to fail, leads to this sort of risk. So it is hard to get too excited about the state-owned electricity networks being another source of unfunded risk for taxpayers.

However, what if we do want the 3% ‘risk element’ reflected in network tariffs and electricity prices? Well in that case there needs to be a separation between the ‘dividend’ available to the state government as owner and the revenue raised through network charges.

For example there could be an explicit ‘insurance fund’. The government can only get a return from the state-owned company based on the true cost of government debt (2%). But if we want network revenue set on the basis of the cost of risk (5%) then the difference – the 3% return on capital – has to be kept away from the government. This could be done by requiring the state-owned firm itself to hold a fund as ‘insurance’ against future events that effect the electricity network. If the state-owned enterprise spent $100m on new infrastructure, the borrowing cost would be 2% and the ‘insurance’ cost would be 3%. Electricity prices would be based on the total (5%) but the company would be required to keep the ‘insurance bit’ (3% or $3m per year) aside in a separate fund. The fund would be drawn down whenever there was an event that would otherwise involve a taxpayer ‘bailout’.

The key part of this alternative approach is that the state government would need to commit not to ‘raid’ the fund. In other words, it would have to ‘tie itself to the mast‘, say through legislation. If it could do this then its net return is only the 2% cost of debt and the government has no incentive to ‘gold plate’ the network.

In brief, the real underlying issue – the ‘interest rate gap’ – arises because the regulatory system has not properly considered the risks involved in running a state-owned network company, the way those risks are allocated between taxpayers and electricity users, and the burden of the payout when a bad risk eventuates. We have ended up in a distorted system because the issue of risk allocation has been ignored. Currently the risks (including sovereign risk) are built into network charges creating a pool of money that the government has an incentive to (a) seize and (b) spend. Until the risk-allocation problem is tackled, this, and other distortions, will continue to plague our utility industries.

8 Responses to "Risk, gold-plating and over-pricing for electricity"
  1. Stephen

    Much to agree with here. A few quick comments.

    1. I think it is possible to make too much of reliability/expenditure trade-offs. The reliability of electricity supply in the metropolitan areas of developed economies of the world is to all intents and purposes the same. We all need very high reliability and almost always get it. The issue seems to be that some firms are much better at it than others, and this seems to be point to focus on.

    2. I agree a large part of the issue is risk allocation, but perhaps even more so, the valuation of risks – what risks are tax payers actually bearing for network service providers they own (or indeed for any other service providers they own)? CAPM is so obviously an inappropriate foundation for thinking about this. I guess somewhat embarrassing that such remarkable electricity prices increases have been needed to draw attention to this.

  2. The other solution would be for the Government to guarantee the debts of the privatised electricity networks, so that they too can borrow at 2% for regulator-approved-investments. Then the regulated return can be reduced to 2%.

  3. The Qld Govt adopted your suggested approach with water assets constructed in response to the drought(e.g Gold Coast Desalination Plant). They earn a rate of return equal to the state’s borrowing cost only.

    I agree with your sovereign risk comments, but I dont follow your insurance logic. If the govt seizes the extra 3% they will have to fund any bailouts (govt as insurer). If you assume that more capex leads to a commensurate increase in the cost of any bailout, why would this incentivise gold-plating?

    Alternatively, if the electricity co kept the 3% in an insurance fund, the electricity co would have to bail itself out (self insurance). The only way I see these two scenarios incentivising gold-plating is if the govt is risk-seeking, or if insurance costs (3%) are overpriced. Both of which are separate issues from your discussion.

    The problem of government as insurer is that electricity prices dont appropriately reflect risks, leading to inefficient overconsumption of energy. As you note, this happens frequently for floods etc, but it doesnt have to in electricity. Why settle for second best?

    What am I missing?

  4. Will – my poor explanation. As I understand the argument, the government seizes the 3% risk premium at present because it is happy to have an unfunded liability on the government balance sheet. Put another way, the argument depends on short-termism by politicians.
    As I said in the post, I will take the political economy argument as given. There is a ‘prior’ discussion about political incentives that I have (quite deliberately) avoided. For example, one of my colleagues has stated to me that the underlying argument is clearly wrong as politicians suffer when power prices rise. He believes that the gold plating argument is just wrong.
    So my post assumes that the politicians are happy to take the 3% ‘insurance’ premium and spend it rather than accumulate it as a capital reserve. But this appears to be an assumption behind the ‘gold plating’ argument.

  5. Big effort Stephen. Are you exploring this in order to submit something to some consultation round?

  6. This is a topic I’m interested in, and am sorry to not have enough time to spend looking at it a lot more closely right now. Please excuse my ignorance if I’m missing something already mentioned with my question. 1. Do the values of numberous state and federal grants provided to the rapidly expanding renewable energy companies providing generation facilities reduce or cloud the values of this gold plating effect. 2. Has anyone done an actual numbers analysis to show the exact values shifting between each party in the process (generators, regulators, customers) in a case study, for example, in Western Australia taking into account capital costs, cost per unit of electricity produced etc (or is this information unavailable – in WA the information is hard to get).

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