Who bears the risk of bushfire compensation?

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SP-AusNet is being taken to court in a class action for compensation for the Black Saturday bushfires. If the Court decides that SP-AusNet is liable to pay compensation, should this compensation be a cost that SP-AusNet can pass through to electricity consumers?

The media today are saying ‘yes – and that it is the Australian Energy Regulator’s (AER’s) fault’. But the story isn’t that simple. Fairfax gets the story only half-right here. In contrast, the ABC does a much better job here. Perhaps the ABC journalist has the “PhD in electrical engineering and a Masters degree in energy policy” that the Fairfax journalist claims is required to understand what is going on?

The actual AER draft decision is here. It is all about ‘insurance pass through events’. In brief it says that if:

  • an electricity transmission or distribution company has an (efficient)  insurance policy (or had one at the relevant time);
  • the liability exceeds the level of insurance coverage; and
  • the relevant circumstances were beyond the company’s control;

then the company can pass the excess cost (i.e. cost above insurance coverage) onto consumers through prices.

A key issue is whether or not the company acted appropriately. This latter point is clear in the AER’s Draft Decision:

The kinds of circumstances that may lead to such an excess cannot be self-insured nor could the DNSP have taken actions to reasonably prevent these circumstances from occurring or to substantially mitigate the relevant cost impact. In these circumstances, the DNSP should not bear any excess costs not covered by an insurance policy.

So – if the Court finds SP-AusNet liable – the real question will be whether or not SP-AusNet took appropriate and adequate care to avoid their lines starting fires. If not then, on my reading of the AER’s words, there can be no pass through. If so, then the cost of compensation beyond any insurance cover (if ‘material’) can be passed through to consumers.

This all seems pretty sensible. The regulator has done the right thing in determining ex ante who bears the relevant risk (here most of it is borne by SP-AusNet), and it appears that the cost of insuring that risk was considered and built into prices. SP-AusNet could then choose its insurance cover (or could have self-insured) but to the degree that they did this efficiently and there is an uninsured cost that it could not have reasonably avoided, the consumers bear the risk.

This doesn’t mean that risk is well handled more broadly in our utility regulation. Two broader points are:

  1. Some risks are not well specified and handled in our regulations. For example, if demand begins to fall but fixed network costs do not change (perhaps because the fall was not foreseen) then the fixed costs will be spread over a smaller quantity of ‘sales’. So price rises. This is the exact opposite of what happens in normal markets where a fall in demand leads to a fall in price (just look at the iron ore price over the last few months). So unlike pretty much every other business in the economy, our regulated utilities generally do not bear the risk associated with changes in demand for their products.
  2. Risk is endogenous to the regulatory decision. I have discussed this before. The regulator decides what risks are borne by the regulated business. But regulators then benchmarks the business’ compensation for risk (i.e. the return on equity) as if risk was ‘given’. This tends to lead to excessive compensation and too-high prices.

 Regulation is all about working out who bears what risk and who pays for it. Let’s give credit to the AER where the problem has been thought through sensibly and focus on those areas that need reform.

 

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