ETEF Deferred Again

On 20 January 2009, the NSW Treasurer Eric Roozendaal and Energy Minister Ian Macdonald announced that the March 2009 roll-off of the Electricity Tariff Equalisation Fund (ETEF) has been deferred until 27 September 2009. This is the second time in six months that ETEF has been deferred.

ETEF commenced operation on 1 January 2001, and its goal is essentially to mitigate the cost to state-owned electricity retailers of having to perform a social duty. Prior to ETEF, NSW had vesting contracts between generators and retailers, which were agreements to supply electricity at a fixed price to ‘non-contestable’ customers who were on a fixed tariff.

In 1995 the state-owned electricity business was split into three generators (Macquarie Generation, Delta and Eraring) and three retailers (Energy Australia,Integral Energy and Country Energy). Each retailer is responsible for a franchise, which is a geographical area of the state for which they own the electricity distribution assets. The retailers are free to compete against each other and to charge what prices they can for contracted customers, but pricing to customers who are not on a contract is regulated by the Independent Pricing and Regulatory Tribunal (IPART). Further to this, the state-owned retailers are obliged to operate as a ‘Retailer of Last Resort’ (RoLR) to customers in their franchise areas. This means that if a customer signs with another retailer, and that retailer goes bankrupt, their power supply agreement shifts back to the retailer responsible for their franchise. RoLR ensures that the politically sensitive issues of electricity supply and pricing are not victims of free-market instabilities.

This leaves the retailers in a very vulnerable position. They are exposed to variable wholesale electricity prices while being constrained to charge fixed tariffs for much of their demand. Unlike private energy companies which can choose only to offer contracts to particular demographics, the state-owned retailers must offer power to all. Generators have far more ability to pass on increases in fuel or operating costs, as the NEMMCO dispatch process is essentially a reverse auction.

Since the NSW state government is the ultimate owner of all six utilities, it faced the dilemma of a lop-sided market. To help avoid the situation of hugely profitable generators and loss-making retailers, ETEF was introduced.

The energy cost component of the regulated tariff, or Regulated Energy Cost (REC) is set by IPART and is based on their estimation of the Long Run Marginal Cost (LRMC) of the generation system. The equalisation fund works by receiving payments from retailers when they were paying less for electricity (to service their regulated load) than the REC and making payments to retailers when the wholesale price is higher than the REC. Figure 1 shows the operation of the scheme at the half-hourly level.

Figure 1 – Operation of the ETEF

If the ETEF ‘bucket’ is emptied, then the generators are required to tip some money in. In such a case, they should be in a good position to do so, as the ETEF money that was extracted would have been ultimately paid to them via the NEMMCO settlements procedure. The generators are entitled to get the money back once the ETEF fund is sufficiently back in the black.

Up until 2005, turnover in the ETEF regularly exceeded $300m, but this has fallen in recent years. Figure 2 shows the annual turnover and fund surplus against the total GWh each year that were priced at more than $300/MWh.

Figure 2 – ETEF Turnover

There are several issues with the ETEF system, including:

• The scheme gives advantages to the state-owned retailers in NSW over external players. Since Full Retail Contestability (FRC) started in 2002, privately owned electricity retailers have been free to compete for customers in NSW. In order to ‘win’ a regulated customer from a franchise, the private company must entice the customer to sign a contract. In effect this means that the contract offer price must be lower than the ‘default’ rate that a regulated customer is on. Since the default rates are set by IPART, and as the rates can be kept artificially low due to to ETEF, the profitability of winning franchise customers is questionable. Despite FRC being in effect for seven years, many domestic customers remain uncontracted (including the author).
• The fact that ETEF covers a significant part of the state-owned retailers’ load, they have less need of market-based hedge contracts. This in turn hinders the development of the electricity derivatives market.
• Since ETEF blunts the effect of high prices in the market, this discourages new generation investment, for example in gas-fired ‘peaker’ plants.

Despite the above, the 2007 Owen Inquiry made no specific recommendations into ETEF beyond noting that it was being phased out (and that many submissions had called for an acceleration of its demise).

Under a 2006 plan, the phasing out of ETEF was to begin in September 2008, and would be gone completely after June 2010. There were five phases of 20% decreases in the amount of regulated load covered.

In August 2008, the government announced a change to this plan and deferred the September roll-off. This now meant that March had to be an initial 40% drop rather than the second 20% decrease.

Now the March roll-off has been deferred, the September 2009 decrease becomes an abrupt 60%. Table 1 shows how the schedule has changed.

Table 1: ETEF Schedule Revisions (% decrease of ETEF cover)

The whole episode has created several problems for the retailers, including:

• Those retailers who prepared for the March roll-off would have built a hedge position for 40% of their default load over the six months to September. Any retailer in this position would now be overhedged for this period. They are now faced with the decision of remaining overhedged and effectively running a speculative position or closing out the position regardless of profit or loss. Board policy would most likely favour selling it.
• With the government’s track record on deferring dates, the retailers now have the dilemma of whether to take the September roll-off target seriously. If they hedge (or leave existing hedges in place) and this date is moved, they will find themselves overhedged for the period of October 09 to March 2010. This time, the figure would be 60% of default load rather than the previous 40%. If on the other hand they assume that the government will again blink, they may find themselves under-hedged for the same amount.

To put some likely figures around the issue, we have done some approximate (and conservative) calculations based on figures taken from various publically available sources. Figures on ETEF-covered load (either per franchise or aggregate) are difficult to come by, but we estimate that it forms around 12% of state load in peak periods and around 10% of off-peak). Using 2008 Figures as a base, we can imply that if all the state-owned retailers had hedged all of the additional ETEF load expected in the March 09 rolloff, then they would have found themselves collectively overhedged to the tune of around 16TWh, with a notional value (based on Q2 and Q3 futures settlements on the day of the announcement) of nearly $700m. This is on top of approximately $375m notional of over-hedging the 20% that was supposed to roll off in September 2008.

Notional value of course does not mean that the retailers have paid this, as swap and futures contracts are ‘contracts for difference’, which means that the hedging cost is actually the difference between the fixed price and the ultimate pool price-based settlements. Alternately, if the retailers had chosen option-based contracts (such as future options), then they would face the market risk on the option premium instead.

For example, consider the following hypothetical scenario:

1. On June 30, 2008, the retailers use flat futures contracts to hedge the 20%
   of regulated load targeted to roll off in September 2008 plus the extra 20%
   scheduled for March 2009.
2. After hearing that the rolloff has been postponed, the retailers close out the
   roughly 200MW of hedges for Q408 and Q109 on 1 September 08.
3. On hearing that the March rolloff has been postponed, the retailers close out
   roughly 400MW of hedges for Q209 and Q309.
4. Based on a small net fall in futures prices (around $4 on average) over the
   period concerned, the retailers face a combined loss of over ten million
   dollars from the two postponements.

While it is true that the change of plans could have alternately made money for the retailers (if prices had risen instead of fallen), it is also true that they could have faced far heavier losses if there was a sharper fall than that observed. If, rather than close out the hedge positions they had been kept and run to maturity, then there would have been a combined loss of around $1.5m on the Q408 position alone, with the others periods still current at the time of writing.

While we can’t be certain whether all retailers hedged all of the load, if they did not, then this is either indicative of scepticism regarding the rolloff schedule, or the difficulty in getting a reasonably-priced hedge (with respect to the regulated tariff-based revenue). Neither is good news for the retailers or the government.

The government still appears to be moving ahead with a sale of the three state-owned retailers. This sale has been delayed after the push to sell retail and generation together failed, costing Morris Iemma his job. No date has been set for a sale, nor have any other details of the plan been released. It is unclear as to whether the ETEF deferral is related to the government’s sale plans, and if so, what outcome it was supposed to achieve.

In the author’s opinion, one clear achievement of yet another ETEF backflip is to add to the considerable uncertainly that currently exists in the electricity markets. With vague privatisation plans hanging over NSW retailers and growing uncertainty surrounding the federal CPRS scheme, ‘business as usual’ is becoming increasingly difficult.