AUSSIE ENERGY MARKET FAILS! Politics, bad business, or both?

ANALYSIS: The chaos in the Australian energy market is a sign of greater worries ahead, writes economist Tiago Valente.

As a young man vested with views of egalitarianism and equality I decided to pursue Economics at university. Luckily for me, I was encouraged by both my parents who are retired mechanical engineers who had worked in the electricity industry in Sydney.

Back then, when I found out through my parents that the distribution and production for electricity in NSW was going to be privatised, I instantly knew this was a mistake. Twenty or so years on, my fears have been substantiated. Let’s find out why.

Every laissez-faire economist, who ever said privatisation was good for the consumer, would have used something along the lines of the following rhetoric: 

The problem with the above statement is that not all markets are perfect. This theory applies to markets suited for perfect competition. There are four main assumptions for perfect competition:

1. Goods bought and sold in the market are identical

2. Buyers and sellers have perfect information about all substitutes and pricing information

3. There is little to no government presence. We only have buyers and sellers.

4. There are no barriers to entry in the market.

So, the biggest problem is this very last statement, no barriers to entry. Electricity production is a highly complex process that requires a very large CAPEX expenditure to begin with, and is also highly regulated – we can’t let any Dick and Joe create his or her own power station … for good reason. Therefore, it is not easy for a firm to enter the market to reap above average profits. Since it is not easy to do so, we will not see the efficiency gains of increased competition.

What most people would not understand is that electricity production is more alike to an oligopoly. An oligopolistic market is one that more closely represents a monopoly than perfect competition.

An oligopolistic market is controlled by a few private entities as opposed to one, the latter being a monopoly. The main characteristic relatable to an oligopoly and monopoly is that both can set prices as they have market control, and because of a lack of competition they can freely do so. They are price makers not price takers. Due to high barriers to entry, electricity production could never resemble perfect competition.

Another issue with privatising electricity production lies in the fact that electricity consumption follows the characteristics of a public good.

Public goods are goods whose consumption benefit society, as opposed to private goods, which benefit individuals. For instance, if I bought a new pair of shoes, that is a private good, because I would benefit from its consumption. You’re not going to gain any benefit from me wearing new shoes.

However, consumption of a public good like the Defence Force, for example, benefits society. This is because public goods are non-rival and non-excludable, and the consumption of public goods benefits society, as opposed to just benefitting individuals.

The characteristics of public goods are non-rival and non-exclusive. Non-rival means the consumption of the good does not diminish its availability to another person. If I consume the services of the Defence Force, my consumption of that service does not diminish its availability to someone else. The Defence Force provides me a service to me to protect me from foreign invaders, but when I consume that, I do not reduce the availability of that service to another person.

Excludability means I can, through wearing my newly bought shoes, exclude you from wearing that exact pair of shoes. If you want to wear the same shoes, you’d have to buy another pair, a different private good.  Non-exclusive means I can’t stop you from consuming the good. An example of a public good that is non-exclusive would be a public beach. I cannot prevent you from enjoying the services of a public beach.

Are renewables the answer? (Image: Supplied)

Electricity consumption shares characteristics of a public good because it is non-exclusive. I cannot exclude you from consuming electricity because you connect to the grid, and you consume what is available. It is rival because we can only consume what is available, and if we have a shortfall of supply vs demand, then we encounter the situation of load shedding and blackouts.

But this is the other more important characteristic of electricity. It benefits society because “once a unit of capacity is added to the system, all consumers benefit from the increased reliability that it provides.” Furthermore, electricity provides the basis for comfort, education and living in a modern society. On those merits, electricity production and consumption benefits society.

Let’s recap: the assumptions of free markets don’t replicate for electricity production due to high barriers and because electricity consumption as a whole benefits society. Therefore, if you open a public good to a market that is not aligned to perfect competition, you have the potential for market failure.

What does market failure look like? Market failure occurs when resources are not efficiently allocated in the market. This tends to occur in monopolistic or oligopolistic markets, where firms in that market are price makers, not price takers.

If I have the power to increase prices due to market forces, then I will, and this is what we are experiencing now on the east coast of Australia. I am in no way blaming private operators who are in business to deliver profits, that is their incentive. However, the short-sightedness of politicians who were quick to privatise our public industries without careful consideration have some responsibility.

Australia is blessed with resource inputs that produce electricity – coal, gas, and uranium. Leaving our resources to be exported and expatriated to other businesses globally makes sense in the eyes of a free marketer. But like I said, electricity consumption is not a good well suited to the free market. It’s a public good. If we are to follow the free market, we should have intervened in the market like Norway did.

Norway enacted the Norges Bank Investment Management fund, taxing oil and gas exploration in the country. This fund is worth US$1.35 trillion and is being used by Norway to fund the energy transition from fossil fuels to renewables. Norway has the largest uptake of electric vehicles in the world.

What Norway did was not in the purviews of free markets. They understood that if market failure occurs, which is occurring right now in the fossil fuel market, they have a fund to fall back on to benefit their society. But that’s the beauty of foresight. Unfortunately the path to restoring stability in the grid without a sovereign fund will be troublesome for Australia, with the bill likely to be picked up by the taxpayer.