structurE of The Australian
Electricity Industry

Updated August 2006

The restructuring of the Australian electricity industry has now been proceeding for 16 years since the industry itself set up a reform working group during 1990. This reform process has been the most profound and major restructuring in the 100 year life of the Australian electricity industry.

The restructuring consists of:

• introduction of competition;

• unbundling of ESI functions;

• reorganisation of the electricity market;

• separation of network charges;

• privatisation of electricity businesses in some States;

• formalisation of ESI regulation.

Introduction of Competition

A major objective of ESI restructuring in Australia has been to introduce competition into the Australian electricity industry wherever possible. The two ‘wires’ functions - transmission and distribution - are considered to be natural monopolies. In contrast, the generation and retail supply functions have been opened to competition.

Unbundling of ESI Functions

Until the mid-1990s, in some Australian states (eg Victoria, South Australia and Tasmania) the four functions of generation, transmission, distribution and electricity retailing (also called ‘electricity supply’ in some countries) were carried out within a single, vertically-integrated, monopoly business. In other States (eg New South Wales and Queensland) generation and transmission were contained in a single monopoly business, while distribution and retailing were carried out by a number of businesses, each with a monopoly franchise covering a specified geographical area within the State.

A major objective of electricity industry restructuring in Australia has been to unbundle the four functions into separate businesses:

• several competing generation businesses have been established in each State;

• a single monopoly transmission business has been established in each State;

• geographical monopoly franchises for distribution have been retained in States that already had them and have been created in the other States. In some States, the number of existing franchises, and therefore of distribution businesses, has been reduced;

• a two tier system has been established for electricity retailing in each State:

▪ ‘first tier’ retailers are attached to a distribution business with a monopoly geographical franchise in that State. First tier retailers can sell electricity to customers throughout the State, whether or not the customers are located within the accompanying distribution franchise. The retail business is “ring fenced” from the distribution business (ie established as a separate accounting entity within one holding company);

▪ ‘second tier’ retailers are stand-alone businesses not attached to a distribution business in the relevant State. Second tier retailers can also sell electricity to customers throughout the State. A second tier retailer in one State may be a first tier retailer in another State.

reorganisation of the electricity market

The reorganisation of the electricity market is the third major change in the structure of the Australian electricity industry. Currently, the reorganised electricity market is in three parts: wholesale, ancillary services and retail.

Wholesale Electricity Market

The major Australian wholesale electricity market, the National Electricity Market (NEM), comprises the sale of bulk electricity by generators to electricity retailers and large end‑use customers in southern and eastern Australia.

The NEM operates in the States of New South Wales, Victoria, Queensland, South Australia and Tasmania and in the Australian Capital Territory. Western Australia and the Northern Territory will always be excluded from the “National” Electricity Market because of the lack of electrical interconnections and the vast distances between their load centres and the interconnected electricity network in the southern and eastern States. Western Australia has a wholesale electricity market that operates only in that State.

The NEM operates on the world’s longest interconnected power system – from Port Douglas in Queensland to Port Lincoln in South Australia – a distance of more than 4000 kilometres. Up to AUD7 billion of electricity is traded annually in the NEM to meet the demand of the almost eight million end-use customers.

The NEM commenced on 13 December 1998 and it currently operates under a detailed set of rules called the National Electricity Rules. The NEM comprises a physical spot market with energy traded through a commodities-type pool and a spot price set every five minutes (and averaged over half hour periods) by the most expensive generator selected to run. All electricity sold at the wholesale level is accounted for through the pool (this is called a “gross pool” or “energy-only pool”). There are six geographical regions in the NEM and constraints on interconnectors can cause marginal spot prices to separate between the regions.

The market operator for the NEM is the National Electricity Market Management Company (NEMMCO). The owners of the company are the five States and the Territory within which the NEM operates. NEMMCO was established in 1996 to fulfil the roles of both market operator of the NEM and operator of the power system that underpins NEM operations. NEMMCO is responsible for generator dispatch, reliability management and financial settlements in the NEM.

In addition to physical spot trading through the NEM, there is a separate over-the-counter short term forward trading market for electricity. In this market, purchasers lock in energy prices through financial hedging contracts (“contracts for differences”). Under a standard bilateral hedging contract, the purchaser (typically an electricity retailer) agrees to purchase a specified physical quantity of energy from the spot market at a set price (the “strike price”). If the actual price paid in the spot market by the purchaser is higher than the strike price, the counterparty to the contract (typically an electricity generator or a financial institution) pays the purchaser the difference in cost. Conversely, if the price paid is lower than the strike price, the purchaser pays the counterparty the difference.

Hedging contracts are financial instruments and can be traded in a market similar to other financial markets. There are numerous variations on the standard hedging contact available in the market, often containing complicated financial arrangements. The purpose of hedging contracts is to manage the price risks involved in purchasing electricity from the wholesale spot market. Prices in the spot market are highly volatile and the spot price can spike to several hundred times the average price for short periods.

Ancillary Services Markets

The National Electricity Market also includes a range of different markets for ancillary services, managed by NEMMCO, including:

• eight distinct markets for Frequency Control Ancillary Services in which providers make offers of services to manage frequency within specifications up to a 5-minute horizon; and

• long term contracts for Network Control Ancillary Services and System Restart Ancillary Services negotiated between NEMMCO (on behalf of the market) and the market participant providing the service.

Retail Electricity Market

The retail electricity market comprises sales of electricity by retailers to end‑use customers. Within the area covered by the NEM, the retail market is partly competitive and partly operates on a franchise basis.

In the competitive retail market, electricity retailers compete to supply the vast majority of large customers who choose not to purchase directly from the wholesale market and smaller customers who opt out of purchasing electricity from their first tier retailer. Such customers are termed ‘contestable’.

In most jurisdictions in which the NEM operates (eg New South Wales, Victoria, South Australia and the Australian Capital Territory), retailers can sell electricity to all end-use customers down to the household level, ie all customers are contestable. Where this is the case, customers may continue purchasing electricity from their local first tier retailer and the tariffs they pay are controlled by the electricity industry regulator. Alternatively, customers can choose to purchase electricity under a competitive retail contract from a first or second tier retailer in their State. There are no controls on prices under such competitive retail contracts.

In Queensland and Tasmania currently only larger customers can be offered competitive retail contracts by retailers. Smaller customers continue to purchase electricity under controlled tariffs from their local first tier retailer. All small customers will become contestable in Queensland by July 2007 and in Tasmania by July 2010. However, the Tasmanian Government has reserved a final decision as to whether retail contestability will be extended to households and small businesses (from 1 July 2010) until a public benefit test has been undertaken.

Under this structure for the retail electricity market, retailers actually shield retail customers from the price volatility in the NEM wholesale spot market. In effect, retailers provide price risk insurance for retail customers, with the retail price paid by the customer including an insurance premium component.

Currently, there is a move to abolish retail price controls for all customers in all jurisdictions in which the NEM operates. This is likely to be introduced progressively over the next few years as competition in the retail electricity markets in each jurisdiction becomes more effective.

Separation of network charges

Originally, network charges, covering the cost of transporting electricity from the generator to the point of end-use, were bundled together with energy charges in calculating the electricity price to be charged to the end use customer.

Following the establishment of the NEM, both generators and end-use customers are required to pay separate network charges. In the wholesale market, market participants who purchase electricity directly from the spot market are responsible for also paying connection charges and ‘use of system’ charges directly to their local transmission and distribution network owners. In the retail market, network charges incurred by end-use customers are paid for them by their electricity retailer who packages these network charges together with the energy charge. In some electricity bills the network charges are separately identified but many bills continue to show one price to the end‑use customer.

Privatisation of Electricity Businesses

For the 50 years prior to the mid-1990s, the majority of electricity businesses in Australia were owned by State governments. Some distribution/retail businesses were owned by local governments (municipalities) and a handful of relatively small electricity businesses located in remote areas were privately owned.

Commencing in the mid-1990s, some State governments (eg New South Wales and Victoria) consolidated their hold on the Australian electricity industry by legislating to take ownership of the local government electricity businesses. After unbundling the electricity industry functions into separate businesses, some State governments (eg Victoria and South Australia) sold these businesses to the private sector, including foreign owners from the United States, United Kingdom and South-east Asia. All other States retained electricity businesses in government ownership.

More recently, there has been wave of selling of electricity businesses by the original private sector owners to new private sector purchasers. These new purchasers often own more than one electricity business. The end result has been some rebundling of the ownership of the previously unbundled ESI functions, eg a single owner may own both an electricity generator and a retail business, though these must be operated as separate businesses.

Formalisation of Regulation

Prior to the mid-1990s, regulation of the Australian electricity industry was carried out on an informal basis because most of the businesses were government-owned and were operated as a public service rather than as profit-making commercial ventures. For example, increases in electricity prices were often agreed in informal meetings between the senior management of the electricity businesses and the relevant government Minister.

Once competition was introduced into the electricity industry, and particularly as some electricity businesses became privately owned, a more formal system of regulation was required. Consequently, State and territory governments established new agencies to regulate the electricity industry (plus often other industries as well). By mid-2004, this jurisdictional-based regulation resulted in the Australian electricity industry being regulated by 13 separate agencies. Commencing in 2005, this situation was rationalised with regulation of the industry being progressively transferred to national regulatory agencies.

Currently, regulation of the electricity industry in Australia is mainly carried out by two relatively new statutory commissions that were established under the National Electricity Law and commenced operation on 1 July 2005:

• the Australian Energy Market Commission (AEMC); and

• the Australian Energy Regulator (AER).

The Australian Energy Market Commission (AEMC) has responsibility for rule-making and market development in relation to the NEM. The AEMC reports directly to the Ministerial Council on Energy (MCE). The MCE includes Commonwealth, State and Territory energy ministers, in addition to ministers from New Zealand and Papua New Guinea as observers. The MCE has the power to direct the AEMC to carry out reviews of the National Electricity Market and the National Electricity Rules.

The AEMC is responsible for:

• administration and publication of the National Electricity Rules;

• the Rule making process under the National Electricity Law;

• making determinations on proposed Rules;

• undertaking reviews on its own initiative or as directed by the MCE; and

• providing policy advice to the MCE in relation to the National Electricity Market.

The Australian Energy Regulator (AER) performs economic regulation of the wholesale electricity market and electricity transmission networks in the NEM, and enforcement of the National Electricity Law and National Electricity Rules. These functions will expand over time as electricity distribution and retail functions are scheduled to transfer to the AER by the end of 2006.

Under the National Electricity Law and National Electricity Rules, the AER’s key responsibilities, as at mid-2006, include:

• regulating the revenues of transmission network service providers by establishing revenue caps;

• monitoring the wholesale electricity market;

• monitoring compliance with the National Electricity Law, National Electricity Rules and National Electricity Regulations;

• investigating breaches or possible breaches of provisions of the National Electricity Law, Rules and Regulations;

• instituting and conducting enforcement proceedings against relevant market participants;

• establishing service standards for electricity transmission network service providers;

• establishing ring-fencing guidelines for business operations with respect to regulated transmission services; and

• exempting network service providers from registration.

As at mid-2006, State and territory regulators continue to be responsible for regulation of electricity distribution and retail functions within the jurisdictions in which the NEM operates. This includes the responsibility for regulating retail prices and distribution network use of system charges. At present, the individual regulators adopt somewhat different regulatory approaches within their jurisdictions. Subject to agreement by the individual jurisdictions, the responsibility for regulating electricity distribution and retail functions is scheduled to be transferred to the AER by the end of 2006 and it is likely that a single national approach to regulation will then be adopted.

Structure of the Australian Electricity Industry

A multi-national research project carried out by the International Energy Agency’s Demand-Side Management Programme developed four generic models for the structure of electricity industries.

The four models are:

Model 1 - Vertically integrated monopoly

Model 2 - Unbundled monopoly

Model 3 - Unbundled, limited competition

Model 4 - Unbundled, full competition

Descriptions and diagrams of these models are available here.

In the case of the Australian electricity industry, the original structure before the mid-1990s was similar to Model 1. Following the restructuring in mid-1990s, the industry structure is similar to Model 4 in States where all customers are potentially contestable (eg New South Wales, Victoria and South Australia) and to Model 3 in those States where only some customers are contestable (eg Queensland and Tasmania).

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