In a previous post I highlighted the work of Simon Orme and the Institute for Energy Economics and Financial Analysis (IEEFA) exposing the supernormal profits reaped by monopoly energy networks. They define supernormal profits as the actual profits made by these statutory monopolies over and above that which was allowed for under regulation. (Under national energy laws, the Australian Energy Regulator [AER] regulates the total amount of revenue that can be collected by energy transmission and distribution networks to avoid profiteering from their monopoly position).

Supernormal Profits

The context and how supernormal profits are realised is highlighted in the earlier post, which was based on IEEFA’s 2022 report. They have now published a new report which updates and refines the first report and includes figures for the 2022 financial year. The headline finding is that in the last year the energy networks reaped a massive $2bn in supernormal profits (on top of and eclipsing their regulated “allowed” profit of $1.4bn). This was a significant increase on the approximate $800m supernormal profits across the networks in 2021 and brings the total supernormal profits reaped since 2014 to over $11bn. Overall, this added an average of $185 per customer to energy bills in 2022, although there were significant differences between states and network providers.

The industry attacked the report, claiming the IEEFA analysis is flawed because it treats every variation from the AER’s allowance as a potential supernormal profit, and because consumers benefit from the incentive schemes which contribute to the extra profits. Unsurprisingly, I disagree with the industry critique, but I also have a different approach to that of the IEEFA.

As per my previous post, I think this work on supernormal profits is really important. It is a welcome focus on and quantification of profit-levels, particularly when the issue of profit-taking is largely ignored in energy debates dominated by prices, reliability and emissions. However, I also suggested that, despite the industry reaction, the IEEFA approach is fairly conservative – a critique (deliberately) from within the regulated monopoly framework which utilises a neoclassical concept of profit that is limited and problematic.

Two Graphs – Two Theories of Normal Profit[i]

This neoclassical conception of profit as a normal and unobjectionable cost of production (and hence the target of attack being “supernormal” profits) is clearly evident in the graph below from the 2023 IEEFA report.

The second line of the graph clearly includes the normal profit allowed by the regulator as a standard part of the cost. Indeed, the fact that they use the same cost base for both actual revenue and allowed costs is a nod to what it theoretically should cost in a properly regulated (perfect?) market.

The detail of the report goes further in allowing up to a 30% increment on allowed profits before the supernormal profits are viewed as “excessive”. This is to allow for the asymmetry of information (where the regulator has less information on network costs than the network businesses). In this context, I pity the poor consumer advocates in underfunded NGOs being asked to comment on billions of dollars of expenditure and financial engineering! The concern around lack of information reflects traditional economic literature on imperfect markets, a concept which not only implies and centres a “perfect market”, but also adopts the orthodox economic interpretation of profit as a cost of production. Indeed, the distinction drawn between normal and supernormal profits inevitably normalises a certain level of profit as a return on capital.

However, it is possible to draw the graph differently using the same IEEFA data, but with a different theoretical starting point.

This graph more clearly shows that in both the projected (allowed) and actual cases, the customers are paying the same ($12.1bn), and that $3.4bn of that is going in profits to the network owners. I argue that this is a better reflection of the dynamics at play because the goal of any capitalist enterprise is to maximise profit. With total revenue set, the only way to grow or maximise profit is to cut costs – which is clearly shown in the second line of my graph. In this sense, IEEFA’s “supernormal profits” are simply the outcome of normal business operation.

Side note: given this normal business operation, there appears little justification for the additional funding provided to network providers under efficiency incentive schemes. Those schemes cost rather than benefit consumers, and are unnecessary when the networks already have normal business incentives to improve efficiency/cut costs. I note that the IEEFA report (pg 26) comes to the same conclusion, despite the differences in our theoretical frameworks.

Conclusions

Again, there are caveats to the above discussion (see endnote), but the differences in the two graphs reflect not just different theories of profit, but different purposes and outcomes.

The IEEFA analysis is an argument for better regulation, so the analysis of supernormal profits in the first graph shows a revenue-take and profit above a theoretical optimum cost-base that would apply if regulation had been better.

By contrast, my graph, based on the same data, draws attention to the overall cost to consumers of the privatisation (or corporatisation) of these natural monopolies. In this context, I note that some energy networks remain in public hands, but the regulation and mode of operation of such government businesses is the same – with the important distinction that what energy consumers pay in profits to state enterprises has benefits in lower taxes or better public services. This is not the case for private companies. But either way, the quantum impact is clear: this network model added $3.4bn in total to energy consumers’ bills in 2022.

Economic orthodoxy and business interest would suggest that this cost to consumers would be more than balanced by the greater efficiencies of capitalist production which result in lower prices in the long term. However, this is ideology rather than analysis. The data shows that very little of the increased profit is driven by improved technology and processes.

According to AER data, in 2022 capital structures and cost of debt were the two biggest contributors to cost savings, while the IEEFA report (pg 26) explicitly rejects the idea that increased productivity is the source of supernormal profits. It points out that networks with average and even below-average productivity have still been getting very substantial supernormal profits.

Given this, and the $3.4bn cost last year for the privilege of privatised/corporatised energy network provision, I again wonder if it is time to think about whether there are better ways to supply energy.

Endnote

---

[i]              The depiction in the graphs is obviously over-simplified. In reality, the picture of energy profits is more complicated than either of the graphs above. The total revenue figure is more flexible than shown as projections for allowed revenue will inevitably be imprecise even if all assumptions are correct, and the amount of revenue allowed to be collected each year is varied by the regulator to take account of some financial changes (e.g. interest rates and inflation), allowed cost pass-throughs and other factors. Allowed revenue is also reset every 5 years, based in part on previous outcomes.

Further, as the IEEFA report (Appendix 1) notes, there are limitations on the AER’s published data, and definitive profitability data for each of the 18 network providers is not publicly available. Partly this is because these regulated networks often operate as part of larger financial entities with regulated and unregulated revenues and expenditures. In this context, I am grateful to IEEFA for piecing together the available data and providing both data and analysis that is accessible and understandable by “energy outsiders” like me.