Tag Archives: IEEFA

Social Services and Energy Distribution: The Treatment of Surpluses and Profits in Pseudo Markets

Arising from neoliberalism’s obsession to not just analyse the world in market terms, but to make the world into a market, governments in Australia and elsewhere have privatised or outsourced a range of services which had previously been provided by government departments or authorities. South Australia followed this ideological venture in a range of areas, but in this post I simply want to focus on two examples: social service provision and the electricity distribution network.

While the two industries are obviously different, in both cases there was an attempt to mimic or impose market discipline where there was no competition and no real market. Social services are a government monopsony where service users are not the customers so the theoretical link between utility, market demand and price is broken, while energy distribution networks are a natural and legislated monopoly.

Much could be written about the structures and regulation of the “markets” that were established, but I want to focus on just one aspect: the inconsistency in the treatment of profit. This treatment has consequences for social service delivery and energy prices, and ultimately therefore, for equality.

Social Services

The provision of social services, such child and family support, financial counselling, community health, housing and homelessness support, addiction help, and disability services are an essential part of a government’s role in a modern society. But the neoliberal vision and the potential to cut costs by outsourcing services to organisations with lower pay or less regulation led to the creation of pseudo-markets where charities and not-for-profit (NFP) organisations (and some private companies) periodically bid for government tenders to provide services. The successful tenderer is then contracted to provide services at the agreed price, with the government apparently happy in the knowledge that the competition between tenders has ensured value for money.

Heading text from SA government contracts for social services. The terms prevent surplus accumulation.

There are some good reasons for government outsourcing of some social services (and much hubris in relation others), but the treatment of the cost of services and profit in the South Australian government contracts is curious. The government holds most of the cards in any contract negotiation, and generally does not allow for an operational surplus in a contract price. Further, given that the government pays for service provision in advance, it wants to ensure that the money is spent on the services it paid for. And so, the standard SA government contract with NFP service providers has a clause (10) allowing the government to require repayment of any advanced funding which has not been expended in a given year. While there is flexibility for the government not to require repayment, some departments aggressively pursue such repayment.

At best this is a lop-sided contract, with one party (the government) agreeing a price for the provision of a service, and then reducing that price if the service provider manages to make savings – even though the service has been provided as agreed. Despite government rhetoric of outcome-based approaches, the clawing back of unexpended funds is completely input-focused.

However, the ramifications are broader because the lack of operational surpluses and the claw-back of funding means that NFPs struggle to find surpluses to build robust balance sheets and invest in organisational sustainability and development. It is then no surprise that the sector is characterised by an under-investment in technology (as reported in multiple annual surveys) and by short-horizons with a reliance on the next government contract to maintain staff and services.

To be clear, the fact that organisations are not-for-profit does not mean that they can’t lawfully or shouldn’t make a surplus on any service or in any year – it simply means that any surplus has to be put back in to the organisation and can’t be allocated to members as a dividend or other profit distribution. However, the contractual limitations on building and keeping such operational surpluses is detrimental to the sustainability of NFPs and stops them providing more and better services to the people who rely on them.

Electricity Distribution

The pseudo-market created in energy distribution is quite different. By contrast to the government monopsony in social services, the energy companies who bought the privatised energy networks operate in a more standard business framework with the cost of services being paid for by energy consumers (accounting for about 40% of energy bills). However, because the networks have monopoly power, their operations are regulated by laws which limit the aggregate revenue they can get from consumers.

As I have noted in a previous post, the calculation of this aggregate is complex and contested, but it is theoretically based on the cost of service provision, including an agreed rate of return on capital (i.e. profit) – with the regulator determining what costs and profit rates are appropriate.

This allowance of a return on capital contrasts to social service provision in that an agreed rate of profit is viewed as a normal cost of service provision – a cost not usually allowed in NFP contracting (noting that, in theory at least, both have separate allowances for administrative overheads). The result of this is that these private companies can accumulate profit to re-invest to build the company and to distribute to shareholders in a way that NFPs can’t.

However, the difference does not stop there. As I have reported previously, the Institute for Energy Economics and Financial Analysis has produced reports highlighting the “supernormal” profits energy distribution companies have made when their actual costs have come in below the costs agreed by the regulator. In 2022, this amounted to $199m for SA Power Networks and around $2bn across all network providers nationally. While the differences in estimated and actual costs may be factored into future regulatory determinations, this money is not immediately clawed back by the regulator or consumer – indeed, there is a whole incentive scheme built in to the cost calculation to encourage such cost-savings.

A Modest Proposal

There is no doubt that NFP service providers would love to be able to keep their operational savings and surpluses to reinvest in their organisation and services, or even to have an incentive system which mirrored that which enables energy networks to benefit from cost savings.

For governments to be consistent, they should either allow NFP service providers to retain profit (i.e. money not spent when they have provided the agreed services) as per the energy regulation, or force energy networks to refund to customers the above-regulated profits when their costs of service provision are lower than the regulated amount. Energy network owners would still be better off than social service NFPs as the former would still get their guaranteed return on capital, but in relation to the unexpected savings and surpluses, it is a simple proposition that what is good for the goose is good for the gander. But such outcomes are about power (of the political economic kind), not policy, and I suspect in this case it is energy consumers who will continue to be plucked.

Revisiting Energy Supernormal Profits – A Tale of Two Graphs

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.

Figure 6 from IEEFA report showing FY22 network cost and profit outcomes, on two lines: 1. Revenue = $8.7bn cost + $1.4bn profit + $2bn supernormal profit. 2. Cost = $8.7bn cost base + $1.4bn profit

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.

Alternative model of the IEEFA data on network costs and profits, showing two lines of the same length: 1. Allowed = $10.7bn costs + $1.4bn normal profits 2. Actual = $8.7bn costs + $3.4bn profits.

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.