Carbon price pass through in electricity costs: factors to consider

21 Jun 2012Archived News Climate Change Matters

As of 1 July 2012 a carbon price will be added to the cost of your electricity.  In most cases retailers will have the right to pass through these costs under existing energy supply arrangements.  The legislation sets the carbon price for the first three years of the scheme, starting at $23 per tonne of carbon, then rising to $24.15 for 2013-14 and to $25.40 in 2014-15.  After this transitional period it is anticipated carbon prices will be determined through a traded market in carbon permits.  


Factors influencing the final costs of carbon in your electricity account

Converting carbon to electricity costs

A tonne of carbon needs to be converted to your electricity unit costs, generally in cents/KWh.  This conversion is a function of what is known as the Carbon or Emissions Intensity Factor.  This factor expresses a carbon dioxide equivalence of emissions per megawatt hour (tCO2-e/MWh) of electricity.   As a guide, for its 2012 Compliance Year the NSW Greenhouse Gas Scheme adopts a factor of 0.976*.   At this starting point, without consideration of issues below, at $23 per tonne of carbon, the carbon price equates to around $22.45/MWh or 2.24 cents/KWh.  

Different fuel sources, different costs

Further, since the carbon price will be levied on large emitters, in this case electricity generators, not all generators will incur the same cost.   This means that carbon costs across the generation sector will vary.  Ultimately, the cost to the emitter is dependent upon their fuel source, for example, coal generation has a higher Carbon Intensity Factor than an equivalently sized gas fired plant.  Even within the coal generation industry emission intensities vary – brown coal generation (the dominant fuel source used in Victoria) has a higher carbon concentration than its ‘black’ counterpart – mainly used in NSW. In addition, the generation mix - renewable generation compared to non-renewable, varies from state to state.  Likewise, electricity retailers will generally obtain their electricity from a mix of generation fuel sources, and as a result carbon costs will vary across individual retailers. 

Notification of carbon pass through has begun

Retailers are now starting to advise end users of their carbon pass through costs on their existing contracts, with effect from July 2012.  For some time, new business quotes have included a separate carbon cost component.   We understand that retailers will be adopting the practice of detailing their carbon charges separately and as such, carbon costs will just be another element for consideration in the selection of your electricity retailer. 

Dig a little deeper...

However, understanding the inputs into carbon pricing in the wholesale electricity market becomes significantly more complicated. The amount that an electricity retailer will pass through will naturally be determined by the magnitude of its increased costs, and the terms of its supply agreement, which will give it the right to pass through these additional costs. 

However the cost determination is not a straight forward proposition. 

Most retailers operating in the east coast wholesale National Electricity Market (NEM) seek to hedge a significant proportion of their electricity costs.  They do this as a risk management tool, often out of necessity, to mitigate against a moving spot market in the NEM which at times can be very volatile.  These hedges often take the form of financial derivative contracts as they operate externally, but parallel to, the physical NEM.  Their value is ‘derived’ from wholesale electricity prices in the NEM.  In most incidences the other party to these contracts will be a generator.  In essence, the benefit to both parties is price certainty.  For a retailer, hedging fixes their costs and for the generator they secure a fixed revenue stream.

Therefore, a retailer’s electricity costs will to a large extent be dictated by its hedge agreements.    

As these contracts are forward looking, that is, they cover a volume of electricity into the future often at a fixed price, potential issues arise when an underlying component of the market changes (often unknown – not contemplated at the time of first agreeing the hedge contract or if it was, its cost may not have been), which causes a potential change to the economics of the transaction - like the introduction of a carbon price.  How these agreements respond to regulatory changes depends on their terms and the view adopted by the industry and its participants.  The guiding principle is to restore the parties, as close as possible, to their original commercial position, prior to the ‘change’ by accommodating a price adjustment.  Over the years a variety of these provisions have been formulated. They include market and regulatory disruption events designed to allow the parties to negotiate their original contract terms to reflect the impact of the event.  Or more recently, to allow for an industry standard that uses an average intensity factor for the NEM, to calculate the pass through cost.

What does this mean for electricity consumers and the challenges in quantifying these costs?

The treatment of carbon under these pre carbon tax hedging agreements will have a significant impact upon the costs incurred by a retailer in relation to their electricity and carbon costs. 

Retailers will often have an extensive portfolio and mix of these hedge contracts – which can often run into hundreds of millions dollars that will have been entered into at different times of the carbon debate and therefore give rise to a different approach.  So the point to emphasise is the complexity and breadth of the variables involved in quantifying and calculating these costs, will vary across retailers.  This is further made difficult by the fact carbon pricing is a new concept and there is no universal standard that can be applied across a mix of generation and individual contracting positions.  As the NEM operates on a ‘gross pool’ basis, into which most types of generation supply, its carbon intensity will constantly vary throughout the day and it will represent an average intensity, that is, it is not generation specific.  While emitters will pay on actual CO2 pollution such an amount may not equate to the carbon pass through costs calculated using an average emissions intensity factor under a pre existing hedge arrangement.   

All in all, this will make it very difficult for consumers to assess an individual retailer’s pass through arrangements and costs.

Different electricity retailers, different pricing positions

Perhaps the proof of this complexity is reflected in the position that retailers are taking, which is not uniform.  For example, one major retailer has stated that they are unable to quantify their carbon costs upfront and the charge will be levied on a monthly basis, as it becomes known.  

Another retailer has stated that the impact of the Clean Energy Future package on the energy supply chain is complex and they are unable to “precisely determine the impact...on their business”.  Their approach will be to make a ‘reasonable’ assessment of the likely cost impact, which will be a forecast and prorated across their customer base.

If your business is concerned about how carbon pass through has been calculated...

Consumers can always ask their retailers to provide them with detail on how they have calculated their carbon pass through costs.  This would seem a reasonable request given the materiality of carbon on electricity prices.  Evidence of the materiality is that the ACCC has recently indicated they will be monitoring the statements made by businesses over their carbon costs.

How far consumers can escalate the request for more detailed information and what their retailer is willing to disclose, will to a large extent be dependent upon the relevant provisions in your energy supply agreement. 

These provisions should spell out the mechanism by which the retailer will treat these costs and their rights and obligations in passing it through.  While it is difficult to provide a standard form of wording that may apply, in most cases they will use terminology such as, a ‘reasonable estimate’ of our (retailers) increased costs or require a best endeavours approach when determining their increased costs.  Other relevant issues include the level of information that your retailer may have to disclose about the considerations that sit behind these costs, or the manner in which they allocate these costs across their customer base and have applied them to your account.  In some cases such contract provisions might be relatively prescriptive while in other instances the approach may be somewhat vague.  A case by case approach will be needed.  

There are a number of sources that can be used as a guide for establishing an upper price band.  One of the reasons for fixing the carbon price for the first three years, as opposed to relying upon a traded market, is that it at least sets an upper limit - $23/tonne of CO2.  As discussed earlier, while this may not directly calculate to a 2.3 cents/KWh electricity price equivalent, it does provide a benchmark that should not materially exceed this price ceiling. Further, IPART (the NSW pricing regulator) have recently released their determination for regulated retail tariffs for the 2012/13 year, which includes a carbon cost component.  IPART has calculated that the impact of the carbon price on regulated prices to be around $170 for a typical household in NSW in 2012/13.  A typical household consumes about 7MWh a year, which equates to around $24.28/MWh (2.43 cents/KWh).  This is also grossed up to include GST and losses, which will be the practice. 

If you have concerns about the manner in which your carbon costs have been calculated or if the treatment of these costs is potentially inconsistent with the terms of your supply agreement, Energetics can review and assist in the assessment of your carbon charges.       

 *IPART – Fact Sheet, “The NSW Pool Coefficient - which represents the average emissions intensity of electricity sourced from the electricity grid in NSW.”

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