Shock to the System: Surging Coal and Gas Costs to Raise Wholesale Electricity Prices

Key Takeaways:

Inflated input costs due to the Russia-Ukraine conflict, supply shortages and rising demand are pushing wholesale electricity prices higher.

Electricity retailing and generation industries must adapt to changing conditions.

Consumers are set to lose out as wholesale prices begin to flow through to retail bills.

Businesses face higher production and utilities costs, and need to maximise their energy contracts.

High prices are set to continue into 2022-23, but are projected to ease over the next five years.

Coal and gas costs are on the rise

Wholesale electricity prices have surged in 2021-22, as the Russia-Ukraine conflict pushes coal and gas prices to eye-watering heights. High input costs have sent the National Electricity Market (NEM) into a short-term crisis. Coal supply shortages and major generator outages have also placed upward pressure on wholesale prices.

Consumers and businesses alike should take notice – the NEM is Australia’s main wholesale electricity market, covering all Australian states and territories except Western Australia and the Northern Territory.

Extreme weather events are also raising electricity demand. Above-average temperatures in early 2022 got the ball rolling, while a cold snap in June is challenging under-pressure generators to keep up supply. Flooding in Queensland and New South Wales have also put pressure on wholesale prices.

High prices, restricted supply and growing demand are creating a perfect storm for consumers and businesses. Although all NEM states are feeling the heat, Queensland and New South Wales have experienced particularly large wholesale price spikes in 2021-22.

Interestingly, inflating wholesale prices are reversing recent trends in the NEM. Wholesale prices declined significantly over the two years through 2020-21, as massive investment in renewable generation capacity and low demand pushed prices down. The COVID-19 pandemic lowered demand for electricity, as business confidence declined and manufacturing activity slowed.

To some degree, rising wholesale prices are set to affect all corners of Australia’s economy. Soaring prices have had flow-on effects on the following broad sectors:

Electricity retailing and generation industries
Consumers
Businesses

Price rises will immediately affect electricity retailers and generation industries, which will flow through to consumers and businesses. Households must ultimately keep the lights on, and businesses need power to be productive. However, these three groups will experience rising prices very differently.

How is the energy sector adapting?

Yallourn Coal Fired Power Plant in Victoria, Australia

Wholesale electricity prices directly affect revenue for electricity generation industries. Increasing prices are set to benefit generators, as they try to pass higher gas and coal input costs onto retailers through the wholesale market.

On the one hand, generators are likely to be positively affected, as significantly inflated prices support revenue growth. Wholesale price rises typically benefit generation industries, as they receive more revenue per megawatt hour of electricity they produce. However, this isn’t all good news for generators; they rely on managing input costs to maximise profit margins.

Coal supply shortages are damaging generators’ ability to operate at full capacity. For example, Origin Energy’s large-scale Eraring coal-fired plant has been operating at lower capacity due to upstream coal shortages.

Although growing prices usually boost revenue for generation industries, firms need to keep a lid on input and production costs. Global supply chain disruptions therefore threaten fossil fuel generators. If their local inputs are not available, they have to source them from costlier international markets and risk eating into their profit. Consequently, supply chain management and procurement strategies are becoming even more critical for generation firms’ success.

New Zealand also recently experienced increasing wholesale prices, which boosted large generation companies’ revenue in 2020-21. Many larger firms in Australia and New Zealand operate both retail and generation businesses as vertically integrated gentailers. This strategy helps hedge risk in wholesale markets and can create economies of scale for larger firms. The generation business benefits if wholesale prices rise, while the retail business can lower costs if prices fall.

While rising wholesale prices increase purchases for retailers, gentailers balance this out by controlling generation businesses. However, the short-term situation for smaller retailers is much bleaker. Prices are inflating to the point where some smaller firms are having to exit the industry, as they struggle to fully pass on costs without losing customers.

Retail electricity prices begin to bite

Wholesale prices represent approximately one third of retailers’ costs for supplying electricity to residential consumers. Distribution and transmission costs actually have a greater total effect on consumers’ pockets. Furthermore, there is usually a lag between wholesale price changes and retail prices, as many retailers lock in futures contracts to guarantee consistent supply and make sure their end users aren’t left in the cold. However, wholesale prices are notoriously volatile and still strongly influence how much consumers and businesses pay for electricity.

Households are bracing for higher electricity bills, as retailers start to pass through inflated prices. The Australian Energy Regulator introduced a Default Market Offer (DMO) in 2019. The offer caps prices that retailers can charge for default contracts, known as standing offers, in New South Wales, South Australia and parts of Queensland. It also serves as a benchmark price for consumers and retailers.

The DMO is rising in 2022-23, and the equivalent Victorian Default Offer is also set to increase. These changes will hurt consumers and small businesses. Moreover, they signal that future price hikes are on the table as retailers scramble to pass on costs and remain viable.

Businesses will need to manage their energy contracts

Large businesses are also grappling with increasing utility costs. Booming electricity prices will negatively affect energy-intensive firms, such as manufacturing and mining companies. Firms that use large volumes of electricity often enter into contracts differently to consumers and smaller businesses. Companies can directly enter into agreements with generators, and transmission firms can supply large industrial companies with electricity if they have the right facilities.

As larger firms need significant amounts of electricity from the grid, they often use agreements that are more flexible than traditional retailing plans. Therefore, they can be more exposed to fluctuating wholesale prices. Paper and steel manufacturers are likely to struggle as increasing utilities costs squeeze their profit margins. Aluminium smelting firms are particularly exposed to rising electricity prices, as utilities costs made up almost 30% of industry revenue in 2021-22.

Procurement and supply chains must work overtime to make sure energy contracts are as efficient as possible. In response, firms may need to outsource these functions, which is likely to benefit procurement and supply chain consultants. Unfortunately, many businesses could find it hard to escape price rises in the short term. How easily firms can adapt to spiking energy and other prices may rely instead on their ability to pass costs on to end users.

Sustainability: a ray of sunshine for businesses

While firms may have little control over electricity price trends, current conditions provide opportunities to more fully embrace sustainable business practices.

Consumers’ rising concern about environmental issues encourages businesses to focus on sustainability. By cutting carbon emissions and improving their business models’ sustainability, firms can benefit in two major ways:

Capturing growing consumer demand for sustainability.
Reducing costs through lowered energy usage.

Some larger firms may extend sustainability into their supply chains in response to volatile international conditions. A short-term shift may be needed to protect energy-intensive businesses from problems down the line. By more closely aligning with local suppliers, these firms can reduce reliance on global supply chains and limit their exposure to potential future shortages. However, this strategy relies on creating strong relationships with local upstream suppliers.

Easing prices on the horizon

Wholesale prices are projected to remain high in 2022-23 due to the ongoing Russia-Ukraine conflict and supply shortages. Consumers and businesses are set to lose in the short term. However, wholesale prices are forecast to somewhat ease over the next five years as costly coal-fired plants close and renewable generation capacity grows. Nevertheless, Australia’s transition from fossil fuels is expected to be a bumpy ride, as volatility likely persists in wholesale markets. Any energy policy changes under the newly elected Labor government will also significantly affect Australia’s electricity market transition.

IBISWorld reports used to develop this release:

Australian industry reports