Robbing Peter, the electricity consumer, to pay Paul, the taxpayer

Snowy Hydro is a "corporatised" business owned by the New South Wales, Victoria and Commonwealth governments. NSW is the majority owner.

Snowy’s function is to store water for irrigators and to generate electricity. However, a poor regulatory framework means Snowy is motivated to operate in ways that have adverse public policy outcomes.

One regulatory distortion is that Snowy earns nothing from storing water for irrigation, one of its two key functions. All its revenues come from its other "product" - electricity generation. Although there are regulatory requirements on releases for irrigation purposes, these do not provide the same sharp incentive structure that financial benefits ensure.

One outcome of its poorly designed revenue structure may be a sub-optimal level of water storage to take advantage of needs that arise in droughts. That at least is the view of one irrigator body, Lakes R Us, who have applied to the National Competition Commission to have the whole of the system declared as an “essential facility” so they can store more water in the high dams. This would essentially allow storage for much longer periods than is presently permissible, rather than the wasteful "use it or lose it" regulatory structure that presently prevails.

In addition, there are other poorly structured regulations that bring considerable costs to consumers and other producers. These include the impact of renewable energy certificates (RECs), the main Commonwealth vehicle to force energy consumers to subsidise high-cost renewable energy.

Snowy has been given an annual baseline level of generation above which it earns RECs that are worth about $40 per MWh (i.e. somewhat more than the value of electricity itself). Because it does not receive penalties for underperforming, it operates its system so one year it generates strongly and the next year it builds up its reserves. This allowed Snowy to earn some $67 million in essentially phantom RECs in 2003.

Not only did this not contribute in net terms to the largely misguided government policy of reducing greenhouse gas emissions but it actually increased emission levels. This is because 20 per cent of Snowy’s RECs may have been created through pumping water uphill for re-use. Though the energy used in pumping is netted out from the REC creation, shifting water from an underperforming year to a hard generating year creates a credit. In pumping water uphill, Snowy uses almost twice as much (coal-derived) energy as it produces in subsequent generation.

In addition, Snowy has mastered how to exploit a constraint between NSW and Victoria by generating in such a way that it, and not its Victorian competitors, has monopoly access to NSW during rare half-hour periods when the price is very high. It is estimated that last year Snowy earned about $40 million through using this mechanism.

It might be argued that none of this matters. After all, Snowy is a government-owned firm and it is earning profits that are transferred back to the public shareholders. However, robbing Peter, the electricity consumer, to pay Paul, the taxpayer, creates considerable inefficiencies. These include "mis-incentivising" irrigators to use water when it is less valuable. Additional costs follow from activities by other energy producers and energy retailers to reduce their exposure to the price distortions that emerge from Snowy’s manipulation of regulatory opportunities.

Moreover, the inflation of Snowy’s profits as a result of its taking advantage of a distorted regulatory structure may have been a motivating factor to it embarking on an investment spree that has seen it buy a retail business (RED Energy) and a new gas fired generator south of Melbourne. None of the private shareholder-owned energy businesses saw a commercial case for building such a facility at this time.

Governments are whipping up a crisis in water with their propagandist exhortations and regulations designed to force conservation on urban households. Any shortages of urban water in eastern Australia are pure governmental contrivances that could be readily resolved by a new dam. The real issue, however, concerns efficient water use for the other 90 per cent of water that is used in irrigation and industry.

The Lakes R Us application highlights some major distortions to water regulation. These and the regulatory loopholes which Snowy’s management have been skilfully exploiting should be the catalyst for a comprehensive review of Australia’s most important water and hydro electricity business.