Pricing our way to a fairer energy future

*This is the second part of a two-part article on tariff reform in Australia's energy market. Part one – Talking bull about disappearing demand – was published yesterday.

Electricity consumption and peak demand have grown almost uninterrupted in the National Electricity Market for many decades. However, in the last five years, despite some of the hottest summers on record, grid-sourced energy consumption dropped and peak demand remained relatively stable.

Even more critically, demand is well below where it was projected to be. Network service providers were, until recently, responsible for projecting many of the demand patterns in the NEM and most projected that the trend of steady growth would continue. This projected growth in peak demand justified a large proportion of the roughly $40 billion that NSPs spent augmenting the network over the past few years. However, work by Mike Sandiford has found that NEM-wide consumption in the last 12 months was around 14 per cent lower than where you'd assume from trends before 2008-09, and summer peak demand in 2014 was around 15 per cent below trend.

Recent work by Hugh Saddler estimated that under 25 per cent of the drop in demand to date, relative to projections, was caused by stagnant industry output and closures – well over 50 per was delivered by energy efficiency and energy conservation. A further 15 per cent in the drop in demand for grid-supplied energy came from solar photovoltaic panels and small generators. This rapid drop appears to be a global phenomenon, with demand dropping around the world as solar PV costs fall, households become more attuned to energy efficiency and the types and efficiency of appliances change.

Some people have argued that this drop in demand has pushed up electricity costs for households, and further reductions in demand will push up bills even further. This is demonstrably false.

The recent fall in demand has reduced the wholesale cost of electricity. This means that all energy users should pay less per unit of electricity that they consume, and energy users that have become more efficient will benefit doubly by paying less for each unit of electricity and paying for fewer units of electricity.

The story is more complicated for network costs. NSPs should respond to the drop in peak demand by reducing further grid augmentation, which will mean significant future savings for consumers. However, NSPs can't undo the investment that they've already sunk into expanding the grid. The intent of the current regulatory system is that NSPs are compensated for any investments they've already made, irrespective of whether they later turn out to be unnecessary. We could legitimately debate whether this is fair, but for now we'll focus on the implications under the current regulatory and tariff system.

A drop in demand cannot increase sunk network costs. With NSPs passing on network costs via electricity consumption (MWh), a 20 per cent drop in demand on average should mean that networks increase their per MWh charges to make up the shortfall. Even the most mathematically ungifted among us should be able to work out that this will not change consumers' total network charges. If I buy 10 apples at $1 each, I'll pay $10. If I buy 8 apples at $1.25 each, I'll also pay $10. It's not exactly rocket science.

However, while the drop in demand won't push up network costs, it will change how sunk network costs are divided. Consumers that reduce their consumption will pay a smaller proportion of the sunk costs of the grid, and consumers that don't will pay a higher proportion of the sunk costs of the grid. Many would see this as equitable, but not all, so it does strengthen the case for a review of the way that tariffs are set.

In summary, consumers' electricity bills have increased in recent years, largely because NSPs spent around $40 billion to augment the network, despite much of this augmentation being unnecessary. This is a problem with forecasting and reliability standards, not a problem with demand. The drop in demand has actually placed significant downward pressure on electricity bills, by reducing wholesale electricity costs, having no impact on sunk network costs and reducing the need for further investment in new network capacity.

However, misunderstanding is rife. At a recent public event on energy markets a confused audience member stood up and suggested that we should increase consumption to lower electricity bills. This is not an isolated incident – we've heard similar statements at many forums.

The future of tariffs

The fall in demand for electricity reinforces the need for reform of electricity tariffs arising from the growth in air-conditioning demand and supply from rooftop PV and other forms of distributed generation. 

As discussed, in the past the lack of cost-reflectivity in tariff structures was manageable and the cost of advanced metering prohibitive. However, changing energy-use technologies have made tariff reform critical and significant advances in metering technology – even since the smart-meter rollout in Victoria – have made it viable.

When the NEM was established, consideration of price signals was strongly focussed on the need for price signals to encourage investment to expand generation and network capacity as and when needed. More recent discussion of tariff reforms have also emphasised the need for price signals to encourage efficient behaviour by energy users. However, in many parts of the grid we now have excess capacity, so we also need to consider how we will pay for sunk investments. For sunk investments we believe that equitable tariffs are the key issue, rather than efficient price signals.

There are a range of options for tariffs that could balance equity and efficiency, and all should be considered. However, some tariff structures that are currently being proposed fail on both grounds. While it is reasonable that households pay some form of 'per day' charge (to reflect connection and billing costs), predominantly charging for network costs through unavoidable 'per day' charges provides no price signal to reflect the impacts of peak demand on future investment, and would be deeply inequitable. The idea that a low-income household with extremely limited energy use should pay just as much for sunk network investments as a household with several large air-conditioners is patently inequitable.

In addition, if we change tariff structures we have to think about transitional issues, as this can have significant impacts on existing investments by generators, NSPs and, particularly, energy users. It is often forgotten that energy users have collectively made billions of dollars of investment in energy management and end-use equipment based on current tariff structures. In the last two years some NSPs changed the way they charged large energy users without any consultation. These changes undermined these energy users' significant investments in equipment and practices to reduce their demand or peak demand. This is totally unacceptable.

In summary, there is a strong case for reviewing tariffs, and this is a global, not just an Australian, phenomenon. The Australian Energy Market Commission is currently undertaking a review, which the authors strongly encourage energy users to get engaged in. Tariff structures will affect the future of Australia's energy system.

Hugh Saddler is a research fellow at The Australia Institute. Rob Murray-Leach is chief executive of the Energy Efficiency Council.