Productivity Commission releases a bomb

The Productivity Commission has released a report today delivering a scathing critique of electricity network regulation.

While the body was actually commissioned to prepare an analysis of benchmarking to better regulate electricity networks and the role of interconnectors, it has largely ignored its terms of reference. Instead it has taken a swipe at just about every aspect of the regulatory regime governing electricity networks. And for good measure also had a go at solar PV, proposing the small-scale renewable energy target be abolished. 

The report makes it plainly clear, illustrated in the chart below, that contrary to Tony Abbott and Barry O'Farrell's repetitive mantra, electricity prices have skyrocketed well before the carbon price and the reason lies almost entirely with electricity networks, shown in the expanding black part of the bar. 

Most of the recommendations re-state what Ross Garnaut recommended in his 2011 report about network regulation:

-- We are overbuilding network capacity and this is costing consumers large amounts of money to little benefit;

-- We need to ideally privatise the network distribution businesses and at least remove the cost of capital free-kicks they receive;

-- The incentives in place governing networks are biased towards building additional network assets and against non-network alternatives such as better managing demand;

-- The Australian Energy Regulator needs greater powers and better resourcing to exercise those powers effectively ;

-- We lack a nationally co-ordinated approach to planning the transmission system which would be best handled by AEMO (contrary to the ridiculous recommendation by the AEMC that came straight out of dictates by Queensland and NSW state governments); and

-- We need wider roll-out of smart meters and time of use pricing that better reflects the costs consumers place on network capacity during peak demand periods.

Lots to like on addressing peak demand, but misses practical realities

This report is a very useful contribution to the energy policy debate, but as is always the Productivity Commission's inclination, it largely ignores the value of second-best transitionary policies where political, social and technical practicalities get in the way of first-best solutions.

The Commission points out that we've got to fix our pricing structures for electricity to reflect times of network capacity constraints, observing:

“Households and smaller businesses are generally not exposed to time-based, cost-reflective network pricing. Thus, users are not encouraged to shift consumption away from peak demand periods, leading to hidden subsidies between peaky and non-peaky consumers, and over-investment in peak-specific investments. Currently, a low-income household without an air conditioner is effectively writing cheques to high-income users who run air conditioners during peaky periods.”

The report points out that peak demand events occurring for less than 40 hours per year (or less than 1 per cent of the time) account for around 25 per cent of retail electricity bills. The Commission estimates that a household running a 2 kW (electrical input) reverse-cycle air conditioner and using it during peak times receives a subsidy of around $330 per year with a peaky customer costing double that of a non-peaky customer.

To address this, the Commission proposes an accelerated roll-out of smart meters and critical peak pricing. This would be prioritised to those areas where network upgrade costs are likely to justify them.

While the report concludes that critical peak pricing must be passed-through to end consumers, I would suggest that this is not necessarily required. What is essential is that electricity retailers are charged by network businesses according to the strain their customer base impose on network capacity, but are then left free to alter their pricing structures to end-consumers however they like (with retail price regulations removed).

Retailers may then find it is better to give some consumers a flat electricity rate but bundle this with a range of demand management devices or energy efficiency interventions. This could end up delivering a superior result than just stabbing a relatively energy-ignorant consumer with a sharp price signal, which they have little idea how to avoid. This has been the experience of several utilities overseas and was covered in Climate Spectator several months ago.

While the Commission is pretty much spot-on with its recommendation about cost-reflective pricing, this has been recommended by others countless times stretching back over a decade and little has been done (for a rundown see this article). The one exception being in Victoria for which the government got mauled by the media and Liberal opposition. 

I've had conversations with a range of government officials at state and federal government level where they've agreed on the need for accelerated roll-out of smart meters. But when I ask why it's not happening they shake their heads and say it's just not politically doable. According to these officials, politicians were already nervous about time of use pricing, but have been completely scared off by the experience in Victoria.  

In light of this reluctance to roll-out more cost reflective pricing what do we do? On this the report is largely silent.

Also the Commission has fallen into the trap of thinking that investments in alternatives to network augmentation should be governed by incentives given to network businesses. Yet demand management alternatives to network upgrades aren't a natural monopoly. The trick is not to get networks incentivised to do demand management, but rather to create a clear price signal for demand management providers to compete against network augmentation and against each other.

Related to this point, while the Commission takes a swipe at solar PV feed-in tariffs, of benefit to distributed generation it does recommend the implementation of:

“Arrangements that provide for direct payments from distribution businesses to distributed generation providers, which reflect the network value of their distributed generation capacity and output.

However network businesses could argue that they already provide for such payments.

The problem here lies with how these payments are left entirely to the discretion of the network business and don't generate a transparent and clear price signal about what a generator would need to do to qualify. 

Instead of one-on-one confidential negotiations between the DG proponent and the network business, the regulator should set capacity payments for generation provided during peak periods based on the avoided value of network upgrades. If DG doesn't supply during the peak period they don't get paid, but at least they know what is on offer in advance and can plan accordingly. 

This is a good report and helps reinforce some of the positive things coming out of the AEMC's Power of Choice review. But on demand management there's more to this than just critical peak pricing and incentives for network businesses.