Talking bull about disappearing demand

There is a bizarre idea being pushed by some that consumers using less electricity is a problem. That might be for suppliers but it isn't for consumers or the economy as a whole. A move to fixed charges might help suppliers with their 'problem' but it won't help the economy.

A lot of public debates at the moment remind us of Macbeth's witches, with people arguing that foul is fair and fair is foul. In other words, talking bull.

Electricity markets in Australia, and globally, are experiencing profound shifts in both the way that energy is used and the way it is supplied. These shifts are disruptive for both traditional business models and the structure of energy markets, but are by no means necessarily 'bad' for consumers – in fact they offer significant opportunities. However, realising these opportunities will require significant regulatory changes, as will working through the disruptions towards new business models and market structures. At present, unfortunately, too much electricity policy debate seems to be focussed on trying to hold back the tide of change.

Some commentators have recently suggested that the recent drop in demand is a 'bad thing' because it will raise electricity bills for consumers. This is nonsense, and fails to understand the difference between unit price and total annual cost, which depends on both unit price and the number of units consumed.  It is even nonsense in terms of unit price alone, because falling demand has already reduced the generation cost component in unit prices and is reducing the upward pressure on total network costs.

However, changes in supply and demand patterns do affect how the costs of electricity supply are shared amongst consumers. We argue that an open, rigorous debate on tariff reform is overdue, and that shifting electricity supply costs towards unvarying 'daily charges' or fixed 'capacity charges' would be the worst outcome.

Back to basics - the National Electricity Market

With apologies to energy experts, it's worth recapping on some simplified basics of the National Electricity Market. The cost of electricity supplied to consumers in the NEM includes the cost of generation, network infrastructure and retail.

Generators operate in a theoretically competitive market. In the past, when demand was high, for example during the late afternoon and early evening period on weekdays, retailers paid more to buy a unit of electricity supply (megawatt hour – MWh) from the wholesale pool. When demand was lower, for example in the hours after midnight, the cost per MWh decreased.

In recent years, falling levels of overall demand have led to an excess of generating capacity, almost eliminating periods of very high prices in the market. In the competitive wholesale energy market, consumers benefit from this drop in demand and generators' profits are reduced. In the longer term, we expect supply and demand to move into balance, and when that occurs more pronounced variation in the cost of generation with time of day, day of week and season of year can be expected to re-emerge.

The transmission and distribution networks (poles and wires) are operated in a very different way. The role of networks is to provide secure, reliable connection between generators and consumers.  Network service providers (NSPs) have historically built networks to cope with their expectation of peak demand. This means that energy consumers' collective peak demand strongly influences the cost of providing network services. In contrast, consumption (MWh) has relatively little impact on the cost of providing network services.

Network companies have been set up as regional monopolies. To prevent them exploiting their monopoly power they are regulated and, in some cases, owned by governments. Network companies are paid based on the costs of providing network services, including regulated returns on any assets that the regulator considers are necessary for the function of the network.

Every five years the regulator looks at what a NSP is proposing to spend over the next five years, how much money they say they need and whether this is reasonable. For example, a NSP might ask the regulator to approve $1 billion over five years to compensate them for providing network services. The regulator also considers the NSPs proposed tariff structure to recoup this revenue. Even though the revenue allowance is very poorly related to consumption (MWh), NSPs have traditionally recouped revenue by passing a 'per customer' and 'per MWh' charge onto retailers.

Finally, retailers provide billing, hedging and administrative services to most consumers, and bundle up the complex costs of electricity supply (including generation and network costs) into simple tariffs for consumers.

Tariff structures in changing times

The electricity bills for most households, and some small businesses, are currently structured to include a fixed daily charge and a variable fee based on consumption (kWh), which includes generation, network and retail costs. This billing regime evolved for a number of reasons, including historic reliance on spinning-disc 'accumulation' meters that can only measure consumption.

This tariff structure clearly doesn't match the structure of the costs of supplying electricity to that consumer, which will be affected by their consumption at different times (generation costs) and how big their maximum demand is and whether it coincides with local system peaks (network costs).

Larger businesses have generally faced pricing structures that more closely reflect the cost of various patterns of use, typically involving a combination of a fixed charge, time-of-use consumption charge and peak demand charges (e.g. highest kVA or kW within a monthly or annual period). However, these charging structures are also rarely perfectly aligned to the cost structure faced by electricity networks, often having relatively low charges for use during critical peak periods.

For many years the negative impacts of these charging regimes were somewhat ameliorated by the mix of consumer appliances, regulatory regimes and the (limited) use of demand-management programs, such as off-peak water heating rates. In this context, consumption charges were a poor but workable proxy for the total costs of supply.

In the past decade this context changed. Most critically, the rapid uptake of air conditioning has caused significant price rises and cross-subsidies. Homes with large air conditioning units pushed up peak demand, increasing both generation costs and network costs. However, because consumers often only use air conditioning systems for short periods of time and are charged close to the average cost of supplying electricity, their bills don't reflect their impact on the electricity system. The Productivity Commission recently estimated that households with air conditioning systems are subsidised by other, often low-income, households, by around $350 per annum.

The recent uptake of solar PV and distributed generation has, so far, had a much more limited impact on network costs than air conditioners. However, the costs of providing network services to homes with solar PV are very poorly correlated with the amount of  grid-sourced electricity that they consume. Solar PV owners can provide multiple benefits to the grid but also use the network for multiple services, including exporting energy, topping up solar supply and providing a back-up.

In summary, there is a very good case for reforming network charges, even before we consider the recent drop in grid-sourced demand.

*This is part one of a two-part article on reform in Australia's energy market. Part two, looking at the future of tariffs amid falling electricity demand - will be published tomorrow.

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

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