Tweaking the framework for electricity's new era

Major transformations are underway in the energy sector, and power network owners need to be on board for the competition changes in the areas of generation and consumption.

The electricity industry in Australia has undergone a number of transformations in the past two decades, and we are on the cusp of a further fundamental shift in the way electricity is produced and consumed.

From a paradigm of the one-way delivery of electric power from the largest generators to customers, we are seeing a shift to a new paradigm in which the primary service provided by the electricity network will be a platform for the trade of electricity services between suppliers and customers – both large and small.

The convergence of communications and energy transport and the uptake of smart meters and other household devices brings opportunities for innovation and competition. It has become feasible for small customers to be actively integrated into the electricity market. The full benefits of these developments will only be achieved if the appropriate regulatory arrangements are in place.

My presentation today focuses on whether the current regulatory framework will support changes in technology and market developments, and what reforms are necessary, if any.

Can the regime respond to emerging competition in a timely and adaptive way? How will new, 'disruptive' technologies impact the way energy is delivered to and by consumers over the next 10 years? What does this 'new world' look like and how quickly might it materialise? Do we need to re-think network services so that we make the best use of existing infrastructure?

To answer these questions, it is helpful to look back at the past to understand the evolution of energy regulation and the underlying thinking at the time, and to ask the question: should the same principles apply?

Competition at the heart of early energy market reforms

Twenty years ago electricity was primarily generated at large industrial-scale generating plants and transported to consumers via the dendritic transmission and distribution networks. The large generators were at the core, with supply radiating to electricity consumers. Generation, planning and pricing was centralised.

The design of the National Electricity Market, which was established in late 1998, is the product of the competition policy reforms and a pro-competitive policy mind-set of the early 1990s. The idea was to introduce competition wherever feasible. Reforms included:

– structural reform: separating potentially competitive functions from monopoly infrastructure, and establishing a competitive industry structure for commercial functions

– competitive neutrality: establishing corporatised governance structures for significant government businesses

– access: enabling regulated access to monopoly infrastructure, with independent authorities to oversee prices

– market design: establishing a national electricity market, with associated institutions to oversee the rules and manage the market.

With the establishment of the National Electricity Market, Australia introduced competition into the generation and retailing of electricity. The operation of generation and transmission is now coordinated through the Australian Energy Market Operator. Investment in generation is commercially based and significant investment in networks is subject to a net benefit test. This was a substantial change in the way the electricity industry was organised and operated.

Such reforms have proven effective at delivering a reliable, stable supply of electricity, and on-going investment in a competitive, efficient generation sector. The market-based regulatory framework has proven robust to changes in government policies, consumer preferences and technology. The design of the energy market has proven robust to challenges including changes in comparative costs of generation (such as for renewables), periods of scarcity and periods of excess generation capacity. Further, when there was the need, generators responded to market signals for investment in peak demand capacity without the need for any central authority to direct or to purchase capacity.

Competition in generation and retail has delivered benefits to the Australian community and has ultimately meant more efficient electricity prices for consumers.

In contrast, the energy networks are monopoly businesses. There is no competition for the core service of transporting energy between suppliers and consumers through the 'poles and wires' (both large and small). We therefore regulate their prices and services.

But some services, which may be provided by a network business, can be subject to competition or are potentially contestable and the regulatory framework allows for these services to be treated differently.

Before a network business submits a regulatory proposal to us, we undertake a ‘framework and approach’ process that clearly and transparently sets out how we will apply aspects of the regulatory framework. The process provides an opportunity for the businesses, community and other interested parties to have a say on which services should be regulated, and how prices for those regulated services are determined. Levels of regulation for services are determined in accordance with 'degrees of competition'.

A service can be defined as part of the core services of the common network and its costs included in the revenue allowance for network services. Alternatively they could be classified as an individual service used by only some customers and a price set for that service. Or they may be negotiable and a negotiating framework is set up. Where there are options for competition, regulation may be limited or removed altogether.

So, will the competition principles that underpin the current regime still be relevant going forward? I'll come back to this question. First, let's consider the major developments underway in the energy sector.

Transition to the smart electricity grid of the future

New challenges have emerged in the industry. We have seen rapid growth in the penetration of air-conditioning units, which increase demand at peak times and drive-up the need for network investments.

We have also seen over a million households install roof-top solar PV. This has reduced the utilisation of network transport services even though, at most times, the networks can deliver power to these customers more cheaply than the current unit cost of solar generation.

These developments may be further magnified as customers invest in smart appliances and battery storage, which could substantially shift the amount customers withdraw from or inject into the network from one moment to the next.

With improvements in IT and communications, all customers are potentially generators, consumers or providers of other ancillary services, integrated into the electricity market. The term ‘prosumers’ reflects that consumers of electricity are also often producers of electricity, and may switch from net consumption to net production in response to changes in market signals.

Ideally, these ‘prosumers’ would be willing and able to directly or indirectly respond to local market conditions, so that they make efficient decisions as to the best time to, for example, use their electric dryer and dishwasher or, possibly in the future, charge and discharge their electric vehicles. They would also make informed decisions about when to install an air-conditioning unit, or when to invest in energy-efficient appliances.

There are several potential benefits from the increasing penetration of small scale generation, smart devices, and demand management and storage, and the integration of these services into the electricity market. The integration of even small players into the electricity market:

– facilitates the integration of small-scale variable renewable generation (such as solar PV)

– increases the resilience of the electricity network by increasing the range of production and consumption responses to supply, demand, and network shocks

– increases the utilisation of the network by reducing the need to build network capacity to cater for a relatively small number of peak periods per year, thereby reducing the need for unnecessary and costly network augmentations

– allows customer choice when it comes to managing their electricity consumption, rewarding customers for reducing local consumption at times when it is most costly to supply that customer, and rewarding customers for increasing their local production at times when that production is most valued

– helps customers make informed decisions regarding investment in appliances, energy efficiency, and local generation and storage, ensuring that energy efficiency and generation technologies can compete on a level playing field, and preventing unnecessary waste and stranding of existing assets. This does require reforms to network pricing, which I will come back to.

Perhaps the most significant benefit from increasing the integration of small customers into the electricity market is that it will lead to a range of new services. In fact, it may mean a host of yet unknown services that will deliver real value to consumers and society more generally.

How will the networks respond?

The response of incumbents to 'disruptive' technologies in other sectors might give an indication of the possible responses by electricity networks. First, an incumbent firm may attempt to thwart the emergence of the disruptive technology. Restricting access to facilities or information are examples of this.

Second, the incumbent may decide to argue the new technology should be incorporated into the regulated business and be provided within the revenue-price cap. This would mean that customers will carry the risks of new technology by including contestable activities within the regulated asset base. It can also mean that the full benefit of innovation will not be delivered if the rights to development are gifted to a handful of 'privileged participants'.

Finally, the incumbent may re-define its product to adapt to the new market. An analogy is that we have a large investment in a production system capable of producing more than one service. As the market changes, so can plant be re-configured, production diverted or a service re-badged to meet the needs of an emerging market. This is what we need to see in the network sector, with a transformation from the network sector seeing itself a one-way carrier of energy, to a platform to support generation, storage and demand management. Tariff reform – from energy-based usage charges to a demand based service charge – is an essential part of this response in redefining the nature of the service provided by the regulated network.

How does the changing environment impact the services delivered by the electricity network?

Let me be clear about what my view is on how 'disruptive' technologies could impact monopoly network businesses in the next 10 years or so.

There are concerns about recent falls in demand across the electricity market and the potential for widespread disconnection from the electricity grid. This assumes that in the not-too-distant future consumers will be able to cost-effectively generate and store electricity themselves and not look to the grid for secure supply. How plausible are such assumptions?

This is just one scenario modelled by CSIRO as part of the Future Grid Forum, which models accelerating disconnection after 2035 based on the possibility of lower battery costs, among other things. So even if local generation and storage become cost-effective alternatives, it seems unlikely that 'flight from the grid' en-masse would be a reality in at least the next 10 years. I say this assuming that we fix prices so that we do not hasten the demise of the network by sticking with energy-based network pricing.

Further, there is significant uncertainty about electricity demand across the electricity market over the next 20–30 years. Although demand has fallen in recent years, AEMO’s forecasts are relatively flat over the next 10 years.

There are many variables that could lead to higher or lower future growth. For example, while solar and battery technology will continue to improve, we are also likely to see increased penetration of electric vehicles that are charged from the network – with a significant increase in the load of those households that use them. Weather conditions can also significantly affect demand, especially during peak periods. It is very difficult to say what is going to happen beyond 10 years or so.

Although the core network businesses' 'poles and wires' may never face 'like-for-like' competition, it is clear that some services that have been typically provided by the network businesses are becoming contestable. Competition is emerging around the margins and could deliver new and innovative services to energy customers.

The increasing use of smart devices and local generation facilities by even the smallest customers fundamentally changes the way we should think about the electric power system and the services it provides.

From a paradigm of one-way centrally managed electricity supply, the industry is transforming to a new paradigm in which the energy network exists to provide a platform for the two-way trade of electricity, with all customers and suppliers, large and small, able to be integrated with and respond to local market conditions.

Does the regulatory framework facilitate emerging competition?

The idea of relying on competition wherever feasible is at the heart of the early energy market reforms. It is just as relevant today. The principles on which the framework is founded are future proof. It is just as important to separate potentially competitive functions from, and enable access to, monopoly infrastructure. We should always be mindful of market design and ensure competition is on a 'level playing field'.

We have a regulatory framework that can accommodate changes in technology and market developments. We also have a set of principles that guide our decisions under that framework. There are two mechanisms to facilitate emerging competition.

First, as I have noted, under the current regulatory framework, services that become contestable over time can be classified according to the potential for competition. Under the rules, services may be excluded from regulation.

Second, there is the option, through ring-fencing guidelines, to define whether and how a distributor can carry out potentially contestable activities in conjunction with its regulated activities. Ring-fencing of unregulated services is necessary to ensure that network businesses do not shift costs between regulated and unregulated activities. In other words, if network businesses are allowed to offer services in a contestable market, the costs should be clearly outside the regulated asset base. Ring-fencing may also set out rules for non-discrimination or prohibit a network business engaging in a potentially contestable activity.

We support the introduction of contestability into services where competition is viable. The discipline of competition produces better outcomes for customers in the long run than can be achieved through regulation.

Although the current regulatory framework is fundamentally sound, there are important further reforms being considered by the AEMC following decisions by the COAG Energy Council. These reforms can be readily adopted by the regime and will enable the transformation of the industry towards a 'smart grid future'.

Priority reforms

The Power of Choice reforms endorsed by the COAG Energy Council, are necessary to keep the regulatory framework 'future ready', and should remain high on the sector's reform agenda.

As a priority, we consider reforms to the way distribution businesses set and structure network prices are required. First, cost-reflective pricing is an efficient way of responding to changes in peak demand. Second, as long as customers face tariffs that do not reflect local network congestion, they will not face the correct incentives for investment in and use of local generation and smart devices.

Metering is another important area of reform and is a good example of a potentially contestable service. To date, regulated network businesses have exclusively provided, maintained and owned the majority of electricity meters installed on residential premises.

Most electricity metering services have involved basic tasks of installing and maintaining assets, and manually relaying basic consumption data to reconcile market systems. As highlighted in the Australian Energy Market Commission’s Power of Choice review, advances in metering technologies have the potential to fundamentally change the traditional role of metering in the market and expand the range of products and services available to consumers.

For example, advanced metering with communication capability (smart meters) are capable of recording consumption on a near real time basis, and differentiating consumption at different times of the day. This can provide consumers with better information about their consumption and more control over how they manage their use. In so doing, advanced metering can support greater consumer participation and choice in the market. Better consumption information can also help consumers weigh-up competing retail price offers, such as whether to switch to a flexible retail offer or take-up different demand-side participation products, which could also be provided competitively.

However, the current rules around the provision of metering services have not kept pace with these advances in metering technologies. The existing arrangements inhibit investment in the provision of metering technology that can support the uptake of a range of new and innovative energy products and services.

There is currently a degree of exclusivity in who can provide metering services in the National Electricity Market. The rules still mandate that regulated networks are exclusively responsible for provision of the meters that the majority of residential customers have on their premises.

The AEMC is currently considering proposed changes to the rules that would allow competition in the provision of metering services, including open access to meter functionality and information. These changes are important in promoting greater consumer participation and choice, thereby permitting the potential benefits of advanced metering to be realised.

Indeed, for the current New South Wales network pricing resets, we 'reclassified' certain metering services so they can become open to competition – consistent with the AEMC's recent recommendations.

In summary, there are significant gains to be had from improvements to advanced metering, pricing and customer participation in generation and demand-side management. These reforms can reduce market distortions and reduce costs to consumers – by empowering them to manage their energy use and save on energy costs by shifting their consumption away from peak times. They will also deliver fairer outcomes for those customers that do not impose higher loads on the grid.

What does ‘success’ look like in energy regulation?

There has been substantial investment in our electricity network. Investment over the current five-year cycle alone is forecast at over $43 billion – more than doubling the value of the electricity asset base over this time.

What does the transformation of the energy sector, with the ability of small customers to be actively integrated into the electricity market, mean for the existing network infrastructure over the next 10 years?

It means we need to re-consider network services so that we make the best use of existing assets. This 'new world' means we will utilise the network in different ways.

The network is no longer only about transporting energy from 'A to B'. The vision of the network that I have outlined in this speech is a platform for the two-way trade of electricity. Although the core network services are unlikely to be rivaled in the near future, emerging competition which utilises new technologies will rely on gaining open access to the network.

The current regulatory framework is the real 'success story'. It supports the energy network vision because the regime is founded on a principle of enabling competition wherever feasible. Although reforms to pricing and metering in particular are necessary, there is not a need to completely re-think the underlying regulatory framework. We have largely got it right.

It is good regulatory practice to take a principles-based approach rather than a 'destination-based' approach. In this era of rapid development in technology and the high rates of change, it is a bold decision of the regulator or the policy maker to anticipate the future dominant technology. Regulation should not be about 'picking winners' or rewarding network businesses with guaranteed returns when competing with other services. It is better to allow the market to 'decide' than for the regulator or the policy maker to favour a particular technology or solution and have customers carry the risk.

We cannot regulate innovation. We can however create an environment in which innovation may flourish. The purpose of regulation should be to establish a basis of access to the network to support competition of services in this exciting new world.     

Andrew Reeves is acting chairman of the Australian Energy Regulator. This is the transcript of a speech delivered at the Energy Networks Association’s 2014 Regulation Seminar in Brisbane this week.

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