Do Current Pricing Structures Resist Disruption of the Electricity System?

If rising electricity bills could be one of the major drivers of a clean energy transition, I started thinking that the way this electricity system works should be elaborated more upon. It is actually quite complicated… So, during my stay in Melbourne I connected with Australia’s premier innovation precinct anchored by the University of Melbourne: The Carlton Connect Initiative. At this place I interviewed Dylan McConnell who is a research fellow at the Melbourne Energy Institute.

What Drives this Australian Clean Energy Transition?

As stated in my previous article, political certainty is of the utmost importance for a rapid and consistent deployment of renewable energy technologies. Think of the German Energiewende for example, they got the whole solar boom set in motion because of a radical governmental decision made in 2010! Roughly 10% of the total grid capacity is solar, but so far this Australian clean energy transition predominantly entails the rapid deployment of small-scale solar, better known as rooftop solar.

“Australia has the highest penetration rate of rooftop solar of any country on a per capita base. There are 1.5 million solar systems in Australia right now out of roughly 8 million households.” – Dylan McConnell –

solar-rooftops

Though, politics paved the way, politics can still be seen as one of the main drivers of rooftop solar in many of both directions. Thanks to politics, rooftop solar has been incentivized under the so-called small-scale renewable energy schemes as part of the bigger scheme called the RET.

Simultaneously, it was also because of politics that this RET got reduced recently during a reviewing process that on top of this actually recommended to get rid of this lucrative small-scale promotion scheme. Isn’t that weird? They almost wanted to get rid of the scheme that basically kick-started their entire clean energy transition! But…! The reason that it didn’t happen is because of the political power of solar generators.

This is that moment when you think “Seriously?”? Australia does have in contrast to Europe, where fossil fuel companies clearly dominate policy through intensive lobbying,  a powerful association called Solar Citizens that very intensively lobbied against any changes in the solar schemes during the RET reviewing.

So How do Renewables and Electricity correlate? 

In Australia, electricity bills that are passed on to consumers by retailers consist of wholesale prices, network prices and environmental costs. Wholesale prices are the direct result of competitive electricity markets. Network prices account for maintenance of “the poles and the wires” and environmental costs primarily relate to the costs of funding renewables through renewables promotion schemes. To illustrate, when it comes to rooftop solar, most people don’t realize that through their electricity bills non-participating electricity users are paying for very generous benefits for a small group of solar households. However, I agree such schemes are highly relevant in order to boost the necessary innovations of the electricity system. But when it comes to equality and rooftop solar, it’s actually an example of how the rich get “richer” and the poor get “poorer”.

When I asked Dylan what he found the most exciting part of his research so far, he directly answered with the merit-order effect.

“I would have never thought that the merit-order effect would be so fascinating and cool. And I think it is a good story to explain why we get lower power prices through adding renewables.” – Dylan McConnell –

I agree! Prices on the wholesale market are set according to supply and demand. The merit-order is a way of ranking available generating technologies in the market according to their cost. Renewables are generally characterized as low-cost generating technologies. So, the Merit Order Effect, put simply, means lower electricity prices when additional renewables get introduced. Theoretically, this means that the more renewables enter the market, the lower electricity bills will get. Some even argue that declining electricity prices as a  result of renewables potentially could compensate for higher environmental costs. In fact, for this to happen considerable amounts of large-scale renewables should be added to the grid and in Australia you’ll primarily find small-scale solar on rooftops.

Schermafbeelding 2016-02-21 om 13.03.52
Merit Order Effect: The more renewables get introduced to the grid, the lower the electricity prices gets.

I hear you thinking “but why don’t we just add more and more large-scale renewables?” It’s a win-win, right!? Unfortunately, it’s not that easy. To date, renewables can’t provide a base load to the grid, which is crucial for a secure and reliable supply of electricity. Furthermore, it requires huge investments and for now there’s no real incentive for the generators. Renewables compete with their existing asset base and there’s already too much overcapacity…

Whether the promotion schemes are inequitable or not, it was because of the early adopters and the generous funding by renewable promotion schemes that a rooftop solar boom got loose in Australia. You could say that consumers fulfilled an important role in the clean energy transition! Sadly enough, these solar households can’t set a Merit Order Effect in motion by themselves to reduce overall electricity prices and benefit the non-participating households. The result is that the vast majority of households is still stuck to high electricity bills. These wholesale prices are being passed on by retailers to consumers’ electricity bills at a base rate or a premium depending on the type of electricity the consumer is paying for (i.e. “grey” or “green” power). However, at least 50% of the electricity bills accounts for network costs that serve for “the poles and the wires”. Australia is so spacious and spread out that maintaining the electricity grid is a very expensive component. Did you know that Australia has the longest electricity grid in the world?

“In New South Wales 55% to 60% is just for paying for the poles and the wires!” – Dylan McConnell –

The network companies in Australia are regulated entities that have a regulated asset base. They operate as natural monopolies and have an asset base that is worth multiple billions of dollars in Australia! Current regulation in place permits them every year to set their tariffs for the network costs as such that they recover a suitable return on their asset base. Technically, they are an essential service provider that has to provide a secure and safe supply of electricity. These network companies recoup millions of dollars in return and potentially could play a crucial role in the deployment of renewables. Unfortunately, these network companies are regulated entities and can’t participate in any generation activities. Maybe they could participate in deploying energy storage?

The way these network companies set their tariffs, basically their pricing structure, potentially has a negative impact on electricity bills. To date, effectively you’re paying for a certain capacity on the grid and, obviously, this capacity is highly important for stability of the grid, but these pricing structures create a problem to society that is known as the Death Spiral! On top of this, network companies can’t deal with consumers. This means that they have a certain cost that they pass on to the retailers, who then pass this cost on to the consumers.

How Does the Death Spiral Impact Innovation?

Essentially, as a consumer, you’re paying for a certain amount of capacity from the grid at a certain amount of time. The problem with this revenue recovery model of network companies is that the more households operate solar panels the lower demand for electricity gets. But the revenue that needs to be recovered is exactly the same as before. You know what happens? In order to recover the same amount of revenue, the grid maintenance costs go up accordingly. At the same time such higher costs encourage more customers to either to leave the grid or become more energy efficient.

In short, every time the demand for electricity becomes less the maintenance costs for the grid will increase in order to recover the same amount of revenue over a smaller amount of customers and less electricity. This downward spiral is the so-called Death Spiral… The long-term expectation and the long-term solution to this problem would be energy storage.

Now that’s fine as you can manage to do that, but energy storage primarily benefits households that operate solar, who can permit themselves to leave the grid or lower their electricity dependency. At the same time, you could argue that in order to prevent the Death Spiral network companies should operate grid-based storage to use the electricity generated by renewables more efficiently and benefit those that are still heavily dependant on the grid. Good thinking!

From a societal and efficiency perspective it does make more sense to operate grid-based energy storage instead of customer-sited energy storage. Network companies could use energy storage to stabilize the grid instead of having society paying for it. Unfortunately, due to the regulatory frameworks installed, this is never going to happen. Network companies can’t operate grid-based energy storage and even if they would, the first consequence would be increasing infrastructure costs that will be passed on to the consumers. The installation of grid-based energy storage would increase electricity bills once again. And as long as there isn’t enough renewable capacity in the market the Merit Order Effect in combination with energy storage won’t be strong enough to compensate for the higher network costs.

Conclusion…? The regulatory framework installed pricing structures of network companies should be changed in order to boost innovation, accelerate the deployment of renewables, optimize the grid and lower costs to society. Although consumers are motivated to become more self-sufficient and energy efficient, what would be more efficient and convenient from a societal perspective? An optimized grid with larger shares of renewables and lower societal costs or more consumer independency? Furthermore, retailers end up with the problematic consequence of the Death Spiral, because network companies can’t deal with consumers. The core notion is that  often regulatory frameworks have to be changed in order to boost innovation instead and lower cost to society! You know, even for consumers that can’t operate batteries nor solar panels, the effect of the Death Spiral could be minimalized by just changing pricing structures.

“Think of different pricing structures! At the moment we pay 25 cts/kWh. In reality we probably should pay 10 cts/kWh and say 250 dollars per kW connection per year to the grid. If you’re gonna have a 4 kW connection, you pay 1000 bucks a year and for a 3 kW connection you pay 750 bucks. Then it doesn’t matter. You’ll keep paying for the grid connection even when you electricity usage goes down. This is just one the multipe solutions…” – Dylan McConnell –

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