Category Archives: Demand

Rational Gold-Plating

Much has been written and spoken about electricity prices, particularly the role of network prices in driving up household bills. I’ll admit I haven’t listened to this Background Briefing, but there is one point I have wanted to discuss for a while:

Federal Treasury estimates that 51 per cent of an average household bill is spent on network costs. Most of that is going towards paying off the $45 billion network companies have spent on updating our poles and wires over the last five years.

The definitive work on electricity pricing is the Australian Energy Market Commission’s 2013 Electricity Price Trends.¬†From page ii onwards gives a good summary of the biggest price drivers in the last 12 to 24 months. Yes the various ‘green’ schemes have an impact, making up 17% of the average bill. These include legacy solar feed-in-tariffs, which look incredibly generous in hindsight. I think there are some houses in the ACT and Queensland still getting 60c/kWh, where at the moment about 20c/kWh will give you a 10-year payback. The carbon price contributed about 10%, the RET a bit less, and then the state efficiency schemes even less.

The real action is in network prices, making up almost exactly half of the average residential bill. This has risen in the order of 40% in the last few years, driven by the network investments. The question for today then is “Are network operators trying to rip us off?”

I have heard in a number of places now the charge that network companies are cynically using the network investment return rules; that when they build new networks they can claim a 10% return on investment through power prices. Network businesses are state owned or regulated, so the amount they can charge is regulated by a central agency, like IPART in NSW. The allegation at the centre of the Gold Plating charge is that knowing these rules and wanting to make money, the networks built unnecessarily large infrastructure. The Background Briefing cited above claims this is demonstrated by unused or oversized infrastructure, like substations that aren’t being used. This doesn’t look great, but I argue this isn’t as sinister as it appears and that network companies are making rational business decisions. Two things drive this; the time it takes to make investment and infrastructure decisions and the fixed costs associated with upgrades.

In 2006-7 I was working for Sydney Water, a massive electricity user in NSW. About 1% of state demand, or 2% if the desalination plant is running. During this time I was in meetings with the network provider about upgrades to the Sydney ring main. The ring main is the circuit of wires under Sydney that powers everything. It’s all underground, under roads and under buildings. Upgrading it is a big job, and it was going to happen one day. Wires can only carry so much current, and at some stage they must be upgraded as demand in the city grows. That time was coming and planning was well underway. So these meetings were going from about 2005 until the project finished in around 2012, about 7-years worth of planning. The result is a $400m or so project that greatly increased the capacity of the main and improved its reliability. If you’re interested I’m pretty sure the solid grey building near the light rail and Bellevue park near Central is the new substation associated with this project. Planning electricity upgrades takes a long time because it is a massive job.

So in 2006 they were nearing capacity of the network and wondering what to do about it. This conversation was being had all over the network; the initial build outs of the 70s and 80s were reaching capacity and needed to be replaced.

Considering the Sydney example again, how are the costs apportioned in a big job like this? I don’t know the specifics, but in smaller projects I’ve worked on, getting staff to site, foundation work, meetings and the big one, closing roads to do the work, can take up as much as 80% of the total cost. These are the fixed costs. It doesn’t matter what capacity you install, these costs are the same. The network infrastructure is 20%. Since it’s such a massive job just showing up, you might as well put the biggest cable you can in the hole. Even if you double the carrying capacity of the infrastructure, that only increases the project cost by 20%. This means there is a very strong technical incentive to oversize the infrastructure as it avoids those fixed costs.

Compounding this, how do you decide how big to make a network anyway? Residents don’t call the network provider and tell them they’re thinking of doubling their load with a new air conditioner and to some degree neither do industrial customers. The rational thing is to observe trends and make a guess. And the trends in electricity use in the National Electricity Market have side swiped virtually everyone.

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This graph from The Conversation tells the story. If you were making electricity decisions in 2007 the data says electricity use grows every year, for almost the last 30 years (this trend goes back a long time). I did not see anyone, anywhere, predict the decline in electricity use that happened from 2009. Even two years into the decline the market operator was forecasting growth in the following years. Now though we have just finished the 4th straight year of declining electricity use.

Put all this together; it is a massive job upgrading electricity infrastructure, requiring disruption to supply, holes under roads and co-ordination of dozens of stakeholders. Of the cost of upgrading, a small component is impacted by deciding to go large, so network companies upgrade based on a 20-year forecast. The previous 20 years showed unrelenting growth and no one predicted the slide. What would you do? Exactly what the network companies did. Mitigate fixed costs by upgrading massively when you have to and assume the trend of the last 20 years is going to continue. The greatest risk then is an oversized network and increased cost; the greatest risk of an undersized network is blackouts, political tension and increased costs as the fixes are done urgently.

So I argue; network businesses made rational decisions with the information available to them. I agree there is an incentive to oversize based on the infrastructure return-on-investment rules, but this is dwarfed by the incentive to build big networks when you have to. Given the networks are state regulated there is good argument to reign in those investment rules, but I don’t think it would make much difference. Network businesses are large, unwieldy and rightly conservative organisations. As a result, we have some of the best electricity supply certainty in the world.

What can a consumer do about rising network prices? Leave the network. And the more people leave the greater the incentive for those remaining to go as network costs fall to a smaller customer base.¬†This is something I am *very* interested in at the moment and can’t wait to see what happens.

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Why are electricity bills going up?

Gillard and Abbott are trading rhetoric at the moment, trying to blame someone for increases in electricity bills. I’m not touching the politics of this issue as I’m pretty confident the political discussion will be neither edifying nor enlightening.

I’ve talked a bit on my other blog about how an electricity bill is structured. This is important background in considering how electricity bills have increased over time.

This pdf, from the NSW Government looking at the drivers behind the recent price rises is pretty unequivocal on the recent causes:

“At least 80% of the percentage increases in the IPART 2010 determination of regulated retail tariffs are attributed to increased network charges.”

There are definitely other contributors; the Mandatory Renewable Energy Target; feed-in-tarrifs for solar panels, in recent times Yallourn powerstation being underwater isn’t helping, and a few other little regulatory odds and ends have contributed. Also, now that the carbon price has been introduced, that will increase bills as well.

The rest of the bill, the cost of energy, hasn’t changed nearly as dramatically in the last few years. A glance through the Australian Energy Market Operator’s numbers at the bottom of the page confirms this.

So why are we suddenly spending so much on the network? Again there are a multitude of reasons; assets reaching the end of their life and needing replacement; and some perverse incentives for State governments to “gold plate” their networks, but that contribution isn’t likely to be too significant. No, the big reason is our increased prosperity and desire to air condition our homes.

This excellent piece from Matthew Wright at Climate Spectator describes the economics of increased air conditioning demand and the corresponding network demand outcomes. Being more of an industrial specialist, I was astonished by the size of some of these numbers. Residential air-conditioning loads across the grid could be as high as 16GW; for comparison, that means if everyone turned on their AC at once, about 16 large coal-fired power plants must ramp up to full power. Off the top of my head 16 is about the number of plants of that size in Australia.

So, when all the consumers suddenly have the capacity to double their electricity consumption with the flick of a switch, what does this do to an electricity network? One of the more illuminating parts of Gillard’s recent speech on this topic was the “Roads are like Electricity Networks” analogy. To avoid congestion (which, stretching the metaphor, means black outs) the network must be sized to handle the maximum possible demand.

Are there alternatives? The Draft Energy White paper puts the electricity network upgrade costs at about $7000 per 2kW (which is pretty standard) air conditioner installation. Since residents aren’t charged connection fees for new big equipment, and nor are they charged demand fees like industrial customers, this extra network construction cost must be averaged across the grid in “network costs”. Even if you don’t have a glorious new LG ArtCool to drop your temperature during the cricket.

One idea is to make customers pay that upgrade cost at the point of sale. “That’ll be $2000 for the Air Con, and $7k for your network upgrade”. While broadly sensible, I doubt many politicians will find quadrupling the sticker price on an air conditioner palatable.

Improve the efficiency of air conditioners? Wright’s article above suggests this approach and I agree it has merit. The problem I see is the political reality of this sort of intervention. The so-called Pink Batts scheme was also designed to address this problem; better insulated houses means lower air con loads and lower peak demand. Further, there is good evidence that it was successful in this aim as electricity use in the NEM (the Eastern states and SA) has decreased for the last three years. There were other factors of course, but on the only metric available it seems successful. But, despite the technical success it was a political disaster for Labor and Peter Garrett. I suspect politicians will be nervy in future about committing to this sort of diffuse incentive for fear of the repercussions. Incentives for solar hot water could also have an impact, and the Small-Scale Renewable Energy Target does help a little in this area. However, as most electricity use replaced by solar is off-peak the peak demand impact is likely to be small.

My preference leans toward a couple of different demand side response ideas. First, and there are various moves afoot to achieve this, a market that trades demand would provide incentives for large industrial users to switch off at times of high demand. This will probably work at lowering demand, but the customers switching off will be the first to benefit financially, with the trickle down to residential consumers likely quite slow.

The standout, and for a number of reasons, is a proper smart meter network. There would be flow on effects, which will make a lot of people grumpy, like time-of-use pricing and perhaps the ability to remotely switch off loads, but it is the most effective way for consumers to make informed decisions about their energy use and costs. The common cry from those opposed is that “it will make me pay more”, which is not entirely true. More accurate would be to say that smart meters COULD make you pay more, but they will also give you powerful tools to pay less.

Trials as part of the Smart Cities program showed customers on Magnetic Island were saving up to $25 a month on their electricity bills, by responding to price signals through their smart meters. Why not let people in the wider network have this opportunity, and if some people’s bills go up, maybe they will have a stronger incentive to curb their energy use?