Economic surplus

Economic surplus

Why wrong pricing has caused the electricity ‘death spiral’

Caught in the death spiral? wikimedia

The electricity ‘death spiral’ is raising considerable angst. Residential demand for power appears to be declining. This has led to higher prices to cover fixed network costs. The Australian Energy Market Commission (AEMC) has highlighted the relationship between embedded generation (such as home solar systems) and network pricing in its Strategic Priorities.

So what is the ‘death spiral’?

The idea is simple. The cost of the electricity network – the wires and poles that bring power to our homes and workplaces – is pretty much fixed. It depends on peak demand, not on the everyday electricity load. The network is built to meet a specified level of reliability so that our power doesn’t go out (too often) on exceptionally hot days in the middle of summer when we all turn on our air conditioning. So most of the time the network costs are just a fixed cost of delivering electricity that doesn’t depend on the amount of electricity that consumers buy.

However, to pay for the network, consumers pay a charge based on electricity consumption. Roughly speaking, network charges are set by taking the fixed cost of the electricity network and dividing by the predicted quantity of power that consumers will buy. This gives a per kilowatt hour (kWh) network charge. As individuals, if we use more electricity we pay more of the network cost. If we use less electricity, we pay less. At the end of the process the network owner gets about the same amount of money, but who pays that money varies with consumption.

Unfortunately, turning fixed costs into variable charges can lead to nasty outcomes. And that is what is happening in electricity.

If consumers have no alternative but to use the electricity network to buy power and power demand is insensitive to price, then there is not too much harm. The variable network charges push up the cost of every kWh we consume but we can’t avoid the payment and, with insensitive demand, we don’t react too strongly to the higher price.

These are the traditional assumptions for electricity pricing. However, the development of rooftop solar power (photovoltaic or PV systems) and more energy efficient buildings and appliances, means these assumptions are wrong.

When consumers install PV systems, their demand for traditional electricity falls. These consumers reduce the amount they ‘use’ the network. But the fixed network costs do not change. So these fixed costs are spread over a smaller volume of electricity. And this means that the price of that electricity has to rise for everyone else.

Of course the rise in price encourages more consumers to adopt power-saving technologies and to install PV systems. So these consumers also reduce their consumption of traditional power. But the network costs are still fixed. So the price of electricity has to rise for everyone else.

And so on.

In the extreme, this ‘death spiral’ can undermine the electricity power system. More likely, it will lead to a group of haves and have-nots. The well-off, who can afford to install PV systems and buy power saving appliances will avoid much of the high power prices. Those who cannot afford solar systems and new energy efficient appliances will pay a high electricity price.

So how can we avoid this outcome? The obvious solution is to fix the pricing. The problem is created because a fixed cost has been turned into a variable price. If the network charges are turned back into fixed charges that can only be avoided by disconnecting from the electricity grid, then the problem disappears. Installing a PV system will not reduce your network charges, only your power charges. The have-nots will not have to pay higher network charges because the haves cannot avoid those charges.

Put another way, when you generate your own power you do not pay for the power that you no longer use. But if you are still connected to the electricity grid, and have the option of using that grid, you do pay for the grid.

Unfortunately, this obvious solution may be politically unpalatable. Network costs make up about 50% of our power bills. It would take a brave minister to tell all those consumers who have spent a lot of money installing PV systems that the savings they thought they would receive have just been reduced by about 50%. The consumers would, quite reasonably, be outraged, particularly as governments have, in the past, encouraged households to install PV systems.

Further, fixed network charges are not without their own equity issues. Is it simply a uniform charge to all power users? Do small households pay the same network charge as big households? Do the rich pay the same as the poor?

One alternative is to break the regulatory contract with the network owners. In other words, tell the network owners that, even if they have efficiently built a network based on government-set standards to the government-announced predicted levels of power demand, the government is not going to allow the network owners to receive appropriate compensation for the costs of building the network.

Put simply, force the network owners rather than the PV owners to ‘take a bath’.

Surprisingly, this solution is more practical than it sounds, at least in the short term, for all states except Victoria and South Australia. In New South Wales, Queensland, WA and Tasmania, the state government owns the electricity network. So the party that will ‘take the bath’ is the state government – or more correctly, the state taxpayers.

In Victoria and South Australia, the electricity networks have been privatised and the private owners would have a strong argument for compensation if the regulatory contract is broken. Again, the state taxpayers will end up bearing the cost of such compensation.

However, breaking the regulatory contract is only a short-term solution. Longer term, a death spiral can emerge so long as fixed network costs are turned into variable customer charges for power. Any effective solution must fix the pricing problem.

So what are the lessons here?

First, for the state governments thinking of privatising their electricity networks – make sure you fix the pricing problem first, because nobody is going to pay a lot of money for a network with a broken regulatory system.

Second, when dealing with utilities such as electricity, make sure prices follow basic economic principles. Don’t assume customers have no options because as technology changes, options appear. Fixed costs need fixed charges.