5 April  2012 – Energy expert Alan Pears says the current inquiry into the feed-in tariffs in Victoria runs the danger of looking only at pricing issues within the existing framework and ignoring the huge benefits that a “free and fair market” might allow.

Another factor is the potential benefits of ridding the system of the monopoly power of network operators and providing better more fair treatment of investors in distributed generation, he says.

“[The debate] is all about costs within the existing electricity industry to most people.  My point is that it’s much bigger than that, and we need to look at what a free and fair market would allow,” Professor Pears told The Fifth Estate.

“Also we need symmetry: energy consumers are allowed to do all sorts of terrible things to power quality and demand, but they don’t face the requirements distributed generators do. Why not? This is one example of a fundamental problem: everyone wears blinkers when looking at policy in this area.”

His other submissions are to the National Energy Savings Initiative and the Draft Energy White Paper.

“The Draft Energy White Paper submission simply shows the document is a disaster, and the only path forward is to start again with a more representative process,” he says.

“My National Energy Savings Initiative submission uses the renewable energy target as a model for having two types of permit, which play complementary roles”.

Following is the submission by Professor Pears to Victorian Competition and Efficiency Commission Feed-in Tariff Inquiry

The discussion of FiTs has been distorted by the focus on costs and benefits of existing distributed generation options in relation to the existing energy market.

There is a clear basis for supporting emerging distributed generation solutions based on valuation of broad societal benefits, not just impacts on the existing electricity industry.

But this support needs to be simple enough, certain enough and appropriately sized to drive long term beneficial outcomes while avoiding excessive windfalls.

This submission proposes a package of an up-front incentive and a FiT equal to the real time retail price of electricity paid by the host of the distributed generation system. It also highlights the need to recognise and overcome the monopoly power of network operators and ensure fair treatment of investors in distributed generation.

A balanced approach to thinking about FiTs
Discussion of FITs has been held within the context of the existing energy market structure and rules, and from the perspective of the existing energy supply industry. This has led to debate about the appropriate level of FiT that reflects its impact on costs within that market framework. But the present electricity market is distorted in many ways, so this is not the way we should look at FiTs.

In the present electricity market, electricity networks have monopoly power, which distorts the role of distributed energy systems. In particular, a distributed generator that wishes to sell electricity directly to a neighbour cannot do so.

This removes the option to sell excess electricity at a price close to the retail price its neighbour would otherwise pay. For example, in a free and fair market, a distributed generator could sell its electricity via a short power line (which they would have to pay for) to a neighbour for approximately the retail price. But present energy market rules forbid this.

Discussion about a FiT should be based on correcting a market distortion. At present, if a distributed generator wishes to sell excess power to a neighbour, the electricity must be delivered via the existing electricity network, and must be sold through the formal electricity market, at wholesale price.

This creates a situation where the network operator can require unduly expensive infrastructure, smear costs, or can simply delay or stop sale of the electricity because of limitations in the local network infrastructure.

Clearly, a simple test could be applied to the situation: the cost of establishing and operating an alternative cable to the potential customer(s) could be used to judge whether the network was applying monopoly power or not.

Another aspect of the debate that is rarely considered is how distributed generation compares with installation of energy efficiency measures or, indeed, measures that increase energy consumption, within a site.

This is a matter of applying symmetrical standards to both demand and supply. If a distributed generator does not sell excess electricity to the grid, its effect is equivalent to installing an energy efficiency measure that reduces on-site electricity consumption (complete with the risk of a sudden failure affecting the need of the site for imported power from the grid).

So if the distributed generator can make arrangements to sell its excess power to a neighbour via an alternative route or store its excess on-site for use at other times, its impact on the network is no different from the kinds of actions electricity consumers can take at any time without financial penalty, requirements for back-up generation payments or other barriers.

Indeed, any small consumer is free to install energy consuming equipment that causes significant impacts on local power quality, such as low power factor equipment, or increases pressure on local network capacity, equipment that creates harmonics, and equipment that causes power surges.

Dealing with these kinds of problems is seen as the “normal” business of the electricity supply industry, and the costs of doing so are smeared across all customers.

Yet, if similar impacts are caused by a small distributed generator, the electricity supply industry can insist on expensive remedies.

So there is a fundamental case to argue that a small distributed generator should be able to either freely make independent arrangements to sell its excess generation to neighbours at a price agreed between them, as long as it arranges for independent delivery of that electricity, or pay a fair price for use of the local network at the times it uses it.

The cost of installation of the necessary alternative supply infrastructure provides a baseline for estimation of a “fair” price for delivery of the electricity.

On this basis, a fair FiT price could be set at the retail price at time of delivery minus either the cost of marginal local network use or the cost of an alternative independent delivery mechanism.

Any FiT price lower than this reflects the distortions of the present electricity market model, and there is a case for the distributed generator to be compensated for this distortion, which is leading to non-optimal electricity solutions.

A FiT as a legitimate subsidy
A second dimension of a FiT is its role as a means of encouraging roll-out of emerging technologies that deliver some societal benefit(s) (such as reducing greenhouse gas emissions, increasing local employment, improving reliability of electricity supply, etc), and/or are disadvantaged by existing market distortions. In this context, a FiT can be seen as one of a number of possible subsidy mechanisms.

Typically, the cost of a new technology declines at around 20 per cent per cumulative doubling of production. So when total sales double from say 1000 to 2000 units, we expect to see the cost decline by around 20 per cent.

Then, when cumulative sales double again from 2000 to 4000, we see another 20 per cent cost reduction. So, where socially desirable technologies are competing with an established technology that has historically received large public subsidies and has market power based on its dominance, there is a case to assist early movers to adopt the emerging solutions. However, the size of the subsidy should decline fairly rapidly as the benefits of economies of scale and technology improvements are gained.

Climate change
In the case, of climate change, it is expected that carbon prices will increase over time, with the scale of the price rise depending on the stringency of the abatement targets and the cost of the means of reducing emissions.

For example, Treasury modelling has estimated that 2020 carbon prices could be between $34 and $60 per tonne, depending on target stringency.

So there is a case for society to subsidise abatement measures that are more costly today in recognition of their future larger benefits. The fact that subsidies today will also reduce the cost of the abatement solution and hence future carbon prices relative to existing estimates adds to the strength of the argument for a subsidy.

For example, if roll-out of distributed generation reduces the carbon price in 2020 by $10 a tonne, the whole of society gains a return on the subsidy.

It should also be recognised that the Commonwealth government intends to offer some high emission power stations billions of dollars of “transitional subsidies”.

These subsidies work against the economics of competing solutions and, as such, provide an argument for low emission options to receive matching benefits. This adds to the absurdity of determining the size of FiTs on the basis of existing electricity industry costs and benefits.

In this context, the detailed design of the subsidy mechanism, whether an up-front subsidy and/or a FiT, should be determined based on the relative societal merits of the options.

At present, we have a mix of up-front Commonwealth government subsidies (via SRET) and FiTs set by state governments. Both forms of subsidies are paid for by electricity consumers, via energy retailers.

It could be argued that it would be more appropriate to fund subsidies (apart from those that correct energy market distortions) via public funds. But governments have chosen to fund these subsidies from energy bills as a way of shifting the cost away from the government budget to the energy sector, so it is easier for the government(s) to balance their budgets.

It is this pragmatic decision that has led to a situation where the setting of subsidy levels has been framed in a context of the “real” savings to the electricity supply sector rather than societal benefit. This is, itself, a distortion.

Distributed generation and the electricity system
Within the energy market, distributed generation is a “disruptive” technology. If it is widely installed in an appropriate form, it will reduce the need for investment in energy supply infrastructure, and may bring other benefits.

For example, consumers in areas of high fire risk may gain a much more reliable electricity supply, while insurance costs for energy networks are reduced or the high cost of underground networks is avoided or reduced.

However, early movers may not be able to demonstrate sufficiently large beneficial outcomes to reach the scale where the full benefits from avoided infrastructure are gained. This is a transition issue, not an excuse to deny distributed generation a fair deal within a long term context.

The present debate about FiTs is based on the characteristics of specific technologies, and the extent to which they add to or avoid costs for the existing electricity supply industry.

So IPART has determined its estimate of the “appropriate” FiT based on the marginal costs avoided by the existing electricity industry when existing technology photovoltaic systems are installed.

But incorporation of even small amounts of electricity storage into PV systems, or emergence of combined distributed wind-PV or micro-hydro using the water supply infrastructure would lead to very different outcomes in terms of costs and benefits for the electricity industry.

Similarly, unrelated changes to the demand profile (as we have seen with the explosive growth in airconditioning) can affect the short term value of distributed generation to the energy supply industry.

At present, the electricity industry largely keeps distributed generation at arms length. It could, as an alternative, offer distributed generators varying prices for power, depending on when and how much power the generators provide.

For example, a network could pay an incentive for PV installers to orient PV systems north-west, to help with afternoon peaks. Incorporation of even 0.5 kWh of storage into a small PV system could allow it to delay some of its contribution until the evening peak and introduce some useful controllability of demand.

Beyond this, incentives could be paid to manage demand, to reduce or shift peaks. In this context, incentives for distributed generation would be seen as part of a broader strategy to reduce overall costs.

So discussion of FiTs (and other incentives) needs to move beyond existing technologies and electricity systems to the role of distributed generation in emerging systems. Pricing of incentives  needs to encourage lower cost overall solutions within this broader context, not just focus on individual technologies and today’s circumstances.

The case for varying FiTs and other incentives at different locations
There is a strong case for incentives supporting distributed generation (and energy efficiency and demand management) to vary with location. For example:

  • In many fringe of grid situations, power line losses are large, often as much as 50 per cent. So distributed generation, energy efficiency and load management at the point of consumption can save twice as much energy (much of which may not actually be paid for by the end consumer under a range of subsidies and distortions), as well as providing other electricity services.
  • In bushfire-risk areas, energy networks face a range of high cost options (undergrounding, aerial bundled cables, improved controls, etc), high insurance premiums, or shutting down high risk power lines at times of fire risk. Distributed energy solutions (and energy efficiency and demand management) combined with local energy storage offer potentially lower cost, higher service standard solutions
  • Networks face upgrade costs in many parts of their grids where capacity is being reached – often caused by consumer purchases of energy consuming equipment that is not priced to include its impacts on network costs.

Proactive investment in a combination of distributed generation, energy efficiency, energy storage and load management can, as demonstrated by some of the Solar City projects (eg Magnetic Island), deliver substantial demand reduction and lead to deferral or avoidance of the need for infrastructure upgrades.

Arguments by electricity companies that distributed generation does not save on infrastructure costs reflect the focus on specific technologies and situations rather than integrated solutions:

  • Demand peaks in different areas occur at different times, for different reasons. For example, in many non-gas areas, the peak can occur late at night, when off peak electric hot water systems switch on.
  • Many electricity industry costs are “smeared” over time and location because of practical limitations and political realities, so consumers and distributed generators do not see clear and appropriate price signals

If incentives for distributed generation were targeted by location and time, this would increase the potential for businesses to develop appropriate packages of measures, and would enhance the economics of more targeted campaigns to drive roll-out of integrated packages of measures.

For example, a team could work with local appliance and equipment retailers and local government to run an intensive intervention in a local area.

Is a FiT the best form of incentive?
No incentive is perfect and, in many ways, combinations of incentives can be preferable.

An up-front incentive is cheaper to administer and helps to overcome a strong tendency of households and businesses to heavily discount future benefits, especially where there is a history of frequent policy changes, as has occurred in the renewable energy and energy efficiency sectors.

But it does not provide an incentive for actual ongoing delivered performance. An up-front incentive can also be varied by geography and over time (as long as this is done in ways that do not undermine market confidence and create boom-bust outcomes), so it can reflect local circumstances, as discussed earlier.

A FiT has the opposite characteristics to an up-front incentive. It provides an effective incentive to maintain ongoing performance. It also maintains the attention of the recipient, as it is visible on every energy bill, reinforcing the benefit being gained.

If the recipient is paying off the cost of the distributed generation system over time, the benefit being gained can be compared against the repayment cost, so its impact on cash flow is visible.

A FiT may also be seen as a form of insurance against increasing electricity prices or a form of stable return on investment (unlike the risks of investing in shares). But it does not address the tendency to apply a high discount to future benefits.

A FiT can also be designed to decline over time for either a given installation or for future installations, in recognition of increasing retail electricity prices, future carbon prices or other factors.

The key issue here is that such declines must be transparent and certain at the time of the generator purchase decision, to avoid application of irrationally high “risk premiums” by potential buyers.

A potential issue with FiTs is the period over which they apply. This can create uncertainty regarding future revenue or even mislead. For example, not many people seem to have realised that the Victorian government’s ”transitional FiT” applies only until 2016 for all installations that receive it, so its value declines for later installations.

There is the further question regarding whether a net or gross FiT is preferable. Each approach has its strengths and weaknesses.

If the FiT is set at the same price as the purchase price of electricity, then this debate is irrelevant. Indeed, this approach also offers significant communication and marketing benefits, as potential investors in distributed generation know that, whether they avoid buying electricity or export, they receive the same benefit.

This neutralises the incentive to install large export-oriented distributed generation systems, or to undersize capacity to avoid losing money on a low export price.

Both a reduction in net electricity consumption and an attractive export price provide an incentive for the host of a distributed generation unit to pursue additional measures that either reduce their consumption or increase their exports.

This is a valid and positive outcome, as it amplifies the impact of the distributed energy unit by encouraging additional energy efficiency and demand management.

Indeed, the emotional response to try to get a negative energy bill or “get back at the electricity industry” seems to be surprisingly powerful in some cases!

In the case of the reduced consumption, the host saves the retail price per unit saved. In the case of export, they save the FiT price. Where the two prices differ, the situation can become more complicated for the host, as increasing exports may become more or less profitable than reducing consumption. This can lead to perverse outcomes.

Overall, a combination of some up-front incentive and a FiT priced at the same level as the electricity purchase price (on a real time basis) seems to be best from the perspective of ease of communication and market motivation.

These incentives should vary with time (on a planned and transparent basis that does not undermine certainty for decision making) and on a geographical

basis to encourage long term avoidance of energy supply infrastructure investment.

Even if this creates some market distortions, this must be seen in the context of large existing market distortions! And simplicity is worth a lot.

Conclusion

There is a clear basis for supporting emerging distributed generation solutions based on valuation of broad societal benefits, not just impacts on the existing electricity industry. But this support needs to be simple enough, certain enough and appropriately sized to drive long term beneficial outcomes while avoiding excessive windfalls.

For information on how to locate Professor Pear’s other submissions, contact: editorial@thefifthestate.com.au