Pricing, transparency key components in an effective energy sector

25/02/2009 - 22:00

A number of reform challenges lie ahead for WA's electricity sector.

Pricing, transparency key components in an effective energy sector

A number of reform challenges lie ahead for WA's electricity sector.

GIVEN the significant debate under way on proposals for further reform of the electricity industry, it is an appropriate time to look at what progress we have made, what are the current challenges, and what further reforms are needed.

What progress has been made?

The Economic Regulation Authority reports annually to the energy minister on the wholesale electricity market (WEM).

Recognising that the WEM is relatively young and was designed to take account of Western Australia's concentrated industry structure (which means a competitive structure will take time to evolve), the conclusion of the ERA in its most recent report (released in December) was that the market is performing well.

The report noted:

- new generation participants have entered the market, meaning Verve Energy's share of generation capacity will fall from about 77 per cent in 2007-08 to about 60 per cent in 2010-11; and

- the market has attracted strong interest from investors in new generation, with 699MW of new generation capacity in service and more than 1,100MW of additional independent generation under construction.

In my view, this new generation would not necessarily have been expected under the old integrated monopoly structure. There have been new, innovative and financially competitive ways of increasing the state's generation capacity - an advantage of a competitive environment.

Outcomes indicate that, at least until the Varanus Island incident, prices have tended to decline and become less volatile in both the short-term energy market (STEM) and the balancing market, and prices in both have responded to scarcity.

The report identified several short-term issues that affect the performance of the market and made a number of recommendations for change and also identified several, more fundamental, market design issues that will need to be considered over the medium and long term as the market continues to evolve.

There are two very important issues to be kept in mind when looking at future changes.

First, the requirement for full cost reflectivity must be included in any market (re)design.

Second, any proposals for change should be subjected to a thorough cost/benefit analysis to ensure that the benefits of any proposed change will outweigh the costs.

Broader STRUCTURAL AND REGULATORY ISSUES

The report also commented on several broader issues.

- Level of regulated retail tariffs.

Regulated retail tariffs in the South West Interconnected System (SWIS) are currently set at levels that are well below costs. In January the Office of Energy (OOE) recommended residential tariffs be increased by 52 per cent in 2009-10, 26 per cent in 2010-11 and 13 per cent in 2011-12.

In the absence of cost-reflective tariffs, retailers will not be able to compete with Synergy for those customers who have the option of remaining on the regulated tariff. This will delay the entry and expansion of new retailers and preserve a concentrated retail sector. Fewer retailers buying into the wholesale market will also act to deter new entrant generation.

- Introduction of full retail competition (FRC)

Currently, customers in the SWIS consuming 50MWh per annum or less can only be supplied by Synergy.

In the absence of a clear timetable for FRC, existing retailers other than Synergy will be unable to achieve critical scale and the entry and expansion of new retailers will be delayed.

Both of these outcomes will have adverse implications for the prospect of new entrant generation.

- Market structure.

Both retail and generating activities within the WEM are currently dominated by state-owned businesses - Synergy and Verve. This concentration has led to a quasi-bilateral monopoly market structure in the WEM. Such a structure is likely to reinforce the barriers to new entry resulting from non-cost reflective tariffs and the absence of FRC.

The ERA, in its report, considered suggestions that there would be a benefit from merging Verve and Synergy.

While acknowledging the current financial position of Verve, any relatively small administrative savings made by merging Verve and Synergy would be quickly more than offset by the disincentive to new and existing players in the market, which would remove the competitive tension and inevitably lead to higher prices.

The poor financial position of Verve is significantly due to the combination of the vesting contract with Synergy and the lack of cost-reflective retail tariffs. It is this area (perhaps combined with a capital injection needed for replacing outdated or inefficient generation plant) that will provide a solution to Verve's current financial problems.

- Greenhouse and renewable schemes

A carbon pollution reduction scheme (CPRS) puts a price on emissions of greenhouse gasses. This ensures that investment and operating decisions take account of the negative externality associated with such emissions. Properly designed, this should help promote efficiency.

In contrast, an expanded mandatory renewable energy target (MRET) deliberately favours certain generation plant technologies over others. In the absence of a CPRS, this may be a second-best option for reducing greenhouse gases.

However, with the commencement of a CPRS, an expanded MRET is more likely to promote investment in renewable plant (particularly wind in WA) that is not justified by the prevailing cost of carbon and hence is inefficient.

Reliability OF SUPPLY

One question that has been asked is how the current market structure guarantees security of supply.

A quick but unsatisfactory answer is that nobody can guarantee supply under any system, as it is impossible (either practically and/or financially) to build a system to cope with every possible adverse event.

However, there are a number of ways in which the energy market seeks to ensure reliability of supply.

It is the role of the Independent Market Operator (IMO) to ensure that there is sufficient generation capacity in WA.

The IMO, through a very transparent reserve capacity mechanism, seeks to secure sufficient capacity to meet the peak demand and energy needs in the medium term. It is worth noting that the IMO bases its forecast of peak demand on a one-in-10-year peak demand event and applies to this a reserve margin.

For example, in 2009-10, the IMO has allowed for a total reserve margin of 400MW. The market rules for the WEM prescribe the process and if it was deemed that a higher margin (greater security) was appropriate, then this could be done through the rule change process (noting of course that the higher the reserve, the greater the cost which will reflect in tariffs).

This independent, open, transparent and non-political process has now been in place and operating effectively since October 2005 and has resulted in significant new generation.

If generation capacity is adequate, the next reliability issue is the transmission and distribution network. In the SWIS, this is almost entirely the business of Western Power. The ERA is responsible for monitoring Western Power's performance and standards are specified under the access arrangement and in Western Power's transmission and distribution licenses. The ERA has a number of powers (including potential fines) to deal with a breach of licence conditions.

This is also a transparent process. The level of public information that is now available with respect to the state of the networks and comparisons of performance would not have been available under the integrated monopoly of the past.

Conclusion

The electricity reforms in WA have been worthwhile and the market, while still developing, is working well. WA will continue to benefit from those reforms.

There are changes needed and in thinking about those changes the overriding objective should be one of economic efficiency - this will be in the long-run interests of all electricity consumers.

Any further reforms should seek to exploit all opportunities to create competitive tensions in the marketplace (regulation is a very 'second best' option).

To continue the consistent theme throughout this article, three other guiding principles to assess future reforms should be:

- cost-reflective pricing across all aspects of the market;

- transparency; and

- vigorous cost/benefit analysis.

n This article is an edited version of a paper 'Energy Market Reform in WA - A Progress Report', presented to the 10th annual WA Power & Gas conference in Perth by Lyndon Rowe, the chairman of the Economic Regulation Authority. The full speech is available at era.wa.gov.au

 

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