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Select Committee on Electricity Prices
27/09/2012
Electricity price increases in Australia

TROUGHTON, Dr Paul, Manager of Regulatory Affairs, EnerNOC Pty Ltd

[16:11]

CHAIR: Welcome, Dr Troughton. Do you have an opening statement for the committee?

Dr Troughton : I do. I will try to keep it brief to keep you awake at the end of a long day!

Senator EDWARDS: Aren't there any Australians in the energy sector?

Dr Troughton : Not many, no!

Senator EDWARDS: We have just been beset by Englishmen!

Dr Troughton : EnerNOC is a demand response company. By demand response we mean paying electricity users for measured reduction in their consumption at times when the grid needs it—when either there is a physical issue or prices are very high. Everywhere around the world that demand response has been allowed to compete in the market, it has proven to be the cheapest way of dealing with critical peaks in demand. This is really what the NEM needs. Peaks are the root of all evil in the NEM at the moment, and they do need to be fixed. The fundamental idea is that it is much cheaper to pay people who are willing to change their behaviour for a few hours in a year to do so than it is to build a load of infrastructure that is only going to be used for those few hours in the year.

The interesting thing about looking at commercial and industrial demand response, which is what we do, is that it does not need any subsidy and it does not need a smart meter rollout. It does not need a consumer protection campaign. It does not impact on vulnerable consumers. It is just about reaching out specifically to people who are able and willing to make changes and giving a very pointed incentive to them to do so.

This is not new. It has been over a decade since it was recognised in various reports that the design of the NEM is flawed, in that it basically only really deals with the supply side. It treats electricity demand as being an unchangeable fact—that you forecast it and it will come—and then it is the purpose of the electricity market to give enough strong incentives for all of the various participants to go out and build the infrastructure needed to meet those forecasts. And that has worked, in that the lights have stayed on, but it is a very expensive way of doing things. If you can move away from this predicting and providing into trying to see whether you can treat that forecast as not being unchangeable, then you can get a more intelligent and cheaper outcome.

We have known about this supply-side bias for a long time, but it has not yet been fixed. There have been lots of reviews and lots of vague recommendations but no actual meaningful action. While that has been going on for the last decade, $16 billion worth of supply-side infrastructure has been built, and that should not have been needed.

Senator THORP: How much?

Dr Troughton : $16 billion. That is based on Bruce Mountain's modelling that I think he referred to earlier. So the bulk of that spending is on distribution and transmission network infrastructure. That is what has dominated so far. Looking into the future, things change a bit, in that generation is going to become a much more significant component. The draft energy white paper the government put out at the end of last year had $82 billion worth of generation and transmission investment required by 2030, and within that $82 billion there were 14 gigawatts—which is probably $10 billion or so—of open-cycle gas-turbine peaking generation. Now, that capacity is there to deal with extreme peaks in demand as well as with the volatile output you get from intermittent renewable generators, like wind and solar. You can just go out and build these very inefficient open-cycle peakers to address that; it works, but it is expensive. If you allow demand response to compete to provide that same service, you can get a much cheaper outcome.

The AEMC have been doing the Power of choice review. They put out the draft report earlier this month, and there is a lot of good stuff in there. Various people today have already referred to the idea of demand-side bidding—so allowing demand response to be sold into the wholesale market. That is crucial first step towards redressing some of this supply-side bias. It does not solve the whole problem but it is a step in the right direction. In particular, it means that specialist third parties, like us, can get involved for the first time, so we can go and find people who we think should be able to change their behaviour, persuade them that it is a good idea and help them to do so. At the moment, we cannot do that because the only parties that can initiate any kind of demand response activity are the retailers or the networks. They have had 12 years or so to do that and they basically have not, and that is why change is needed. So that is a good reform.

However, there are a couple of areas where the AEMC are not going far enough. The first is looking at network regulation, a perennial topic today. The networks have a strong preference for going out and building infrastructure. Everyone recognises this, and we need some way of fixing this. Basically, I think it means we need to have a more hands-on regulatory approach. It has been very laid-back, 'We'll trust that they know what they're doing,' a sort of broadbrush approach. It needs to be more hands-on, it needs to have targets and it needs to have sticks as well as carrots. The idea is that it should be self-evident to the network business, and the CFO should tell them, that it is in their best interests to avoid doing capital works where it is more efficient to do something else. There was talk about the risk of overincentivising them and so on. But the point is that, if you address peak demand—the very narrow, sharp peaks in demand—through demand response rather than by building network infrastructure, it is so cost-effective by comparison that you can afford to make it considerably more profitable for the network business so that it is really a no-brainer for them to do it. And, looking at the whole picture, everyone comes out ahead. The total costs are reduced. There is more profit there but much less spent in total, so consumer bills come down. That is what a solution has to look like.

The other fundamental area that the AEMC have not considered is the design of the wholesale market. They are just not prepared to consider changes to this. One of the comments made by David Swift from AEMO this morning was that the environment in which the market is operating has changed, particularly with the falling demand and the changing resource mix that we have. My view is that this change in environment means that it is time to reconsider: is the design of the electricity market we have here the right one for this new environment? The design we have is an energy-only market. It is a design that was very fashionable in the nineties, and there are still many economists who say it is very elegant. But there are not many other markets now that are sticking with this very extreme design. It is very abstract. We trust that independent generators will make the right decisions about what to build based on what the derivatives markets tell them, rather than having any opinion as to how much capacity we might need.

The other regions that have energy-only marketshave generally realised that it does not deal well with very peaky demand. The issue is that, in order to give the right incentive to go out and build new generation, you need to allow astronomically high energy prices to occur on a fairly regular basis. There has to be a real threat of them appearing, and we have seen that in South Australia. The other issue with the energy-only design is that it basically discourages demand response, for a whole range of interrelated reasons, and it does not seem likely to cope well with the transition to renewable generation which is inevitably coming.

So, of the other markets that have or had energy-only designs, some are actively moving to capacity-based designs, a more modern element where you have a capacity market and an energy market and they work together. The UK is an example of that, and that is explicitly to help with the transition to having more renewable resources. Of the others,both Texas and Ontario have introduced overlays into their market where they have something capacity-like that is there to allow demand response to have a level playing field to deal with the peaks. So that is a sort of halfway house that seems to be working for them, and they are pushing further in that direction. We are facing many of the same challenges as those markets, and we should seriously consider adopting some of the same solutions.

Senator MILNE: Thank you. You have identified this peak demand issue as being critical, and you talked about attacking that and getting it down with demand side rather than building new supply. You were here when I was talking to the Energy Efficiency Council about the same matter and the AEMC's recommendations in the recently brought down report. They say it has gone far enough, it is fine and it has attacked this issue of aggregating demand savings and enabling that to now be accessed. You say, though, that some of the recommendations do not go far enough and that they need some sticks—obviously mandated targets but also penalties. Would you just like to be specific about what you think we ought to do?

Dr Troughton : The key outcome we are looking for is that it is more profitable for a network to do the right thing than to build more infrastructure. As to how you can achieve that, there are many different ways that have been used in different places. I am not a good enough regulatory economist—I am not an economist at all—to come up with a very specific way of doing it, but the basic principle I would look at is that it should be driven by what costs they are incurring versus the costs they are avoiding. At the moment there is a fundamental split in the way that spending by networks is treated by the regulator. There is capex, which as far as the network business is concerned is a good thing because you earn a return on it, and there is opex, which is universally a bad thing: surely, if your operating costs are high, you are being inefficient. That causes a real problem for demand response in that they have these incentives to go out and do capex stuff and to minimise their opex, whereas what demand response is doing is reducing capex in exchange for some more opex. So you need to equalise that treatment. I am sorry to mention the UK again, but I think the term they use there is totex, total expenditure. They do not really care whether it is operational or capital; it is just spending as little as you can to achieve the necessary outcome. That approach seems like something that has to happen first.

In terms of how you incentivise them, how you set targets and what sticks and carrots you have, the carrot is clearly that you can earn more profit by doing this. The stick is that if you have not taken this seriously—'We've given you this opportunity to do something better and you've chosen not to bother,' which seems to have been the case with previous incentive schemes around demand response—then you have to have some level where, if you go below that, it hurts you. Presumably you can do that by adjusting the WACC on their asset base—or something which they are not going to want to happen so that it forces them to take some action. By having a stick, you do not have to set the carrot disproportionately high.

Senator MILNE: I do not know if you were here this morning when the transmission companies were here, but I asked them why there was such a serious underspend in the incentives that they had—the dollar value that they had had approved—and I asked them, 'How do you account for the fact that you have only spent 15 or 20 per cent of whatever the approved allocation was?' They went into some explanation of how they had a five-year time frame and this happened and that happened—and nothing happened.

Dr Troughton : They will get round to spending it eventually—yes.

Senator MILNE: And they will get round to it eventually. I accept that this whole thing needs to be totally rethought and so on. However, we do have a system whereby a certain amount of money is allocated for demand management, to incentivise demand management, as it currently stands. What will we need to do to tweak the existing system, pending at the same time, in parallel, coming up with something that is going to be better in the long term? What would we need to do to tweak it at the moment to have them spend the 100 per cent of what they have for incentivising demand management rather than just 15 or 20?

Dr Troughton : I do believe them—that they will spend the money eventually. It is there on a 'use it or lose it' basis. Unfortunately, there is not much built into that scheme to make them spend it in a way that is useful. I am sorry, I am probably going to sound a little bit pessimistic here, but I do not think there is much that can be done to fix the incentives to networks before the next regulatory cycle. They are all staggered in different states, so 2014, I think, is when the first big tranche of them comes.

Senator MILNE: My concern here is that there are billions of dollars allocated right now for the next period for building new supply infrastructure. It is clearly not necessary. I am just sitting here frustrated that billions and billions are going to be spent on building and we do not need to be spending that money. If we as legislators get to the point where we say, 'This is ridiculous; we are building stuff we do not want and actually it is probably in the wrong places because the technology is all coming on,' and so on and so forth, there must be something. You cannot just say that there is a sort of locked-in inertia and we all have to just sit back and watch it happen.

Dr Troughton : I share your frustration, but I do not have an answer for you there. The risk is that, if you reach in and meddle part way through the cycle then everyone is going to throw up their arms in horror in terms of regulatory risk and 'we will never be able to raise money again', costs will go higher and so on. I do not have an answer for how you can prevent inefficient spending now that has already been approved without raising all those kinds of flags.

Senator MILNE: But given that all that was approved on a demand projection—which has now been shown to be very wrong—prior to the GFC, and clearly everybody got it wrong, if they acknowledge the demand projections on which the supply side was approved, surely there must be some mechanism; there must be something here that you must be able to say, 'Since we got the assumptions wrong then the spending must be wrong.'

Dr Troughton : Unfortunately not within the current rules. It would have to be something which would be treated as being retroactive. No, I do not think this is a good thing but it is just how it seems to be.

Senator MILNE: Thank you.

Senator THORP: One of the three actions that you recommend in your introductory paper is around capacity market. Could you clarify what you mean for a poor layperson's benefit?

Dr Troughton : Certainly. Sorry, this does get a bit esoteric—the possibilities of different market designs. I think the latest paper I read had 16 of them; there is a great variety.

The business of an electricity market is to try and make sure that supply and demand always meet. All markets are like that. What is different about the electricity market is that supply and demand have to meet not just every year or every quarter but second by second. The concept of capacity is fundamental; the investment decisions are all about building capacity, not buying energy. In a capacity market, that is how you do it. As the market operator or regulator, looking forward two or three years with your demand projections—which, hopefully, are really good demand projections—you can say what capacity you need to keep the lights on to an adequate standard and then you go and secure that much capacity at an auction. That way you find the clearing price for capacity. All of the existing generators can offer their capacity, and new entrants, if they are needed, will offer you a certain amount because they know that, on the basis of that commitment, they can raise the money to go and build a power station. Similarly, if you are doing demand response you will know that, three years hence, you can find 500 megawatts of demand response that will definitely be there during peak times and it will cost X amount. So you put in a bid for that amount. The idea is that you are trading on the ability to deliver that level of capacity a few years ahead.

Senator THORP: What is the big difference between that and our current arrangements?

Dr Troughton : With the current arrangement nobody says how much capacity we need. Instead, there are forecasts of how high we think demand will go. People know that, with energy prices being set on a five-minute basis, if we have a bit of a shortfall they can get extraordinarily high—to $12,900 a megawatt hour at the moment. If supply and demand are bit tight in a particular region, the price has a risk of going that high. On that basis, they speculatively go out and build a generator or some demand response capability in the region. In that case the risk of getting the demand forecast wrong is entirely with each of these proponents who want to go and build something, rather than there being a central decision taken about how much we want.

But the mechanism you then have to make that work is that, if you build that generator, that high price will, to a large extent, not happen. So you actually end up selling derivatives contracts based on the fact that you will have the asset there producing some revenue stream dependent on the spot price. It is the derivatives contracts that underlie your ability to raise capital for the investment. There are an awful lot more parties involved—middlemen and so on—and a lot more credit risk involved. And there is no-one who is essentially accountable for actually making the right decisions to keep the lights on. That is pretty much why other markets have not really followed this path very much. They want to be able to say that we will have enough capacity to keep the lights on rather than saying they gave indications to the market and the market used its infinite wisdom. That is not very accountable.

Senator EDWARDS: Dr Troughton, you have been here most of the day.

Dr Troughton : I was listening this morning.

Senator EDWARDS: What has alarmed you about what you have heard today?

Dr Troughton : I suppose the main alarming bit was that the AER believes that the rule changes that are currently happening for network regulation will suffice. That really does not seem likely.

CHAIR: Why is that?

Dr Troughton : Because it is fixing a few of the minor issues but still sticking to the same path. It does seem that the regulator here does not want to regulate. They are very reluctant to say—

Senator EDWARDS: He gets belted all the time.

Dr Troughton : Yes, exactly, and obviously you need to fix that. It is almost like they do not want to have an opinion on what is a good thing for the companies they are regulating to do and what is a bad thing—which is fine; that is how the original model happened. As somebody mentioned earlier—I think it was Bruce—it was basically copied wholesale from the UK. But, if you look at how the model in the UK has evolved, you see that the regulator is being considerably more prescriptive now. They are saying: 'We will set targets, so these are the deliverables we want, and we will set up incentive arrangements around each of them, where if you underperform it hurts you and if you overperform you get rewarded.'

Senator EDWARDS: So where have they got that backing from? Is it legislative or regulated backing?

Dr Troughton : I do not know.

Senator EDWARDS: So it happens in the UK—

Dr Troughton : And it is very common in the many US regulatory structures that are more interventionist.

Senator EDWARDS: yet we cannot do it here.

Dr Troughton : Yes. It seems to be a philosophical issue.

Senator MILNE: In the UK, David Green from the Clean Energy Council suggested that the inclusion of an environmental objective in the electricity market legislation enabled them to see how that played out across the market. If we were to do the same here, it would at least provide some incentive or some direction for the regulator, as the objective of the market would be to meet whatever the environmental objective was, surely. Is that one way to go?

Dr Troughton : I imagine that would—

Senator MILNE: It would be a start anyway.

Dr Troughton : have some effect, and in particular on each specific decision—everything gets referred back to the National Electricity Objective. So, if you have got that in there, then that should change some decisions. But I still think there is a change in approach needed to have an opinion on what a good outcome looks like.

Senator EDWARDS: The previous witnesses, who are still here, said we have failed to benchmark against international pricing, mechanisms or any of those things, which is where the lack of resources for the regulator come in. He really does not know what he is capable of because he does not know what everybody else in the rest of the world does—or he does but he does not have either the capacity or the ability to influence the change which is required.

Dr Troughton : I would say the regulator is outgunned by the regulated businesses, because if—

Senator EDWARDS: It is outgunned by the regulated businesses?

Dr Troughton : Yes. If I were a regulated business then my best dollar spent would be in trying to swamp the regulator with information so that they could not make effective decisions.

Senator EDWARDS: One of the grid operators two days ago expressed a lot of sympathy for the regulator, telling the committee that he was under-resourced and lacked the skills. Your assertion is that that seems to serve the businesses quite well.

Dr Troughton : Yes. I am not accusing anyone of acting badly—

Senator EDWARDS: No, I know. We are just trying to fix this thing.

Dr Troughton : Everyone is responding to the incentives that are in place in the existing regime. They are doing the right thing—

Senator EDWARDS: It is what it is.

Dr Troughton : Yes.

Senator EDWARDS: Whether it's an excrement sandwich or whatever it is, it is a sandwich; but we have to try and make the sandwich a bit better.

Dr Troughton : Yes. If you look at what is submitted to the AER for each of these regulatory determinations, there is a proposal from each network and a response, and then you get various extra iterations. There are hundreds or thousands of pages, from each network, of argument and backup information. It is an enormous task. It is very depressing to think that all these people are wasting this time doing that. Much of it is not actually dealing with the main issues; it is throwing lots of miscellaneous detail.

Senator EDWARDS: So, if we were far more prescriptive, we would not have the reams of paper and research bombarding the regulator so that he did not have any time or any chance at all to adequately review it all. It is death by information, isn't it?

Dr Troughton : Yes. I think trying to review on individual decisions rather than on 'this is the aggregate outcome we want' is the wrong approach.

Senator EDWARDS: I started all that by asking what you were alarmed at. What were you pleased to hear today? You are our last witness and you are obviously a learned gentleman, so I am interested in your view.

Dr Troughton : I am pleased to hear that people are supporting the idea of demand-side bidding in the wholesale market, because we think that is an essential first step.

Senator EDWARDS: Is that because you feel that billions of dollars that has been invested in infrastructure has just completely missed the mark?

Dr Troughton : Yes, but the most direct way to address that is through network regulation. However, the way that demand response has typically been used to a very limited extent by networks has been to say: 'We need to build or upgrade this particular substation by this particular year. If we can delay that by one year or two years that means we don't have to spend the money so soon, so the time value of money is saved. We can use that money to pay for demand response to allow that delay to occur.' That is the typical shape of projects; the regulatory investment test for distribution and transmission are all shaped along those kinds of ideas: here's what we want to build but we can build it later. While it is obvious that you should do that, it is a really difficult thing for demand response to do, because the value of the demand response to the network business is quite high for that year or two. Then they upgrade the infrastructure and it has no value to them for the next 20 years or so, until the next upgrade is needed. In terms of going to try to find customers who are able to modify their behaviour—reduce their demand when needed—in order to bring about those reductions in peak it is very hard to say: 'We've got this deal for you the next summer. Can we get you to put your procedures and processes in place, install this box on the wall, modify your control systems and do all these things? It will be great next summer and then we'll never need it again.' It is not a very sellable idea. From the point of view as a business doing this, you are trying to get a return on your investment in finding these people, persuading them to do so, putting the hardware in and so on in a year or two. It is really hard. So, although most of the value is in the network deferrals, the nice thing about having the wholesale market there is that it has an open-ended opportunity. It may not have so much value yet, although I suspect it will increase, but the fact is that you can sign people up and say, 'Come on board! This is a long-term program.' It is essential to making it work and to getting a good depth of participation, rather than just getting the lowest hanging fruit—the really easy ones.

Introducing that helps you to address the network programs, even though it is a very indirect route to it. The nice thing about that is that once you have people engaged in doing demand response it is often called the gateway drug for energy efficiency. The fact that people are suddenly paying attention to their energy consumption—they have the information, the five-minute data on what their consumption is and they have cash coming into the business from their engagement with the energy market—means it suddenly becomes much easier to say, 'Let's spend that money on this efficiency improvement which overcomes the money-up-front problem of many efficiency programs. There are a whole lot of good things that should flow from that. That is why I am excited about it.

CHAIR: Thank you, Dr Troughton. It has been a most interesting discussion and a good way for us to finish the day. You are now excused.

Committee adjourned at 16:44