Adjusting Electricity Supply with a Price Mechanism

OHASHI Hiroshi
Program Director and Faculty Fellow, RIETI

The outlook for Japan's electricity supply this winter remains unclear. Especially in Hokkaido, a target to save over 7% of electric power usage from FY2010's level has been set. Given the uncertain direction of the nuclear power policy and reasons such as the increasing procurement cost of fossil fuel, Kansai Electric Power and Kyushu Electric Power, as of late November 2012, applied to the Ministry of Economy, Trade and Industry for an approximate 10% increase in electricity rates for households. Other power companies are expected to follow suit.

Given the tight supply constraint and the pressure to increase rates, there are strong voices calling for the reform of the electricity system. Apart from mistrust of the present system, there are expectations that if the reform promotes competition and new entries, it would contribute to the security of the energy supply whose capacity is presently insufficient, and thus, effectively curb the rate increase.

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Many Western countries have introduced the separation of power generation and distribution and/or liberalization of power retailing as part of their privatization and deregulation efforts of public utility services in the 1980s. In the field of economics, many empirical studies have since been conducted on the electric power market. What became clear were the difficulties in designing an electricity system due to its unique characteristics as a commodity and its nature as a public utility.

Electricity has two unique characteristics. First, its demand changes significantly depending on the season of the year and the time of the day. Second, it is difficult to store, and therefore it is necessary to match the supply with the demand at every second.

As electricity cannot be stored on a large scale, many power-generating facilities have to stand by in preparation for the peak times that only last for very short periods. As an example, for Tokyo Electric Power's service area in 2009, the electricity level at 12% of that of the peak time was generated with 45% of the power-generating facilities. Maintaining underutilized facilities for peak times was possible because, in exchange for the supply obligation, a system that ensures the recovery of facility investment costs was in place.

Under this "cost-based pricing," consumers were able to use as much electricity as desired at the fixed unit price. Nevertheless, this system was severely criticized after the Great East Japan Earthquake as one of the factors that discouraged the electricity companies from making cost reduction endeavors, allowing them to maintain excessive facilities.

To increase the utilization rate of the existing facilities in the face of supply shortages, it is necessary to hold down demand during peak times and spread it out over the off-peak period. One of the methods for compelling demand shift from the peak is planned outages, but this method causes significant dissatisfaction among users.

In order to hold down peak demand while securing the users' options, it is necessary to convert electricity unit prices, which have been fixed hitherto, into variable prices that reflect the demand-supply balance. This is the background reason for why the deregulation of the electricity market is necessary. Once deregulated, by increasing prices during the peak times and thereby reducing demand, the efficient operation of power-generating facilities will become possible, as is shown on the chart.

Figure: Electricity pricing in the deregulated marketFigure: Electricity pricing in the deregulated market

In order for Japan to achieve electricity deregulation, institutional reform and infrastructure development are indispensable. First of all, it is necessary to design a market that adequately reflects the demand and supply on prices. Specifically, a wholesale electricity market must be developed whereby power generators and retailers that supply electricity to users trade electricity. In this market, prices fluctuate depending on supply and demand, and retailers' procurement prices rise during peak times. Users determine electricity usage based on the procurement prices indicated by retailers.

Naturally, in order to grasp the prices on a real time basis, the use of next generation power meters (smart meters) needs to become more widespread. The need for a system that automatically manages energy demand in an optimal fashion should also increase.

Investing incentives in power-generating facilities in the deregulated electricity market are based on excess profits (rents) earned from power generation at increased peak prices, as the chart indicates. If the excess profits are sufficient businesswise, investments will increase and the capacity of facilities will expand, which will reduce peak prices. On the other hand, if the excess profits do not cover the investment costs, investments will not increase, and the capacity of facilities will decrease, which will lead to increased prices.

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While many political parties set campaign pledges to phase out nuclear power, a key challenge for the future is how to secure supply capacity while promoting electricity deregulation. Discussed below are three important points regarding the institutional reform of the electricity market from the perspective of securing supply capacity.

The first point is how electricity rates should be set after deregulation. Many countries have introduced ceilings on electricity prices following electricity deregulation. As a result, the market mechanism has not functioned properly, and there are concerns about insufficient investments in power-generating facilities due to the "missing money problem" pointed out by Peter Cramton, professor at the University of Maryland.

Curbing the price hikes for peak power in order to protect users would not sufficiently contain power demand, resulting not only in the higher probability of blackouts but also in diminished investment incentives in power-generating facilities. In response to such concerns, measures are being taken in the eastern United States to encourage businesses to make investments for power generation by requiring power retailers to secure supply capacity a few years in the future and thus making them bear part of the power-generation risk through forward market transactions. Nevertheless, how to secure adequate investments while price signals from the demand and supply of electricity remain distorted is not a simple matter even from the economics perspective.

Such situation might have been foreseen when the Japanese government announced the Basic Policy on Electricity System Reform in July 2012 which indicated the introduction of a system that guarantees the recovery of investments in the long-term as a safety net. This system, however, is based on the same concept as "cost-based pricing," which only replaces the existing regulatory system with another regulation.

Price hikes for peak power are inevitable in electricity deregulation. The institutional reform needs to be undertaken with the negative side of the deregulation made fully disclosed to the public.

The second point is the way to control demand for peak hours effectively. If electricity demand becomes more responsive to price fluctuations, controlling peak-time demand would become easier; thus introducing smart meters that make prices visible is especially effective. Also effective are services that support demand control by aggregating the needs of users at peak times. In the business services sector, service providers (aggregators) have emerged that collectively manage the needs of multiple building owners through the Building Energy Management System (BEMS). It is important to nurture such services as well.

From the policy aspect, measures for demand control need to be evaluated from the perspective of cost effectiveness and compared with the option of building new generating facilities. Such process will help set priorities among measures for securing supply capacity, which are currently being implemented in various forms on an individual basis, and enable efficient policy formulation.

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The last point concerns the promotion of competition. As the decreased power supply during peak hours will increase prices, businesses might be tempted to hold down power generation deliberately and thereby make undue profits. To prevent such use of market power, which has also become an issue in various countries, it is necessary to establish a governance system that can supervise the power-generation sector in a highly transparent manner. For example, a system in which a neutral entity independent from the power distribution sector monitors the power generation on a real time basis could work as a check against the exercise of market power. In discussing the separation of power generation and distribution, a system to secure competition needs to be examined at the same time.

Electricity deregulation holds potential for various new financial products and retail services associated with market transactions. At the same time, deregulation would require us to change our use of electricity more drastically than at present. We should not lose sight of the important aspects of electricity deregulation as words such as the separation of power generation and distribution and retail liberalization are taking the lead.

>> Original text in Japanese

* Translated by RIETI.

December 4, 2012 Nihon Keizai Shimbun

December 4, 2012