Challenges in Japan's Electricity Utility Reform: Preventing a rise in power rates and supply shortage
Faculty Fellow, RIETI
With the passage of amendments to the Electricity Business Act on June 11, 2014, Japan's power retail market is set to become fully liberalized by around 2016, moving the electricity utility reform into its second phase. Under the new system, regulated electricity rates for households and small shops as well as restrictions on entry into the retail market will be eliminated, giving all consumers a free choice of electricity suppliers.
Looking to the emergence of a huge new market, a series of non-power companies—including automobile manufacturers and telecommunications service providers—have announced their plans to enter the electricity retail business. While it is expected that greater competition will lead to better services at lower prices, there are lingering concerns over the possible consequences of liberalization because of the unique nature of electricity and its need to serve the public interest. In this column, I would like to make three arguments by focusing on electricity prices and power supply capacity.
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First, let me draw attention to transitional measures intended to smooth the way for the full liberalization of the retail market. When the amended law enters into force, electricity pricing regulations will be eliminated in principle. However, as a transitional measure, regulated prices will be kept along with unregulated prices for the time being until sufficient competition is in place. Thus, those who wish to continue to purchase electricity at regulated prices may do so by not opting for unregulated prices.
Introduced during the 1973 oil crisis, the current three-tiered electricity pricing is designed to encourage voluntary efforts to conserve electricity. A higher rate is applied to households with higher levels of electricity consumption (tier-3 users) to provide an incentive for efficient use of electricity. Meanwhile, extra profit collected from those households is used to lower the rate offered to those with the minimum consumption level (tier-1 users) so as to maintain access to the basic utilities that are considered to be necessary to secure the "national minimum" of an adequate standard of living.
Allowing new entries to the retail market while requiring the conventional power suppliers to continue to offer regulated prices would induce new entrants to engage in cream skimming, i.e., offering lower-than-regulated prices selectively to tier-3 users. Should this happen, liberalization—even if it works to lower prices in the short term—could result in higher prices for tier-1 users over the medium to long term, eventually making it impossible to secure the national minimum.
In order to prevent this from happening, the government must take all possible measures to ensure the adequate protection of users in shifting to the liberalized regimes, such as having tier-1 users covered under the universal service obligation. It also needs to implement extra measures to enhance energy conservation so as to ensure that the planned liberalization will not stand in the way.
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Second, what will be the impact of the planned liberalization on electricity bills? Under the current regulated pricing system, users have been able to use unlimited electricity at a virtually fixed rate. In order to prevent the occurrence of critical situations such as an electricity supply shortage associated with the risk of power demand fluctuations, power companies must maintain sufficient power generation capacity to meet the peak demand.
Under the fully distributed cost (FDC) method, all costs associated with the construction or expansion of power plants can be automatically passed onto consumers in the form of an increase in regulated electricity rates. Therefore, power utility companies have an incentive to invest in the construction or expansion of power plants even when they are operating or expect to operate far below their capacity. However, in the aftermath of the March 2011 earthquake, this pricing method came under scrutiny and has been criticized for undermining cost-saving incentives and thus resulting in the presence of excess facilities. Once the retail market is fully liberalized, investments in underutilized facilities such as peaking power plants would involve significant risk regarding fixed cost recovery. Because of this prospect, power utility companies would reduce investments in power generation facilities. And to the same extent as the reduction in facility investments, we can expect electricity rates to decrease relative to what they would be under the FDC pricing method.
In the postwar high economic growth period when electricity demand was rising rapidly, the presence of excess capacity in facilities did not pose any major concern because even those operating well below capacity at the beginning were expected to reach full capacity in due time. Today, however, such is no longer the case, and it is hard to expect a significant upward trend in power demand in the future. Seen in this light, it is a rational decision to liberalize the retail market so as not to provide excessive investment incentives.
On the other hand, tight supply under the fully liberalized regime would put upward pressure on electricity prices. Theoretically, higher electricity prices should stimulate investments in power plants. In reality, however, the development of new power plants usually involves a long period of time and considerable risk. Therefore, if higher electricity prices are to serve as an efficient incentive to induce power plant investments by private-sector companies, they should be able to offer significant economic rent or excess profits.
After all, the outcome of the planned liberalization—i.e., whether or not it will lead to lower electricity prices—is subject to change depending on the current state and future prospects of the supply-demand balance. If there is sufficient supply, electricity prices will go down due to the workings of the market mechanism. If there is insufficient capacity to meet the demand, electricity prices will go up. However, since it is uncertain whether such higher prices will provide an efficient incentive to induce investments in power plants, the tight supply situation may turn into a permanent problem.
A lack of sufficient investments in power plants has been a cause of concern in the United States and some European countries where the electricity market has already been liberalized. They have been trying to find ways, through trial and error, to help make power plant investments economically feasible, for instance, by creating a mechanism called "capacity market" to enable electric power companies to collect fees to cover the fixed costs of new power plants and establishing a forward market where they can trade in and disperse risk. It is about time for Japan to start considering similar measures.
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Third and lastly, what will be the prospects for renewable energy? In the fully liberalized retail market, there will be new players focusing on the sale of renewable energy with greater environmental value. Assisted by the feed-in-tariff system introduced in July 2012, electricity generated from renewable energy sources except for hydropower has increased to account for more than 2% of total power supply in Japan. Expanding renewable power generation capacity would help lower electricity rates if it can substitute for thermal power generation using high-cost fuel to a considerable extent.
Using the Institute of Electrical Engineers of Japan (IEEJ)'s standard power system model, my research team simulated the impact of the large-scale, nationwide introduction of solar power generation, which has been growing rapidly in recent years. The figure below shows our estimation of the portion of electricity demand that would have had to be met by non-solar power plants on the peak summer and winter days in 2012, calculated for three different scenarios concerning the penetration of solar power.
In summertime, electricity demand reaches its daily peak shortly after noon due to the heavy use of air conditioners, and solar power—which is generated during daytime—can help alleviate peak loads. One important effect of this is to save on fuel costs by eliminating the need to use aging, oil-fired thermal power plants as peaking power plants. However, with a further increase in solar power generation, the peak demand time for non-solar electricity will shift to later hours when solar power is not generated. Accordingly, the peak load reducing effect of solar power generation will diminish and so will the fuel cost saving effect.
Meanwhile, in wintertime, electricity demand peaks in early evening when the amount of sunshine is not enough. Therefore, solar power generation has little effect in reducing peak loads.
What we can see from the above is as follows: increasing solar power generation capacity to a certain level helps reduce peak loads, but its effect on reducing fuel costs will diminish with more solar power plants put into operation, and, eventually, the fixed costs of solar power plants will become too large relative to their benefits.
The point at which a decrease in variable costs achieved by reducing peak loads is offset by a net increase in fixed costs resulting from building more solar plants as replacement for decommissioned thermal power plants represents the socially optimal level of the total solar power generation capacity. According to our calculations, the optimal capacity is approximately 15 million kilowatts, which is roughly the same as the current total solar power generation capacity in Japan.
Given that, it is imperative to review and redesign the current feed-in tariff system that is disproportionately in favor of solar power generation, even taking into account the value of solar power generation as environmentally-friendly and distributed power generation.
From the viewpoint of maintaining sufficient supply capacity, it is also important to seek to alleviate the tight supply by means of reducing power consumption. Demand response, a program under which end users reduce their electricity usage in response to a request from their power suppliers, has been gaining popularity in the United States and Europe as a service that virtually allows users to earn money by selling the electricity saved. This helps reduce the overall output of power generation. Thus, demand response can be defined as "negative" production of power and effective as a means to abate climate change.
Presently, various measures for securing stable power supply, including off-the-grid power generation and renewable energy projects, are being implemented individually and in a non-coordinated manner. It is about time we should integrate all of those measures from a cross-cutting perspective and define the future energy mix that would minimize social costs.
* Translated by RIETI.
June 26, 2014 Nihon Keizai Shimbun
August 15, 2014
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