Towards a better understanding of electricity prices

APPrO Magazine - February 27, 2017: The best defense against rising electricity prices is a healthy understanding of the causes of price increases. The methods policy makers choose for supporting this understanding will have a major impact not just on our pocketbooks but on the nature of our workplaces, the shape of our cities, the quality of our environment, and possibly even who will be chosen to govern in future.

As reported by virtually all news media, the issue of electricity prices is now making a big comeback in public conversations. Reasonable people are asking more pointedly than ever – why are my electricity prices so high? It’s a question that can’t and shouldn’t be passed off lightly. Public figures and industry leaders will be dealing with it directly in one way or another, likely right up to and through the upcoming electoral cycle, undoubtedly including the 2018 Ontario election. Unfortunately there are no easy answers. The difficulties inherent in dealing with electricity prices will almost certainly be one of the top challenges for leaders of government and industry in the coming months and years. A serious conversation on realistic principles and practices is needed.

The concern about rising prices expressed by industry and the public is legitimate and cries out for action. The danger is that overheated emotions may prevail. Solutions may be demanded and offered before the problem is properly understood. Fortunately, there is still time to develop a better understanding before the parties prepare their next election campaign platforms. The quality of debate and the strength of the ultimate resolution will both benefit from a brief pause to develop a clearer explanation of what has led to today’s electricity prices and what can be done to curb them.

In order to have a productive discussion, basic information will be needed. In Ontario’s case for example one needs to ask: How do Ontario electricity rates truly compare with other provinces, with other regions of North America and with other countries? How do they compare historically, and most important, how do they compare against the alternative options available today? The Globe and Mail article of January 9 and other sources cited below are starting to establish the kinds of baselines that will be needed.

One has to be careful when talking about electricity rates. Although electricity rates are primarily a matter of economic policy, they are also social policy. For the most part, it is other people’s money we are talking about. A good deal of sensitivity is required. The same statement can mean one thing to an international trader and something entirely different to a pensioner having difficulty with rental payments. Whatever point is being made, it will be necessary not just to talk about rates, but also to get used to the delicacy of the subject. It is also very important to separate rates from bills. Rates are going up, but consumer bills are also a function of consumption. So with a very warm summer, when usage rates are high, customers are seeing the impacts on their bills of both higher rates and higher usage.

Despite all the heated rhetoric to date, very few practical solutions have been put on the table so far. Both government and opposition parties have at times felt obliged to skip quickly past a proper analysis of the causes, and jump right to “solutions,” sometimes resorting to very simple actions like mandated rate reductions. This leads to band-aids and quick fixes, while leaving the core problems unaddressed and potentially causing greater problems in the future.

Some of the public commentary to date has been almost indistinguishable from election banter, suggesting that waste, mismanagement, green power contracts, and the privatization of Hydro One are the only issues in play, and that a change of government will somehow put an end to all such negatives. While any of these may be legitimate issues to raise, properly fixing them requires instituting long-term accountability measures that balance reliability, cost control and environmental responsibility. The opposition may argue that a change of government would help to put such accountability in place. However a change of government is not synonymous with accountability. If you want to see downward pressure on prices, it’s better to separate out the politics, work on specifying the accountability mechanisms you want, and securing broad support for them, while campaigning for your preferred political party in parallel. Ensuring that the media is properly briefed will likely be critical.

Establishing a baseline of quality information

While it is true that Ontario electricity prices have risen rapidly in recent years, it is also the case that some commentators have mischaracterized the causes of current prices, and others have vastly over-stated the level of price increases. There have been wild statements made to the effect that Ontario’s electricity prices are the highest in North America or that they have hit some other kind of stratospheric record. First of all, the public needs a dependable and credible base of information about prices on which to build their views. The Ontario Energy Report and the OEB’s Regulated Price Plan Report are reasonable places to start. These and other sources demonstrate that Ontario electricity prices may be relatively high compared to other provinces in Canada, but they are nowhere near the top in North America.

Making another contribution to public understanding, the Globe and Mail published a review of electricity policy and related issues in a special feature January 9. Its explanation of why electricity is so expensive in Ontario might be summarized as: a) Infrastructure upgrades and new generation built in the early 2000's to replace coal-fired generation, b) construction of more capacity than was actually needed, at least in part because of unexpected drops in demand after construction was authorized, c) minimum revenue guarantees built into certain generation contracts, d) renewable energy procured beyond our immediate needs, e) political interference and f) stranded debt. Although this list is thought provoking, it is not sufficient for identifying or ranking priorities for action. The Globe did not attach cost estimates to these causes, nor did it provide any means for readers to judge which of the causes might be most serious today. Perhaps these omissions are an indication of how difficult it is to get a grip on the underlying problem.

In January 2016 Martin Regg Cohn wrote a remarkable editorial in the Toronto Star titled “Why cheap hydro was too good to be true.” He patiently explained how most of the notable causes of recent price increases were direct results of one government policy or another, usually policy established in response to a clear demand from the public. For example, in the early 2000s, air pollution was a hot topic and public policy consequently focused on reducing the number of smog days. After the big northeast power outage of 2003, the driver became reinforcing infrastructure to reduce the likelihood of brownouts and blackouts. Then there was the move to install green power. And in 2010 the hot issue became keeping new gas-fired power plants out of urban areas. Each policy was driven by popular demand, expressed in a government decision, and led to long term price increases. Society may want to re-examine these decisions now, but it cannot undo the policy choices of the past.

***

A basic prescription for achieving reasonable prices: A major effort at improving market efficiency, mixed with a healthy dose of patience while building public understanding, and a certain amount of courage for tackling misconceptions.

***

Bravely paddling against the popular trend, Mr. Cohn wrote, “[T]he inescapable reality is that waste and bungling alone cannot explain the recent increases in hydro prices. … One reason prices are rising so fast is that electricity costs were kept artificially low for decades, suppressed to give us a competitive advantage over neighbouring jurisdictions. … The deliberate lack of investment in electricity infrastructure during the late 1990s artificially kept prices low, but forced subsequent governments to spend billions more to make up for those lost years.”

Few have the courage to speak so directly. Dwight Duncan, Ontario’s Minister of Energy and Minister of Finance for much of the 2000s, is one of the few exceptions. He told the APPrO 2016 conference that all three major political parties have at times been less than forthright with the public about the prospects for reducing prices. More of this kind of courage will be needed if we are to get past the log jams that seem to impede public discussion in this area.

Getting at the causes of price increases

Martin Regg Cohn offered several plausible explanations for recent rate increases. He focused on new costs resulting from conscious decisions to make the power system stronger, cleaner, and less visible in residential communities. A more complete list of explanations for the recent price increases probably runs like this:

1. Ontario’s less than ideal natural resource profile

The main reason that Ontarians pay more for power than their Canadian neighbours is the physical fact that Ontario doesn’t have large amounts of attractive hydro-electric sites left to develop. Ontario developed its best hydro sites in the first half of the last century and unlike Quebec and Manitoba, doesn’t have more inexpensive, environmentally benign, hydro options to serve consumers’ needs. Recognizing this, as a province we moved to add coal, nuclear and other sources, with a variety of cost and performance profiles, in various phases over the last 50 years. No one source can be blamed for the resultant cost increases. As our supply mix has grown to rely proportionately less on the legacy hydro-electric power and more on the newer sources, it has become gradually more expensive.

2. Political intervention

Ontario experienced high levels of public discontent over the planned location of two gas fired power plants in 2009 and 2010. The government decided to move the plants after contracts to build them had been signed. The credit or blame for this policy lies not with any one party. The pressure to move came from all three political parties. Nonetheless, the power from the plants in their new locations is expected to be much more expensive than it would have been under the original contracts. This additional cost was the basis for concerns raised by Ontario’s Auditor General Bonnie Lysyck. Yet when public opinion shifts away from accepting power plants in urban areas, the higher costs can be seen in two ways: as a sign of mismanagement or simply an indication of how the cost of doing business has changed in response to evolving public attitudes.

3. Phasing out coal

Ontario decided to phase out coal fired power, largely to protect human health, but also to reduce carbon emissions, between 2003 and 2014. This was an ambitious commitment but turned out to be popular because cases of asthma declined and smog went down. Ontario could also claim it made the greatest single carbon reduction in North America. However, retooling a significant portion of the generation portfolio was required, retiring very effective generating capacity early, and committing to new long term costs.

4. Yesterday’s artificially low rates and deficit financing

It’s often said today’s debt is tomorrow’s taxes. The same is true of electricity pricing. The old Ontario Hydro was insolvent, primarily due to the cost overruns of Darlington and political decisions to freeze rates at artificially low levels and pay for the difference with debt financing. This left ratepayers in Ontario with over $20 billion in stranded debt that then had to be recovered. The decision to end the artificial freeze meant that all the previous costs would now have to be addressed directly. These legacy costs are being paid off by current ratepayers through a debt retirement charge built into every electricity bill. In addition, a portion of the legacy debt is also embedded in distribution charges.

5. Green Power

The raw cost of Ontario’s green power program, initiated in 2009, is now reflected in the OEB’s annual report on the Regulated Price Plan. In fact, the cost of each type of power on the grid is shown here. Most of this green power was procured through a standard offer program – providing set rates, and not using the benefits of competition to provide customers with the power at the lowest bid cost. Virtually all supply sources have a cost line in this report, showing the amount the OEB projects consumers will pay in the coming year, above the commodity cost, for each type of power. In this analysis, green power (solar, wind, hydro and biogas) clearly add costs to the system – but they are not the only source to do so. In fact non-green power adds more cost than green power, and more recent procurements have been able to secure renewable power sources at much lower prices, adding little or no cost for some green power.

6. Market inefficiency, often arising from inconsistencies between contract terms and shifting market dynamics

Generators have on many occasions identified opportunities in which they could offer power to the system in new ways that would reduce costs for consumers. For example, many of the legacy contracts with natural gas generators are for baseload power. With the emergence of the problem of surplus baseload generation over the last several years – due to the reduction of demand and the strong performance of the nuclear fleet – we have sometimes been burning gas for baseload power that is not needed at the time. However where certain changes to contracts and/or market rules could address this problem, it often becomes an uphill battle with counterparties to make those changes. There is hope that the market renewal process now being led by the IESO will open channels through which propositions that would save money overall, creating stronger incentives for efficiency while remaining fair to contracted parties, will be ushered in through the necessary channels.

7. Unexpected drop in demand

Ontario’s demand for electricity fell off unexpectedly in the years following the economic downturn of 2008 and has never caught up. In the late 1990’s and early 2000’s Ontario was flirting with undersupply and planners projected that the system would need to be expanded to serve 40,000 MW of demand by 2017. New capacity was procured to meet those projections, but when the demand tailed off, consumers were left with certain costs for the over-capacity. Peak demand in Ontario is now around 24,000 MW.

8. Catching up with grid upgrades that had been postponed in past years

There was a prolonged period of under-investment in generation, distribution and transmission during the 1980s and 1990s. This helped keep rates down temporarily but only postponed the inevitable when upgrades became necessary to maintain reliability.

9. Social policy

Ontario has a number of examples where power system investments were made for industrial policy, social policy and/or Aboriginal economic development reasons. There is also a rural rate assistance program. These policies may be justifiable in each case, but they add costs to the system that have to be picked up by ratepayers.

10. Innovation – building a smarter more flexible grid

Many of the system upgrades underway, and others that are likely ahead, are intended to ensure the grid is flexible and able to accommodate the types of innovation expected in the near future. Consumers appear to want technologies that enable flexibility and choice for themselves and that keep the system ready to adapt to further innovation. These innovations will likely save consumers money when they are used. However getting ready for them is likely to cost more.

Surveying the variety of causes above, interesting patterns become apparent. For one thing, for the vast majority of factors contributing to the price of electricity, no one, neither consumers nor government, can make a big impact in the short term. Most aspects of today’s price are determined by past actions. As a result, for these components of cost, the best course of action likely includes working to improve physical efficiency and market efficiency, while also working on increasing the level of understanding of the basic components of price. For those components of price for which something impactful can be done, the changes will likely have primarily long term effects. Even the possible lengthening of debt repayment schedules, although it can offer short term rate relief, has its main impacts over the long term. In this area as well, one of the main activities of value will be working to develop an improved level of understanding. Put another way, the greatest savings are available by making carefully developed long term changes that will make the system more stable and efficient. This is not an easy message to communicate but an important one.

How to reconcile sometimes chaotic political debate with sensible public policy

From an economic perspective, the ideal price is the price that delivers the most efficient behaviour. From a political perspective, the ideal price could be something quite different. Politics and economics are inseparable for this reason: The quality of our decision making on electricity prices will be directly related to how well the leaders of our public discussions leaders transfer an understanding of economics into political discussions. Durable solutions will require recognizing both economic and political principles. For example, rather than responding to rate objections with across-the-board rate reductions or subsidies, governments could help those most in need with direct financial support, while allowing relatively free movement of the fundamental price signal.

Political debate serves an important purpose in clarifying issues and attracting attention. However it is not an ideal format for resolving all energy policy issues. For example, if an unnecessarily contentious tone in the debate reduces the likelihood of political compromise, then oscillations /swings in public policy will be more frequent, and the cost of electricity will be driven up unnecessarily. It is much preferable if parties to the debate can be shown the side effects of their prescriptions, before policy is hardened. Proposed solutions can then be modified to make them more widely acceptable, more durable, and less costly in the long run.

Based on this premise, a prize should be awarded for the political leader who can most effectively bring calm and reason to the discussion of electricity prices. With public debate built on a well-understood objective base of information, both the government and the opposition parties will be better able to respond when unexpected and/or contentious issues arise that require public attention.

Generators and others have often tried to stress the value of electricity at the same time as its cost. Any effort to deepen understanding of the issue will have to devote attention to explaining how to assess the value derived from using electricity, and how to ensure the value-to-cost ratio continues to improve.

Whatever specifics may be in contention, generators will likely find themselves in the middle of the debate. Being both a key topic of the discussion, and also interested parties in the outcome, generators’ ability to comment effectively is limited. Despite this difficulty, it is crucial that generators contribute actively and constructively to the debate.

What are the solutions? To find answers, look at the causes of price increases like those outlined above, paying heed to the nature of Ontario’s system. In general, a prescription for achieving reasonable prices might reasonably be expected to include a) a major effort at improving market efficiency, b) a healthy dose of patience while building public understanding, and c) a certain amount of courage for tackling misconceptions in advance of and during the likely public debates ahead.

There’s no doubt about it – electricity prices will be an election issue in 2018. The preparation and jockeying for position has already started. The governing Liberals are on the defensive, with both opposition parties sure the public is with them.

All parties would be wise to avoid the temptation to offer simple explanations and easy answers. Be open with the public and acknowledge the depth of the issue. Before making any announcements, spend some time communicating with segments of the public who are prepared to learn how this works. Find ways to defuse the overly-emotional hot buttons. Commit to long term solutions fully cognizant of the related responsibilities, and comprehensive, balanced assessments of success. Take the issue to heart and make sure no one puts emotionally-charged messages ahead of durable long-term solutions.

Authored by Jake Brooks - read full article here