Coordination of supply in network industries
Network industries involve firms cooperating in order to meet customer demands. Their success depends upon parties mutually agreeing on certain interconnection standards in order to combine components together. This need for coordination was often ensured by keeping the major supply components in-house.
Thus, railways were vertically integrated to ensure that the package comprising train types, tracks, junctions, signalling, workshops, stations and other facets could be coordinated without negotiated compromises with independent businesses. Difficulties arose in the UK system when track and trains were placed with different businesses and each attempted to foist joint costs on to the other. Some privately owned freight lines continue to operate like this – notably with Brazilian and Australian iron ore supply routes. In the case of Australia, BHP and Rio spend hundreds of thousands of dollars a year on legal advisors to maintain control of their rail lines and what they carry; they do so to combat constant attempts by regulatory authorities seeking to force them to open their facilities to other users. Their imperative is to avoid any interruption to their shipments, since even short delays mean huge costs.
This vertical integration was also standard for electricity supply. Not only were generation and transmission under common ownership but so also, in most cases, was local distribution. Integration ensured that the lines and the different sources of supply optimised the needs of the market. In most of Australia that meant maximising the use of the cheapest source of supply, coal, while using more flexible, higher cost gas or supply constrained hydro to fill in peaks and ensure reliability. The coal generators remain lowest cost but, since most of their costs are in fixed plant and incurred whether or not they are generating, only when they can continue running continuously for prolonged periods. Coal generators are also not easily adaptable to stop-start operations.
Of course, with integrated electricity systems, especially where government is the owner and a monopoly is in place, there is a risk that the workforce or politicians will take control and boost costs. To a greater or lesser degree there was such loss of cost control in Australia. The competition policy reforms of the 1990s followed by privatisation reversed this and brought massive productivity gains– in the case of generation in Victoria, the former state government monopoly employed four times as many people (including contractors) as the new private owners and was unable to operate with the reliability the private owners achieved. Considerable gains were also made in poles and wires operations. The benefit of these was seen in stable prices, with upward movements in 2007-8 (when the millennial drought cut hydro supplies) and subsequently, when the progressive increase in subsidised renewables forced the closure of coal generators.
Another network industry, air travel, never had integrated services. But the airports impose requirements on the airlines. To use an analogy with electricity supply, airports would not tolerate a sizeable and highly variable proportion of their landing slots being taken by aeroplanes that arrive unscheduled and demand to be serviced ahead of scheduled arrivals. In other words, airports would not allow non-despatchable renewables to squeeze out scheduled arrivals. Airports which tried to operate in that way would need to make comprehensive adjustments to their charges so that the variable suppliers’ costs were reflected in the prices they paid. Any such airport in competition with others would find scheduled airlines re-locating to avoid facing discriminatory treatment as a result of the airport’s accommodation of random arrivals.
Disruption from new technologies
While the effects of competition in forcing down costs and forcing suppliers to pass these reductions is standard economics, Schumpeter considered this process to be far less important than innovation where new competitors were so potent that they displaced the established suppliers. This outcome, now referred to as disruption, can be seen today with taxis, perhaps hotels, certainly newspapers. Where Schumpeterian market disruption occurs, the losses to incumbent suppliers with sizeable sunk costs in newly obsolete technologies must be accepted.
Many claim that renewable energy is such a disruptive technology. Bill Shorten is not alone in maintaining that energy from wind and solar is the “technology of the future”.
This may well be its destiny but, if so, it would be one of those very rare technologies that have achieved that triumph as a result of government subsidies. And the subsidies in place over the past two decades do not, at least yet, appear to have brought the infant industry into maturity. Its sponsors continue to abuse those advocating a cessation of renewable subsidies under the Renewable Energy Target and under the National Energy Guarantee (NEG).
Former Energy Minister, Josh Frydenberg, argued that the NEG he was promoting was “technology neutral”. By that he meant the carbon tax (emission intensity scheme) that was central to the NEG placed a price impost on energy supplies in proportion to the greenhouse gas emissions they entail. It would not actually be technology neutral unless the greenhouse gas free sources are also the cheapest sources. In the absence of that, their scarcity in relation to the regulatory requirements of abatement would result in them commanding a premium price over alternative generation sources.
Frydenberg may have accepted the industry’s claims that renewables would be competitive five years from now, hence there would be no premium price required. The ACCC certainly seems to have done so, since it recommended the removal of the subsidy to rooftop solar installations from 2021, as the subsidy would not then, it claimed, be needed.
The NEG also required “firming contracts” for non-despatchable generation (i.e. wind and solar). Minister Frydenberg estimated the cost needed to “firm up” wind and solar supply would be around $16 per MWh. That is 20 per cent on the spot price, clawing back some of the $80 per MWh subsidy wind currently receives (small scale solar receives $40 per MWh plus the variable value of feed in tariff subsidies.). Some proportion of this, perhaps all of it, would be incurred even without a regulatory requirement since risk assessment departments in retailers would require the capacity they contract for to be firmed up.
No market participant really expects wind and solar to achieve cost parity with coal – anyone who did so would also acquiesce in the elimination of the subsidies. Instead we see these augmented with batteries and the, perhaps now forestalled, $10 billion Snowy 2 water recycling project. In addition, the Australian Energy Market Operator has embarked on an aggressive purchase of reserve capacity and is foreshadowing a considerable expenditure to link wind rich regions to major markets.
The artificial disruption of established energy supply sources from wind subsidies has undermined the energy markets based on meeting customer requirements at lowest costs. The effects will now be difficult to unscramble. Elimination of the wind subsidies and abandonment of new taxpayer subsidies to renewables is an essential first step. Whether this will allow markets to apply a self-correction in light of the on-going policies of subsidies being promoted by the alternative government is dubious. But at least the Liberals, having rid themselves of the cancerous effects of Malcolm Turnbull’s mistaken policy preferences, have an opportunity to search out a solution.