ONTARIO NEWS

How to properly assess the risk of DER proliferation

 

Editorial

It may not be apparent but many people believe Ontario and other regions could be on the precipice of a serious energy sector debt problem in the near future. Ironically, the options for dealing with this potential debt problem are closely tied together with the options for encouraging technology innovation and expansive new investment opportunities. The energy industry is facing a need to define principles appropriate for dealing with the financial consequences of Distributed Energy Resources (DERs).

     This is a subject that’s hard to discuss without sounding like a fear-monger. But it’s only fair to put the issue into the public arena for open discussion in the near term. If the risk can be discounted after discussion, then the energy sector and society as a whole will be better off. If the risk is judged to be significant, then early attention will be preferable for everyone, customers and industry alike.

     As is often the case during periods of disruptive change, there is good news paired with bad news, attractive opportunities combined with serious dangers. To summarize the bad news first, the energy sector is facing the risk of large-scale financial dislocation that could damage a wide range of investments, new and old, over an extended period of time. The medicine could do as much damage as the disease if not properly managed. Now for the good news: Many positive business opportunities are emerging and, if mitigating action is taken soon, there is time to prevent the upheaval, and make sure it does little or no damage.

     The greatest challenge may be finding the determination to take appropriate risk mitigation steps on behalf of the energy-consuming public. It may be difficult to summon up the necessary resolve considering the unfortunate fact that political credit is not always awarded to those policy makers who help to avert a problem.

 

The nature of the problem

     Why is there a risk of financial upheaval? Two major factors are at work. First you have the spread of new technology for producing, storing and managing power, sometimes at costs below that of the existing infrastructure. Second you have existing infrastructure with debt that’s potentially at risk, debt that’s for all practical purposes in public hands, regardless of whose name is actually written on the assets. These are investments that aren’t “too big to fail.” They are assets that are “too public to fail.” Yet, protecting these assets could sometimes be at odds with putting the best-priced technology into service for customers as a whole. If the danger is not managed, the questionable “public assets” could grow, even as they become more uncompetitive in the market. This is what could lead to a “debt-quake” down the road.

     Let’s take a practical example. Imagine that a medium-size factory or shopping centre is having trouble caused by minor imperfections in the quality of electricity service related to their location in a weaker part of the electrical grid. An entrepreneurial contractor comes along and offers to build them a complete micro-grid, with emergency backup, solar panels, and a high tech control system. A long term gas contract can secure the CHP part of the system for many years at an attractive price. They don’t need to connect to the grid, although they’d like to be able to sell surplus power. All in, the cost of power from the new system looks as good or better than what the customer can expect from the provincial/regional market, and they’d have improved power quality and green credentials on top of the financial savings.

     One such customer could be a source of innovation and economic development. Two or three could be a growth opportunity. But sooner or later, the proliferation of such projects could leave the existing infrastructure in a precarious position: Fixed debt payments and a declining customer base.

     There is plenty of economic theory on the subject of “creative destruction” and stranded costs as various industries respond to changing technology. Some assets and some companies lose relevance and go out of business while others recognize the opportunities and rise to replace the outmoded. Although this kind of economic process is not without pain, and certain social inequities need to be mitigated - especially in regulated sectors, such modernization driven by economics is typically net positive overall.

     Many people welcome the trends that are leading in this direction. These forces have already spurred positive new investment and helped reduce carbon emissions in a big way. Tom Rand, writing in the Globe and Mail October 1, extolled the potential opportunities for Canadian clean technology entrepreneurs and said, “The energy status quo is being upended … change will be faster and more unreasonable than we think.”

 

As long as the net benefits are positive, competitive new investment should take precedence over the protection of old investment

     Durable principles are needed to guide policy makers and regulators through these waters. Whenever assets need to be written off, particularly publicly-guaranteed assets, the debate can get contentious. If and when debates arise about endangering or writing off publicly-guaranteed assets, it will be important for everyone to have access to the same basic set of facts. Prolonging the debate about when and how to walk away from an obsolete asset however, is likely to raise the cost for everyone.

     The extent to which jurisdictions like Ontario can expect to emerge unscathed is directly related to their readiness to enter such difficult discussions with a clear and reasonable set of principles, guidelines and standards. Exactly which assets are unsustainable, and which newcomers would be unfairly exploiting the situation? And in the unlikely extreme case, which assets should benefit from relief, paid for by other customers, with all the questionable consequences that implies? More realistically, how to ensure the responsible jurisdiction does not find itself in such an undesirable position in the first place?

     To be sure, Ontario and other jurisdictions should seek to avoid these no-win situations where the viability of publicly-guaranteed assets is pitted against the opportunity for newcomers to provide better quality and lower cost service on a competitive basis. If circumstances are allowed to progress too far, there are no winners. There are only unhappily shared costs, prolonged inefficiency, and missed opportunities for innovation.

     No government should have to condone, much less authorize, the imposition of a stranded cost recovery charge purportedly necessary to protect existing investments threatened by lower cost services. As APPrO wrote in its submission to the OEB on April 12, 2019: “Any jurisdiction which creates a significant risk that exit fees will be charged on projects that are otherwise economic is actually driving away investment, loudly broadcasting inappropriate economic signals throughout the economy, discouraging innovation, and deeply damaging its ability to adapt to future conditions. While it’s necessary to ensure that uneconomic investment does not take root, given that (exit fees) would fundamentally rely on shifting costs to other consumers, customers are always better off when investment in economic new technology proceeds and when regulatory conditions are not weighted against such investment.”

     Yet with a relatively modest effort, a process and a set of principles can be established that would avoid these negative consequences. It would require proactive collaboration between government, industry and regulators, working on a transparent basis. It would mean establishing shared goals and principles, designed to serve the public interest when publicly-guaranteed assets are threatened by new technology. As outlined in the paper above, regulators can help the economic process, by working with government and investors to establish transparent tests of economic viability. These tests would produce meaningful, replicable signals to determine whether a given investment is reasonable and economic, before steel goes into the ground. They would virtually eliminate any need for stranded debt mitigation measures after investments are made.

     Brian Rivard, writing in a policy brief published by the Ivey Business School, recommends breaking Ontario’s Global Adjustment cost into three components and collecting them through separate charges designed to more accurately reflect the causes and benefits of the costs. This would “reduce the potential for inefficient adoption of distributed energy solutions and future electricity costs for Ontario consumers.” This is an example of the kind of solution that can emerge from proactive thinking on how to manage leftover costs, without damaging the competitive market.

 

Why the situation is serious, but not dire

     It is only fair to examine current trends, which appear ominous in some respects, and take precautions. However, there is no reason to take hasty action that would distort market signals or dislocate other positive investment activity.

     Misunderstandings about stranded costs are surprisingly common. Untangling some of these misunderstandings can help to prevent hasty moves that might be regretted later.

     The risk of stranded cost is not a new story. Fears of a utility “death spiral” have arisen under various circumstances in the past, and none have ever come to pass purely as a result of the entry of new technology. When it comes to adapting to change, utilities have long term value to a large number of people. This gives them more breathing room than other types of industry. In economic terms, an asset is only stranded if an anticipated shortfall in net revenues occurs as a consequence of changes in regulatory or government policy.

     No one can prevent under-utilization of assets. It’s a normal condition of economic activity and in fact healthy and expected during times of transformation. Some assets lose their competitive edge and must be retired. That is appropriate in economic terms. Consequently, remedial action to alleviate so-called stranded debt after the fact is rarely justified and always creates waves of distortions and inappropriate economic signals.

     Sunk costs are often contentious, but they shouldn’t be. Sometimes people with attachments to existing plants bemoan walking away from “good equipment.” They will often talk about all the money that went into the old assets, implying that it should all be recovered before something new is built. But that reasoning is faulty. Sunk costs are gone. If the all-in cost of a new service is less than the operating cost of the old system, it doesn’t make sense to keep using the old asset, even if you have to swallow the sunk costs.

     When does under-utilization of an asset become so severe as to be considered “stranded” and qualify for debt relief paid for by previously uninvolved parties? The question is roughly like asking when does one city’s financial insecurity become so severe that they should qualify for a bailout from other cities. There is no right answer and there is no economically rigorous way to determine the right answer. The better question is how to avoid getting into dire circumstances in the first place.

     In the case of the electric power system, there’s a complicating factor often called grid adaptation. Grid operators in all cases make operational and physical adjustments to their systems, to reflect the characteristics of their particular supply and consumption mix. In some cases, they install special equipment to regulate frequency, in other cases they upgrade transmission lines to connect generation. To accommodate renewables in recent years, grid operators have made a wide range of adjustments, most of which turned out to be modest costs in the big picture. These are technical decisions that should continue to be made on a technical basis without being influenced by the desire to favour new or existing technology.

     However, when new technology threatens to displace existing assets, those kinds of grid accommodation costs can become contentious. They should not be so. There are good technical standards and economic guidelines that can be applied to determine when and how to accept the cost of accommodation. The economic principle is pretty simple: The cost of accommodating new resources on the grid should first and foremost facilitate meaningful economic competition between the resources. Unless the new resource is fundamentally uneconomic, the incremental cost of accommodating the new resource on the grid should neither be a subsidy to the new resource or a disincentive to it. Grid infrastructure should facilitate competition, even if that means a little bit of cost for technical accommodation within the grid.

 

Conclusion

     Even if a debt-quake is not a major risk, it’s important to deal with the perceived risk proactively, because many market participants believe it to be a real possibility. Concerted action needs to be taken in the near future to avert both the possibility of a debt-quake and the possibility of inappropriate risk reduction measures.

     When the cost of new technology drops, a few new entrants can create waves throughout a much larger system. Lower cost technology can compromise the value of much larger long term assets. It can force changes in unexpected places.

     These changes don’t mean that you stop using the existing assets, but they do require a new lens when it comes to assessing new investment going forward. The cost of inaction is potentially massive increases in the size of the problem, well beyond the ability of simple unobtrusive policy measures to control or manage.

     What you can say with absolute certainty is that it is much better to design competition-friendly measures to prevent extreme under-utilization of assets, particularly those that are part of shared infrastructure, than to try to clean up a mess after the fact. Any steps under consideration must be carefully developed, and fully reconciled in advance with affected stakeholders, so as not to damage the environment for new investment.

     To ensure that investor confidence is maintained, without incurring unnecessary cost, a firm public commitment should be made to implement measures in the near future, following full consultation, that would prevent extreme under-utilization without impeding current market-based investment.

     With appropriate preventive measures, at the same time as averting a potential earthquake the energy sector would be opening the doors to positive new investment and innovation.

— Jake Brooks

 

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