Editorial
Something is amiss with the pricing of electricity in Ontario. Considering that taxpayers are currently spending more than $5 billion per year to subsidize power consumption directly, an amount that will keep rising if the current system remains unchanged, this can’t go unexamined for long.
While it is perfectly fair and reasonable to work to minimize the price of electricity for consumers, doing so may not be easy. The electricity picture cannot be reduced to simple black and white. As general principles, most people would agree that the price needs to be acceptable to consumers but it cannot be one that would starve the system of resources. Under-pricing of electricity can have serious consequences, sometimes worse than the original problem.
Energy pricing is not black and white. Consumers need to see the whole picture.
Improving the system for pricing electricity is timely and well worth a closer look, considering that Ontario is poised to make some big choices in the near future.
Part of respecting customers is being transparent about all the costs that have historically been built into the price of power.
In the first few months of 2020, the IESO will be hosting a range of consultations on the Annual Planning Outlook and related initiatives to ensure reliability and market operations for decades ahead. At the same time, the Ontario government will likely be considering measures that could affect both the Planning Outlook and the future of the sector. Embedded in each of these processes will be crucial questions about what new investments need to be made in the power sector, who should make them, and how the costs should be shared between different types of customers. With rapid technical transformation already underway linking together energy systems, IT, transportation, and commerce, these planning processes will decide nothing less than what kind of energy system we will leave to future generations.
Yes, governments can do things to reduce electricity prices. However, quick and easy fixes are rare. The most powerful tool in the policy maker’s toolbox is competition. This means that extreme care is necessary to keep abreast of change while making sure that price reduction efforts don’t sideswipe the unique ability of competition to minimize overall costs. More detailed recommendations are outlined below, but the primary conclusion for those seeking to cut prices is this: Seek out savings and efficiencies, by all means, but don’t mess up the economics that are already working to hold down prices.
The ill effects of artificially low prices
In economic terms, the right price is achieved when producers don’t want to raise it further because that will cause consumers to buy less, and consumers don’t want to drop it further because that would cause producers to make less than what’s required. The traded-offs are a little more complicated in the case of electricity because shortages can be devastating, and quality control is essential. For this reason, governments and regulators have built complex systems to guarantee reliability of supply, even though these systems inevitably impact prices, sometimes in less than efficient ways.
In principle you have four major types of problems when prices are pushed to artificially low levels:
1. The direct cost of the subsidy to reduce prices
2. The unnecessary physical waste of electricity caused by the fact that lower prices make energy efficiency less attractive
3. The cost to shore up production capacity when lower prices lead to underinvestment and/or underproduction of a needed service
4. The indirect cost of inefficiencies caused by economic distortions throughout the economy, and the erosion of long-term confidence in the fidelity and predictability of prices.
Volumes have been written on each of these kinds of problems. To add a little colour to each of the above, consider the following:
The direct cost to taxpayers, currently running at $5.6 billion in this fiscal year, is arguably money that could be used for roads, schools, hospitals and the like. Is it safe to assume that government spending on short term reduction in power prices is more important than building the next hospital or other public sector priority? In addition, given that Ontario borrows to finance its incremental spending, subsidizing electricity also comes with added interest costs paid for by taxpayers, further eating into the money available for spending on other public priorities.
The unnecessary physical waste goes well beyond convincing consumers to turn down thermostats and turn off lights. Anyone who has considered whether to buy a more efficient appliance knows that current power prices directly impact the choice of hardware that gets installed. Reduced prices cause reduced investment in efficiency equipment and process improvements. These effects are multiplied when industry considers how to upgrade its physical plant. Necessary re-investment is distorted by any kind of subsidy. Wasting energy also means unnecessary environmental degradation, which is not always accounted for in the economic calculations.
The cost to shore up production capacity in Ontario is one of the main reasons we have the “Global Adjustment,” a massive part of our electricity bills, currently running at more than 9 cents per kWh or $15.9 billion per year. Although the GA includes some costs unrelated to production, it generally represents the cost of ensuring production that can’t be collected through market prices. In Ontario, if market prices for electricity rise, the higher costs for consumers would be effectively offset by reductions in the GA during the same month. Total costs wouldn’t change much, while efficiency and transparency would be improved. In this way, Ontario consumers are reasonably well protected against rising market prices. On the other hand, it’s practically a law of nature that whenever policy makers push prices below their natural market level, sooner or later they will be obliged to make compensating out-of-market payments to prevent shortages of supply. Consumers are not well protected against the ill effects of artificially depressed market prices.
Economic inefficiencies include the foregone benefits of investments that would have been made in new production capacity and in energy efficiency had prices been allowed to remain at their natural economic level. In addition, all investments in Ontario that need to factor in electricity prices have the added uncertainty of not knowing if or when government policy may change the effective price of electricity. This means a wide range of investments carry an embedded risk premium, raising the cost of a large portion of Ontario’s economic activity.
Prices are the glue that holds markets together
You don’t need a degree in economics to appreciate the fact that freely-established prices make markets work. Prices do two things very well: They help consumers decide how much to buy, and they tell producers how much to make and how much capacity to build. The fact that each producer and each consumer makes his or her own assessment of cost vs. value means that millions of transactions are constantly at work using very precise signals to make finely tuned decisions. It typically leads to efficient behavior by consumers, producers and investors. Under normal conditions, if there’s not enough of a product in one area, the price rises to a point at which supply increases to meet demand. If price rises too high, competitors crowd in, pushing prices down. This effect of competition is good for consumers and arguably exerts a kind of discipline on suppliers that can’t be matched by artificial price controls.
Markets are not perfect and countless economists have studied when it’s appropriate for government to step in and correct market failures. For example when non-market factors artificially limit supply, or when producers externalize costs onto other parts of the economy, intervention is sometimes justified in economic terms, purely to compensate for the undesirable effects of an unregulated market.
What happened when governments tried to depress electricity prices in the past
Pushing down electricity prices is not a new idea. In fact, governments have repeatedly taken bold initiatives to control prices, sometimes at great cost to themselves if not to customers.
In 1993 the Ontario government under then-Premier Bob Rae imposed an artificial price freeze, which added to provincial debt, ensuring that a later price catch-up would be inevitable. In 2002, the government of Ernie Eves shut down the retail electricity market and set an artificial price cap, hindering the very same competitive market his government had worked to establish. In 2011, the government of Dalton McGuinty introduced a subsidy called the Ontario Clean Energy Benefit, with major costs to the public treasury. In 2017, the government of Kathleen Wynne constructed an elaborate scheme called the Fair Hydro Plan to postpone payment of long term debt, in an effort to reduce short term prices. In 2019, the government of Doug Ford adopted much the same pricing system but financed price reductions directly from the public treasury rather than through long term electricity sector debt. The Ford administration’s approach saves interest costs, a troubling expense that was criticized by the Auditor General, but puts a significant burden on the fiscal plan of the province.
Each of these price reduction initiatives had an underlying problem. In one way or another they inflated long term debt, virtually guaranteeing that future consumers would have to pay for today’s rate reductions, with interest. The question ultimately becomes whether it’s right for one generation to transfer costs to future generations. At the time of the Fair Hydro Plan, Mark Rodger of BLG asked, “[C]ould the OEB's legislated guiding principles be revised to expressly include a new mandatory criterion of only establishing ‘just and reasonable intergenerational rates’?”
Ironically, history has usually shown that governments that have tried to make large-scale reductions in electricity prices were ultimately not rewarded for doing so at the polls.
Welcome to the new world of dynamic electricity prices
Controlling the rising cost of energy is important but it may be only a cog in a much larger wheel of change, over which consumers have every reason to want to exercise some form of control. In the future, reasonably priced electricity may be available through a much broader menu ofoptions than it is today. Very likely there will be multiple suppliers to choose from, and different types of service packages to choose from. For those who would rather not deal with all that choice, there will be standard service packages, likely employing aggregation under the watchful eye of a regulator. Of course the total price charged to consumers will still matter. However, maintaining the underlying system supporting consumer choice and competition between suppliers will likely remain an essential part of achieving overall cost control.
Here’s an example to illustrate why the best options for electricity price control will not be as simple as in the past. In one community, Developer A builds a new subdivision that features solar panels, fuel cells, battery storage and electric vehicle chargers attached to each house. The purchase price of the homes is a little higher but the home buyers anticipate lower energy bills and maybe a little revenue from selling services to the grid and other customers. Developer B builds another subdivision across the street with no power generation capacity, hoping to rely on a combination of regulated and market prices. Customers in Development B buy power from customers in Development A when the price is attractive. The LDC, the local power distributor, has been able to defer the construction of a new substation in the area because demand on the system has been reduced by Developer A. Costs are under control for everyone.
If the government then takes steps to push down overall electricity prices, either through regulation or public borrowing, customers in development B will buy less power from development A. This forces the LDC to expedite its new substation, increasing costs for everyone, with additional negative impacts for Developer A customers because they lose revenue.
Never underestimate the value of competitive principles for acquisition of capacity.
When a community is active in the market in any way, an unexpected reduction in prevailing prices can create extra costs, damage its investments, and reduce its level of self-reliance. As the energy system becomes more diversified, communities are likely to be hedged, with as much investment on the supply side as on the consumption side. Pricing systems need to be carefully designed so as not to discourage this kind of local investment whenever it’s economically efficient.
In any discussion about prices it will be relevant to look at why environmental groups have often seen a need for power prices to rise. Many offer the classic economic argument that environmental costs are systematically externalized by the energy system. Environmental costs are significant and are a market failure that can be most efficiently corrected by re-incorporating amounts reflecting environmental costs into energy prices. Although power bills would rise, environmental costs would decline, the argument goes, yielding lower overall costs for consumers. Theoretically, this kind of pricing would be an example of market economics working properly, taking into account certain costs for environmental protection that would otherwise be improperly externalized onto consumers.
Moving forward
Although cost control is a priority, it is also necessary to have a discussion about the appropriate level of pricing, what is economic, how to ensure reliability, and what is fair to all parties. Premier Doug Ford has set out priorities that call on industry and government to show respect for consumers, and to recognize that government is a customer service business. These are constructive principles to build on.
While power suppliers may have different financial drivers than consumers, everyone should be able to acknowledge the shared goals of a) ensuring that customers are content and b) the energy system is safe and stable. As part of the same process, any work that is done to manage the pricing regime will need to be accompanied by a clear narrative on reducing prices, what is doable and what makes sense.
Although detailed prescriptions for achieving these goals will depend on further public discussion, several of the key ingredients that will be needed are already clear. First, it will be essential to base public policy decisions on objective evidence that is shared and tested publicly. Second, it will be important to maximize transparency so that all participants have the same basic information. Third, performing rigorous Cost Benefit Analysis prior to making major decisions will help to avoid serious mis-steps. Fourth, recognize the distinct types of risk in the system and allocate risks separately to the parties best able to manage each type. Fifth, pay close attention to existing assets and be sure to maximize the value derived from them before procuring new resources. And finally, cultivate political stability by clearly delineating the role of the policy maker from that of the regulator and avoiding hasty spur of the moment actions.
In any effort to achieve affordability, two parallel sets of initiatives will be needed. One for the market-based components of electricity prices and another for the non-market components. Where you have competitive markets there are opportunities to use market forces to push prices down naturally, and a viable explanation for consumers when prices don’t go down as quickly as expected. Where you have administratively set costs, such as for regulated transmission rates, you have different levers for pushing down prices, and much more difficulty explaining the reasoning behind prices to consumers. Therefore, it’s necessary to continue the long term drive to enhance competition in power markets, maximize the proportion of costs that are set through competitive processes, and expose the non-competitive parts of the system to systematic well-informed scrutiny so as to enable price pressure to be exerted on them through regulation and other means.
Continue the drive to enhance competition in power markets, maximize the proportion of costs that are set through competitive processes, and expose the non-competitive parts of the system to systematic scrutiny.
Regardless of whatever else Ontario may do, it’s important to recognize that market-based price formation drives economically efficient actions and is the policy maker’s best hope for minimizing prices. The market applies zillions of timely rewards and punishments for market participants and encourages consumers, producers and investors to demonstrate their best economic behaviour. And it does all this in a predictable way, acting even-handedly with all players, like an almost perfect regulator.
Although artificially depressed power prices may seem attractive to passive consumers, they have long term costs for everyone. This is true simply because people make less informed and less efficient decisions in cases where competitive pressures are eroded. Ontario consumers would not benefit from a system that operates at an inefficient level of production and consumption, or which reduces the rewards for making physical investments to correct imbalances. Unimpeded price formation is one of the best opportunities to balance the system physically, green our supply mix, and set up incentives to do more of the right thing in the future. Part of respecting customers is being transparent about all the costs that have historically been built into the price of power. Past governments have asked the power system to do more than just produce low cost power. It’s also been asked to help with social goals like job creation, economic development, cleaner air, and moving industrial development out of suburban areas.
There’s little doubt that this is an opportune time for industry, consumers and the government to work together to find solutions. There is both fiscal pressure to act soon, and enough runway to allow the benefits of well-developed plans to play out before the next election.
Power pricing is a politically sensitive subject complicated by a need to reinforce public understanding of the issue. Although there is a lot of work ahead in finding viable cost savings, there is almost as much work required in explaining to consumers what works and what doesn’t, and how the most satisfactory price reductions are those that that are predominantly driven by market forces.
—Jake Brooks, Editor
See also APPrO’s open discussion on Creative ideas for reducing electricity prices.
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This editorial represents the views of the author. It is intended to prompt further discussion and may not reflect the position of APPrO or of any APPrO member.