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Why should we be thinking about the potential disruptions in the energy sector?

FSR Topic of the Month:

How should we look at the interaction of public policies and technological trajectories when the trajectories are not known?

by Michelle Hallack and David Lopez[3]

Week 3

Why should we be thinking about the potential disruptions in the energy sector?

The exercise of thinking about scenarios in the energy sector is not a new exercise, Shell produces comprehensive scenarios since 1970. A well-functioning energy industry depends on long term investments, and for that, it is important to think about how demand (culture, economics, industrial changes) and policies will evolve. Some would say that in the 70’s one of the main variables were the oil shocks, in the 80’s the political transformation associated with the decline of Soviet Union, in the 90’s the rise of environmental concerns (the restrictions for CO2 emissions), in the 2000’s the dynamics of recessions (Shell, 2013). From the policy side, one can say that we had two important movements in the industry organization, associated with technology transformation, but mainly driven by political trends: (1) the post-war trend associated with centralization of the power systems in a vertically integrated monopoly, often a public utility strongly associated with the increasing scale economy of electricity generation (for instance, large hydro, coal and nuclear plants), (2) after the 80’s there is a liberalization movement, with increasing introduction of competition, smaller but still utility-scale technologies such as CCGTs, Combined Cycle Gas Turbine (Percebois and Hassen, 2017).

We are probably on the verge of a new transformation in the energy industry, even if it is not clear exactly its dimension and the possible paths that it might follow. Either social and political trends are interconnected with this transformation, the current energy industry uncertainty is strongly associated with what will be the technological path that the power industry will follow. In this context, the innovation dynamic becomes central.   

Decentralized energy through rooftop generation is undeniable, and it will change the functioning of the power system. See for instance Mejdalani et al (2018) for an example of the recent exponential increase of PV solar generation and some of the potential in LAC. Nevertheless, this transformation in the power system may require changes in policies and regulation. Especially, two regulatory challenges emerge from it: (1) cost allocation problem and (2) disruption potential.

The first one is straight forward and has been broadly discussed in the literature, the cost allocation problem assumes that the power flows will be bi-direction and users will use the system as a back-up. A consequence of it is an urgent change in the way to price the network, especially for many countries where the tariffs are volumetric and have no location nor time signals. The fixed costs associated with the system should be allocated through fixed charges. The commonly held idea that the grid and energy were necessarily complementary products may lead to perverse incentives and flourish the famous utilities’ death spiral. Under these circumstances, there is a general call to decrease cross-subsidies in the tariff structure.

This trend has also a technological and disruptive counterpart. New technologies decrease the measurement costs of energy consumption and production, and thus decreases the costs of implementing locational and time signals, in other words it is less expensive to allocate better the costs to users. However, it may raise some income distribution problems, which may not be minor, as we are seeing in many countries’ social demonstrations against programs increasing tariffs or changing tariffs structures.  This kind of policies needs to be carefully considered, explained, negotiated and compensated. The tricky part here, is that, the costs of energy can strongly impact not just the expenditure of low-income families (usually the focus group for compensation policies) but also the middle-income population. In the same group of pricing discussion and logic, there are other challenges brought by the implementation of new technologies, such as how to price electrical vehicles charge stations?  Or how to price the smart metering services and how to allocate costs? (It is just two of several pricing transformations will be seeing).  

Pricing adaptation is an important challenge and policy maker and regulators will need to tackle it. However, is this stream of reasoning enough to tackle the potential transformation of new technologies in the power sector? Is it the only (or main) challenge for policy makers? If the transformation of the technology is strong enough to provoke a disruption in the industry organization, the answer is no. Price should not be the only key variable to trace a public policy strategy for the future. The coordination problem in the new emerging industry is much larger than just prices, it should contemplate the new services specificities and players in the field. How would then interact? What will be the new services? What are the economic characteristics of the new services? In this context, the main regulatory variable here is to prepare institutions to adapt regulation while keeping credibility and predictability (see for instance Vazquez and Hallack, 2018 and Vazquez et al 2017).

The big problem of disruptions is that even if we do not know what will happen, we know that it will not keep the previous trends. Transformations like the one caused by cell phone for telecommunication industry or streaming for the music industry are just a couple of industry disruptions examples. Today, the cost of off-grid solutions is still huge if compared with an integrated system, and it is just efficient to some marginal cases (access to isolated communities for instance). Moreover, imagine the consumer will trade energy, or even say that their wash machine will trade energy seems too awkward. And it will not happen if there is no disruption, if the costs have a linear format, and if technology does not pass to the tip point of becoming exponential. But, just for fun, let’s imagine if the cost of the battery shut down (lithium, or even some kind of hydrogen), let’s imagine the efficiency of the PV solar panels raise, or even the technologies associated with building constructions (as painting, roof and construction material can evolve to cheaply include power generation), let’s imagine that your Alexa (or another virtual assistant) is able to communicate with other Alexas in the neighbourhood and optimize the wash machines schedule. This would not just change the way to price the system, but it would question the system. How far are we? Is it worth to think about it?

Considering these disruptions are costly, because it demands policymakers and regulators to think about scenarios (even with low probability), promote regulatory impact assessment the potential under multiple scenarios and promote a dynamic of periodic ex-post evaluation. It means to empower regulators with a new set of tools to allow adaptation while keeping credibility and predictability.  Not considering it and keeping the status quo of the regulatory tools, however, can become also largely costly if unexpected innovation comes. It can generate technology and organization lock-in and stranded assets.

Moreover, these choices may generate a perverse logic for developing countries. Countries with a lower level of innovation, where there is lower lobby from innovative firms to push transformation in regulation and policy, may evaluate that the cost for an institutional preparation for a potential disruption too high, as it seems too far away. It means that for these countries the disruption costs would be probably higher. The countries with a higher level of innovation (often the more developed countries) usually have more players interested in adaptation, it included adapting to rules and policies. As a consequence, it is expected lower disruption costs. In other words, probably the countries with higher benefits for innovation will have also lower adaptation costs, as it will be smoother. The countries with lower innovation will probably have higher adaptation costs.

[3] This is the result of thoughts and discussion among the authors; thus it is their own responsibility. It does not reflect any form of institutional view or perspective.