Electric dreams: Choosing functional over perfection in energy policy

By Matt Rennie, EY Oceania Energy Transition Leader

In 1772, in La Beguele, Voltaire wrote Le Mieux est l’ennemi du bien, roughly translated as “the perfect is the enemy of the good”. Almost 100 years later, Harold Demsetz directly applied it to the design and execution of public policy, deriving what he called “The Nirvana Fallacy”, where policy design sets out to compare and aspire to an ideal norm against an imperfect institutional arrangement. 

The Nirvana Fallacy was a useful check for public policy makers, to remind them that the application of pure theory has shortcomings when applied to the grittiness, untidiness and imperfection of the real world. Such suggestions may seem obvious, but in the world of economics, where rules and laws work best in vacuums, that ubiquitous phrase “ceteris paribus” (all other things being equal) that makes all theories work is often left unsaid. As Churchill said, the best plans rarely survive the involvement of human beings. 

The history of our energy policy

Many still do not understand that Government no longer has the power to make the types of energy laws that it used to. The architecture of Australian energy policy making was established in 1996 through the Australian Energy Markets Agreement, a system establishing a rule maker, a rule enforcer and a market operator overseen by a Council of Governments from the states, territories and the Commonwealth.

In enacting this regime, each of the states and territories agreed to suspend their ability to make any energy laws in their own states which contravened the national law and electricity rules, and in doing so, gifted extraordinary power to the rule maker to organically amend the regime to fit the changing times. 

There are immense benefits to doing so. In a changing market, industry needs a clear and transparent basis to operate, and having a cooperative process for the evolution of law based on market observations has led to great operational advancements in the rules. The Australian Energy Market Commission (AEMC), as rule maker, has shouldered the responsibility of developing, responding to, and deciding upon the many hundreds of rule change requests, a process requiring it to balance the needs of society, customers and investors in forming what are more or less judgements on whether rule changes are required. 

Advocates of Westminster systems may find the notion of a non-elected organisation changing law without the discipline of first and second reading speeches and parliamentary debate challenging, but any detailed analysis of that perspective would prove the status quo. The existing regime is a success, avoiding the need to achieve complete agreement by all States and Territories on points of operational flexibility deep within the 2500 pages of the rules. It is, to coin a phrase, the “least worst” option. It was, however, a framework ahead of its time, for without it, Australia would have no chance of navigating the energy transition that is upon us.

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The phrase “energy transition” is used in a variety of ways to refer to a variety of changes that are underway. Sometimes, it refers to the transition from “conventional” generation sources – primarily coal or lignite as it is referred to in Europe – to large scale renewable energy and the consequent changes in system flexibility, reliability and resilience.

Other times, it refers to the connective tissue between the distribution system and the customer, spanning the rise of electric vehicles, the trend towards solar and batteries on households, the increased use of “IoT” devices and appliances (for example, smart lighting that can be controlled via phones, sound systems and other connected home paraphernalia), and most importantly the platforms that will monetise and commercially link these with each other and with the overall system. These two transition points are linked – it will be possible, for example, to keep the lights on in homes using power from electric vehicles, therefore providing flexibility to the system to aid the transition away from coal. 

Balancing of theory with reality

Recently, the nature of the rule changes that the AEMC and industry have sought have shifted. During the early years of the regime, most of the changes were operational, designed to ensure that the rules better reflected the realities of the market. This has increasingly given way to those targeted at both aspects of the transition. One of the more interesting recent examples has been the rule change on Marginal Loss Factors (MLFs). 

MLFs occupy a meta part of the regime. It is neither necessary that the general public know what they are, nor how they operate. They fall under a heading of things that customers just assume industry and Government get right–like a calculation method for allowable safe ingredients in food, or requirements for the design of furniture sold for our living rooms or bedrooms. A year ago, a small and under-detailed rule change submission made its way into the public domain, seeking to replace MLFs with average loss factors (ALFs) after a period of extreme volatility in MLFs, sparking a battle between renewable energy companies and the AEMC which is spilling into the newspapers and forcing public hearings. 

MLFs are an adjustment factor applied to the price that generation companies get paid for their output and customers must pay for their consumption. The vast majority of recent new generation investment and expected future investment is by renewable generation companies. If renewable generation companies were apple farmers, MLFs represent the number of apples that fall off the truck as it goes to market. They therefore do two things – they punish farmers that live at the end of congested or bumpy roads; and they send a signal to other farmers not to start farming on the same road. 

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The trouble with MLFs is that they are reset each year based on the new state of the market. They apply to all renewable generators, both existing and new, and they have been fluctuating, wildly, and getting lower and lower. In fact, the materiality of year-on-year revenue reductions have caused some renewable generators to suffer financial distress, have caused lenders to those generators to restrict returns to equity, or to require refinancing, and most importantly has led to most renewable energy companies signalling that they will no longer invest.  

The risk to renewable investment

The period from the initial rule change proposal to the draft determination released in late November saw these views played out on a narrow public stage – narrow in the sense that only those in the industry were aware it was playing out. These perspectives intensified when the AEMC released its draft determination which decided against any change to MLFs, on the basis that the importance of locational investment signals must be weighed up against theoretical economic efficiency and other considerations, playing down the threats of investment shortages by the industry.

During public hearings held in early December, QIC (accounting for around $700bn of infrastructure investment globally), and the Clean Energy Investors Group (comprising the majority of installed renewable capacity in the NEM) reaffirmed that under an MLF regime, they would not provide the renewable investment necessary to enable the energy transition. While the signals, all agreed, would be more accurate for new investment, the impacts on past investment would be so dire as to halt any further projects. 

Demsetz and Voltaire would be proud. Our society expects that the NEM will have 40 per cent renewables in the next 20 years. The some $20bn investment to make this happen will be provided by the same companies that are signalling they will not invest if MLFs remain as they are. 

The MLF rule change process is an interesting milestone in the evolution of the energy framework because it lays bare the reality that rule making by the AEMC involves trade-offs between technical, investment and economic factors, and that these trade-offs are getting more difficult as the transition evolves. Whether the AEMC will modify their decision before making their final determination in January remains to be seen, but all of industry will be watching. Not just those interested in this outcome, but for those looking to the AEMC for leadership when other rule changes are devised and put forward on other aspects of the transition. 

With hundreds of rule changes envisaged over the next 15 years, it is not one decision that matters, but the process and the consultation that led to it, the transparency of the economic analysis that underpins the balancing of the perspectives, the way in which the economic theory is interceded with real life investment decision making and most importantly the experience of those with the pen. 

Regardless of the outcome on MLFs, make no mistake that this rule change tells a tale of Australia’s balancing of theory with reality, and there is no more important time to get the balance right.