Sumiko Takeuchi: Japan's Power System Reform Without Principles — Considering Stable Power Supply and Liberalization

2021/05/19

"Electricity is not an avocado." This is a passage from an editorial by Nobel laureate Paul Krugman in the New York Times. In February of this year, Texas, USA, was hit by a record-breaking cold wave, leaving more than 4 million households without power for several days, and some consumers reportedly faced electricity bills of up to 1.7 million yen for five days. Krugman criticized the energy system in Texas, which had previously been evaluated as a leader in electricity liberalization, as being "based on the idea of treating electricity and avocados as the same thing." Many people likely thought it was obvious that electricity and avocados should not be treated the same. However, what happened in Texas is by no means a fire on the other side of the river. Although it did not lead to a blackout, Japan also experienced tight supply and demand and soaring electricity prices in January of this year. I would like to consider the challenges facing our country's power system.

The primary objective of power system reform is to lower electricity costs by improving efficiency. The electric power business is broadly divided into three business areas: power generation, transmission and distribution, and retail. If efficiency in the power generation business improves, a low-cost power supply can be expected. The liberalization of the retail business is more significant for providing consumers with diverse options than for improving efficiency.

Power systems must have their institutional designs arranged according to various conditions such as the country or region's resource endowment, topography, weather, and industrial structure. It is also said that "among liberalized electricity markets, no two designs are the same. A large-scale experiment is underway, and we can learn from comparative research" (Robert Wilson). However, because the subject of the "experiment" is electricity, the ultimate livelihood and production good, the pain of failure is too great. Unlike avocados, I would like to organize the reasons why an institutional design that ensures a stable supply is necessary by looking at the unique product characteristics of electricity.

First, electricity cannot be stored in large quantities. Therefore, it is necessary to secure production capacity (power generation capacity) to generate the required amount when it is needed. The phrase "simultaneous and equal amount," which is the golden rule for electric power companies, expresses exactly that supply and demand must be perfectly matched at the same timing. Inventory cannot be held, and yet out-of-stock situations are not permitted.

With normal goods or services, when demand exceeds supply, it simply becomes impossible to supply the incremental demand. If communication volume surges during the New Year holidays, some users may find it difficult to connect their mobile phones, but it does not mean that all users become unable to use them. However, in the case of electricity, the entire system collapses. That was the case with the prefecture-wide blackout that occurred in Hokkaido in 2017.

Furthermore, because it is the "infrastructure of infrastructures" that supports all other social infrastructures such as water, transportation, and communications, society will be enormously affected if it is interrupted. The social costs when a blackout actually occurs are very large, and it is necessary to maintain power generation facilities required for a stable supply above a certain level. Electricity is a very troublesome good.

The power generation facilities that produce such a good called electricity actually provide three types of value. These are energy as the final product (kWh value), the value of a call option to be able to generate the required amount when needed (kW value), and the value of flexibly following fluctuations in supply and demand to maintain the quality of kWh (frequency, voltage, etc.) (ΔkW value). Now that it is liberalized, the electricity market has become a place mainly for trading energy called kWh, but how to maintain the other two values is extremely important for a stable supply.

A concern when liberalizing electricity is who will secure the supply capacity for a stable supply and how. For a stable supply of electricity, as mentioned above, the capacity to generate the required amount when needed must be secured. If facilities are only operated during "emergencies" when supply and demand are tight, there is a high possibility that the fixed costs of the facilities cannot be recovered. Since it was clear in other countries that liberalized earlier that there would be an under-recovery of fixed costs for power generation facilities in a liberalized market, Japan has spent many years discussing the creation of a system (capacity market) to pay compensation for future facility capacity (kW), and the first auction was held last September. A certain amount of compensation will be paid for securing 1 kW of power generation capacity in 2024.

In fact, there are mechanisms other than the capacity market to provide compensation for kW value. Texas, USA, decided to leave fixed cost recovery to the significant price spikes that occasionally occur in the kWh market (wholesale electricity market). As a result, the price of 1 kWh of electricity soared to about 1,000 yen, and even then, supply and demand did not balance, leading to the implementation of rolling blackouts. However, one way of thinking is that it is necessary to tolerate such price hikes for "emergency facilities" that rarely have the opportunity to earn to recover their fixed costs. The essay by Krugman introduced at the beginning quotes Professor William Hogan of Harvard University, who was deeply involved in the construction of the Texas power system, as saying, "Price spikes are 'not convenient,' but they are natural for the system."

However, it is hard to imagine that such a surge in electricity bills would be accepted in Japan. Furthermore, since operators cannot be expected to maintain, let alone build, new power plants in anticipation of uncertain price spikes that may or may not occur over several years or decades, the decision was made to establish a capacity market. However, there has been significant pushback from retail operators who have not borne such costs for more than four full years since full liberalization, and rumors have been spread that it is a support system for coal and nuclear power, with some even suggesting it should be fundamentally reviewed. However, that would mean following Texas, which talked about electricity and avocados on the same level.

The essence of liberalization lies in the adjustment of supply and demand through fluctuations in prices. However, if highly regressive electricity rates soar, it becomes a political issue, and politics and administration will again intervene in the supply-demand adjustment system that was supposed to be left to the market. In Japan as well, due to the price surge in January, electricity bills for consumers who had chosen retail rate menus linked to fluctuating market prices skyrocketed, and this was even taken up in questions in the Diet. However, supply-demand adjustment through price fluctuations is the foundation of market principles.

If consumers chose that menu after the retail operator had sufficiently explained the risks, there is no reason for politics to intervene. There must have been sufficient benefits when market prices were low. The necessity of support for some retail operators is also being discussed, but many operators have been able to avoid damage through risk management. If politics and administration are to intervene in a market that has supposedly introduced market principles, a considerable justification would be required.

Furthermore, some point to a market structure where major power generation companies withhold sales or where the separation of generation and retail is insufficient. However, that is not the essence of the problem. In the first place, power generation companies have an obligation to supply customers with whom they have contracts, but they have no obligation to generate electricity for the consumption of users with whom they have no contractual relationship. They have no obligation to procure expensive spot liquefied natural gas (LNG) and put it into the market additionally. Even if the separation of generation and retail were thorough, the result would be the same if the generation company and the retail company entered into a bilateral contract. Rather, the risk is increased by allowing a business model that assumes a good like electricity—which leads to a critical situation if interrupted—can always be procured if bought on the market one day in advance.

It is necessary to examine whether increasing new entrants based on such a business model truly brings benefits to consumers, and conspiracy theories will only distort the essential discussion.

The tight power supply and demand and the surge in wholesale market prices that occurred at the beginning of the year exposed major flaws in the discussions on Japan's power system reform to date. Although the causes of the tight supply and demand are complex, there is no doubt that the main reason is that Japan's power supply was excessively dependent on LNG, a fuel not suitable for storage, following the shutdown of nuclear power plants. In previous discussions on system reform, learning from preceding cases in Europe and the US, there were discussions on how to secure the three values provided by power generation facilities, but there was almost no discussion on constraints when fuel procurement becomes insufficient. In Japan, which is so poor in fossil fuel resources and has experienced the Pacific War (described as "starting with oil and ending with oil") and the oil shocks, the fact that preparations for fuel constraints were not incorporated into the power system reform is a shocking lack of a sense of crisis. From the perspective of stable energy supply and security, a total inspection of the current power system reform is necessary once again.

What was the purpose of suddenly and fully liberalizing the electricity market after the earthquake, which had been proceeding cautiously before the earthquake? I am not denying liberalization. In a scheme where cost recovery is ensured in the form of a fully distributed cost method, capital investment tends to become excessive. It might be different in an era when society is growing and must build facilities one after another, but in a society that has entered a period of stagnation, it is rational to introduce a mechanism that encourages efficiency. However, if one seeks the benefits of market principles, one must also tolerate the risks. Did Japan's system reform have such principles?

In addition, Japan simultaneously proceeded with another challenge: a major review of nuclear policy. What troubled the US and the UK the most was how to achieve a soft landing for nuclear power—an ultra-long-term business requiring massive investment—in a liberalized market, but Japan innocently proceeded with liberalization while leaving nuclear policy neglected. Holding nuclear power plants that do not operate even after spending enormous safety measure costs, and simultaneously being occupied with responding to liberalization, the physical strength of major electric power companies has significantly declined, with the ratings of some regional electric power companies dropping to BBB. In this situation, Japan's electric power business must deal with major social change trends such as climate change, intensifying disasters, and the progression of population decline and depopulation.

To overcome these megatrends and leave a better power system for future Japan, isn't it required to redefine the principles of reform once again?