Questions FIT to ask on the cost of electricity

Glen Campbell's song (photo credit freefoto.com)

Electricity is perhaps just another commodity.  An early legal case in Philippine jurisprudence established that it is a “thing” that could be taken, and therefore be the object of a crime (of theft).  But it is now more than just a thing.  It is too expensive, and as an object of business, it attracts “power” players (pun intended) more than usual. Lately, the drive to protect Mother Earth has caught on, and in its wake is a law, the Renewable Energy Act of 2008 that grants incentives for the use of renewal energy in the production of electricity.  Among the key elements of the new law is something called FIT.

How did FIT come into being?

The so-called Feed-in-Tariff (FIT) has become controversial.  A group called Foundation for Economic Freedom (FEF) opposes it on legal grounds and as a matter of fairness to the consuming public.  Others, such as Sen. Angara and foreign investors who offer to produce electricity from wind and solar, would like it implemented.  The idea, as the name suggests, is to “feed in” these new sources of electricity into the national grid.

Apart from the merits of using renewable energy (RE), the feeding-in is supposed to add to the capacity of the local power industry to meet demand and thereby avoid future shortages or brownouts.  The FEF opposition is not grounded on an aversion to green initiatives but on flaws in the FIT scheme as currently proposed by government agencies.  FEF believes that the price of electricity is already too high (indeed it is now the highest in Asia and higher than in many parts of the Western world), which impedes economic progress and discourages investment.

Still, the FIT is a scheme to attract investment in the area of electricity generation. It guarantees a new RE producer a higher-than-normal price.[1]  That higher price is paid for by monies collected from consumers (the power distributor collects these monies when it bills the end-user, and passes them on to the operator of the transmission grid, who in turn pays the new power producer).  The FIT is therefore a subsidy scheme paid for by consumers.  Each year, the Energy Regulatory Commission (ERC) will decide several FIT rates – differentiated by technology – for renewable energy producers; thus, there will be a FIT rate for wind, which differs from those for solar, hydro, etc. Each FIT producer is then also guaranteed that it can sell what it wants to the grid (in other words, there is a “take-and-pay” provision in the FIT scheme along with the guaranteed fixed FIT price).

Many questions arise on how the FIT scheme will work.  The correct answers depend on details, some yet unknown or still to be decided.  However,  FIT is not an entirely new concept.  It was used in other countries with varying degrees of success, and some are already phasing out their FITs.  We are either playing catch-up or already behind the times!

Will the price of electricity rise?

The most important question of course is how it would affect the final end-user price of electricity.  Related questions are those related to the manner and implementation of the FIT scheme, in particular, whether the current proposals provide an overly generous guarantee to new RE power producers, in pretty much the same way that provisions (such as “take or pay”) of Independent Power Producer (IPP) contracts of the 1990s and early 2000s did.

It may be noted that the provisions of the IPPs have resulted in losses to government corporations that are now still being recovered from consumers through charges in their electric bills that have nothing to do with their current consumption of electricity.  Indeed, the current high price of electricity for the end-user involves a significant element attributed to the IPPs (called the purchased power adjustment, or PPA, whereby certain costs incurred by IPPs are recovered from consumers).  The PPA was at one point almost as expensive as the actual generating cost of the electricity consumed by the end-user.  One interpretation of this state of events as regards the IPP-PPA component of the current price of electricity is to say that we are continuing to pay for the effort made in the 1990s and 2000s to solve the problem of shortages at that time.  If the FIT scheme were to result in future burdensome charges on the consumer, then this could be seen as a price that we pay for the decision to “go green.”

 

 

With or without the FIT, we can expect or envisage the entry of RE producers so long as they can sell their electricity at a price that reflects a reasonable rate of return.  Indeed, as of today, when the FIT is still “in the works,” we already have significant production of electricity from such renewable sources as geothermal energy and hydroelectric power.  As FEF has pointed out, the Philippines’ carbon “footprint” is at present quite small because of our greater reliance on renewable energy in comparison with more advanced countries.

As noted, the FIT gives incentives for new RE entities to enter the power generation market.  Thus, the FIT would be expected to increase the amount of electricity supplied.  Ordinarily, assuming that the factors underlying demand for electricity remain unchanged, we might expect that the greater amount on offer would bring about a lower market price. This would of course be the outcome if the price of electricity is set by market forces and there is enough competition.  There is some basis for such an expectation because under existing laws, we are mandated to have a deregulated wholesale market for electricity.  Progress in such deregulation has been uneven, but according to some observers, there has been progress.  There have been scattered reports that deregulation has already resulted in the alleviation of power outages in certain parts of the Visayas.

But complicating the picture is the fact that the retail price of electricity is regulated.  It is set by the ERC.  On the other hand and as already indicated, the wholesale price is now increasingly subject to market forces.  The FIT scheme applies to the wholesale price and is therefore a retrogression from the trend toward market deregulation because it would involve the government in setting a fixed (albeit adjustable over time) price for new RE producers.  A government official has admitted that the currently proposed FITs —  soon to be subjected to public hearings —  are based partly on ensuring a 16% annual rate of return to new RE entrants.  Is this desirable or wise?

But what happens when the retail price of electricity is regulated?  The price cannot be set too high that quantity demanded falls too much,  thereby lowering the aggregate profits of producers.  The price cannot also be set too low because, even if there is more quantity demanded, the aggregate profits of producers will also be too low.  (Does this mean that the regulator has become an entity that sets the price of a governmentally-approved cartel?  Or is the better plan to have the ERC simply “shadow” the wholesale price set competitively by market forces?)

What if the underlying wholesale price (the one at which non-FIT producers transact) remains where it has been, but there are now new entrants benefitting from the FIT?  The likely initial outcome is that the quantity demanded will remain unchanged but of course, there would be more quantity supplied.  In other words, there would be what economists call “excess supply.”  This means that the existing producers will likely earn lower profits because they will have to “share” the market with the new entrants.

But there is a catch:  Existing producers with IPP contracts will continue to earn as before because of the guarantee provisions in these contracts (and many of these contracts are long-lived).  The FIT producers will also be insulated from market fluctuations given their guaranteed FIT rates.  Thus, the adverse impact of any excess supply could fall on fossil producers without IPP guarantees, as well as on existing RE producers not currently eligible for FIT.  Now, think about it for a moment.  If you were an existing RE producer, and the FIT rate set by ERC is higher than the wholesale price, wouldn’t you be tempted to shut down, and re-incarnate yourself as a new RE producer to take advantage of the FIT?  Alternatively, you could sell out to another RE producer with a FIT.  What this means is that FIT could well act as a Trojan Horse that brings back the specter of regulated prices that were set in the past at close to monopoly-price levels to the detriment of the consuming public.

For consumers the most important question then is whether they will continue to have to pay the currently high price of electricity. It seems that the answer in part is that it is a matter for decision by ERC in its rate-setting function.  ERC could decide to aim at a price in the wholesale market that is unchanged for fossil producers, but then it would have to un-do the unregulated nature of the market because it will have to come up with a rule for how the fossil and renewable-energy producers can co-exist.  The ERC could refrain from influencing the wholesale price which would fall so that a greater amount demanded at the lower price would be consistent with the amounts supplied by producers. But the lower price is likely to require more government subsidies for existing IPPs and FIT producers, which ultimately the consumers will pay through the PPA and the FIT components of their electric bills.  There is only so much revenue to be extracted from the consumers, and if they have to pay the FIT, and the existing producers are guaranteed their profits from the PPA, it seems that on balance, the consumer will pay more.

Is there a sensible alternative to FIT?

The alternative counter-factual is to imagine a situation where there is no FIT, and the wholesale market price attracts new investment from all players in order to meet possible increases in demand.  In this case, and as pointed out by FEF and other analysts, the new power sources will likely be the less costly fossil and geothermal sources.  Thus, it is obvious from basic economics that FIT should not at all be implemented if the goal is efficiency or the best price for the consumer.  Here, the focus of public policy should be on strengthening the competition in the wholesale market and not on going “green.”

How long will the consumer pay for FIT? Can he avoid paying?

A secondary question is whether consumers would have to pay the FIT subsidy for a relatively long period.  The latest proposals suggest a period of 20 years, supposedly so that the new entrants can recoup their investments.  In this regard, since the FIT has its “take-and-pay” provision, does it then have a similar effect on the final retail price as the the IPP contracts with their “take-or-pay” guarantees? [2]

For the individual power consumer, it seems that the best way to avoid the high price of electricity is to do a self-FIT, by producing his own solar/wind/water power, and opting out of the grid.  But then, how would the traditional power producers survive?

The effect of technology and why it pays to wait

Almost lost in the hoopla in favor of renewable energy is the idea of “grid parity” noted by Boo Chanco.  If in five years’ time, the cost of electricity from the sun falls to the level of the cost from fossil fuels, why would we even need today to attract new renewable energy producers with a guaranteed profit over the next 20 years?  If Boo Chanco is correct, then it pays to go slow in implementing FIT.  This is so because of a provision in the FIT rules on “degression.” [3] Degression justifies a lower FIT price over time as the cost of renewable energy declines (as expected).  Indeed, if there is grid parity in five years, there would be no basis for any more FITs at that time.

CONCLUSION

The answers to the above questions will determine whether as consumers we have become FIT to be tied. It seems that this is one occasion when procrastinating, while strengthening the competitive nature of the wholesale electric market, is the better choice.

—–

  1. According to the Energy Regulatory Commision (ERC), the Feed­in Tariff or FIT refers  to  a  renewable  energy  policy  that offers  guaranteed  payments  on  a  fixed  rate per kilowatt‐hour  for renewable  energy  generation,  excluding  any  generation  for  own use.  The FIT varies by technology and is subject to approval by the ERC.
  1.  The dangers of “take or pay” were not confined to the Philippines.  The consumer and the public sector continue to bear the burden of these provisions. A Senator who has criticized the IPP contracts characterized them as “gross mismanagement.”  The IPPs were subjected to a governmental review in 2002 and some contracts were renegotiated; however, the idea of reneging on them was not seriously entertained given “the importance of preserving the Philippines’ reputation in international markets.”
  1. According to the FIT rules, degression refers to the reduction of FIT rates over time, to take into account the maturing of renewable energy technology and the resulting cost reduction. But degression applies only to new FITs, and not to “old” FITs: once a new entrant gets a FIT for 20 years, his FIT is fixed for that period.  Thus, ERC can reduce all FITs for entrants in 2013, but such a decision will not apply to entrants before 2013.


Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s