Ditching the Notion of Least Cost

In a previous post, I have raised the possibility of Indonesia, our biggest source of coal, closing its ports because of the COVID-19 pandemic. Fortunately, this didn’t happen as we would have major problems given that we source 90 percent of our coal from Indonesia.

But this doesn’t mean that we should refrain from overhauling our energy sector. After all, this pandemic has exposed vulnerabilities in our energy sector especially since we are a fossil-reliant power country.

A study by the Institute For Energy Economics and Financial Analysis (IEFAA) discussed how the COVID-19 pandemic has revealed the weaknesses of the power sector. 

The report entitled “Philippines Power Sector Can Reach Resilience by 2021” stressed that our energy market, which relies heavily on fossil fuels because our energy planners prefer the least cost method, has not delivered on its promise of being the cheapest cost of energy. On the contrary, our reliance on large scale fossil fuel plants with guaranteed contracts have resulted in grid inflexibility, and price instability.

The researchers noted that the sector for so long has focused almost exclusively on mobilizing capital for large volumes of baseload capacity that runs on imported fuel. Unfortunately, coal plants are inherently inflexible, and in the Philippines 80% of baseload coal plants are inflexible.

The lockdown, the IEFAA said, has exposed the downside of the guaranteed contracts with coal plants.

According to the authors, with the depressed demand for power, coal plants are turning to their mid-merit load factors, which have a higher per kilowatt-hour rate. This is all thanks to our power sales agreements (PSAs) that ensure capital recovery for coal plants. 

The study pointed out that our PSAs have provision for capacity payments, which is the payment to ensure that the coal investor can recover their capital “it is designed to ensure IPPs can recover their capital costs and repay their loans on a timely basis. This means that neither the financial sector nor the power sector is liable for the risk they take, as these are passed on to end-users who are ill-equipped to manage such risk.”

And with the depressed demand for power, coal plants are turning to their mid-merit load factors, which in turn increases the cost per kilowatt-hour. Thus, Filipino consumers have to pay more for every kilowatt-hour, thanks to the pass-on cost provisions of the PSAs.

By just how much will consumers have to shoulder for these capacity payments? According to the study, if there is a 10% decline in energy sales volume for 2020 and if power comes from fossil plant with the usual PSA with the capacity payments clause, then end-users will have to fork out PHP9.679 billion (USD 193.573 million) in 2020. Now, that’s a lot.

All this could have been avoided if we had fixed-term contracts where our consumers will pay the same price regardless of the power demand. As I have been saying in the past, these pass-on provisions burden the consumers. I have been proposing for fixed-price contracts to protect consumers. This is the same recommendation of IEEFA of making fixed cost procurement.

Looking at our PSAs will help us understand what we are doing wrong in the energy sector. Having fixed-price long terms contracts will reduce our power rates regardless of technology. And as I have pointed out in previous blog posts, our PSAs are similar to asking Juan deal Cruz to shoulder the risks through the pass on costs, because our energy planners have a faulty appreciation of the least cost. But in reality and as IEEFA has stressed, big-scale fossil fuel plants have not delivered the least cost system but rather caused price instability.

Our least-cost approach has been faulty as we only base our decisions on the cheapest energy to generate by comparing technologies and choosing which sources are ‘cheaper’ than others. We exacerbate the problem by regulating the costs that can be passed on to Juan deal Cruz according to the returns we feel are owed to the investors rather than what consumers deserve.

The IEEFA study emphasized that the COVID-19 pandemic has highlighted the need for the market to turn to more flexible dispatch strategies especially because of the dramatic drop in demand during the lockdown months. It is recommending for the Department of Energy to start pushing for grid flexibility, modular system, a moratorium on new inflexible power, and for the Energy Regulatory Commission (ERC) to remove pass-through cost provisions and carve out curtailments for inflexible plants.

I would add further to these recommendations. As the government orders the immediate development of indigenous sources, our procurement rules should also change as the present rules for evaluating PSAs do not differentiate indigenous and imported energy. Thus, ERC should require distribution utilities to testify during procurement that there are no indigenous resources in the franchise area or that there are no offers from indigenous power producers.

It makes a lot of sense to recommend grid flexibility, modular dispatch, and grid upgrades via the inclusion of more renewable energy. This is nothing new. Renewable energy, after all, offers flexibility to a power system as they are capable of rapid start-up and dispatching adjustable capacity.

Plus, the prices of renewable technologies have been falling in the last few years. IEEFA noted that “The deflationary price trajectory of renewable electricity generation and storage triumphs over the cost of generating and moving electricity from a large fossil-fueled power plant.”  We can also have a fixed price for power sourced from indigenous materials. 

The IEEFA said it best when it noted that “Power sector planners assumed that a large system lock-in such as coal would lead to the least-cost system. Unfortunately, this lock-in for countries that import coal has led to inflexibility, price instability, and high prices.” And as we rebuild our economy, let us build better by addressing the ills in the energy sector. We can start by ditching the notion of least cost where we forget about the risks and only look at the upfront cost.

It bodes well for us to make a swifter transition to renewables. Unfortunately, the COVID-19 pandemic has paralyzed most economic activities. By now we should be working double hard to revive our economy. We can start by addressing the high power rates in our country by replacing traditional sources of power with renewable energy to support businesses as they recover. The construction of renewable power plants will also provide more jobs for Filipinos, too.

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