Will network operator batteries hurt competition?

All regions across Australia are grappling with the rapid change in how and when electricity is generated and consumed. The huge uptake of Distributed Energy Resources (DER) – in particular the growth of rooftop PV – is eroding the security and reliability of the electricity system and undoubtedly creating huge challenges for network operators.

Many network operators are attempting to address this problem through battery storage assets that provide network support services. In Western Australia, recent changes to the Electricity Networks Access Code (Access Code) allow expansion of the role of the network operator, Western Power. It gives them an unprecedented ability to use regulated battery storage assets for network support, to generate unregulated revenue and directly compete against other market participants without any ring-fencing restrictions.

To better understand the implications of these changes, the Australian Energy Council engaged Oakley Greenwood to produce an independent report. Here we look at Oakley Greenwood’s key findings and consider what the Access Code amendments mean for competition in the Wholesale Electricity Market (WEM).  

The case for network battery storage

In April 2020, WA’s Energy Transformation Taskforce released its DER Roadmap that sets out a framework to allow the further development and integration of DER into the South West Interconnected System (SWIS) over the next five years. It emphasised that the increase in rooftop solar PV and its passive use will result in daytime demand falling, as soon as 2022, to levels where there will be a significant risk of instability in the SWIS.^[i]

The DER Roadmap drew on Tom Clancy to describe this as a ‘clear and present challenge’, and proposed Actions 5a and 5b to deploy grid-side batteries to better control the impact of rooftop PV on the distribution network.^[ii] Action 5a called for the deployment of Western Power community PowerBanks in 10 network locations by December 2020, while Action 5b required Western Power to develop, by October 2020, a plan for installing batteries to provide the additional storage services it believes will be needed through 2024 in the event that those services do not emerge from the market.[iii]

To facilitate this, changes were made to the Access Code – you can read more about these in a previous EI article – that, for the first time, allowed Western Power to use regulated battery storage assets to earn unregulated revenue and compete without ring-fencing. This attracted widespread concern among stakeholders but despite consistent feedback during the consultation process few amendments were made.[iv]

To fully understand the implications of the Access Code changes Oakley Greenwood was asked to assess:

1. the impact on market participants from the network operator being able to provide regulated and unregulated services from network connected batteries; and,
2. what measures should be considered to prevent or mitigate any negative impacts on competition.

Changing the playing field

The Oakley Greenwood report is compelling reading. It suggests that the Access Code has fundamentally changed the playing field, allowing the network operator to access opportunities in the competitive market, overly incentivising it to invest in network connected batteries, giving it a first mover advantage and risking the crowding out of competition.

The intention of the Electricity Industry Amendment Bill 2019 was for Western Power to not “use storage works for the purposes of participating in the WEM (including in respect of the provision of essential system services or providing retail energy services to customers)”[v] . Instead, Western Power can now provide some services, such as essential system services, directly to the Australian Energy Market Operator (AEMO) via bilateral contracts. In addition, Western Power can lease the battery to a third party to provide services directly into a specified energy market and by doing so, can monetise the economic benefit the battery provides via a lease payment/arrangement with the third-party intermediary.[vi]

Even more significant, the Oakley Greenwood report suggests that the changes to the Access Code are unlikely to lead to outcomes that are consistent with its overarching objective to “promote efficient investment in, and efficient operation and use of, services of networks in Western Australia for the long-term interests of consumers”.[vii] The key reason is that part of the New Facilities Investment Test (NFIT) – specifically Clause 6.52 (b) (ii) – allows  the full capital cost of a grid-side battery investment to be recovered based on its potential to produce net benefits, with this expenditure to flow through to higher reference tariffs. This means that, at a minimum, Western Power will recover the full cost of building a battery asset that provides ‘net benefits’ and if the battery is able to be used to sell services into competitive markets (such as essential system services or a lease), it will also retain:

• 100 per cent of the net incremental revenue up to a materiality threshold of $1 million for the year; and,
• 70 per cent of any net incremental revenue that exceeds the materiality threshold.

Case study: Same asset, different revenue

To draw out how the Access Code would operate in practice, Oakley Greenwood presents a hypothetical case study where Western Power has three options to alleviate a network constraint:

1. a grid-side battery,
2. demand-side management network support; and,
3. network augmentation.

All options provide exactly the same level of service to the network business however, the options have different costs and ‘net benefits’ because of their ability to provide services to other non-network parts of the electricity value chain.

Table 1: Options to address network constraints

In the above scenario network augmentation is the lowest cost option, but a grid-side battery is the option that produces the highest overall economic benefit and Western Power should, rightfully, invest in the grid-side battery. In this circumstance, if Western Power achieves the additional estimated benefits of $250k forecast as accruing to other parts of the electricity value chain (e.g. by selling ancillary services or leasing out the battery to third parties for their use), the overall revenue that Western Power would generate from the battery is either:

• $1.25m per annum ($1m + $250k) if the $1m materiality threshold had not been reached; or,
• $1.175m per annum ($1m + [70 per cent * $250k]) if the $1m materiality threshold was reached.

In comparison, if a market participant decided to make an investment in the same battery at the same upfront capital cost, delivering exactly the same benefits to the network and other parts of the electricity value chain - and assuming it had exactly the same weighted average cost of capital (WACC) as Western Power - the potential revenue of $1.049m is materially less than that accruing to Western Power based on receiving a:

• $799k annual payment from Western Power for the network support provided by the battery; and,
• $250k annual benefit from providing services into the competitive market.

So, even in the best-case scenario a third-party participant cannot match the revenue flows of Western Power.

But what happens in a bad-case scenario? Well, the result is effectively the same with Western Power earning materially more than the third party.

Let’s assume, for example, that the forecast benefits to other parts of the value chain did not fully eventuate due to an unforeseen increase in the supply of those services by other market players, and only 50 per cent of the expected revenues, at $125k per annum, are received for the life of the battery. In this situation, the overall revenue that Western Power generates from the battery still covers its cost of owning, operating and maintaining the grid-side battery, as it would be either:

• $1.125m per annum ($1m + $125k) if the $1m materiality threshold was not reached; or
• $1.0875m ($1m + [70 per cent * $125k]) if the $1m materiality threshold was reached.

By contrast, a third party making the same investment and suffering exactly the same lower level of earnings from non-network services, would receive revenue of $0.924m – lower than the cost of owning, operating and maintaining the battery – based on receiving a:

• $799k annual payment from Western Power for the network support provided by the battery; and
• $125k annual benefit from providing services into the competitive market.

This simplified case study highlights the problems created by the Access Code changes that allow Western Power to earn unregulated revenue from its regulated battery storage assets. According to Oakley Greenwood, Western Power appears to be overly incentivised to make investments in network connected battery storage due to its ability to fully recover the cost of the asset plus capture either 100 per cent or 70 per cent of the unregulated revenue that can be generated from those assets. This incentive to over-invest comes at the expense of procuring such services from other market participants (because Western Power would give up the possibility of earning excess returns, over and above the actual cost of the investment), or from adopting alternative options for its network services.

Although these changes are still quite fresh, it has already created negative consequences and started a ‘spiral’ that will further restrict competition.

It’s argued that if market participants provide these services, then Western Power wouldn’t need to own and operate network connected batteries, but third parties are already at a disadvantage with Western Power getting a first mover advantage through its community PowerBanks and not needing to release the Network Opportunity Map until later in the year. But, most importantly, third parties have little incentive to compete when they face such an uneven playing field. There is the likelihood they will earn less revenue than Western Power for exactly the same asset providing exactly the same services, while being fully exposed to market risks and facing far greater uncertainty.  If third parties stay out of the market for the reasons outlined above, the argument will mount that Western Power is being ‘forced’ to fill the void, creating an ongoing spiral with competition and innovation losing out.

How can this be fixed?

The Access Code changes were partly made to address immediate network security and reliability concerns. But the Access Code puts an undue amount of reliance on ex-post regulatory interventions to overcome potential issues. This becomes apparent in the inherent assumption that:

• any over-investment allowed into the Regulated Asset Base (RAB) under the NFIT (as discussed above) will be identified and corrected by the Economic Regulation Authority (ERA) during any ex-post review;
• the Access Code specifies several Guidelines that are to be developed by the ERA and these will overcome the shortcomings in the Access Code; and,
• the Access Code provides the ERA with the ability to implement ring-fencing arrangements if required.

This approach will put significant pressure on the ERA, relies on a time-consuming ex-post process and will not be able to correct one of the major shortcomings of the use of the net benefits test in the NFIT, namely its potential to crowd out investment from the competitive market.

As Oakley Greenwood notes:

“Generally, regulation seeks to enact policies and principles set by a rule-making body and to put in place mechanisms that incentivise the regulated party to reveal its efficient costs of operation. The Access Code does not appear to do this in this case.

Leaving the decision regarding the need for ring-fencing to the regulator – particularly without an explicit instruction and guidance regarding policy expectations and the criteria to be applied – is not an appropriate substitute for the development of rules and regulatory mechanisms that provide clear and commercially viable signals that incentivise behaviour that aligns with policy objectives”[ix]

While responsibility for ring-fencing is placed on the ERA, Oakley Greenwood also points out, and the ERA have confirmed, there may in fact be some considerable limitations on the ERA introducing ring-fencing in the context of a network connected battery that is used to provide ancillary services, or is leased to a third party that provides services into a competitive market. This would be a concerning development and one less check on the network operator.

The future of network connected batteries in the WEM

Oakley Greenwood has produced an instructive report that thoroughly considers the consequences of the use of regulated network connected batteries to compete in the market and generate unregulated revenue. The warnings in the Oakley Greenwood report are clear: Western Power is incentivised to make inefficient investments in network connected battery storage and this will crowd out competition.

The Access Code changes have steered away from implementing the necessary checks and balances and there is instead a reliance on ex-post intervention from the ERA to correct any issues. With uncertainty over the ERA’s ability to implement ring-fencing for a network connected battery, market participants will be hoping that the future Guidelines are adequate or that there is scope for amendments to improve the Access Code.

View the full Oakley Greenwood report here.

[i] See page 6, DER Roadmap

[ii] See page 16, DER Roadmap

[iii] See page 71, DER Roadmap

[iv] The State’s Economic Regulation Authority also cautioned in its Report on the effectiveness of the Wholesale Electricity Market 2020 that Western Power has an “incentive to make it difficult for third parties to invest in batteries that would compete with its own investment in batteries”. 

[v] See page 21, Electricity Industry Amendment Bill 2019 Explanatory Memorandum

[vi] See p21, Energy Transformation Strategy: Proposed Changes to the Electricity Networks Access Code consultation paper

[vii] See page 43, Electricity Networks Access Code 2004

[viii] In reality, the contribution of non-network benefits to the overall business case is likely to be much greater than this. Appendix A of the Oakley Greenwood report provides more detail on the likely benefits accruing to a grid-side battery in WA.

[ix] See page 29, Implications of network ownership of grid-side battery assets on competition in the Wholesale Electricity Market