Chairman’s Message

Tatsuya Terazawa

Tatsuya Terazawa
Chairman and CEO
The Institute of Energy Economics, Japan

Chairman’s Message
“Challenges for the power sector: The need for changes"

Message for June 2024

The power sector is becoming more important than ever because it holds the key to decarbonization. A highly digitalized society cannot be maintained without stability in the power sector.
 Nevertheless, the power sector is currently facing several challenges which are not limited to a single country but are similar among many of the advanced economies. It is worth looking into actions that would be necessary and appropriate for all countries.
 Belief in the laissez-faire of the day-ahead market to resolve everything is becoming outdated. New policy interventions and systems are required.

<Main Points>

  • Stability of power is becoming a new element of energy security.
  • Demand for power is growing after decades of remaining flat.
  • Decarbonization of the power sector is the key to the success of the global energy transition.
  • The intermittency caused by renewable energies must be dealt with.
  • New challenges require new approaches to the power sector.
  • New system to ensure investment in dispatchable power is necessary.
  • Zero-carbon baseload power generation is required.
  • Enhancement of the grid capacity must be accelerated.
  • Demand side management needs to be explored.
  • Comprehensive strategies are needed for the power sector.

  • 1. Stability of power as the new element of energy security

    In our highly digitalized society, it is hard to imagine a world without electricity. We already struggle to spend one day without electricity. As we push forward with electrification, any future interruption in power supply would have grave economic and societal consequences.
     We have traditionally considered the stability in the supply of oil and gas as the core elements defining energy security. It has most often been related or limited to the Middle East situation.
     With the growing importance of electricity, we now have to consider stability of power supply as part of our new definition of energy security in addition to the resilience of supply chain of critical minerals and clean energy technologies. This new energy security is already at risk because the power sector faces at least three major challenges. We need to consider new approaches.

    2. Challenge 1: Strong growth in power demand

    For the past two decades, the demand for power remained relatively flat in many advanced economies. Slow economic growth and improvement in energy efficiency have been the factors behind the sluggish demand.
     The era of flat demand growth appears to be ending and power demand is growing in many advanced economies. The best example of growth may be in Texas where its Independent System Operator (ERCOT) is expecting a doubling of peak demand for electricity in the next five years. Higher power demand for data centers, triggered by AI, the acceleration of electrification, led by the shift to EVs and heat pumps, and a growing demand for industrial activities, resulting from reshoring, are all contributing to an increase in power demand. In addition to an expected strong inflow of companies and people moving into Texas, the region will experience a further demand growth triggered by the production of green hydrogen and by data mining for cryptocurrency.
     There has to be sufficient supply capacity expansion to meet the strong demand growth.

    3. Challenge 2: Decarbonization of the power sector

    To realize carbon neutrality, decarbonization of the power sector is essential. In fact, the G7 Leaders have pledged to decarbonize the vast majority of the power sector by the mid-30’s. More renewable energies will be deployed and nuclear power will expand in countries which choose to do so.
     While unabated thermal power generation capacity using fossil fuels needs to be replaced due to decarbonization policies, the process must be managed carefully to ensure stability in power supply. A disorderly transition may lead to disruptions in supply.

    4. Challenge 3: Need to deal with intermittency

    With the deployment of more renewable energies, especially the variable ones such as solar and wind, the potential for intermittency of power generation will substantially increase. As the supply and demand must be balanced at all times to ensure stability of the power system, the growing intermittency will become a very serious issue. The balancing will be more difficult to achieve if fossil fuel power plants are retired due to decarbonization and competition. There will be less dispatchable power to offset the intermittency.
     On March 22, 2022, the greater Tokyo area came very close to experiencing a blackout due to a shortage of power. In combination with several other factors including the reduced reserve capacity, a cloudy day caused the loss of nearly 13 GW of solar power capacity on that day. The issue of intermittency will become even more serious as more variable renewable energies are deployed.
     A cold winter storm in February 2021 paralyzed the power supply in Texas. The situation was aggravated by cloudy days which led to the loss of solar power generation while freezing rain disrupted generation from wind turbines.
     In contrast to increasing intermittency on the supply side, the growing demand led by data centers requires a steady 24/7 power supply. There will be a premium for stable baseload power supply.

    5. A new system is needed to respond to the new challenges.

    The current power market structure of many advanced economies was designed when the demand growth was weak, when the power reserve ratios were sufficient, and when gas turbines were the main source of additional supply capacity available on relatively short notice. The power market was liberalized to depend on the day-ahead wholesale power market with the expectation that the market can contribute to ensure stability of supply and demand. The assumption was that the signals from the day-ahead power market would ensure sufficient investment in gas turbines to stabilize the supply and demand.
     With decarbonization, the power market is becoming dominated by renewable energies which are subject to almost zero marginal cost. On the other hand, the higher variable costs of the thermal power plants are causing their market share to drop substantially forcing many into retirement. Only a limited number of fossil fuel power plants have been newly invested with the consequence that there seems to be insufficient dispatchable power to deal with the growing intermittency. We need a new system to respond to the new challenges.

    6. Action 1: Investment in dispatchable power

    As a result of the expansion of renewable energies with nearly zero marginal costs, it has become more difficult for dispatchable power, such as thermal power generation, to recover its fixed cost through the power markets. This has substantially reduced the incentives to invest in dispatchable power. As we expand renewable energies to decarbonize our power sector, we also need to ensure the long-term financial stability for developers and investors in dispatchable power.
     To address this structural problem, Japan has initiated a new system named “Long-term decarbonization power source auction”. The system guarantees the recovery of fixed cost for 20 years for qualified power sources including gas fired power plants, pumped hydro and batteries among others. Gas fired power plants need a plan to eventually decarbonize their operations by switching fuel to hydrogen/ammonia. The new system, however, requires the operators to return 90% of the profits realized through the operation of the power plants while it does not compensate for losses which can only be carried over to offset future profits.
     The results of the first auction have recently been announced. The gas fired power generating capacity that was awarded came very close to the planned capacity, while bids for battery power storage capacity were four times larger than the eventual awarded amount. Overall, the new system seems to be satisfactory for securing capacity for dispatchable power.
     But looking into details, there are potential problems. Shortly after being awarded the support under the new system, JERA, the world’s largest thermal power generator, suggested delaying its decision to construct two gas fired power plants. The company is citing uncertainties surrounding the operation of those plants.
     Most of the operators that were awarded support for the batteries are not well known in Japan. There are concerns about their reliability as suppliers of power during intermittency while they may choose to charge and discharge their batteries only when they are certain that it is highly profitable.
     It seems that the new system requires reform to achieve its original objectives.

    7. Action 2: Investment in zero-carbon baseload power generation

    With the larger intermittency resulting from a growing deployment of variable renewable power, there is a stronger need for stable baseload power generation. For the decarbonization of the power sector, such baseload power generation must be zero-carbon. The growing power demand for data centers which requires a 24/7 stable power supply, is adding to the absolute requirement of a zero-carbon baseload power generation. There are several good candidates for zero-carbon baseload power generation.
     Hydro Power is certainly the first good candidate to come to mind. The challenge is that the best locations have already been developed and there remains a limited number of available locations for new hydro power, especially in the advanced economies.
     Geothermal energy is another candidate. With the introduction of “enhanced geothermal power” utilizing fracking technologies, the available locations for geothermal power generation are expected to increase substantially.
     The third candidate is nuclear power. There is renewed interest in nuclear power especially with the potential of SMRs, small modular reactors, which is expanding the possible locations for installing nuclear facilities. For example, SMRs may be constructed to support data centers and can also be used to supply power to the emerging economies with modest size of economy and power demand. The challenge for nuclear power is the financing. The huge amount of funding needed to cover upfront costs and the long-time horizon have deterred new investment in the advanced economies. The RAB, the Regulated Asset Base, introduced in the UK guarantees return for the investment and starts providing cash even during construction. As the RAB could be an acceptable model, the Japanese Long-term Decarbonization Power Source Auction system could be improved by incorporating some of the features of the RAB to finance nuclear projects.

    8. Action 3: Investment in the grid

    Factories producing grid related equipment, such as transformers, are now operating at near full capacity globally. The vast deployment of renewable power is leading to massive grid investments not only at the distribution level to connect the distributed power sources, but also at the transmission level to connect the remote areas rich in renewable power sources, such as solar and wind resources, with power consuming centers within the region.
     There is also a need to strengthen interregional transmission lines to connect different regions to help address the intermittency problem, as different regions may have different weather conditions.
     But with all those reasons to further expand the grid, investment may not materialize in a sufficient and timely manner. Permits generally take time and acceptance by the local communities is not easily granted. Acquisition of land also takes time.
     The economics are not favorable and the long construction periods do not help. Achievement of higher rate of utilization of the grids may require time before building sufficient flow or could stay at a low utilization level if used only for occasional balancing. A mechanism to recover costs must be established, especially for interregional transmission lines.
     The Japanese Government has announced a “Master Plan” to construct long distance transmission lines. The Government has introduced a mechanism to recover the cost for interregional transmission lines which, in addition to charging for the use of the transmission lines connecting adjacent regions, includes collecting a nationwide charge for all users of power. The fee will be collected on the grounds that such transmission lines help expand the use of renewable energies. For specially designated strategic long distance transmission lines, part of the collected fees will be paid in advance during the long construction period to help finance such projects. But while the mechanism is already in place, the huge price tag of those transmission lines is attracting attention.
     There is also a need to utilize the existing grid at its maximum potential when there is available capacity at any given moment. Policies must be introduced to make the shift from conservative and fixed level use of the grid to flexible and dynamic use of the grid. Japan has recently made this policy change. It is now time to utilize the power of AI to make the existing grids smarter and to maximize their use.

    9. Action 4: Demand side management

    Just adding capacity to meet the growing electricity demand is too costly. Efforts on the demand side can offer cost-effective solutions. For example, if peak demand can be reduced (peak shaving) by shifting some of the load to off-peak hours, the investment to expand capacity for power can be reduced. If demand can be created when there is an abundance of variable renewable power, during a particularly sunny day or when the winds are strong, and if demand can be reduced when the renewable power generation drops, renewable power could be utilized more efficiently. Effective use of batteries could amplify the potential of demand side management.
     This concept of demand side management has been around for a while but its actual scale has been modest in many countries. Several impediments must be overcome. Power rate menu to incentivize demand side management must be widely introduced. Demand-Response ready appliances must be widely introduced to cope with the needs for turn-up demand and turn-down demand. Smart meters with the necessary communication function must be deployed. Distribution network must be expanded physically or made smarter to absorb the flow of electricity from the end users. Aggregators must be able to have access to the data of the users and the distribution networks. Aggregators must also be able to make profits from the frequency markets by supplying the necessary power to stabilize the grid.
     In addition to shaving the peak demand, efforts to be more efficient in the use of power are essential. In particular, making data centers more efficient in their use of energy is urgent.

    10. Comprehensive strategies for the power sector

    Since 1973, when the world experienced its first oil crisis, various strategies have been put into place to enhance energy security, especially for oil and gas.
     Now we need to address a new definition of energy security by ensuring the stability of the power supply and demand. This will require a set of comprehensive strategies, including reform of the power market, regulatory reforms, and wider use of AI. Compared to the dynamic IT sector, the power sector has been considered relatively dormant. However, further digitalization must be accompanied by comprehensive strategies in the power sector. The power sector is now in the spotlight.