Tatsuya Terazawa Chairman and CEO The Institute of Energy Economics, Japan
Message for June 2025
<Main Points>
1. Japan’s liberalization of its power sector
Japan has been liberalizing its power sector since the mid-1990s, starting with the liberalization of its wholesale power market in 1995. The retail power market has been gradually liberalized since 2000, with full retail liberalization implemented in 2016 following the Fukushima nuclear accident in 2011. As a result, power generators and retail power suppliers participate in the wholesale power market to determine the pricing of electricity. It was widely believed in Japan that we were following the global trend to liberalize the power sector and to rely on market mechanism.
2. Near blackout in 2022
On March 22, 2022, the region supplied by TEPCO, the Tokyo Electric Power Company, came close to a blackout due to the shortage of power supply. The Minister of METI, responsible for energy, had to appeal to the public that day to reduce power consumption by both industry and households. There was an unfortunate combination of multiple factors. The day was unseasonally cold, resulting in surge of power demand for heating. Many nuclear reactors were still offline since the Fukushima nuclear accident. A mid-scale earthquake a few weeks before had paralyzed some thermal power plants. It was also a cloudy day, reducing power generation from solar PVs to near zero.
3. Lack of incentives to maintain/expand power generation capacity
On top of the factors described in item 2, the power industry had stopped investing in new power generation as conventional power, thermal power in particular, had been losing to renewable power in the wholesale market. Many older, less efficient thermal power plants had been decommissioned as well. It was difficult for conventional power with significant variable costs to compete with renewable power with minimal variable costs. Incentives were not there to maintain or expand power generation capacity.
4. Capacity market was introduced with limited impacts
As the Government of Japan had been aware of this challenge even before the near blackout, it had already introduced a capacity market in 2020 to ensure that there would be sufficient capacity to meet the power demand. The capacity market was designed to secure a predetermined scale of power generation capacity in a certain year through an auction which will take place four years before the specified year of power supply. OCCTO, the public entity established to coordinate the nationwide power balance, was commissioned to collect the cost to pay for the investment through the capacity fees charged to retail power suppliers. Rather than depending solely on the wholesale power market, which was balancing the demand and supply of power one day before the target day, it was hoped that this four-year time frame and payment assurance would lead to sufficient investment to maintain and expand the power supply capacity. Unfortunately, the four-year time frame was too short for investment in new power generation capacity. Assurance of payment for just one year was also not sufficient for power companies that usually recovered their investment over 20 years. The result of the first auctioning of the capacity market, conducted in 2020 with the target year of 2024, made it clear that the capacity market would not resolve the concern about the shortage of power supply capacity.
5. Introduction of the Long-Term Decarbonized Power Source Auction
To address the weakness of the capacity market, a new system was introduced by the Japanese Government in 2023. It was named the Long-Term Decarbonized Power Source Auction (LTDPSA). The system assured the recovery of the fixed costs for 20 years after the operation of qualified power generation facilities. On the other hand, 90% of the profit generated through the operation had to be paid back to OCCTO, which manages the system. Any losses from operation had to be assumed by the power generators. The cost to support the fixed cost was designed to be recovered through fees charged against the retail power suppliers. Each year, OCCTO, under the guidance of the Government, would determine the scale of capacity that would be secured through the auction system for each type of power generation. The target facilities included thermal power plants utilizing 100% hydrogen/ammonia combustion as well as hydrogen/ammonia cofiring. Hydro power and other renewable power sources were also part of the system. For solar PV and wind power, however, it was widely understood that they would be developed using the FIP (Feed-in Premium) mechanism. Energy storage, including pumped hydro and batteries, was also included. To address the urgency of a shortage of power capacity, gas fired power plants were also included as a short-term exception, based on the pledge that they would be eventually decarbonized using hydrogen/ammonia or CCS. The results of the first auction came out in April 2024 with mixed outcomes. Batteries received the highest interest by far. A reasonable number of investments were secured for gas-fired power plants, reflecting the need to expand dispatchable power generation capacity as soon as possible. But for other types of power generation, the results of the auction were unimpressive.
6. The results of the second auction
Improvements were made after the first auction. Investment for safety enhancement of nuclear reactors was added. Fixed cost elements associated with the use of hydrogen/ammonia were added to the assured recovery mechanism. The results of the second auction were announced on April 28 this year. Three nuclear reactors expecting restart in the near future received awards. Batteries continued to receive very strong interest. But there was just one project of cofiring with ammonia that received the award. In fact, there was only one cofiring project that applied for support. It was also a disappointment that the auction did not result in much additional supply capacity in the Tokyo area where the supply capacity is most insufficient.
7. Improvements towards the third auction
Analyzing the results of the second auction, the Japanese Government is already suggesting further changes to the auction system, which is expected to be conducted early next year. The rate of return for batteries is expected to be lowered from the current 5% to 4%. On the other hand, the rate of return for power sources with long lead times, such as those using hydrogen/ammonia, is expected to be raised from 5% to 6%. The cost of hydrogen/ammonia is expected to be covered up to 40% capacity utilization. The ceiling of support for hydrogen/ammonia usage is expected to be raised. For example, retrofitting to cofire ammonia at levels higher than 20% will be covered by the support system up to 378,000 yen per kW per annum. This would be significant increase compared with the 100,000 yen ceiling in the second auction and the 74,000 yen ceiling in the first auction.
8. Points for interest for international readers
For international readers engaging in hydrogen/ammonia, the improvements in the LTDPSA should be closely followed. While the CfD (Contract for Difference) by the Japanese Government is widely known, this auction system could have an equally important role in the development of hydrogen/ammonia use. By providing a favorable support system, power companies in Japan would be more incentivized to retrofit their power plants to cofire with hydrogen/ammonia. They may decide to construct new power plants fully dedicated to hydrogen/ammonia combustion. As the cost of hydrogen/ammonia would also be covered up to a ceiling, the auction system could provide policy support to introduce hydrogen/ammonia beyond the CfD, which has limitations due to budget constraints of three trillion yen (roughly $20 billion) pledged today. Even for the international readers not directly associated with hydrogen/ammonia, the evolution of policies in Japan to ensure sufficient power generation capacity could offer valuable lessons for designing power markets in their respective regions. The basis for pursuing power sector liberalization and dependence on simple market functions must be reviewed in light of variable renewable power with minimal variable cost and intermittency dominating the wholesale power market. I believe that a complementary mechanism to ensure investment in dispatchable power generation capacity must be explored. The need to decarbonize the power generation sector would also require a complementary mechanism, especially when the use of hydrogen/ammonia is considered as an option. I would like to follow up on this issue of power market design under the energy transition in future Messages. Experience and insights from global readers are highly welcome.
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