Pearls and Irritations

After a progression of schemes, such as the Emissions Trading Scheme (ETS), The Carbon Pollution Tax (CPT), Direct Action, including the Renewable Energy Target (RET) as well as dabbling with the Emissions Intensity Scheme (EIS) and the Clean Energy Target (CET) we have now being presented by those proud parents, Malcolm Turnbull and Josh Frydenberg, with the latest addition to the energy policy family, the NEG, the National Energy Guarantee. Will it work and how; is it better or worse than its alternatives; and what are the key issues to address if it proceeds?  

The story so far

The final Finkel report was released in June 2017 and sought to address the trilemma of energy reliability and security, emissions reductions in the electricity sector and energy affordability. The draft report had proposed for the objective of electricity emissions reductions, the adoption of the Emissions Intensity Scheme. This provided credits for reducing emissions released in the production of electricity. This was rejected by the Coalition’s conservatives on the spurious grounds that it was in effect a carbon tax.

The final report proposed a new mechanism to address emissions reductions and that was the Clean Energy Target. Like the EIS it provided credits for lower emissions but only for generators that emitted below a certain threshold level. It should have been obvious that if the conservatives rejected the EIS they would also reject the CET.

Since then the COAG Energy Council has accepted every recommendation in the Finkel report other than those dealing with emissions reductions. At the same time we had the panic that issued with the release of the AEMO report, 2017 Electricity Statement of Opportunities, which forecast short term potential electricity supply problems for the summer of 2018 and the three subsequent summers, though at a relatively low probability of occurring. Compounding this was the political reaction to the already long foreshadowed closure by AGL of Liddell coal power station with its replacement with renewable energy on the same site. This produced hysteria in both the coalition conservatives and our PM who even appeared to be considering nationalisation of Liddell.

Most recently we have been hearing various hints about the Government walking away from the CET and doubts about what if anything would replace it. Minister Frydenburg opined that given the falling cost of renewable energy there was no need for subsidies or other form of government support which completely missed the point that there was a need for both a target and a viable mechanism to drive emission reductions.

Enter the NEG

Yesterday  the PM released a statement committing the Government to accepting the recommendation of the Energy Security Board (ESB) for a new National Energy Guarantee targeting both emissions reductions and system security and reliability. The ESB is chaired by an independent, Kerry Schott, with another independent as the deputy chair and the other members being the heads of the AEMC, AEMO and the AER, the three regulatory and policy agencies for the electricity sector. The advice of the ESB is set out in a letter. In his press statement the PM highlighted that the NEG would deliver affordable and reliable electricity. No mention was made of lower reductions in the headline to the statement!

There is a strong irony in having the CET recommended by Finkel being replaced by the NEG, recommended by his recommended entity, the Energy Security Board. Nevertheless, Finkel has indicated support for the NEG, remarking that there is “more than one way to skin a cat”.

The first question to address is how is the NEG supposed to work and to what end?

The NEG is to operate by imposing two regulatory obligations on electricity retailers, these being:

1. Reliability guarantee 

This is an obligation for retailers to meet a given percentage of their load requirements with flexible and dispatchable resources, which means that the market operator can schedule these resources at short notice. In effect this provides a strategic reserve for the system, which is arranged by the retailers rather than centrally contracted.

The retailers can contract with generators that are able to supply flexible and dispatchable energy, which would include gas, hydro,biomass and batteries but not necessarily base load coal fired stations. Base load coal fired power stations do not meet the requirement of being flexible in that they cannot supply additional power at short notice. This is an implication that does not appear to have been picked up in the media or by coal industry supporters. In addition to contracting with suitable generators the retailers could contract with major customers to establish contracts to reduce demand at short notice or by remote control.

It is important that the reliability requirements are not politically driven. The ESB envisages that the reliability standards would be as determined by the Reliability Panel at the Australian Energy Market Commission (AEMC, which is the rule maker for the National Electricity Market). The Australian Energy Market Operator (AEMO, the operator of the wholesale electricity market) would then determine how the reliability standard is translated into an operating requirement in each region. Based on this framework retailers would enter into contracts with generators and major customers to have the capability to meet the reliability requirement in the guarantee.

2. Emissions guarantee 

The first step for the emissions guarantee would be for the emissions reduction target to be set by the Commonwealth, consistent with Australia’s international emissions reduction commitments. Consistent does not mean the same as, as will be made clear shortly. This in turn would be translated into a requirement for retailers to meet an emissions guarantee by obtaining supply of electricity at an average emissions level consistent with the emissions reduction target.

An interesting point here is that there will be a secondary market developed in emission reductions as those retailers with a surplus will seek to sell to those with a deficit. Hence a market in emissions reductions and hence in carbon will develop and a price emerge.

The policing of the two-pronged guarantee would be the responsibility of the market regulator, the Australian Energy Regulator (AER). The intention is to introduce the reliability guarantee by 2019 while the emissions guarantee would come into effect in 2020, the end date for any new projects under the Renewable Energy Target (the RET continues to 2030 for renewable generators that have approval by or before 2020).

The second question to address is how effective would the NEG be in principle relative to the Clean Energy Target in regard to emissions reductions?

There are some important issues about the design and implementation of the NEG that can affect how effectively it operates. These will be addressed as part of the next question. However, it is possible to come to an in principal view on how a well-designed NEG would operate relative to a well-designed CET.

The NEG should in fact deliver better and more cost effective results than the CET. As I identified in an earlier blog the CET is a third best approach to reducing emissions. First best are market based, whole of economy approaches such as Emissions Trading Schemes and carbon taxes while second best was the proposed Emissions Intensity Scheme. The major deficiency with the CET is that the EIS applies incentives to reduce emissions only to generators that operate below a certain emission threshold. Unless the threshold was set very high it would provide no incentives for owners of fossil fuel generators to lower emissions. There would under a CET be no incentive for a black coal generator to delay leaving the market in preference to the exit of a brown coal generator. This is not the case with the NEG which not only provides an incentive for lower emission generation to enter the market but also an incentive for lower (but not low) emissions generators to stay and invest relative to higher emission generators.

In addition the NEG does not rely on retailers purchasing certificates from generators and hence operates at a lower cost than the CET. The NEG relies on market incentives to propel retailers to select and contract for the lowest cost mix of generators that will meet their emission requirement.

Also the NEG has the benefit of integrating in the one mechanism the energy reliability and emissions reduction objectives which has being a major deficiency with the current RET mechanism.

Finally, the NEG has the flexibility to allow for changes in the emission reduction targets and the reliability requirements.

I suspect that the conservatives in the coalition did not appreciate these attributes of the NEG when the decision was taken.

It should also be noted that the benefits of using market-motivated retailers applies equally to the reliability guarantee where they are equally motivated to contract the most cost effective reliability arrangements.

However, there are some potential downsides to the NEG that need to be borne in mind in the design stage. A lot of misplaced emphasis has been placed by the government on achieving some level of reductions in energy prices. This is beyond the ability of any mechanism focussing on emissions and reliability to deliver as I make clear in the next question below. In the event that the actual price outcome is not in accord with the projection of a reduction in the price of the average bill of around $100 per annum, politicians being politicians ,may find themselves under pressure to tamper with the NEG mechanism to seek to deliver lower prices.

In turn this creates potential uncertainty in the minds of investors and market participants which can create barriers to investment and hence prove counterproductive to the success of the policy. Hence it is important that the policy mechanism is made tamper proof by legislating the mechanism by which the guarantees are put in place and ensuring that the energy agencies, AER,AEMO and AEMC ,operate completely independently.

The PM and others also made great play about the NEG being technology neutral and in one sense that is so in that the emissions and reliability mechanisms do not target particular technologies but only emission and reliability outcomes. However, a key point is that the fossil fuel technologies generate emissions which have an environmental impact and hence a social cost which does not reflect in the market price of the fuel and of the energy it produces. A first best approach would be to price the social cost of emissions but that is too much to ask for. The only consolation is that, as noted above, price for emissions will emerge in the market.

Third, does the NEG have the ability to achieve substantial savings in energy costs?

The PM made a big point of stating that the ESB estimates that typical household energy bills will fall by an average $110-$115 per year over the 2020-2030 period. This was taken up in the media as a key element of the proposal. However, the reality is this is the weakest aspect of the proposal, not relative to other alternative mechanisms to deliver reliability and emissions reductions but because energy prices are dependent on a host of other factors. For example, the recent hike in wholesale market and hence retail prices over the last year reflects the over contracting of LNG into the international market.

There can be no guarantees about the future course or electricity prices. What is more correct to say is that the NEG will deliver lower prices than alternative mechanisms to reduce emissions or increase reliability. As noted above, it is important that the Government does not oversell this aspect of the policy but rather state that the policy will have a favourable impact on prices relative to alternative policies and back away from a firm target of a reduction in bills. The actual price of energy is an outcome of a host of factors including the international price of gas, most of which are beyond the control of governments.

Finally then, what are the critical issues that need to be addressed to make the NEG a success?

The first critical requirement is to achieve bipartisan support for the NEG, which in fact was the major potential benefit of the CET. What federal Labor will need to understand is that the NEG can operate effectively in delivering emission reductions as well as improved reliability. In the event that Labor does not feel the emission reduction target set by the coalition is adequate it can quite easily adjust the target. However, the mechanism does not need to change.

Another critical issue is the level of the emission reductions target. There is a tendency for many to conflate this with the emissions reductions target committed to in the Paris Agreement. This is not correct. The first point to appreciate is that Australia’s target to reduce emissions by 26-28% by 2030 relative to the level in 2005 was part of a broader commitment to hold human-induced temperature increases to below 2 degrees Celsius and as close as possible to 1.5 degrees and for all parties to periodically review the commitment to ensure the target reductions are adequate to this broader task. The first review will occur in 2018. Hence the target is subject to variations over time in the light of the latest scientific evidence on the impact of climate change.

Even if we accept the 26-28% target for the time being, this is the target reduction for the whole economy. The electricity sector is the largest emitter, accounting for 35% of total emissions. Moreover, it has by far the greater capability to reduce emissions in a cost effective manner. Modelling by the Commonwealth Treasury indicates that the optimal reduction of emissions target for the electricity sector would be a multiple of two to three times the rate of reduction for the rest of the economy. It is just not possible to achieve the same level of emission reductions in other sectors as can be achieved in the electricity sector. Moreover, reductions in emissions that can be achieved in the electricity sector enhance the ability of other sectors to make emission reductions. A classic case of this is that lower emission intensity electricity produces lower emissions in the transport sector with the use of electric vehicles.

A third issue is the implications of the NEG mechanism for the market structure in the NEM. This links to the commissioned review by the ACCC on retail electricity prices. The ACCC found insufficient competition in the generation and retail market with an adverse impact on prices and barriers to entry. It argues that the market position of the large, vertically integrated entities that combine generation and retailing has been a key factor in reducing the level of competition. The NEM will in fact encourage a greater level of vertical integration and hence creates a conflict between the reliability and emission reductions achieved through the NEG mechanism and the objective of increasing the level of competition in the market and hence lowering prices.

A fourth issue is to ensure that the reliability guarantee and its associated requirements are set by the appropriate agencies, namely the AEMC and the AEMO and do not become a political tool. This is critical because any uncertainty about the integrity of the application of the policy will create a reluctance with investors and the energy market participants to commit to investment and undermine the objective of transitioning over time in an efficient and effective manner to a secure , reliable and low emissions electricity system.

In summary, while some of those who have supported its adoption in preference to the CET may see it as a way to allow for longer and larger involvement of fossil fuel in electricity production and lower electricity prices, it is in reality an efficient and effective mechanism to deliver the twin objectives of lower emissions and increased reliability. However, its integrity needs to be built into its design to ensure the certainty required by the market to make the policy a success in delivering its target outcomes.

Michael Lambert is a former Secretary of NSW Treasury, involved in the development of the National Electricity Market, former non-executive of Energy Australia and a director and senior adviser on health economics at the Sax Institute.

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