MICHAEL LAMBERT. An Update on the National Electricity Market and the National Energy Guarantee.

Mar 29, 2018

The Council of Australian Governments (COAG) Energy Council meets in the second half of April to consider a report from the Energy Security Board on the proposed initial design of the National Energy Guarantee which seeks to address both emissions reductions and improved reliability in the National Electricity Market.

Back in June 2017, the Finkel report was released which sought to address the policy trifecta for the electricity market of improved reliability and security, lower emissions and affordability. The report was sound in its analysis and its recommendations and there was general support in government for its approach, with one major exception. The conservatives of the Federal coalition could not stomach the recommendation of a Clean Energy Target, continuing their climate wars. However, the Energy Security Board(ESB), which was created based on a recommendation from Finkel saved the day with an alternative scheme, a National Energy Guarantee(NEG), announced in October 2017, which cleverly integrated into one framework the targeting of emissions reductions and improved reliability. In the second half of April the COAG Energy Council meets to consider the recommendations from the Energy Security Board on the preliminary design of the NEG which will require the approval of the Commonwealth and all members of the National Electricity Market, namely NSW, Victoria, Queensland, South Australia , Tasmania and the ACT. So, what is the guarantee, what has happened to date and what are the key issues to address?

Update on the NEM 

Before I cover these questions, let us consider the state of play of the NEM. The ESB has produced its initial  The Health of the National Electricity Market Report, the production of which is an outcome of the Finkel report. At the outset it acknowledges that the state of health is poor:

“The NEM is not in the best of health. The immediate symptoms are a power system where reliability risks are increasing, electricity bills are not affordable and future carbon policy is uncertain”. 

So much for the Government’s policy trifecta of reliability and security, affordability and emission reductions. There are certainly challenges that need to be addressed which are highlighted in the ESB report including:

  • The reduction in the level of dispatchable power which is provided by coal, gas, hydro and diesel generation and by hydro and battery storage.  Continuing uncertainty about Australia’s emissions policy combined with flat demand has discouraged investment and hence reduced the reliability of the system. Reliability is the ability to match demand with supply in a flexible manner. There is a need for more flexible, dispatchable power which does not mean new coal plants which are not readily dispatchable.
  • The security of the system has been adversely impacted in the transition from fossil-fuelled power to renewable power. Security is the ability of the system to quickly recover from adverse events and continue to produce electricity to the required quality and level. Coal, gas and hydropower plants have spinning generators that are synchronised to the frequency of the power system and this “synchronous” generation provides security and stability.  This is not an argument for not transitioning to renewable power but of accessing this security and stability by other means such as large-scale batteries, synchronous condensers and pumped hydro plants and contracting for the ability for very fast injections of power. Work is proceeding in this direction based on the recommendations of Finkel.
  • Transitioning the transmission and distribution system (the poles and wires) to reflect a more distrusted and diverse generation sector. The poles and wires were designed to transport power from a concentrated area of large scale coal fired generation such as the Hunter and La Trobe Valleys to areas of demand. The renewable energy zones, where sunlight, wind or pumped water sites are plentiful are not where coal generation and transmission links are. This challenge has been usefully described in a recent Grattan Institute report.
  • Establishing an effective and efficient approach to driving emissions reductions in the electricity sector while maintaining reliability and security.

All of this points to the essential need of an energy strategy and plan, as identified by Finkel, which is the responsibility of the COAG Energy Council.

Update on the NEG

In the meantime, the ESB is progressing the development of the NEG which seeks to integrate and address improved reliability and reduced emissions in the electricity sector and may contribute to a modest reduction in electricity prices. The NEG does not address system security which is the ability of the system to recover quickly from adverse events which is being addressed through other avenues.

In an earlier post back in October I provided a qualified but nevertheless positive assessment of the NEG which I concluded was in principle superior to what it displaced, the Clean Energy Target, though inferior in regard to an emissions reductions approach than a cap and trade emissions scheme which applies across the entire economy.  The guarantee works by placing an obligation on retailers and large registered customers operating in the NEM to ensure that the electricity they contract for with generators is reliable and the emissions produced consistent with the emissions reduction target.

Reliability of a power system is the ability to produce sufficient electricity to meet demand. The reliability requirement is established to ensure there is every likelihood that there will not be a deficiency in the supply of electricity relative to demand over the forecast period. Retailers are required in contracting to ensure there is an adequate level of dispatchable capacity generation, that is capacity that can be quickly called on to meet any surge in demand or cover a deficiency in supply. The market operator, the Australian Energy Market Operator(AEMO), undertakes and publishes annual forecasts of electricity supply and demand over a ten-year rolling period for each of the regions of the NEM. The purpose is to identify and gap between supply and demand in the market over the forecast period. The gap and the level of contracting to achieve the reliability standard will be determined by the Reliability Panel at the Australian Energy Market Commission, the standard setter for the market.  If a deficiency is identified in the forecast supply relative to demand, the AEMO looks to the market to develop sufficient capacity to close the gap. If it looks like the gap will not be closed in a timely manner, this will trigger the reliability guarantee for retailers to contract for capacity to eliminate the gap. The capacity can be either fast response, dispatchable power provided by generators such as hydro or gas plants, batteries or demand responses whereby contracted customers have their loads reduced if there is excess demand.

The emissions requirement differs in that it is an ongoing requirement to achieve targeted reductions in emissions generated by the electricity system. What is proposed is that the Commonwealth Government will set an emissions reduction target for the electricity sector, consistent with its international obligations for achieving emissions reductions for Australia as a whole. Under the Paris Accord on climate change member countries agreed to set a requirement to achieve reductions in emissions globally that will stabilise increases in global temperatures at not greater than 2 degrees Celsius and ideally at not greater than 1.5 degrees. Targets were agreed with each member country for reductions in emissions for the period to 2030 relative to the base year of 2005. The Paris Accord requires that the targets set by each country are reviewed in each five-year period in line with the ongoing requirement to limit the extent of global warming. The next review is in 2020.

Australia nominated a relatively modest target of reducing emissions by 26-28% by 2030 relative to the 2005 level. As an aside it is unlikely that Australia will achieve even this modest target without changes in policy and approach, noting that since the abolition of the carbon tax, which was designed to morph into emissions trading scheme, emissions have started to increase.

The National Energy Guarantee has several helpful features, namely:

  • It would for the first-time energy and climate change policy are integrated which in the past have been treated as separate matters
  • By establishing a longer-term target for reducing emissions in the electricity market in a way that is technologically neutral it will provide much-needed certainty for investors in the electricity sector, noting that the current Renewable Energy Scheme, which currently provides incentives for renewable energy generation, will cease to fund additional incentives from 2020.
  • Provides a market- based approach to achieving reliability and emissions reductions which in principle should achieve the lowest cost solution.
  • It is projected by ESB to increase contracting in the wholesale market, as distinct from spot market purchases, increasing liquidity in the contract market which could reduce wholesale electricity prices relative to what they would have otherwise have being.

In February the Energy Security Board released a consultation paper seeking input and views on the design of the NEG with submissions due by 8 March. It has received a substantial number of submissions- I counted 144 on the website. The submissions have been made by a range of parties including market participants, environmental organisations, consultants, private citizens and academics, think tanks and government organisations. A paper setting out the design of the NEG will go to the COAG Energy Council in April and, if approved, the ESB would then develop the detailed design of the Guarantee, in consultation with industry. The detailed design would then be submitted to the Energy Council in mid-2018 for approval, followed by consultation on the instruments implementing the final design in the second half of 2018.

The intention is for the reliability requirement to start in 2019 while the emissions requirement would start in 2020 to replace the renewable energy target. The States and Territories are still able to set their own emissions reductions or renewable energy targets.

Certain concerns can be identified from a review of the submissions. I will highlight four of these.

First, the ACCC expresses in quite direct terms concerns about the potential impact of the use of retailer contracting on market competition and states that competition must be at the forefront of the design and not tackled, as the ESB indicates, once the design has occurred. The ACCC points out that the wholesale market, in which retailers, large users and generators trade and contract is highly concentrated resulting in higher wholesale prices. The ACCC is currently undertaking an inquiry into electricity supply and pricing which, in its preliminary report, has found evidence of insufficient competition in the retail and wholesale markets. The three gen-retailers (i.e., they are vertically integrated, owning both a retail business and generation capacity), AGL, Origin and Energy Australia, have about 70% market share in the NEM and 48% share of generation (greater than 60% in NSW, Victoria and South Australia). This dominance makes it difficult for non -vertically integrated retailers, having limited access to longer-term contracts with generators, to manage their risk exposure and hence reduces their competitiveness.

The ACCC is calling on the ESB to ensure the retailer requirements of the NEG do not reinforce the market dominance of the big three. Ideally, this would require gen-retailers not prioritising their own retailers over other retailers in contracting out generation. It is difficult to see how this can work short of organisational separation. The final ACCC report on competition in the electricity market goes to the Commonwealth in June 2018, the same timing as the final design of the NEG.

The second major issue is one that the Commonwealth and not the ESB has responsibility for and that is the setting of the emissions target. On this, both environmentalists and the major market players agree that the emission target needs to have a long-term trajectory and for it to be an ambitious target. All the indications are that these hopes will be dashed. The Commonwealth, inexplicably, has made clear that it will be set for the electricity market the same target that Australia signed up for the nation as a whole, that is a 26-28% reduction relative to the 2005 level of emissions by 2030.  The current Paris Accord targets set for countries are not sufficient to meet the target of limiting climate change to 2 degree Celsius and hence it is likely that at the 2020 review the targets will be increased.  In any case, Australia is unlikely to meet its current target by 2030 if it adopts the national target for the electricity sector, a point stressed by Tony Wood in the Grattan Institute submission to the ESB. The reason is that the electricity sector is responsible for 35% of total emissions and has the most cost-effective and realisable opportunities to reduce emissions relative to all other sectors of the economy. Furthermore, it is a key enabler for other sectors to reduce emissions. Converting to electricity powered transport will not make much sense if power is produced largely by fossil fuels.  As a broad benchmark, based on previous Commonwealth Treasury modelling, the target for the electricity sector should be about double that for the nation as a whole, that is a 50 to 60% reduction by 2030.

Delaying the transition to lower emissions will increase the cost and difficulty of the transition as well as risking more unfavourable environmental impacts if other countries follow the Australian lead. As pointed out by a number of the major participants in the electricity market, the key problem impacting on the market in recent years, adversely affecting investment plans, has been a lack of certainty about climate change policy. Setting a target which appears unreasonably low and is certain to be forced up in the five-yearly reviews of the Paris accord, is not a way to engender market confidence.

The third issue with the NEG is that while applying the reliability and emissions requirements to retailers can be made to work, subject to addressing the competition issue referred to above, the obligation sits more naturally with generators. The linking by the NEG of financial contracts to physical supply of electricity complicates the mechanism and may reduce liquidity and transparency in the contract market.

The final issue to note is that there is a lack of clarity in the relation between the reliability requirement and the role of AEMO with respect to its Reliability and Emergency Reserve Trader (RERT).  Each year AEMO undertakes a 10-year forecast of the demand and supply position in the market under a number of scenarios, covering each of the regions of the NEM. This is published and then AEMO seeks expressions of interest in each region of the NEM for dispatchable capacity and options to contract to reduce demand at short notice. This begs the question of the role of AEMO and its RERT relative to retailers in respect to the reliability requirement.

One other issue that is not as central as the others set out above is the treatment of what are termed Energy Intense Trade Exposed (EITE) activities. These are currently exempt under the Renewable Energy Target and the Commonwealth is considering exempting them from the impact of the emissions requirement. Given that the shift to renewable energy will reduce electricity prices it is not clear what is the logic of an exemption which will increase electricity prices for EITE activities.

It is to be hoped that the members of the NEM put considerable pressure on the Commonwealth on each of these issues, particularly on setting an appropriate emissions reduction target and a longer-term trajectory as well as ensuring that the NEM operates with an enhanced level of competition.Hopefully,Victoria, Queensland and ACT can broker a more sensible deal.

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

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