Reliable power at a reasonable price — is it possible and how?

Those interested in the development and progression of Australia’s energy policy looked on with interest in 2017 as the debate bubbled away.

The market for smart energy management is gaining momentum as businesses take control of their energy costs and renew their focus on energy efficiency, demand management and on-site generation.

On the policy front, things have moved a little slower.  While the Renewable Energy Target (RET) has achieved years of continued success and stability, Australia is facing an uncertain future in terms of reviewing and refreshing a comprehensive long-term national energy policy.

The Council of Australian Governments (COAG) Energy Council met in November to try and bring some clarity to the energy dilemma. The meeting was its first since the federal government announced its long-awaited response to the Independent Review into the Future Security of the National Electricity Market delivered by Dr Alan Finkel AO (Finkel Review). That government announcement in October decided against the Finkel Review’s proposal for a nationwide Clean Energy Target (CET) (despite accepting virtually every other Finkel Review recommendation), deciding subsequently instead to sponsor a National Energy Guarantee (NEG) as a successor to the RET which expires in 2020.

The COAG meeting deferred the decision on whether to adopt the government’s NEG plan until April 2018. The states, as expected, have asked for more modelling of the NEG by the new Energy Security Board (ESB). South Australia has asked for an explanation from the Commonwealth as to why a CET is no longer acceptable, asserting that a NEG would “stifle investment in renewables, extend the life of dying, inefficient and uneconomic coal power stations, and enrich the generators with the most market power”. To proceed, the NEG requires unanimous support at COAG. So, for now at least, it remains a waiting game for business and consumer. 

What is inescapable is that there is no such thing as free reliable and sustainable energy. The question now is whether we want to pay a little bit more for reliability and security of supply, or a lot more in wider social welfare costs due to an unreliable, insecure system.

Any potential solution will undoubtedly need to:

• reduce system and pricing volatility allowing business to predictably plan their energy costs;
• provide appropriate signals to facilitate rational investment in base load and renewables to meet future demand;
• stabilise the macroeconomic conditions necessary to maintain and attract sustained investment in energy and industry (both traditional and digital economies).

It is clear, in my view, alternative policy solutions have not been fully explored due to the nature of the National Electricity Market (NEM) and a failure to undertake a review or refresh of it in order to adapt it to the evolving demands of our society.

In simple terms, the current NEM (due to its lightly interconnected and sprawling network) permits material regional pricing differences based on regional characteristics. While this in itself leads to some disparity and volatility in the market, that volatility is exacerbated by two distinct characteristics — state and territory sovereignty and secondly, the NEM in Australia (unlike many other OECD jurisdictions) being an ‘energy-only’ spot market, in which electricity generators are paid for the energy they produce but not the capacity they make available. Both of these factors go to the heart of the reliability problem Australia now faces. As the contribution of renewable technologies to Australia’s energy mix continues to grow, the NEM in its current form presents challenges for successful and sustainable integration. For example, the current policy and contractual arrangements do not necessarily favour based load so having the appearance of favouring renewable energy. This, in fact, is the consequence of the energy only market. Ultimately, it disincentivises base load generators to stay in the market and deters market entry by new ones. Renewables, on the other hand, have had the benefit of the RET to sponsor their market entry. This results in a type of asymmetric system where the baseload necessary for a reliable and secure system is absent and that does not help the sensible development of renewables either.

There are two possible solutions (one proven and one prospective) and both have a common feature — a capacity payment mechanism.

I drafted the rules for the Irish Single Electricity Market (SEM). The SEM is basically like the NEM except that it included capacity payments as well as energy payments for generators. With capacity payments, generators get paid for being available and payments are set at a level to ensure that sufficient generation is available to meet demand so there is an incentive to stay on.

The Northern Ireland Authority for Utility Regulation (one of the SEM sponsors) outlined the following reasons for its decision to have an explicit capacity payment mechanism:

• Prices avoid the peaks of an energy-only pool.
• Provides a stable ‘bankable’ income that would help attract new entrants.
• The volatility, referred to above, would attract regulatory and political attention that would reduce confidence in the market from an investment point of view.

The move led to reduced system volatility, reduced rivalry between renewable and conventional sources of power and, ultimately, brought about a secure and sustainable energy system in Ireland. 

Businesses were able to operate with confidence knowing the lights will stay on; with pricing in the system so reliable, renewable energy operators were encouraged into the market (and not always with a subsidy).  In response to the concerns about generators abusing market power in bidding into the SEM, Ireland incorporated express prohibitions on generator authorisations and market rules against gaming or engaging in activity that would be an abuse of market power.

Other jurisdictions have recognised that theoretical approaches to the market, based on political sentiment one way or another, cannot be allowed to get in the way of energy security and reliability.  Alberta in Canada is a striking case given its similarities to Australia, both economically and industrially.  Alberta’s 2016 review of its wholesale electricity market surprisingly resulted in the adoption of a capacity market solution to facilitate an orderly transition away from coal generation. Like in Ireland, Alberta found that a capacity market for electricity would:

• reduce price volatility and market uncertainty;
• drive efficient use of the existing transmission system rather than building new transmission before it is needed; 
• ensure secure, sufficient electricity supply and provide investors with a stable revenue stream while preserving key market characteristics such as incentives that drive innovation and cost discipline.

The Finkel Review recognised the need to modernise the NEM to ensure an orderly transition to a reliable and low emissions electricity system and investigated capacity compensation. However, the review put a fundamental market redesign in the ‘too hard’ box as it was not within its remit to be so wide-reaching. 

This is why we now have the Australian Energy Market Operator (AEMO) looking at ways to ameliorate the current crisis, largely focusing on responses such as demand side management.  

And while the NEG helps too, it’s important to consider whether those remedies can be sustainably accommodated within a system crying out for a redesign.

What sort of redesign? Well, when we compare the justifications for introducing a capacity mechanism as referenced and Prime Minister Malcolm Turnbull’s recent statements, the similarities are stark. “The National Electricity Guarantee will lower electricity prices, make the system more reliable, encourage the right investment and reduce emissions without subsidies, taxes or trading scheme. It is truly technology-neutral, offering a future for investment in whatever technology the market needs — solar, wind, coal, gas, batteries or pumped storage.”

So, the NEG will do all the things that capacity mechanisms do, and electricity generators, through imposing purchasing pattern requirements on retailers, will remain available for dispatch based on regional demand. This goes beyond an energy-only market and begins to suspiciously look like a capacity payment mechanism.  In net terms, more baseload power will be guaranteed across the country but some states will undoubtedly face a requirement to source more emissions guaranteed power, ie, renewables. We won’t know until the regional numbers are crunched. Guarantees like these always carry a cost though — the question is who will bear the cost and where in the market will it be borne. Even though these guarantees are designed to shield against market failure, there are costs involved.

The next question is whether it will get through a NEM rule change process given the negative sentiment historically attached to such mechanisms in Australia? Or will it lead COAG to consider asserting more direct control by regulators instead of effectively being outsourced to the retailers?

Either way, the retailers must feel like the meat in the sandwich, between the NEM and the generators. There is no detail on how these guarantee requirements will be executed — via an auction, through bilateral contracting or a contract for difference?

Further, the ESB’s initial advice appears to be based on a normal, functioning competitive market in a relative state of equilibrium. This point is made as the ESB’s advice is based on a regionalised outcome with outsourced execution to retailers but pays no attention to the state of competition in each of those markets. For example, how will the scheme work in markets of high concentration and low contestability as against highly competitive markets? Is market behaviour so predictable so as to point unilaterally to a lower cost outcome in concentrated markets? Was the Australian Competition and Consumer Commission given the opportunity to review this advice?

Ultimately, the cost involved in introducing a capacity payment mechanism to the Australian market certainly seems less material when one considers the social and economic costs resulting from our failure, perceived or otherwise, to guarantee energy supply. 

While our energy mix is a policy decision, what everyone really needs is reliability at a reasonable price.

Image credit: ©stock.adobe.com/au/Simon Kraus