The Energy Security Board's (ESB's) advice to Energy Ministers is that the existing energy-only price signals are no longer enough to deliver the required level of firm capacity to ensure reliability of supply in the National Electricity Market (NEM). The ESB recommends a longer term capacity price mechanism, plus immediate reforms aimed at reliability and a more orderly retirement of ageing generation.
The ESB's recommendation for a capacity mechanism follows significant stakeholder concern from some parts of the energy sector over the need for, and costs of, reform. Despite the lack of consensus within the industry, the ESB says explicitly valuing capacity will enable market participants to provide the required resource adequacy (reliability), and reduce the need for States to intervene in the market unilaterally.
Detailed design work to come – but we have the 'straw proposal'
The ESB has outlined its preferred design elements for a capacity mechanism through a detailed 'straw proposal' of a certificate-based (physical) Retailer Reliability Obligation (RRO). Under the largely decentralised model, retailers (and 'opt-in' large customers) would bear the compliance burden and forecasting risk. Importantly, the ESB has also:
- committed to ongoing consultation in the design settings of the capacity mechanism; and
- acknowledged there is work to be done to understand the costs and benefits of the mechanism.
New Immediate Reforms for Resource Adequacy (Reliability)
While consultation on the capacity mechanism continues (over the next 18 months), the ESB has recommended some immediate reforms focussed on State-specific tools and existing market mechanisms. These were not previously canvassed in the ESB's April options paper. They are:
- providing all State Energy Ministers with the power (in addition to the Australian Energy Market Operator) (AEMO) to trigger the current (financial) RRO (described in more detail in Table 1), which is the same power the South Australian Minister currently enjoys; and
- creating a Jurisdictional Strategic Reserve (JSR) enabling States to procure power reserves beyond the current reliability standard for the NEM. This JSR would become part of the Reliability and Emergency Reserve Trader (RERT) portfolio under AEMO's control.
In addition to these actions, the ESB has recommended:
- the adoption of common investment principles for States for underwriting new investment in the sector (e.g. renewable energy zones, renewable generation, transmission), or delaying thermal generation exit through orderly exit management contracts. The ESB recognises, from recent experience, that the States will act unilaterally to manage local political risk associated with these matters but is looking to encourage commonality of approach; and
- increased information provision around mothballing and seasonal shutdowns of generating units through existing Medium Term Projected Assessment of System Adequacy (MT PASA) processes.
Why is change needed?
The ESB has concluded that, without change, the existing market and regulatory arrangements are unlikely to deliver an efficient mix of dispatchable capacity into the future. It says the market must change to address the range of uncertainties facing investors and the States.
The ESB has concluded that, over the medium term, the reliability standard of the NEM will be met and that the RERT can manage near term challenges.
However, the ESB considers longer-term reliability will be dependent on participants and jurisdictions having sufficient confidence in the market and its revenue streams so that:
- existing market participants have sufficient commercial incentives to keep the existing plant in the market;
- new market participants in replacement technologies have the confidence to invest; and
- the States have confidence that the market will deliver sufficient dispatchable generation to meet demand, reducing intervention in the market.
It sees a capacity mechanism as an "investable" and long term signal to achieve this, where an energy-only market (with the current market price cap) no longer can.
Immediate reforms
The immediate reforms are focussed on giving the States specific triggers and tools based on existing market mechanisms (e.g. RRO and RERT). They also seek to establish common investment principles when the States do intervene in the market, for example underwriting new investment or delaying exit of existing firm generation. By leveraging existing market mechanisms and increasing transparency and consistency around State intervention, the ESB hopes to maintain a strong foundation for a future capacity mechanism.
To assist with managing the exit of existing firm generation, the ESB has recommended increased information provision around mothballing and seasonal shutdowns to support notice of closure requirements. This will involve changes to require generators to:
These changes provide transparency around unit availability beyond the current information provided by MT PASA.
Some other changes that were canvassed in the ESB's April options paper were ultimately not recommended by the ESB. This was due to stakeholder opposition as well as the ESB's view that the policy objectives of managing an orderly transition could be met through a combination of existing processes, making it unnecessary for additional costs and regulatory burdens to be incurred by participants.
Next-stage reform: the capacity mechanism
The ESB seeks in-principle support from Energy Ministers for a capacity mechanism to be developed over the next 18 months.
It has outlined a 'straw proposal' as a starting point for detailed design work. The starting point is:
- AEMO would identify reliability risk periods on three-year horizons.
- AEMO would assess and certify resources (generators, storage, demand response) for their eligibility to create 'capacity certificates'. This would be technology and fuel neutral.
- Retailers (and large customers who 'opt-in') would need to hold sufficient 'capacity certificates' to cover their actual share of peak demand in the reliability risk period.
- The obligation would be ongoing. However:
- compliance reporting would only occur when a reliability shortfall occurs in the identified reliability risk period; and
- the 'capacity certificates' would have a vintage relating to a specific period of reliability risk (for example, after 4pm on February weekdays).
- The forecast risk would sit with retailers as to the 'capacity certificates' they acquire depending on their assessment of the reliability gap materialising. Being 'short' in the case of a reliability shortfall could expose a retailer to significant compliance costs, as well as partially funding AEMO's RERT procurement.
The ESB says the certificates will specifically value capacity. In turn, investors can derive certainty from revenue streams by selling certificates to liable entities in circumstances where energy-only price signals would not provide that certainty.
Table 1 provides a snapshot of the current RRO and the proposed capacity mechanism, based on what we know so far.
What's been left on the table?
The selection of design settings for a capacity mechanism, and building consensus on the need for such a mechanism and its settings, will remain a challenge. Further work on the costs and benefits of the capacity mechanism needs to be undertaken, including impacts on consumers (large and small).
The ESB has also left open the possibility of retaining the current financial RRO and tightening the definition of the types of financial contracts that would 'qualify' as wholly or partly supporting 'reliable' supply, to ensure better linkage to physical resources underpinning the financial contracts.
What can you expect if you are a resource provider or retailer
In the immediate term, generators will face some increased information provision obligations as part of MT PASA.
Retailers and generators should also be aware RRO triggers may be expanded to State Ministers. Generators with Market Liquidity Obligations (MLO) may need to ensure a compliance strategy and systems are in place to commence "market-making" on short notice.
At this stage, all of the design elements of a capacity mechanism, and even fundamental structure, remain up for grabs. Table 1 provides a snapshot for now, but elements may well change. Stakeholders should remain engaged with the process.
The ESB's recommendations will impact a range of market participants, and ultimately consumers. We will keep you informed of developments as they arise and offer you tailored insights and assistance along the journey.
