A high Market Price Cap plus a capacity mechanism is not “double dipping”

For several years the Energy Security Board (ESB) has been designing a capacity mechanism for the National Electricity Market (NEM), work which recently passed to governments.

Capacity mechanisms are common around the world, providing additional assurance regarding investment in reliable supply to meet demand, but always sit alongside an energy spot market that balances supply and demand from day to day. These spot markets look broadly similar to the NEM’s existing energy-only market design, and we will largely retain our 25-year-old energy market even if we introduce a capacity mechanism alongside it.

However, a question arises as to whether the presence of a capacity mechanism necessitates some change to the energy market’s design, particularly its pricing freedom. A change seems initially intuitive. We know that a high price cap is required to reward capacity in an energy-only market, so if capacity is rewarded outside this market, wouldn’t retaining a high market price cap be “double dipping”?

The AEC publishes today some excellent analysis prepared by CEPA economic consultants that shows there is no need to change the energy market, and “double dipping” won’t result. This is fortunate, because if the NEM were to make a major change to its pricing constraints, it would introduce a lot of operational complications that would require their own resolutions.

CEPA developed their analysis around the capacity market that the ESB were designing until the job was shifted to governments, however their line of thought can equally be applied to other capacity mechanisms, and potentially even that which is now operating in the Wholesale Electricity Market of Western Australia (WEM).

We take a brief look at the report.

Low market price caps drive the need for capacity mechanisms, not the other way around

One of the reasons it is often assumed that the NEM’s spot market price cap would be lowered in the presence of a capacity mechanism is because capacity mechanisms often exist alongside low energy price caps. This is certainly the case in the WEM.

But this confuses cause and effect. Many electricity markets, when they were introduced, decided against providing the pricing freedom the NEM has always enjoyed. An energy-only market is unworkable under a low-price cap, and so in those cases a capacity mechanism is essential.

But the reverse does not hold, indeed there are international examples of capacity markets operating alongside energy markets with relatively high price caps.

Despite multiple revenue streams the total should not go up

Suppliers will engage with a market based on the totality of the revenues they receive, which in turn determines what consumers pay. Many examples already exist, and CEPA cite returns to renewable generators from the combination of energy and renewable certificate revenues. Gigawatts of plant have already been invested that would not have been economic on one revenue source alone.

Indeed, we can even see this process happening from day to day. During times of supply surplus, renewable generators bid into the energy market at the negative of the certificate price and comfortably continue to generate even when they have to pay AEMO for the privilege. Thus, the bigger the certificate price, the lower the energy price, and vice versa.

A woody analogy

CEPA present an analogy of the price of wood planks and sawdust. Since a sawmill produces both, it can be expected that if one product’s price (planks) is persistently high enough to cover most of the mill’s costs, the other (sawdust) can be sustainably sold at a low price.

Figure 1: Analogy of an efficient market with by-products

Source CEPA Report

However, if we then attempt to cap the price of one product (planks), the market will adjust and the price of the other (sawdust) will go up. Collectively, consumers are not better off, and meanwhile the cap has distorted prices in both products away from their efficient levels.

Figure 2: Effect of capping one market with by-products

Source: CEPA Report

Some maths to back it up

Hopefully, by now the reader will be thinking “well that all makes perfect sense” and have identified their own examples. But, as economists are wont to do, CEPA have backed up this commonsense with some algebra. Page 28 describes a simplified model of an electricity market. CEPA have developed this within an Excel Spreadsheet that Energy Insider readers are welcome to download here and experiment with.

The simplified model does not pretend to forecast actual revenue streams at different price caps, but adequately demonstrates that we can be confident that double dipping will not occur.

Good news

CEPA’s invalidation of the “double-dip” narrative is a rare bit of good news for those involved in the thankless task of designing a capacity mechanism. This is because the NEM’s high price cap is relevant to more things than supply investments. It introduces financial risk into operations, which, for a reliability-critical product like electricity, is a necessary feature.

Generators contract with retailers to insure them against high energy prices. Having contracted, a generator’s greatest fear is that having struck these contracts, plant will fail at the critical time, and it will therefore make large contract payouts whilst not receiving spot income from the market. This fear is beneficial for the power system as it encourages generators to invest in the reliability of their plant for such critical times, which in turn underpins customer reliability.

However, if the energy market is capped to a low price, these risks and fears disappear, and the incentive to maintain reliable plant declines. In those electricity markets with low energy price caps, such as the WEM, an entirely different administrative penalty mechanism is employed to recreate an incentive to physically deliver. As performance and penalties are determined centrally, these mechanisms are challenging to design and controversial.

If governments wish to introduce any form of capacity mechanism into the NEM by the middle of this decade, then it would be more sensible to rely on the existing market price risks to reinforce performance incentives rather than to introduce a new administrative performance mechanism. Indeed, it may be the only practical approach in such a timeframe.

Conclusion

As capacity mechanisms continue to be contemplated in the NEM, there are discussions about whether consequential adjustments are required to the spot energy market. Some groups have rushed to an assumption that its price cap should be reduced. Their first thought is that absent this, capacity will get paid twice.

But CEPA’s bit of deeper thinking readily demonstrates that this is not the case. As happens in numerous markets, investment cases will hinge on the totality of revenue sources.

This is a welcome relief for the designers of a capacity mechanism. If the energy market’s price cap had to be consequentially lowered, a whole new line of reforms around administratively-determined capacity performance incentives would be required.