The falling cost of wind and solar generation is delivering more than 10,000MW of new renewable capacity to the National Electricity Market. Wind and now large scale solar PV are expected to oversubscribe the Renewable Energy Target by 2020.
These new generators are smaller and more modular than the coal fired generators that have anchored electricity generation in Australia for decades. This has the capacity to significantly reduce barriers to entry in the wholesale market, increasing competition and accelerating innovation.
To date a key barrier for renewable generation has been its intermittency, which means its owners have not been able to offer contracts to retailers in the forward wholesale market, where around 80 per cent of electricity is bought and sold (because they can’t guarantee when the wind will be blowing or that the sun will be shining). Contracting is a key risk management tool for both generators and retailers in the naturally volatile electricity market.
This is the main game in the electricity market. Until now, renewables generators have been dispatched first (because their output can’t be controlled; they also have the advantage of zero marginal cost of generation) but have been paid only the spot price when they generate.
Being able to sell renewable generation in the forward contract market by firming it with dispatchable generation is the critical next step as renewables play an expanding role in the generation mix.
Now new derivative products are emerging which may help solve this. AGL and ERM have both separately launched new derivative products designed to firm wind and solar generation respectively. The emergence of these products also highlights some important differences in the treatment of these different technologies.
AGL's Wind Product Firming Unit (WPFU) is a product available for wind generators in South Australia and Victoria. Using the reliability of AGL’s thermal generation portfolio, it allows wind farms to expand their market offering beyond vanilla power purchase agreements, and facilitates their participation in the broader wholesale energy market. Wind generators in those states can now enter forward swap contracts with AGL which guarantee supply for wind generators in the future when they are producing less energy than their forecast capacity. In other words, this enables wind generators to still honour a forward supply contract to counterparties even if the wind isn’t blowing. The top up supply is provided at the spot price.
This means the wind farm operator may still want to hedge the price risk, in case spot prices are high at that time and it needs to pay AGL for the volume it has hedged. Such hedging is a normal part of the current wholesale market.
While AGL has offered a volume swap for wind energy, ERM has introduced two products which offer price swaps for solar generators in Queensland, Victoria and NSW. The first product provides greater certainty about the value of electricity produced during daylight hours, for periods that broadly match the production profile of a single-axis tracking solar generator. The second product addresses the largely predictable need to cover the absence of generation from the approach of sunset to sunrise.
ERM’s solar profile product is focussed on the daylight hours of solar production. It pairs a monthly electricity swap with a forward settled large-scale generation certificate (LGC). The profile is based on a typical solar farm production and is wider in summer (longer solar production) and shorter in winter.
ERM thinks this is useful because it will improve price transparency for the periods that match typical solar generation. This derivative will improve detailed understanding of the value of electricity during daylight hours, which continues to change as more solar capacity is installed.
ERM’s solar firming product effectively provides a guarantee of electricity price during darkness. ERM anticipates that this enable a complementary hedging strategy for solar generators. Solar generators could sell flat, round-the-clock swaps on the open market, and buy back the solar firming product therefore leaving themselves exposed to pool prices for only the few hours that their solar generation does not correlate with the firming. This residual risk maybe mitigated through insurance strategies, battery storage, contractual agreements with peaking generation, or alternatively held on their books as an open risk position.
The emergence of these types of products will assist renewable generators in being able to sell electricity in the forward contract market, effectively by guaranteeing price protection at times when their intermittent generation is not expected operating. The ERM profile product is also expected to help the market value solar generation more accurately, which will reduce risk and therefore overall cost.
This significantly reduces the barriers for new renewable generators to enter the market, either as a hedge for a retail book, or to support demand from a larger industrial electricity user. If effective, this will be a significant development in the wholesale market. It will increase competition, reduce barriers to entry and accelerate greater innovation in the market.
Furthermore, through the sale of firming products, it provides a revenue source for those technologies, such as flexible generators, storage, and demand-side activities, that are physically needed to cover the natural gaps in the production of wind and solar.
These new renewable based generators will still need to manage price risk. This can be through additional contracting with other generators, using technologies like storage to cover their position at specific times or other insurance products available in the market.
Sustained falls in the cost of new wind and solar generation means that these technologies are now at the core of most new investment. In response to this change, participants in the National Electricity Market are innovating to extract more value from their existing assets while delivering value to the growing pool of new entrants in the market. This is exactly what markets are supposed to do.
The National Electricity Market was set up as an energy-only market precisely for this reason. These new products are likely to innovate further, and may find competition from other market participants over time. There are reports of intermediaries developing trading hubs between different generation providers to deliver similar solutions. The types of boutique solutions that emerge are likely to be far more elegant and efficient than any government regulation or rule.
These innovations have the potential to disrupt the wholesale market by enabling new entrants, improving price visibility, and introducing new ways of transacting between generators and customers. They may also restructure the commercial relationship between firm and renewable generators.
Disruption is one of the cornerstones of the success of Andrew Forrest’s Fortescue Metals Group. FMG’s ability to get things done in the face of seemingly insurmountable barriers can be illustrated no more vividly than when BHP and Rio Tinto sought to prevent the then start up iron ore miner from accessing its rail lines in the Pilbara. FMG built its own and outdid its rivals by extending those lines to Perth. Now FMG wants to apply the same zeal to energy and green steel.
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