NEG: Contracting to achieve compliance

A key feature of the proposed National Energy Guarantee (NEG) that has been emphasised by the Commonwealth Government and the Energy Security Board (ESB) is that no new intangible assets such as certificates or permits will underpin the NEG's operation. Rather, the NEG mechanism will focus on contracts, leveraging the current contracting practices in the market.

Contracts are just one of the ways proposed by the ESB that a liable entity (being registered as Market Customers in the National Electricity Market (NEM)) can demonstrate compliance with the NEG.

Liable entities could demonstrate their compliance by:

• holding sufficient contracts to meet their emissions threshold and (any) allocated reliability requirement;
• owning generation assets whose generation has not been contracted to other entities for the purposes of compliance with the NEG;
• unhedged load; or
• in the case of the emissions requirement:
• surrendering 'exemption certificates' purchased from Emissions-Intensive, Trade-Exposed (EITE) businesses; or
• acquiring eligible offsets.

The market uses a range of contractual arrangements in connection with electricity generation, some directly connected to the underlying generation, others with little to no link with actual generation. Given the indirect line between many common electricity-related contracts, there will need to be a balance in the way in which the NEG's design reflect current contracting practices while meeting the aims of the emissions and reliability requirements with precision.

The consultation paper proposes a spectrum of design options for both the emissions and reliability requirements which, depending on the design adopted, could have a significant impact on the outcomes achieved by the NEG and the compliance burden on liable entities. For example, tracing actual generation to liable entities to establish compliance may result in a more precise outcome insofar as achieving the stated aims of the NEG, but would place a heavier compliance burden on liable entities than if estimated emissions levels are deemed as applying (for the emissions requirement) or an ex ante approach is adopted (for the reliability requirement).

Emissions requirement

The Commonwealth Government has indicated it would set the emissions trajectory by reference to an annual average emissions per MWh requirement. Accordingly, compliance would need to be demonstrated by a liable entity showing that the average emissions levels of its load in a compliance year is less than, or equal to, the level imposed on the entity under the NEG.

The ESB outlined three categories of contracts that may qualify for demonstrating compliance with the emissions requirement:

• contracts specifying a generation source (eg a power purchase agreement between a solar farm and a retailer);
• contracts not specifying a generation source, but which do specify the emissions level of the underlying generation (a category of contracts that does not currently exist);  and
• contracts not specifying either the generation source or emissions level of underlying generation (eg over-the-counter or exchange traded swaps and caps).

While the ESB seems to indicate at some points that it may be possible for liable entities to report selected contracts to demonstrate compliance with the emissions requirement, it also contemplates a contrasting regime under which all generation within the NEM in a compliance year needs to be 'matched' with the relevant Market Customer.

In the latter scenario there would need to be a clear link between the:

• generation 'claimed' by liable entities for the purposes of emissions requirement compliance in a year; and
• generation sold in the NEM in that year.

Where a liable entity is 'claiming' generation by virtue of a contract it holds, the extent to which that contract is physically backed would be important to provide assurance that the objective of reducing emissions is being met. The ESB raises this point in relation to the reliability requirement, but curiously not in relation to the emissions requirement.

As an example of the second category, the ESB suggested that new instruments may be established that relate to generation from multiple generators, such that the emissions level 'stapled' to the contract would essentially be an average of the subject generators. As the ESB notes however, this would require a 'true up' of sent out generation from those generators against the contracted capacity to ensure that liable entities can only claim MWh actually generated for compliance purposes. Accordingly, while the exact generation source of each MWh may not be named, there would need to be a clear link between these contracts and the source generation.

A similar issue arises with contracts in the third category. As multiple financial instruments can be executed in relation to a generator, to prevent double-counting, it would be necessary to identify or certify which contracts can be used for emissions requirement compliance. Again, this would mean there is a clear link to the source generation.

The ESB's proposed concept of deeming a contract's emissions level based on the average emissions level of a group of generators in a previous year is somewhat at odds with the aim of reducing emissions levels as it bears no resemblance to actual generation during the compliance year.

The ESB's proposed treatment of unhedged load raises a similar issue. It is standard practice for retailers to have a portion of their load unhedged. If the design required generation to be 'matched' with liable entities, the unhedged load generated in the NEM during a year would need to be taken into account in calculating the average emissions levels for each liable entity so, while there will be no contract for which an emissions level may be determined, the emissions level must be determined for the load itself. The ESB's suggestion of applying a punitive emissions level to a retailer's unhedged load would mean there is no link to electricity actually generated in that year. In this case, the ESB proposal (deeming the emissions level by reference to the average emissions per MWh of uncontracted MWh) would be more reflective of the objective of the emissions requirement.

The Commonwealth Government has also proposed that EITE businesses would be entitled to apply for an exemption certificate for the electricity they use to carry out their EITE activity. This certificate could be sold to the business' retailer, who could claim an emissions requirement exemption. There are no details on how a liable entity would apply such a certificate to its load for compliance purposes, so it is not clear whether the certificate would be apportioned across a liable entity's load, or whether it would be possible to nominate the portion of a liable entity's load to be deemed exempt. If this flexibility is permitted, it is likely that liable entities would be incentivised to nominate the most emissions-intensive portion of their load, which may have an impact on reducing emissions. Again, the design of the emissions requirement mechanism in this regard will impact the degree to which the NEG's aim of reducing emissions is able to be achieved.

Reliability requirement

The primary aim of the reliability requirement is ensuring the power system's ability to reliably meet peak demand. The ESB proposes to achieve this by compelling long term investment in dispatchable electricity (at a point in time that may be earlier than the point the market would otherwise have responded) in circumstances where AEMO forecasts there will be a reliability gap.

While the ESB appears to acknowledge that the market would eventually respond to forecast gaps, it seems there is a desire to trigger that response earlier so that potential consequences to system reliability (that could foreseeably arise from a 'just in time' market response) would be avoided.

Given the contracts required to underpin new development would normally be a minimum of 10-15 years, whereas the forecast reliability gap may be for a shorter period, it remains to be seen whether the reliability requirement will be enough to prompt the development of new dispatchable generation.

As with the emissions requirement, where a liable entity seeks to demonstrate compliance by contract (rather than physical ownership), the physical backing of the contracts eligible to demonstrate a liable entity's share of the peak demand requirement at the time of the reliability gap will be important in achieving the objective of improving power system reliability. The ESB has indicated that purely financial instruments, with no link to physical generation, may not be eligible for reliability requirement compliance purposes. Accordingly, while power purchase agreements and swaps that specify the source generation may be eligible, weather derivatives are likely to be excluded. Unlike the emissions requirement, demand response measures would also be eligible for compliance purposes.

The ESB notes that, to avoid double-counting, certification of the financial instruments eligible for reliability requirement compliance purposes would be required, but did not provide details as to how such certification would occur. This issue is discussed further below.

Reporting compliance

As noted above, the administrative burden of compliance with the NEG will depend on the final design of the emissions requirement and reliability requirement mechanisms.

The ESB has proposed that a new registry be created for monitoring and reporting compliance with the emissions requirement (and potentially also the reliability requirement), which would draw information from AEMO's dispatch and settlement data and emissions levels reported by NEM generators under the National Greenhouse and Energy Reporting scheme.

If the NEG mechanisms are framed at the more precise end of the spectrum of options discussed in the consultation paper however, the AER (as regulator) would also require information to establish which liable entities can claim which generation for compliance purposes. While AEMO dispatch and settlement data would provide the regulator with details of the total generation and liable entity loads, the individual MWh within those totals would then need to be allocated to:

• the relevant:
• governing contract; or
• retail arm of the corporate group (where non-contracted vertical integration is being relied upon for compliance); or
• the pool of uncontracted energy.

Although it is Market Customers who will be liable entities, the involvement of generators would likely be necessary to verify that a particular Market Customer is entitled to claim the generation nominated by that entity for compliance purposes.

If there is need to 'match' actual generation with contracts (or unhedged load) in a compliance year, issues arise for existing financial instruments. In particular, where there are more financial instruments in relation to a particular generator than actual generation, it is not clear how the ESB contemplates that generators and Market Customers determine which existing contracts a liable entity is able to count towards its compliance with the emissions and reliability requirements. Without clear direction on this point, there is a risk of double-counting and potentially disputes between market participants which could have flow-on implications for a Market Customer's compliance.

The administrative burden on market participants will also depend on whether a self-assessment and reporting model is adopted, or whether a central registry of information which the regulator will use for the purposes of assessing compliance is adopted. If the mechanism adopted involves tracing actual generation to the relevant liable entity, it would be necessary to verify/certify a liable entity's entitlement to MWh or contracts claimed for compliance purposes.

The ESB has not indicated whether, if tracing were required, the regulator would play a central role in the verification/certification process (as is the case with the Renewable Energy Target scheme) or whether this would be left to be resolved between generators and Market Customers, with the AER having the ability to audit the supporting documentation to confirm compliance. An example of the latter option could involve a Market Customer nominating:

• the volume of MWh exported by a generator in relevant periods to which it considers it is entitled for compliance purposes; and
• the basis on which it is entitled to those MWh (eg contract with the generator or physical ownership of the generator).

The generator could then be required to verify the Market Customer's claim. Restricting the volume of MWh that a generator could verify to the amount it generated in that period could also minimise the risk of double-counting generation.

Next steps

There are clearly a number of key decisions to be made ahead of the ESB submitting its draft NEG design paper to the COAG Energy Council in April 2018. The views of the Commonwealth and NEM State Governments about how precisely the design of the NEG seeks to achieve the stated aims will also be a factor contributing to the final design, as will the desire of both industry and government for a policy that promotes investment certainty.

Written by Allens Partners Anna Collyer and Kate Axup and Senior Associate Karla Drinkwater. Originally published here.