Putting all your NEGs in one basket?

The Federal Government announced this week that it had accepted the advice of the Energy Security Board (ESB) and would adopt its recommendations to establish a Reliability Guarantee and an Emissions Guarantee, together forming a “National Energy Guarantee” (NEG).

The policy is a considered attempt to deal with the issues of reliability and emissions reduction at least cost.  It also seeks to tackle the investment uncertainty that has plagued the energy sector because of the lack of political consensus on the best way forward.

The NEG’s melding of reliability and emissions has been described as a “technically clever model.”^[i]  That means it is likely to require a lengthy process to provide a detailed design for the market.  In the short term it will be critical for the proposal to achieve bipartisan support and COAG’s endorsement. 

Detail on the proposal is limited at present, but from what’s publicly available we look at some of the issues which may need to be navigated as the NEG is fully defined.

The Reliability Guarantee

The Reliability Guarantee requires that retailers (and large users) prove to the Australian Energy Regulator (AER) that they have contracts in place with dispatchable resources to cover a predetermined proportion of their forecast peak load.  The Australian Energy Market Operator (AEMO) would be responsible for using the National Energy Market (NEM) reliability standard (which is reviewed every four years by the Reliability Panel) to determine the operating requirements for each region.

As the market currently stands, AEMO provides market participants with information about predicted capacity shortfalls using escalating levels of Lack of Reserve notices.  If this information doesn’t elicit a market response, AEMO has the power to intervene using the Reliability and Reserve Trader arrangements, and if necessary issuing directions to scheduled generators or instructions to scheduled loads.

The Reliability Guarantee proposal would have AEMO advise the minimum level and type of dispatchable capacity each region required for future “compliance periods”, taking into account the expected load requirements of market customers in each region, the level of dispatchable and other resources and the interconnector capacity.  As the contracted dispatchable capacity will have different start-up times, this dispatchable capacity would then need to be accommodated in AEMO’s real-time dispatch processes to ensure the reliability standard is met at least cost.

The ESB’s advice specified that compliance with the guarantee would be based on the actual output and availability of the dispatchable capacity.  It also expects that “customers who have flexible dispatchable demand … will be able to participate in the short term hedge market”, and that the resources needed to ensure reliability will be “tradeable between regions within the interconnector constraints”.

The implication of the proposed Reliability Guarantee is that existing financial instruments will need to be augmented to demonstrate compliance.  Retailers which use derivatives to hedge their load in the spot market will now need to differentiate between, for example, dispatchable swap contracts and non-dispatchable swap contracts.  Other instruments such as caps will be similarly affected.  Alternatively, it is possible that some form of dispatchable capacity “rights” could be developed which will allow retailers to demonstrate that they have entered into arrangements with dispatchable generators to ensure that they are available when AEMO requires them.

It is unclear how the compliance periods will work, and how AEMO will optimise dispatchable capacity to minimise costs.  Obliging retailers to cover “a predetermined percentage of their forecast peak load” raises a number of questions about how the percentage will be set, and how the forecast peak load will be determined.  It is possible that the forecast peak load may be overestimated in the interests of caution, with the result that excess dispatchable capacity will be bought, resulting in retailers being subject to additional inefficient costs.

The Emissions Guarantee

The Emissions Guarantee is similar to the Reliability Guarantee and will require retailers to meet certain average emissions levels for their load, however rather than being able to comply by buying offset certificates, the retailers will need to enter into contracts with generators to meet their obligations.

According to the ESB’s advice, “retailers and generators would enter into contracts for the supply of energy at a certain emissions level”, and compliance would be assessed by the AER “against the actual output of the generation units with which the retailer has contracted”.

While the aim of the mechanism is admirable, there may be a number of pitfalls in the high-level design proposed.

The ESB assumes that “retailers typically attempt to fully hedge their load”.  Within the NEM, physical supply and demand are balanced in the spot market through the operations of AEMO.  Aside from specific power purchase agreements (such as those supporting renewable energy generation), retailers’ contracts with generators are strictly financial, seeking to mitigate the financial risk of the spot market by means of derivatives such as swaps and caps.

To be able to meet their emissions obligations, retailers would need to enter into contracts with generators which would allocate a proportion of the generators’ physical output to those retailers.  This will create a risk between the parties that the generator will not generate the energy expected, due to the operations of the market and AEMO’s dispatch of those generators, and retailers will need to find a means to mitigate this risk.

The overview specifies that, “Generation purchased by the retailer from the spot market without a contract will be assigned with the average emissions level of the uncontracted generation capacity available to the market”.  While the principle of allocating an average emissions level to retailers which use the spot market to meet their demand is reasonable, the implication that there will be an assessment of “uncontracted generation capacity” is not.  This suggests that the AER will be charged with scrutinising the contract arrangements of generators to determine uncontracted capacity, and would be an unwelcome regulatory examination, besides being an additional compliance burden.

While the advice suggests that Australian carbon credit units and international units could be used to meet a proportion of each retailer’s obligation, the need to be able trade surpluses and shortfalls suggests that an instrument will need to be developed to provide market liquidity, despite the document asserting that, “there are no ... certificates involved in this guarantee and in this sense it does not involve a price or tax on carbon”.

Finally, the additional compliance obligation to demonstrate to the AER that the retailer has met its emissions targets seems unwarranted and intrusive.  It would be more appropriate and less resource-intensive for the AER to assess the emissions of the electricity sector as a whole, and only conduct more detailed investigations with retailers if the overall target has not been met.

Conclusion

It is difficult to assess the full implications of the National Energy Guarantee on the basis of 12 pages of preliminary documents.  The ESB’s recommendation to the Federal Government does flag that the final design will “benefit from market consultation and testing” and if accepted by COAG next month there would need to be a period of detailed design work.  To achieve the policy certainty industry needs, it will be important that the detail of the Guarantee’s implementation is determined by rigorous consultation with all stakeholders as suggested by the ESB.

 [i] Energy policy technically clever model, Australian Financial Review, 18 October 2017