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The power mechanism is not the right solution to this energy crisis

These are unprecedented conditions for the National Electricity Market (NEM). Wholesale electricity and gas prices are at record levels and futures markets are indicating that these conditions will continue for a while now.

After the announcement of the call for an emergency meeting of energy ministers, there were persistent calls for the introduction of the “capacity mechanism” as a way to resolve the crisis.

Introducing a mechanism that would require consumers to pay for every ‘company’ capacity in NEM might sound like a good idea on paper, but it would be complex, expensive, and not provide protection from our current predicament.

If our goal is a reliable and affordable transition, we must focus on the most cost-effective solutions to reduce our dependence on fossil fuels: demand-side solutions, renewables and storage.

If a clear argument is made for additional mechanisms to support the firm’s capacity, the focus should be on encouraging new investments and only at times when the market is not actually delivering on those investments. It should not be designed to pay for current coal and gas fleets.

severe market conditions

Wholesale electricity prices are at record levels, with average spot prices in New South Wales, Queensland and South Australia exceeding $300/MWh in May. Futures prices are also at record levels, with FY23 contracts soaring over $200/MWh in NSW and Queensland. Spot gas markets were also at such high levels that AEMO is capping prices at $40/GJ in Brisbane, Sydney and Victoria.

The reason for these prices can mostly be attributed to a combination of exceptionally high fossil fuel costs and large portions of the generation fleet being offline.

Large swaths of coal-fired power plants have been disrupted, greatly reducing supply. Approximately 25% of the NEM’s coal capacity, roughly 5 GW, was unconnected at time points during May. These capacity reductions are attributed to technical defects and difficulties in accessing coal.

At the same time, the remaining coal and gas generators, which still generate most of Australia’s electricity, are somewhat vulnerable to the global shocks to the coal and gas markets, depending on contract cover levels.

This leads to higher fuel costs, as they flow to higher bids in the wholesale market. The exposure of each generational portfolio remains a bit murky (analysts flock to ASX Market Updates to get any insight into hedging positions), but with pricing based on the last generator needed, even some exposure to these global forces has a significant impact domestically.

Not surprisingly, the turmoil in energy markets has led to calls for intervention and regulatory changes. These calls include support for the fast-tracking capacity mechanism being developed by the Energy Security Council (ESB).

The ability mechanism was not to provide comfort

The capacity mechanism requires retailers and energy consumers to explicitly pay for capacity. However, it is not clear how the capacitive mechanism would have provided consumers with any protection from current market conditions.

The capacity market cannot guarantee that offline coal capacity will be available for generation, especially if the outage is due to technical failures or reduced fuel availability. Instead, it creates a risk that consumers will pay for this capacity just to stay offline.

Subtle and intricate design choices can try to guard against this, but this could mean much greater administrative complexity and risk for capacity vendors, increasing costs if energy users are required to pay for capacity up front.

Even if we pay for capacity through the capacity mechanism, the proposed mechanism does not provide a barrier against wholesale price hikes.

Generator companies will still seek to recover their short-term costs, and while coal and gas fuel prices are at such high prices, these short-term costs are high. There is evidence of this in other markets, where European markets capacity he does not have Provide protection for customers from price hikes.

UK forward delivery contract at £/MWh
UK forward delivery contract at £/MWh. Source: Ofgem, Available here.

Effective investment frameworks are critical

It is clear that we will need significant investment in NEM during the energy transition, but what is not clear is whether the capacitive mechanism is the best way to achieve this. Capacity markets provide price signals for capacity, not necessarily the flexibility to move to higher penetrations of renewables. Crucially, it also risks expanding our dependence on coal generation by providing them with capacity payments.

While the capacity mechanism is being developed, it creates regulatory uncertainty, which will be detrimental to new investments. For renewables, it will affect negotiations for long-term energy offers, particularly if the capacity mechanism means a lower market price ceiling. There is also new uncertainty for storage investors, unsure how to exhaust capacity.

If a capacity market is introduced that generates revenue for all capacity, there is no guarantee that it will help investments in new storage. The value of new investments depends on how project funders evaluate capacity certificates.

With no record of how “capacity” is priced and uncertainty regarding generators’ ability to sign long-term capacity offerings, financiers are likely to discount future estimates of capacity revenue significantly. The capacity mechanism also creates new downside risks for investors if it ends up prolonging the operation of coal-fired power plants. As mentioned above, projects are at risk of losing capacity, which greatly affects project revenues.

Capacity markets also do not deal well with distributed energy resources. The large amounts of storage that AEMO predicted in its ISP project comes from distributed power resources (three-quarters of the transmittable capacity in AEMO’s step-change scenario by 2050).

Growth in Storage in NEM at AEMO ISP . Project
Growth in Storage in NEM at AEMO ISP . Project Source: AEMO, Draft Integrated System Plan 2022, p. 50

Most of this storage will be in the form of electric cars or home batteries along with rooftop PV. These are not going to be investment decisions that are made based on the price of capacity, so to make sure that this storage is used when it is most valuable we need strong short-term price signals i.e. only the energy market!

On top of all this, the capacity mechanism would create significant headwinds for retail competition and innovation by favoring vertically integrated brokers with physical capacity in their portfolios.

What should we do instead?

The overarching challenge is to reduce our dependence on fossil fuel generation. Continuing to develop renewable energy sources and storage will help. There should also be a renewed focus on demand-side solutions.

Energy efficiency and demand management will be key to making progress in the energy transition at lower cost. There are tremendous opportunities for Australia to improve the energy efficiency of our buildings, particularly at the residential level. This is good for these customers’ bills, but also for their quality of life.

To invest in the new offer, the first thing should be evidence of the need for repair. If there is convincing evidence, the right mechanisms that support new investment and protect consumers from unnecessary risk and cost must be designed, and this should not create new revenue streams for existing generators.

Declan Kelly is tDirector of Public Policy at Flow Power, the energy retailer.

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