6 March, 2018
Key issues for the electricity industry to consider arising from the Energy Security Board's proposed design
What you need to know
The Energy Security Board released the first draft design consultation paper on the National Energy Guarantee on 15 February 2018.
The proposed design of the National Energy Guarantee has the potential to significantly affect existing contracting arrangements in the National Electricity Market.
The Energy Security Board will hold a stakeholder forum on 26 February 2018 and is seeking submissions on the consultation paper by 8 March 2018.
What you need to do
Generators, retailers, large customers, financiers and other market participants should consider making submissions on the consultation paper to the Energy Security Board by 8 March 2018.
Market participants should also stay tuned for further updates on the design of the National Energy Guarantee in April 2018, when the Energy Security Board provides a draft high level design to the COAG Energy Council.
The ESB has released the draft design consultation paper
On 15 February 2018, the Energy Security Board (ESB) released the first draft design consultation paper on the National Energy Guarantee (NEG). The consultation paper is available on the COAG Energy Council's website here.
The ESB was established by the COAG Energy Council in August 2017 to coordinate the implementation of the Independent Review into the Future Security of the National Energy Market released in June 2017 (Finkel Report).
Although the Finkel Report recommended the adoption of a Clean Energy Target (CET) to drive investment in low emissions generators across Australia, in October 2017 the Commonwealth announced the adoption of the NEG in place of the CET in order to deliver both reliable and lower emissions generation in the National Electricity Market (NEM).
Further information on the Finkel Report is available in our alert of 9 June 2017, Finkel Report released: What's in store for Australia's energy future, available here.
The ESB's proposal for the design of the NEG
The consultation paper proposes that the NEG will consist of two parts: an emissions requirement and a reliability requirement. We have set out the key features of each requirement below.
Emissions requirement
The consultation paper proposes that entities that are registered by the Australian Energy Market Operator (AEMO) as a Customer under the National Electricity Rules (ie retailers and large users who are registered Customers) will be required to ensure that the load they purchase through the NEM meets specified electricity emissions targets. In this alert, we refer to retailers and registered large users collectively as "Retailers".
The consultation paper proposes that the Commonwealth will set the initial electricity emissions target trajectory for a ten year period, from 2021 to 2030. To ensure investor certainty, changes to the target trajectory could only apply with five year's notice. Each Retailer will be required to meet the electricity emissions target in respect of its load for the year.
A Retailer's performance against its target would be determined in tCO2-e per MWh with reference to its load and the emissions associated with its contracted and uncontracted purchases during the year.
In relation to "contracted" purchases (ie electricity that is the subject of a hedging contract such as a swap), Retailers would report the terms of their contracts which could specify a generation source (allowing the emissions per MWh to be determined) or the emissions per MWh of electricity that is the subject of the hedging contract.
For retailer-owned generation, the consultation paper contemplates that contracts can be reported as contracts with a specified generation source. If the corporate structure does not allow for this, the retail arm of the business can count towards compliance the emissions per MWh that remain after deducting the emissions sold under contract to other parties.
In relation to contracted purchases where neither the generation source nor emissions per MWh are specified (such as contracts currently sold on the ASX Futures Exchange), and "uncontracted" purchases (ie electricity that is not the subject of a hedging contract eg a spot purchase), a deemed or default emissions level may apply. The ESB is seeking submissions on how these levels should be calculated.
The final design of the emissions requirement may also make provision for emissions offsets (eg by surrendering Australian Carbon Credit Units or similar international units) and other voluntary green programs (eg the National GreenPower Accreditation Program).
The Commonwealth Government also intends to exempt all electricity used in emissions-intensive trade-exposed activities from the emissions requirement. It is expected that this will be similar to the emissions-intensive trade-exposed arrangements applicable under the scheme established under the Renewable Energy (Electricity) Act 2000 (Cth) (RET Scheme), but it is unclear how this will be taken into account in the assessment of compliance.
Reliability requirement
The consultation paper proposes that Retailers will also be required to ensure that they contract sufficient dispatchable generation to ensure that the reliability standard is met in each NEM region (ie each State which participates in the NEM).
This is proposed to work as follows:
Step 1: AEMO forecasts whether the reliability standard is likely (or not) to be met in any NEM region over a forecast period (the length of the forecast period is to be determined, but is expected to be within 2-10 years).
Step 2: AEMO will update its forecasts over time (eg if AEMO receives notification that a generator will be retired or significant outages will occur).
Step 3: If a reliability gap is identified, policy makers will expect the market to react by investing in new generation capacity or by offering additional capacity to the market. The potential for regulatory action to be taken if they fail to do so is expected to incentivise Retailers to invest or enter into contracts underpinning new investment.
Step 4: Retailers will need to know that the instruments they enter into in order to satisfy step 3 will qualify to meet the reliability requirement. They will be required to demonstrate that they have entered into sufficient eligible contracts to cover their share of the peak demand requirement at the time of the reliability gap.
Step 5: If an identified reliability gap remains, a proportion of that gap will be allocated to each Retailer. This will impose a firm obligation on Retailers to enter into the contracts identified in step 3 above.
Step 6: The Australian Energy Regulator (AER) will assess whether each Retailer has met their reliability requirement.
Step 7: If Retailers do not meet their reliability requirement by a compliance date, AEMO will procure resources to fulfil any remaining gap.
Step 8: The AER will levy penalties against any Retailers that have fallen short of their reliability requirement. Alternatively, the ESB is also considering allocating the cost of centrally procuring the resources to meet the reliability gap across all Retailers who have fallen short of the reliability requirement.
The consultation paper proposes four mechanisms in which a contract could be deemed to be a "qualifying instrument" for the purposes of step 4:
- certain types of financial contracts, such as existing swaps and caps, will be considered to be eligible contracts;
- other financial contracts could be certified as being reconciled back to a physical reliable generation source;
- contracts could demonstrate that the generation or demand response that is the subject of the contract is sourced from a dispatchable generator or user; and
- the retail arm and the generation arm of integrated retailers and generators (also called gentailers) could contract with each other so that the retail arm can count the contract towards its compliance measures.
Compliance and enforcement
To ensure compliance with both the emissions requirement and reliability requirement, Retailers will be required to report information from their contracts to the AER. For the emissions requirements, it is suggested that this information will be the counterparty, MWh settled and the timing of the generation (we assume this is intended to be each trading interval for which a notional quantity has been agreed), with emissions data coming from other data sources.
The consultation paper contains little detail on the type of information that will be required to be provided in respect of the reliability requirement.
Generators may also be subject to reporting obligations, although the information which may be required to be reported has not been specified in the consultation paper.
The ESB is proposing an enforcement regime that aligns with the current powers held by the AER including revocation of authorisation as the ultimate step.
However, for the reliability requirement, the ESB has taken the view that the reliability requirement does not necessarily lend itself to a civil penalty regime. It is also considering other financial penalty mechanisms, including the allocation of costs of centrally procuring the resources to meet the reliability gap.
What are the key issues arising from the proposed design of the NEG?
Impact on the existing contracting market
The NEM is a gross energy spot market in which:
- generators are dispatched in five-minute dispatch intervals by AEMO in merit order based on bids submitted in pricing bands and forecast electricity demand;
- Retailers pay a spot price to AEMO for each MWh of electricity consumed, and AEMO then pays the spot price to generators for each MWh of electricity generated; and
- the spot price is calculated on a half-hourly basis as the average of the price of the last MWh to be dispatched by AEMO in each dispatch interval within that half-hourly period (although this will change to match the five-minute dispatch interval from 1 July 2021).
As the spot price can fluctuate significantly between settlement periods and regions (ie the various States) in the NEM, many generators and Retailers separately enter into over-the-counter (OTC) derivative transactions and ASX futures to manage spot price risk. These transactions typically take the form of swaps and caps (and some swaptions).
Although these contracts mitigate financial risk to Retailers and generators, under the proposed design of the NEG set out in the consultation paper, a number of new physical obligations will need to be incorporated into these essentially financial contracts. These would include the emissions levels and dispatchability of the underlying generators. This model may distort the pure financial derivative market that has developed in response to the design of the NEM as a gross energy spot market.
New considerations, such as whether a Retailer would be entitled to terminate a financial contract (or take other steps, such as requiring the counterparty to develop and implement a cure plan) if certain nominated physical parameters of the underlying generators were not met would need to be taken into account.
The fact that a number of hedging contracts also include provisions for the physical settlement of the sale of green products (including large-scale generation certificates and GreenPower rights) do not necessarily provide a sufficient justification to include further non-financial arrangements in hedging contracts.
The sale of these products is often included in hedging contracts in order to implement a "bundled price" for the hedge: the generator swaps its pool revenue and all of the other green products it can create in exchange for a single price (which is often bankable to underpin project financing of the generator). The fungibility of these green products makes their inclusion into a financial contract manageable. Green products can also be traded separately (and they typically are).
The operation of the OTC market and the ASX Futures Exchange is predicated on the fungibility of the instruments. As a fundamental principle, the more homogenous the transactions are, the greater the fungibility and the greater liquidity in the market. There is a real risk that contracts which are linked to generation, rather than being purely fiscal arrangements, will mean that submarkets could be created. This is likely to affect liquidity and could drive up prices because participants cannot use these transactions as easily to manage their risks.
A significant issue for further consideration is how the contract market will deal with:
- gentailer arrangements which utilise a natural hedge; and
- uncontracted positions – the wrong signals could result in a highly contracted market, which will affect the ultimate spot price.
Interaction between the emissions and reliability requirements
The consultation paper does not sufficiently explain how the emissions and reliability requirements are anticipated to work together. For example, if a Retailer chose to comply with its reliability requirement by financing new, reliable gas-fired generation (in step 3 or step 5), to what extent will it be required to finance new, intermittent renewable generation to ensure it continues to satisfy its emissions requirements?
This particularly could be an issue if it was unable to procure sufficient demand response to meet its reliability requirement and so was forced to invest in new, emissions-intensive generation to avoid penalties under the reliability requirement (step 8).
Forecasting the reliability gap
There are a number of different forecasting components associated with the reliability requirement as described in the consultation paper – the initial forward assessment of the reliability gap (step 1); the updated forecasts (step 2) and triggering the reliability requirement.
These components are all interrelated, moving parts. Careful consideration needs to be given in the design of the NEG as to the forecast period; what the consequences are if the forecasting is wrong (if the reliability requirement is to drive efficient market outcomes, Retailers must be able to rely on the forecasting); how frequently is the forecasting updated; and whether the forecasting is independently tested.
Additionally, if the forecasting is wrong, there is the real possibility of a zero warning period before the reliability requirement is triggered (even a one year period would likely be insufficient, see our comments below regarding the trigger point). If the reliability requirement is triggered without sufficient lead time for Retailers to respond as required, this could result in ad hoc, short-term strategies which may not achieve the objectives espoused by the ESB and could drive adverse market behaviours.
Ultimately, inefficient markets and adverse market behaviours are likely to lead to increased prices, which may be passed on to the end customers.
Trigger point in reliability requirement for imposing mandatory investment obligations
The consultation paper recognises that there will need to be a point at which a forecast reliability gap (steps 1-3) triggers the reliability requirement which requires Retailers to procure new reliable generation (steps 4-8).
The consultation paper notes that this possible "trigger point" could be either be a short term point (between 3-12 months before the forecast reliability gap) or a long term point (between 3-5 years before the forecast reliability gap).
Given that:
- reliable generation will likely include generation from coal, gas and hydro sources (and potentially battery storage); and
- obtaining environmental and other project approvals for new coal, gas and hydro power plants can often take in excess of three years (in addition to a lengthy construction timetable),
- then if the trigger was set as anything less than five years a reliability gap would almost inevitably occur in line with the forecast, because new projects would likely not reach commissioning by the time the reliability gap commenced.
In contrast, the ESB considers that a longer trigger period may cause Retailers to defer investments to "wait and see" if the forecast changes, or may prefer that AEMO procures resources to fill the gap instead (step 7).
Book build option
The consultation paper raises the possibility of a "book-build" option as an alternative to allocation of the reliability gap to Retailers. Under this option, the capacity would be bid at auction. This book build auction price may ultimately become the price setter (which may not necessarily reflect efficient pricing and costs, and which may in the long run be passed on to the end customers).
The consultation paper outlines the concept, but at this stage the ESB has not provided detail about the other terms and conditions of these contracts, relevantly whether there will be default terms and conditions as set by the Commonwealth. Careful consideration will need to be given to competition and productivity impacts, and the extent to which the Commonwealth truly wishes to intervene in the market.
AEMO as the procurer of last resort
The ESB suggests as a possible option that the market operator carry out the procurement process if the reliability gap is not met.
We highlight this option for cautious deliberation. Some issues for consideration include: who AEMO would be procuring this investment for; whether AEMO is best placed to efficiently procure any necessary investment; and the consequences of any pricing inefficiencies (while AEMO may allocate the cost to Retailers, these costs may ultimately be passed on to the end customers).
Allocation of the reliability requirement to large energy users
The consultation paper contemplates also allocating the reliability requirement to large energy users who are not registered as a Customer. Large energy users increasingly adopt a wide range of sophisticated pricing mechanisms (for which only a proportion of their load may be subject to spot pass-through arrangements) as part of their electricity procurement process; contract for varying terms (which in our experience may vary from one to 10 year terms) and may have one or more retailers.
How compliance for large users will be monitored, without the disclosure of highly commercially sensitive information to the AER, remains an open issue. The ESB will need to carefully consider the legal complexities in implementing such an arrangement if it does decide to include this allocation aspect in the final design of the NEG.
How does the RET Scheme fit in?
The consultation paper does not include any details of the intended interaction between the RET Scheme and the emissions requirement.
Issues that arise include:
- whether the generation from generators who create large-scale generation certificates under the RET Scheme is also able to be counted towards meeting the Retailer's emissions requirement;
- are small-scale technology certificates able to be used (in the same way as the suggestion in the consultation paper that Australian Carbon Credit Units or international emissions units can be used); and
- are existing generators to be "grandfathered" under the RET Scheme by 2020 and the RET Scheme effectively closed (as was suggested in an earlier ESB paper on the NEG).
Disclosure of commercially sensitive information to regulators
The consultation paper places significant focus on the disclosure to regulators of otherwise confidential financial hedging contracts between generators and Retailers.
It will be important to ensure that the regulators have sufficient mechanisms in place to prevent the disclosure of commercially sensitive information (eg pricing) to other market participants.
Design of the reliability requirement
The design of the reliability requirement as set out in the consultation paper is complex and has a number of the features of capacity markets. It borrows some of the features of the capacity market in the WA Wholesale Electricity Market, where generators are assigned capacity credits and trade them with market customers (or themselves) to discharge their individual reserve capacity requirement, or else pay for the shortfall. AEMO determines the reserve capacity requirement two years' ahead, certifies and allocates capacity to generators based on their technical requirements, and determines each market customer's individual reserve capacity requirements.
The WA system has previously been criticised for creating excess capacity in the market, as the system is not highly responsive to changes in demand, and is the subject of ongoing regulatory reform.
Penalties for non-compliance with the reliability requirement
The consultation paper invites discussion on whether the "efficient" costs of centrally procuring resources should be used as an enforcement tool (in place of a financial penalty).
There are a number of issues to be considered with this approach – whether centrally procured resources can lead to efficient pricing outcomes (see comments above); whether the allocation should be based on the Retailer's forecast load (forecast load always differs from actual, and at the time the reliability requirement is triggered it will be triggered based on a forecast); whether the penalties will be on a sliding scale; and what is meant by the statement "the AER will have sufficient discretion to administer the penalties". While it is important to have discretion there should be parameters around that discretion.
Potential implications for competition law and policy
The relationship between the design of the NEG as set out in the consultation paper and competition law and policy are particularly interesting, in an environment where the Chair of the Australian Competition and Consumer Commission, Rod Sims, has been critical of vertical-integration and recently identified energy affordability as a priority area in 2018. The NEG effectively requires Retailers to secure physical positions based on their load, and not solely rely on financial hedges to manage their exposure to the spot market. The size of financial hedges is significantly greater than physical capacity, and so the NEG is likely to create significant additional complexity for competition law and policy.
Conclusion
The proposed design moves the dial on how the NEM operates. It could fundamentally change the dynamics of the existing market.
We encourage all market participants to consider the questions asked by the ESB and respond to the ESB's request for submissions by 8 March 2018.
For further information, please contact:
Tanya Denning, Partner, Ashurst
tanya.denning@ashurst.com
