Draft high level design documents released last Friday

On Friday 20 April, State and Territory Ministers met to consider a draft high level design of the National Energy Guarantee (NEG) developed by the Energy Security Board (ESB). After last minute talks and lobbying, focusing primarily on the adequacy of the proposed emissions targets, the Federal Government secured the support of the COAG Energy Council for the NEG to proceed towards final design stage.

Below, we present a summary of the two major components of the draft NEG design; the emissions guarantee and the reliability guarantee. The majority of the draft design was developed by the ESB, with certain elements of the Emissions Guarantee being led by the Commonwealth. This includes, for example, the approach to setting emissions targets, exemptions for Emissions Intensive Trade Exposed (EITE) activities and the use of international offsets.

We also provide commentary and a high level analysis of the implications for different groups of stakeholders below.

The ESB will consult in May and June this year with the final design released in July. If approved by the COAG Council, legislation and rule drafting will commence in August 2018. The intention still appears to be to commence the reliability guarantee in 2019 and the emissions guarantee in 2020.

Emissions Guarantee at a glance

1. Commonwealth design elements

Emissions target

  • Set by Commonwealth as an annual average emissions per MWh (tCO2-e/MWh).

  • At any time, there would be between 5 and 10 years annual targets set. Initial target set for 10 years (2021-2013), reviewed every 5 years (to align with review cycles under Paris Agreement) at which time at least a further 5 years of target would be set. Changes could only occur with 5 years notice.

2. Application of the Emissions requirement

Legislative implementation

  • For the national electricity market, the obligation will be placed on retailers through the National Electricity Law and National Electricity Rules (Rules).

  • Amendments to Commonwealth legislation will be required to set the targets and facilitate the Guarantee.

Liable entities

  • Emissions requirement will cover entities registered by AEMO as a Customer under the Rules (being retailers and registered large customers) (Retailers).

  • Compliance and reporting requirements managed by controlling corporations as defined under the Rules (consistent with current use by NGERS).

  • Controlling corporations’ loads would be aggregated and their generator emissions would be automatically allocated to the relevant retailer, even if this results in the Retailer being allocated more emissions than its load. The Retailer could then enter agreements to reallocate some of those emissions.

Retail load

  • Retailers will be required to meet electricity emissions target in respect of its own load each year based on wholesale purchases from AEMO and any non-market embedded generation or behind the meter generation.

  • A high level summary of the calculation of emissions intensity for each Retailer’s load is: Emissions per MWh – (Allocated emissions + Unallocated emissions + Voluntary emissions reductions + Banked/Deferred Emissions - Offsets) divided by Total load.

EITE loads

  • EITE activities are likely to be exempted with the precise operation and extent of exemption to be further developed by the Commonwealth.

  • Electricity sold for EITE activities, if exempted by the Commonwealth, will be deducted from Retailers’ loads at a specified EITE intensity. There is a concern to avoid gaming to prevent emissions intense generation being allocated to exempt EITE loads.

Emissions registry

  • “Reallocation approach” through a registry which will provide a mechanism for generation and associated emissions to be allocated to Retailers. This allocation can be separate to physical or synthetic sales of electricity.

  • A registry will combine actual generation data and NGERs emissions intensity data to record all electricity production and its emissions profile for each generator. Registry will be added as enhancement to AEMO’s current systems or newly operated registry by AER.

  • Production and emissions would be accepted by generators and could then be presented by Retailers. Retailers could adjust portfolio after close of compliance year but before reporting date. Through contracts, or separately, Retailers and generators could agree to allocate production and emissions through the registry.

Unallocated energy, emissions and loads

  • Unallocated energy and emissions within registry will contribute to calculating emissions intensity applied to unallocated loads.

3. Flexible compliance options

Carrying forward

  • Carry forward by Retailers should be permitted with appropriate limit and safeguards to be further considered.

Deferred compliance

  • Limited deferral of compliance by Retailers should be allowed with appropriate limit to be further considered.

Offsets

  • Commonwealth is yet to decide on the conditions and use of offsets in the NEG.

4. Reporting and compliance

AER as enforcement agency

  • AER, (through information provided by AEMO and CER) is considered best placed to monitor compliance given planned integration of the “dual requirements” of the NEG and the energy market and existing enforcement tools at its disposal.

Compliance period

  • Benefit of financial year compliance is it aligns with NGERs reporting, but further consideration is required. Compliance reporting should be three months after the end of the compliance year.

Enforcement tools

  • Potential compliance tools will be based mostly on existing AER enforcement tools, in addition to automatic carry-over of under compliance.

5. Other considerations

State and Territory Schemes

  • Emissions Guarantee will co-exist with State targets and State schemes will contribute towards achieving emissions reductions under the emissions guarantee. The issue will be how more ambitious State targets can be additive to the targets rather than subsumed as part of the emissions guarantee.

Voluntary green schemes

  • Retailers will be required to report MWh sold to customers under voluntary schemes, which will be in addition to Retailers’ requirements under the NEG. Under GreenPower, Retailers would still need to surrender LGCs, being additional low emissions electricity they have sourced.

Interaction with LRET

  • LRET remain unchanged, noting it is scheduled to continue until 2030.

  • Projects can benefit from both LRET and the Emissions Guarantee.

Reliability Guarantee at a glance

Eight high level steps to the reliability requirement

The ESB high level draft design is consistent with the eight step process set out in the February Draft Design Consultation Paper

Forecasting the requirement

  • AEMO will publish a forecast of reliability in each region for the next 10 years through the annual Electricity Statement of Opportunities (ESoO).

  • Given the forecast could lead to imposition of an obligation, an accountability framework will be introduced, featuring rules requiring transparency and consultation. Participants will also be able to “dispute” assumptions and parameters in the forecast.

  • The current Reliability Standard (a maximum expected unserved energy in a region of 0.002 per cent of the total energy demanded in that region for a given financial year) will be reviewed to better capture the increasing peakiness of the NEM.

Updating the requirement

  • The forecast will be updated by AEMO annually or if there are material changes to supply/demand outlook such as major generator retirement.

Trigger

  • The market will be expected to react to any forecasted material gap, such as through investment in new capacity or by offering additional capacity. The definition of materiality will be defined following further consultation.

  • If a material gap continues or a new material gap arises three years from the forecasted gap, AEMO will be able to trigger the obligation after getting approval from an independent entity such as the AER.

Liable entities

  • Applies to retailers and large customers, including ones that are not directly registered in the NEM.

  • The threshold size for retailers and large customers will be set after further consultation.

  • If triggered, liable entities are obliged to secure sufficient qualifying contracts for dispatchable capacity to meet their share of system peak demand that would be expected to occur one in every two years (safe harbour). The ESB notes that demand above that level will be most cost effectively met via demand response.

  • Large customers will be able to have their reliability obligation managed by a retailer.

  • EITE businesses are not exempt from the reliability obligation.

Qualifying contracts

  • It is not yet clear how much of a liable entity’s share of peak demand needs to be covered by qualifying contracts for dispatchable capacity.

  • Cap and swap contracts are likely to qualify, while weather derivatives and certain insurance products are unlikely to qualify.

  • Only contracts bought from centrally cleared trading platforms and/or reported to centralised trade repositories will qualify. The impact of this on gentailers is discussed below. Large customers who are subject to the reliability requirement will be able to use their existing contracts to comply.

  • AEMO will conduct a voluntary “book-build” 3 years and, if required, 2 years out from the reliability gap to help match new capacity entering the market with buyers of contracts.

Procurer of last resort

  • One year from a forecast gap, AEMO will procure any remaining required resources through the enhanced RERT or Strategic Reserve including by using reverse auctions. Where a gap warrants earlier action, AEMO or a state government may apply for an expedited rule change permitting AEMO to act beforehand.

  • Resources procured by AEMO must be ‘out-of-the-market’, i.e. it must not have been traded on the NEM.

Compliance

  • Contractual positions are to be disclosed to the AER once AEMO begins to act as procurer of last resort. These are used to measure compliance following the forecasted gap.

  • Compliance will not be assessed where AEMO acts as procurer of last resort and the actual system demand does not exceed a 1 in 2 year expected peak demand. Instead, the cost of AEMO’s procurement will be shared between Retailers in the region where a gap was forecast.

  • Compliance by liable entities will only be assessed if AEMO acts as procurer of last resort and the actual system peak demand exceeds the 1 in 2 year expected peak demand.

Penalties

  • Liable entities who fail to meet their reliability obligations will face penalties which include at least some of the cost of AEMO procuring the required capacity.

Comments on emissions guarantee

  • The need to change Commonwealth legislation creates an implementation risk unless the Government can obtain Labor party support.

  • It may also mean that if Labor wins the next Federal election, any increase in the targets will require legislative changes and possibly cross-bench support depending on the Senate make up.

  • The Emissions Guarantee is an emissions intensity scheme which requires Retailers to procure generation (at least notionally) such that the average emissions intensity of its load is at or below the target. While it is not a certificated scheme, the allocation through the registry has the same effect, although probably not giving rise to a proprietary right. Given that the emissions intensity of the generation can be allocated separately to the physical or notional supply of electricity, we would expect that a market price for emissions separate to electricity will develop. This should provide some support for new renewable projects but depending on the emissions target, it is likely to be much lower powered than the RET scheme.

  • The uncertificated nature of the scheme may also create a challenge for determining who has the benefit of the allocation from renewable projects - offtakers under existing agreements have generally sought to assume all the “green” benefits of the project. The relevant clauses often assume some form of certificate or proprietary right.

  • The purpose of the reliability guarantee is to incentivise retailers and customers to support dispatchable resources. In the absence of a forecast reliability gap on current AEMO modelling (although this could change if the Reliability Standard is amended), there does not appear to be a high powered incentive at this stage at least, for new capacity.

  • The reliability guarantee has a number of important areas of detail to be determined. For example:

    • The approach to qualifying contracts no longer appears to require an express “tracing” to physical generation. However, it still leaves the problem that the synthetic nature of the contract market means that MWs can be sold more than once – there seems to be scope for gaming. We assume then that there will be more criteria required for qualifying contracts. For example, renewable projects are often done as a swap but presumably those contracts would not qualify unless firmed up.

    • A critical issue remains for the next round as to how much of the peak load needs to be covered by qualifying contracts.

    • Non-compliant Retailers will bear a share of the cost of AEMO procured capacity. How much will be critical. The safe harbour increases the risk for non-compliant Retailers as you would be expect that only a small number will be non-compliant and would therefore potentially have a higher exposure to the cost share. This is a big issue for large customers who might be exposed as discussed below.

  • There remains a concern that only having a conditional obligation for the period of the reliability gap will not be sufficient to underwrite large amounts of new capacity which usually require long term contracts. The AEMO book-build may also crowd out a larger private response such that the dispatchable solutions are skewed to an aggregation of smaller and less expensive projects. This may assist demand response.

  • We see the main value of the reliability guarantee over time as providing support to, and potentially delaying retirement of, existing dispatchable assets.

Impact on renewable industry

  • Potential for continuing uncertainty as to renewable policy post-RET given the need for changes to Commonwealth legislation to implement the emissions guarantee.

  • Likely to provide a separate market value for low emissions but may not provide a strong incentive for more renewable investment in the absence of more ambitious Commonwealth targets and reliability guarantee may increase the cost of, and temper the appetite for, ambitious State based targets.

  • The direct exposure of large customers to the reliability guarantee may further incentivise large corporates to bypass retailers and directly underwrite both renewable and firming capacity.

  • Need to review existing contracts for allocation of the emissions guarantee benefits and deal with allocation of benefits in new contacts.

  • The paper states that LRET will not be “closed” in 2020 when the LRET target is likely to be met such that new projects post-2020 can continue to register and create LGCs until 2030, accelerating their decline in value as the scheme approaches expiry.

Gentailers and small retailers

  • The ESB has been very cognisant of the competition concerns raised and has sought to provide comfort to small retailers.

  • Gentailers are automatically allocated emissions from their own generation. As the brown coal generators in Victoria are owned by gentailers, this should help reduce the intensity of the unallocated emissions. It will be interesting to see how Queensland coal generation is allocated given the level of government ownership across generation and retail.

  • In relation to gentailers, the ESB states that only contracts bought from centrally cleared trading platforms and/or reported to centralised trade repositories will qualify. The suggestion seems to be a level of forced disaggregation - this needs clarification. First, OTC electricity derivatives are currently exempt from the post-GFC requirement to report OTC derivative transactions to trading repositories. If this is to become required, then this has a number of cost and administration implications. Putting this to one side, there theoretically also seems to be nothing stopping a gentailer from entering a hedge between its generation and retail arms (which are often separate companies) and reporting it to a trade repository. Third, it suggests physical PPAs between related entities won’t qualify.

  • We will be interested in the next round to see the comments by small retailers on whether the items above, the conditional trigger, AEMO’s book build and large customers being the subject to the reliability guarantee address their concerns.

Large customers

  • Large customers and EITEs are subject to the reliability guarantee. While this can be outsourced to retailers, this will require careful thought on procurement strategies.

  • For example, one issue is that retailers and large customers contracting positions are opened up to the AER at the time AEMO commences procurement. However, there is a lag between that point and the gap. The ESB has noted that it will consult on how to update contracting positions between this point and when liability may be apportioned (ie if there is peak demand outside the safe harbour). You can see a situation where retailers may refuse to supply large customers during this lag period unless the retailer can source dispatchable capacity contracts (which will presumably be in short supply) given the potential exposure or seek to allocate that exposure back to the large customer.

Next steps

With the sign off from the COAG Energy Council, the ESB will conduct further consultations as they proceed towards a final NEG design. The ESB will lead the process of further refining the NEG design, with the Commonwealth contributing on some design elements, such as the setting of an emissions target, determining conditions for exemptions for EITE activities and determining the eligibility of offsets.

The final NEG design will be accompanied by draft legislation for its implementation. The final design will be presented at and voted on at the next meeting of the COAG Energy Council in August 2018 with legislation to be implemented before the end of the year.