The new independent Energy Security Board (ESB) has released an initial public consultation paper with high-level design options for the Australian Government’s new energy policy, the National Energy Guarantee (NEG). As detailed in our previous article, the NEG obliges electricity retailers to source electricity from both renewable generators (the emissions guarantee) and more reliable generators (the reliability guarantee).

As expected, the paper highlights the complexity of the NEG and the detailed design process that is required across the spectrum. Stakeholders have a real opportunity to play a key role in designing Australia’s new energy future by providing submissions on the paper.

Emissions guarantee

The emissions guarantee requires retailers and other market customers to meet an emissions target for their load on an annual basis. This target will initially be linked to Australia’s commitments under the Paris global climate agreement (which requires a 26–28% reduction in emissions below 2005 levels by 2030). However, it is envisaged that the target can be adjusted over time, and the emissions guarantee will continue post 2030 (unlike the RET).

Retailers and other customers must meet their emissions target by sourcing at least part of their load from zero or low-emissions generators. This is designed to underpin the future development of further renewable and other low-emissions generators following the end of the RET scheme in 2020. However, the emissions target will differ from the RET in that there will not be separate certificates which are created. This is to create stronger linkages between the times of peak generation and peak load, and to smooth the build out of new generation.

The ESB has invited submissions on the architecture of the scheme, including:

  • calculation of emissions – there are many challenges in calculating the emissions intensity of a retailer’s or large customer’s load. Currently, retailers and other customers enter into a range of contracts with generators. Where these are linked to underlying generating plant – like a power purchase agreement with a specific power station – the calculation of the emissions intensity is relatively easy. However, where these are more generic – like the widely traded $300 electricity cap product – or where a retailer buys from the pool, the question of emissions intensity is harder.

  • The ESB has put forward a range of options as to how to address these issues, while preserving the derivative market. Also, the ESB has contemplated that the emissions guarantee will foster the development of a new form of contract specifying an emissions intensity but not an underlying generating plant. This could potentially enable renewable generators with multiple assets in the same region to sell a bundled, zero emissions product. In the short term, we think market participants will start addressing the question of attribution and emissions intensity in new contracts that they enter into.
  • emissions target – the Commonwealth Government is seeking to develop an emissions reduction target for the NEM that is in line with Australia’s Paris commitments, but which can be adjusted according to changes in Australia’s energy market. The ESB is seeking input on how often this target can be reviewed and adjusted in response to forecasts or levels of demand, as the Commonwealth Government has indicated it wants for a “self-adjusting” emissions target.

    The interaction between these targets and Australia’s obligations under the Paris Agreement will also need to be factored in. The proposal to only allow the Commonwealth Government to change emissions reduction targets with 5 years’ notice provides welcome investor certainty in Australia’s short to medium term emissions targets, however runs the risk of locking in weak emissions reduction targets and has the potential to create further political uncertainty over Australia’s energy policy, particularly if government choices are constrained by the politics of a tight Parliament.
  • compliance flexibility – the ESB is seeking to achieve a balance between ensuring compliance and minimising compliance costs. As a means of striking this balance, the ESB has suggested permitting retailers to defer emissions requirements (eg up to a limit of 20% of its emissions) for a compliance year. The ESB contemplates that there could be trading in low-emissions contracts (as retailers and other customers look to satisfy their emissions requirements). However, the absence of a certificate that can be traded separately to the underlying energy (similar to the existing RET scheme) could make trading more difficult where a retailer who was long in low-emissions energy still required the energy to meet their load. The ESB is also exploring the use of offsets (domestic and international) to meet compliance, but is seeking to set limits on usage by retailers (at an absolute level or based on the size of retailers’ loads). For example, the offset rules may require retailers to look at domestic NEM opportunities before relying on credits such as Australian Carbon Credit Units (ACCUs). Given offsets under the Paris Agreement might be cheaper than new green generation, it is important the NEG strikes a balance between regulating offsets and Australia’s access to international carbon markets.

  • exemptions – consistent with the current Renewable Energy Target, the Commonwealth Government is seeking to exempt electricity used from emissions-intensive-trade-exposed (EITE) entities. While this is consistent with the RET, further rules will need to be developed around what constitutes EITEs and how any credits generated by EITEs will be dealt with.

Reliability guarantee

The reliability guarantee is aimed at ensuring there is sufficient dispatchable capacity (coal, gas, pumped hydro, batteries or demand response) to enable secure and reliable operation of the power system. The need arises from the increasing penetration of intermittent generation. As with the emissions guarantee, the obligations will be placed on retailers.

Pleasingly, the ESB does not propose a guarantee which operates all the time, but rather one that is only triggered when a shortfall is forecast in a region. The proposal is designed to give retailers sufficient warning of a “reliability gap” so as to elicit investment with a fall back of AEMO intervention if this does not occur.

The guarantee has eight steps.

Step 1 – Forecasting the reliability gap

AEMO will assess whether a gap exists in the future by comparing the forecast capacity in a region against forecast demand (each based on a 1 in 10 year probability of exceedance). While AEMO can build on existing processes, this will require it to publish a new methodology, assumptions and draft projections for public consultation. The size and period of any gap in a region will be published to encourage a market response.

The critical issue is how far ahead this gap needs to be forecast (which then dictates when the guarantee is triggered as discussed further below). The ESB seems to be suggesting somewhere between the existing published Medium Term PASA (projected assessment of system adequacy), which is two years in advance, and the Electricity Statement of Opportunities, which has a 10 year forecast horizon. Too short a period may mean there is insufficient time for the market to respond. Too long a period means reliance on less certain data and the risk of the gap changing through updates.

As discussed below in step 5, when forecasting the gap, it appears that AEMO will not take into account interconnector capacity.

Step 2 – Updating the gap

Regular updating is needed but forecasts that change too often mean the market will not have a certain investment signal. The ESB suggests a 2-3 year horizon lends itself to monthly updating while a 10 year horizon lends itself to annual or quarterly updating.

Step 3 – Triggering the guarantee

The trigger imposes compliance obligations on retailers to ensure they fill the gap. If they do not respond, it can lead to AEMO intervention. The ESB suggests a trigger for short term gap forecasting of somewhere between 3 months and 1 year of the gap. If long term gap forecasting is chosen, it suggests 3 to 5 years ahead of the gap. The obvious difficulty here is that the time required is dependent on the size of the gap and the size of the investment required. A small gap can be dealt with quickly. A large gap will take time - there is an obvious interaction between the trigger and the 3 year notice period of closure that will be required from large generators as a result of the Finkel Review. There seems to be scope to have more than a “one size” fits all approach and triggers calibrated for “major” gaps and “minor gaps”.

The ESB also queries whether the guarantee is only triggered for the first year of the gap or all of the gap. This is an important issue as significant investment may not flow if certainty of recovery is only for a short gap period.

Step 4 – Qualifying instruments

Once triggered, the gap will be allocated to individual retailers (step 5) who will need to show they have sufficient qualifying instruments to satisfy their share of the gap (step 7).

What qualifies is one of the most difficult aspects of the guarantee given the NEM is an “energy only” market (ie no capacity payments) and has separate physical and contract markets. The intent of the guarantee is to incentivise retailers to invest in dispatchable capacity by either developing or contracting it. Retailers use a variety of means to manage their exposure to the volatile wholesale market including owning generation, project specific power purchase agreements (PPAs), demand side response, over the counter (OTC) derivatives, ASX exchange traded products, weather derivatives, outage insurance and finally a prudent level of residual market exposure. The issue is to what extent these approaches can be “traced” to actual dispatchable resources and should therefore qualify for compliance.

  • Where retailers own physical assets there is no tracing issue but still a concern as to gaming – a retailer may seek to count all of the capacity of the asset it owns. In contrast, in an arms’ length transaction that retailer would take into account the reliability or lack therefore of the asset. We would have thought this is solvable by a registry approach discussed below.

  • Project specific PPAs can be easily traced and would qualify; insurance and weather derivatives cannot so do not qualify.

  • Financial contracts such as OTC derivatives and exchange traded products are the hardest bucket. They are the backbone of the market and come in a variety of flavours. They are financially settled and so do not need to be backed by physical generation. The MWh traded can far exceed the actual physical capacity. The ESB suggests that qualification might be limited to caps and swaps and that these contracts could be certified against physical capacity. Thus any contract of this type issued or traded would come with a certification as to the level of physical backing which could be traced through to a generator. As not all energy resources are equal, there would also need to be a methodology as to the “firmness” of the resource – the ESB gives an example of adjusting the capacity of a windfarm.

  • It seems clear that the ESB is measuring the gap and compliance in terms of capacity (ie MW). While the policy does not allow certificates, one approach would appear to be to have generators and demand side response be qualified by AEMO as having a certain level of dispatchable MW and maintain a register (not too dissimilar to the register for the emissions guarantee). The register could maintain a record as to the attribution of those dispatchable MW through contracts or ownership to prevent over-selling.

Step 5 – Allocating the gap

The paper suggests either allocating the gap to retailers or to AEMO who would then do a book build. AEMO would match retailers with insufficient or excess capacity and retailers and new entrants who wish to invest in new capacity. AEMO would clear the market by allocating contracts to successful buyers and sellers for the duration of the gap. This does not seem workable for a large investment as we doubt that contracts for the duration of the gap will be sufficient to underwrite significant new capacity.

If the gap is to be allocated to individual retailers, it is not clear how. There is also a question posed of whether large customers who are not registered in the market (ie who buy through a retailer) should have direct obligations. The concern is that such customers contract cyclically with retailers (eg every 3 years) or have spot price pass through arrangements and so retailers will be unlikely to invest in capacity based on those customers. We agree with the ESB’s concerns about the legal complexity and impacts of such an approach.

While the ESB queries whether only the gap is allocated or whether it is all the peak demand, we think the latter is more likely. However, how this is determined potentially years in advance is very difficult. If compliance is done on an ex ante approach, the two options given are AEMO’s forecasts or the retailers’ forecasts. Both have significant issues. If ex poste compliance is used, then actual load can be used.

The ESB notes that in allocating the gap, interconnector capacity will need to be considered. However, it may be easier to consider this in determining whether there is a gap in the first place in step 1.

Step 6 – Compliance

Compliance can be ex ante, ex poste or both.

Ex ante involves retailers reporting on their qualifying contracts relative to their gap share to the AER sometime after the trigger but before the forecast gap. If the gap is not filled, non-compliant retailers would be penalised and AEMO would procure the remaining gap.

Under an ex poste approach, retailers would report to the AER after the gap has passed. This would be much easier but then the reliability event could occur because in fact it was not realised the gap still existed. Alternatively, AEMO fills the gap and it becomes difficult to assign responsibility.

It seems more likely that a combination may work where one can be less onerous. For example, if there is a high powered ex poste penalty, an ex ante “check” can be used to identify if the problem still exists but the check does not have to be of granular resolution or have onerous penalties. However, the ESB will need to provide further details on what percentage of qualifying contracts is required to cover retailers relative to their gap share. This will assist retailers to determine what sort of hedging arrangements they require to fill any identified gaps.

Step 7 – AEMO last resort procurement

If the gap is not filled, AEMO can do so. The concern is the distortionary effect on the market. Retailers may choose to rely on AEMO or new capacity may prefer AEMO contracts. If AEMO procures too early, then the market does not get an adequate chance to respond. If too late, the gap may not be filled. A shorter timeframe for AEMO suggests a mechanism very similar to the existing Reliability and Emergency Reserve Trader (RERT) which AEMO has not considered satisfactory. In the background, there is also the Finkel recommendation for a strategic reserve. These seem to potentially overlap.

Step 8 – Penalties

The ESB seems to have moved away from its earlier suggestion of the penalty being cancellation of retailer authorisation which was a “paper tiger”. Sensibly, they propose the AER having a range of options commensurate with the level of non-compliance, which will include the existing civil penalty regime under the National Electricity Law. However, the ESB also contemplates penalties based on a formula (eg quantifying the volume shortage multiplied by market price cap/value of customer reliability) or an allocation of costs to meet the gap, which could result in significant monetary consequences for non-compliant retailers.

Concluding comments – reliability guarantee

In concept, the NEG has a sensible approach of seeking to incentivise a market response only where a need is identified. It may be hoped that the very existence of such a regime will provide a new consideration in building wholesale portfolios such that there are no future gaps. However, there is still much detail to work through which represents a key opportunity for stakeholders to provide valuable input on. There a number of fundamental issues. The first is calibrating the timing of forecasting, triggers and AEMO procurement such that the market has a chance to respond and understanding the impact of an “overhanging” strategic reserve. It maybe that some of these issues could be addressed through different treatment of different sized gaps. The second is allocating the gap fairly and providing sufficient incentive and certainty so that retailers will invest rather than free ride on others or AEMO. While demand side offers hope, generation investment has relatively long pay back periods and some certainty of revenue will be required from the regime. The third issue is that limiting the qualifying criteria does not inhibit the contract market in which liquidity is arguably already a problem. The fourth one is of scale – the spreading of the gap among retailers may make it difficult for any one retailer to invest to fill a large MW gap. The compliance obligation may also be a potential barrier for new entry and exacerbate concentration concerns. The fifth issue is transition - the paper does not discuss the treatment of existing contracts and existing day 1 gaps (if they exist).

Implementation of the NEG

The ESB has indicated that there is a strong preference for implementing the final design of the NEG through amendments to Australia’s existing energy legal framework through amendments to the National Electricity Law, National Electricity Rules and other ancillary Commonwealth legislation. This is dependent on the COAG Energy Council agreeing to these changes, as well as the AEMC approving the requisite rule changes. It is unclear the extent to which legislative changes at a Commonwealth level will be required, however there may be a technical requirement for amendments to legislation relating to reporting and information in respect of emissions. This will (at least in part) require some level of bipartisan energy policy.

The conceptual level of the NEG design means there is scope for meaningful feedback from industry to influence the outcomes. Stakeholders should keep a note of the public forum and webinar on 26 February 2018 and seek to provide written submissions by 8 March 2018. With the high-level NEG design paper to be published in late April, and various other working papers and workshops expected later in the year, stakeholder input will be paramount in developing the appropriate NEG legislative and rule change requirements to help design Australia’s energy future.