WA government’s energy market review proposes significant reforms to Western Australian energy market

In brief

On 25 July 2014, the WA Treasurer and Minister for Energy Dr Mike Nahan released the Department of Finance’s Electricity Market Review Discussion Paper (Discussion Paper). The objective of the Discussion Paper (and the market review more generally) is to reduce wholesale electricity costs (without adverse effects on safety and reliability) and more generally, reduce the WA government’s exposure to the energy sector.

Summary of current market structure

The WEM is currently a capacity market. Each retailer must acquire capacity credits from the Independent Market Operator (IMO) or generators directly to match their individual capacity requirement. The IMO sets each individual capacity requirement based on its estimate of the overall capacity requirements of the South West Interconnected System. The IMO is also responsible for assigning capacity credits to generation facilities.

Key findings and reform packages

The key issue identified by the Discussion Paper is that wholesale electricity costs in the Western Australian Wholesale Electricity Market (WEM) are significantly higher than the National Electricity Market (NEM). As a result retail customers pay a high price for electricity and the WA government funds a very large (and increasing) government subsidy.

The Discussion Paper proposes two market reforms to address the high cost of wholesale electricity (discussed further in detail below):

  • retaining the WEM capacity market but introduce changes to increase the effect of market forces in the WEM, or
  • replacing the WEM with a NEM-style energy only gross pool market.

The Discussion Paper also canvasses a number of non-market reforms, including:

  • disaggregating Synergy into multiple retailers and generators (which may include creating one or more ‘gen-tailers’),
  • introducing full retail contestability for retail customers and allowing Synergy to offer dual fuel (bundled electricity and gas) products, and
  • increasing private sector investment in network assets.

With respect to the Verve-Synergy merger, the Discussion Paper notes that the supply arrangement between the generation and retail business were amended under the merger and that it should be viewed as an ‘evolutionary step’ for future reforms.

Findings in relation to the state of the market

The core components of retail electricity prices are network costs and energy costs. The Discussion Paper compares retail electricity costs in the WEM to the NEM and concludes that whilst WEM network costs compare favourably to the NEM, energy costs in the WEM are significant higher than in the NEM.

The Discussion Paper identifies the following as reasons for higher generation costs in the WEM:

  • the on-charging of capacity costs, resulting in retailers and ultimately customers bearing the economic burden of over-investment in generation capacity,
  • the cost (express and implicit) in the bilateral contracting arrangements under which effectively all generating capacity is presently traded on the WEM (in particular the lack of transparency around pricing, limiting the extent that bilateral trades can meaningfully inform forward prices), and
  • the lack of competition amongst generators.

The Discussion Paper identifies over-investment in capacity as a major contribution to these costs. In 2012-2013 average capacity utilisation for the WEM was 35%, indicating that retail customers are paying for a significant amount of capacity which is not being utilised.

Option One: Amend the WEM

The current market design requires the IMO to forecast future capacity requirements. This Discussion Paper notes that forecasting is inherently difficult and prone to overestimation and that as a result the current market design does not facilitate efficient new entry (citing the 35% average capacity utilisation as evidence of this).

The WEM reform proposals are focused on allowing future generation capacity to set by market forces (as opposed to IMO forecasts). This could be achieved by pricing capacity credits via an auction. An alternative is to move the responsibility for procuring capacity from the IMO to market participants. In each case the IMO may continue to have a role in facilitating a capacity market.

A longer term reform is replacing the current bilateral contracting regime (where risk and reward is contractually allocated between the parties) with an exchange model where generation capacity is traded under standardised contracts supplemented by a variety of financial management tools to manage the risk of low probability, high cost events. The Discussion Paper considers that over time this would reduce transaction costs and lead to better informed pricing decisions.

Option Two: Move to a NEM gross pool market

Introducing a NEM style energy only gross pool would be a significant change to the WA energy market. The NEM gross pool operates essentially in real time, with the market operator sending dispatch instructions every five minutes and prices set each half-hour (based on real time supply and demand).

Under a gross pool, increases in generation capacity are achieved through price signals (ie high spot prices). Generators and retailers typically hedge their exposure to price volatility through swap arrangements. The Discussion Paper notes that adoption of an energy gross-pool in WA would not be feasible unless Synergy’s assets are first structurally separated (as this model is not suited to concentrated markets).

Reform timetable

The electricity market review is being led by a steering committee comprising one industry and two government representatives. Responses to the Discussion Paper are due on 12 September 2014.

Various industry participants/stakeholders are likely to have contrasting opinions on the reform proposals canvassed by the market review and it will be intriguing to see how the government manages these competing views.

Ultimately, the message from the Discussion Paper is that significant reform the Western Australian energy market is likely to take place in the short to medium term and parties will need to adjust quickly to the new market model (whatever form it may take).