Market re-design needs to factor in carbon, or there’s no point

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The debate over energy-only and capacity signals will be redundant if the new market design does not factor in carbon emissions and climate change.

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The Energy Security Board has set out on a process to re-think the design of the country’s main electricity market in what will be the biggest change in the sector since the National Electricity Market was first put together two decades ago.

Countless submissions have been filed, and we’ve been through them all. One over-riding theme emerges: If the new market design does not have carbon in mind, and deliberately ignores environmental factors as the current framework does, then the re-design is pointless.

The EUAA (the lobby group for large commercial and industrial electricity consumers) wants an explicit carbon price. Of course, this is what all the environmentalists want. And if you ask economists how to manage carbon pollution they would generally support a carbon price via cap-and-trade as the theoretical “best” way .

ClimateWorks and other organisations want a carbon objective written into the National Electricity Law [NEL].  ITK’s view is that without an explicit carbon objective the ESB’s reform process probably won’t work.

That’s because the rules of all the different markets will have to be constantly changed to cope with shifts in Government policy towards decarbonisation.

Europe’s ETS is now heading towards its 4th iteration and is starting to become very effective with the cost of carbon now exceeding the coal cost for black coal generators.

To be clear, carbon and decarbonisation don’t get a mention in the ESB Directions Paper. As I say, this means that the process is fatally flawed from the get go.

So given that everything else is just rearranging the deck chairs, fiddling while Rome burns, and missing the forest for the trees, what are the main issues in front of the ESB as it approaches its market redesign task?

Perhaps the main points made by participants were that there was a lot (too much) change, a discussion about capacity and day ahead markets.

To that I would ask: Do we need better markets for ancillary services, or how is the market design going to incorporate the inevitable move to very low inertia?

Energy versus capacity markets

An excellent summary of energy and capacity market pros and cons was written by Greg Williams from the AEMC, and can be found at capacity market debate. Greg articulated the widely held concerns that:

The transition will hasten the retirement of the remaining coal-fired stations;

Wholesale prices are unusually high as increased VRE (variable renewable energy, or wind and solar) hastens coal-fired retirements; and

Spot prices will become increasingly volatile making it more difficult for investors to appropriately time their investments in firming technologies including demand response (my words).

As Greg puts it, market designers normally allow for reliability in one of two ways.

First, there is  a price driven approach (NEM, ERCOT, NZ, Singapore and part of Canada). In this approach the market price cap is set high providing a price signal for new investment.

Historically, this has worked well in Australia but in my opinion more recently less so, partly  because there are so many interventions in the market.

By way of contrast Peter Cramton wrote a strong discussion of the theory underlying an Energy only market, using ERCOT (based in Texas) as the example. See Crampton – Electricity market design.

Crampton observes that the reliability issue arises because consumers have no way to express their reliability preference:

“In other industries, reliability is not an issue. Prices rise and fall to assure supply and demand balance, but in current electricity markets there is typically insufficient demand that responds to price and consumers are unable to express a preference for reliability. Thus, there is a need in current markets for the regulator to determine how this preference for reliability is expressed.

“As we will see, one approach to reliability is to rely solely on spot prices but to include administrative scarcity prices at times when reserves are scarce. The preference for reliability is imbedded in the scarcity prices. Setting higher scarcity prices enhances reliability in providing stronger investment incentives.

“An alternative approach is to more directly coordinate investment with a capacity market, although this is best done as an addition to, not a substitute for, administrative scarcity pricing, since it is the scarcity price that motivates capacity to perform when needed.”

An alternative view to Energy only markets is the solution to all problems was summarized in another excellent paper, Grubb & Newberry, UK market reform emerging lessons  reviewing the UK electricity market evolution.

As the UK has virtually just about phased out coal, the article  is well worth the time.

Electricity, delivered to each voter’s home and critical to modern existence, is inevitably politicized. The main question is how to reduce the adverse effects of inevitable interventions.

The move to auctions, fixed price contracts with the price set at auction for renewables and firm capacity, backed by a government-guaranteed credible counter-party, and even the Carbon Price Support, seem steps in the right direction.

The second approach adopted in much of the USA and in Europe is quantity driven. In this approach the energy price ends up closer to SRMC (short run marginal cost) but the total price paid by consumers also includes a separate reliability or capacity cost.

Those with a lot of time on their hands can read an annual 656 page review of  the PJM market (in the eastern states of the US) including the capacity element here.

For now in order to provide a touch of perspective the 2018 Electricity price breakup for PJM is:

Figure 1 PJM price breakup. Source: Monitoring analytics
The knocks on capacity markets

The two essential knocks on capacity markets is they impose costs on consumers without incentivizing new capacity.

For instance the UK capacity market has costs of around  1 billion sterling per year,  according to the July 19 UK capacity market review.

This works to around $A5/MWh, something like 6-7% of the average wholesale price based on UK electricity consumption of 350 TWh.

Since then capacity prices have fallen so about 8.4 sterling/kw/year on 50 GW or Stg400 million per year.

Figure 2 Source: UK Govt, Capacity market outcomes

But then the second and more important  part of the knock is those prices are too low to incentivize new capacity and all that happens is that existing capacity receives extra revenue.

Figure 3 Source: EPRG

Were this to translate to Australia, how would it help with the central problem obvious to everyone except Matt Canavan and that is replacing the ageing coal fleet with a 21st century technology fit-for-purpose system?

In another theory paper, Olga Weiss and others compared an energy-only versus a capacity and energy market for the case of Israel, concluding energy only provided the lowest total system cost.

Responses to market design

The ESB published a market design issues paper and requested submissions by 30 September. Your analyst has been as busy and happy as a fox in a chicken coop reading close to 60 submissions. The submission naturally reflect the agenda of the organization making the submission..

Many of the submissions reflected very deep knowledge of  the NEM and there has been clearly a lot of background analysis on what is good and bad and thinking about what the future may be. ITK would like to award participation stars to all respondents.

The bullet points below represent ITK’s thinking having read many, even most, of the submissions.

  • The ESB paper still skirts around the main structural issue, that is modernizing the thermal generation fleet with 21stcentury fit for purpose supply and basing it round a decarbonisation target.
  • There are many (more than 21) reforms
Too many detailed rule changes, not enough focus on the big issues

I knows that markets and prices work. I believe in the power of price as much as I believe in gravity.

But as we enter a period of massive transition including rebuilding significant sections of the transmission system, an electricity physical process which has become infinitely more complex with peer-to-peer, highly distributed generation, virtual generators, and two-way flows of power, a system where power system control is rapidly shifting from physical inertia based to power electronics, it has to be asked whether markets driven by process driven regulators running years behind the pace of physical change is really the best solution.

As we can see below the bewildering number of actual and proposed rule changes is likely to be a complete nightmare for customers and everyone else. Transmission is going to be unreliable while its rebuilt, software systems will have to become way more complex.

The possibility of error is going to skyrocket.

Some will likely make lots of money but in my view there is a good case for a more centrally planned system.

This would start with a decarbonisation target, a carbon price and some centrally driven transmission build.

A start does need to be made on zero emission dispatchable power. A way needs to be found to give new solar farm owners a return on capital despite the fact there will be a surplus of lunchtime power.

My view is its highly questionable whether the many rule changes actually attack the easily identified central problems.

Lots of support for the current energy only design

As far as we can peer into the shadows of the future two of the main design issues being contemplated are “Day ahead markets” and “Capacity markets”.

Each of these is a major topic in itself and according to evidence and points made in a number of the submissions neither will necessarily do much to improve things.

Here’s Stanwell again on the day ahead market:

“The overseas markets that have Day-Ahead arrangements were designed for objectives other than integrating VRE, and for systems that are operationally distinct from the NEM. There has been little justification of why a DAM would efficiently solve the challenges of the NEM. They would likely add complexity while conflict with the need for greater flexibility”

Capacity markets have been well analysed and there is more negative data about them than positive.

Offering multi-year contract to Yallourn as the Victorian Government appears to be about to do will likely stuff up anyone else thinking of supplying the service. And by the way if there was more transmission from NSW to Vic another 1300 MW is instantly available.

Yes, it’s easy to be a critic but football fans know that management and the coach do matter.

National Electricity Objective carbon not in scope but that’s problem No 1

ITK’s understanding is that a review of the National Electricity Objective was specifically not on the agenda, and yet ClimateWorks made it the central point. I agree with that.

Alan Pears also made it a focal point of his submission albeit for a different reason.

The National Electricity Objective currently is:

“To promote efficient investment in, and efficient operation and use of, electricity services for the long-term interests of consumers of electricity with respect to: (1) price, quality, safety and reliability and (2) security of supply of electricity the reliability, safety and security of the national electricity system”

The complaint is that there is no carbon objective in the NEO (National Electricity Objective) whereas in reality one foundation of electricity “development” is to emit less carbon.

This hidden reality needs to become National Law because in the end the practical issues has always boiled down to replacing Australia’s ageing coal generators with something else.

Here is what the EUAA (large energy users had to say)

“Therefore, central to any 2025 market design must be the consideration of the inevitable decarbonisation of the energy sector. This must be supported by a clearly defined emissions trading scheme that delivers an unambiguous price on carbon.

“This is what owners, operators and investors in energy generation are looking for in order to make the long-term investments in energy infrastructure that we so desperately need” (emphasis added)

This is what large energy users (over 50% of total consumption want). It’s basically what 70% of  the Australian public want. It’s what the generation industry wants to plan the future properly.

Ok not every generator wants that but most who look to reinvest current cash flows into the future need it. It’s certainly what the transmission industry needs to provide another piece of certainty around investing in transmission ahead of generation.

How much intervention?

A number of submission note that intervention results in distorted markets. There are two legs.

One leg is policy intervention, eg the RET or Snowy 2 or “big stick”. Of course this point has now been made more forcibly and clearly by Guy Dundas from the Grattan Institute.

There is some irony though as some of  those complaining about policy intervention also want more physical control  and essentially centralisation of DER.

The second leg is reliability based within the current rules eg  AEMO intervention in South Australia.

This suppresses price in the short term but also suppresses the  investment signal. Indeed intervention of this sort sends a long-term signal that scarcity pricing won’t be achieved.

ITK believes there is a legitimate question as to the extent of policy intervention compared to market outcomes.

Policy intervention comes because policy makers don’t like the market outcome.

For instance an energy spot market coupled with a contract market won’t guarantee a reliability objective, nor will it prevent scarcity pricing, nor will it prevent coal generators closing abruptly, nor will it achieve decarbonisation..

Policy and rulemakers have too many overlapping agendas that are out of kilter

A number of submissions focus on the amount of reform and redesign of the “system” and note that things are being done our of sequence.

In particular there were several submissions that viewed the timing of the COGATI process and the market redesign as being at odds and that the COGATI process should follow the market redesign

Despite a specially commissioned KPMG report on this topic I was most taken by Stanwell’s submission.

It pointed out that the COGATI process logically comes after the market redesign and contained a diagram of the current timing of the various processes

Figure 4 Source: Stanwell

Its easy to gloss over in  the diagram but note that AEMO is doing a Renewable Integration Study due Q1 2020, the COGATI process, and more generally the number of studies due over the next few months.

The ESB needs to be cognisant of industry’s continued concern about the timing, process and lack of detail of the COGATI consultation. Discussions at the latest Working Group indicated that the AEMC are shifting away from a core tenet of the reform26, while the process has provided a dearth of detail on the other components. Stakeholders have been very limited in their ability to provide comment as insufficient detail has been provided, and the AEMC is presenting the reform package in three progressive steps.” Stanwell Submission.

Here’s another chart produced by KPMG in a report commissioned by the AEC (essentially the thermal generator lobby group) that shows just how many reforms are going on BEFORE considering the major COGATI and Market redesign process.

Figure 5 Source: KPMG
Coal generators increasingly acknowledge the future

Delta Electricity’s part owner Trevor St Baker has often argued that Vales Point B has a long future. However, on every graph of future coal generator closures, it’s first on the list after Liddell. Here’s what Anthony Callan, Executive Manager Marketing at Delta, submitted:

“Vales Point could retire in 2029, or earlier depending on technical and financial considerations, noting the three year notice of closure requirement. However, it is possible to extend Vales Point for a further fifteen to twenty years with significant new investment commitments should there be role on the market to provide affordable and reliable electricity. “

Significant support for “system security services” market

A number of submissions noted the difficulty of getting paid for providing system security services.  Engie for instance said:

“Currently the EO market does not sufficiently value system security services. We need to better understand system security services so that the market can invest in them. “

ITK sees this as part of the broader debate about where AEMO’s role ends and that of the generators begins.

The “Do no harm” rule for instance has been heavily criticized equally Engie is not a fan of AEMO’s proposed rule change that “requires primary frequency control from all generators”

These might be voltage or current or frequency control for instance but there are other services as well. In general ITK expects that batteries would excel at providing some of those services. Modern inverters can also help.

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