The NEG: No guarantee of success

Watt Clarity

The NEM and its associated – but quite separate – contract markets are a complex physical and economic system, and since commencement nearly two decades ago changes to either have been incremental, long in gestation, and actively debated.

So it’s more than a little surprising that the federal government’s proposed National Energy Guarantee (“NEG”) framework, which would represent the largest and most significant set of changes to those markets yet, has been unveiled with great haste, no consultation, and very limited detail, but has received widespread, if cautious, acceptance.

Even more surprising when almost nothing in the Finkel Review – to which the NEG is a response – recommended or presaged these particular changes, or anything closely resembling them.

Partly for reasons of space but also because I suspect it’s both less well understood and a bigger change to the NEM design than its counterpart “Emissions Guarantee”, I’ll focus here on four issues arising from the NEG’s “Reliability Guarantee” (“NEGRG”).

1) Administered Investment

A fundamental concept underlying the NEM’s design was that market prices would drive capacity investment or exit, with individual market participants responding to price signals and deciding when, how much, and what sort of generation capacity to invest in (or decommission), and whether or not to modify their demand in response to prices. Provided these signals reflected supply-demand balance and the underlying economics of generation and demand, then reliability (the ability of installed capacity to meet demand at all times) would be maintained via competitive market dynamics – tightening supply-demand balance driving higher prices motivating new capacity investment etc.

AEMO was given a “backstop” role in monitoring and if necessary providing for physical reliability up to the mandated NEM standard through mechanisms such as the Reserve and Emergency Trader powers, which was designed to not mute the high price signals that would otherwise flow from reduced reliability.

The NEG’s Reliability Guarantee thrusts AEMO into a “central planner” role of dictating the minimum dispatchable capacity levels to be built in the market, which are then administratively enforced via retailers being required to contract a specific proportion of their peak demand with certain forms of generation or demand response providers. Capacity investment will therefore be primarily driven by centrally-planned targets and administrative compliance requirements, not market price signals.

Apparently the judgement has been made that there has been a collective “failure” of market participants to invest in new capacity in response to recent high prices and that this is definitive evidence that a core design principle of the NEM was wrong. Alternative explanations for this “failure to invest” (yet) such as:

• complete lack of clarity around investment risks such as carbon policy,
• disruption in key fuel markets (gas supply), or
• simple lack of time to respond to the sudden closure of large generators, appear to have been discounted.

Even if it is accepted, other possible solutions to this “market failure” – such as the Finkel Review’s recommendations to further evaluate capacity and day-ahead markets – have been discarded prematurely.

(That said, the Finkel Review’s proposed “Generator Reliability Obligation” (which would not proceed under the NEGRG) was a rather poorly thought through response to the same alleged market failure.)

2)  Dispatchables Ain’t Dispatchables

There is a strong focus in the NEG reliability framework on “dispatchable” resources (generation or controllable load response), but no real discussion of the important differences between different types of “dispatchables” as far as their contribution to system reliability goes.

A couple of key points:

• “Dispatchability” is not a binary concept. There are many different factors affecting the controllability and robustness of different generation or demand-side resources (startup or notice times, energy production / storage constraints, ramp rates, minimum run times, annual availability, failure rates, mean time between failures, mean time to repair, …). These differences can make it very hard to directly compare different forms of dispatchable resource, and to quantify their contributions to system reliability in isolation.
• Reliability is a property of the entire system, not of individual generators or generation types. It is from the interplay between generation, demand, and the unpredictable factors driving them (outages, weather etc) that system reliability levels emerge. This means that any given type and quantity of “dispatchable resource” could have very different contributions to reliability at different times or in different regions of the NEM (and in fact the same is true even of non-dispatchable resources, which also make some contribution to reliability)

AEMO’s task of determining minimum “percentages of dispatchable resources” which retailers must contract under the NEG Reliability Guarantee is going to be very challenging, and it will be equally difficult to quantify and summarise the contribution of different individual dispatchable resources via blunt percentage metrics.

As a simple example, consider a 100 MW gas-fired generator which may take 10 minutes to start up but can then generate continuously, versus a 100 MW demand response contract which can operate to reduce load within seconds, but only for a maximum period of 1 hour, with no subsequent reduction then available until the next day.

Clearly these resources contribute very differently to system reliability depending on the nature and duration of any threat to supply-demand balance. It is completely unclear how such different sources – which both meet the broad criteria for dispatchability – would be treated under the NEGRG.

3)  Contracts Are Not Physical

The “Advice document” produced by the Energy Security Board (“ESB“) describes the role and nature of electricity market contracts in terms which are overly simplistic and potentially very misleading. This is important because it significantly understates the complexity and potential side-effects of enforcing the proposed Reliability and Emissions Guarantees.

And while AEMO, AER and AEMC currently have little or no direct involvement in them, the contract markets are integral to the efficient and effective operation of the wholesale electricity sector.

There is not space here to go into the detail of how these markets operate, but a fundamental issue is that electricity contracts used in the NEM are overwhelmingly financial derivatives linked to a NEM regional spot price, but with no references to physical generation output or retail demand. They are standardised and tradeable “pieces of paper” used by market participants to hedge (or seek profit from) the financial risks arising from the volatility of NEM spot prices. AEMO and AER currently have virtually no role in operation or oversight of these contracts, which are either bilateral “over-the-counter” (“OTC”) trades between counterparties (who do not have to be physical participants in the spot market), or standardised electricity futures contracts on the ASX Energy (“ASXE”) exchange-traded platform.

The structure of the NEG Reliability Guarantee seems to assume that these contracts are akin to simple energy purchase agreements where retailers buy physical electricity from generators. This is not the case. Production and delivery of electricity does not occur under derivative contracts, only monetary exchanges. Retailers may enter into various types of derivative contracts with generators , but also with other retailers, or with purely financial counterparties such as banks. Regardless of counterparty, these are financial contracts and are only very rarely linked in any way to volumes of physical electricity actually produced or consumed.

Futures contracts traded via ASXE do not represent physical electricity and carry no information on the identity of any generator or retailer which may have originally sold or bought them (in fact the counterparty to any futures contract traded is the futures exchange itself). Generators can sell OTC or futures contracts and fully meet their contractual obligations without physically running any generation – not infrequently this is their most economic approach.

The proposed NEGRG arrangements imply that these contracts and futures instruments will henceforth need to carry identifying data and specify physical parameters showing their “source”, that source’s “dispatchability”, how to measure actual generation volumes and so on. This is a dramatic and radical change to the nature of electricity contracts, making them much more like agreements for physical supply, and could have substantial effects on the overall operation of the wholesale markets well beyond any impacts on reliability.

The ESB Advice is very unclear here, but there are hints that measuring compliance with the NEGRG may involve assessment of “actual output and availability of the dispatchable capacity” specified in the relevant contracts. This is a concept completely foreign to the operation of most current electricity derivative contracts, and could lead to very economically inefficient participant behaviour if enforced literally.

In being linked to specific sources of generation, storage or demand-side capability, contracts would become much less standardised and therefore far less interchangeable and tradeable; it is likely that liquidity via secondary trading in the contract markets would substantially decrease. It is unclear that futures contracts could be adapted at all to the proposed NEGRG requirements, and might wither away entirely.

Decreased tradeability, liquidity and supply of contracts seems far more likely to increase contract prices and contracting costs – and therefore wholesale electricity costs – than to lower them.

Finally there is a significant risk that the greater complexity and reduced liquidity of the contract market will substantially advantage larger integrated participants like the “big three” gentailers who own and control both retail and generation assets, relative to smaller players, again leading to less competitive and efficient overall market outcomes.

4)  What’s The Role Of The Spot Market?

With the NEG placing an enhanced quasi-physical role on the electricity contract market, and completely altering the basis for capacity investment, the role of the spot market may be correspondingly diminished to something more like a “balancing” or “overs / unders” market, where differences between contract positions and actual demand and generation levels are liquidated. The ESB Advice document states that the “cost of any non-compliance [between NEGRG contract quantities and physical generation volumes] is based on the real time spot price”. In the same section, the document also discusses how the “actual requirement for flexible, dispatchable capacity would be dynamic, varying dispatch period by dispatch period”, and a potential need for AEMO to “develop processes to the inform the market as to the estimated requirement and dispatch that in real time”.

Although this is almost exactly what AEMO already does in operating the real time spot market – namely calculates and schedules, dispatch interval by dispatch interval, the controllable resources required to balance demand – the statements in the ESB Advice seem to imply a different or additional real time process, without attempting to explain what this is or how it differs from the current spot market.

Without more detailed information it’s difficult to comment further, but given the far-reaching changes proposed to the current contracting framework, it’s not hard to anticipate correspondingly significant changes to the spot market itself.

Conclusion

Although it has been presented and in some quarters hailed as a “solution” to the ills besetting the wholesale electricity sector, the NEG in its current, very preliminary and sketched-out form is nothing more than an outline of one possible framework among many. It doesn’t appear to build on nor address much of the careful analysis in the Finkel Review, and its present embryonic structure raises at least as many questions as it purports to answer.

It seems far too premature to declare the NEG a potentially effective – or even workable – approach to dealing with the challenges of the energy transition, let alone the most efficient solution. Hopefully the processes of consultation and development which the government has now promised to embark on will properly address the concerns above, and lead to a practical and effective strategy for the NEM’s further evolution.

This article was originally published on WattClarity. Republished here with permission