ESB initiates Capacity Mechanism design
Fast Facts.
In its final advice to Energy Ministers, the ESB identified that the existing NEM arrangements were unlikely to ensure resource adequacy into the future as the energy system transitions.
The NEM relies on spot price volatility and financial contracting to incentivise new investment to meet the reliability standard. This is delivered through the NEM market price cap (currently $15,100/MWh), which allows peaking generators which operate infrequently to achieve higher than normal returns in times of supply shortfalls or demand spikes.
The continuing high penetration of variable renewable energy (VRE) and distributed energy is putting downward pressure on energy spot and contract prices. This is leading to a deterioration in the economic viability of incumbent thermal generators, and the Australian Energy Market Operator (AEMO) has now forecast that most retirements of coal fired plant will occur before the end-of-technical lives of these plant.
The growing penetration of weather dependent VRE is also leading to increased price volatility in the NEM. This further increases the risk for investors in new peaking plant, challenging their ability to form reasonable, predictable forecasts of future prices prior to committing capital. These concerns have caused various governments to intervene in the market or trigger their own investments, such as the NSW Electricity Infrastructure Roadmap.
To address these challenges, the ESB recommended “the detailed design for a capacity mechanism that ‘unbundles’ the value (of) capacity from (that of) energy be developed.”[1] The ESB suggested that such a mechanism would provide greater certainty about reliability outcomes, reduce the tendency of governments to intervene, and drive new investment in technologies that can deliver firm and flexible resources through consistent market-based signals, as thermal generators exit the system.
The Energy Ministers endorsed this recommendation and tasked the ESB with providing advice on the detailed design of a capacity mechanism that could be in place by 2025 or earlier, with the advice to be provided by December 2022. The ESB has now released two initiation papers for consultation with submissions due by 10 February 2022:
o A Scope of Works to provide stakeholders with clarity on scope, approach and process; and
o A Project Initiation Paper, which outlines the key components of the mechanism and potential options.
Background
What is a capacity mechanism?
Electricity market designs have tended to fall into two camps – energy-only or energy-plus-capacity markets. Each has aspects within the market design that target resource adequacy.
An energy-only market relies on a high market price cap to incentivise sufficient investment to meet a predetermined reliability standard. Peaking supply that is needed rarely to support reliability of supply should, in theory, be able to earn sufficient revenue in those short periods to earn a return on the investment. Financial contracting typically emerges to allow transfer of risk between customers and generators.
In an energy-plus-capacity market, the capacity mechanism aims to replace extreme volatility with a combination of fixed and variable revenue streams to de-risk investment, up to the level of reliability needed. Capacity mechanisms are typically designed with processes that look ahead two to three years to address future reliability needs that may arise in the market. In a transitioning energy market, capacity mechanisms provide medium to long-term electricity supply security by ensuring that investors can be guaranteed a return for investing in plant and then making that plant available in times of extreme shortfall.
A capacity mechanism is designed according to the reliability needs of the particular market or jurisdiction. Typical design elements include:
Suppliers receive capacity payments commensurate with their contribution to reliability of supply, which can be thought of as an availability payment – with penalties often applied in the event that a capacity provider is unavailable. The capacity valuation of a particular plant may vary according to its dispatchability and reliability.
Customers (retailers and large customers) indirectly fund the capacity payments according to their contribution to system demand in times of greatest system need, providing an incentive for them to support investment in new capacity.
It is worth noting that the NEM already has the Retailer Reliability Obligation (RRO) to promote resource adequacy. However, this a ‘financial’ mechanism, rather than a ‘physical’ mechanism; the difference being that the procured capacity of a ‘physical’ mechanism is tied back to individual power plants, while this is not the case for the ‘financial’ mechanism. The ESB considered an option to modify the RRO by altering the definition of ‘qualifying contracts’ to increase the likelihood of a physical linkage to the financial market. However, the ESB has paused further development of this option.
Why is a capacity mechanism needed?
As the Australian economy transitions to a lower emission generation profile, AEMO’s Draft 2022 Integrated System Pan (ISP) Step Change scenario anticipates a near doubling of the electricity consumed from the grid, and significant investment in renewable generation, storage, and firming generation.
Given stakeholder concerns about:
the downward pressure on energy spot and contract prices from increasingly high penetration of VRE, placing pressure on existing, less economic generation to exit the NEM;
the increased volatility of energy prices resulting from the growing penetration of weather dependent VRE, leading to increased risk for investors; and
the recent propensity of governments to intervene in the market in response to reliability concerns,
the ESB has recommended market arrangements that explicitly value capacity and encourage investors to take long-term capacity risk. The ESB has not indicated that there is a revenue adequacy (or “missing money”) issue; rather, the present allocation of risk between market participants should be adjusted to reflect the changing power system.
Objectives and principles of the capacity mechanism
The ESB’s development of the detailed design options will be assessed against the National Electricity Objective (NEO), and informed by a design objective and design principles set by Energy Ministers. The ESB has recast the design objective put forward by the Energy Ministers into two separate but related objectives, being to:
1. Ensure investment in an efficient mix of variable and firm capacity that meets reliability at the lowest cost by:
o facilitating the timely entry of new generation, storage and flexible resources;
o facilitating or complementing the orderly retirement of ageing thermal generation; and
o complementing other market arrangements addressing resource adequacy.
2. Increase government and community confidence that the market will deliver resource adequacy, thereby reducing the need for interventions over the longer term. [1]
The Energy Ministers provided 14 design principles, from which the ESB has developed the following assessment criteria that will be considered alongside the NEO:
Achieving the optimal level of reliability;
Appropriate allocation of risk;
Technological neutrality;
Minimise regulatory burden; and
Emissions reduction.
Key Issues
The current and future transition of the energy sector is requiring a re-examination of the design of the NEM to ensure that it continues to meet the NEO. Introducing a mechanism that values capacity separately from the energy price, however, is a significant and controversial change, as it alters the original NEM design and arguably doubles up on the incentives for new investment already contained within the energy-only market, ahead of any capacity shortfalls actually being experienced. Part of the ESB’s process will be therefore to demonstrate why new market arrangements are needed to support investment for a future net-zero emission NEM, and to ensure a design process which reflects the actual needs of a rapidly transitioning system.
Capacity Mechanism Options
The ESB has indicated that it is seeking feedback on two ‘physical’ options:
Option 1, encompassing:
Option 1a: A decentralised mechanism, where retailers are incentivised to procure capacity, which in turn is expected to drive investment in the required resources. Compliance would most likely be determined by whether certificates covered their actual load throughout the at-risk period. The severity of the penalties will influence compliance. Markets that operate capacity mechanisms with a decentralised approach include France, and California.
Option 1b: A hybrid decentralised mechanism where the evaluation will be done ex ante against the forecasts that have been centrally determined, and the retailer's actual demand is not considered. Markets that operate capacity mechanisms with a hybrid approach include the PJM Interconnection in the United States (Reliability Pricing Model).
Option 2: A centralised mechanism, where a central body determines the capacity requirement and has responsibility for procuring the necessary resources to meet the reliability requirements. AEMO would purchase required capacity on behalf of participants and distribute payment to liable companies based on their actual demand during the forecasted at risk period [1]. Markets that operate capacity mechanisms with a centralised approach include the United Kingdom, Ireland, and the Western Australian WEM.
The choices between these options, and their design elements, have different implications for risk allocation between parties. The range of design elements that need to be considered when designing a physical capacity mechanism include:
The definition of capacity;
Transmission constraints and interconnection;
Market power mitigation;
Certificate trading and procurement;
Forecasting methodology and the determination of capacity demand; and
Compliance, incentives, and penalties.
Each of these elements form the building blocks for the design of a capacity mechanism, with both centralised and decentralised options sharing many of the same elements.
Market power mitigation
While there are several design elements that require detailed consideration in the design of a capacity mechanism, the potential concentration of capacity and the associated issues of market power have considerable influence. There are several ways in which market power can arise:
Capacity being, by its nature, prone to scarcity and the resultant market dynamics, can allow market power to be created, subject to the stringency of the underpinning reliability standard and the barriers to market entry;
Market structure, including vertical integration, can lead to the ability to exploit market power by those with greater market share in either generation or retail markets, which can hamper market liquidity and transparency; and
Lumpiness issues, whereby there can be mismatches between the sizes/needs of suppliers and buyers, subject to the transaction costs and the availability/design of secondary trading mechanisms, creating circumstances where market power can be exploited.
Next Steps
A Scope of Works and Project Initiation Paper have been released for stakeholder feedback until 10 February 2022. This feedback will inform further work on the design and development of the capacity mechanism.
The key four phases for the process to December 2022 are:
Identify and develop a preferred approach of either a decentralised or centralised mechanism, based on stakeholder feedback to the Project Initiation Paper, with an Indicative Report to Ministers in March/April 2022;
Develop a detailed straw-person for the preferred option for consultation by April 2022;
Prepare a draft detailed design for consultation by August 2022;
Develop final design and recommendations for Energy Ministers by December 2022. [2]
Our Insights
There is a diversity of views as to whether a capacity mechanism is a necessary and useful addition to the NEM market design. Ultimately, the answer lies in whether, in the absence of a capacity mechanism, appropriately priced energy will be available to consumers in the NEM throughout, what will be the most transformative period in history, over the next ten plus years.
Putting the detail of the mechanism aside, and the issues around the subject of climate change and the role that thermal coal power stations play in accelerating it, the NEM is changing very quickly. Not two years ago, AEMO’s 2020 ISP identified Central as its most likely scenario. At that time, there were some market participants speaking of Fast Change as a more probable scenario, but none (that we are aware of) were planning on that basis. Step Change 2020 was a step too far for the market – to accept it as most likely was to admit that not a single coal fired power station in the NEM would operate to its full technical life. When AEMO released the ESOO in late 2020, minimum demand was telling a story more akin to Step Change 2020.
AEMO’s selection of Step Change as its most likely scenario the Draft 2022 ISP is extremely significant, and particularly given the changes between Step Change 2020 and Step Change 2022. Step Change 2020 forecasted that by 2040 there would be 8.6GW of coal remaining in the NEM; Step Change 2022 reduced this to zero. Put simply, all the economic signals in the NEM are pointing towards the rapid acceleration of the exit of synchronous generation, and nobody knows how quickly this will occur. It is arguable that designing a mechanism to backstop a lack of availability of synchronous generation is nothing other than prudent in this environment, all other things being equal.
The devil of course, lies in the detail, and there are a range of design elements yet to be resolved through what will no doubt be an intense debate. There are few neutral industry parties in this issue; coal fired and other “must run” generation will do well if a capacity mechanism is introduced and will extend the economic life of these plants beyond where they would be in an energy-only market. Renewable generators are relying on the end of coal and to take its place as the new base load generator; new VRE development projects are therefore relying on the pipe being clear for new plant. Any capacity mechanism will need to be scoped and sculpted to provide clear signals and incentives for investors, and assurances for policy makers, without transferring excessive cost or risk to consumers.
The ESB will need to sensibly balance the costs and benefits with a conservative eye. The ISP process has demonstrated that change is not linear; a low probability yet high value reliability event may end up being something that customers look back on and wish they had agreed to pay for.
For more information, contact Simone Rennie at srennie@renniepartners.com.au
[1] ESB, Initiation Paper – Capacity Mechanism Project
[2] ESB, Scope of Work and Forward Project Plan - Capacity Mechanism Project
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