No Guarantee of Success

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.

 


About our Guest Author

Allan O'Neil Allan O’Neil has worked in Australia’s wholesale energy markets since their creation in the mid-1990’s, in trading, risk management, forecasting and analytical roles with major NEM electricity and gas retail and generation companies.

He is now an independent energy markets consultant, working with clients on projects across a spectrum of wholesale, retail, electricity and gas issues.

You can view Allan’s LinkedIn profile here.

Allan will be sporadically reviewing market events here on WattClarity

Allan has also begun providing an on-site educational service covering how spot prices are set in the NEM, and other important aspects of the physical electricity market – further details here.

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10 responses to “No Guarantee of Success”

  1. […] article was originally published on WattClarity. Republished here with […]

  2. Ken says:

    The first paragraph in section 1 “A fundamental concept underlying the NEM’s design was … etc etc” outlines the intended outcome of the NEM and in this paragraph the writer implies that this dream can, in an ideal world, be accomplished. I would challenge this underlying assumption. I believe it is not possible to devise a free market framework where price signals will provide feedback that will deliver a stable and technically desirable out come. I think the free market economy is, for a great many processes, the best of a bad bunch of alternatives, but for making and delivering electrical energy to consumers is one of the silliest ideas I have ever come across. No amount of tuning and fine tuning will ever work – the whole idea stupid. The NEM is a process where a small number of people can make some money. From that point of view it works. But there are no other winners only losers in the NEM landscape.

  3. observa says:

    Well frankly the penny is slowly dropping that you can’t build a reliable system from unreliable componentry. That’s a fundamental axiom of engineering and where in the world did so many bright sparks ever witness a precedent to the breaking of that rule and yet they charged ahead with active promotion of power generation at the mercy of sunlight and weather. If your first year apprentice mechanic hadn’t understood that axiom of engineering by second year you’d have to fire him for the sake of your customers.

    Power is an essential service so like police and the fire brigade, if you want to outsource its provision you don’t go round accepting tenders that have fine print saying no one will be on duty at night or when the wind don’t blow or blows too hard, even though the tender price looks good.

    Where do we have to go with a communal power grid for a level playing field? Well whatever the supreme guru thinks the price of CO2 should be to get the earth’s temperature back to the temperature only the supreme guru knows it should be is imposed on all the tenderers. Then they are only allowed to tender those electrons to the communal grid they can reasonably guarantee 24/7, all year round.

    Yeah I know all those red faces that thought they could ignore that fundamental engineering axiom and have to tell all the mums and dads with rooftop solar that if they can’t guarantee their electrons they can keep them. That’s why even Chief Scientists duck such retrospectivity with the bleeding obvious.

  4. Chris O'Neill says:

    “you can’t build a reliable system from unreliable componentry. That’s a fundamental axiom of engineering”

    The person who wrote that knows nothing about engineering.

    • Ken says:

      I would agree that the author may know very little about engineering. However what is so unusual about that in the current debate about how the NEM works? There seems to me to be a plethora of economists and bankers and spin doctors with virtually no rational professional engineering input. We would not have the mess we now have if engineers had been left alone to deliver cheap, clean reliable power.

    • observa says:

      Well try a chain is as strong as it’s weakest link. I’m not saying wind and solar power can’t be made reliable to contribute to a reliable grid system but at what cost and that was completely overlooked or deliberately ignored. Why were so many so stupid or culpable in doing that?

  5. David Headberry says:

    Allan
    Thanks for the very useful dissertation. What the article does is to highlight that the sketched outline has a number of wrinkles that have to be addressed, and that addressing them might not be as straight forward as implied..
    I am concerned that the NEG overlaid by the incipient 5 minute settlement rule change will have an even greater downward pressure on competition and lead to even higher prices.
    Is a GT which can provide energy within 10 minutes a “reliable” source under 5 minute settlement? Is a battery that discharges within 5 minutes a reliable source under 5 minute settlement, noting that it then increases demand as it recharges? Is a coal fired generator with the minimum ramp rate a reliable source under 5 minute settlement?
    The more I dig into the NEG and 5 minute settlement, the more I realize that the economists involved really don’t understand the limitations of the technologies that our electricity system needs to ensure that electricity supplies are reliable

    • observa says:

      “What the article does is to highlight that the sketched outline has a number of wrinkles that have to be addressed, and that addressing them might not be as straight forward as implied..”

      Wrinkles! The problem is we have a bunch of beauticians trying to put lipstick on a pig. 5 or 10 minutes despatchability is not the issue but the really big picture- http://anero.id/energy/wind-energy/2017/october
      or worse still-
      http://anero.id/energy/wind-energy/2017/june

      Now while that wind energy sector can produce an annual average output of installed capacity around 30%, just ask yourself what sort of storage investment would they require to even guarantee 5% or 10% of their capacity 24/7 all year round? They haven’t had to but get to dump those peak outputs at almost zero cost onto the market and leave all the thermals to pick up the insurance tab for all the troughs. Nice work if you can get it particularly when you’re further subsidised to do it via cash transfers from Govt mandated taxes on your competition. I guess you could call it a free market and we’ll no doubt all be free of despatchable thermal power sooner or later.

  6. Graeme says:

    Good article.
    The NEG proposal has a problem – around 85% of forward contracts are now done through the ASX24 futures, and bilateral OTC contracts are only a small part of the market.
    The September 2016 system black was not due to a failure of contracting, reliability or dispatchable generation – it was due to system instability and lack of synchronous inertia.
    However, the January 2017 problem was a market contracting failure. There was apparently a lot of customer load that had not contracted with generation, and generators were left undispatched because they had not been contracted.
    Why would customers choose spot exposure rather than take out a contract?
    I suspect that a large reason is because the $300 Administered Price Cap enabled them to go uncontracted without a significant spot exposure.
    The Administered Price Cap has not been reset for many years. It needs to be re-examined, and re-priced to take account of much higher current short-run marginal costs.

  7. Yili ZHU says:

    The contracts for reliability guarantee may not require financial contracts, i.e. the derivatives. Dispatchable generators and load may sell their dispatchable capacity into the market in 1 MW packets for each 5 minutes dispatch intervals. This can be standard contracts tradable in secondary market. The challenge would be for AEMO and AER to enforce compliance. It would be a serious challenge to verify that a dispatchable generator or load have the dispatchable capacity available for each dispatch intervals and they have not sold more capacity than physically available. This verification would involve checking the technical and operational data records, not merely a reconciliation of contract volumes against physical demand.

    It is possible, but I think it would be cost prohibitive.

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