19 April 2018

10 things to look out for in the National Energy Guarantee announcement

This article was written by Louis Chiam and Estelle Petrie.

The most significant change to Australia’s energy markets since the ill-fated 2011 carbon tax is set to be endorsed this Friday 20 April 2018 by the COAG Energy Council.

After 6 months of brainstorming, public consultations and closed-door discussions the Energy Security Board (ESB) is seeking in principal support from State and Territory Ministers for its draft design of the National Energy Guarantee (NEG). While details of the design have been kept under wraps, a number of key elements have been signalled.  

Here are the 10 things that the KWM new energy team will be watching for in Friday’s announcement.

Contractual instruments

The NEG is designed to integrate with the existing contracts market in the National Electricity Market (NEM). To meet both a reliability obligation and an emissions obligation, retailers will be required to contract with or invest in particular generation, storage or demand response. The question of what contractual products will be eligible under the NEG to satisfy these obligations is therefore central to its design.

Currently, retailers and other market participants hedge their exposure to volatile electricity spot prices through exchange traded and over-the-counter swap and cap contracts.  This (mostly) deep and liquid market for financial instruments is sometimes ‘blind’ to the ultimate generation sources, and not surprisingly contract market liquidity was a key concern for the majority of stakeholder submissions to the ESB consultation. Like others, Goldwind Australia were concerned that attempting to physically track financial contracting arrangements will reduce transparency and liquidity.

1.  How the draft NEG design balances the incorporation of emissions and reliability attributes in contracts without disrupting the market and making it less liquid.

More complex contracts could reduce liquidity and also increase administrative costs for retailers trading in contracts. For example, Origin Energy stressed in its submission to the ESB that there would be practical and logistical complexity in imposing eligibility criteria upon contracts for the purposes of the Reliability requirement. Reports on the draft NEG indicate physical backing of contracts is unlikely to be required.

2.  Whether the draft NEG will permit purely financial contracts, which do not specify a generation source, to qualify to meet reliability obligations.

Stakeholder support for including contracts without a “physically backing” was strong in the ESB consultation. However, the ESB noted that physical backing can provide incentive for continued operation of physical assets and help promote fulfilment of the reliability requirement.

3.  The emissions guarantee and stapled securities - how emissions characteristics will attach to contracts.

There was some divergence in the ESB consultation process on how emissions should be calculated where generation sources or emissions intensity for a contract is unknown.

For example, AGL supported using deemed emissions in situations where emissions targets are likely to be met, while Origin Energy opposed deemed factors for contracts that do not specify a generating source, arguing it would diminish liquidity or create avenues for underreporting. Telstra proposed an Emissions Methodology which would require generators to contractually account for information on emissions intensity based on generation source.

A number of submissions suggested allowing the development of a stapled security for the purposes of meeting the emissions guarantee. AGL suggested that the emergence of novel contract products and new financial products (e.g. contract which staples wind and gas) should be supported in the NEG along with measures to support assessing the emissions intensity of these products.

4.  Whether the draft NEG takes the approach of deeming emissions when a generation source or emissions profile of a contract is unknown. We’ll also look at how the draft NEG approaches the use of stapled securities to satisfy emissions obligations.

Improved forecasting

A central component of the NEG, the reliability guarantee, will be critically dependent on forecasting the quantity of contracted dispatchable power, and whether this will meet the forecasted demand peaks. Several submissions to the ESB consultation argued that the accuracy of AEMO forecasting would need to improve to be effective under the NEG.

In addition to questions about how the reliability gap is calculated, the COAG Energy Council will be asked to consider the period set for forecasting and triggering the reliability gap under the draft NEG. A number of submissions to the ESB supported a shorter reliability gap trigger, with Infigen noting that a shorter forecasting and trigger period would reduce the risk of over-forecasting.

The NEG contemplates that once a reliability gap is forecast there will be a point at which the reliability requirement is triggered and the market will be required to respond. A short reliability trigger will improve accuracy, but reduce the time in which the market has to meet that reliability shortfall.

5.  How the draft NEG balances this trade-off between accuracy and relevance: how will the ESB balance forecasting accuracy an adequate lead time to ‘fill’ any gap.

Media speculations suggest the draft will contain a 10 year forecasting period with a 3 year trigger and that AEMO will need AER approval to trigger the reliability obligation. This is longer than some submissions suggested. For example, Canadian Solar, Infigen and Snowy Hydro all proposed forecasting periods of less than 3 years.

Compliance mechanism

Closely related to forecasting issues are questions around the choice of compliance mechanism. These relate broadly to when compliance should be measured and the way compliance will be enforced. (Yes, this is a technical legal issue but, hey, we’re lawyers.  And as you’ll see below, this has broader ramifications.)

The ESB consultation flagged that the reliability requirement could either be measured prior to a predicted gap (an ex ante approach) or following the predicted gap (an ex post approach). The vast majority of submissions favoured an ex post approach to measuring compliance, to allow for the use of actual (as opposed to forecasted) data relating to the reliability gap, a retailer’s load, and their contracted position.

While an ex ante approach requires more intensive forecasting and assessment (to manage a shortfall that might not occur), an ex post approach raises risks that insufficient capacity will be procured prior to a reliability gap, for example, because participants have an incentive to game the system by under-contracting and hoping that no shortfall materialises.

6.  Where the ESB lands on this issue in their draft design; ex ante or ex post?

The ESB consultation anticipated the market responding to forecasted reliability gaps. However, the draft NEG will also include a mechanism for enforcing compliance, which will be directly affected by when compliance is measured. The ESB consultation flagged that AEMO might act as a ‘procurer of last resort’ and also raised the possibility of including a book-build option as a method of meeting anticipated gaps. Non-compliant retailers and specified energy users would then be charged the costs AEMO incurred in doing so.

The majority of submissions supported AEMO acting as the procurer of last resort where a prevailing gap was forecast a year in advance. Whilst few submissions directly commented on the book build option, Origin Energy expressed limited support for the idea, if further details regarding the management and ownership were available. On the other hand, several respondents noted significant competition issues with the book build option.

7.  Whether the draft NEG favours certainty of forecasting or of capacity, and what form (if any) the provision for the book build option will take.

Media coverage on the draft NEG suggest that a combined ex post/ex ante approach will be taken, with AEMO able to step in as procurer of last resort if a gap still exists one year in advance of its forecast date.

Alternative compliance

8.  How the draft NEG design integrates existing and emerging alternative compliance mechanisms.

For example, the ESB consultation flagged the potential use of offsets under the NEG. However, this was met with strong opposition from a number of stakeholders. Origin Energy and AGL both suggested caution in using offsets which have been created outside of the NEM, while AGL suggested limiting the use of offsets to only those that assist in providing price stability, liquidity and are considered reputable.

9.  The detail given to demand response as qualifying instruments under the draft NEG.

The ESB consultation paper also canvassed the possibility of investing in demand response as a measure to meet peak demand. It contemplated demand response products qualifying to meet reliability obligations under the NEG but does not address the intricacies of demand response contracts.

10.  How the NEG integrates or interacts with existing renewable and green programs, such as the Renewable Energy Target and GreenPower Schemes.

Some submissions to the ESB consultation were supportive of continuing voluntary green programs, but opposed their integration with the emissions requirements.

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