Finkel Review - Electricity: Design for a market in transition

In brief

In the fifth of our series analysing the Finkel Review, we look at signals for new investment in the National Electricity Market. The Review's responses to this issue reject sweeping changes to the wholesale market structure, but call for more immediate and targeted measures to support the transition of the energy market. Partner Anna Collyer and Law Graduate Maddy Foote assess solutions and opportunities for investment signals in the wholesale market, and the requirement for them to promote reliable, secure and affordable electricity.

Key themes

• Market signals for new investment in the National Electricity Market have been the subject of significant industry debate. The Finkel Review concludes that the current market design cannot deliver the reliability we need in these changing times.
• The overriding criteria for investment certainty across the industry is a stable and predictable carbon policy. However, the transition occurring in the market will continue to occur, driven by market opportunity, technological advances and customer choice, and it is necessary to ensure a market design that accommodates this transition.
• The Finkel Review rejected a radical move to a capacity market in favour of more immediate and targeted responses, to ensure reliability. The recommended responses are a combination of market design and more interventionist proposals, reflecting a shift from relying on pure market forces to a greater degree of central control.

Background

The Finkel Review is the product of an extensive examination of all aspects of the future of the National Electricity Market (NEM). (See our previous articles Finkel: the solution for our energy future? for a broad overview; Finkel Review – Gas: A revolving door or real change? for a more specific look into gas; and Finkel Review – The importance of regulatory certainty for renewables for its implications for the renewable energy sector.

The Federal Government, and now the COAG Energy Council, has supported 49 of the 50 recommendations of the Finkel Review, with further consideration to be given to the Review's recommendation for a Clean Energy Target. We have previously discussed the over-arching need for a stable emissions framework.

The grid is currently undergoing a transformation, as conventional synchronous energy is displaced by variable renewable energy. An emphasis on incentivising renewable energy development through the Renewable Energy Target, combined with falling energy demand, has resulted in decreased investment incentives for synchronous energy. This has led, in turn, to the retirement of coal-fired power generation, increasing wholesale prices and concerns over unreliability in the absence of adequate replacement generation.

The Finkel Review assessed possible solutions to these failed market signals, and the Australian Energy Market Commission (the AEMC) has recently commenced a Reliability Frameworks Review that will consider the Finkel Review's recommendations. We explore these recommendations below.

What did the Finkel Review say about the wholesale energy market?

Key features of the current NEM design – the basics

The Finkel Review considers these key features of the NEM design:

Benefits of a competitive capacity market

In a competitive capacity market, a central market operator or 'central buyer' procures capacity from generators to guarantee sufficient energy supply for future demand. One of the key benefits of the capacity market is that price signals are effectively set by the market operator, rather than the market.

Submissions to the Finkel Review proposed the use of a capacity market to supplement the current energy-only market.¹ This supplementary capacity market concept has been implemented in the UK, as part of a recent suite of reforms designed to incentivise capital investment in electricity infrastructure and ensure sufficient electricity supply can meet forecast demand.²

However, other submissions to the Finkel Review, notably from the Australian Energy Market Operator (the AEMO) and the AEMC, cautioned against the implementation of a capacity market, noting that transferring market control to a centralised operator may weaken price signals. This is primarily because the market operator does not have the same incentive to drive efficient, economic investment decisions as market participants who would otherwise bear the investment risk.³

A capacity market was introduced in Western Australia in 2005 and functions through a series of capacity contracts. Energy consumers may then procure the 'balance' of electricity exceeding the contracted capacity, through a supplementary energy pool, which operates similarly to the NEM energy-only market.

However, the WA capacity market has faced problems associated with excess capacity commitment in the electricity market. In 2016–17, excess capacity amounted to 23 per cent on top of actual energy demand, the price of which is ultimately borne by consumers.⁴ Recent reforms to the WA electricity market seek to improve the price signalling in that market.

Ultimately, the Finkel Review considered that the introduction of a capacity market 'would require a long-term and costly departure from the existing market framework'.⁵ Therefore, the Review recommended against any further assessment of this as a solution to the present investment signalling issues.

Should Australia implement a 'day-ahead' energy market?

In contrast to proposals for a capacity market, the Finkel Review was more supportive of the introduction of a 'day-ahead market'.
In this market structure, the prices for delivery are scheduled for each interval in the following day. The schedule is optimised based on expected real-time constraints. To correct for inevitable errors in forecasting real-time constraints, generators may make up any difference in price through a real-time 'balancing' market.

Day-ahead market design has been implemented in many jurisdictions world-wide, including most European and North American markets. The Scandinavian energy market, of Denmark, Finland, Sweden and Norway, known as Nord Pool, operates as a day-ahead market. In that market, bids to procure and generate power are submitted by 12pm on the day before delivery. After this deadline, the hourly prices for the following day are calculated and trades are settled. Differences between amounts contracted in the day-ahead market and residual demand are balanced in Nord Pool's 'intraday' market, known as Elbas.⁶

The Finkel Review considered that day-ahead markets could provide a more efficient means for generators and consumers to assess commitment requirements, as this structure provides a 'greater forward transparency of supply conditions'.⁷ Accordingly, this would allow generators to evaluate generation schedules and reliability requirements with more certainty than under the current real-time market. The Review also noted that the introduction of a day-ahead market may provide protection against deliberate gaming of the system, as generators must financially commit to bids on the previous day.

However, the day-ahead market is not entirely immune to the transformative effects of renewable energy generation. The unpredictability of wind and solar generation may mean that generators are more likely to prefer settlement of bids closer to delivery. For this reason, balancing markets such as Elbas are becoming increasingly important, to counteract the imbalances between forecast volumes for renewable energy generation and actual procurement.

Complexity in the potential change to five minute settlements

The AEMC has been working on a Rule change proposal, initiated in May 2016, to move from half hourly settlement in the NEM to five minute settlement, so that financial settlement matches physical dispatch. The current market design reflects the technology available at the time for metering and data processing.

Reflecting the complexity of the issues arising from this Rule change proposal, the AEMC took the preliminary step of issuing a Directions Paper;⁸ and, on 4 July 2017, announced it was deferring its draft decision for a further two months, to allow it sufficient time to assess the large number of submissions received in response to the Directions Paper.

A key purpose of the proposed change is to improve price signals in the market by removing potential distortionary incentives for bidding behaviour. Eg under the current arrangements, generators may withdraw generation capacity in the final five minute period of a half hour trading interval, in order to artificially increase the spot price.

The improved prices signals are intended to provide technology-neutral investment incentives. This market design would also provide clearer signals to technologies that can respond within shorter timeframes, which is particularly important in the context of the energy market transition.

The AEMC Directions Paper comments on two of the market design proposals that have now been canvassed by the Finkel Review. First, it notes that a similar alignment has been pursued in capacity markets (eg in the United States). However, price signals could be expected to be stronger in an energy-only market. Second, the Directions Paper highlights the lack of 'gate closure' in the NEM, with settlement based solely on volume that can potentially be rebid up until dispatch. Accordingly, Finkel's recommendations in relation to a capacity market and day ahead market are significant in the ongoing consideration of this fundamental market design change.

Notice of closure requirement

The time it takes for new generation to be planned, financed and constructed in response to the NEM's investment price signals was another issue the Finkel Review identified. The effects on the NEM of this time lag are further complicated by the fact that renewable generation (as well as being intermittent) tends to be constructed in significantly smaller plant sizes than traditional thermal power stations. Essentially, this means large chunks of generation are leaving the market and replacement generation is taking too long to fill its place.

To address this issue, the Finkel Review recommends that certain generators be required to provide a binding three year notification of intention to shut down their plant, together with a non-binding register of intended closure dates for large generators.

In the discussion on this issue, the Review starts to canvass some of the issues that would need to be considered in designing this obligation. It suggests that only generators whose retirement would lead to reliability issues should be subject to the obligation, excluding smaller generators from the requirements. It also proposes that flexibility would be required – eg in cases where there is no net impact on available capacity, such as where an existing generator brings forward new generation.

It seems that requiring a private sector industry participant to make and communicate a significant business decision three years ahead of its implementation would be a challenging requirement to meet, particularly in an industry that is likely to be subject to significant ongoing change.

Nonetheless, the proposal has been supported by a number of industry participants, and the Business Council of Australia has endorsed its further consideration – it will be very interesting to see how this develops.

Addressing price signals in the wholesale electricity market

The Finkel Review emphasises the importance of taking a holistic approach to polices seeking to achieve multiple objectives for the electricity sector, including security, reliability, affordability and emissions reductions outcomes.

The Review makes recommendations for an industry undergoing substantial and ongoing change. While it is clear the industry is in transition, it is not clear how the transition will continue to evolve. It will, however, be driven as much by market opportunity, technological advances and customer preferences as by the prevailing policy framework.

In this context, rather than recommending sweeping changes to the fundamental market structure, the Finkel Review has focused on targeted responses, with the potential to investigate longer-term structural options.

There is a significant emphasis on demand side participation in the market, which seems to provide fertile ground for new services and industry participants to engage. This theme has continued to be pursued, particularly by new AEMO CEO Audrey Zibelman.

The AEMC is also taking action on energy reliability and, on 11 July 2017, commenced a review into the frameworks that support reliability in the NEM. Among other things, the Reliability Frameworks Review will consider the recommendations from the Finkel Review, including the generator reliability obligation, the suitability of a day ahead market and the role of demand side management.

Ultimately, price signals in the wholesale market need to ensure viable, long-term investment. While the Finkel Review concluded that is unlikely a capacity market can, or will, provide the right solution, regulators and market participants will continue to explore alternative means of addressing the reliability of the NEM, as the market itself continues to evolve.