Preparing for the NEG's Reliability Guarantee - be alert, not alarmed

In brief

Following the recent release of the National Energy Guarantee High Level Design Document by the Energy Security Board, Partner Anna Collyer and Associate Mark Leersnyder report on the proposed Reliability Guarantee component of the National Energy Guarantee, which seeks to improve the supply and demand signals being sent to retailers, large energy users, and investors in generation and demand response. This article looks at what retailers, large customers and energy project investors could be doing to prepare for the Reliability Guarantee — if they decide to do anything — and is part of a series in which Allens examines aspects of the proposed National Energy Guarantee.

An update — how will the Reliability Guarantee work?

The National Energy Guarantee (the Guarantee) scheme proposed by the Energy Security Board (ESB) includes a 'Reliability Guarantee', which aims to encourage investment in dispatchable electricity generation and demand response in the regions of the National Electricity Market (NEM) that are forecast to require additional generation to meet peak demand.

The design of the proposed Reliability Guarantee has been developed over the last couple of months, and the ESB has refined the key concepts through stakeholder consultation and analysis. The ESB's High Level Design Document does a good job of summarising how the Reliability Guarantee will work, so this article contains only a brief review. In short, the Reliability Guarantee will work by:

• (Forecasting) Having the Australian Energy Market Operator (AEMO) forecast peak electricity supply and demand in each of the NEM's regions over a 10-year horizon to identify any gaps between the level of predicted demand and supply.
• (Updating and waiting) Having AEMO update its supply and demand forecast, and allowing some time for the market to resolve any shortfall in supply during times of peak demand.
• (Triggering) If a gap between supply and demand is still forecast on a three-year time horizon, AEMO will request that the Australian Energy Regulator (the AER) or Reliability Panel declare the 'triggering' of the Reliability Guarantee.
• (Liability assessment) Once the Reliability Guarantee is triggered, liable retailers and large energy users will assess their likely share of the system peak demand and secure sufficient qualifying contracts to cover this demand. The system peak demand may be determined by reference to the peak demand that would be expected to occur once every two years, in much the same way as engineers design stormwater systems for '1 in 100 year storms'.
• (Qualifying contracts) By a defined compliance date, liable entities will need to have entered into sufficient qualifying contracts to cover their likely liability — such contracts being over-the-counter or exchange traded swap and cap contracts, the procurement of which will be assisted by AEMO, which will facilitate a qualifying contract book-build. Vertically integrated gen-tailers will not be able to use their own generation as a qualifying contract unless it is purchased from a centrally traded platform or reported to a centralised repository.
• (Procurer of last resort) If retailers do not adequately respond to a forecast shortfall in supply by one year out from the forecast gap, AEMO will procure the remaining resources required as a 'procurer of last resort'.
• (Compliance) If AEMO procures resources as a last resort and the actual system peak exceeds that which would be expected to occur once every two years, the AER will review the contract positions of the liable entities at the compliance date to determine whether adequate qualifying contracts were in place. The concept of assessing liable entities compliance against a 'one in two year' probabilistic model of the system peak demand, rather than the actual peak demand, is an attempt to avoid punishing liable entities in those years where peak demand is actually much higher than could reasonably be expected.
• (Penalties) Penalties will be assigned to those retailers and large customers that are found to have failed to have entered into sufficient qualifying contracts at the compliance date.

Should the energy industry prepare for the Reliability Guarantee?

There may well be some parties who choose to do nothing as a result of the Reliability Guarantee, given that the AEMC and the Reliability Panel are not currently forecasting a shortfall in electricity supply relative to demand in the next 10 years. In adopting such a 'wait and see' approach, these parties are assessing or assuming that:

• there will not be a forecast supply/demand gap in a region of the NEM where they have exposure; or
• if there is, that it won't persist long enough to trigger the Reliability Guarantee three years out; or
• if it does, then either:
  • their existing qualifying contracts will cover their share of the system peak demand; and/or
  • the forecast supply/demand gap will be closed no later than one year from when the gap is forecast; or
• if not, AEMO will not procure resources as a procurer of last resort, or the actual system peak demand will not exceed that which would be expected to occur one in every two years; or
• if this does occur, that the quantum and likelihood of penalties being imposed for failing to meet their reliability obligations is an economically rational response, compared with covering their share of system peak demand or otherwise actively closing the supply/demand gap.

While this approach may suit some participants — and there is value in understanding the trade-offs between taking action and doing nothing — it seems more likely to us that prudent parties with an eye for risk and opportunity will see the Reliability Guarantee as a means of improving the NEM's signals for unmet demand, rather than as a stick to penalise inaction. Accordingly, we expect most parties to consider how they can make the most of the signals the Reliability Guarantee will provide.

What steps should the energy industry take?

The signals sent by the Reliability Guarantee can be seen as being aimed at two distinct target audiences: (1) retailers and large electricity users; and (2) investors in electricity generation and demand response capability. We have considered some of the ways that each of these audiences can prepare for the Reliability Guarantee, and actively manage the risks and opportunities arising from it.

Retailers and large energy users

The steps retailers and large energy users could take include:

• Engaging in the development of the Guarantee: The development of the Guarantee is continuing at pace and there is still scope to influence its development before a final design is approved in August 2018. Retailers and large customers are likely to want to understand and have their say on:
  • the threshold size of retailers and large customers who will be 'liable entities' and what administrative burden this may impose;
  • the structure of the 'accountability framework' that will lead to improved forecasting of supply and demand, and what additional reporting and information requirements this will mean;
  • the definition of a 'material' gap in supply and demand that would trigger the Reliability Guarantee;
  • the method for determining 'system peak demand' (including the probabilistic determination of a 'one in two year system peak'), and the ability to challenge and interrogate the assessments of regulators;
  • the types of contracts and arrangements that will constitute 'qualifying contracts';
  • the regimes for centrally trading and registering qualifying contracts; and
  • the level of penalties that may apply for failing to meet reliability obligations.
• Determining the potential for downside exposure: Once the Guarantee's details become clearer, retailers and large users should undertake an assessment of their potential exposure in the event that a supply/demand gap is identified. This assessment could consider the type of response that may be required to close such a gap; an assessment of the retailer's or large customer's share of peak demand; and the potential costs and benefits of entering into contracts, or not, to close the gap.
• Developing a strategy to monitor and respond: Once the potential for exposure can be quantified, retailers and large customers should develop a strategy that includes:
  • a monitoring program that keeps an eye on the potential for supply/demand gaps in the NEM's regions, to give early warning that the Reliability Guarantee may be triggered; and
  • taking, or planning to take, proportionate responses to the risk that the Reliability Guarantee may be triggered. This may include developing the internal capability to identify and respond to supply/demand gaps, entering into qualifying contracts as a matter of course, or entering into other arrangements that hedge against the risks that the Reliability Guarantee will be triggered and penalties are meted out.
• Building the Guarantee into BAU: Parties should build the potential impact of the Reliability Guarantee into their 'business as usual' planning and investment decision making. That is, it should be something that retailers or customers are considering when determining whether, or where, to expand their retail operations or businesses.

Taking these steps will allow retailers and large customers the time to develop least-cost solutions to the possibility of higher electricity costs and penalties.

Investors in electricity generation and demand response capability

The steps investors in electricity generation and demand could take include:

• Developing the capacity to read the signals: Investors in new generation and demand response capability should develop their knowledge of how (and where) a supply and demand gap, if identified, is likely to stoke demand for new generation or demand response in certain areas of the NEM. This reading of the Reliability Guarantee's signals should become part of business as usual, and be included in any due diligence or strategic review.
• Developing a strategy to monitor and respond: Investors should develop a similar monitoring and response strategy to that of retailers and large customers. This strategy should weigh the pros and cons of waiting until the last minute to build new generation in order to capitalise on high prices (driven by AEMO's last-minute procurement exercise), versus the potential of missing out on the window of unmet demand to faster-moving competitors.

Taking these steps can position investors to capitalise better on the opportunities highlighted by the signals the Reliability Guarantee is designed to provide.