ACCC's recommendations for contract markets

In brief

As part of the ACCC's Retail Electricity Pricing Inquiry Final Report, the ACCC made two key recommendations in relation to contract markets: that the National Energy Laws be amended to require the reporting of over the counter trades to a repository administered by the Australian Energy Regulator; and that the Australian Energy Market Commission introduce market making obligations in South Australia. Separately, the Energy Security Board has been considering the best way to implement the National Energy Guarantee.

Overview

The National Energy Guarantee (NEG) comprises an emissions guarantee and a reliability guarantee and is being considered this week by COAG Energy Council. Under the NEG, retailers will be required to enter into contracts in order to comply with both the emissions and reliability requirements. The Energy Security Board (ESB) has not specified the exact mechanism for how retailers will enter into these contracts; however, the ESB has indicated that when the reliability requirement is triggered, retailers will need to secure qualifying contracts to cover their share of peak demand and secure future compliance. These qualifying contracts will be submitted by the retailers to the Australian Energy Regulator (AER) to demonstrate that their net contract position sufficiently covers the reliability gap period. The purpose of this is to secure the reliability of the power system through a regulated system of contracting and investment.

How do retailers purchase electricity?

The NEM covers five regions: New South Wales, Victoria, Queensland, Tasmania and South Australia. Prices are set in the NEM by bidding generators. At each five-minute increment, generators bid to offer their electricity for dispatch to the market. The Australian Energy Market Operator dispatches the cheapest bid first, the next cheapest bid after that, and so on. The final bid required to meet demand is the 'dispatch price'. The spot price is currently set at 30-minute increments (moving to five-minute increments in 2021) by taking the average of the six dispatch prices over that 30-minute period. The spot price is paid to generators for the electricity that they dispatch during that period, regardless of their individual bid values. The lower the generators' bids, the lower the dispatch price and spot price will be.

Due to volatility in the market, market participants try to hedge their exposure by entering into hedge contracts either via:

• over the counter (OTC) trades in which a generator and a retailer would contract directly; or
• the ASX Energy Market, where derivatives of the NEM spot market are traded.

Transparency in OTC markets

In the Retail Electricity Pricing Inquiry Final Report, the ACCC acknowledged that retailers and generators actively participate in hedging strategies. However, the ACCC is concerned that there is a lack of price transparency in the OTC market which 'impedes the transmission of price signals in the market' and ultimately leads to uncertainty for market participants.

The ACCC has recommended that the OTC repository be administered by the AER which would require that OTC trades be reported to a registry and published in a de-identified format (this information gathering function was previously undertaken by the Australian Financial Markets Association). The ACCC considers that this change would allow market participants to understand pricing trends and make a more informed decision when choosing to contract in the OTC market or the ASX Energy Market (which is public).

The ACCC recommendation is directed at increasing general transparency in the overall OTC market, especially in circumstances where trades on the ASX are made public. In contrast, the reporting obligations under the NEG reliability requirement only arise when the reliability requirement is triggered, and are confined to retailers demonstrating the adequacy of their qualifying contracts. Previously, the ESB recommended that a trade repository that centrally collects records of OTC trades would be necessary to give effect to the objectives of the NEG. However, in the Final Detailed Design dated 1 August 2018, the ESB noted that in their view such a repository was not necessary as the Market Liquidity Obligation would be enough to safeguard competition.

Vertical Integration in South Australia

The ACCC identified that vertical integration within a region has a 'mixed impact on wholesale and retail competition'. In particular, the ACCC noted that vertical integration acts as a flexible hedge. For example, a vertically integrated business can calculate the cost of generating electricity for its retail arm and determine whether it is more profitable to hedge with its retail arm or trade the electricity with other participants in the NEM.

While the ACCC noted that vertical integration allows so-called gentailers to efficiently manage their wholesale market risk on the NEM, the ACCC also noted that the decline in standalone generation has limited other retailers from managing their wholesale market risk, which could potentially create a substantial barrier to expansion in the retail market.

This issue is particularly acute in South Australia, where there is a very low level of trading on the NEM contracting market. This has been exacerbated by the closure of Northern power station in May 2016, which resulted in a significant reduction in the supply of energy within the state. The small number of generators has meant that hedging is difficult and participation within the market is low. Whilst South Australia does possess a number of renewable generators, these do not offer firm hedges and fail to provide standalone retail participants with an adequate means of mitigating risk. The ACCC has therefore recommended that there be market making obligations in South Australia which require generators to make offers to buy and sell hedge contracts (ie OTC trades). This already occurs in Tasmania, where Hydro Tasmania (effectively the state's sole generator) is required to offer retailers hedging contracts at a volume and price that allows market participants to adequately manage their market risk.

The ESB has proposed a similar market making obligation, the Market Liquidity Obligation, which will be imposed in the event that the reliability requirement of the NEG is triggered. The Market Liquidity Obligation would require large vertically integrated retailers to make contracts available through a centrally cleared platform for the period of any reliability gap. What constitutes a 'large' vertically integrated retailer has not yet been determined, but the ESB has noted that it would need to involve more than one retailer in each region of the NEM. The ACCC has recommended that any market making obligation that is implemented in South Australia be interoperable with the Market Liquidity Obligation.

Where to from here?

Implementing the ACCC's recommendations concerning OTC trades and market making obligations will require government action and collaboration. The recommendations regarding OTC trades will not dramatically alter the status quo: the ACCC's recommendation does not fundamentally change the way that parties make OTC trades; rather, it increases price transparency through reporting obligations. In relation to market making obligations in South Australia, Tasmania's experience with a similar market making scheme will most likely guide policy. There is likely to be further consultation on these reforms, particularly as they intersect with the NEG. Whether the NEG will be accepted by COAG remains a live issue. In any event, it is possible that the South Australian government will follow Tasmania in implementing a domestic market making policy of its own.