The energy market has failed. Here’s what should happen now

The wholesale electricity market is the financial engine of the National Electricity Market, designed by governments in the late 1990s to match power generation with demand at lowest cost. It has been largely a success since then.

The wholesale spot price varies to reflect the lowest cost supply combination of coal, gas, hydro, and renewables. Various contracts outside the spot market enable generators and customers – retailers and large users – to manage their financial risks.

Several physical problems emerged over the past six to nine months that led to more than a quarter of the coal-fired plants in the NEM being offline. Some of these problems were technical or mechanical, and some related to external factors such as coal mines being flooded.

Prices began to rise alarmingly, from less than $100 per megawatt hour to $300 and more. Gas generators, usually the safety valve to meet short-term peak demand, were unable to meet demand either because of gas delivery constraints or because the price they had to pay on the spot market was too high even with the elevated power prices.

AEMO used all the tools at its disposal to try to correct the market, but they were clearly inadequate for the continuing nature of the problem. The market had failed.

So AEMO suspended the market. This means that AEMO now sets the price that generators receive in each state, and it directs which generators will run. If a generator is forced to run at a loss, they will be compensated.

This deals with any concern that generators were either put in an impossible position, or might have been trying to take financial advantage of the extraordinary market conditions.

The situation was not primarily caused by too much reliance on coal or renewables, the age of the coal plants, or even the failure of governments to implement integrated climate change and energy policy.

Rather, it was primarily caused by the concurrent unavailability of multiple coal-fired generators and physical and financial limitations on their gas-fired cousins.

The decisions made so far by the new federal government have been clear, measured and appropriate. Beyond AEMO’s decision to suspend the electricity market, the government needs to act on the availability and price of gas in the short term.

East coast gas producers sell most of their gas under contracts, and two-thirds to overseas buyers. There is some limited flexibility to respond to short-term demand in either the export or domestic markets.

Gas price jumped on European demand

Since the Turnbull government introduced the Australian Domestic Gas Security Mechanism, the Australian Competition and Consumer Commission has published the export parity netback price as a reference for domestic contract pricing.

That price had been around $10 per gigajoule. Demand from Europe to address issues with Russian gas supply after the invasion of Ukraine resulted in that price jumping to about $40, a level unsustainable for gas or electricity consumers in Australia.

Neither the ADGSM nor an east coast gas reservation policy would address the immediate problem.

Instead, the government should sit down with the gas producers and make clear that enough volume at a fair price must be available domestically.

If the gas producers won’t do that, the government should introduce a windfall profits tax, revise the rules of the petroleum resource rent tax, or find a way to legislate for both volume and price.

Gas producers should accept a fair price

A tax on windfall profits, or the threat of one, would address the immediate gas pricing problem, would not meet any reasonable definition of sovereign risk, and would be removed when the windfall ceases.

The gas producers should not want to destroy the domestic market, and they should accept a fair price.

This approach does not fix everything, because there will be physical and contractual limits on getting gas where it’s needed. The government could further consider requiring that export contracts include a flexibility allowance for gas to be diverted to the domestic market to address the sort of issue we now face.

From today, the focus of AEMO, the power industry and governments will be to address the immediate issues with offline generators and restore the normal operations of the NEM.

There will be lessons to be learned, and some of the market rules will undoubtedly need changes.

Beyond these immediate priorities, the federal and state energy ministers must return to the urgent task of agreeing on market reforms to deliver Australia’s long-term energy transition.