Seeking a pragmatic way to keep the lights on

The high-level design for a capacity mechanism may be complex and controversial in some areas, but it is also pragmatic and timely, given that the NEM is off the road after a major pile-up.

Concerns that the NEM might not be fit for the purpose required of the electricity market in a transition to a zero-emissions future have been around for the best part of a decade.

They gained most voice after the Finkel review of the security of the market and were expressed in the form of the National Energy Guarantee proposed by then-prime minister Malcolm Turnbull.

That policy was intended to drive lower emissions while ensuring that reliability was maintained at lowest cost.

Tragically, the first element was rejected by elements of the Coalition party room. Soon after, Turnbull’s prime ministership was roadkill.

The Energy Security Board was given the task of driving a NEM reform program, with a critical element being a capacity mechanism in the market to ensure that dispatchable electricity is available to maintain reliable supply. The high-level design paper is the much-delayed result.

Many have argued that the market would deliver investment in reliable supply at lowest cost if there was clear policy guidance

Many industry participants and analysts have argued that the market would deliver investment in reliable supply at lowest cost if there was clear policy guidance on governments’ expectations for reliability and lower emissions.

The absence of both led to government investment ahead of an efficient market-led response, and therefore great investment risk.

The ESB’s paper describes the result as a “misalignment between the expectations of governments and the needs of investors”.

The proposed design includes major choices that strongly reflect this background. The need for ministers to have confidence that capacity will be available when needed leads to a design that favours simplicity and certainty over complexity, uncertainty, and minimising cost.

The ESB’s proposal for the Australian Energy Market Operator to determine future capacity requirements and procure that capacity via a centralised process is one example.

Certainty likely to involve added cost

The ESB does not hide from the risk that this approach can err on the side of higher cost through more procurement than might have arisen from a more decentralised system with greater involvement of market participants.

It suggests that this risk can and will be avoided, or at least minimised, through careful design, but that is a hard ask. Adding certainty for governments is very likely to bring added cost.

The controversial element of this design lies with the role of different technologies and how fossil fuel generation might participate in the capacity procurement and payment processes.

Australia’s federal, state, and territory governments are all committed to net zero emissions by 2050, and some have interim, 2030 targets and programs to support renewable generation.

Some ministers value the right to exclude coal and/or gas generators in their jurisdictions from capacity payments on the grounds they would prolong the operating life, and associated emissions, from such plants.

Some renewables industry voices have expressed similar concerns.

There is a solution.

One of the 14 principles that the energy ministers set down for the ESB is a focus on continued reduction of electricity sector emissions. Despite the commitments to targets, there is still no clear policy framework to meet this principle.

To deliver a capacity mechanism that meets the complete set of ministers’ needs, the ESB seeks “further guidance on continued emissions reduction in the context of net zero and how the principle can be operationalised in the design”.

It would probably be a little optimistic to expect a policy for electricity sector emissions to emerge from this simple request. Yet it is this request that can provide the answer to the concerns described above.

The ESB’s design paper is high level, and several of the key elements have yet to be fleshed out. These include the design of the capacity auctions and the way in which different technologies might be valued.

Completing these details is the task for the next half-year.

The capacity mechanism proposed by the ESB is a pragmatic and necessary solution to a real problem. Continuing without it would be no more sensible than wishing that the energy market operator had not suspended the NEM last week.

The important task is to rigorously test the design with industry proponents and ensure it includes flexibility to respond and adjust as today’s uncertainties become clearer.

Done well, the capacity mechanism will be a valuable next step in Australia’s energy transition.