Underwriting generation assets: comments on the Government's public consultation paper

Author Gilles Walgenwitz, Alister Alford

Date November 2018

The Australian Government is seeking to respond to the recommendations developed by the Australian Competition and Consumer Commission (ACCC) following public concerns that the National Electricity Market (NEM) is not operating in a way that "delivers the best price outcomes for households and businesses", nor maintaining the level of competition across the market necessary to contain prices. 

In October 2018, short public consultation paper was published by the Government. Energetics reviewed the document and below are our high level observations, together with a transcript of an interview that our General Manager, Energy and Carbon Markets, Gilles Walgenwitz conducted with Footprint News.

Reforms to the NEM should enhance existing market mechanisms and contracting arrangements, and encourage competition

Aside from the overarching principle that any reforms should support the operation of the market and not create distortions, Energetics also emphasizes the importance of maintaining competition in the wholesale contract market, noting that:

  • Few end users are directly exposed to the spot market
  • Typical contract negotiations focus on observable wholesale contract market prices (typically ASX Energy futures) with an adjustment for an end user’s consumption patterns
  • Lack of competition in wholesale contract markets can result in excessive contract risk premiums eroding end-users’ ability to benefit from possible reductions in spot market prices
  • If counterparty diversity and contract market liquidity falls, then market efficiency falls and the market power of incumbents increases.

Energetics has the following concerns:

  • The proposed support mechanism should have much more focus on the greenhouse gas emissions intensity of the proposed project. We believe that this mechanism is compatible with a reduction in the overall electricity sector’s emissions and the consultation paper is not setting criteria that are sufficiently well defined to avoid subsidising a project that would increase emissions intensity across the sector.  Further, on the description of project eligibility criteria, the wording is vague. The public consultation paper states that "the project would be unlikely to result in an increase in electricity sector emissions to a level that is more than minus 26 per cent of the sector’s 2005 levels by 2030".  There are significant problems with this proposed eligibility condition, as reducing emissions should relate to an individual project’s emissions profile and not depend on the performance of the whole generation fleet.  Besides, this criterion should be worded more strongly along the lines of the project "should not result in an increase…"  Finally, whilst the project eligibility criteria refer to the impact on electricity sector emissions, there is no merit criterion relating to the emissions intensity of the proposed project.  Overall, the 'proponent eligibility requirements' should consider and be much more specific about both the emissions intensity of the project and its firming ability.
  • The public consultation paper lacks details on how the relative cost effectiveness of the different proponents will be assessed and how cost and financial risk to taxpayers will be evaluated.
  • On providing a floor price as surety for projects under the scheme, $50-$60 per MWh would be sufficient for firmed renewable energy generators, but both not necessarily for gas fired generators considering current fuel costs. Government loans and capacity payments would seem to be the more viable alternatives to the support mechanisms proposed in the public consultation paper. Given the potential to integrate gas and renewable energy to provide firm contracts, Energetics recommends not limiting the support mechanisms but rather focusing on the risk adjusted cost/benefit to taxpayers.
  • We see challenges in the suggested establishment of a capacity market.  If we look to the example of the capacity market set up in Western Australia, there are significant costs associated with generation capacity being on standby, which may not be needed.  We believe that such a capacity mechanism would reallocate the management of demand risk from the generation side to consumers and would negatively alter the liquidity of financial hedge markets. Providing a low floor price, a contract for difference or other support mechanism through financial hedges is a more appropriate approach over setting up a separate market. 

    To maintain a competitive market, one possible support mechanism may be that the Government enters into an arrangement to purchase $100/MWh strike caps if the initial cap contracts cannot be replaced and the cap market price is insufficient to support the project. In effect the Government would be selling a 'put caption' which guarantees the gas fired generator would be receiving some revenue if the initial end user contracts cannot be replaced.

One of the principles expressed in the consultation paper, is support for a level playing field.  However, in stating that "the best and lowest cost generation options" will include consideration of projects to upgrade or provide "life extensions" to existing generation assets also known as brownfield projects, Energetics argues that such projects must demonstrate viability for about 20 years so that contribution to the proposed project encompasses a relatively similar time horizon to that of a greenfield project or, alternatively, that the currently unclear cost effectiveness test applied to the different projects clearly takes into account the potentially large different project lifetime of brownfield and greenfield projects.

Energetics monitors the Australian electricity markets daily and provides commercial and energy markets advice, as well as due diligence services on long term Power Purchase Agreements.  We will keep you informed of developments and our views, as they arise. 

Gilles was interviewed for Footprint News in an article titled "Energy plan must be fair, cautions Energetics", 5 November 2018. The article is featured below, reprinted with the editor's permission. 

Interview: Energy underwriting plan must provide level playing field: Energetics

The Morrison government must ensure plans to support investment in both new and old power plants don't unfairly disadvantage new power stations, according to Energetics' general manager of energy and carbon markets, Gilles Walgenwitz.

He was commenting on a government consultation paper on underwriting investment in building new power plants, expanding existing ones, or extending their life.

The paper is broadly based on an ACCC recommendation that the government offer floor price support for new generation projects only, in years six to 15 of their life, if the projects have successfully secured short-term contracts with several large customers.

Walgenwitz noted it would be very difficult to compare the costs and benefits of a coal-fired power station extension that feeds more electricity into the grid for only five or 10 years, to a greenfields project that establishes a new asset supplying firm power for 20 years or so.

He added that the consultation paper contained only a vague reference to ensuring projects don't result in excessive greenhouse gas emissions by the electricity sector.

It would be much more transparent and effective to set clear, project-specific emissions intensity standards, he told Footprint.

Emissions intensity should also be one of the criteria used to compare the merits of projects that apply for support, he added.

Nevertheless, Walgenwitz said the ACCC's proposal and the government's discussion paper were welcome developments that could help overcome a significant barrier to investment in generation.

Companies interested in power purchase agreements often have difficulties entering an offtake agreement with a term of 10 years or so, which is what power plant proponents are looking for, Walgenwitz said.

"Entering a 10-year deal can be a big ask," he said.

Companies recognise there is a risk that, at the end of a long-term contract, they may be worse off than business-as-usual, Walgenwitz said.

They can much more readily contemplate contracts with a life of five to seven years, he said, which could then be augmented with government support.

 

Relevant services: Energy and carbon markets