NEM Capacity Mechanism – the first steps

Articles Written by Anthony Groom (Partner), Jee-Seon Lee (Partner)

On 20 June 2022 the Energy Security Board (ESB) released its design paper on the capacity mechanism in the NEM.

Being released so soon after the suspension of the NEM the paper is being treated in some quarters as having been prompted by that event. However development of a potential capacity mechanism has been contemplated for some time (the project to develop the current paper was initiated in December 2021). It is also not clear that, of itself, a capacity mechanism would have been sufficient to address the unfortunate combination of the impact on fuel prices of a war and the impact of ageing base load generation. That said in the longer term a capacity mechanism is likely to improve the security of the market – the key concern is whether it does so at an efficient cost.

The key objective of the work being undertaken on the capacity mechanism is to provide for a planned and co-ordinated transition of the NEM from its current reliance on fossil fuel generation to providing secure and reliable power to consumers from clean energy resources.

It is acknowledged that there are no immediate, simple fixes to the fundamental transformation of a complex physical and financial market which operates across 5 participating States and Territory. There are a range of competing interests which will need to be balanced while enabling the electricity sector to embrace the opportunities which lie ahead. The need to secure energy security and reliability while providing a certain path towards transition of the energy mix in the NEM will come at a cost to consumers. However, a failure to provide that certainty also comes at a high cost, as the recent events in the NEM have demonstrated.

This article provides an overview of the key elements of the capacity mechanism proposed by the ESB.

What does the capacity mechanism look like?

The NEM is an energy only, mandatory gross pool for the wholesale trading of electricity with an underlying financial contract market that enables retailers and generators to manage their risks and exposure to spot prices.

Currently, the incentives for capacity providers (new and existing) to offer their capacity to the market is driven by the market price settings (cap, floor and cumulative price threshold), contract markets and other regulatory mechanisms which seek to ensure that reliability standards can be met and managed in the NEM, including the Reliability Emergency and Reserve Trader scheme and Retailer Reliability Obligations.

However, as the Australian energy sector accelerates its transition to renewable energy, ESB proposes that a more direct form of investment signals in the form of a capacity mechanism is required in the NEM to meet the NEM’s reliability and capacity requirements.

The key elements of the proposed capacity mechanism are:

  • AEMO will forecast demand and determine how much capacity is required to meet that demand on a centralised basis and identify whether a reliability gap exists over a long term planning horizon.
  • Capacity will need to be defined having regard to the availability of plant at a given period to provide the capacity (season, time, weather, technology and physical state/performance of the plant dependent), the region in which it operates (may not strictly reflect the NEM regions) and any other factors which are likely to affect capacity being made available in the NEM, including transmission constraints;
  • AEMO will set the maximum quantity of capacity that could be awarded to  capacity providers ranging from thermal energy, variable renewable energy, energy storage to demand response providers;
  • AEMO will need to set the target requirement for capacity – this will need to take into account:

1. existing supply and new capacity resources which are at “committed” or operational stage; and

2. reliability gap or surplus – being a function of the level of “unserved energy or USE” (that is, whether there is any demand that is not met by capacity). If the USE is above the reliability standard required, there is a gap and if the USE is below the standard, then there is a surplus;

  • AEMO will procure the capacity to meet the target through a competitive auction process – such capacity will likely be a product that is delivered annually for a particular delivery year, with sufficient lead time in the auction process and the delivery year to allow new capacity to be built and enter the market;
  • The capacity provider who is assigned the relevant “capacity product or certification” will have an obligation to make that capacity available with financial consequences if that obligation is not met.

Within that broad framework, there is still much work to be undertaken in refining the details of the mechanism including resolution of issues such as:

  • How long term investment support would be provided to support financing of new investment through the capacity procurement mechanism;
  • Retailer’s role and ability to participate in capacity procurement;
  • How frequently auctions are to be run to reflect the need for planned retirement of existing generation, sufficient lead time for new entrants to develop capacity, any changes in forecasts;
  • Auction price setting principles including whether there should be different/multiple price bands,  whether differential pricing should apply to existing and new capacity and any offer price caps and floors to be applied for the capacity auction;
  • Setting capacity provider’s performance obligations and the resulting financial consequences for failure to provide capacity; and
  • Nature of the capacity product or certification. For example, in the West Australian Wholesale Electricity Market that has a capacity market, capacity credits are assigned to facilities and those credits are always held by those facilities. They cannot be transferred by holders of capacity and are not tradeable commodities. However, they are “allocated” for settlement purposes to those retailers who are required to fund the capacity based on their customers’ peak demand.

Who is eligible to participate?

It is proposed that both new and existing capacity providers including thermal generators, variable renewable energy providers, storage and demand side capacity will be permitted to participate in the capacity mechanism.

This is to enable existing ageing thermal power stations to exit the market and for new clean energy capacity providers to enter the market in a predictable manner so that reliability and security of energy supply in the NEM can be maintained.

How are capacity payments funded?

ESB proposes that the AEMO will fund the cost of procuring capacity by recovering those costs through retailers who will ultimately pass through those costs to their customers.

Other considerations

As the capacity mechanism is being introduced alongside an existing energy only market with various existing regulatory framework and State and Commonwealth government schemes, there are a number of other significant matters which will need to be taken into account in the detailed design phase.

These include:

  • Impact of transmission constraints on capacity provider’s ability to make capacity available – this involves both intra-regional and inter-regional transmission constraints given the interconnected nature of the NEM;
  • How capacity is to be procured across different regions of the NEM, particularly if each State has a different policy position on what type of capacity can participate in the mechanism. For example, the Victorian Government’s current policy is that fossil fuel generators in Victoria should not be eligible to receive capacity payments;
  • Whether interconnectors can play an active role in the capacity market; and
  • Impacts of existing schemes, such as out of market funding provided through ARENA, VRET, NSW long term energy service agreements and ACT Large Feed in Tariff scheme, on the capacity mechanism to ensure there is no overpayment for the same capacity.

The proposed capacity mechanism is an attempt at providing for a careful balancing of certainty versus costs. It will require co-operation between the participating States and Territory for the mechanism to be successfully implemented in a manner that is not overcharged with regulatory and administrative complexity.

The capacity mechanism design paper is open for public consultation until 25 July 2022. It is expected that the detailed design will be submitted to the Energy Ministers in February 2023, with the desire to commence the capacity mechanism on 1 July 2025, with special auctions being held to allow for an interim capacity mechanism to apply before that time.

Important Disclaimer: The material contained in this article is comment of a general nature only and is not and nor is it intended to be advice on any specific professional matter. In that the effectiveness or accuracy of any professional advice depends upon the particular circumstances of each case, neither the firm nor any individual author accepts any responsibility whatsoever for any acts or omissions resulting from reliance upon the content of any articles. Before acting on the basis of any material contained in this publication, we recommend that you consult your professional adviser. Liability limited by a scheme approved under Professional Standards Legislation (Australia-wide except in Tasmania).

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