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.
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:
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;
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:
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.
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.
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.
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.
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