Independent Review into the Future Security of the National Electricity Market Preliminary Report, Dec 2016 (docx 04 mb)

Capacity markets

Most electricity markets globally include some form of mechanism to direct investment towards maintaining security and reliability, such as prescribed reserve margins, capacity payments or a combination of these measures (Table 5.1).

Table 5.1: Comparison of Energy Market Designs

Options	Used	Characteristics
Energy only.	Texas, Alberta, Australia (NEM), Nord Pool (North east Europe), Ontario.	Energy spot market, high price caps, reserves not enforced, secondary financial hedging. Alberta has announced that it will move away from an energy only market.
Energy only with administered capacity payments.	Argentina, Chile, Colombia, Peru, Spain, South Korea, Ireland.	Central determined capacity payments supplement energy revenues.
Energy with a requirement to cover reserve margin.	Southwest Power Pool, California, some Canadian markets.	Reserve satisfied through bilateral contracts, reserve monitored but no central market.
Energy with reserve requirements, central capacity market.	Australia (Wholesale Electricity Market in WA), PJM Interconnection, New England Independent System Operator, New York Independent System Operator, Midcontinent Independent System Operator, Brazil, UK (new), Ireland (new), Italy.	Administered capacity market, centralised capacity market, auction. WEM capacity requirement is met by bilateral contracts, in practice the capacity market has not been run.

Source: AEMO

Under a capacity market, the market operator bids for capacity based on estimated future demand and capacity requirements. Participating generators receive payments for being available, regardless of how much they ultimately generate. Unlike energy-only markets, the investment signal comes from the operator, instead of the market. Some stakeholders have suggested that a shift towards a market with capacity payments for certain services is required. For example, AGL has submitted a rule change request to the AEMC to introduce an ‘Inertia Ancillary Services’ market to the NEM⁵⁵.

Designing and operating capacity markets can be challenging. It requires operators to predict future electricity demand. Projections can therefore result in under or overinvestment in generation capacity. Overinvestment can increase the prices paid by consumers. In addition, capacity markets can limit innovation in the event that all options to meet supply, including demand response, are not considered consistently.

Consultation questions

The design of the NEM has significant implications for maintaining security and reliability objectives in the context of the transition taking place in the electricity sector. It is critical that the design of the NEM provides appropriate incentives for efficient investments that achieve secure and reliable electricity supply.

5.1 Are the reliability settings in the NEM adequate?

5.2 Is liquidity in the forward contract market for electricity adequate for the needs of commercial and industrial consumers and, if not, what can be done?

5.3 Are commercial and industrial users experiencing difficulties in obtaining quotes for supply?

5.4 What impact will an increasing level of renewable generation have on the forward contract market and what new products might be required?

5.5 Rule changes are in process to make the bid interval and the settlement interval the same, both equal to 5 minutes. Are there reasons to set them to a longer or shorter duration?

5.6 What additional system security services such as inertia, as is currently being considered by the AEMC, should be procured through a market mechanism?

5.6.1 How can system security services be used as ‘bankable’ revenue over a sufficient period of time to allow project finance to be forthcoming?

5.6.2 How will generators and retailers mitigate price risk in such a market?

Chapter 6: Prices Have Risen Substantially

Australians should pay no more than necessary for a secure, reliable and low emissions electricity supply. Electricity is an essential service and price rises affect all consumers – industrial, commercial and household. The least well off in our community, in particular, struggle to cope with electricity price rises. Affordability must be carefully considered in developing new measures to meet security and reliability.

Traditionally, Australians have enjoyed very low electricity prices by OECD standards. This is no longer the case. Over the five years to FY2013, Australian electricity prices rose by around 10 per cent annually driven primarily by network investments⁵⁶. Figure 6.1⁵⁷ provides a comparison of average Australian household electricity prices with those in other OECD countries. Comparisons are provided on both a market exchange rate and purchasing power parity basis. Purchase power parities are the currency conversion rates that equalise the purchasing power of different countries by eliminating differences in price levels between countries. The OECD average is weighted by consumption to account for different market sizes. Figure 6.1 shows that Australia’s electricity prices are now above the OECD average but when purchasing power is accounted for, they are still below most other countries. Price rises have moderated in recent years but are now expected to begin rising again in the next three years in most states and territories because of increases in the wholesale price driven by generator closures, gas supply constraints and international parity gas prices. This will place further financial pressure on consumers and undermine the competitiveness of Australia’s economy.

The electricity prices that consumers actually pay are made up of a number of components:

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  wholesale electricity charges;
  
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  network charges (transmission and distribution); and
  
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  retail charges, including the cost of compliance with the RET.