Could renewable energy and demand reduction lead to the collapse of the energy market ?

The aim of this post is to understand the impact of renewable energy (RE) and demand reduction (DR) on the business model of the Australia electricity industry.

At a macro level the level of impact of RE and demand reduction DR on the electricity market will depend on how quickly RE and DR emerge, the degree of correlation of these elements with market changes, the resilience of the market, and the flexibility of the market to change.

The following graph demonstrates that it is expected that RE will form a significant part of the energy supply in the next 30 years (DRET, 2012):




Figure 1 Australia's electricity generation mix to 2050 - AEMO medium demand scenario

The following diagram outlines recent changes to electricity demand:



Figure 2 Recent changes to electricity demand and GHG emissions in the NEM (Saddler and Anderson 2012)

There are four markets in operation in Australia – the NEM, WAEM, NT, and Horizon Power. Any policy measures must be conscious that currently each of these operates under different regulatory regimes (although the NEM is by far the most significant market).

Electricity markets are a combination of financial, physical and communication flows that together enable: financing and development of generation and network assets; determination of demand and delivery of physical electrons; establishment and settlement of wholesale prices; and for retail pricing to be set and settled with consumers.  This is outlined in the following diagram :



The emergence of RE and DR must interplay with other key trends (DRET, 2012) :

• change in peak demand due to proliferation of low cost electronics;
• political importance of reducing electricity prices; 
• complexities of emergent gas markets and impact on local spark spread; 
• commercialisation of new technology; 
• ensuring the regulatory environment is attractive for capital investment; 
• deregulation of the energy market; 
• levels of CO2 emissions and attitudes to climate change; and 
• existing infrastructure is “locked in” given it is built.

Areas of this market that require particular resilience and flexibility include:

• the general ability to deliver reliable and secure supply; 
• network infrastructure development; 
• effective operation of the spot market and hedging contracts; 
• generator capacity to cover peak and base load demand; 
• fair regulated return on assets that does not create split incentives with RE and DR.

The impact of the RE on the “merit order” has been documented to negatively impact generators (Ketterer, 2012) (Sensfuß, 2007), by reducing the value and increasing volatility of the wholesale market (Ketterer, 2012) (Green, 2010).

A report commissioned by Macquarie Generation (Skelton, 2012) relating to RE posited that:

• the financial loss would be $11.3 (B) to existing generators; 
• existing generators could choose to bid more aggressively or retire units the merit order effect will be less and prices for consumers higher; 
• RE displaces gas fired generation first which may diminish environmental benefits (i.e. solar in particular displaces peaking plants which are mainly CCGT); 
• uncertainty of prices may jeopardise future investment and risk supply. 

Whether these impacts materialise will be driven by policy. DR also has impact on the revenues of generators, however depending on the regulatory regime the reduction in revenue from decreased demand can be matched by decreases in marginal costs through peak load abatement (Abhyankar N, 2011)

3.2 Network operators

Network operators are somewhat protected from significant changes to the market. For example in the NEM their revenue and capital expenditure are based on 5 year rolling plans submitted to the Australian Energy Regulator (AER) (Davison, 2010). Once approved income is based on this allowable revenue against the approved costs (which include a return on capital). The impact of RE and DR is the networks ability to adapt to more distributed generation (AEMC, 2009) and to some of the technical challenges presented by new intermittent power. These challenges are broadly categorised as (AEMC, 2009) maintenance of system voltages (given wind and solar bring little reactive power), management of power system inertia and maintenance of power system frequency.


3.3 Retailers and Consumers

Retailers are passed cost changes from generators and network providers and pass these costs to consumers. Modelling for the RET scheme indicated that the cost to consumers would be $4.6 (B) in wholesale electricity prices however this can be mitigated by DR as 25% of retail electricity costs can be attributed to peak load requirements (DRET, 2012) Clearly there will be significant increases in network charges depending on the geographic expansion to the network (Skelton, 2012) .

Few believe that RE and DR will lead to collapse of the energy market and that in general “…the current market is framework is capable of absorbing change” (AEMC, 2009). Having said that the participants in the market have complex financial arrangements and are very interdependent (AEMC, 2012). AEMC explores scenarios which could lead to distress in market and outlines that prolonged period of high spot prices could impact on hedge contracts, credit exposures, and debt covenants.

Generators could fail if there were sustained low prices, or if there was sustained outages of generation or transmission. RE and DR could influence these risks if:

• reduced futures pricing lead to increasing credit exposures; 
• changes to the RET can also put pressure on long term power purchase agreements which do not have pass through clauses; 
• lost generator income reduces asset renewal programs leading to increasing likelihood of outages; 
• intermittent generation increases the systemic cost of proving reliable generation; 
• intermittent generation leads to peaking plants having “tight capacity margins” (AEMC, 2009). 

In reality many of these risks are mitigated by existing laws and regulation – both specific to the electricity market and general Australian corporate governance (such as Australian Financial Services Licence requirements). Market participants are also protected contractually (with Force Majeure clauses and insurances). Retailer risk is managed through a process called Retailer of Last Resort (ROLR) (AEMC, 2012) however this is not full-proof if it leaves retailers over-exposed. There are also physical protections in the system with dispatch being managed every five minutes for both network capacity and maintaining frequency.

Some argue that in the mid-term these variations should not be a problem if a market for carbon inclusive hedging develops and depending on the distribution of wind assets and range of time weighted prices (Green, 2010) (which in the UK was only 4%) .

While RE and DR are only two factors impacting on the current electricity market, this report demonstrates that they introduce significant uncertainty into a market that does not deal well with uncertainty. The following are some key solutions for the integration of RE and DR measures into the current market:

• DR incentives for Network Service Providers (NSP’s). There have been various structures put in place around the world. (Alvarez, 2010) looked at several schemes and found that where mandatory DR targets were put in place there was little incentive for efficient deployment of DR schemes by NSP’s. More effective schemes are revenue decoupling and white certificates which create market based incentives for investment;
• Encourage measures that link load curtailment to generation revenue. (Abhyankar N, 2011) outlined some ways to remove split incentives by allowing utilities to capitalise expenditures (in contexts where revenue allowances are tied to capital expenditure) and to benefit from share savings schemes;
• Better forecasting and “smart grid” infrastructure that enables greater resilience, market signalling and market flexibility;
• Encourage efficient clusters of new generation to minimise network costs through incentives based on location (AEMC, 2009);
• Manage spot market caps over time to manage tight capacity issues;
• Efficient costing of new generation by exposing customers to distributed network costs more directly;
• Need to have inter-regional flows and appropriate charging (AEMC, 2009);
• Constant strategic review (DRET, 2012);
• Need a framework that clearly signals the appropriate form and level of new generation and retirement of old capacity (AEMC, 2009);
• Encourage a market and system for deployment of inertia and reactivity in the network (AEMC, 2009);
• Consistency and bipartisanship on key policy areas such as the RET and Carbon Tax;
• Careful management of regulatory change as participants are increasingly privatised.

In a period of significant complexity and change there are many factors that are weighing on the future of the Australian energy sector. The policy measures above address this uncertainty and provide solutions that, along with existing market frameworks, ensure a seamless transition to a more sustainable future.






References

Abhyankar N, A. N. (2011). Impact of large-scale energy efficiency programs on utility finance sand consumer tariffs in India. Stanford: Energy Policy.

AEMC. (2012). NEM financial market resilience, Issues Paper. Sydney: Australian energy market commission.

AEMC. (2009). Review of Energy Market Frameworks in light of Climate Change Policies. Sydney: AEMC.

Alvarez, a. R. (2010). Impact of Energy Efficiency Incentives on Electricity Distribution Companies. IEEE TRANSACTIONS ON POWER SYSTEMS , 1865-1872.

Climate Change Authority. (2012). Final RET Review Overview Document.

Davison, M. (2010). Austrlalian energy market overview. Adelaide: Wesex consulting.

Department of resources, e. a. (2012). Energy white paper 2012.

Green, R. V. (2010). Market behaviour with large amounts of intermittent generation. Energy Policy , 3211-3220.

Ketterer, J. C. (2012). The Impact of Wind Power Generation on the Electricity Price in Germany. Leibniz Institute for Economic Research at the University of Munich.

Leveque, F. (2006). Introduction. In F. Leveque, Competitive electricity markets and sustainability (pp. 1-21). Cheltenham: Edward Elgar Publishing.

Sensfuß, F. (2007). Assessment of the impact of renewable electricity generation on the German electricity sector An agent-based simulation approach v. DISSERTATION . Karlsruhe.

Skelton, R. (2012). Renewable Energy Target Review - Discussion Paper Response from Macquarie Generation.