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Law \ Legal

More detail on the ESB’s proposed capacity mechanism


What the future looks like for retailers and generators

8 min read


The Energy Security Board (ESB) included a proposed capacity mechanism as one of the reform pathways set out in its final advice on the post-2025 redesign of the National Electricity Market (NEM). The capacity mechanism has received the most attention of all pathways contained in the final advice, and the need for such a market mechanism has arguably been heightened by the suspension of the NEM in June 2022.

That same month, the ESB took the next step in relation to the capacity mechanism by releasing a high-level design paper which sets out its vision for a capacity mechanism in further detail (the Paper).1 According to the ESB, the proposal seeks to address energy security by ensuring we have the right amount, and the right mix, of capacity available in the market, when and where it is needed.

With so much recent commentary on the perks and pitfalls of a capacity mechanism, this Insight takes a step back and unpacks what we know about the proposal and what it will look like for both generators and retailers in the future.

What will the capacity mechanism look like?

The Paper includes a number of departures since the ESB first proposed a capacity mechanism in its final advice to ministers in August 2021.2 For a summary of that initial proposal, and what the hypothetical future might have looked like then, see our previous Insight here. Now that we have more information, let’s again look ahead to 2028, from a generator’s and retailer’s perspective, and this time with the benefit of the clearer picture provided by the ESB.

Overview

At this stage it appears most likely that AEMO will be tasked with forecasting energy requirements for each year and will procure capacity from the market for that year through centrally run auctions. Both new and existing capacity providers will be eligible to participate in the auctions and will be paid:

  • for their availability during that delivery year; and
  • if they bid availability in the market during periods of system stress,
  • therefore providing generators and capacity providers with an additional revenue stream.

The costs incurred in procuring capacity will be passed through to consumers via retailers.

What will the market look like for generators?

Whilst the focus of this section is on generators, this information applies to all capacity providers.

If a centralised approach is adopted, AEMO will be responsible for forecasting ‘at-risk periods’ and procuring capacity for those periods. Generators will be subject to a ‘de-rating’ process which will form an input into AEMO’s reliability forecast and be used to determine the maximum amount of capacity certificates that can be awarded in an auction.3 De-rating is the process by which the nameplate capacity of a generator or battery is scaled down to the level of expected output during at-risk periods.

How will generators be de-rated?

How generators will be de-rated is yet to be set out in detail. What we do know is that the de-rating process will be informed by when the generator is expected to be called on to provide capacity and may be determined by either of the following:

  • pre-defined period: de-rating is determined according to discrete periods of the year, eg between 4-7pm on summer workdays.4
  • events-based definition: de-rating is determined according to a forecast of an event occurring, eg an unserved energy event.5

The choice of de-rating method depends on the predictability of at-risk periods and how concentrated they are throughout the year.6

Regardless, the ESB’s preference is to de-rate resources based on future estimates of capacity, rather than relying on historical performance during at-risk periods.7 For new generators entering the market, this might mean that de-rating factors are reviewed once the resource has commenced generation so that more accurate data is available.8

Different technologies will have different de-rating factors depending on their characteristics. For example:

  • Thermal generators (coal and gas) receive the highest factors, with constraints narrowed to factors out of the operator’s control, such as the impact of environmental conditions (particularly temperature) and forced outages.9
  • Variable renewable generation (wind and solar) receive low factors with constraints relating to seasonality and the location of the capacity provider.10
  • Storage (hydro and batteries) receive a wide range of de-rating factors which depend on the level of storage and controllability during at-risk events. For hydro, this relates to river flows for run of river hydro, energy constraints for pumped hydro and droughts for traditional hydro. For batteries, this relates to storage limitations and the need to reserve capacity for other services they may provide, eg FCAS.11

It is also intended that demand response can participate in capacity markets through an assessment of what the counterfactual usage of that customer would have been.12

AEMO will conduct competitive sealed-bid auctions to procure the forecast capacity and all capacity providers, both new and existing, will be eligible to participate. The ESB’s preference is that auctions for each delivery year will be staggered as follows:

  • an initial auction held several years in advance of the delivery year, which is configured to procure less than the forecast capacity requirement (to mitigate any risk of consumers bearing the cost of over-procurement); and
  • one or more supplementary auctions held closer to the delivery year, with the last auction configured to procure the entire updated capacity requirement. These auctions may also allow some secondary trading, enabling participants flexibility if their circumstances have changed since a previous auction.13

This approach aims to ensure that the capacity mechanism can play a role in supporting new investment (by holding the initial auction several years in advance to align more closely with project development timeframes) whilst also ensuring accuracy (to reduce the likelihood of over procurement).

If a generator is expected to be on a long-term outage or mothballed during the period for which capacity is being procured, it will not be permitted to participate in the capacity auction.

What about new generators?

The Paper suggest that new entrants to the market will receive additional support under the mechanism. Eligibility to receive this additional support will likely be linked to whether the new capacity is consistent with the net-zero emissions targets.14 Some support which may be available to new generators includes:

  • longer-term contracts in order to strengthen investment signals. This may include:
    • contracts which guarantee both price and quantity for a specific term; or
    • contracts which guarantee price only through a price lock-in option for a specific term; and15
  • different auction participation rules for new capacity (such as different offer price caps and floors).

Generators will receive revenue from AEMO in two parts:

  1. The first part of the payment will be made for providing year-round availability which is to be assessed at regular intervals throughout the relevant delivery year.
  2. The second part will be made if the provider bids availability in the market during periods of system stress, such as an actual lack-of-reserve event. Following the event, the capacity provider’s actual bid availability is measured and, if it meets its de-rated capacity, it will receive the payment. It will not matter whether the lack of reserve event was forecast or unexpected.16

So, if generators do not dispatch in periods of system stress, they will not receive the secondary portion of the payment (or benefit from high spot prices). The ESB expects that these payments will be made throughout the year, with a true-up at the end of the delivery year, but this will be considered further in the detailed design.

At this stage, it looks like generators will not be subject to a penalty regime for non-performance (with the ESB favouring an incentive-based model), but this could be introduced in the detailed design phase.

Given the quantity of new generation which needs to be constructed in the NEM over the coming decades17, ideally the capacity mechanism would fulfil a dual purpose of ensuring that supply is available when needed, as well as promoting investment in new generation and firming infrastructure (such as batteries and pumped hydro).

Whether the capacity mechanism will promote new investment will depend on:

  • the term of the capacity contracts awarded following an auction – if they are only one-year contracts, this does not move the dial for financiers and investors in terms of revenue certainty;
  • whether the de-rating process is sufficiently robust such as to provide certainty for investors that factors will not be arbitrarily decreased or decreased during a contract year; and
  • how far in advance auctions will be held (such that they can have an impact for greenfield projects).

What will the market look like for retailers?

Costs

AEMO will recover the costs of procuring capacity through retailers, possibly on a ‘per MWh’ approach using AEMO settlements. Costs will be passed through as set out in the diagram below.

19434D diagram Energy Capacity mechanism_D.jpg

19434D diagram Energy Capacity mechanism_D.jpg

19434D diagram Energy Capacity mechanism_M.jpg

What role could retailers play in procuring capacity?

Despite its preference for a centralised approach, the ESB is considering involving retailers in procurement of capacity under the following options:

  1. Option 1: AEMO purchases certificates at an initial auction which retailers then acquire to meet their own projected requirements. This would provide visibility of retailer forecasts and would transfer forecasting error risk to retailers. However, AEMO would still need to recover costs of any surplus certificates it had purchased, and retailers would also need to be able to purchase additional certificates outside of the centrally procured pool in the unlikely event that their forecast capacity was higher than AEMO’s.18
  2. Option 2: retailers are allowed to participate as buyers alongside AEMO in the capacity auction. This means retailers could indicate their future capacity requirements and increase transparency. However, AEMO would need to procure capacity to meet the projected demand, irrespective of the retailer participation in order to support reliability. The ESB notes that this option is likely to increase the administrative costs of the mechanism.19

Next steps

Interested parties should make submissions on the Paper by 25 July 2022.

After consultation is complete, the ESB will commence the detailed design process based on stakeholders’ input to present to Energy Ministers in December this year.



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