04 Aug 2016
Renewable capacity totals approximately 2,000 MW, around two thirds of peak demand. However, at times of peak demand, the system is often reliant upon an ageing fleet of gas-fired generators and a relatively small interconnector to the neighbouring Victorian region.
"Extreme volatility, which is required for an energy-only market with high penetration of renewables, is inconsistent with customer, investor and community expectations."
Dr Tim Nelson, Head of Economics, Policy and Sustainability, AGL & Adjunct Associate Professor, Griffith University
In recent history, South Australia’s energy supply has been influenced by decisions intended to offset the effects of climate change.
Meanwhile, the National Electricity Market (NEM) was created in the 1990s as an ‘energy-only’ market. Electricity generators are paid for the energy they produce but not the capacity they make available.
Most of the time excess capacity in the market ensures prices reflect short-run marginal costs (e.g. the cost of buying coal and gas). But at times of peak demand, prices are permitted to increase significantly which allows generators to recover the heavy fixed costs associated with building the infrastructure.
When the NEM was created, there was little focus on reducing greenhouse gas emissions and almost no wind or solar generation in operation. At the turn of the century, everything began to change.
Concerns about climate change resulted in a number of policies introduced to incentivise investment in new renewable electricity generation capacity. The 20 per cent Renewable Energy Target (RET) and various state government Premium Feed-in Tariff (PFiT) policies resulted in relatively rapid investment in renewable generation.
But almost no attention was paid to the interaction of these climate change policy decisions with the ‘energy-only’ electricity market design.
The economic characteristics of solar photo-voltaic (PV) and wind are different to those of coal and gas-fired power stations. While solar PV and wind farms involve significant capital costs, they have very low short-run costs (the sun and wind are free!).
Coal and gas-fired power stations have higher short-run costs as they must purchase gas and coal to produce electricity. Therefore, existing solar PV and wind farms will generally always be more cost-effective than existing coal and gas-fired power stations - if the wind is blowing or the sun is shining.
But solar PV and wind generation are considered ‘non-firm’ or ‘intermittent’. In other words, if the sun isn’t shining and the wind isn’t blowing, available capacity doesn’t produce any energy.
The Australian Energy Market Operator (AEMO) estimates only 10 per cent of wind capacity and 31 per cent of solar capacity in South Australia can be relied upon at times of peak summer electricity demand.
Therefore, there is a need for other ‘firm’ capacity to be available to meet demand when wind and solar PV aren’t available. But this capacity is only remunerated when it is needed via the energy it produces.
Tsen Wong, Associate Director, Resources, Energy & Infrastructure, ANZ
For decades, much of Australia has enjoyed the benefits of reliable, safe and affordable electricity. The bulk of this electricity has come from coal-fired power stations – the sheer abundance of coal makes it one of the cheapest and most reliable forms of generation.
However, as governments around the world grapple with the challenge of climate change, the high carbon intensity of coal-fired power generation has come under scrutiny.
Australia is in the fortunate position of having the resources for fuel switching to occur and, to date, significant investments have been made in wind and solar energy. The increase in renewables has, in part, been driven by domestic policy settings, including the Renewable Energy Target (RET) scheme.
Since the RET commenced in 2001, the Australian energy market has undergone a period of significant change. Public awareness of climate change, improvements in energy efficiency, a shift away from industrial production to services and the increasing penetration of rooftop solar generation, have coincided with sustained increases in energy prices.
These factors have all lead to a decline in demand. Yet despite this decline, renewable energy generation continues to be added to the National Electricity Market, as both State and Federal Governments strive to reduce greenhouse gas emissions.
The recent price spikes in South Australia, a state which now relies heavily on renewables for its power, were caused by a confluence of events, including the need to rely on gas-fired generation at a time when gas prices were high.
While discussion continues as to who or what was to blame for the price increases, one thing is clear – there is a need for energy policy and climate change policy to better align.
While energy policy is driven by the need for secure and affordable energy (an objective met by coal), climate change policy is driven by the need to deliver emission reductions, and the high cost of renewables is not a primary concern.
On August 19, the COAG Energy Council will meet. According to Josh Frydenberg, Minister for the Environment and Energy, the meeting provides “a timely opportunity to discuss recent developments in South Australia” and “… seek to put in place policies that provide for a lower emissions future while ensuring affordable, accessible and stable energy supply.”
ANZ welcomes regulatory reform which will facilitate investment in the energy sector in an efficient manner, providing appropriate market signals and incentives to drive investment in low carbon and sustainable solutions.
This is vital for capital providers (both debt and equity) who need certainty of their ability to recover and earn an appropriate return over capital employed.
An environment where investment certainty can be achieved is one where risks over the life of the project can be appropriately allocated, absorbed and priced, so as to be commercially successful for all parties involved.
Overarching management of critical issues such as intermittency, matching capacity with demand and the ‘insurance value’ of existing gas generation, is also necessary to ensure the benefits and costs of renewable generation are evenly spread.
A more integrated energy and climate policy represents a sensible step forward in ensuring the transition to renewables occurs in a way that is economically efficient and leads to positive outcomes for consumers.
While the 20 per cent RET was a national policy, South Australia’s wind resource (regional South Australia can be a reliably windy place) meant most new wind generation was built in South Australia.
Around one in four households in South Australia has installed solar PV on their rooftops. But the gradual substitution of coal and gas for wind and solar (and declining electricity consumption) has resulted in the closure of the Northern and Playford power stations. This has led to concerns about system security and the potential for extended periods of pricing volatility.
Pricing volatility is effectively the economic means by which ‘energy-only’ markets provide enough revenue for an ‘optimal’ generation mix. Heavy fixed costs associated with building power stations are recovered at times of peak electricity demand.
With the introduction of very low short-run cost renewable generation via climate-related public policies such as the 20 per cent Renewable Energy Target, pricing volatility must become extreme to ensure capital costs of firm complementary thermal generation or battery storage technologies can be recovered.
This brings us to a critical point: extreme volatility, which is required for an energy-only market with high penetration of renewables, is inconsistent with customer, investor and community expectations.
A 2016 study found the NEM would require a market price cap of between $60,000 to $80,000 per MWh for revenue adequacy if the system was supplied by 100 per cent renewable energy – six times higher than today. Prices would need to be able to increase by a factor of around 1,500 in half-an-hour.
It is not clear why such an outcome would be desirable given the high fixed-cost nature of renewable energy. In simple terms, in the long-run it is hard to justify continued reliance upon an ‘energy-only’ market in an environment where the cost of energy is zero (i.e. sun, wind) but the comparative cost of developing capacity to produce the energy is high and fixed.
Where to from here?
So where does all this leave South Australia and the broader NEM? It is imperative Australian policy makers integrate climate change and electricity policy.
The design of the NEM should be reviewed to ensure it is fit for purpose given the legitimate goals related to decarbonisation of Australia’s electricity supply.
Dr Tim Nelson is Head of Economics, Policy and Sustainability, AGL Energy and Adjunct Associate Professor at Griffith University
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
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