Presentation to the Australian Economic Forum

20 August 2009

John Tamblyn Chairman Australian Energy Market Commission



Good afternoon, everybody. First of all, thank you to the Economics Society of Australia for this opportunity to speak with you. My topic will be impacts of climate change policy on the energy market, and the adequacy of the energy market framework to accommodate the transformation - the very major transformation – climate change policy will involve. We have been asked to review that important question, and to recommend to the Ministerial Council on Energy any changes to the market design arrangements for energy that would better equip the market to respond to climate change policies. I should say at the outset, our terms of reference for that inquiry ask us expressly not to review and comment on the climate change policies themselves, but take them as they have been announced by the government, noting the ongoing negotiations, and consider how those announced policies would impact on the energy market.

I want to focus briefly on what the structure and design of the current energy market is, and some of the challenges it's facing currently. I will briefly describe the review we have been asked to do, but focus on the likely impacts of climate change policy on the market and changes that might be made to the market design to better accommodate climate change policy.

Going firstly to the market design, the energy market has been reformed over the last ten years, such that its market structure is that, generators and retailers' purchase energy, in a competitive wholesale market interconnected across the regions of Queensland through New South Wales, Victoria, South Australia and Tasmania, also the ACT. Progressively we are introducing competition at the retail level, where retailers are competing in the supply of energy to final customers. In some jurisdictions the smallest customers are not yet contestable, but in many, they are. The network sectors - transmission and distribution - are, largely speaking, natural monopoly service providers, and they are subject to economic regulation.

The important point to make is that the investment and operating decisions in the energy market are made by decentralised energy businesses. Generators and retailers make commercial decisions in the competitive energy market place. In the regulated sector, the distribution and transmission businesses make investment decisions and operation decisions within the framework of economic regulation. Equally, on the demand side, energy consumption decisions are made by numerous large and small customers based on the prices and quality of services available in the energy market.

This is not a government-managed sector but a decentralised and commercial sector where behaviour is directed by the incentives of market competition and economic regulation.

In terms of its performance since the reforms in the mid to late 1990s, reliability in this competitive structure has been high, over the last ten to 12 years. Yes, we have seen some isolated events, including in Victoria and South Australia earlier this year, where we had some very severe weather events and some outages, but by and large, the decentralised marketplace for energy services has delivered consistent reliability. We've also seen significant investment in the market over time, in generation and network. Largely, that investment has been made on-time to maintain the balance of supply and demand, and competition has broadly been effective in keeping prices in line with efficient resource costs.

So we have an energy market which has been working effectively up until now, but it is facing some emerging challenges. After a period of surplus capacity in generation and network, we now see a quite tight supply and demand position emerging. We've seen continuous strong growth in demand. There is now an emerging requirement for significant investment, in generation and transmission, both for replacement of old assets and to augment infrastructure to meet growing demand. The drought has also put some constraints on the availability of capacity that's already in place.

Importantly now we also have some significant economic and policy uncertainty impacting on the market. At a time when investment requirements are high, the global financial crisis has had an impact on investment financing capacity in the market. Most importantly the advent of climate change policy, the specification of that policy, and the understanding of how it will impact on the energy sector, has also had an impact on the investment climate as people wait to see the rules of the game before they invest in the new technology that will be required.

The context in which we've been asked to conduct our review by the MCE is: how capable is the market design that I've described of managing the very significant structural and behavioural transformations that will be driven by climate policy? If there are weaknesses or stress points in the market design that could be changed to better equip the market to respond, we should make recommendations on what changes should be made.

Let me say a few things about the likely impact of climate change policy on the energy market. Other speakers have also commented on aspects of this. The emission intensity of our generation sector is very high - we're heavily based on coal - and the imposition of a price on emissions is going to drive a very significant change in the structure of, and technologies used in, the energy market. We are going to see a very significant change over time in the merit order of generation, moving from coal, which is the current emphasis, towards gas and ultimately to renewables and, presumably, new, low-emission intensity technologies in the more distant future. These are very significant changes in the generation sector.

Also, there will be important changes in the flow of power across the existing transmission and distribution networks, as we see different generation technologies connecting to the network in different locations. At the moment, the network is heavily focused on supply from the coal-based generation sectors - Latrobe Valley, Hunter Valley, and the coal regions of Queensland – however, gas and renewable resources are likely to be located elsewhere and connect to the network at different locations, placing pressures on weaker parts of the network. We'll also see very significant impacts on energy costs and prices, partly driven by the carbon price itself, but also driven by the very significant investments that will be required in responding to the incentives of climate change policy.

A few quick comments on the expanded RET. That is clearly intended to stimulate significant investment in renewable generation via the obligation of retailers and large energy users to take a specified proportion of their energy from renewable sources. I note here that the ability to bank certificates created by renewable investments is likely to encourage early renewable investment in the currently available technologies, predominantly wind but solar may also have a role to play. The certificates created by these early investments can be banked for use at later times, encouraging early investment in the currently viable renewable technologies.

Wind generation is likely to be located remotely from the current shared transmission network. So we'll have a challenge in linking new renewables to the current network - to get supply from those remote sources to demand centres. Another feature that other speakers have mentioned is that wind and solar are intermittent sources of generation. For reliability, there needs to be predictable load following generation in place to make sure reliability of supply can be maintained. So wind generation will need to be backed up by reliable generation sources such as gas, for example.

I now want to comments on the wholesale market, the transmission sector and the retail sector, in terms of whether the market design is well equipped or not to manage those changes.

First of all, focusing on the wholesale market, where generators bid into the marketplace and retailers buy their supply. The wholesale market spot price is subject to a relatively high regulated price cap compared to other markets around the world. It can go as high as $12,500 per megawatt hour and there is the ability to adjust the price cap over time as necessary. The intention is to set the spot price cap high enough to make it economic for peak generation to enter the market. That generation needs to be available for peak periods, where they might only run for a small number of hours a year, but they can earn sufficient revenue in that short period of time, at these high prices, to make it economic to enter the market.

The spot price, and the related contract prices that are based on the spot price provide the primary signals for investment in new generation in sufficient time to maintain the balance between supply and demand including at those peak times. We also have “safety net” arrangements to manage reliability in the short term if needle peaks in demand risk exceeding available capacity. In circumstances where there may be temporary short fall in available generation- such as last January/February in Victoria and South Australia - the market operator can intervene to either contract for extra capacity or direct that load be shed, to keep the system in balance. By and large, the price signals in the wholesale market have kept supply and demand in balance including at times of peak demand and without the need for intervention by the market operator.

However, we are now facing some challenges. This is a chart prepared by AEMO - the market operator's statement of opportunities. The black line is predicted demand. The dark blue bars are installed or committed capacity, and the light blue areas show the opportunities or requirements for investment in new capacity sufficient to match that black line of forecast demand. For South Australia and Victoria, which this chart shows, as early as 2009/10, there is a projected are gaps between committed and installed capacity, and forecast demand. In the past, the price in the marketplace has elicited investment in a timely way but currently, the global financial crisis, together with uncertainty about the details of climate policy, is impacting on investment confidence and timelines. So we have a market that's worked well in the past, but the potential for emerging supply/demand imbalance is now introducing some reliability risks.

Our assessment and our review has concluded that in the medium to long-term, the current market design remains capable of maintaining the supply/demand balance provided the price cap is adjusted flexibly, sufficient to elicit new investment in peak generation. As I have mentioned, the price cap can be, and is, adjusted from time to time. The challenge, we think, is to maintain the short-term supply/demand balance given the likely lags in investment over the next two to five years. Our draft findings - which I quickly cover here basically focus on improving the market operator's tools for management of short-term reliability while persisting with the energy-only market, with its high price cap and the ability to adjust that price cap to maintain the balance of supply and demand over the long-term. We will make some recommendations for improving AEMO's short term intervention powers, which I won't go into detail on, while emphasising that we think the market design is resilient in the longer term.

Some stakeholders, in commenting on our preliminary findings have criticised that view and have said, consistent with some overseas markets, now is the time to be thinking about a capacity market as well as remunerating generation for energy despatched in the energy market. We have not been persuaded to that view, but there are different views about that question.

Looking at network investment and operation, as I have said, that is currently a regulated sector. Within the regulated framework, the Australian Energy Regulator can and does provide sufficient regulated revenue to cover the investment and operating requirements of the networks, and to provide return on and of the capital that's invested in the sector. For the shared network those investment and operation costs are passed directly through to customers. Where generators or large loads connect to the shared network the capital and operating costs of connection assets are determined by bilateral commercial negotiations between the connecting party and the network. So far, that system has worked effectively but that's a point that I'll come back to.

A quick illustration of where the current transmission network is in the interconnected regions on the eastern, southern coast. You can see it hugs the coastal regions, and it's particularly dense around the coal-based generation sectors of the country. That is a configuration that's based on the history of the energy market. As well we've got isolated networks in Western Australian and in the Northern Territory. Here are a couple of maps indicating, on the left, where the wind resources are concentrated. This is wind at 80 metres, and it's showing wind speeds in metres per second. The red areas are between 7 and 10 metres per second. The blue areas are lower rates.

You can see that we have the best wind resources in Western Australia, the west of South Australia, the west of Victoria, and parts of Tasmania. You'll note those resources are quite distant from where the existing network is. Equally, the geothermal resources, with the red being the most prospective areas, are also located quite remotely from where our current network is. This illustrates the important challenge in terms of the infrastructure to be built, to bring those renewable energy resource from the most prospective areas through the transmission system to demand centres.

The challenge I've identified here is how to provide incentive for the efficient timing and sizing of the network required to connect remotely located renewable resources, a matter that Ross Garnaut first identified. We think the current arrangements for bilateral commercial negotiation of connection links to the meshed network will not achieve efficient connection outcomes where there are clusters of renewable generators located remotely who are likely to seek connection over an extended period. We will be proposing changes to the framework to address that issue.

Improving the management of congestion on the shared network is a further issue we have identified that will require changes to the framework. We think there'll be different flows around the network, including stronger flows on weaker parts of the network in response to climate change policies. We also think there will be increased energy flows between regions as a result of increases in renewable generation. For example, South Australia or Victoria may need to build additional network to transport renewable power to serve, for example, New South Wales or Queensland. We think there's an argument now for introducing inter-regional charges for transmission which reflect the usage of network in one region which is serving the energy demands of consumers in another region. This is another area of potential change to the network framework which we think would be worthwhile. These slides present some details of how that will be done, but I won’t go through that now.

Regarding the congestion problem we have formed the view that there is a need to give a signal to new connecting generators about the cost their investment decision and their usage will impose on the network, in terms of new investment requirements. We think generation needs to see a price signal reflecting those long run costs and we also think there may be an argument for some form of short-term congestion price signal to promote better management of congestion in the short term.

I now turn to energy markets and consumers. Here I'm focusing particularly on the household sector and the small business sector, which is currently - except for Victoria - subject to retail price regulation. As a number of other speakers have said, climate policy is going to involve significant changes in carbon inclusive energy cost and prices. For the objectives of climate policy to be served, customers need to see those changed costs and prices because they will drive the behavioural changes and changes in consumption patterns which the policy is intended to achieve.

The point that I want to focus on is that with regulated retail tariffs there is a high risk that the regulatory regime will not be sufficiently nimble to pass through rapid and potentially volatile cost changes to final customers, quickly enough to maintain the viability of retailers and to enable continuing development of competition. Future carbon inclusive energy costs are going to be uncertain and potentially volatile. They'll be driven by an uncertain future carbon price and uncertainty about the extent of carbon costs pass through in energy prices. The impact on the energy cost will depend on the carbon intensity of the generator that is setting the marginal spot price at different times of the day, week or year. So there's uncertainty in predicting how far that carbon cost will be internalised in energy costs. In regulating retail prices regulators will be trying to project a future price path in this very uncertain world. We think there is a need for change in the framework to address the risks this will involve.

Retail price regulation is a state government responsibility and it will be up to individual state governments to respond to our recommendations. However, the approach we propose to recommend is that, where price regulation continues, there should be more flexibility in those arrangements to allow the timely pass-through of costs in prices, in order to keep the retailers viable. If those costs are not passed through quickly, retailers will have problems, and there could be a risk of retailer failures and determination in the competitiveness of retail markets. We also want to continue to promote the effectiveness of retail competition. If those costs are not being recovered quickly by retailers, we won't see competitive entry and rivalry in the market.

We have a number of guiding principles in mind to achieve more flexible price regulation and continued support for competition. Firstly we suggest that governments clarify that the objective is to promote effective retail competition and that the role of price regulation is to provide a safety net for those customers that don’t engage effectively in the competitive market. This will protect them against the potential to exercise market power where competition is not yet effective. Its purpose is not in our view to try to predict the most efficient price that is possible in the retail market and to set that as a target for retailers to beat. If that is done, there won't be competitive margins under the regulated price, there won't be incentive to enter and we won't see competition developing, contrary to the policy intent.

We also think that the price caps should recognise that future costs and prices are likely to change rapidly and be more volatile There needs to be enough under the price cap to accommodate those rapid changes and we think there should be an option to reopen and reset price caps after 6 months if there is evidence of material change in carbon inclusive energy costs. We also suggest that if costs and prices go down for example, through the 6 import of lower priced carbon permits, there should be symmetrical adjustment to price caps. Customers should see price reductions if costs fall, as well as price increases when they rise.


My concluding comment is that by and large, the current design of the energy market, the focus on competition at the wholesale and the retail level, and on efficient incentive regulation at the monopoly network level, remains the best overall market structure and design to manage the transformations and adjustments that will be driven by climate change policy. However, we've identified a number of quite significant areas where the market design and framework can be, and needs to be, changed to better facilitate those adjustments. The other concluding point to make, as other speakers have, is that climate change policy will result in significant cost increases and changes in behaviour - there will be significant price impacts; there will be challenging structural changes - which won't necessarily be smooth or seamless. That is a necessary implication of the implementation of climate change policies. Seeing the prices and costs that the policy imposes is the necessary and intended means of changing behaviour, of changing consumption patterns of promoting business innovation and structural change, and of achieving the long-run objectives of the policy.

Thank you for listening to me, and I would be happy to respond to any comments or questions you have.

Thank you.

Questions from the Floor:

Q. What are your views on the question of whether incumbent generators should receive a long term location signal as well as new entrant generators?

A. DR TAMBLYN: Yes, thanks for the question. Could I just indicate this whole question of congestion management and location signals is quite a complex matter. Analysing it properly and developing a workable solution, we think, needs more time than our review down to 30 September allows. We intend to consider a couple of different approaches for introducing more effective location signalling. One is, to give the right signal to new entrant generators of what the full cost of their entry will be including the cost of their capital investment, their operating costs and the costs they would impose on the network.

A related question –is to recognise the existing network is a valuable resource. The capacity being used by current generators has an opportunity costs. Should they also see a signal of the cost they are imposing through their use of the network which has an opportunity cost. Is that a consideration they should have in mind, when they are considering exit – for example, in the case of technologies that over the medium to longer term will not have a viable future when faced with a carbon price. So the issue of what sort of locational pricing mechanism, who should pay it and what are we trying to signal in terms of costs to which participants will be given more detailed analysis.

The particular issue you've raised is should incumbents see a signal as well as entrants, or are we signalling future impacts on the network to new entrants generators only? This remains an open question. Views differ, depending on whether you're an entrant or an incumbent. But what's the right resource allocation signal for better location decisions and 7 management of congestion on the network in future is a matter that's going to be addressed in a further work program following our 30 September report.

Q. The question I have on renewables really goes to the issue of, in fact, storage of power. It seems to me that you have a major problem in that the power isn't necessarily generated at the time you needed. It's actually good to see in the last presentation that that got a little bit of attention there, in terms of storing solar power, but it seems that with things like wind, for instance, it happens when the wind blows, and not at the time you necessarily want the power to be feeding into the grid. How much attention is that actually getting, in terms of storage solutions? It would seem that our best storage solution in Australia is a little bit limited at the moment, given that we've got a drought and we can't use the hydro.

A. DR TAMBLYN: From my point of view - but others will have a comments also - we are looking at what signals can be provided through the competitive or regulated market processes for commercial responses to the prices and commercial opportunities that will arise in the future under the incentives provided by climate policies. In the context of intermittency, because the wind will not be blowing all the time, the introduction of much more wind generation will raise reliability questions. There needs to be either storage or backup generation. In our view, it is for the market place to come up with those solutions in response to the commercial opportunities created by the price and cost changes that will be driven by climate policy. What technologies, what assessments of their effectiveness and financial viability, in our frame of reference, are matters for the marketplace to decide.

Wind is always likely to have a degree of variability no matter what you do. A lot of people would say that if you have enough wind farms all over the country - well, you can't put them all over the country, but enough wind farms scattered, then you tend to smooth that. But I think that's still got some limitations to it. There's some work going on overseas at the moment, using huge battery banks. They're sodium-sulphur batteries that they're considering putting in place, so that you can have a few hours at least of dispatchable power, even when the wind gets too strong or drops away altogether. But there always will be variable power from wind and it's a real trick to minimise the amount of backup you've got, and you can do that by things like wind forecasting, which is getting better and better. So there's a whole array of things that can be done, but I think, in the end, we're still going to have to have some sort of levelling system or device or backup.

Q. A question for John Tamblyn, but perhaps if I can generalise it, you mentioned the importance of price pass-through and - being clearly signals for users, which is the whole purpose of putting a price on carbon. Are there any restrictions you see, or rigidities in commercial relationships such as long-term contracts with aluminium smelters? And perhaps more generally, the two Johns, would you like to comment on energy efficiency opportunities in Australia - the way forward?

A. DR TAMBLYN: Well, a quick response from me on that. In terms of long-term contracts and established energy market relationships with smelters and others, they are embedded in history, and they are realities. I would make the point though, that potlines are used, particularly in Victoria and elsewhere, as demand-side responses when there are short-term shortfalls in available generation capacity. Potlines in Victoria are the first call if there's a need for load-shedding. They can turn off for a limited number of hours and so reduce peak 8 demand before more general load shedding is resorted to. So: yes, there are pricing and contractual arrangements which are embedded, but the flexible use of that capacity has been negotiated and can be used.

Looking at energy efficiency, I acknowledge the comment made by the New South Wales Government speaker this morning, that the energy market is strongly supply-side driven, and the demand side is not as well, and as actively, represented. Robyn has commented that there are arrangements, regulatory and other, outside the formal energy marketplace that might address either incentive or obstacles for the demand side and for energy efficiency responses. . The Commission is also partway through a review looking at the energy market design arrangements to see if there are obstacles or barriers to more efficient participation on the demand side and whether efficient incentives could be added to encourage greater demand-side participation. There's a range of initiatives on that front, but it's very much work in progress, and it remains underdone at the moment, and there are opportunities for more progress in this area.

Q. You mentioned the need to have a look at retail price caps to make them more flexible - the potential to open them up every six months. This looks to me like a huge growth industry for regulators, because they might be invited to set price caps more regularly. But if we've got a situation where what we're really concerned about is market power abuse, and it is, effectively, a competition policy tool rather than a device for market efficiency, did the Commission - could it, under its terms of reference - or did it look at alternative forms of regulatory form, which were perhaps - given it's a safety net, as you describe it, or perhaps an ex post form of regulation rather than ex ante - which I think actually goes to the issue that Robyn alludes to: are we actually trying to deal with some sort of welfare issue through the price cap, or are we trying to actually deal with some abuse of market power issue through the price cap? Because I think it still remains fundamentally confused in retail electricity.

A. DR TAMBLYN: The short answer is no, we haven't looked in detail at an ex post regulatory approach- which I presume you are saying, would seek to correct any mischief or mis-pricing after the fact, as opposed to a forward-looking approach to regulation. No, we haven't looked at that. If I could take a step back , as I understand and read the COAG-MCE policy on this question, the medium-term objective is to promote and develop effectively competitive energy retail markets so that we don’t have market power problems to manage in that future state of the world. As we are trying to facilitate the development of effective competition at the retail end, retail price regulation is an interim measure pending achievement of that goal. This requires encouragement of entry and vigorous competitive behaviour between retailers - which we see, I think, pretty effectively in Victoria and less so in other jurisdictions, where it's still developing. But that's the objective. So you don’t want an approach to price regulation that squeezes out viable retailers and results in regulators having a permanent role.

Your question implies, though, that we are seeing market structures which don’t deliver competitive outcomes all the time and particularly in the unregulated large customer retail sector. At the larger retail customer end, it is true that in different jurisdictions, when the interconnectors bind, there can be transitory short-term market power to set wholesale prices in particular regions - take South Australia, for example. What should be done about that and any implications for retail competition and prices? Is the Trade Practices Act adequate? Do we need to have extra regulations to oversight that sort of conduct? I think these are 9 10 wider policy questions that are not currently under consideration.

I'd simply make the point that - monopoly rents, if they are taken for a period of time - I think it was Fred Hilmer who first said this - are the signal for innovation, entry, and competitive responses, in order to take away that rent. So regulating to dampen price and profit signals which suggest there's an opportunity for profitable entry, may well lock in uncompetitive structural frameworks rather than promoting the conditions to break them down. Currently, in the energy market, we rely on competition policy and law to regulate market power, and we have a safety net in place in the energy sector to protect vulnerable or ill informed customers. But we are not looking to impose further regulation on either pricing or market conduct beyond the arrangements currently applying to the small customer sector of the energy retail market.

MC: Thank you for that, and I think I will have to draw this session to a close. So perhaps you can join me in thanking the three speakers again for their presentation this morning.