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Allens Arthur Robinson

Focus: Energy – November 2002

Energy market review draft report

In brief: Comments on the COAG Energy Market Review Panel's draft report are due by 6 December. Partner Grant Anderson (view CV) looks at the principal recommendations. Future articles will examine some of these issues in more depth.

Introduction

The COAG Energy Market Review Panel (the Panel) released its draft report on medium to longer-term energy market directions on 15 November. The Commonwealth Government's initial response will be announced on 25 November and it is proposed that the final report will be submitted to the Ministerial Council on Energy in late December.

While the Panel considers that the reform of Australia's energy markets has brought significant benefits to date (an additional $1.5 billion per annum to the wider economy), it also states that:

... the reform of Australia's energy markets is far from complete and significant deficiencies remain that require attention. Without these deficiencies being addressed, Australia's energy market will not only fall short of reaching its full potential, but it risks losing the valuable benefits gained over the past 10 years.

The Panel is therefore concerned to ensure that these deficiencies are addressed by COAG in the shortest possible timeframe. The major deficiencies identified by the Panel, and its recommended solutions, are discussed below.

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Single regulator

The large number of energy market regulators has long been an area ripe for reform. As the Panel recognises, the multiplicity of regulators and regulatory instruments applying in each jurisdiction is an impediment to a truly national energy market and imposes significant costs on energy industry participants who trade in more than one State or who trade in both electricity and gas.

The rationalisation of regulators and harmonisation of regulatory requirements, while clearly sensible, is a matter that will require a significant degree of political willpower, as it is likely to raise concerns relating to jurisdictional sovereignty and the accommodation of regional sensitivities. However, as jurisdictional cooperation in the areas of corporations, credit and trade practices law demonstrates, this is not impossible to achieve.

The Panel has tackled this issue head-on. It proposes the establishment of an independent national specialist regulator (the National Energy Regulator) that will take over:

  • the regulation of the electricity and gas transmission and distribution access regimes that are currently administered by the ACCC and the various jurisdictional regulators;
  • the electricity and gas licensing functions that are currently undertaken by the jurisdictional regulators (including the development of associated consumer protection codes);
  • the role of NECA in enforcing the National Electricity Code; and
  • the role of the National Competition Council and the Commonwealth in deciding on pipeline coverage under the Gas Code.

The Panel has eschewed the idea of a cooperative approach involving retention of the existing regulators with a consistency of approach. Instead, it has justified the establishment of a national specialist regulator on the grounds of the complexity and specialised nature of energy markets, and the need to ensure the creation of a national energy market. This recommendation has, however, already come under fire from the ACCC on the grounds that specialist regulators are more susceptible to industry capture.

Associated with this regulatory rationalisation is a proposed overhaul of the processes for changing the National Electricity Code and the Gas Code to make them more streamlined, responsive, apolitical and industry-driven. Under this overhaul, changes to the National Electricity Code and the Gas Code would be proposed by a NEMMCO-supported standing committee and a new Gas Advisory and Code Change Committee respectively, each of which would be responsible for undertaking industry and user consultation in relation to the proposed change. (In passing, it is noted that it might be preferable for the electricity standing committee to be entirely independent of NEMMCO, albeit including a NEMMCO representative). The National Energy Regulator would then be responsible for simply approving or rejecting the proposed change, following a merits review (but with no further consultation). The National Energy Regulator itself would have no power to initiate code changes or to amend code changes submitted to it.

In addition to the abolition of NECA, the National Electricity Tribunal would also be abolished, with decisions of the National Energy Regulator being open to appeal on their merits to the Australian Competition Tribunal (it is partly for this reason that the Panel suggests that the National Energy Regulator should be created under Commonwealth legislation). However, this is a little curious: the Australian Competition Tribunal specialises in competition matters and yet the matters that may be appealed from the National Energy Regulator are not just competition-related. Indeed, it might be more consistent with the rationale for a specialist industry regulator that there be a specialist industry appeals body.

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NEMMCO

The Panel's proposed restructuring of the energy regulatory framework would see a considerably enhanced role for NEMMCO. As well as being responsible for advancing changes to the National Electricity Code, NEMMCO would be responsible for:

  • monitoring compliance with the National Electricity Code and reporting possible breaches to the National Energy Regulator (the regulator itself would be responsible for oversighting NEMMCO's compliance with the National Electricity Code); and
  • a more coordinated approach to transmission network planning (see below).

NEMMCO would continue as a 'not for profit' company, funded by market participants and owned by government. However, its ownership would be expanded from the existing National Electricity Market jurisdictions to include the Commonwealth and, at their option, Western Australia and the Northern Territory (these two jurisdictions might want to participate if, for example, they wished NEMMCO to assume a network planning, market operation or code maintenance function in their markets).

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Policy formulation

In recognition of the expectation that Governments should play an important role in the development of energy market policy (but should not be involved at an operational level), the Panel has recommended that the Ministerial Council on Energy be established as the body responsible for energy market policy oversight.

In what is likely to be a politically controversial suggestion, this recommendation has been accompanied by a recommendation that the NEM Ministers' Forum be abolished, with the result that the Commonwealth, through its membership of the Council, will clearly have involvement in policy developments relating to the National Electricity Market. The rationale for this recommendation is to create one national policy forum for all electricity and gas market issues (including issues affecting electricity markets outside the National Electricity Market).

The Council would be able to draw on advice provided by the National Energy Regulator, NEMMCO and the Gas Advisory and Code Change Committee. However, the Council would have no power to give executive policy directions (or to veto electricity or gas code changes) instead, such policy could only be established through legislation (eg changes to the National Electricity Law or the National Gas Access Law).

The Panel has also emphasised the potential conflict of interest arising where Governments own businesses which operate in markets that are regulated under rules established by those same Governments (particularly where, as is the case with electricity generation and retail, the Government-owned businesses compete against privately-owned businesses). This has led the Panel to recommend the privatisation by NSW and Queensland of at least their generation assets, a recommendation that has already provoked a strong reaction from NSW.

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Price signals

The Panel considers that the energy-only design of the National Electricity Market is well-placed to provide a strong set of investment signals, with there being no need to introduce capacity mechanisms designed to encourage future development of generation capacity. However, the Panel has found that this potential is impeded by market distortions. Accordingly, in another politically controversial recommendation, the Panel has recommended the abolition of the NSW Electricity Tariff Equalisation Fund and Queensland's Benchmark Pricing Agreement, as well as the introduction of full retail contestability in all markets and the removal of retail price caps.

The exposure of residential electricity consumers to price signals is also expected to encourage demand side participation. Of course, for this to occur, it is necessary that such consumers be provided with time-of-use meters so as to enable retailers to develop, and electricity consumers to take advantage of, innovative products that encourage load reduction at peak time. Accordingly, the Panel recommends that all contestable customers be provided with interval meters within 10 years (such meters to be owned by distributors and included in their regulated asset base).

In order to provide further impetus to demand side involvement in the National Electricity Market, the Panel has recommended the introduction of a revised demand reduction bidding system which would enable users (including retailers and aggregators) to bid price and volume into the market to reduce load. To encourage demand reduction bidding, demand reduction bids would be paid on an 'as bid' basis (rather than at the system marginal price) so as to enable the bidders to reap the financial benefits associated with demand reduction. Such payments would be funded by increased pool prices. A failure to reduce demand in accordance with a bid would result in the bidder paying the associated costs (eg the costs of acquiring the required ancillary services).

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Electricity transmission regulation

The Panel recognises that an integrated electricity transmission network is essential to inter-regional trade. In addition, interconnection is a means of reducing the market power of regional generators and allows reserve capacity to be shared between regions (thereby reducing the cost of such capacity). However, it is the Panel's view that '[t]he current state of transmission is one of the most significant problems facing the NEM'. In particular, the Panel is of the opinion that there is a need for further interconnection so as to create a strongly integrated national electricity market that does not fragment into separate regions (characterised by significant price separation) during periods of high demand.

The Panel has therefore made four key recommendations that are directed at achieving a properly functioning and cohesive interconnected transmission system.

The first recommendation is the development of firm financial transmission rights (FTRs) to encourage inter-regional trade. Under the Panel's proposal, NEMMCO would auction and underwrite these FTRs, which would apply to existing regulated interconnectors and would be funded by inter-regional settlement residues on regulated interconnectors and by the proceeds arising from the FTR auctions. Any residual exposure would then be covered by market participants through a separate levy.

In order to enable NEMMCO to manage its risk (and to reduce the likelihood of such a levy being made), NEMMCO would be able to fix reserve prices for, and the volumes of, FTRs. This process would replace the current inter-regional settlement residue auctions, with the result that the proceeds from these auctions would no longer be available to reduce transmission use of system charges. (However, the Panel is presumably satisfied that the general reduction in pool prices because of the implementation of the FTR scheme will effectively compensate consumers for the loss of this benefit). The Panel has further recommended that NEMMCO should (either itself or through a financial intermediary) establish and operate a secondary market to facilitate FTR trading.

The second of the Panel's recommendations is the introduction of incentives and penalties to encourage regulated transmission network service providers (TNSPs) to improve their network performance by exposing them to the financial consequences of network outages. The incentives would be structured so as to encourage the minimisation of outages during peak periods. Conversely, penalties would be payable where a significant price separation between regions occurs and the interconnecting transmission line is operating below a target capacity level (being a target which is set so as to account for the likelihood of outages that are beyond the relevant TNSP's control). This will not be easy. As the Panel euphemistically observes, '[a] challenge for the [National Energy Regulator] will be to adjust the approach to network regulation to balance the current predominant focus on cost minimisation to also include the need to ensure network capability, especially at peak times.'

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The third recommendation is that the existing transmission pricing arrangements be changed so as to increase their cost reflectivity, thereby encouraging the efficient use of transmission networks by generators and other users and resulting in the implementation of efficiently timed, sized and located new investment. Under this recommendation, loss-averaging and postage stamp pricing would be eliminated and generators might be required to pay transmission use of system charges.

In this vein, the Panel has recommended an increase in the number of NEM regions (which should not simply be dictated by jurisdictional boundaries), followed by the introduction of full nodal pricing in seven to 10 years. Again, this is likely to be a politically controversial recommendation as it may result in pricing differentials between consumers - particularly between urban and regional consumers. However, to the extent this is the case (and the Panel suggests that a move to increased regions might actually reduce prices in most new regions by reducing the proportion of smeared costs borne by users in those regions), the Panel recommends that Governments instead put in place transparent direct subsidies to affected consumers. An example of such a subsidy is the Victorian Government's Special Power Payment scheme.

The Panel's final major recommendation relating to transmission is the introduction of a more nationally focused and coordinated approach to transmission network planning. This entails a pivotal role for NEMMCO in both inter-regional transmission planning (in place of the Inter-regional Planning Committee) and intra-regional transmission planning, although responsibility for planning the non 'backbone' parts of the transmission network would be delegated back to the TNSPs. The advantages of using NEMMCO in this capacity are said to include its understanding of the whole transmission network by virtue of its role as market and system operator, its independence from TNSPs, and its access to accurate and detailed information about transmission network performance and constraints. Under the proposed new planning regime:

  • NEMMCO would continue to provide independent and accurate information in relation to the potential for transmission augmentation opportunities; and
  • in the event of a failure by the market to react to any such augmentation opportunity, NEMMCO would conduct a competitive tender process for the augmentation as a regulated investment - the 'trigger' for this process would be the traded price of firm FTRs sustainably exceeding the unit cost derived from the net present value of the new transmission augmentation.

This regime would replace the fraught 'regulated benefits' test. It is proposed that a complementary approach would also be developed for intra-regional transmission. In each case, the National Energy Regulator would be responsible for approving any proposed transmission augmentation. However, the reason for requiring the regulator's approval is unclear, and requiring it runs the risk of encouraging the regulatory duplication that is present in the existing system.

As is evident from the above, and as is acknowledged by the Panel, 'transmission network pricing raises a number of complex issues which are yet to be resolved'. This reflects the considerable complexities in this area and the fact that there are not likely to be any perfect solutions. Indeed, even if the Panel's proposals are accepted in principle, the devil is likely to be in the detail and the actual implementation of these proposals is likely to continue the vigorous debate between regulated and market interconnectors as to their respective places in the National Electricity Market.

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Electricity distribution regulation

The Panel has made the following recommendations in the context of the regulation of electricity distribution networks:

  • there needs to be increased certainty as to how gains from cost reductions are to be shared over time and how particular investments will be treated in the cost base;
  • price caps (rather than revenue caps) should be used because, if actual demand exceeds forecast demand, revenue caps result in suboptimal returns with the result that there is a reduced incentive to augment and maintain the network;
  • incentives should be introduced to encourage network operators to meet prescribed minimum service standards; and
  • embedded generation should be treated equitably.

Unfortunately, the Panel offers no detailed suggestions as to how these recommendations should be implemented. A number of these issues have been recognised for some time as requiring redress however, the apparent difficulty in dealing with them (particularly in the case of embedded generation) may well reflect their intractable nature.

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Generator market power

The Panel concludes that there is insufficient generation competition in the National Electricity Market, as evidenced by the number of periods in which generators have excessive market power and in which there is pool price volatility. Accordingly, it has recommended that the NSW-owned and, possibly, Queensland-owned generators should be further disaggregated (so as to remove their portfolio nature) and then privatised. This would result in a larger number of generators with a more dispersed ownership, and therefore in more competition. However, NSW has already rejected this recommendation. In this regard, it is relevant to note that both NSW and Queensland have been actively seeking to reduce the proportion of State-owned generation by encouraging private sector investment in new generation. Examples include Tallawarra in NSW and Callide C, Millmerran and Tarong North in Queensland.

For similar reasons, the Panel has suggested that the WA Government's generation business in the South West Interconnected System should be disaggregated rather than left intact (as is the current proposal).

Finally, the Panel has recommended that, in considering generator mergers, the ACCC should explicitly take into account the possibility of the merged generator exercising market power.

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Financial contracts market

The Panel has found that the electricity financial contracts market is extremely illiquid and is dominated by retailers and generators. However, in its view, the removal of regulatory uncertainty, the abolition of the NSW Electricity Tariff Equalisation Fund and Queensland's Benchmark Pricing Agreement (which encourage less contracting and therefore reduce the liquidity of the market), the reduction of generator market power (which should correspondingly reduce spot price volatility), and the introduction of the hedge provided by firm financial transmission rights, all of which are discussed above, will assist in the development of a liquid financial contracts market. In addition, the Panel recommends that the assessment of any proposed change to the National Electricity Code should explicitly consider the impact of the change on financial markets.

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Natural gas

The Panel is of the view that, despite encouraging developments, '[s]ome significant barriers to a truly competitive natural gas market remain'. This is largely the result of a high level of upstream ownership concentration across the basins that supply the eastern gas markets. This is a vexed issue because upstream competition is vital for gas consumers to benefit from the downstream reforms and the Panel has not been able to make any substantial recommendations in this regard. Instead, its principal input in this area is to advocate that separate (rather than joint) marketing be implemented wherever practical - for example through the scrutiny of all future marketing arrangements (new or renewed) to determine whether they substantially lessen competition and, if so, whether they should be authorised on public benefit grounds.

The Panel has made a more substantial contribution in relation to the regulation of natural gas pipelines. In particular, it has recommended that:

  • the National Energy Regulator be able to make a binding pre-investment determination that a proposed pipeline is not covered by the Gas Code;
  • pipeline owners be given an option not to have price regulation imposed on a proposed new pipeline for the first 15 years of its operation (following which it would be assessed for coverage based on whether the pipeline owner exercises market power) - however, this option is only to be exercisable if there is a sufficient vertical separation of ownership of the pipeline from upstream or downstream market participants, tariffs for access to the pipeline are published and the pipeline's capacity is fully tradeable;
  • prospective pipeline owners take advantage of the potential to enter into an agreement with the National Energy Regulator to 'lock in' for extended periods of time key regulatory parameters such as the WACC and depreciation schedules; and
  • a code of conduct be introduced for non-covered pipelines - this code of conduct would, for example, address the ringfencing of pipeline operations from upstream or downstream interests, the provision of information to the market relating to the nature and pricing of pipeline services and the offering of tradeable capacity.

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Greenhouse gas emissions

The final major area addressed by the Panel's draft report is that of greenhouse gas emissions. The Panel recognises that coal-fired capacity is significantly cheaper than less greenhouse intense capacity. As a result, greenhouse gas abatement measures will impose a cost on the community.

The Panel therefore recommends that the existing range of diverse, sometimes conflicting, measures - namely, the Commonwealth's Mandatory Renewable Energy Target, the Greenhouse Gas Abatement Program's Stationary Energy Projects, the Generator Efficiency Standards, Queensland's 13 Gas Scheme and the NSW Electricity Retailer Greenhouse Benchmarks - be replaced with an economy-wide national emissions trading system that is not specific to any particular technology or fuel type and which focuses on carbon reduction rather than the use of renewable energy sources. In this way the Panel seeks to ensure the adoption of greenhouse gas abatement measures that are the most efficient and least costly. The traded goods sector would be exempted from this scheme (subject to meeting world best practice in energy use) until Australia's main competitors have joined a greenhouse gas scheme.

The proposal that the Mandatory Renewable Energy Target be abolished has already been strongly opposed by the renewable energy industry on the basis that it would jeopardise thousands of jobs and billions of dollars of investment, much of it in regional Australia. In the industry's view, a broader scheme such as that proposed by the Panel would not provide sufficient incentive for the development of the small scale power generators that characterise the renewable energy industry.

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Conclusion

The Energy Market Review Panel has made a number of far-reaching recommendations in relation to the reform of Australian energy markets. A number of these are controversial and it can be expected that they will be vigorously debated by Governments, industry participants and energy consumers. However, irrespective of whether all of the recommendations are adopted, the one certainty is that the next few years will be a period of considerable change in the electricity and gas markets. It is important to keep abreast of these issues as many of them will have a direct effect on stakeholders.

We will continue to monitor and report on the progress of these issues, and on the outcome of the other energy market reviews which are currently being undertaken. If you would like any further information, or would like help in preparing a response to the draft report, please do not hesitate to contact any of the people listed below.

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