Necessary conditions for an effective energy-only market in Western Australia

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Necessary Conditions for an Effective Energy-Only Market in Western Australia

A Report for EnerNOC

31 July 2014

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Report Authors

Adrian Kemp

Luke Wainscoat

Oliver Nunn

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This report is for the exclusive use of the HoustonKemp client named herein. There are no third party beneficiaries with respect to this report,

and HoustonKemp does not accept any liability to any third party. Information furnished by others, upon which all or portions of this report are

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and statistical data are from sources we deem to be reliable; however, we make no representation as to the accuracy or completeness of

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obligations is assumed to revise this report to reflect changes, events or conditions, which occur subsequent to the date hereof. All decisions in

connection with the implementation or use of advice or recommendations contained in this report are the sole responsibility of the client.

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Contents

Executive Summary iii

Requirements for an energy-only market to promote efficient outcomes iii

Why the NEM and SWIS market characteristics matter for choice of market design iv

Implications for WA of an energy-only market design v

1. Introduction 1

2. The Theory of Energy-Only Electricity Markets 2

2.1 Structure of an energy-only market 2

2.2 Price determination 3

2.3 Investment decisions 6

2.4 Promoting efficient outcomes 7

3. Necessary Conditions for an Energy-Only Market to Promote Efficient Outcomes 8

3.1 No generator can have substantial market power 8

3.2 No limit on wholesale market prices 12

3.3 Liquid hedging products to manage financial risks 16

3.4 No restrictions on entry and expansion 17

3.5 No limitations on consumers responding to wholesale market price signals 18

3.6 Market outcomes need to be predictable 21

3.7 Key features of an energy-only market to deliver efficient outcomes 22

4. Energy-Only Markets in the NEM and the SWIS 24

4.1 Stylised description of the NEM and the SWIS 24

4.2 Why an energy-only market is more likely to promote efficient outcomes in the NEM 25

4.3 Why an energy-only market is unlikely to promote efficient outcomes in WA 30

4.4 Implications of adopting an energy-only market for WA 30

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Figures

Figure 1: Participants in an energy-only wholesale electricity market 2

Figure 2: The merit order of generators 3

Figure 3: Electricity prices in peak and off-peak periods 4

Figure 4: Average daily electricity price in South Australia (January 2009) 6

Figure 5: Level of electricity used and total capacity in Alberta, Canada (June 2013 to June 2014) 12

Figure 6: Example of missing money 14

Figure 7: Welfare loss from a lack of demand-side responsiveness 19

Figure 8: Spread of total generation per trading interval in the SWIS in 2013 25

Figure 9: Spread of total demand per trading interval in South Australia (2013) 28

Figure 10: Approximate maximum demand of energy-only markets (2012-13) 29

Tables

Table 1: Price caps in energy-only markets 15

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Executive Summary

Designing wholesale electricity markets to deliver electricity to consumers efficiently both now and

into the future has been a key focus for economists. What we have learned is that a pure market-

based approach, where electricity suppliers compete to supply consumers within a market where

energy price signals are provided to both consumers and suppliers is best, if it were possible to be

implemented.

In practice, nowhere in the world has such a pure market-based wholesale electricity market

design been adopted.

This is because the specific characteristics of electricity systems, and of each region in which a

market is being introduced, mean that compromises to the pure market based approach are

needed to ensure that efficiency is promoted.

When Western Australia (WA) first examined the problem of how to promote efficiency in electricity

supply, it adopted a wholesale market design known as a capacity-plus-energy market. Its

principal feature is that signals for investment in generation capacity are created through a

separate market for capacity, which is linked to administratively set capacity prices.

This reflected in part the challenge of making a purer market-based design work in WA, where

incentives for investment in generation capacity are created only through the wholesale electricity

price equating supply with demand over each market price settlement period – a so called

‘energy-only market’. Now, WA is investigating whether changes to its current wholesale market

design are warranted to promote more efficient use of electricity, and production and investment

in electricity generation – the Electricity Market Review.

It is in this context that EnerNOC – a third party demand response aggregator operating in WA –

asked HoustonKemp to:

outline the necessary conditions for the successful implementation of an efficient energy-only

wholesale electricity market;

examine how well the south-west interconnected system (SWIS) of WA satisfies those conditions,

compared to the National Electricity Market (NEM) operating on the east-coast of Australia;

and

outline the possible implications for WA, should an energy-only market design be adopted.

Requirements for an energy-only market to promote efficient outcomes

There are several minimum market design requirements for an energy-only market to deliver

efficient outcomes, namely:

a sufficient number of generators to ensure that no one generator can exercise substantial

market power;

a sufficiently high market price cap to allow incentives for new generation investment;

no restrictions on generators entering and expanding capacity;

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restrictions on the co-ownership of generators and retailers if the market is sufficiently small such

that it limits the opportunity for a liquid hedging market to develop;

ability for demand-response to be incorporated into the market; and

sufficient public information to allow for independent forecasting of market conditions.

In our opinion, these requirements need to be carefully considered as part of the design of an

energy-only market.

In addition to these design requirements, consideration needs to be given to the specific

circumstances in the market. Specifically, for an energy-only market design to produce efficient

outcomes, the market needs to be sufficiently large so that:

new generation entry does not have such a significant impact on wholesale market prices that

it creates a barrier to entry;

there is scope to create sufficient competition amongst existing generators to prevent market

power, while still realising economies of scale; and

a sufficiently liquid hedging market can develop.

Why the NEM and SWIS market characteristics matter for choice of market

design

The SWIS is a fairly small single region, whereas the NEM is a substantially larger and more complex

system of five interconnected regions. The SWIS would be the smallest unconnected energy-only

market in the world if it switched from being a capacity-plus-energy market.

The two principal elements of the NEM that assist in it operating efficiently as an energy-only market

are:

the structure of its market; and

the reliability settings that apply to the NEM.

The benefit of efficient investment incentives provided by an energy-only market is significant for

the NEM because it is a large and complex system. The benefit of these incentives would be lower

in the SWIS because the market size and generation mix in WA makes efficient investment choices

less complex.

The large size and interconnected nature of the NEM also assists in preventing firms from using

substantial market power. By contrast, the SWIS is much smaller and therefore faces a greater risk of

market power being used by generators.

The reliability settings, including high price caps, allow the NEM to provide incentives for efficient

investment and electricity prices, whilst ensuring that the risk of blackouts is low. For an energy-only

market to produce efficient outcomes, the structure of the SWIS will need to ensure that generators

do not have market power under an associated high price cap.

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Implications for WA of an energy-only market design

There is a significant risk that an energy-only market in WA will be unable to provide sufficient

limitations on the potential for the exercise of market power, leading over time to higher prices than

would otherwise have been the case in the absence of market power.

To address market power concerns in place of a very large generation business there will need to

be a number of small independent generators created to ensure sufficient supply side competition,

potentially losing the benefits of the associated economies of scale.

To provide adequate incentives for new investment, the market price cap would need to be

sufficiently high, and there would need to be opportunities for a liquid market in hedging products

to develop.

To ensure efficient investment in new capacity occurs, there needs to be scope for the demand-

side to participate in the market.

Overall, in our opinion an energy-only market is not likely to promote efficient outcomes in WA,

given the current characteristics and in particular the small size of the market. Certainly, it would

not be possible to simply “port” the NEM market design to WA without modification and expect an

efficient, or even workable, result.

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1. Introduction

HoustonKemp has been asked by EnerNOC Pty Ltd (EnerNOC) to outline the necessary conditions

for the implementation of an effective energy-only wholesale electricity market in Western Australia

(WA). As part of our analysis, we have been asked to describe the theoretical foundations of

energy-only markets so as to highlight what would be required to ensure that electricity is delivered

efficiently to consumers in WA, should such a market design be adopted.

The context for our report is the Electricity Market Review (the Review) that is currently being

overseen by a Steering Committee appointed by the government of WA. The Review has three

objectives:1

reducing costs of production and supply of electricity and electricity related services, without

compromising safe and reliable supply;

reducing government exposure to energy market risks, with a particular focus on having future

generation built by the private sector without government investment, underwriting or other

financial support; and

attracting to the electricity market private-sector participants that are of a scale and

capitalisation sufficient to facilitate long-term stability and investment.

There is currently a capacity-plus-energy market operating in WA. This effectively means that

electricity retailers are required to purchase a certain amount of capacity to generate electricity in

addition to the electricity itself. By contrast, retailers need only purchase electricity (ie, capacity is

not purchased separately) in an energy-only market.

One of the aims of the Review is to consider whether the capacity-plus-energy market in WA should

be replaced by an energy-only market.2 We understand that our report is to inform the Review’s

consideration of alternative options to the current wholesale market design.

The remainder of our report is structured as follows:

section two describes how a simplified energy-only market operates and promotes efficient

outcomes in terms of investment in generation, and prices for the supply of electricity;

section three describes a number of conditions that must hold for an energy-only market to

promote efficient outcomes, and the effect of those conditions not holding; and

section four explains why an energy-only market is unlikely to work as effectively in WA as it

currently operates in the National Electricity Market (NEM).

1 Government of Western Australia, Electricity Market Review, Phase 1 Terms of Reference, January 2014, p.3. 2 Ibid, p.6.


2. The Theory of Energy-Only Electricity Markets

The starting point for our report is to provide a simple and stylised description of how an idealised

energy-only market should operate to promote efficient outcomes.

2.1 Structure of an energy-only market

The basic structure of an energy-only market is set out in Figure 1 below and consists of:

generators that produce electricity and supply it to a centralised power pool;3

a market operator that is responsible for the power pool. It determines which generators will be

called upon to produce electricity based on the principle of meeting the required electricity

usage in the most cost-effective way;

retailers that purchase electricity from the power pool in order to supply the end-users’

requirements for electricity; and

end-users that pay retailers for using electricity.

Figure 1: Participants in an energy-only wholesale electricity market

An energy-only market also requires transmission and distribution networks to transport electricity

from generators to end-users. However, these networks operate in the same manner no matter

what the design of the wholesale energy market. The regulatory and operating arrangements for

networks are therefore not relevant to this report.

The distinctive feature of an energy-only market is that there are no obligations on any participant

to ensure that a pre-determined amount of generation capacity is available to the market. The

availability of, and investment in, generation capacity arises from the price signals created by the

power pool.

3 Generators may also contract directly with retailers.


2.2 Price determination

Electricity generators submit bids to the power pool which specify the quantity of electricity they

are willing to supply, and at what price, for each five minute interval of the day (or a similar short

period of time). Figure 2 below shows a stylised merit order, ie the amount of electricity that each

generator is willing to supply, and at what price, in order of least expensive to most expensive.

Base load generators, such as coal-fired plants, are typically willing to supply a large amount of

electricity at a low price, whereas peaking plants (such as gas fired plants) are typically willing to

supply a relatively small amount of electricity at a higher price.

Figure 2: The merit order of generators

An important feature for theoretical energy-only markets to promote efficient outcomes is that end-

users face real time electricity prices4 and so they reduce the amount of electricity they use when

prices rise.5 This is reflected in the downward sloping lines showing the amount of electricity required

by end-users at different prices in Figure 3.

4 In practice, real time prices may be prices that change multiple times per day, but this is a deviation from the theoretical ideal, and so results in less efficient outcomes. 5 We discuss in section 3.5 how this condition is typically treated in energy-only markets.


Figure 3: Electricity prices in peak and off-peak periods

The amount of electricity required by end-users varies over each time period. For example, the two

red lines in Figure 3 represent the amount of electricity required by end-users at peak and off peak

periods. The electricity price for a given period will be that at which the electricity required is the

same as the total amount that generators are willing to supply for that price (represented by the

merit order). Figure 3 shows that the price and quantity of electricity supplied will be higher in peak

periods than in off peak periods.

The price at which electricity is supplied during each period is determined by the offer lodged by

the most expensive generator that must be dispatched to meet requirements for electricity in that

period, the ‘marginal generator’.

Generators maximise their profit by bidding the cost to them of supplying one more unit of

electricity, assuming they cannot change their generation capacity (a generator’s ‘marginal

cost’), when there is no risk of electricity shortages and generators are not able to affect the price

through their own bidding behaviour. This is the most profitable bid price for generators because:

offering a higher bid price risks not being dispatched when the generator would otherwise earn

a profit over its operating costs; and

a lower bid will result in the generator not recovering its operating costs on the marginal unit

supplied.

The marginal generator will earn its marginal cost which is approximately equal to the cost of

operating and maintenance, but does not include the fixed costs of building the plant. The other


plants that generate (the infra-marginal plants) will earn more than their operating and

maintenance cost, allowing them to earn revenue that contributes to their fixed costs.

Generators can profitably bid higher prices when there is a risk of there being a shortage in

electricity because the risk of not being dispatched is reduced. For example, generators can bid

the maximum possible price when they know for certain (or near certainty) that there will be

shortages because all generators will be dispatched. In general, generators will bid higher prices

when the risk of a shortage is greater.

However, there will never be an involuntary shortage of electricity in an ideal energy-only market in

which all users face real time prices and are able to react to them. End-users would voluntarily

choose not to purchase electricity when prices rise to a sufficiently high level such that the benefit

of receiving electricity supply is less than the price of receiving it.

This means that prices are allowed to rise to theoretically very high levels (according to the

willingness to pay for electricity of the marginal user). Indeed, this is necessary for an energy-only

market to promote efficient use of, and investment in, electricity generation capacity.

In practice, the maximum price that generators can receive may be limited by the market

operator, through the setting of a market price cap. Ideally, this is set at the cost to the marginal

customer of there being an interruption to their electricity supply. This concept is sometimes referred

to as the value of lost load (VOLL) because it is the value of not receiving electricity load. The VOLL

is often more than 100 times higher than the marginal cost of a generator. Therefore, prices can rise

very substantially when there is a threat of a shortage within an energy-only market.

Figure 4 below provides an example of how prices can rise very substantially for short periods in an

energy-only market. The average daily price in South Australia in January 2009 was around $30 on

most days. However, the average daily price rose to above $1,000 on four days. Generators

earned revenues on those days that were more than 30 times the revenues of more typical days.


Figure 4: Average daily electricity price in South Australia (January 2009)

The periods of very high prices may be short, but the revenue they generate can be substantial

because the prices are so high. These prices are required to ensure that all generators are able to

recover their fixed costs of investing in plants.

2.3 Investment decisions

The decision to invest in generation in an energy-only market is made on commercial grounds.

There is no requirement from the government or regulator for firms to have contracted, or built, a

particular level of generation capacity.

An electricity generator will invest in new capacity when it is profitable to do so over the life of the

investment, ie when it expects to earn at least its operating costs, fixed costs and an appropriate

return on capital from making the investment, taking account of the risks involved. This decision will

depend upon the fixed costs of the investment, expected operating costs, and the expected price

of electricity over the lifetime of the asset.

The key variables that will affect an assessment of the expected price are:

expectations of demand; and

current market capacity and expected investment.

The incentive to build a particular type of plant will depend on how often the price of electricity is

expected to rise above the marginal cost of that type of plant, taking into account any changes in

prices caused by the investment. For example, the price of electricity might currently be above the

marginal cost of a base load plant at all times, whilst it is only above the marginal cost of a peaking

plant on some occasions. However, base load plants are typically much more expensive and the

investment in a base load plant may lead to a substantial reduction in prices, and therefore it may

be more profitable (and efficient) to build a peaking plant.


Generators will have an incentive to invest using the most cost-effective type of plant that is able to

earn a profit, because any other approach may lead to a competitor undercutting it by building a

cheaper plant. In this way, the mix and level of investment should be efficient.

2.4 Promoting efficient outcomes

Prices should often be equal to the operating and maintenance costs of the marginal generator in

an energy-only market, ie prices will usually be relatively low. However, there will be short periods of

very high prices. These prices allow generators to earn a return on their fixed investments.

Prices will tend to rise when the usage of electricity approaches the total capacity of all generators

and will fall once this leads to new entry and there is excess capacity. Therefore, prices will tend to

rise and fall depending upon the amount of excess capacity available.

Prices should be at the efficient and competitive level in the long run, which is the long run

marginal cost of supplying one more unit of electricity, because:

a higher price will mean that it is profitable to enter. Entry will push prices down towards the long

run marginal cost; and

a lower price will mean that some firms are not recovering their costs leading to exit (or lack of

entry when demand increases) and higher prices.

The level and mix of investment should be efficient because the price signals result in investment

when it is profitable and competition ensures that generators invest in the most cost-effective

plants.


3. Necessary Conditions for an Energy-Only Market to Promote Efficient Outcomes

Energy-only electricity markets require a number of conditions to be satisfied so as to promote

efficient use of, and investment in, wholesale electricity supply. In this section we explain each

condition, and outline those modifications that are usually made to the theoretical energy-only

market design to address the practical realities of electricity systems.

3.1 No generator can have substantial market power

The critical starting point for an energy-only market to deliver efficient outcomes is to have a

market structure such that no one generator is capable of exercising substantial market power to

raise prices above competitive levels.

As a matter of principle, generators that compete against one another can increase their profits by

more closely matching their customers’ needs and by cutting their costs. This leads to lower prices,

higher output and therefore greater efficiency.

Market power is the antithesis of competition. Substantial market power will be present in an

electricity market if prices persistently exceed the marginal cost of supplying electricity over the

long-run. This leads to retailers paying higher prices for electricity. Some of these higher prices will

be passed on to end-users who can be expected to use less electricity, and hence derive less

benefit.

Some amount of market power, which we term ‘pricing power’ in electricity markets, is essential for

the market to work efficiently. For example, generators can increase their bids over and above

their own marginal cost when there is a risk of a shortage in the supply of electricity. This is necessary

for there to be an incentive to invest in new plants.

However, substantial market power is the ongoing ability of a firm to raise prices above competitive

levels without rivals taking away customers in due time. A generator has a substantial degree of

market power when it has the ability to increase prices to such an extent and with sufficient

frequency that the average long run wholesale electricity price exceeds the long run marginal cost

of supplying wholesale electricity to the market, including a return on capital and accounting for

risk. Substantial market power will lead to inefficiently high prices and inefficiently low levels of

electricity use by end-users.

3.1.1 Presence of market power

The existence of market power amongst generators depends upon a number of factors, but the

most crucial are:

the number of generators and their market shares;

barriers to entry and expansion; and

the potential for imports of electricity from another region.


Market concentration

First, all other things equal, market power would be expected to be lower when the market is less

concentrated, ie there are more suppliers, each holding less market share. There are a number of

reasons for this including:

a generator with a larger market share can benefit from a higher price over a larger quantity of

sales if it is able to change its bids in a manner that increases the price of electricity;

a generator with a larger market share is more likely to be able to affect the price of electricity

because its bids make up a larger proportion of the merit curve; and

fewer generators may be better able to coordinate their actions in order to increase prices.

Electricity generation markets often have a relatively small number of large participants because

there are economies of scale in electricity generation, ie the average cost of production is often

lower for larger generators. Smaller markets are likely to be more concentrated because they can

sustain fewer large generators.

Barriers to entry and expansion

Second, prices that are above the long run marginal cost of electricity generation would lead to

existing firms expanding their generation capacity and/or new firms entering if the market was

competitive. This would have the effect of pushing prices back down towards the long run

marginal cost. However, there are a number of reasons why there may be barriers to entry and

expansion that prevent this from occurring in electricity generation markets including:

there are very large sunk costs to building a new power plant and generators do not receive

any revenue when they do not sell electricity in an energy-only market. The price of electricity

over the life of the plant is uncertain, and therefore there will be a risk that prices will not rise

sufficiently to allow the entrant to recoup its fixed cost of investing; and

there are substantial regulatory barriers to building a new power plant and connecting it to the

relevant electricity grid. The cost, time and risk involved in complying with these regulations will

increase the risk of entry and reduce the profitability of doing so.

The large sunk costs of entry are a greater barrier to entry in smaller markets where the entry of a

new plant of a fixed size (such as 200 MW) will have a more significant impact on the price of

electricity because:

the uncertainty regarding the effect of entry will be greater in a small market in which entry can

be expected to have a more significant impact on prices; and

a larger entrant relative to the current level of supply will result in a larger fall in the wholesale

electricity price.

Barriers to entry are also more significant when demand is falling because this can be expected to

result in falling prices and a reduced profitability of entry.

Imports from another region

Lastly, it is common for energy-only markets to be connected to each other through

interconnectors. These allow for the import and export of electricity between regions. The use of

pricing power in one region may push up prices in that region and so attract imports. These will

have the effect of pushing prices down and mitigating the pricing power. The extent to which this


will occur depends upon the capacity of the interconnector to import electricity, and imports will

only occur if the connected region has lower electricity prices than the one in which pricing power

may be used.

The barriers to entry that can be present in electricity generation markets in combination with there

being a fairly small number of large suppliers mean that energy-only markets can be susceptible to

substantial market power. Further, there are some intrinsic features of electricity generation that

also make it susceptible to the exercise of substantial market power, including:

electricity cannot be easily and cheaply stored so customers have little choice but to buy the

product in every period;

electricity generators cannot all be turned on and off quickly and so there may be periods

where generators are not able to respond to higher prices; and

there is rarely a close substitute for electricity and customers do not usually substantially reduce

their electricity usage in response to an increase in prices. This unresponsiveness makes

increasing prices more profitable for generators.

3.1.2 Impact of substantial market power

The impact of substantial market power will be prices that are above the efficient level and

electricity usage being less than the efficient level.

Substantial market power also distorts the way that prices encourage investment. It may lead to

prices that are high enough to indicate that further investment is needed when in fact there is

already sufficient capacity, leading to:

over investment if entrants cannot observe that market power is being used; and

under investment if high prices are observed whilst potential entrants wrongly think market

power is being used.

3.1.3 Addressing market power in practice

Market power amongst generators can be addressed in two broad ways:

specific rules can be set regarding the process by which generators bid into the power pool.

For example, a rule may state that firms must bid their marginal cost or cannot bid over a

certain level;

competition laws that apply to all sectors in the economy will also apply to generators. These

laws usually proscribe, for example:

> mergers that substantially lessen competition;

> collusion between firms; and

> the use of substantial market power for some particular anticompetitive purposes.

Specific rules may prevent market power from being used but they can have other detrimental

effects as described in section 3.2 below. The application of general competition laws to

generators may help to prevent the anticompetitive behaviours they are designed to address.

However, they are not generally able to prevent firms from unilaterally using their market power to

increase prices.


Box 1: Managing market power in the energy-only market in Alberta, Canada

Alberta, Canada has an energy-only market with specific rules that help to reduce the use of

market power. Under the Fair, Efficient and Open Competition Regulation, no market participant in

Alberta is permitted to control more than 30 per cent of Alberta’s total generation capacity.6 This

places a limit on market concentration and it implies that there will be at least four generators. The

most significant issue with a market share cap is that generators will not have an incentive to

expand once they reach the cap even if they would be best placed to do so. This can lead to

inefficient investment and higher prices than would otherwise be the case.

The Fair, Efficient and Open Competition Regulation has a number of other requirements that can

restrict market power, including that generators:7

• should always offer electricity from each plant that is capable of operating except under

certain conditions;

• should not collude with another market participant to restrict competition; and

• should not manipulate market prices.

These rules help to prevent firms from unilaterally or collectively using their market power. A recent

report found that Alberta’s market was effectively competitive.8 This is likely to be due to a number

of factors including these regulations. In particular, we understand that:

• Alberta has a price cap of CA$1,000/MWh;9

• Alberta had a total generating capacity of 14,568 MW in 2013 whilst peak electricity usage was

11,120 MW – see Figure 5. Therefore, Alberta has a fairly large consumption of electricity and

there was substantial excess capacity in generation;

• there are five large generators;10

• there is substantial interconnection capacity of 900 MW to other regions;11

• there is some demand side responsiveness to prices;12 and

• industrial and commercial customers account for approximately 80 per cent of electricity

usage, contributing to Alberta having a fairly flat load profile, with a very high load factor,

exceeding 81 per cent.13 The result of this and the excess capacity is that there is rarely a threat

of scarcity, and therefore opportunity to use market power.

6 Alberta Utilities Commission Act Electric Utilities Act, Fair, Efficient and Open Competition Regulation, s.5. 7 Ibid, s.2. 8 Market Surveillance Administrator, State of the Market Report 2012, p.1. Effective competition was defined as that which achieves efficient investment with the lowest possible short-run inefficiencies, over a reasonable timeframe, and where open competition ensures neither collusion, abuse of market power, or anti-competitive practices. 9 NERA, Review of Alternative Approaches to Setting a Wholesale Electricity Market Price Cap, October 2013, p.41. 10 Alberta Energy, available at http://www.energy.alberta.ca/Electricity/682.asp accessed on 25 June 2014. Market Surveillance Administrator, State of the Market Report 2012, p.14. 11 Ibid. 12 NERA, Review of Alternative Approaches to Setting a Wholesale Electricity Market Price Cap, October 2013, p.40. 13 Alberta Energy, available at http://www.energy.alberta.ca/Electricity/682.asp accessed on 25 June 2014 and HoustonKemp analysis of information provided by EnerNOC.


Figure 5: Level of electricity used and total capacity in Alberta, Canada (June 2013 to June 2014)

To summarise, the condition that must hold in order for an energy-only market to promote efficient

outcomes is that no firm has the ability and incentive to use substantial market power. Prices will be

higher than the efficient level if this condition does not hold, and the level of investment is likely to

be inefficient.

3.2 No limit on wholesale market prices

The price of electricity and the extent to which it is expected to change over time provides

incentives for generators to invest, shut down, maintain and run their plants in the most efficient

way. Any limitation to the way prices are set has the potential to restrict the way that this incentive

operates.

3.2.1 Reasons for price limits

There are three broad reasons why limits on wholesale prices may be set in energy-only markets:

to set prices when there is a shortage of electricity;

to limit the use of market power; and

to reduce electricity prices in the short run.

First, there would be no need for a limit on prices in an ideal energy-only market. End-users facing

real time prices would choose not to obtain electricity when prices rose to sufficiently high levels.

This reduction in the use of electricity would mean that the production and usage of electricity

were equal at the prevailing price in all periods, with no involuntary curtailments due to generation

shortages.

In practice, the vast majority of end-users do not face real time prices and would find it very difficult

to react to them in an efficient way even if they did. Therefore, they are not able to choose the

price level at which they would prefer not to receive electricity. It follows that shortages in the


supply of electricity may occur because its usage is not restricted by end-users facing high prices. In

this case, the market price could be any level when there is a shortage. In those instances, market

operators set a limit on prices to prevent them from increasing to an arbitrarily high level which is

above the level at which customers would be indifferent between paying for electricity and

experiencing an interruption in service.14

Second, price limits can be used to limit the ability and incentive of generators to use their market

power by bidding higher prices or offering to supply less electricity. Other rules such as forcing

generators to supply electricity or banning them from manipulating prices may have similar effects.

Lastly, price limits will reduce average prices in the short run by limiting price spikes. This may be

attractive to voters and end-users. This may lead to such policies being pursued by politicians or

regulators. However, any positive effects will be short lived as we explain below.

3.2.2 Impacts of price limits

Energy-only markets will often be characterised by some short periods of very high prices. These

periods of high prices are required for generators to earn a return on their fixed costs.

Setting a price limit at the expected VOLL should not limit the ability of generators to recoup their

investments because prices would not increase above this level if customers were able to react to

real time prices. The VOLL is likely to be substantially higher than average electricity prices. For

example, the maximum price cap in the NEM was set at $13,100 for 2013/1415 whilst the average

price was $42-$62 depending on the region.16

Price limits that are lower than VOLL have an immediate effect of reducing the price level when

there is a risk of shortages. This would tend to lead to lower average prices. However, it would also

significantly reduce the expected return on investments in new plants, in particular in peaking

plants which do not run when prices are low. Therefore, there would be less investment in those

new plants. This issue is sometimes referred to as the ‘missing money’ problem.17 An example of this

is shown in Figure 6. It depicts the number of hours in a year that the price reaches each level. The

missing money is the shaded area, ie it is the revenue that is not earned by generators as a result of

the price cap. This missing money is larger if the price cap is lower and if prices would have

otherwise reached higher levels more often.

14 It is possible to estimate the value that customers place on the reliability of electricity supply. This may not be the same as the limit on the electricity price (for which, see Table 1). AEMO is currently undertaking a review of the value of customer reliability – the amount that customers are willing to pay for the reliable supply of electricity. Previous estimates have been between $41/kWh and $58/kWh in the NEM for 2010: Australian Energy Market Operator, Value of Customer Reliability Issues Paper, March 2013, p.14. 15 The market price cap in the NEM is set with reference to the cost of the marginal generator needed to satisfy the market reliability requirements. As such, the VOLL in the NEM may be higher than the current value of the market price cap. 16 Australian Energy Market Commission, Fact Sheet: The Reliability Settings, p.1. Australian Energy Market Operator website, http://www.aemo.com.au/Electricity/Data/Price-and-Demand/Average-Price-Tables, accessed 27 June 2014. 17 Hogan, W., On an “Energy Only” Electricity Market Design for Resource Adequacy, September 2005, Center for Business and Government John F. Kennedy School of Government Harvard University.


Figure 6: Example of missing money

This missing money prevents some generators from recouping their fixed costs and so it deters entry.

Reduced entry may lead to more instances of blackouts and prices would reach the price limit

more often. The existing plants would be run for longer than their efficient life resulting in higher

maintenance costs. These effects would lead to higher prices than would otherwise be the case in

the long run.

A price cap can also prevent the demand side of the market working effectively. Without a cap,

end-users would always have the option of purchasing electricity if they were willing to pay a

sufficiently high price. This will lead to an efficient outcome in which those who value a supply of

electricity the most will receive less interruptions because:

end-users that are willing to pay the price of electricity will purchase it; and

end-users that would rather have an interruption in their electricity supply than pay the price of

electricity will reduce their consumption accordingly.

Consumers are not able to signal their different willingness to pay for electricity above a price cap.

Therefore, in the event of a shortage, there will be random blackouts even amongst those willing to

pay more than the price cap.


3.2.3 Price limits in practice

Table 1 below demonstrates that there is a wide range of price caps in energy-only markets.

Table 1: Price caps in energy-only markets

Jurisdiction Price Cap (AUD$/MWh)18

National Electricity Market $13,500 in 2014/1519

Texas $5,306 in 2013, increasing to $9,550 in 201520

Singapore $3,823 in 201421

Alberta $993 in 201422

New Zealand $9,313 to $18,626 in 201423

Alberta has the lowest price limit in Table 1. While this seems not to have affected investment in the

market, the unique features of that market contribute significantly to this outcome. Specifically:

there is not a great need for peaking plants in Alberta because the load profile is fairly flat and

there is substantial spare capacity to produce electricity (see Figure 5 above). Peaking

generation represents approximately 500 MW of capacity (or 3 per cent of installed capacity in

2013).24 Furthermore, the price only increased to over CA$990/MWh (relative to a cap of

CA$1,000) in around 50 hours of 2013, or 0.6 per cent of the time;25

there has been substantial cogeneration capacity built in Alberta in the last ten years which is

associated with the development of oil sands projects that build generators for steam and sell

power to the grid. This has reduced the need for peaking or other plants;26 and

Alberta has two interconnectors, with a total capacity of 900 MW.27

Texas has an energy-only market that is operated by the Electric Reliability Council of Texas

(ERCOT). The Public Utility Commission of Texas (PUCT) determines the price cap taking in to

account recommendations from ERCOT. PUCT increased the cap from US$3,000 to US$4,500 in

2012, and will raise it to US$9,000 from 2015. The reasons for increasing the cap included that spare

capacity in the market had fallen and that a higher cap was needed to provide the proper price

18 Currency conversion was undertaken using exchange rates from xe.com as of 28 June 2014. 19 Australian Energy Market Commission, Schedule of reliability settings, 20 February 2014, p.1. 20 Public Utility Commission of Texas, PUC Rulemaking to Amend PUC Subst. R. 25.505, Relating to Resource Adequacy in the Electric Reliability Council of Texas Power Region, Order Adopting Amendments to s25.505 as Approved at the October 25, 2012 Open Meeting, p.51. 21 Energy Market Company, Singapore Electricity Market Rules, Appendix 6J, pp.2-3. 22 Alberta Electric System Operator, ISO Rules, Section 201.6 Pricing, s.3(1). 23 Electricity Authority website, available at http://www.ea.govt.nz/operations/wholesale/spot-pricing/scarcity-pricing, accessed 30 June 2014. A recent High Court decision regarding Genesis owned Huntly generator’s power offer prices during an “Undesirable Trading Situation” has led to generators bidding around NZ$3,000/MWh during periods of high demand, which can therefore be considered a de-facto market price cap. NERA, Review of Alternative Approaches to Setting a Wholesale Electricity Market Price Cap, October 2013, p.18. 24 Alberta Electric System Operator, 2013 Annual Market Statistics, p.10. 25 Ibid, p.5. 26 Market Surveillance Administrator, State of the Market Report, December 2012, p.47-48. 27 Alberta Energy, available at http://www.energy.alberta.ca/Electricity/682.asp accessed on 25 June 2014.


signals such that there was an incentive for the construction of new generation.28 Reliability issues in

2011 have also led to an expansion of the emergency demand response program in Texas.29

The detrimental effects of price limits when they are lower than VOLL mean that they cannot be

used to control market power in energy-only markets without significantly limiting the efficiency of

the market. Therefore, an efficient energy-only market must have a structure that prevents market

power, ie a market with sufficient participants, without high barriers to entry and expansion and

which allows prices to rise to potentially very high levels.

To summarise, the condition that must hold in order for an energy-only market to provide an

efficient outcome in the long-run is that prices can rise to VOLL. There is likely to be under

investment if this does not hold, in particular in peaking plants. This will lead to higher average

prices for end-users and poorer reliability.

3.3 Liquid hedging products to manage financial risks

Having a high price cap under an energy-only market is not sufficient, in and of itself, to provide

appropriate incentives for new investment. In practice, a liquid market in hedging products to

allow both retailers and generators to manage the risks associated with high wholesale prices in the

energy-only market is also required.

3.3.1 Why retailers hedge their risks

End-users are generally not able to respond to electricity prices in real time. Therefore, retailers

usually offer fixed price contracts to end-users. It follows that the revenue received by retailers for

each unit of electricity supplied is fairly stable.30 However, the price paid by retailers for wholesale

electricity is volatile and can increase substantially in some periods.

The combination of a volatile cost and stable revenue leads to retailers’ returns varying greatly over

time, and there can be circumstances when retailers may not be able to pay for the wholesale

electricity they require if prices are sufficiently high. Furthermore, retailers must supply electricity to

their customers, ie they do not usually have the option of not supplying if the wholesale price is too

high.

The returns to generators are also volatile because their revenue increases substantially when there

are price spikes, whilst their costs are fairly stable. The volatility in electricity prices results in both

retailers and generators having a wide range of potential returns to their investment.

Retailers and generators are both better off if they can reduce their risk exposure without incurring

substantial costs. They are natural counterparties to each other because their returns are inversely

related to each other.

3.3.2 Efficiency of hedging

Generators can benefit from hedging contracts because it reduces the risk of investment in new

facilities and hence such contracts may assist generators in attracting the capital they require.

28 Public Utility Commission of Texas, PUC Proceeding Relating to Resource Adequacy and Reserve Adequacy and Shortage Pricing, Order Adopting New s.25.508 as Approved at the June 28, 2012, Open Meeting, pp.6-7. 29 Synapse Energy Economics, Demand Response as a Power System Resource, 2013, pp.49-55. 30 Retailers will be constantly acquiring new customers who may be offered fixed price contracts at different prices to current customers and so the revenue earned by a retailer may change slowly over time.


The ability to enter into hedging contracts increases the efficiency of electricity retailing because it

reduces the risk faced by retailers. This will lower their costs and the barriers to entry for new retailers.

Lastly, it may not be efficient for retailers to hedge all their exposure to wholesale prices if some of

their end-users are able to respond to real time electricity prices. The reason for this is that complete

hedging may reduce the incentive for the retailer to pass on the real time wholesale prices to its

customers.

There are a number of reasons why hedge contracting may be restricted. First, there may be

transaction costs in entering into the contracts. Second, the market for hedge contracts may not

be liquid if generators also own retailers and therefore do not need to offer hedge contracts to the

open market.

Synergy currently supplies a large proportion of wholesale electricity and an even larger proportion

of retail electricity in WA. It follows that Synergy is not likely to provide hedging contracts to third

parties, and as such the hedging market would not be liquid if there was an energy-only market

under the current ownership arrangements.

The Australian Competition and Consumer Commission (ACCC) has been concerned that mergers

between generators and retailers may reduce the liquidity of hedging markets in the NEM.31 This

may lead to greater costs of hedging, less competitive pressure from new entrant retailers and

higher prices for end-users.

To summarise, the condition that must hold in order for an energy-only market to provide an

efficient outcome is that retailers and generators can hedge their exposure to the wholesale

electricity price without incurring large transaction costs. Prices to end-users are likely to be higher if

this condition does not hold because retailers and generators will face higher costs and barriers to

entry in the retail sector would be greater.

3.4 No restrictions on entry and expansion

An energy-only market can lead to efficient investment because generators will respond to price

signals by building, expanding or shutting down plants as necessary. Any restriction on the ability or

incentive for suppliers to expand, enter or exit will prevent an energy-only market promoting

efficient investment in, and retirement of, generation plants.

The restrictions on entry that generators may face include:

planning regulations that apply to building new plants;

environmental and other regulations that apply to the operation of a new plant; and

costs involved with connecting to the electricity grid.

These restrictions will increase the cost of entry and expansion. This is likely to lead to higher prices

and greater market power for the existing generators. The restrictions will have a greater effect on

efficiency if they have a more significant impact on the behaviour of generators.

In practice, regulators usually attempt to design rules that assist potential entrants that are seeking

access to a power pool. For example, the NEM has detailed rules regarding how generators can

31 For example, see ACCC website, http://www.accc.gov.au/media-release/accc-opposes-agls-proposed-acquisition-of-macquarie-generation, accessed 30 June 2014.


connect to the system including the process for applying, information required and the

responsibilities for the relevant parties that are part of the application.32 The AEMC recently

reviewed how generators connect to the transmission network and how they access the wholesale

market via transmission.33

3.5 No limitations on consumers responding to wholesale market price

signals

In addition to avoiding restrictions on entry and expansion on the supply side of the market, it is also

important that there not be any restrictions on consumers responding to price signals created within

the market. This requires that the usage of electricity changes in response to the wholesale price of

electricity, which can at times be exceedingly high.

Demand side responsiveness refers to how the quantity of electricity used is affected by changes in

its price. This requires consumers to benefit from reducing their usage of electricity when spot prices

are particularly high. This, in turn, needs:

end-users to face prices that vary over time; and

appropriate tools to be available that allow end-users to manage efficiently their electricity

price risk.

3.5.1 Efficiency of demand side responsiveness

Energy-only markets lead to efficient outcomes when customers face the real time prices of

electricity and are able to respond to them by using more or less electricity. This is efficient because

customers are able to choose the optimal amount of electricity supplied to them at any price. This

will result in electricity being supplied up to the point when the marginal cost of supplying the

electricity is equal to the marginal benefit of the customers receiving it.

End-users are not able to react to the underlying cost of electricity supply if they cannot react to

prices in the short run. Figure 7 shows how this leads to efficiency losses. The price faced by end-

users is constant over the two diagrams whilst the marginal cost of supply is higher in the left

diagram because it is a peak period. The downward sloping line in both diagrams represents end-

users’ combined willingness to pay for different amounts of electricity.

Consumers use more than the efficient level of electricity in the peak period because there are

consumers who are purchasing electricity despite the marginal cost of its supply being higher than

their willingness to pay for that electricity. The loss of welfare caused by this is represented by the

green shaded triangle.

32 National Electricity Rules, Chapter 5. 33 AEMC, Transmission Frameworks Review, Final Report, April 2013, p.ii.


Figure 7: Welfare loss from a lack of demand-side responsiveness

Consumers use less than the efficient level of electricity in the off-peak period because there are

consumers who do not purchase electricity despite the marginal cost of its supply being lower than

their willingness to pay for that electricity. The loss of welfare caused by this is represented by the

blue shaded triangle.

In reality, the usage of electricity constantly varies, rather than there being two distinct periods.

Therefore, there are numerous different periods, each with a welfare loss from usage not

responding to prices in that particular period. It follows that two part tariffs alone would not prevent

there from being a welfare loss.

The amount of electricity consumed is efficient when end-users can choose the amount they use

depending upon the price. In the limit, this includes choosing to purchase no electricity, ie to

choose to have their supply interrupted. There is no need for involuntary blackouts if customers

respond to real time prices because there are always customers willing to voluntarily cease

consuming if prices are sufficiently high.

3.5.2 Why the demand side may not be responsive

End-users are not able to respond efficiently to real time prices because it is too complex for most

of them to do so. It would require an end-user to know how much electricity each device was

using, the price of electricity in real time and the consequences of using less electricity. Responding

to real time prices would also be a costly exercise, and therefore it would not produce a net

benefit for many end-users.

Furthermore, end-users typically do not have the technology necessary to respond to real time

prices. For example, small scale end-users may have an electricity meter that only records the total

amount of electricity used. In this case it is impossible to impose different prices at different times of

the day. This situation can be rectified by the introduction of new electricity meters.

An alternative manner in which the usage of electricity can vary with price is through third party

demand-side response firms, if permitted by the design of the electricity wholesale market. These

firms can reduce the quantity of electricity used by paying end-users directly. In particular, they


may be able to pay end-users to use less electricity when wholesale prices rise to very high levels.

This requires a mechanism that:34

provides an objective baseline against which the amount of demand curtailed can be

assessed; and

transfers the value of demand curtailment at each point in time to the consumer engaged in

demand reducing activity.

Such a mechanism creates potentially further benefits by allowing third parties to aggregate

demand savings and so lower the overall cost of delivering demand response activity to the

market. A demand response mechanism in an energy-only market will generate revenue for the

third party (and therefore end-users) when prices spike. This results in an uncertain revenue stream

that is likely to be less attractive than regular availability payments which end-users can currently

receive in WA.

3.5.3 Implications of unresponsive demand

The effect of electricity usage not responding to prices is that:

it is more likely that generators will be able to use market power to increase prices because an

increase in prices does not lead to less usage of electricity;

there will be over investment, in particular in peaking plants. These peaking plants will be

required to fulfil electricity requirements by end-users at peak times. This will lead to higher

average prices for end-users; and

there may be involuntary blackouts as electricity usage does not respond to high prices that

occur when there is little or no spare capacity remaining.

The greater the proportion of customers that face real time prices, the more efficient an energy-

only market will be. In particular, the efficiency of the demand side is most increased if those end-

users that are most willing to accept an interruption in their supply face real time prices. It is more

efficient for these end-users to not receive electricity rather than for there to be a random

allocation amongst all users, some of which may face a very high cost of an interruption in supply.

3.5.4 Demand side responsiveness in practice

Incorporating demand-side response into an energy-only market design so as to improve the

efficiency of the market is a current focus for electricity market design. In practice two principal

approaches are being adopted, often together, namely:

improving the price signals provided to consumers, through the adoption of smart metering

technologies that facilitate the use of innovative pricing structures; and

directly allowing the demand-side to ‘offer’ into the energy market.

Box 2 describes the demand-side response mechanism that is being developed in Singapore.

34 NERA, Compensating Demand Curtailment to Increase Efficiency in the Operation of the NEM, May 2012, p.12.


Box 2: Demand side participation in an energy-only market – National Electricity Market of

Singapore

The Energy Market Authority (EMA) in Singapore is introducing a demand response programme to

enhance competition in the energy-only National Electricity Market of Singapore (NEMS).35 It is

expected to be implemented in 2015.

This programme enables some consumers to reduce their electricity usage, in exchange for a share

in the system-wide benefits as a result of their actions. Such reductions typically take place when

wholesale prices in the NEMS are high or when additional resources can improve system reliability.36

The EMA has identified several benefits of the demand response programme, including that it:37

• provides an additional option for consumers to participate in the NEMS through demand side

bidding and to manage their electricity usage in response to price signals;

• reduces the wholesale electricity prices during peak periods as more expensive generation

units need not be scheduled to run;

• promotes more efficient investment in the NEMS as demand response is expected to reduce

‘peaks’ in electricity consumption where prices are typically higher. In the long term, this

reduces the need to invest in expensive generation units that are only run infrequently to meet

‘peak’ demand; and

• provides an additional resource to improve system reliability as consumers reduce consumption

in response to high prices during periods when supply conditions are tight (eg due to

unplanned outages or gas supply disruptions).

In summary, the condition that must hold for an energy-only market to provide an efficient

outcome is that all customers are able to respond to changes in prices in real time. Without this

ability there will be over investment in generation capacity and under investment in demand

reduction activity. The efficiency losses will be greater as the proportion of total supply that is not

able to respond to prices increases.

3.6 Market outcomes need to be predictable

Generators base their investment decisions on their expectations of the profitability of new plants

over their lifespan, taking account for risk. This decision will depend upon the fixed costs of the

investment, expected operating costs, and the expected price of electricity over the lifetime of the

asset.

The key variables that will affect an assessment of the expected prices are:

expectations of demand; and

current market capacity and expected investment.

Greater uncertainty regarding the expected electricity price will increase the volatility of the

expected returns and the risk of an investment. Investors will require a higher return from the

35 Energy Market Authority, Factsheet on the Demand Response Programme, October 2013, p.1. 36 Ibid. 37 Ibid.


investment if there is a greater risk. This will ultimately mean that the cost of a new investment will be

greater if the expectations of electricity prices are very uncertain, leading to higher prices for end-

users.

There are a number of reasons why demand (and therefore prices) may be difficult to predict

including:

the government may build a reputation for changing regulations frequently;

there may be uncertainty regarding the connection to other networks; and

there may be uncertainty regarding the growth of the underlying economy.

It is standard practice for regulators in energy-only markets to publish reports on the usage of

electricity and the capacity of generators. This assists market participants in forecasting prices and

making investment decisions.

AEMO publishes reports under the banner of ‘Electricity Statement of Opportunities’. These reports

provide frequent updates on changes to the generation fleet and electricity consumption trends in

the NEM. This information facilitates informed and efficient decision-making by participants,

investors, and jurisdictional policy makers.38

In summary, future price paths must be reasonably easy to predict in order for an energy-only

market to be efficient. In particular, the government or regulators should not act in a way that

makes it very difficult to predict future prices. Otherwise, investors will require higher returns, leading

to higher prices.

3.7 Key features of an energy-only market to deliver efficient outcomes

In summary, there are several minimum market design requirements for an energy-only market to

deliver efficient outcomes, namely:

a sufficient number of generators to ensure that no one generator can exercise substantial

market power;

a sufficiently high market price cap to allow incentives for new generation investment;

restrictions on the co-ownership of generators and retailers if the market is sufficiently small that

it limits the opportunity for a liquid hedging market to develop;

no restrictions on generators entering and expanding capacity;

ability for demand-response to be incorporated into the market; and

sufficient public information and regulatory certainty to allow for independent forecasting of

market conditions.

In our opinion, these requirements need to be carefully considered as part of the design of an

energy-only market.

While these design requirements should be considered as a minimum for promoting efficient

outcomes, in practice whether they can be addressed simply through the design depends on the

38 Australian Energy Market Operator website, http://www.aemo.com.au/Electricity/Planning/Electricity-Statement-of-Opportunities, accessed 27 June 2014.


specific circumstances of the market. The wholesale electricity market needs to be sufficiently large

so that:

new generation entry does not have such a significant impact on wholesale market prices that

it creates a barrier to entry;

there is scope to create sufficient competition amongst existing generators to prevent market

power while still realising economies of scale; and

a sufficiently liquid hedging market can develop.


4. Energy-Only Markets in the NEM and the SWIS

This section considers the implications of adopting an energy-only market design for the south west

interconnected system (SWIS). In addition, we consider the implications of the specific NEM energy-

only market design for WA.

4.1 Stylised description of the NEM and the SWIS

The NEM is a wholesale electricity market which provides electricity to approximately 9.3 million

customers, and comprises of five interconnected regions: Queensland, New South Wales and the

Australian Capital Territory, South Australia, Victoria and Tasmania.39

The NEM is a large network with a total electricity generating capacity of around 49,110 MW.40 It

has around 200 large generators, five state based transmission networks (linked by cross-border

interconnectors) and 13 major distribution networks that supply electricity to end-users.41 The NEM

had an average total demand of 22,500 MW in 2012-13, and a maximum demand of around

32,500 MW.42

The SWIS supplies electricity to around 1.1 million customers in a geographical area of 261,000

square kilometres.43 It is not connected to any other region, and therefore it must have sufficient

generation capacity to supply all its electricity requirements.44

In 2013-14, the summer peak of electricity usage was 3,702 MW, while the winter peak up to the

end of June 2014 was 3,222 MW.45 Electricity demand varies substantially throughout the day, with

overnight demand being much lower than daytime demand.46 Similarly, daily peak demand varies

considerably throughout the year, ranging from less than 2,000 MW to over 3,700 MW on a

weekday, depending on the temperature range.47

Figure 8 below shows the variation in the amount of electricity generated (and used) in each

month in 2013.48 The median generation for each trading interval is just over 2,000 MW for most

months. The maximum for 2013 was 3,737 MW, ie the peak is almost double the median which

indicates that electricity usage is relatively peaky in WA compared with the NEM. The load factor in

2013-14 was 56 per cent compared to 65 per cent in the NEM.49

39 Australian Energy Regulator, State of the Energy Market 2013, p.20. 40 Australian Energy Regulator, National Electricity Market, p.25. 41 Ibid. 42 Australian Energy Regulator, State of the Energy Market 2013, p.21. 43 Independent Market Operator, SWIS Electricity Demand Outlook, June 2014, p.17. 44 Ibid. 45 Ibid. 46 Ibid. 47 Ibid. 48 Since it is an isolated system total generation and electricity usage (including losses) are the same. 49 Independent Market Operator, SWIS Electricity Demand Outlook, June 2014, p.28. The load factor for the NEM is calculated based on an average total demand of 22,113 MW in 2013-14, and a maximum demand of 33,770 MW. This is based on total demand plus non-scheduled generation.


Figure 8: Spread of total generation per trading interval in the SWIS in 2013

The SWIS has a total capacity of 6,171 MW50 which is broken down approximately into 30 per cent

coal, 30 per cent gas and 20 per cent dual fuel (gas and liquids) with the remainder being demand

side management, liquids, renewables and dual fuel (coal and gas).51

4.2 Why an energy-only market is more likely to promote efficient

outcomes in the NEM


are:



4.2.1 Structure

Three of the NEM regions have substantially higher electricity usage than the SWIS, namely, Victoria,

New South Wales and Queensland. South Australia has a similar level of peak electricity demand to

WA, whilst Tasmania has a lower peak electricity demand than WA.

Large interconnected regions are more likely to benefit from an energy-only market for the

following reasons:

the benefits of efficient investment are greater in larger, more complex markets; and

50 HoustonKemp analysis based on data from the Independent Market Operator available from http://data.imowa.com.au/#facilities accessed 25 June 2014. 51 http://www.imowa.com.au/reserve-capacity/capacity-in-the-swis


there is less likely to be market power in larger markets, holding all else equal.

Benefits of efficient investment

The price of electricity in an energy-only market should provide an incentive for firms to undertake

the most efficient:

amount of generation investment;

type of generation investment;

location for generation investment; and

investment in interconnectors.

The benefits of providing the incentive for firms to act in this way are greater in larger, more

complex systems, where it would be difficult for a regulator or government to estimate what the

most efficient type of investment was. The NEM is such a large and complex system and so can

benefit greatly from the appropriate investment signals.

For example, efficient investment incentives would not create much benefit for one town (without

links to any others) with stable demand, if the most efficient investment was to have one base load

plant and one peaking plant forever. A regulator could see this and ensure investment was

efficient without using an energy-only market.

Market power

Larger markets are less likely to have generators with market power for the following reasons:

the barriers to entry are not as significant in larger markets because an entrant of a given size

will have a smaller effect on the price of electricity. Where a new entrant is necessarily relatively

large, this will increase the risk of investment and the extent to which prices will have to rise

above the long run marginal cost before entry occurs; and

larger markets can sustain more generators of a significant size. This means that the market can

be less concentrated whilst having generators that are of sufficient scale to be efficient.

The three larger regions in the NEM have significantly higher peak demand than the SWIS.

Therefore, the risk of there being market power in those markets is substantially lower than in the

SWIS. The lack of market power allows the market operator to have a relatively high price cap

which allows for efficient investment signals.

Tasmania has a lower peak demand than WA, but it has some important characteristics that differ

from WA.

First, Hydro Tasmania owns and operates approximately 2,300 MW of hydro capacity that supplies

around 80 per cent of Tasmania’s electricity demand.52 This form of electricity generation can be

turned on and off relatively quickly meaning that changes in electricity usage can be met without

the need for a large amount of generation from gas peaking plants.

52 Electricity Supply Industry Expert Panel, An Independent Review of the Tasmanian Electricity Supply Industry, Final Report, March 2012, p.76.


Second, Tasmania is interconnected with Victoria and the rest of the NEM through Basslink, which is

able to import 480 MW to Tasmania, a substantial proportion of peak demand.53 This allows

electricity to be imported when there is a threat of shortage in Tasmania, further reducing the need

for peaking plants.

The Tasmanian government recently established an expert panel to conduct an investigation into

the current position and future development of Tasmania’s electricity industry. The panel found

that, amongst other things:

Hydro Tasmania had the ability to profitably increase spot and contract prices on a sustained

basis.54 This is because Hydro Tasmania’s output is required to meet Tasmanian demand under

virtually all market conditions.55 Therefore, it had a unique level of market power in the NEM;

and

the market power of Hydro Tasmania is causing a lack of retail competition because new

retailers would be reliant on electricity supply and hedging contracts from Hydro Tasmania.56

Retailers will not make investments where there is a material risk that, after such investment is

made, Hydro Tasmania could exercise its market power to the retailers’ significant financial

detriment.57

It follows that Tasmania has faced problems with having a generator with market power and WA

faces the same risk if it adopts an energy-only market.

South Australia exhibits similar electricity usage to WA in terms of the level of maximum demand,

summer peaking, and the high level of maximum demand relative to the median. For example,

Figure 9 shows the South Australia electricity usage for 2013 which is similar to Figure 8 showing

electricity usage for WA.

53 Ibid. 54 Electricity Supply Industry Expert Panel, An Independent Review of the Tasmanian Electricity Supply Industry, Final Report, March 2012, p.89. 55 Ibid. 56 Ibid, p.xvi. 57 Ibid, p.vi.


Figure 9: Spread of total demand per trading interval in South Australia (2013)

The major difference between South Australia and WA is that there are interconnectors between

South Australia and Victoria. They are able to transmit 680 MW of electricity from Victoria to South

Australia.58 In 2013, 2.2 GWh was transmitted from Victoria to South Australia.

Generators in WA can profitably increase their bids above their short run marginal cost when there

is a threat of scarcity in WA. This will lead to higher electricity prices. In South Australia, electricity

can be imported when there is scarcity of generation in that state. Therefore, the ability of

generators in South Australia to increase prices will be limited. There may be times at which the

interconnectors are working at full capacity and then generators in South Australia will have some

pricing power. However, there is the potential for this to result in greater investment in

interconnector capacity in the long run, further restricting any generator market power. Therefore,

the interconnectors reduce the risk of market power being used in South Australia relative to WA.

Many energy-only markets have interconnections with other regions such as in Alberta, Texas, the

Netherlands, New Zealand’s north and south islands, and the NEM regions. Figure 10 shows that WA

would be the smallest energy-only market in the world that is not connected to another region.59

58 The Heywood interconnector can currently transmit 460MW from Victoria to South Australia. A number of options are being investigated to increase this limit, most of which would involve an addition 90MW to 190MW of capacity: Australian Energy Market Operator, South Australia- Victoria (Heywood) Interconnector Upgrade, January 2013, p.III. Murraylink can transmit 220MW from Victoria to South Australia: Energy Infrastructure Investments, Murraylink Transmission Company Pty Ltd, Murraylink Revenue Proposal, May 2012, p.2. 59 The size of the market here is based on the level of peak demand.


Figure 10: Approximate maximum demand of energy-only markets (2012-13)60

Lastly, there is a substantial amount of hedging in the NEM. This is an important feature of the NEM

because it allows both retailers and generators to reduce their exposure to risk.

4.2.2 Reliability settings

The reliability standard and the reliability settings in the NEM help to ensure there is sufficient

investment in generation capacity. The reliability standard is a maximum of 0.002 per cent of

unserved energy for each region per financial year. The reliability settings include:61

a market price cap which is the maximum spot price in each half-hourly trading interval and is

$13,500/MWh for 2014/15;62 and

the cumulative price threshold, which governs the imposition of an administered price cap. This

cap will be applied when the sum of spot prices in a region in 336 consecutive trading intervals

exceeds the cumulative price cap which is $201,900 for 2014/15.63

These both act to limit prices and profits when electricity supply is scarce. However, they have

been set at a relatively high level so that there is an incentive to build peaking plants if they are

needed to meet the reliability standard.64

60 Colours indicate interconnected regions within each system. Note that some of these systems have additional connections with other systems. 61 Australian Energy Market Commission, Reliability standard and settings review 2014, Australian Energy Market Commission Terms of Reference to the Reliability Panel, April 2013, p.1. 62 Australian Energy Market Commission, Schedule of reliability settings, 20 February 2014, p.1. 63 Ibid. 64 The AEMC has assessed the appropriate level of the price cap based on the MPC required for a peaking generator to be profitable with the current reliability standard. See Australian Energy Market Commission, Reliability Standard and Reliability Settings Review 2014, p.18.


4.3 Why an energy-only market is unlikely to promote efficient outcomes in

WA

The SWIS is a smaller and simpler generation system than the NEM. This has two effects that reduce

the benefits of an energy-only market and increase its costs relative to those in the NEM:

the benefit of efficient investment is smaller in the SWIS because it is a smaller, simpler system;

and

the risk of market power being used in the SWIS is greater than the NEM because the SWIS is a

smaller system.

First, it would be easier for a regulator to estimate what the efficient investment mix is in the SWIS

because it is smaller than the NEM and only consists of one region. Therefore, the benefits of

efficient investment signals are likely to be less in the SWIS.

Second, there is a significant risk that an energy-only market in WA would be susceptible to

generator market power because:

it is a fairly small market and therefore the barriers to new entry will be significant;

the market is currently highly concentrated, providing generators with a greater ability and

incentive to use market power;

it has peaky demand, providing an opportunity to use market power; and

it is not connected to any other system, and therefore there are fewer constraints on generators

increasing prices.

Prices are likely to be higher than the efficient level if generators use substantial market power.

Furthermore, the prices will not reflect actual scarcity of generation capacity and so the incentives

to invest will be distorted.

One mechanism to prevent market power is a price cap. However, prices need to rise substantially

in some periods for there to be an incentive for investment. Therefore, a price cap that was low

enough to restrict the use of market power would result in inefficient investment.

It may be possible to restructure the market to allow for a greater number of smaller generators in

order to reduce the risk of substantial market power being used. However, since the system’s peak

demand is currently only around 3,700 MW, each generator would have to be of a fairly small

scale, and as such these generators may have higher costs.

There is also a risk that retailers will not be able to obtain sufficient hedging contracts if there are a

number of large vertically integrated retailers/generators because such firms are unlikely to make

hedge contracts available on the open market. This would result in market power for retailers and

higher prices for end-users.

4.4 Implications of adopting an energy-only market for WA

In summary, the SWIS is a fairly small single region, whereas the NEM is a substantially larger and

more complex system of five interconnected regions. The SWIS would be the smallest unconnected

energy-only market in the world if it switched from being a capacity-plus-energy market.



are:



The benefits of efficient investment incentives provided by an energy-only market are significant for

the NEM because it is a large and complex system. The benefit of these incentives would be lower

in the SWIS because the pattern of investment required in WA is less complex.

The large size and interconnected nature of the NEM assists in preventing firms from using

substantial market power. By contrast, the SWIS is much smaller and therefore faces a greater risk of

market power being used by generators.

The reliability settings include high price caps that allow the NEM to provide efficient incentives for

investment whilst ensuring that the risk of blackouts is very low. The structure of the SWIS will need to

ensure that generators do not have market power if a high price cap is adopted as part of an

energy-only market. This implies that the market structure will need to be examined so that in place

of a very large generation business there will need to be a number of fairly small generators.

Overall, in our opinion an energy-only market is not likely to promote efficient outcomes in WA,

given the current characteristics and in particular the small size of the market. Certainly, it would

not be possible to simply “port” the NEM market design to WA without modification and expect an

efficient, or even workable, result.

HoustonKemp.com

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Necessary conditions for an effective energy-only market in Western Australia