Insights

19/06/17

Finkel report: A blueprint for reform that will take us half way there

Our thoughts at a glance:

  • The final Finkel report broadly seeks to respond the two key policy challenges facing Australian energy policy – being (a) the need to better manage the integration of renewables into the NEM; and (b) to respond to the global trend towards a more intelligent and decentralised electricity supply chain.
  • On the first issue – policy to support system security – the report responds with a number of concrete and valuable proposals, the three central elements of which include:
    • a technology neutral Clean Energy Target (CET) which would reward all new generators that produce electricity below a specified emissions intensity threshold – rather than the Renewable Energy Target, which currently only subsidises renewable generation.  It remains to be seen whether the CET will be sufficient to incentivise significant fresh investment into gas-fired generation, given the high cost of gas;
    • requiring all generators to provide at least three years’ notice prior to closure to ensure better management of generator closures (exactly how these regulations would operate in circumstances where a generator’s owner was no longer willing to operate the asset, invest in maintaining it or was in financial difficulty remains to be seen); and
    • a Generator Reliability Obligation for new generators such as wind and solar which will apply to new investment in a region where the level of dispatchable capacity falls below a certain threshold.
  • On the second issue – the need to adjust our framework to reflect the longer term disruption that is occurring in the grid – the findings are less concrete and there are some significant deficiencies.  In particular, the Report:
    • doesn’t deal with smart meters or electric vehicles, in any material way;
    • is shallow when wrestling with the critical issue of price signals and tariffs;
    • wrongly assumes that all individual consumer behaviour around DER (particularly demand management and storage) will be beneficial for network costs; and 
    • despite recognising we face “paralysis by analysis” – still refers most key questions for further review and creates an entirely new regulatory body.

Summary

In our update last Friday we summarised the key recommendations in Dr Alan Finkel’s Final Report on the Independent Review into the Future Security of the National Electricity Market.  As we noted, the Final Report is a comprehensive document and contains 50 individual recommendations in support of a wide-ranging policy vision for the future of the NEM. 

The Final Report deals with many of the issues that we raised in our recent White Paper, ‘Wrestling with the Electricity market Transformation’.  In that White Paper we identified two distinct policy challenges facing the NEM:

  1. the decentralisation of the energy ecosystem as a result of new technology and falling costs, with major implications for the design and operation of the grid; and
  2. wholesale market design, the impact of the Renewable Energy Target (RET) and changes in the nature of generation has raised questions about the ability of the current energy-only wholesale market design to deliver reliable and cost effective electricity supply.

In our view, the Final Report has delivered a number of clear, actionable and important recommendations to deal with the second of these challenges.  The Finkel report recommends a number of specific measures to increase the security of electricity supply, emphasises the need for an orderly transition to a low carbon environment with a clear policy direction and stresses the importance of more efficient gas markets in delivering that orderly transition.  These are welcome and important policy recommendations. 

We are less sure that the Final Report has delivered a clear road-map to allow the grid to manage the disruption posed by decentralisation of the energy ecosystem in an efficient and cost-effective way.  The key recommendations in the report in relation to improved system planning identify the key issues, but give little specific guidance on the future direction to be taken. 

The Final Report focusses on the importance of rewarding consumers for the benefits that individual actions such as demand management and storage can have to the broader system.  However, it does not clearly identify that the actions of individual consumers can also have negative effects on the efficient operation of the broader system and the importance of ensuring that price signals are properly aligned with the total cost of individual actions.  It is an easy political sell to suggest that consumers should be rewarded for taking actions such as installing solar panels or battery storage, but it is equally important to ensure that the system-wide costs of such actions are taken into account.  For example, customers should continue to properly contribute to the cost of maintaining their connection to the grid even if they use that connection less frequently.

Citing a Productivity Commission report, the Final Report noted a danger that the policy process in the NEM can sometimes descend into “paralysis by analysis”.  While we are hopeful that the proposed Blueprint will help move past analysis into action, and welcome the recommendation that COAG recommit to a national approach to energy matters, on our reading only 15 of the recommendations are for specific actions to be taken, with the others highlighting important issues and recommending that other bodes develop plans or investigate matters (including the key recommendations around the future of and governance arrangements in relation to the grid such as recommendations 5.1, 5.3 and 5.5).  We also remain to be convinced that the formation of yet another body in this sector (the Energy Security Board) will contribute to more streamlined decision making process.

Overall, the Final Report outlines a blueprint for action that seems well suited to addressing the short to medium term risks facing the NEM in terms of security and reliability of wholesale supply.  These issues are clearly pressing and the recommendations on these issues are, for the most part, specific and able to be implemented.  However, the report has not grappled with the longer term disruptive forces facing the electricity system.  Nor does it provide a specific plan on how to ensure that this disruption is implemented in a coordinated manner that works for all users of the system, rather than allowing some users to take advantage of inefficient price signals and regulatory or policy regimes.

Detailed overview of the Final Report

The remainder of this update examines the individual elements of the Final Report in more detail, other than the first section that outlines the measures that are currently being taken to improve the resilience of the NEM ahead of the FY18 summer.

Figure 1 – Elements of the Final Review Blueprint (Final Report, page 32)

Finkel Review  blueprint

Chapter 2 – Increased security

The Final Report defines energy security as the power system’s capacity to operate in the event of emergencies such as unexpected loss of generation or load.  It identifies emerging threats to energy security from natural and human sources such as cyber-attacks and extreme weather conditions and highlights that there has been a reduction in the supply of essential services that help to maintain system security such as physical inertia due to:

  • increased penetration of variable renewable electricity generators; and
  • withdrawal of synchronous generators.

In order to maintain a steady supply of security services, the Panel makes 12 recommendations in relation to security including that:  

  • a package of Energy Security Obligations be adopted which requires transmission network service providers to provide and maintain a sufficient level of inertia, mandates that new generators have fast frequency response capability and an update to connection standards;
  • the AEMC review the regulatory framework for allowing distributed energy resources to participate in the provision of system security and subsequent measures to better incentivise and orchestrate such participation;
  • AEMO revise the black system restart plans for each NEM region in case there is a system-wide blackout and regularly test black start equipment and processes;
  • the Energy Security Board prepare an annual report on cyber security preparedness of the NEM.

These recommendations have benefited from detailed work done by other bodies, particularly AEMO’s analysis of past system security events and the ENA / CSIRO’s Electricity Network Transformation Roadmap and are generally well targeted and actionable, providing a good platform for future reform in this area. 

Chapter 3 – A reliable and low emissions future

Everyone who has worked in or been exposed to the electricity sector understands that uncertainty in the political sphere about carbon abatement policy has created a hostile climate for investment in the NEM over the past decade.  This fact informs the key insight in the Final Report, which is that the costs of ‘business as usual’ are higher than committing to a long term emissions plan (Figure 2).  The Final Report notes that “For a sector characterised by very high-cost and long-lived assets, policy transparency, credibility and durability are key.

Figure 2 - Residential price, NEM average 2017 to 2050 (Final Report, page 90)

NEM average 2017 graph

According to the Panel, the singular most important feature of a carbon abatement policy is to ensure it is adopted quickly by government and has wide support to stimulate investor confidence.  The Panel recommends:

  • implementing a technology neutral Clean Energy Target (CET) for the electrical sector in order to reward all new generators that produce electricity below a specified emissions intensity threshold;
  • regulations that all generators must provide at least three years’ notice prior to closure to ensure better management of generator closures – exactly how these regulations would operate in circumstances where a generator’s owner was no longer willing to operate the asset, invest in maintaining it or was in financial difficulty remains to be seen; and
  • a Generator Reliability Obligation for new generators such as wind and solar which will apply to new investment in a region where the level of dispatchable capacity falls below a certain threshold.

As with the recommendations in relation to increased security, these are clear, specific and actionable recommendations that lay a sound platform for reform.  The CET and Generator Reliability Obligation are discussed in more detail below.

Clean Energy Target (CET)

The CET is a technology neutral mechanism which aims to provide incentives to encourage low emissions generation (such as wind and gas) while not directly imposing a penalty on high emissions generation.  All forms of electricity generation are eligible for the scheme as long as they produce electricity below the specified emissions intensity threshold.  The report does not recommend what this threshold should be, but the modelling exercise relied on by Review (which was calibrated to achieve a 28% reduction in emissions by 2030) set a threshold of 600kg of CO2/MWh.  Under a CET, eligible generators would receive certificates for the electricity produced below the relevant threshold and retailers would be required to buy these certificates to show that a pre-determined share of their electricity is sourced from low emissions generators.

To avoid significant disruption to the energy sector it is recommended that the RET would continue to operate until 2020 in its current form.  The CET would then commence after the expiry of the RET.

In our white paper, we urged policy makers to consider an emissions intensity scheme (EIS), which is generally regarded as the most efficient way to achieve carbon abatement goals.  The panel grapples with the choice between a CET and EIS, and suggest that:

the single most important characteristic of any emissions reduction mechanism to be adopted by governments is that it is agreed expeditiously and with sufficient broad-based support that investors can be confident it will endure through many electoral cycles.

the Panel is hesitant to argue definitively that one mechanism, between the EIS and the CET, is superior to the other. The differences in theory may be less significant than how well the chosen scheme is implemented and aspects of its detailed design, such as a predictable process for parameter changes and a robust and proportionate compliance and enforcement regime.

The Final Report also notes that the CET would build directly on the experience of operating the RET, which was well understood by market participants.  These points are well made and ultimately the difference between the two schemes is one of degree – both share the same desirable feature of being technologically neutral, and in that respect are a clear improvement on the RET.

Generator Reliability Obligation

To promote reliability in the electricity supply, the panel recommends that the AEMC oversee a new Generator Reliability Obligation that would be imposed on variable renewable electricity (VRE) generators connecting to the NEM.  Under the arrangement, there will be a (non-specified) minimum dispatchable capacity required for each region to maintain system security and reliability.  In circumstances where there are high levels of VRE penetration in a particular region, the Generator Reliability Obligation would help ensure sufficient dispatchable generation can bolster the electricity supply in order to maintain reliability.

Drawing on work done by AGL, the Final Report calculates presents information on the levelised cost of new generation taking into account the cost of ‘firming’ that capacity (Figure 3).  If these figures, which assume continued downward trend of pricing in wind and solar, are representative then renewable generation would still be highly cost effective even under a reliability obligation. 

Figure 3 - Implied Cost of New Generation (Final Report, page 100)

Implied Cost of new generation graph

Chapter 4 – More efficient gas markets

The Final Report, correctly notes that gas and electricity markets are highly dependent.  As aging coal-fired generation retires, it can be substituted with gas-fired generation, which is a reliable, dispatchable source of supply that is significantly lower in emissions intensity than coal.  The Final Report finds that in the short to medium-term, the NEM is likely to depend on flexible, gas-fired generation to support VRE generation.  However, due to the rising price of gas and depletion of gas supplies, the gas market needs to be highly efficient if gas fired generators are to contribute to an affordable electrical supply.

The Report notes the significant increases of east coast prices in recent years, driven in large part by the LNG projects in in Queensland which have linked Australia to international gas prices.  These price increases have a very significant impact on the short run costs of gas fired generators (Figure 4).

Figure 4 - Indicative relative gas price impacts on generation fuel costs (Final Report, page 111)

To help ensure additional gas supplies and secure affordable gas prices, the Final Report contains a number of recommendations, including that:

  • AEMO should be given greater oversight power of gas supply contracts for gas-fired generators;
  • Governments should help ensure the safe exploration and production of unconventional gas, (including fair compensation for landowners) by working with communities and industry;
  • to assist in securing public support for gas exploration and development, measures be taken to improve the transparency and accessibility of Gas industry performance data e.g. seismic activity, fracking fluid composition, aquifer purity and fugitive emissions.

One of the most significant barriers to securing reliable and affordable domestic gas supplies is public opposition to exploration and extraction of onshore gas resources in NSW and Victoria.  The measures proposed in the Final Report seem like a sensible way to help move the debate forward, although whether they are able to overcome the intense opposition to gas development in some communities remain to be seen.

Chapter 5 - Improved system planning

The Final Report highlights the importance of a more strategic approach to transmission planning.  Transmission network planning increasingly needs to take into account future deployments of large-scale and distributed VRE generation which will increase as coal-fired generation exits the market. 

While recognising the challenges facing the transmission sector, the recommendations in the Final Report in relation to this issue are much less specific than those relating to the wholesale market.  They include recommendations that:

  • AEMO develop an integrated grid plan to facilitate the development and connection of renewable energy zones across the NEM;
  • the COAG Energy Council review the ways in which AEMO’s role in transmission planning can be enhanced; and
  • the COAG Energy Council commission a review of the Regulatory Investment Test for Transmission by mid-2020.

Other than the recommendation relating to the pre-existing proposed reforms to the Limited Merits Review regime (5.4), none of the recommendations in relation to systems planning are specific, clear and actionable.  This is disappointing.  There is no substantive discussion of difficult and important issues such as network tariffs or the way in which overly stringent ring-fencing obligations may create barriers to transmission networks being able to properly assess the desirability of non-network investments.

Chapter 6 - Rewarding consumers

The Final Report recommends that all electricity be rewarded for their actions that enhance the reliability and security of the NEM.  Such actions include demand response, provision of system security services and allowing distributed resources to be orchestrated in line with broader system needs.  The Final Report also recommends that network provides be provided with appropriate incentives to invest in non-network technologies. 

To help incentivise such activities, the Final Report suggests, among other things, that:

  • the ACCC make recommendations on how to improve the transparency and clarity of electricity retail prices to help improve customer engagement with the electricity market;
  • the AEMC be directed to undertake a review to recommend a mechanism to facilitate demand response in the wholesale energy market; and
  • that a study be commissioned to determine whether network businesses are more powerfully incentivised to make capital investments rather than undertake operational expenditure on demand-side measures.

The Final Report correctly emphasises the importance of orchestration of DER resources to achieve the potential system-wide benefits of their deployment.  Unfortunately, the Final Report contains no specific recommendation as to how orchestration could be achieved or incentivised.

In the absence of such orchestration, or a change in price signals, there is a risk that those able to afford the initial costs of DER installation will receive benefits but those that do not will be forced to pay a greater share of network and system costs.  The Final Report observes that low income consumers and those that rent or occupy high-density buildings are unlikely to install DER systems themselves.  As a result, in the absence of a mechanism to ensure that such deployments to result in system wide benefits, these users will bear the brunt of the costs of the transformation of the electricity system without sharing in its benefits.  This is a pressing issue, and will need to be grappled with, but the Final Report provides no clear guidance on the path forward which is disappointing.

Also notable is that the Final Report highlights the importance of smart meters in enabling many of these mechanisms to reward consumer behaviour, but does not contain any discussion of how installation of these meters can be encouraged.  In addition, the Final Report does not contain any discussion about the importance of Australia having a long term strategic plan for the integration of electric vehicles into the grid.  This is a missed opportunity, as electric vehicles represent a long term development that has the potential to cause major changes to the level and location of electricity demand in the NEM, and this should be coordinated. 

Chapter 7 – Stronger governance

The Final Report notes the importance of strong and resilient energy governance in achieving a secure and reliable low emissions system.  It states that good governance requires institutions such as the AER, AEMO, and the AEMC to be ‘trusted, capable, empowered and accountable’, able to act in a coordinated and timely way to the rapid changes that will occur in the NEM.

The Final Report highlights the critical role of the COAG Energy Council, which is responsible for coordinating NEM institutional arrangements.  The Final Report highlighted that the Vertigan Review had found that the Energy Council lacked strategic direction and suggested that, while improvements had been made, more needs to be done to deliver active policy leadership in the energy industry.  To address this, the Panel recommends that the Energy Council develop and implement a strategic energy plan informed by the Panel’s blueprint.  The Final Report also recommends that the Vertigan Review proposals relating to rules change process be implemented by the end of 2017 and that further optimisation be considered by the ESB and other bodies. 

The Final Report also recommends the establishment of a non-statutory body, the Energy Security Board (ESB).  The ESB would be comprised of the chairs of the AEMC and the AER and the Chief Executive of AEMO and two independent members.  The ESB would be responsible for overseeing and implementing the Finkel Review’s blueprint as well as publishing an annual report into the health of the NEM.

Importantly, the Final Report also highlights that the level of commitment by the Federal, State and Territory governments to the existing Australia Energy Market Agreement (AEMA) has waned.  It suggests that a new AEMA be agreed to in order to refocus and reaffirm the Federal, State and Territory governments’ commitment to a national energy and emissions reduction policy.  Whether such a commitment is politically realistic in the current environment remains to be seen.

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