The first public consultation paper on the proposed National Energy Guarantee (NEG) was released by the Energy Supply Board (ESB) on 15 February.
The NEG will create two obligations on retailers (and large direct consumers) of electricity in the National Electricity Market (NEM):
- to ensure their electricity purchases meet emissions reduction targets set for the electricity industry; and
- to ensure “dispatchability” or reliability targets are met for each NEM region.
The objective is to integrate climate change and energy policy into a single investment signal through the NEM spot price.
The ESB proposes that both obligations are implemented as a change to the National Electricity Law (NEL) and National Electricity Rules (NER). Accordingly, the NEG will not apply to non-NEM jurisdictions such as the Northern Territory and Western Australia. It will need to be seen how those jurisdictions contribute to Australia’s emissions reduction commitment under the Paris Agreement.
The NEG will not affect the existing Renewable Energy Target (RET). The RET will continue to operate until 2030.
It is intended that the emissions requirement of the NEG will start in 2020 and the reliability component of the NEG will commence in 2019.
Australian Government Policy Decisions
The emissions target will be set by the Australian Government, and the NEG will be designed to allow the emissions target to change from time to time. The consultation paper proposes that the emissions target can only be amended with 5 years advance notice.
Setting the emissions target, and any trajectory to achieve that target, will obviously be key factors in assessing the obligations on electricity retailers.
Other key policy decisions for the Australian Government include:
- whether to exclude certain energy intensive trade exposed (EITE) industries such as steel and aluminium production/smelting from the emissions requirement of the NEG; and
- whether external offsets such as Australian Carbon Credits Units or international units of an equivalent standard can be used to satisfy the emissions requirement of the NEG.
- It is not entirely clear that the electricity sector will not be required to do the “heavy lifting” to meet Australia’s international emissions reduction obligations (ie. the Paris Agreement). Australia has committed to a 26-28% reduction in emissions below 2005 levels by 2030. The issue has always been whether the stationary electricity sector will need to achieve a higher level of reductions given it is more difficult to regulate emissions from other sectors of the economy. While the consultation paper does note that the Australian Government’s target for electricity sector for 2030 under the NEG is a 26% emissions reduction on 2005 levels, consistent with the national target, this will need to be confirmed.
- The consultation paper notes that if EITE participants are exempted from the emissions requirement of the NEG, the targeted emissions reductions from those participants will need to be obtained from other electricity market participants. This will mean that other users will be cross subsidising the emissions reduction obligations for EITE participants’ electricity consumption. The RET has a similar EITE exemption, but the effects will be different under the NEG.
- The application of an EITE participant exemption will need to be carefully considered. What is to prevent EITE participants from contracting with cheap high emission generation? Given the absence of a direct impost on generation (the NEG is reliant on retailer contracting behaviour driving generation investment decisions) this would appear to provide a loophole for high emissions generating plant to potentially exploit.
Finkel Policy Decisions
The emissions requirement of the NEG is essentially a refined version of the “Clean Energy Target” mechanism proposed by the Finkel Review. The key change has been to place the relevant emissions obligations on retailers instead of setting an emissions intensity obligation on generators. This means that there are no tradable permits or certificates created by low emissions or “renewable” generation technology. Instead, the NEG will mean that retailers will be incentivised to “contract” (see below) with lower emissions generators, or underwrite the development of additional zero or low emissions generations, to reduce the average emissions intensity of their electricity purchases.
The NEG will need to be considered alongside other key Finkel Report recommendations (see link to previous HSF articles), including:
- a possible ex ante/”day ahead” market in the NEM;
- the need for strategic generation reserve and the reliability and emergency reserve trader function (RERT) under the NER; and
- the development of demand response mechanisms.
Electricity retailers will be required to “contract” generation that collectively meets an average annual emissions intensity target (in tCO2-e). This will be a target for the electricity sector, translated into an average level to be met by each retailer in the NEM. As noted above, the emissions target will be set by the Australian Government based on achieving Australia’s international emissions reduction commitments.
A retailer’s load will be the amount of MWh purchased by the retailer from the NEM in any compliance year. As noted above, electricity supplied to EITE participants may be excluded.
The retailer’s average emission intensity for its NEM purchases will be calculated as the weighted average of “purchases” under:
- contracts specifying a generation source, with the emissions intensity of those purchases being determined as the intensity of that generation source;
- contracts that specify an emissions per MWh but do not specify a generation source (the consultation paper provides the example of an exchange traded contract with an emissions per MWh specification);
- contracts that do not specify either a generation source or emissions per MWh (the consultation paper provides the example of existing exchange traded contracts and OTC swaps and caps); and
- uncontracted purchases from the NEM.
- The NEM is nominally a “gross pool”, with all physical generation required to be traded through AEMO. However, the contracting requirements potentially make the NEM operate more like a balancing market/net pool.
- Given the NEM market structure, it is generally not possible to enter into physical power purchase agreements for electricity traded through the NEM (other than power purchase arrangements that occur “behind the meter” and prior to injection into the NEM). This will require emissions intensity specifications to be attached to hedge contracts.
- The implications of the emissions requirement on OTC and exchange traded instruments is unclear. What requirements will apply to determining an emissions per MWh for contracts that do not specify a generation source?
- How will variance between the emissions intensity referenced in a contract and the validated actual emissions performance of the relevant generation plant be reconciled?
- How will contracted capacity operate where the reference generation does not directly correspond to the contracted capacity (for example, cap products, or firm/fixed volume hedge products)?The consultation paper says that where a generator generates less than what it contracted for, only the MWh actually generated can be counted by the retailer. This may also require compensation mechanisms to be included in contracts with generators for generation shortfalls.
- The emissions requirement is focussed squarely on electricity traded via the NEM. However, not all electricity is traded via the NEM (eg. sales to the “local retailer” by embedded generation and direct-connected generation). This may provide an unfair advantage to retailers who are classified as the local retailer for a network area.
- The calculation of the uncontracted (ie. residual NEM) emissions intensity for electricity purchases from the NEM is potentially complex. The residual emissions intensity of the NEM will differ depending on the time of day and year and the consultation paper notes the possibility of using a weighted average measure. However, the consultation paper also notes one option is to deem the residual NEM emissions intensity to be that of the “highest-emitting plant operating in the NEM”, which appears punitive.
- The impacts on existing offtake agreements (both power purchase agreements and hedges) will need to be carefully considered. It is likely that both the emissions requirement and the reliability requirement of the NEG will have an impact on the NEM spot price, which may require the application of adjustment mechanisms under some offtake agreements. Similar to previous carbon policy, this may lead to the introduction of adjustment mechanisms in offtake agreements written prior to the introduction of the NEG, where the impact on prices is not yet known. The consultation paper suggests that the NEG will result in a lower NEM pool price than a certificate-based scheme such as the RET.
- The consequences of a retailer failing to achieve its target average emissions intensity are not yet clear. The consultation notes possible options of civil penalties (perhaps similar to the existing RET compliance penalty), but also mandatory injunctions and enforceable undertakings.
- The ability to “bank” and trade annual emissions intensity over-performance is not clear. Similarly, the consultation paper proposes an ability to potentially roll a under-performance compliance obligation into subsequent years, but the details are still to be developed.
- How will the emissions intensity of battery generation be calculated? This should presumably reflect the contracted generation source used to charge the battery, or be based on the residual NEM emissions intensity at the time the battery is charged.
Reliability requirements will be set for each NEM region. These will likely be based on the existing NEM reliability standard under clause 3.9.3C of the NER.
Retailers will be required to “contract” with generators for a minimum level of “dispatchable, on demand” (ie. reliable) electricity generation where there is an identified reliability gap. Retailers can alternatively develop their own reliable generation capacity.
Australian Energy Market operator (AEMO) will forecast whether the reliability standard is likely to be met in any NEM region over a forecast period. The forecast period will be somewhere between 2 and 10 years out. Where AEMO identifies a “reliability gap” in a NEM region, the relevant retailers in the region will be allocated responsibility for meeting the reliability gap based on their share of the peak load. Penalties will apply to retailers who do not meet their responsibility. AEMO will also retain an ability to step into the market as a “procurer of last resort” if a reliability gap is not met (we assume this is a reference to the RERT function).
- The consultation paper does not describe which types of generation will be considered “reliable” for the purposes of the NEG. For example, is this synonymous with synchronous generation? How will battery storage be considered? While battery capacity could be used to support reliability, the available duration of that support is generally very short-lived.
- The logistical and practical aspects of identifying reliable capacity and which retailer has “contracted” it appear daunting. For example, the NEL and NER will need to identify what is a “qualifying instrument” for the purposes of contracted reliable capacity and it appears that there will need to be a certification process. It is not yet clear how some types of hedge contracts will be treated (eg. caps, and non-firm or “whole of meter” variable volume hedges).The consultation paper notes that these instruments will need to be sufficiently “physically-backed” to qualify.
- How will the contracting requirement affect retailers or generators who have a preference for a lower contracted position? Will the reliability requirement effectively mean that all of the electricity purchased in an affected region needs to be contracted?
- How will retailers’ obligations for a reliability gap be allocated? If a retailer has already contracted capacity for the extent of its load, we presume that the reliability gap obligation should be shared among other retailers.
- If the obligation to meet a reliability gap is fragmented among retailers, won’t there be free rider issues if one retailer then contracts to underwrite the development of additional capacity? How should other retailers who benefit from that investment contribute to the costs of the development? Will the fragmented obligation mean that retailers will look to satisfy their obligations by contracting load reduction capability?
- Will the obligation to meet a reliability gap simply result in a game of “chicken” between retailers as to who will develop the required additional generation capacity?
- Practically, how could retailers with obligations to meet a reliability gap “club” together to facilitate additional generation capacity?
- It should be noted that a reliability gap can arise due to the retirement of existing reliable generation capacity. This could lead to a situation where retailers are incentivised to fund a retiring plant to remain in service for a longer period. We note that the Finkel Review requirement for 3 years advanced notice of plant retirement is confirmed by the consultation paper.
- How will interconnectors between NEM regions be treated? Will it be possible to contract capacity in adjacent regions up to the capacity of the relevant interconnector(s), or take into account settlement residue auction units contracted on the interconnector? The consultation paper appears to suggest that this will be possible, subject to capacity constraints.
- How will AEMO determine when to exercise the RERT function and the amount and type of capacity to be developed? How will the costs of that capacity be allocated (presumably to the relevant retailers who did not satisfy their responsibility to meet the reliability gap)?
- The consultation paper notes that contracted reliable generation cannot exceed an agreed emissions intensity level. The emissions intensity level is not yet specified. This may disadvantage the owners of existing “reliable”, but higher emissions intensity, generation capacity.
- Market participants will need to carefully consider their own specific positions in each of the NEM regions. It is currently unclear who will be the winners and losers from the introduction of the NEG.
- Participants will need to optimise their emissions obligations and reliability obligations under the NEG.
The ESB is seeking feedback from stakeholders on the high level design of the NEG mechanism. A stakeholder forum and webinar will be held on 26 February 2018 and submissions are due by 8 March 2018.
The ESB will then provide a draft high level design paper to energy ministers for consideration at the Council of Australian Government (COAG) Energy Council meeting in late April 2018. If the design paper is approved by the COAG Energy Council, instruments to implement the final designs will be released for consultation in the second half of 2018.
The reforms proposed by the NEG are significant and will have wide-ranging impacts. We encourage all interested stakeholders to make a submission to the ESB.
The contents of this publication, current at the date of publication set out above, are for reference purposes only. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on this publication.
© Herbert Smith Freehills 2019