The role of capacity mechanisms in managing the transition to renewables

As part of the post-2025 market design reforms that aim to develop a long-term, fit-for-purpose market framework to support reliability in the National Electricity Market (NEM), the Energy Security Board (ESB) has been tasked with progressing detailed design work on a mechanism that specifically values capacity in the NEM.  

Recently, the ESB released a High-Level Design Consultation Paper regarding a new capacity market, operating parallel to the NEM, whereby capacity providers would be paid to keep capacity available in case demand overtakes supply.  

As noted in our previous article, capacity mechanisms aim to ensure there is a sufficient energy mix to maintain reliability at lowest cost. This is in contrast to the current design of the NEM, whereby generators are only paid for the electricity they produce, not the energy they store or are able to generate. 

Why is a capacity mechanism needed?

The proposed capacity mechanism aims to address reliability concerns brought on by the anticipated transformation of the generation fleet.  As forecast by the Australian Energy Market Operator (AEMO) in its 2022 Integrated System Plan (ISP), all coal-fired generation is expected to cease by 2043, while electricity demand could double by 2050.  

The transition from ageing fossil fuel plants to clean energy resources needs to be carefully managed, as coal currently accounts for over half of the NEM’s generation output. As the majority of new investment in the coming decades will be in variable renewable energy (VRE) sources, including solar and wind generation, the risk is that the current market design will not be able to deliver resource adequacy and effectively respond to unexpected outages.  Accordingly, the new market must be complemented by dispatchable capacity providers that can generate electricity on demand. The consequence of not getting this energy transition right risks high prices and poor reliability outcomes for consumers.

The introduction of a capacity mechanism would also help address the tension between the risk appetite of governments and investors. The ESB notes that, while governments are increasingly investing to manage risk on behalf of consumers, investors face a number of risks, including the falling cost of new technologies, uncertainty around generator closure dates and demand uncertainty. A capacity mechanism would provide consistent market-based signals across the NEM jurisdictions to allow existing resources to exit the system at the end of their useful life and facilitate timely investment in a favourable mix of new capacity.  

Proposed high-level design

Eligibility

The ESB proposes that all capacity-contributing resources be eligible to participate in the capacity mechanism, as opposed to only new resources. Eligible resources would include thermal plants, batteries, hydro, pumped hydro, and demand-side resources. 

Some commentators have questioned whether the inclusion of existing generators such as coal would be more likely to delay investment in new, fast-start, dispatchable technologies, rather than accelerate them. The ESB has stated this is necessary to:

• increase efficiency in the mix of resources to ensure reliability;
  
  
• avoid over-building capacity before it is required; and
  
  
• ensure efficient coordination of entry and exit decisions of capacity resources. 

The ESB also voiced a preference that States and Territories retain the final say on which generators are eligible for payments in their jurisdictions. However, there is some concern  this could reduce the efficiency of the overall proposal.

The ESB has proposed minimum criteria for participation in the mechanism:

• capacity providers must pass a technical assessment performed by AEMO to confirm the amount of capacity they are eligible to offer in the capacity auction;
  
  
• providers must participate in the auction on a unit-by-unit basis; and
  
  
• the auction clearing process will incorporate network constraints.

Centralisation

The ESB proposes a centralised approach to forecasting and procurement of capacity needs on the basis that this approach is most likely to increase public confidence in the NEM, as well as ensure that sufficient capacity is available when demand overtakes supply. This process would be underpinned by AEMO procuring capacity from providers in competitive, sealed-bid auctions ahead of a delivery year. The core procurement auction will allocate capacity certificates for one delivery year at a time.  

Concerns have been expressed that a centralised scheme could be more likely to over-insure the NEM if AEMO takes a conservative approach to forecasting and procurement. To address this, the ESB is exploring potential hybrid models, where retailers take on some role in forecasting and procurement, as well as in initial capacity auctions. To this end, the ESB is considering the following methods of retailer participation:

• AEMO purchases all capacity certificates in the initial auction and retailers then purchase certificates from AEMO to meet projected requirements; or
  
  
• retailers participate in the capacity auction as buyers alongside AEMO. 

In line with most capacity markets in other jurisdictions, the ESB considers that AEMO should procure capacity as an annual product related to a specific delivery year. The ESB is considering the frequency and timing of auctions, and whether only one initial auction is to be held, or whether supplementary auctions need to occur closer to the delivery date. These considerations relate to the trade-off between the provision of forward investment certainty and the accuracy of capacity forecasts. 

De-rating methodology

Capacity has a physical and deliverability dimension which must be adjusted for weather and outage events. Most capacity mechanisms therefore define a capacity unit in terms of a resource being continuously able to provide 1 MW to meet demand during certain at-risk periods during the year. 

The ESB recognises de-rating – the process by which a capacity provider’s nameplate capacity is scaled down to the level of expected output during reliability compliance events – and the period over which it is de-rated as another essential element of the forecasting process. De-rating translates each MW of capacity into a single deterministic number for each resource, which enables the capacity across the system to be considered interchangeably. De-rated capacity is an input to AEMO’s reliability forecast and determines the maximum amount of capacity certificates that could be awarded to each capacity provider in an auction.

The alternative approach is to treat the capacity from each resource separately. However, this would create many challenges for the optimal technology mix, competition in procurement and differing capacity prices.

A key issue to be considered in the detailed design is the period over which technologies should be de-rated as this can have a material impact on different resources’ expected performance, and network congestion. 

The ESB is seeking feedback on the most appropriate approach to de-rating, whether that be a pre-defined de-rating period, a model based on the occurrence of reliability events, or a hybrid approach.

Capacity provider obligations

Capacity mechanisms can involve a change to the sources of revenue and incentives for capacity providers to perform when needed. As the ESB is proposing a mechanism with centralised forecasting and procurement, there will need to be obligations on successful capacity providers to ensure they deliver the benefits in the market they have been contracted to deliver. These obligations will prescribe what capacity providers must do on the day capacity is required. 

The ESB proposes the imposition of performance obligations on capacity providers to meet the requirements of their capacity certificates in order to receive associated capacity payments and be considered compliant. The ESB has focused on a model for performance obligation that is based on capacity provider availability all year round, with additional requirements to be available during actual lack of reserve events that may be triggered at any time. This model of availability during all periods of system stress throughout the year was preferred over performance obligations for only peak or pre-determined periods of the year. In the preferred model, the capacity payment can be awarded in two parts for availability throughout the delivery year and for being bid available during periods of system stress. 

The ESB recognises the introduction of a capacity mechanism may significantly impact the incentives that drive market decisions, and the scale of monitoring and compliance required to facilitate a culture of performance and compliance. Therefore, the proposed performance obligations require further stakeholder consultation regarding detailed design. Specific issues which need to be considered include the: 

• structure of performance incentives to ensure capacity providers are available during times of system stress;
  
  
• definition of availability during the year;
  
  
• methodology for defining system stress events; and
  
  
• interactions between performance obligations, capacity payments and existing market design. 

The ESB is also considering and seeking feedback on other compliance obligations concerning the role of retailers in procurement, and requirements for new entrant capacity in building assets or participating in capacity auctions.

Transmission capacity

The consultation paper primarily focuses on inter-regional transmission capacity, and recognises that transmission constraints limit the ability of capacity providers in one location to meet demand in another location. The ESB emphasises that a failure to appropriately reflect transmission system capacity in the design risks the capacity mechanism underestimating available capacity in a given location, which would lead to higher costs to consumers and reduced remuneration for providers. This would also lead to overestimation of available transmission transfer capacity during scarce periods. 

The ESB is considering two approaches to account for transmission constraints, through either:

• expected interconnector flows during periods of system stress informing the amount of capacity purchased in a single region, with no explicit participation in neighbouring region capacity actions; or
  
  
• capacity providers and market interconnectors participating in neighbouring region auctions. 

The ESB supports the second option in principle, but recognises the considerable complexity it adds to the overall design. The ESB is seeking feedback on the most appropriate approach to realising the benefits of an interconnected NEM in the capacity mechanism. The ESB is also considering the viability of including a transfer rights or transfer limits approach to ensure interstate capacity sales are aligned with interconnector capacity. 

Cost allocation

The ESB proposes to allocate the costs of capacity auctions, contract awards and capacity provider payments to consumers either through networks or retailers. The ESB considers that cost allocation through retailers using actual demand is the preferred and most transparent approach.

Next Steps

The ESB is seeking stakeholder submissions on its proposed high-level design and the issues raised in the paper.

A draft detailed design paper is forecast to be released in December 2022 with the aim of producing a final design and draft legislation to Ministers in February 2023. The draft detailed capacity mechanism design will be put to stakeholders for further consultation. The ESB aims to implement the capacity mechanism by 1 July 2025.