Looking beyond the NEG: Defining Australia’s future energy mix

By Matt Rennie, Ernst & Young

The South Australian blackouts in 2016 and 2017 enabled a conversation to take place that was long overdue in the Australian power market.

While policy and political vernacular already included the trilemma of affordability, sustainability and security, their relative importance to us as a society, and to both federal and state governments, was untested.

At the root of it, policy development is most efficient when reacting to a specific issue – the energy crisis exposed issues not only in the power system, but in the way we identify, plan, build, regulate and operate power assets in Australia, and how we allow new entrants into our system.

Two out of three – balancing the trilemma

There is nothing more politically complicated than balancing three inversely related limbs of a trilemma in a world defined by soundbites and 140 characters. Yet the NEG may have managed to do it.

When Prime Minister Malcolm Turnbull announced the government’s National Energy Guarantee (NEG) on October 17, he described it as a “game changer”, and perhaps it is. It strikes directly at the trilemma, with two new targets for energy retailers around reliability and emissions. Retailers will be obligated to source sufficient power to guarantee supply and to meet targets to lower greenhouse emissions by 26 per cent by 2030 (on 2005 levels), by buying or generating electricity with a set level of emissions intensity each year.

The former acts as a capacity mechanism of sorts – a market feature that provides more incentive for peaking plant to enter the system – while the latter ensures renewables remain a solid part of the decision tree at all times.

As well as aiming to ensure Australia is generating enough power to meet demand while meeting climate change commitments, the government has said the NEG will also bring down energy bills.

There is little doubt that Australian energy prices are too high – indeed Australia has experienced the highest spike in electricity prices in 10 years of any Organisation for Economic Co-operation and Development (OECD) country. The way the NEG seeks to remedy this is perhaps the most interesting part.

One of the interesting features of the energy crisis was that there were few cost reasons why wholesale prices were so high. Volatility in the market, legitimate but aggressive trading and hedging strategies, and the design of the National Electricity Market (NEM) pricing all played a significant part. These factors played a much more significant role than the increasing proportion of higher cost renewables in the system, despite the claims made by many.

The anticipated design of the NEG, which includes a pledge to remove the subsidies paid to renewables and to ensure agnosticism of generation type, brings the free market back into play.

Market players are now forced to do what they do best – evaluate alternative investment options based on future fuel prices, energy demand forecasts and the continued growth and development of the renewables market.

Lower prices are not guaranteed – the assumption would be that reduced policy volatility, removal of subsidies, the continuation of a reducing cost curve for renewables, and the continued drive for pension fund investment into the power sector globally, will see new capacity brought on at lower prices.

We have a slight concern the capacity mechanism inherent in the NEG may lead to over-capacity and an upwards pressure on delivered prices, and this will need to be managed during the design phase.

A continued focus on network costs will be important, but besides that, the logic seems sensible. The government-quoted reductions in wholesale electricity market prices could materialise due to increased competition driven by the NEG and if supply capacity is deployed at the right times.

An enduring role for red tape

For every free market option, there is a catch, and for utilities, much of the immediate impact from the NEG will be on process.

Australia’s energy generators will have to convince both the government and energy retailers they have the capacity in place to meet forecasted demand, and there will be long days in the back office when the system begins.

Energy retailers will perhaps face the most compliance costs as, like generators, they will be subject to more scrutiny and the need for more transparent processes. It is difficult to see how retailers will avoid the need to disclose portfolio data to regulators, for example, and this will be a significant issue to be overcome.

Three critical issues to overcome

The success of the NEG will require time to have complicated discussions about complicated issues, with three perhaps more prescient than others.

• Overcoming the domestic gas shortage: A future energy mix of renewables, hydro and gas is almost certain after the NEG, and we expect to see coal take a lesser role over time. The role of gas as a fast-start solution to the intermittency of renewables is a key plank in the NEG, but will require us to tackle domestic gas shortage. While recent commitments by Australia Pacific LNG and Santos to supply more gas to the domestic market are good news, more is needed. Discussions around lifting morotoriums around gas exploration and the Northern Territory to explore incentivising drilling into the state’s hard rock may be needed to avoid the slow drift upwards in electricity prices that will result from high priced scarce gas. While a complex intergenerational and emotional issue, there is an unexplored and undiscussed trade off between electricity prices and the supply of gas in Australia.

• Avoiding overcapacity: As noted above, the capacity guarantee in the NEG will incentivise generation to be built on the basis of the provision of capacity at peak times, with these costs being passed to customers. Balancing projected demand and supply is critical to getting the balance right and ensuring the NEG brings stability of supply as designed.

• Meeting technology challenges: It is time to bring the current discussions about what renewables can and can’t do into the mainstream, and to make clear that, at current technology levels there is a maximum amount of renewables that the NEM can support. Ireland is facing these challenges, and has limited the percentage of renewable energy allowed on the grid at one time to 60 per cent. While this represents a substantially higher penetration of renewables than in Australia at present, our National Electricity Market may also need to consider just how much renewable energy is feasible if we are to keep the supply stable given current technology of generators and the transmission grid.

Not fighting, finally talking

The success of the NEG also depends upon long-term bipartisan commitment once the policy is set, to ensure clear investment signals and allow the market to function as designed. If this can be achieved, this new policy has the potential to create lasting change.

We have the chance to think carefully through what our system needs both now and into the future and to make clear what we, as a society, expect from the trilemma. As the cost of renewables fall, they will play a bigger role, as will hydro, and designing the resilience of our system to handle this is critical. Australia is facing this scenario ahead of most other markets – we have few precedents to help guide the way but an opportunity to be pioneers.

For industry, the NEG opens up exciting possibilities for Australia’s energy future – one where decisions around the energy mix are based on economic, market-led forces. We see big opportunities for gas exploration, pipelines and power plants to support peaking supply.

For those companies solely in coal – now is the time to diversify into gas and renewables. The NEG offers an opportunity to revalue dispatchable capacity and for some to perhaps consider how to safely extend the life of coal-fired plants. The NEG’s potentially strong signals to the market will see investment in renewables extend far beyond the RET.

Our message to industry? Hold your nerve. The NEG will bring big changes, but they are positive. Start preparing now to make the most of the possibilities.