The National Energy Guarantee announced by the Federal Government has two obligations placed on electricity retailers:

One is to ensure each state has enough generating capacity to meet electricity demand (the “reliability guarantee”); and the other is that retailers procure a mix of power whose emissions are kept below a set target (the “emissions guarantee”).

Depending on who you talk to and how you chose to decipher the 8-page advice letter from the Energy Security Board, the reliability obligation may:

• not actually be invoked for the next ten years. If you ignore the creative writing in the executive summary and focus on the actual numbers within AEMO’s Statement of Opportunities you’ll see it indicates that after this summer no state is likely to exceed the reliability standard for the next ten years. And that’s before you add 2000MW from Snowy 2.0; or

• it could lead to a complete trashing of our current NEM energy-only market design and the start of a radically different market structure.

At present we have our suspicions it will end up being the former once it makes its way through the sticky mire of the AEMC rule change process.

But given it's likely the members of the Energy Security Board themselves probably aren't clear or disagree on how it might work, we'll confine our attention to the emissions obligation on electricity retailers. 

The NEG could be an effective mechanism to achieve emission reductions

Before outlining the key weaknesses with what is currently proposed we’d point out that the broad policy concept could work perfectly well to drive decarbonisation of our electricity supplies.

The policy at its core involves obligating electricity retailers to procure a blend of power with an emissions intensity that met an overarching emission target.

A retailer obligation is well proven concept that drives considerable abatement activity under the NSW Government and the Victorian Government’s energy efficiency schemes and the Renewable Energy Target.

It’s worth pointing out that in spite of the RET being subject to a cloud of perpetual political uncertainty and attack since its inception, it has underpinned billions of dollars in investment in new low emission power plants that have delivered large amounts of abatement.

There is no reason why the NEG couldn’t do the same and thereby help drive desperately needed investment in new power generation capacity that should help reduce power prices and reduce emissions.

However, there’s a few major problems with what’s currently proposed that must be addressed.

• The emissions target is inadequate

Green Energy Markets tracks the level of renewable energy power generation we can expect from projects that are operating, under construction and expected to be committed via long-term power procurement contracts.

When you estimate what this will produce then combine it with AEMO’s forecasts of future electricity demand and behind the meter solar you end up with a very interesting finding – we probably don’t need any new policy to achieve the Government’s stated emissions target for the NEG that emissions from the NEM be 26% lower than its 2005 levels by 2030.

However, the Government’s 26%-28% emissions reduction target is for the entire economy not just the National Electricity Market. So this leaves us with a question – what happens to the 75% of emissions left in the economy outside of the NEM?

The chart below uses the government’s own projections of the country’s overall emissions adjusted for the NEG emissions target. The dashed line represents where emissions need to be for the government to hit its economy-wide Paris 2030 target – 440m tonnes. 

Australia’s projected total emissions after NEM emissions reduced 26% below 2005 levels

Source: Australian Government 2016 Emission Projections with adjustments by Green Energy Markets to account for reduction in NEM electricity emissions to 26% below 2005 levels.

So, post the effect of the NEG the government is still left with an abatement gap of 132m tonnes to meet its target in the year 2030.

At present the government has just two credible policies slated for implementation that could deliver significant levels of abatement:

• a fuel economy/emissions standard for passenger motor vehicles which according to the government’s own modeling could at best deliver a 11.7m tonne reduction in 2030;

• the phase-out of high global warming potential refrigerant gases known as HFCs. If these were completely phased out by 2030 (actual phase-out date is 2036), it would deliver at most another 15.4m tonnes in 2030.

Beyond these initiatives, there is precious little meaningful abatement we can see coming from other government policies.

• The proposed mechanisms for managing and enforcing compliance are clumsy but can be fixed

At this stage the Energy Security Board is suggesting publicly the scheme will manage compliance through what appears to be an administratively clunky model.

This will involve the regulator reviewing each retailers’ individual contracts for the physical provision of power, instead of the regulator creating standardised compliance units linked to each generator’s emissions that can be readily traded independent of underlying electricity contracts.

This is clearly an effort to distinguish this scheme from the Renewable Energy Target and other forms of emissions trading schemes to gain acceptance from Liberal-National MPs who dislike these policy initiatives.

However, once the political heat surrounding this area subsides we would hope rationality will ultimately prevail.

The concept of what this “contract” might be could then be configured into something akin to an LGC or carbon credit that reduces the administrative burden and costs of compliance.

To illustrate the absurdity of the way the proposed model is being publicly described – where the AEMC’s John Pierce has suggested emissions must be traded with physical power – let’s imagine the situation of Tasmanian retailer Aurora.

Their customers are confined entirely to Tasmania and so their need for power is confined largely to Tasmanian generation composed almost entirely of hydro and wind with no emissions.

Aurora’s physical needs dictate power sources that will vastly overshoot what it might be required to achieve to deliver its share of the 26% reduction target.

The only way to transfer this overachievement in emissions is via a trade in emission credit entitlements that are completely separate from physical power flows.  If John Pierce’s statements are to be taken literally this will not be allowed to occur.

In addition, only allowing the regulator to enforce compliance through the dramatic step of withdrawing a retailer’s license is impractical.  Given this is such a blunt enforcement tool we can imagine the rules will allow the regulator considerable discretion on its application.

For example will the regulator withdraw Origin Energy’s license and transfer its millions of customers to other retailers (who will have no hedging contracts to cover this huge load) if Origin exceed their emissions obligation by just a single tonne of CO2? Presumably not, but what about an 11% exceedance or 15%, how much is too much?

This creates an undesirable situation where the regulator may be tempted to let non-compliance progressively slide amongst some of the larger retailers for fear that withdrawing their license could have adverse consequences for the electricity market as a whole.

Essentially, we might end up with some retailers deemed too big to fail, but then is the regulator also obliged to be equally lenient on smaller retailers? This ambiguity over how the regulator might enforce compliance adds a degree of uncertainty that heightens risk for all market participants and investors in new plant.

We suspect this blunt method of enforcement was selected because it was thought imposing financial penalties tied to how far a retailer exceeded their emission target would look too much like a carbon pricing scheme or the RET.

However, the Government’s own Emission Reduction Fund provides a far more practical way of dealing with non-compliance that avoids the explicit use of financial penalties –a make good provision.

Instead of applying penalties or withdrawing a retailer’s licence, the regulator would be required to procure sufficient low emission power to make up for a retailer’s emissions exceedance. The regulator would then be empowered to recover the costs incurred plus an administrative fee from the non-complying retailer.

Indeed this could also help overcome the problem we have at present where the entry of new, lower cost generation capacity is effectively controlled by the dominant incumbent gentailers.

For banks to finance construction of new projects they generally require a long-term power purchase agreement with what they define as a credit-worthy “investment grade” electricity retailer.

This has prevented most smaller, and more aggressively competitive retailers, as well as large electricity consumers from accessing power from new renewable energy projects that could provide power and emission reductions at vastly cheaper prices than what is available from short-term markets.

However, if they could explicitly delegate to the Regulator the role of procuring low emission power, then we circumvent this barrier to entry.  The regulator would then conduct procurement auctions on a regular basis on behalf of these retailers and large customers.

• Allowing the use of international carbon credits will undermine the NEGs effectiveness in facilitating investment in new power plants

Another key change required to support investment confidence is to drop international carbon credits from eligibility from the scheme. Allowing large scale use of CERs within any Australian emission reduction scheme is not dislike tying our currency with the Russian Ruble.

It opens up the possibility of completely destabilising the Australian emission reduction and electricity market by tying it to global fire hose that can overwhelm it with supply that is a function of decisions by an entity outside of Australian Government regulatory and parliamentary oversight and control.

To appreciate the fire-hose analogy consider that entire emissions quota for the NEG in 2030 is 132.8m tonnes of CO2. By comparison over the past 12 months 144m tonnes of Certified Emission Reduction carbon credit units were issued for which there is virtually no meaningful source of demand.

It is important to recognise that CERs are awarded with reference to a business as usual counterfactual that can be a highly subjective judgement call. And a judgement call that given its global scale can have dramatic consequences for credit supply relative to the size of the comparatively small Australian NEG.

One only needs to consider the huge quantities of CERs that were created through the destruction of HFC-23 to see the potential to rapidly corrupt the environmental integrity of any Australian scheme and destroy the basis for investment in new low emission power plants.

For those unaware of this case it involved Chinese chemical producers manufacturing the highly potent greenhouse gas of HFC 23 with the specific purpose of destroying it so they could earn CER revenue, rather than underlying fundamental demand for refrigerant gases in cooling equipment.

Once such mistakes are made it can be very difficult to unwind them and restore market integrity due to participants entering into binding commercial contracts predicated on use of these credits.

The Climate Change Authority recognised how the use of international carbon credits created the risk of dramatic and difficult to predict impacts on an Australian electricity investors. In its August 2016 report on Australia’s climate goals and policies it observed,

….opening the scheme (an emissions intensity scheme for the electricity sector) to international permits and credits means that the price signal to Australian investors is affected by a range of international factors that are inherently hard to forecast, such as global emissions reduction commitments and rates of technological development.

On balance, the Authority considers that closing the scheme to international permits and credits will improve certainty for investors in Australian low-emissions generation assets, and so improve the scheme’s cost effectiveness.

• Why should consumers pay extra to power plants built decades ago to do what they’ve always done?

The beauty of Finkel’s Clean Energy Target was that it tightly targeted any extra costs borne by consumers for abatement to new low emission projects (and for a limit of 15 years) or low emission generation that went beyond historical levels.

Australia’s Chief Scientist Alan Finkel. Photo: Mark Graham

By contrast the NEG framework as currently proposed is a free for all that makes no attempt to contain rewards to low emission generation that goes beyond business as usual.

If we were to ramp-up the emissions reduction ambition consumers would find themselves facing large hikes in the price for every unit of electricity from hydro generators built back in the 1970’s to do nothing new. That’s because they would receive the same financial reward under the NEG for their business as usual generation that would be provided to a brand new renewable energy plant.

Concluding message: A policy that doesn’t encourage additional power generation capacity won’t reduce our high power prices

One of the prime motivations for the introduction of the NEG is to address complaints from a variety of stakeholders that the current level of political uncertainty is inhibiting investment in new power supply. This lack of investment in new supply has meant that wholesale power prices have risen to extraordinary levels as old power plants have retired.

Yet given the proposed emission target and other weaknesses with the NEG design we’ve highlighted above, it will do very little to encourage investment in additional supply.

In addition, given how clearly inadequate the emissions target is, investors will expect the rules will have to change but will be left uncertain as to when and how.

These issues mean the scheme is also unlikely to deliver a material reduction in wholesale power prices.  This should represent a very compelling argument to electricity consumers and the government that the emissions target should be tightened, and the above suggested changes  to the NEG be implemented as well.

Ric Brazzale is the Managing Director and Tristan Edis is a Director with Green Energy Markets. Green Energy Markets assists clients make informed investment, trading and policy decisions in the areas of clean energy and carbon abatement. 

Follow on Twitter: @TristanEdis