The case for climate and electricity policy integration

Renewable capacity totals approximately 2,000 MW, around two thirds of peak demand. However, at times of peak demand, the system is often reliant upon an ageing fleet of gas-fired generators and a relatively small interconnector to the neighbouring Victorian region.

"Extreme volatility, which is required for an energy-only market with high penetration of renewables, is inconsistent with customer, investor and community expectations."
Dr Tim Nelson, Head of Economics, Policy and Sustainability, AGL & Adjunct Associate Professor, Griffith University

POLICY

In recent history, South Australia’s energy supply has been influenced by decisions intended to offset the effects of climate change.

Meanwhile, the National Electricity Market (NEM) was created in the 1990s as an ‘energy-only’ market. Electricity generators are paid for the energy they produce but not the capacity they make available.

Most of the time excess capacity in the market ensures prices reflect short-run marginal costs (e.g. the cost of buying coal and gas). But at times of peak demand, prices are permitted to increase significantly which allows generators to recover the heavy fixed costs associated with building the infrastructure.

When the NEM was created, there was little focus on reducing greenhouse gas emissions and almost no wind or solar generation in operation. At the turn of the century, everything began to change.

Concerns about climate change resulted in a number of policies introduced to incentivise investment in new renewable electricity generation capacity. The 20 per cent Renewable Energy Target (RET) and various state government Premium Feed-in Tariff (PFiT) policies resulted in relatively rapid investment in renewable generation.

But almost no attention was paid to the interaction of these climate change policy decisions with the ‘energy-only’ electricity market design.

The economic characteristics of solar photo-voltaic (PV) and wind are different to those of coal and gas-fired power stations. While solar PV and wind farms involve significant capital costs, they have very low short-run costs (the sun and wind are free!).

Coal and gas-fired power stations have higher short-run costs as they must purchase gas and coal to produce electricity. Therefore, existing solar PV and wind farms will generally always be more cost-effective than existing coal and gas-fired power stations - if the wind is blowing or the sun is shining.

But solar PV and wind generation are considered ‘non-firm’ or ‘intermittent’. In other words, if the sun isn’t shining and the wind isn’t blowing, available capacity doesn’t produce any energy. 

The Australian Energy Market Operator (AEMO) estimates only 10 per cent of wind capacity and 31 per cent of solar capacity in South Australia can be relied upon at times of peak summer electricity demand.

Therefore, there is a need for other ‘firm’ capacity to be available to meet demand when wind and solar PV aren’t available. But this capacity is only remunerated when it is needed via the energy it produces.

HOME OF RENEWABLE ENERGY

While the 20 per cent RET was a national policy, South Australia’s wind resource (regional South Australia can be a reliably windy place) meant most new wind generation was built in South Australia.

Around one in four households in South Australia has installed solar PV on their rooftops.  But the gradual substitution of coal and gas for wind and solar (and declining electricity consumption) has resulted in the closure of the Northern and Playford power stations. This has led to concerns about system security and the potential for extended periods of pricing volatility.

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INTRACTABLE INVESTMENT

Pricing volatility is effectively the economic means by which ‘energy-only’ markets provide enough revenue for an ‘optimal’ generation mix. Heavy fixed costs associated with building power stations are recovered at times of peak electricity demand.

With the introduction of very low short-run cost renewable generation via climate-related public policies such as the 20 per cent Renewable Energy Target, pricing volatility must become extreme to ensure capital costs of firm complementary thermal generation or battery storage technologies can be recovered.

This brings us to a critical point: extreme volatility, which is required for an energy-only market with high penetration of renewables, is inconsistent with customer, investor and community expectations.

A 2016 study found the NEM would require a market price cap of between $60,000 to $80,000 per MWh for revenue adequacy if the system was supplied by 100 per cent renewable energy – six times higher than today. Prices would need to be able to increase by a factor of around 1,500 in half-an-hour.

It is not clear why such an outcome would be desirable given the high fixed-cost nature of renewable energy. In simple terms, in the long-run it is hard to justify continued reliance upon an ‘energy-only’ market in an environment where the cost of energy is zero (i.e. sun, wind) but the comparative cost of developing capacity to produce the energy is high and fixed. 

Where to from here?

So where does all this leave South Australia and the broader NEM? It is imperative Australian policy makers integrate climate change and electricity policy.

The design of the NEM should be reviewed to ensure it is fit for purpose given the legitimate goals related to decarbonisation of Australia’s electricity supply.

Dr Tim Nelson is Head of Economics, Policy and Sustainability, AGL Energy and Adjunct Associate Professor at Griffith University