Energy Brief: Are Two Energy Markets Better Than One?
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August 31, 2022
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With Australians experiencing higher-than-normal electricity prices, the design of our National Electricity Market (NEM) remains under intense scrutiny from consumers, policy makers and regulators. The NEM is a gross pool market, which means it’s primarily designed for the centralised dispatch of controllable generators. While the gross pool market has served the NEM well for many years, the commercial and practical realities of a system with more variable renewable generation is putting some strain on the market, and the incentives for new investment. This has been the subject of numerous reform initiatives, from five minute settlement to the firming framework being advanced by the Energy Ministers.
Back in 2017, the Oxford Institute of Energy Studies proposed a theory that, to deal with increased penetration of variable generation, two energy markets could be better than one. This brief will explore that idea further.
Separation of supply
In the NEM, generators are dispatched in real-time based on their bids and regardless of technology type. The NEM, like all efficient markets, seeks to set prices based on underlying costs, allowing generators to realise their long-run marginal costs (LRMC) over time. However, compared to traditional dispatchable generators – such as coal and gas generation – renewable generation has a strikingly different cost profile over time.
Similarly, the role of renewable generation and dispatchable generation in energy supply is very different, with:
- renewable generation providing a bulk generation method that will decarbonise the electricity network while also offering a low cost and a very low short-run marginal cost (SRMC).
- dispatchable generation (for example, gas, battery and hydro storage) providing flexible and stable generation that ensures reliability of supply.
With differences in costs, investment drivers, and the role of each generation source, The Decarbonised Electricity System of the Future: The ‘Two Market’ Approach (the Oxford report) contends that there may be merit in separating the market for both.
Separation of demand
In addition to differences in supply, consumers’ behaviour and preferences are also different. Some consumers may have more flexibility to respond to high price signals and maximise their use of lower-cost renewable power, while others may be willing to pay more to guarantee ongoing supply.
With Australians experiencing higher-than-normal electricity prices, the design of our National Electricity Market (NEM) remains under intense scrutiny from consumers, policy makers and regulators. The NEM is a gross pool market, which means it’s primarily designed for the centralised dispatch of controllable generators. While the gross pool market has served the NEM well for many years, the commercial and practical realities of a system with more variable renewable generation is putting some strain on the market, and the incentives for new investment. This has been the subject of numerous reform initiatives, from five minute settlement to the firming framework being advanced by the Energy Ministers.
Back in 2017, the Oxford Institute of Energy Studies proposed a theory that, to deal with increased penetration of variable generation, two energy markets could be better than one. This brief will explore that idea further.
Separation of supply
In the NEM, generators are dispatched in real time based on their bids and regardless of technology type. The NEM, like all efficient markets, seeks to set prices based on underlying costs, allowing generators to realise their long-run marginal costs (LRMC) over time. However, compared to traditional dispatchable generators – such as coal and gas generation – renewable generation has a strikingly different cost profile over time.
Similarly, the role of renewable generation and dispatchable generation in energy supply is very different, with:
- renewable generation providing a bulk generation method that will decarbonise the electricity network while also offering a low cost and a very low short-run marginal cost (SRMC)
- dispatchable generation (for example, gas, battery and hydro storage) providing flexible and stable generation that ensures the reliability of supply.
With differences in costs, investment drivers and the role of each generation source, The Decarbonised Electricity System of the Future: The ‘Two Market’ Approach1 (the Oxford report) contends that there may be merit in separating the market for both.
In the NEM, the value of lost load or market price cap (set at $15,000 per megawatt hour) represents electricity’s maximum economic value for all consumers. However, the maximum economic value of electricity is different for different consumers, so why should all consumers pay the same price?
Two supply markets
The Oxford report proposes a two-market solution that helps consumers better meet their own preferences, which in turn will create clear and efficient price signals for investment.
An ‘as-available’ market for variable generation would be cheaper for consumers and priced to represent the LRMC of variable generation.
- Pricing in the as-available market could be set by the market operator using a reference price based on the LRMC of variable generation. In practice, investment cases may require additional support, as generators in the as-available market would no longer receive volatile or higher wholesale prices. This could include, for example, an auction to determine an annual premium for these projects.
- Dispatch would allow as-available generation to preferentially feed into the network (with some allowances for network constraints and minimum operational demand).
An ‘on-demand’ market for dispatchable generation would act as residual to the as available market. However, the on-demand market could include a combination of generation and battery sources to help bolster supply.
- Pricing in the on-demand market would operate as it does in the current wholesale market – that is, using economic bidding for residual demand. A key principle of the two-market approach is that pricing in the on-demand market would not be distorted by lower-priced bidding from as-available generation. As a result, the demand for and the LRMC of dispatchable generation would be revealed over time.
- Dispatch would operate as it does in the current NEM merit order dispatch, but only include on-demand generation.
Figure 1: Two-market approach to energy flows
Source: The Oxford Institute for Energy Studies
Two supply markets
The two supply markets would be supported by a retail market (including metering and settlements) that reflects consumer demand across both markets separately.
Retailers would purchase ‘hedges’ or wholesale supply of as-available and on-demand electricity separately. It would also provide customers with tariffs that separate as available and on demand power, allowing them to make an informed choice about their electricity consumption and supply, and investment in their own distributed energy resources.
In practice, does two make perfect?
In short, probably not.
While there is some merit in the idea, there are many details to work through and, in practice, implementing two markets for both supply and demand would add further complication to an already complex energy market.
For the supply market, while the idea may provide a pathway to recognise that many as available generators currently participating in the market are responding to incentives other than the wholesale price signal, removing these generators from economic dispatch would have unintended consequences. This includes increasing the market power of critical dispatchable generators in each NEM region, which would increase costs to consumers. Further but related, it is unlikely that there would be sufficient liquidity in the as needed market to support a fully functional market given the limited number of players in this market for each region.
For the demand market, enabling consumers to value emissions reductions and reliability is appealing as this could be a circuit breaker to ongoing policy debate about the appropriate balance between these two objectives. However, again in practice this would be incredibly complex and it is unclear as to whether it would result in a net benefit.
Large consumers in the NEM already have the ability to make a decision on the value that they place on emissions reductions and reliability to an extent. Mass market consumers (that is residential and small businesses) do not have this ability because electricity supply in Australia is considered an essential service and electricity suppliers are required to meet high reliability standards.
However, the idea of asking mass market consumers to value reliability directly is problematic. Mass market consumers already have difficulty engaging in retail markets and choosing retail products that best suit their needs. Asking them to appropriate value reliability and balance this with emissions reductions would require a suite of consumer protections, which could undermine the very principles of what the two demand markets is trying to achieve.
Two markets is an idea and some elements of the framework are worthy of further consideration but it is a stretch to consider this as a solution to the NEM’s current woes.
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Published
August 31, 2022
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