IMO Submission to Electricity Market Review Discussion Paper. Available for Public Review September 2014

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3 IMO Submission to Electricity Market Review Discussion Paper Available for Public Review September 2014

4 Executive Summary The Independent Market Operator (IMO) administers, operates and supports the evolution of the Wholesale Electricity Market (WEM) and Gas Services Information regime in Western Australia (WA). The IMO s primary purpose under both these regimes is to promote competition, transparency and accountability in the WA energy sector. These principles underpin the effectiveness and efficiency of competitive electricity markets, providing price signals for Market Participants and consumers to make optimal investment decisions, manage risks and minimise the long-term cost of energy to consumers. They are also fundamental tenets of the Wholesale Market Objectives, which have guided the evolution of the WEM and the IMO s operational role. Given its background, the IMO is well placed to comment on the key issues and questions raised in the Electricity Market Review (EMR). The IMO considers the EMR as an opportunity to address the root causes of the challenges and inefficiencies that exist in the WA energy industry, while addressing the structural deficiencies and policy gaps. The IMO understands that the EMR Discussion Paper has been designed to elicit comments, feedback and additional analyses to inform the government s decisions in relation to electricity market reform in WA. This submission provides the IMO s views on the reforms that affect the design, operation and administration of the WEM. The IMO has also taken the opportunity to provide further information with respect to some of the assumptions used to inform the reform options, particularly where the IMO has reached different conclusions than those presented. Encouraging competition The IMO supports the Discussion Paper s preference to resolve a number of challenges through increasing the level of competition (e.g. through the introduction of full retail contestability (FRC) and structural separation of Synergy). Encouraging competition is a fundamental tenet of the Wholesale Market Objectives and electricity markets elsewhere, with numerous studies quantifying the benefits of competition. Synergy s wholesale cost of energy The EMR has been driven by the government s need to reduce the large and growing subsidies to government-owned electricity utilities particularly the Tariff Adjustment Payment to Synergy which will total $495 million in The IMO agrees that ongoing subsidisation of Synergy is undesirable and inefficient. The Discussion Paper presents Synergy s cost of wholesale energy to residential customers at more than 18c/kWh. This is compared with an average cost of energy and capacity traded through the WEM of 12c/kWh. The Discussion Paper notes that Synergy s wholesale energy cost is the most significant driver of the growing government subsidy. This inefficient cost is, quite rightly, a key focus of the Discussion Paper. However, the IMO notes that little is Submission to Electricity Market Review Discussion Paper Page 2 of 121

5 provided in the way of supporting information to allow readers to understand the root causes of Synergy s high wholesale energy cost. The Discussion Paper states that this high cost is driven by contract prices and transfer prices across Synergy [that appear] unrelated to market outcomes (page 16) and postulates that Synergy has procured more energy than it required at prices exceeding market prices in the WEM. The Discussion Paper further suggests that the combination of Synergy s protected position in the retail market, its franchise customer base and its subsidy from government is likely to lead to inefficient management of Synergy s portfolio of generation and wholesale contracts, resulting in inflated costs. The IMO notes that generation investment and wholesale power contracts are typically, by their nature, long-term and are likely to continue to drive Synergy s cost of wholesale energy and the need for government subsidies for some time. Given these underlying drivers of Synergy s excessive cost of wholesale energy, which appear to be unrelated to market outcomes, the IMO considers it unlikely that structural and market reform alone would reduce Synergy s cost of wholesale energy to serve its residential customers and therefore reduce the government s subsidy burden. Having acknowledged that Synergy s high cost is a result of a combination of its contract portfolio and high generation costs (reflected in transfer prices), the IMO recommends that the EMR team carefully consider how Synergy s contracts and generation portfolio will be treated in the future particularly if Synergy is structurally separated or FRC is introduced as these will impede Synergy s ability to compete. Wholesale electricity costs in the WEM The Discussion Paper includes a number of price comparisons between Synergy s cost of wholesale energy to residential customers, WEM electricity costs and electricity costs in the National Energy Market (NEM). However, it does not include the necessary contextual information about the different characteristics of the prices and markets to allow any meaningful conclusions. For example: Wholesale market prices are set by the marginal generator, which is predominantly brown coal-fired generation in the NEM. By contrast, the marginal generator in the WEM is typically gas-fired, with higher short run marginal costs. The South West interconnected system (SWIS) faces significantly higher risks to system reliability than other markets, resulting from the volatility of demand in the SWIS, the relatively small size of the system and the lack of interconnection with neighbouring markets. As the Discussion Paper acknowledges (page 47), this has led to the WEM having a more stringent reliability standard than the NEM, which has significant implications for the cost of electricity. The IMO notes that the EMR Steering Committee, at the stakeholder workshop on 21 August 2014, highlighted the National Electricity Market of Singapore, amongst others (New Zealand and Texas), as a more appropriate comparative market to the WEM. Singapore has an energy-only market that is small, isolated (no material Submission to Electricity Market Review Discussion Paper Page 3 of 121

6 interconnection) and where the marginal generator is typically gas-fired. The average wholesale price in Singapore in 2013 was S$178/MWh (A$147/MWh), which is considerably higher than the WEM average of A$120/MWh (12c/kWh). The Discussion Paper has provided price comparisons based primarily on historic prices, even though there may be material future cost savings that are likely to be factored into WEM outcomes. These include a Reserve Capacity cost reduction of approximately $18/MWh in and a further $6/MWh in ($24/MWh in total) due to changes in the methodology used to calculate the Maximum Reserve Capacity Price (MRCP) and the retirement of the Kwinana C generation units. This capacity cost reduction combined with an average energy cost of 6c/kWh ($60/MWh, consistent with the average Balancing Price in ) would reduce the average cost of energy and capacity to below 10c/kWh by Excess capacity costs The Reserve Capacity Mechanism (RCM) has provided an investment regime that has encouraged significant growth in capacity, seeing the WEM transition from a capacity shortfall position in 2006 to a position of excess capacity today. However, it must be noted that the RCM was not the primary driver for the majority of the new investment, with more significant drivers including commitments made either before or around the time that the WEM commenced, renewable energy policies and government policy decisions. The fact that numerous markets with varying market design, including the energy-only NEM, are currently experiencing similar levels of excess capacity provides further evidence that the design of the WEM is unlikely to be a key contributor to the excess capacity situation. Recent forecasts suggest that the NEM does not require new generation investment in any of its regions for at least ten years, and by more than 4,500 MW of generation capacity could still be withdrawn from the NEM without affecting supply adequacy 1. The IMO notes the significant commentary on the additional cost imposed on consumers and taxpayers as a result of excess capacity. The IMO acknowledges that excess capacity has had a financial impact on the market, but considers that the Discussion Paper materially over-estimates this impact the IMO estimates the annual cost of excess capacity to the WEM in to be $45 million (one third of which would be allocated to Synergy s residential customers). Over the past two years the IMO has been working with Market Participants and other stakeholders on reforms to improve the RCM, in particular improving the Reserve Capacity Price (RCP) methodology to ensure it is more responsive to undersupply and oversupply conditions. The IMO recommends that considerably more analysis of the drivers of excess capacity be undertaken, including the extent to which previous investment and contracting decisions are likely to have been driven by expectations of higher electricity demand, before the EMR draws conclusions or makes recommendations. The IMO considers that, in particular, the exposure of Synergy s residential customers to high wholesale energy costs is likely to be driven by a number of other factors, including: 1 Media Release, No New Power Generation Needed for next 10 Years, Australian Energy Market Operator, 8 August 2014, available at accessed 18 September Submission to Electricity Market Review Discussion Paper Page 4 of 121

7 1. the significant increase in Western Power s transmission connection cost estimates which increased the RCP in and but roll off in October 2014; 2. Synergy buying more energy (and possibly capacity) from Verve Energy than required as a result of the Replacement Vesting Contract, which has now fallen away with the merger of Synergy and Verve Energy (although the financial impact has not); 3. the disproportionate exposure of Synergy s non-contestable residential customers to capacity costs contestable customers have responded to peak-related price signals incorporated in competitive tariffs while non-contestable residential customers receive no such price signal and now bear a greater share of the cost; and 4. a possible cross-subsidy of Synergy s contestable customers by its residential customers to make Synergy s competitive offerings comparable with those of private retailers. The IMO cautions that attributing the cause of Synergy s high cost of wholesale energy to excess capacity would seem too simplistic and, by overlooking root causes of the problem, likely to lead to incorrect conclusions and ineffective reform recommendations. Allocation of risks between generators and customers The existence of the RCM moderates the risks for both generators and customers in the WEM. This was by design, as an energy-only market particularly in a small, isolated and weather-sensitive electricity market can deliver very punitive outcomes to Market Participants and/or consumers. The Discussion Paper has not considered the impact of under-investment in capacity on risk allocation between generators and customers. This must be explored before any conclusions are drawn and recommendations made. While the RCM was designed to moderate the risks for both generators and customers in the WEM, it should be noted that a much greater influence on the allocation of market risk between Synergy and the independent power producers has been the terms and conditions of bilateral contracts. Anecdotal evidence suggests Synergy may have taken on a disproportionate level of market risk from its counterparties, through long-term contracts that are likely to continue to drive Synergy s cost of wholesale energy and the need for government subsidies for some time. The IMO therefore cautions that it is unlikely that modifications to the WEM design would materially reduce Synergy s exposure to market risk in the short to medium term. It should also be noted that Synergy s current dominant market share would subdue any interest in the development of a financial hedge market. Even when similar dominant market positions were resolved in Singapore and New Zealand (the EMR s benchmark markets), neither was easily able to establish a liquid financial hedge market. Over time, New Zealand has been successful in developing financial hedge trading, with the New Zealand Electricity Authority (NZEA) encouraging market-making from the six largest gentailers. The IMO notes Submission to Electricity Market Review Discussion Paper Page 5 of 121

8 that the NZEA s encouragement largely consists of the threat of mandatory regulation as a means for promoting voluntary market-making 2. Industry structure and regulation: common reform options The IMO supports many of the reforms considered in the Discussion Paper on the basis that they have the potential to provide material improvements in economic efficiency, encourage private sector investment and deliver significant long-term economic benefits to WA. In particular, the IMO encourages further development of the following reform options: The structural separation of Synergy would reduce the current dominance of Synergy, which remains a barrier to: o effective competition in the WEM, requiring material regulatory measures to mitigate its market power that are a suboptimal alternative to competition; and o new entrants, investors and financiers. The introduction of FRC would lead to improved economic efficiency through: o competition between retailers to deliver lower priced electricity to consumers; and o the introduction of tariffs that reflect the underlying costs of service so that consumers are able to respond appropriately to electricity price signals. The transition to a constrained network access model the assumption that the SWIS is unconstrained is no longer valid. The introduction of a constrained network access model would reduce long-term capital expenditure and significantly improve equity between incumbent and new entrants to the WEM. Without the adoption of a constrained network access model and a market redesign to support this change, the WEM s price-based dispatch prioritisation will increasingly be overridden based on the quality of network contracts, resulting in inefficient outcomes. The introduction of a gas supply hub would establish a transparent and consolidated domestic wholesale gas market, which the IMO considers is the logical next step in the development of the domestic gas sector in WA. Reliability standard The IMO supports informed debate on the appropriate reliability standard for setting the quantity of capacity required in the market. The IMO notes that the current WEM reliability standard (based on a reserve margin above the one-in-10-year peak demand forecast) requires more than 700 MW of additional capacity compared with the NEM reliability standard (which limits unserved energy to 0.002% of annual demand). Provided the community s expectations for reliability continued to be met or managed, a lowering of the reliability standard has the potential to materially reduce the long-term cost of electricity and improve economic efficiency. The IMO notes that a lower reliability standard, coupled with a more responsive RCP methodology, would significantly lower capacity costs. 2 The letter sent to the six largest gentailers, dated 5 June 2014 (available at accessed 19 September 2014) states that the NZEA is starting work on the mandatory approach now to minimise lost time if voluntary measures prove unsuccessful. Submission to Electricity Market Review Discussion Paper Page 6 of 121

9 The IMO recommends caution when considering lowering the reliability standard. Given the reliability risks faced by the SWIS, the adoption of the NEM reliability standard would run the risk of load shedding occurring at system peak, on the hottest summer afternoon. This may be regarded as an undesirable policy outcome. The reliability standard is a key policy setting for WA that materially influences the cost and reliability of electricity for consumers. The WEM reliability standard is currently contained in the Market Rules and is subject to a consultative five-yearly review by the IMO. The IMO considers that such an important policy setting is well beyond the scope of a market operator, and considers there may be merit in the suggestion in the Discussion Paper to establish a Reliability Panel with oversight of reliability standards in the WEM. Option One: Amend the current market mechanism The IMO considers that there are significant opportunities to evolve the current WEM design to deliver benefits for consumers. In particular, the IMO considers that changes to the RCM are required. Potential changes to the RCM In 2011, the IMO commenced investigations into improving the responsiveness of the RCP to market conditions. A range of capacity mechanism designs were considered, including a capacity auction. The IMO acknowledges that capacity auctions offer the appeal of allowing a competitive market to set the price; however, advice received indicated that other electricity markets with capacity auctions had difficulty with designing an effective auction mechanism. Capacity auctions have required a number of administrative measures to mitigate risks related to price volatility and the exercise of market power, needing judgement to be exercised in setting key design parameters not dissimilar to the judgement required in the current administered RCP formula. These judgements must consider the trade-offs between accuracy and investor certainty, and between cost and reliability. Capacity auctions have typically worked better in larger, more competitively structured markets. The current dominance of Synergy represents a significant impediment to the introduction of a capacity auction. Any material changes to the RCM, in particular the introduction of an auction, would likely result in a large value shift between some Market Participants. The IMO suggests that considerable care would be required to manage such a transition. Consequently, it is uncertain whether an auction-based RCM would deliver sufficient benefits to outweigh the risks it would introduce. Rather than immediately changing to an auction-based RCM, the IMO strongly recommends proposed improvements to the administered RCP formula, at least as an initial step, to increase its responsiveness to market conditions and improve incentives in relation to bilateral contracting. A decision to move toward an auction-based RCM could then be more fully considered as part of a longer-term road map. Improvements to the administered RCP formula could be implemented relatively swiftly under the current industry structure (prior to structural separation of Synergy) and would Submission to Electricity Market Review Discussion Paper Page 7 of 121

10 avoid the significant risks and transitional costs of immediately moving to an auction-based RCM while achieving similar outcomes. Making the WEM more efficient The IMO supports the recommendations to: introduce facility-based bidding for all Market Participants; reduce gate closure for the Balancing and Load Following Service (LFAS) markets; introduce co-optimisation of energy and Ancillary Services, which could include competitive markets for Spinning Reserve and Load Rejection Reserve Services; and review the risk-management tools for Market Participants, including the STEM. The IMO considers that these changes are broadly consistent with its Market Rules Evolution Plan 3. The IMO notes that there would be significant benefit in a coordinated implementation of these changes with a constrained network access model. Market governance The Discussion Paper notes that the current structure under which the IMO is both the rule administrator and market operator results in a perceived conflict of interest. This shared responsibility is consistent with the governance structure recommended by the Council of Australian Governments 2002 Parer Review and exists in numerous other electricity markets, reflecting the economies of scope between the functions. The IMO considers there are a number of checks and balances in place to ensure the IMO s activities and decision making functions are performed in a manner which is independent and consistent with the Wholesale Market Objectives. The IMO considers that the delegation of the rule administration function to either the Public Utilities Office (PUO) or Economic Regulation Authority (ERA) would result in other more substantial conflicts with their policy and oversight roles, including the PUO s responsibilities for advising the shareholding Minister in relation to the government-owned electricity companies. The IMO also notes that it has developed considerable experience and expertise in administering the rule change process for the last eight years. If the EMR team or government remains concerned about any potential conflict of interest, the IMO suggests instead that another body such as a Rule Change Panel could be established to approve rule changes. This panel could comprise the Deputy Director General of the PUO, the Chair of the ERA and the Chair of the IMO. Option Two: Adoption of the NEM energy-only market For some time there has been an ideological debate among electricity market commentators and academics regarding the relative merits of electricity market designs that trade capacity and energy as opposed to markets that trade only energy. Each market design relies on very different price signals for ensuring there is sufficient installed capacity to meet maximum system demand. 3 Available at accessed 12 September Submission to Electricity Market Review Discussion Paper Page 8 of 121

11 Energy-only markets rely on a high energy prices or price spikes to induce sufficient capacity. Energy and capacity markets rely on capacity requirements, a reliable income stream and associated incentives/penalties to induce sufficient capacity. In theory, an energy-only market provides an optimal level of capacity investment up to the level of reliability for which Market Participants or consumers are prepared to pay. While this may be theoretically appealing, particularly at a time when the WEM has excess capacity, energy-only markets are untenable if policy makers and governments are not able to tolerate potential public backlash in response to significant price spikes or the rolling blackouts associated with load-shed events. 4 Energy-only markets also require high levels of competition in both the wholesale and retail markets to protect against the abuse of market power. Energy-only markets rely on the risk of sustained high energy prices to signal the need for investment in new capacity. However, this requires a relatively reliable and stable peak demand profile for the price signal to endure long enough and be punitive enough to prompt new investment. WA is characterised by very infrequent and extreme weather events that increase peak demand considerably. Given this peak load profile, an extremely high energy price cap would be required for an energy-only market to be successful in WA. If a sufficiently high energy price cap was not adopted, Market Participants may view extreme weather events as unlikely to be commercially viable to service. The IMO considers that a liquid hedge market would be necessary to allow Market Participants to mitigate the increased price volatility in an energy-only market. As discussed above, developing a liquid hedge market has proven difficult in small energy-only markets. The IMO notes that the EMR does not consider the establishment of a stand-alone, energy-only market in the WEM. The IMO agrees that, if it was decided to move to an energy-only market, it would be more efficient for WA to join the NEM as an unconnected region, rather than to design a bespoke energy-only market requiring its own governance and institutions. The IMO advises that any decision to transition to the NEM should only be made after careful consideration of the potential impact and risks to system security, reliability of supply and market outcomes associated with an energy-only market. Lastly, it should be noted that the NEM, like the WEM, is facing significant challenges and uncertainty as it continues to evolve. Challenges faced by the NEM include falling demand, the continuing growth in embedded generation, the desire to improve demand side participation and the management of network congestion. 4 Capacity Markets Lessons Learned from the First Decade, Spees, Newell and Pfeifenberger, published by the International Association of Energy Economics in Economics of Energy and Environmental Policy, Volume 2, Issue 2, September Submission to Electricity Market Review Discussion Paper Page 9 of 121

12 Conclusion The EMR has highlighted a number of reform options that have the potential to deliver benefits to WA electricity consumers. However, some of these options may expose WA Market Participants and electricity consumers to significantly heightened risks. With careful consideration of the recommendations and effective implementation, WA should have a clear, long-term evolutionary road map for the energy sector that provides increased certainty for all stakeholders. The IMO will continue to work with the EMR team to assist further with analysis and the appropriate consideration of reform options. The IMO looks forward to the opportunity to assist the EMR team and government to implement the reforms adopted by the government. Submission to Electricity Market Review Discussion Paper Page 10 of 121

13 Table of Contents Executive Summary... 2 Table of Contents Market evolution since commencement of the WEM The IMO s role in evolution of the WEM Energy market reform Reserve Capacity Mechanism performance and proposed reforms MRCP review Demand forecasting review Reserve Capacity Mechanism Working Group (RCMWG) High-level comments on analysis and conclusions in the Discussion Paper Subsidisation of Synergy is undesirable, but projections not transparent Allocation of risks between generators and customers Synergy s high cost to serve reflects a problem of contracts and transfer pricing Unprecedented shifts in market expectations Benchmarking of costs against the NEM may be unrealistic Cost of excess capacity is over-estimated and its causes have not been analysed How much excess capacity do we have? Drivers for development of excess capacity in the WEM Financial impact of excess capacity Key policy issues not covered by the Discussion Paper Reliability standard Tariff structures Reference material not made available Consideration of reform options in Discussion Paper Industry structure and regulation: Common reform options Structural separation of Synergy Full retail contestability Constrained network access model Development of a gas supply hub in WA Merits and risks of energy-only and energy-plus-capacity market designs Market design options in the specific context of the WEM WEM reforms recommended by the IMO Move from administratively-derived capacity price to an auction mechanism Energy market improvements Institutional arrangements IMO s responses to the Discussion Questions Market structure Retail markets Wholesale Electricity Market Networks Submission to Electricity Market Review Discussion Paper Page 11 of 121

14 4.5. Fuel Institutional arrangements Summary Appendix A. About the IMO and this submission Appendix B. Comments on data and analysis in the EMR Discussion Paper Appendix C. Case Study Ability of extreme weather events to drive new investment in New Zealand Appendix D. Analysis of market price cap in energy-only market (ROAM Consulting) Submission to Electricity Market Review Discussion Paper Page 12 of 121

15 1. Market evolution since commencement of the WEM This chapter describes the significant evolutionary steps that have been taken since the commencement of the Wholesale Electricity Market (WEM) in This chapter is intended to supplement the historical information in Chapter 2 of the Electricity Market Review (EMR) Discussion Paper published on 13 August 2014 (Discussion Paper), which focused on changes to the industry structure but did not include information on the evolution of the WEM. The IMO considers that this information is valuable for the development of reform options and has drawn on this history in responding to the key issues highlighted in the Discussion Paper. Key points The introduction of the competitive Balancing Market in 2012, along with the competitive Load Following Service (LFAS) Market, was the first major reform to the WEM energy market since its commencement. The competitive Balancing Market is a gross dispatch pool, which determines the physical dispatch of Synergy and independent power producer (IPP) generators all available generators are required to offer their generation to meet demand in each Trading Interval. The competitive Balancing Market was found to have delivered benefits of $14.6 million in its first year of operation. The Reserve Capacity Mechanism (RCM) has provided an investment regime that has encouraged significant growth in capacity. However, it must be noted that the RCM was not the primary driver for the majority of the new investment more significant drivers include commitments and procurement decisions made either before or around the time that the WEM commenced (e.g. Western Power procurement and the Displacement Mechanism), renewable energy policies and government policy decisions (e.g. Muja AB). The WEM has transitioned from a capacity shortfall position in 2006 to a position of excess capacity today. This growth in capacity has ensured that growing energy needs were met during a period of sustained economic growth and has increased competition in the STEM and Balancing Market. More recently, the entry of new capacity has slowed considerably, with no material entry of new capacity for the last three capacity cycles. This slowing has been influenced by: o lower demand forecasts, influenced by refinements to block load forecasting in the last three years; and o the imminent reduction in capacity prices as a result of the Maximum Reserve Capacity Price (MRCP) review. A major review of the RCM was initiated by the IMO Board in September 2010 and continued by the RCM Working Group (RCMWG). The review identified that the current Reserve Capacity Price (RCP) formula does not respond sufficiently to market conditions and creates asymmetrical incentives in relation to bilateral contracting. The review recommended: o an improvement to the RCP formula to address issues with the current RCM design; o a dynamic Reserve Capacity refund regime to align incentives with system conditions; and o harmonisation of the treatment of demand-side and supply-side capacity providers. Significant reforms to the wholesale market require a considerable amount of time in the development of the market design, Wholesale Electricity Market Rules (Market Rules) and IT systems. Based on the IMO s experience, Market Participants must be allowed sufficient time to contribute to the design process, to adapt and test their own systems and to adjust contractual arrangements to ensure reforms gain the most efficient outcomes. Submission to Electricity Market Review Discussion Paper Page 13 of 121

16 1.1. The IMO s role in evolution of the WEM The IMO is responsible for developing amendments to, and replacements of, the Market Rules 5. The IMO also convenes the Market Advisory Committee (MAC), which advises the IMO in development of the WEM. These roles provide the IMO with unique insight into the design, operations and evolution of the electricity market in Western Australia (WA). Through these roles, the IMO works with Market Participants and other stakeholders to identify, develop and implement plans for the development and evolution of the WEM and the Market Rules. The IMO develops a Market Rules Evolution Plan (MREP) 6 every three years to identify and prioritise areas of the WEM which require review and further development. This plan draws on issues identified in consultation with industry stakeholders and is then prioritised by the MAC. The MREP guides the IMO s market development activities and informs the IMO s Allowable Revenue submission for the three-year period. The second MREP in 2009 identified the need to introduce greater competition in the energy market and review various aspects of the RCM. This resulted in significant work programmes in the following years, including the Market Evolution Program (MEP) and the RCMWG, which are described in sections 1.2 and respectively Energy market reform The Discussion Paper notes that Verve Energy was originally required to be the default provider of Balancing and Ancillary Services in the WEM. These arrangements required Verve Energy facilities to be dispatched to account for the differences between Market Participants Resource Plans (which account for bilateral contracts, self-supply and STEM trades) and actual system demand in real time. With Verve Energy providing 89 per cent of capacity at market commencement, this arrangement provided simplicity in the initial market design. However, as noted in the Discussion Paper, this was intended to be a transitional arrangement. By the end of 2009, Verve Energy s share of capacity had fallen to just above 60 per cent. A desire for greater competition, particularly the establishment of a competitive Balancing Market, was expressed by Market Participants in the development of the 2009 MREP. The Verve Energy Review commissioned by government to assess why Verve Energy was in a loss-making position critiqued the market similarly, highlighting the lack of competition in aspects of the WEM. In particular, the Verve Energy Review identified that responsibility for providing Balancing services had become increasingly challenging for Verve Energy as its market share had declined materially with the entry of IPPs into the market. The establishment of a competitive Balancing Market formed a central part of the MEP, which also included the establishment of a competitive market for LFAS. 5 Clause 2.1.2(i) of the Market Rules. 6 Available at accessed 12 September Submission to Electricity Market Review Discussion Paper Page 14 of 121

17 As Figure 1.1 below shows, the development of the MEP took place over a number of years. It commenced with the MREP in 2009 and included the establishment of the Rules Development and Implementation Working Group to develop the design of the new markets and the requisite amendments to the Market Rules. Following an extended period of market trials, the new markets went live in July 2012 and then became fully operational in December Figure 1.1: Timeline for developing the Market Evolution Program Market Evolution Plan established June 2009 MEP Design Process 2010 Work plan approved for Market Rules Evolution Plan Oct 2009 Amended Rules Approved by Minister for Energy 23 March 2012 Amended Rules and Regulations commenced 1 July 2012 Sapere s 2 nd report shows benefits estimated at $14.6m Oct Verve Energy/ Oates Review Completed Aug 2009 Trading System to Market Trial Dec 2011 Trading System to Production April 2012 Trading System Go Live on 1 July 2012 MEP Transition Completed on 5 Dec 2012 The MEP demonstrates that for significant reforms to the wholesale market to be successful, a considerable amount of time is required for development of the market design, Market Rules and IT systems. Market Participants must also be allowed time to contribute to the design process, to adapt and test their own systems and potentially to adjust contractual arrangements. There appears to be some confusion in the Discussion Paper about the nature and role of the Balancing Market. Contrary to the assertion on page 16 of the Discussion Paper, it is not the case that the Balancing Market s purpose is to account for the differences between Market Participants Resource Plans and actual outcomes. Since July 2012, Resource Plans no longer guide the physical dispatch of generation. The current Balancing Market is a gross energy pool which determines the physical dispatch of all Synergy and IPP generators. All generators are required to bid their available capacity into the market in near real-time. Synergy offers its capacity on a portfolio basis, meaning that it must determine an appropriate, economically efficient merit order within its portfolio. The IMO compiles a Balancing Merit Order (BMO) for each half hourly Trading Interval, stacking bids from the lowest price to the highest price. Then, on the basis of the BMO, 7 The full implementation at the end of the July-November 2012 transition period reduced gate closure from six hours to two hours and provided expanded submission flexibility for Market Participants. Submission to Electricity Market Review Discussion Paper Page 15 of 121

18 System Management dispatches facilities (and the Synergy portfolio) to meet the system load in real time (i.e. dispatches the cheapest generation first). This aims to minimise the cost of energy to customers in the SWIS by enabling the lowest-cost generation to be dispatched in every Trading Interval. There also appears to be some confusion about the distinction between a gross pool and a net pool. In terms of the dispatch of energy, a gross pool is one where all energy is bid into and dispatched by the market and priced at the market price. The National Electricity Market (NEM) and the WEM Balancing Market are both examples of gross pools. By contrast, a net pool is one in which generators are only required to bid in energy that has not already been traded under bilateral arrangements. Price caps can be a feature of both gross pools and net pools. While the Balancing Market is a gross dispatch pool, the IMO performs a net settlement in the WEM. Quantities that are covered by hedging tools bilateral contracts and STEM trades are netted off from the gross quantities in the Balancing Market. The principal advantage of the net settlement model is the materially lower level of prudential support that Market Participants must provide to the IMO (due to the lower amount of money cleared through the IMO). The implementation of the Balancing Market on 1 July 2012 coincided with the introduction of the carbon price. Because the Balancing Market provided a means for ensuring the lowest cost dispatch in every Trading Interval, the WEM did not experience a significant increase in prices to reflect carbon costs. Whereas the introduction of the carbon price was estimated to have increased NEM spot prices by $17.70/MWh in the mainland states and $10/MWh in Tasmania 8, the Balancing Price in the WEM only increased by $2.66/MWh from to The IMO engaged the Sapere Research Group (Sapere) to assess the costs and benefits of the MEP prior to its implementation. When Sapere revisited the benefits after 12 months of operation, it found benefits of $14.6 million for the period, up from the estimate of $9.6 million that had been determined prior to implementation 10. The highest priority issues identified in the current MREP 11, covering the period, are aimed at further improvements to the energy market and the extension of competition in the provision of Ancillary Services. The specific items listed in the plan are: improvements to the energy market, including: o reducing Balancing and LFAS gate closures to enable bids to be updated closer to the Trading Interval; o introducing facility-based bidding and dispatch for all Market Participants; and 8 Australian Energy Regulator, State of the Energy Market 2013, page 8, available at accessed 12 September The load-weighted average Balancing Price in (then known as the Marginal Cost Administered Price) was $50.93/MWh. The load-weighted average Balancing Price in was $53.59/MWh. These averages have been calculated from publically available data that can be downloaded from and both accessed 12 September For more information, see the presentations dated 9 October 2013 available at accessed 12 September Available at which should be read with the discussions of the MAC at the October 2013 meeting both accessed 12 September Submission to Electricity Market Review Discussion Paper Page 16 of 121

19 o a range of possible amendments to the STEM, ranging from removing the requirement to submit Resource Plans through to a complete re-design of the STEM to make it more fit for its current purpose, which is now to provide a day-ahead opportunity to manage exposure to Balancing Prices; and the introduction of a market for Spinning Reserve. Prior to the commencement of the EMR, the IMO, in consultation with the MAC, undertook some initial scoping of the improvements to the energy market outlined in the current MREP. However, these market developments have been deferred to enable Market Participants to focus on the EMR. The IMO welcomes the consideration of the above energy market improvements in section 5.2 of the Discussion Paper. In relation to the potential for reform of the STEM, the IMO notes that the introduction of the Balancing Market on 1 July 2012 has redefined the role of the STEM. Whereas the STEM previously determined dispatch outcomes, it now functions much like a day-ahead hedge market for Market Participants to trade around their Net Contract Positions. This change in function has led to Market Participants expressing mixed views as to the usefulness of the STEM in its current form. The IMO welcomes discussion with Market Participants on the value of the current STEM and whether this value would increase if it were reconfigured. The IMO s views on potential energy market improvements are further discussed in section of this submission Reserve Capacity Mechanism performance and proposed reforms The implementation of the WEM occurred against the backdrop of the 2004 blackouts in WA. Capacity inadequacy was identified at that time as a key cause of the load shedding that occurred. At the time that the WEM commenced operation in 2006, the SWIS had a capacity shortage of approximately 200 to 300 MW (based on the reliability standard that was implemented in the initial Market Rules). Even in the summer, continuing growth of peak demand and delays in the commissioning of new generation required Supplementary Reserve Capacity to be contracted to ensure capacity adequacy. However, as a result of a range of measures (see Table 2.3 on page 42), some of which were initiated prior to the WEM s commencement, capacity in the SWIS has grown by more than 70 per cent, from 3,531 MW in to 6,087 MW in Much of this investment was made at a time when it was widely expected that the trend of strong growth in electricity demand would continue, as is discussed in section 2.4 below. This growth in capacity reversed the earlier capacity shortfall and ensured that WA was able to cope with growing energy needs during a period of sustained economic and population growth. While the RCM may not have been the primary driver for the majority of this new investment, it provided a stable regime that accommodated the addition of new capacity when it was required. It is also important to note that the growth of capacity, particularly base load capacity in the early years of the WEM, significantly increased the level of competition in the STEM and the Submission to Electricity Market Review Discussion Paper Page 17 of 121

20 Balancing Market. This is reflected in Figure 3 of the Discussion Paper, which shows that STEM prices reached their lowest point in 2010 following the completion of the Bluewaters and NewGen Kwinana facilities. As discussed in section below, the level of investment has seen the WEM move into an excess capacity position, as has occurred in electricity markets in other developed economies. However, the entry of new capacity has slowed considerably and the number of Capacity Credits in the market will fall over the next two Capacity Years to 5,683 MW in The decline in new capacity is clearly identifiable in Table 1.1, which shows the amount of capacity offered each year during the Expression of Interest (EOI) process and the amount of new capacity that was assigned Capacity Credits in that year. Table 1.1: Capacity offered through EOI process compared to new capacity assigned Capacity Credits Capacity (MW) Capacity offered through EOI 1,192 1,036 1, New capacity assigned Capacity Credits N/A This decline in new capacity investment is consistent with what one would expect in any competitive market in an oversupplied position. In addition, the IMO notes that the design of the RCM, particularly the methodology for allocating capacity costs (the Individual Reserve Capacity Requirement (IRCR) mechanism), has provided an incentive for customers to reduce their demand during system peak demand periods. Reductions in the system peak demand of nearly two per cent have been observed as a result of this market-driven behaviour. This has led to lower demand forecasts, deferring the need for additional capacity investment. Analysis in section 2.3 indicates that this behaviour is dominated by contestable customers who are provided with stronger price signals to reduce their consumption at times of system peak demand, whereas volumetric retail tariffs (such as the A1 tariff) provide no such price signal. The RCM has faced challenges and has evolved to address emerging issues. The IMO notes the impact that a sequence of reviews may have had in slowing investment in new capacity. The following sections provide information about the: review of the MRCP methodology that was completed in 2011; review of demand forecasting processes in 2012; and review of the RCM, including the work of the MAC and RCMWG over 2011 to MRCP review Clause of the Market Rules requires the IMO to review the methodology for setting the MRCP at least once in every five year period. Submission to Electricity Market Review Discussion Paper Page 18 of 121

21 In its 2009 Annual Wholesale Electricity Market Report for the Minister for Energy 12, the Economic Regulation Authority (ERA) noted that the preceding MRCP determination (for the Capacity Year) had elicited a greater level of response through the public submission process than previous determinations. Many of these submissions had expressed concern at the sharp increase in the MRCP, driven particularly by an increase in the estimate of transmission connection costs, which is provided by Western Power. The higher MRCP in resulted in a 41 per cent increase in the RCP for Given these concerns, the ERA recommended that the IMO exercise its option to bring forward the five-yearly methodology review, which the IMO initiated in To assist in undertaking the review, the MAC established the MRCP Working Group (MRCPWG) in 2010 to consider, assess and develop any recommendations for changes to the methodology. The MRCPWG met on ten occasions between May 2010 and June The MRCPWG recommended a number of changes to the MRCP methodology, of which two had a material impact. An independent consultant assisting the MRCPWG identified that the high transmission connection cost estimates provided by Western Power for the and MRCPs were not reflective of the capital contributions actually being charged to project developers that secured connection or were provided with an Access Offer. A revised methodology was developed for estimating transmission connection costs that was based on actual connection costs. This revision reduced the estimated transmission connection cost by 64 per cent and the MRCP by 14 per cent 14. The specification of the reference power station was updated to incorporate an inlet air cooling system, consistent with standard industry practice in the WEM. This has the effect of increasing the Capacity Credit allocation to the facility for a relatively small increase in capital cost, thus reducing the cost per MW. This change reduced the MRCP by a further nine per cent 15. The IMO notes that the high RCPs for the and Capacity Years may have attracted unnecessary investment. However, the review of the MRCP methodology realigned the MRCP with standard industry practice and actual transmission connection costs. Following the implementation of the methodology changes in 2011, the MRCP and RCP reduced by 31 per cent from to This price reduction will take effect in October Available at accessed 12 September The proceedings of the MRCPWG are available at; accessed 12 September IMO, Final Report: Maximum Reserve Capacity Price for the 2014/15 Capacity Year, February 2012, pages 6 (Table 2) and 22. Available at Capacity/imo_final_report_max_reserve_capacity_price_2014_15CB08D52A9766.pdf?sfvrsn=0, accessed 12 September Ibid, page 6 (Table 2). A lower WACC also contributed to the reduction in the MRCP. Submission to Electricity Market Review Discussion Paper Page 19 of 121