Explaining the National Energy Market
Campbell Rickard
The National Energy Market (NEM) History
Before the nineties, Australia’s electricity industry was fully regulated. Its generation, transmission and distributions were all operated by the energy department of each state government. Then, beginning in the early nineties, under pressure to privatise and increase efficiency, New South Wales and Victoria began to corporatise their network. They each formed corporations responsible for generation, distribution and transmission, as well providing sales and marketing to the public. Alongside these changes, both states adopted an internal market which allowed these separate government sponsored institutions to trade amongst themselves. These actions were the first steps to forming a fully fledged private market, the National Electricity Market (NEM) in 1998. The NEM allowed for the pooled sale and purchase of electricity between Port Douglas in Queensland, Port Augusta in South Australia, and Gippsland in Victoria. West Australia and the Northern Territory run on separate networks. Further expansion of high voltage transmission lines has allowed new jurisdictions to become part of the market, such as Tasmania in 2005 when Basslink was completed.
Unlike other commodities it is difficult to store electricity for long periods of time, meaning that under most circumstances power is generated and consumed instantaneously. This presents challenges to market operators to facilitate the market not seen elsewhere.
Market Clearing in the NEM
The NEM is a wholesale market meaning that it connects power generators and retailers as well as some industrial consumers through the transmission network. In contrast, retail consumers purchase their electricity from a retailer via the distribution network.
The process begins at 12:30 pm on the day before the scheduled sale of electricity. Generators submit bids to the market operator (AEMO) specifying the price and the quantity of electricity they are willing to supply to the market for each dispatch period of 5 minutes. This is known as the daily bid. After 12:30, generators are then able to make rebids until 5 minutes before dispatch, however they are only permitted to change the quantity of their offer, not the price. These offers are prioritised in order of cost, with the lowest bidding producers directed to meet the forecasted demand for the dispatch period first. This continues until the market has cleared and the total wattage produced is predicted to meet demand.
For each 5 minute interval, the highest price that a generator receives is averaged over half an hour. This becomes the spot price, which is the cost charged to retailers and large consumers who take electricity out of the NEM. In designing the market in such a way, regulators hope to protect consumers from large price jumps that they might be subjected to if the market price did not have this averaging mechanism.
Grid Protection in the NEM
Cleverly, in designing the NEM, the regulator created a closely linked secondary market intended to protect the grid against unforeseen disruptions. One such market is the trade of Frequency Controlled Ancillary Service (FCAS). These contracts mandate retailers to be subsidised to help prevent blackouts or the destruction of grid property. They offer these services through a competitive process based on price, much like the spot market mechanism described above. However, some elementary knowledge of grid transmission is necessary to properly understand these services.
Electricity does not pass through large transmission lines at a constant voltage. Instead, it oscillates back and forward, ideally 50 times a second or 50hz. This is known as alternating current, or AC. For the grid to function correctly, the AMEO will only tolerate a deviance of 0.15hz from the ideal. Should a generator go offline, power demand will outstrip supply causing the frequency of electricity in the NEM to drop. This will immediately be noticeable to those NEM users who closely monitor the power imputed and extracted into the NEM. If required by their FCAS, a generator may increase the production of electricity until the frequency of the grid returns to an allowable band.
FCAS come in eight varieties which vary in their obligated action and time. The action will either be inputting extra electricity into the grid (a raise) should the frequency drop too far below 50hz, or reducing production and taking power out of the grid (lowering) if the frequency is too far above 50hz. Action duration is limited to 6 seconds (fast), 60 seconds (slow) or 5 minutes (delayed). The required capacity is determined by the AEMO for each jurisdiction, dispatch period and FCAS type based upon the power output of the largest generator and the scheduled demand. Like the spot market, suppliers of FCAS submit bids at 12:30 pm for the following day for all dispatch times. Again, they are able to alter the quantity after the cutoff, but not the price. Each service provider is paid the highest clearing price regardless if it was above their own bid. The payments for all raises are charged to electricity suppliers, while lowers are charged to retailers. This is because raises are contingencies protecting against unforeseen producer issues, and lowers against consumer issues. The percentage of the total paid by each market participant is equal to their proportion of total consumption or production during the dispatch time in that jurisdiction.
Effectiveness of the NEM and challenges
The grid network in the Eastern states has been very successful since its adoption in 1998. It has been able to take advantage of the efficiencies provided by the free-market allocation of resources, whilst mostly avoiding abuses of market power and price gouging. This has not necessarily been true with other countries’ attempts at privatising the electricity market.
In 1996 California became the first state in the US to privatise its electricity market after substantial lobbying efforts from energy companies, most notably the now defunct Enron Corporation. The rules governing the new partial free market were especially complicated, increasing their vulnerability to loopholes and manipulation. It was these laws that allowed companies such as Enron to artificially halt supply and price gouge retailers. Whilst the wholesale market was deregulated for producers and traders, utilities were subject to rigid price controls when selling to final consumers through the distribution network. Additionally in the event of market shortages, retailers were required to purchase power at whatever price necessary to ensure consumption was met. The end result was the bankruptcy of two leading utilities and mass blackouts across California.
Since 1998, Australia has only experienced one state-wide blackout, caused by extreme weather damaging critical infrastructure and the mismanagement of multiple wind farms in South Australia. It is a significant achievement that the NEM has not only been able to allocate power generation efficiently but also distribute sufficient contingency to protect the grid and consumers against severe outages. This should be given additional weight when considering the extreme weather events are so common in this country. However, the NEM is likely to soon face new challenges, and will have to adapt its mechanisms to maintain security and economical allocation.
Challenges Facing the NEM and Proposed Solutions
Whilst the vast majority of power generated in the NEM is still from non-renewable coal power, this has been and will continue to change quickly. Since 2012, 90% of spending on new electricity generation has been on wind or solar. Whilst the technologies currently have a maximum capacity of 17MW this is forecasted to increase to 53MW in the not-too-distant future, nearly the total current capacity of the NEM. For AEMO (the market operator of the NEM) this will pose greater difficulty to scheduling supply to meet demand and is likely to create a far more erratic spot market. Since both solar and wind are variable in their output and subject to elements of randomisation, forecasting their input can at times be difficult. This is likely reflected in the increasing frequency of drastic action by the market operator to stabilise the grid, directing operators to stay online or come online. In 2014 AEMO had to take action in the market a total of 6 times, in 2020 this jumped to 344.
Advising the minister for energy Angus Taylor, Energy Security Council Head Kerry Schott has recommended new policy to help bring greater security to the grid. Under her proposal an additional capacity market would be created. Electricity producers that could guarantee generation over critical periods of high demand/low supply would be awarded certificates by the AMEO. Retailers on the NEM would be required to present these certificates to purchase power from the grid. These tradable securities would perform two functions, provide better signalling for potential investors and reward generators providing grid security.
Before the widespread adoption of variable renewable power in the NEM, the majority of power was produced by large turbines synchronised to the grid at 50 hz. They provided essential services such as inertia and reserve capacity that helped to keep the market stable. Whilst wind and solar have become exceptionally economical and displaced many coal fired power stations, in their most common form they do not provide the same stability features. Under Dr Schott’s plan this externality would be partially corrected allowing markets to factor in the benefits of different generation types.
Additionally, investors monitoring the price of these assets would be able to invest in new generation with greater confidence. This would enable them to meet supply shortages faster, before consumers are forced to pay drastically higher rates. In the absence of such certificates, it only becomes economical for reliable generation to enter the market when there are sufficient periods of higher prices. We view this as a societal cost and is often the reason governments make direct interventions into power markets, despite espousing free market principles. Isolating capacity itself as tradable good will allow firm producers to enter the market at lower volatility and create a more stable generation mix.
Critics of the plan argue that this is a step backwards on our commitments to lower our carbon pollution levels. It has been labelled by prominent green groups as propping up coal intensive power plants. Whilst it is true that coal generation will count as firm capacity, other more environmentally friendly forms will be included and may be more effective when operating as peaking plants. These include pumped hydro, gas and new efficient batteries. Over time these technologies, especially batteries, are likely to develop to be more economical and efficient than thermal coal. Further whilst phasing out carbon intensive power supply is critical and should be achieved as soon as possible, it should not mean sacrificing the robustness of the energy grid.
Campbell Rickard is a Research Analyst at UNIT (University of Melbourne).
References
https://www.youtube.com/watch?v=rvHJ4adUJpk
https://www.nrel.gov/docs/fy20osti/73856.pdf
https://www.afr.com/companies/energy/coal-will-be-paid-to-firm-up-the-grid-20210825-p58ltz
https://australiainstitute.org.au/wp-content/uploads/2021/03/VEPC-system-security-report-FINAL.pdf
https://www.accc.gov.au/system/files/Session%201_Market%20Power%20-%20Frank%20Wolak%20paper%201.pdf
https://en.wikipedia.org/wiki/2000%E2%80%9301_California_electricity_crisis
https://en.wikipedia.org/wiki/2016_South_Australian_blackout
Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.
