Price spikes, compensation and what we might do about it

Nothing like a bit of wholesale market drama to bring out the energy nerds (sorry, ‘insiders’), and the NEM never fails to deliver - for better or for worse. Its not just the die hards this time however; you’d be living under a rock to be unaware of the supply shortfalls and major price spikes that are currently ravaging the east coast gas and electricity markets.

Others have written extensively about what is driving these prices. I wanted to spend a bit of time considering what we might do to stop it happening again. The long term fix is still to build more renewable generation, storage and transmission. However, there are a few other things we might try in the near term to try and stop the current crisis from happening again.

So, what is the key driver of this gas and electricity price crisis? In short, it’s a perfect storm of spikes in international fossil fuel prices, driven at least in part by the war in Ukraine. Layered on top is the fact that big chunks of the coal generation fleet have simply been unavailable - up to 30% of the coal fleet has been out of service over the previous couple of months. These outages have been due to unavoidable maintenance, as these assets require more and more work to keep them running. However in several instances, the removal from service has been due to mechanical failure – see the Callide explosion last year, and ongoing issues with ageing coal assets in several other states.

The combination of increased input costs, plus the tightness of the supply side due to large whacks of generation capacity simply unavailable, has driven the current high prices. When coupled with high winter heating demand, we have seen NEM prices repeatedly spiking to the ‘Market Price Cap’ - currently set at $15,100 / megawatt hour. Once these 5 minute prices pass a rolling average limit – the “Cumulative Price Threshold, currently set at $1,359,100 – the market price is capped at the ‘Administrative Price Cap’, which sees prices capped at $300 / MWh. This price cap is there to protect energy customers from prolonged high prices that can occur where there is an ongoing supply/demand imbalance.

So  – problem solved, right?! Generators have earned a pile of cash, and now customers are protected from having to endure any further higher prices. Well, unfortunately, it doesn’t end there.

The underlying problem of high input prices hasn’t gone away, even if the wholesale price is capped. As others have pointed out, an underlying gas price of $40 / GJ (which is very, very high) will translate to a necessary wholesale spot price of $400 / MWh – but the APC is capped at $300 / MWh. Any gas generators buying gas on spot will therefore be taking a pasting in an APC limited energy market. As a consequence, many of these generators will simply choose not to participate and will make themselves unavailable – by withdrawing their generating capacity from the market. Note that not all generators are facing these input cost pressures, so not all generators can rely on the 'just passing through costs' argument...

Regardless, there are regulatory frameworks in place to manage this issue, however they are imperfect – as we are seeing play out right now.

One option is for AEMO, the market operator, to ‘Direct’ participants – this is as basic as it sounds, with AEMO operators picking up the phone (or rather, sending an electronic instruction) and literally directing a generator to come back online. Generators Directed in this manner can then apply for compensation through the Directions compensation frameworks, which is set at the level of the 90th percentile of the wholesale price for the preceding 12 months. If this isn’t enough, the national electricity rules then allow for further compensation to be claimed, to recoup any additional costs incurred that weren’t covered under the 90th percentile price. Note that this compensation can only be claimed if the generator has first declared itself unavailable (or intends to be unavailable) and has been directed back online by AEMO – this is important!

Another option for compensation occurs where the generator remains online and generates, even when the APC is binding at $300. Any generator who incurs a loss in this way can then claim compensation through the APC compensation frameworks, which are separate to the more general Directions compensation frameworks described above.

Under the APC compensation frameworks, the affected generator can make a claim to be reimbursed for any net loss, due to direct costs and/or opportunity costs incurred, during its continued operation during the ‘eligibility period’. This is the period from when the generator first begins operating through to the end of the relevant trading day.

If you’re thinking this compensation framework sounds like its custom designed for our current conditions, you’d be correct. It’s intended to promote continued operation of plant in a stable manner during an administered price period, by providing generators with confidence that they will recover any and all costs incurred.

Despite this, it looks as though generators are not responding in quite the way it was hoped they would when those clauses of the NER were written. Rather than remaining online and continuing to supply energy in the expectation they would be able to claim these costs back, it appears some are withdrawing their capacity from the market and waiting to be Directed on manually by AEMO. This means they will then be able to claim compensation in accordance with the Direction compensation frameworks.

So, why do generators appear unwilling to utilise the APC compensation frameworks, which were specifically designed for the kinds of conditions we’re currently in? LinkedIn has been awash with suggestions, some more charitable than others, in terms of the motivations and strategies of operators of fossil fuel generation.

Assuming that longer games aren't being played, its possible the reason the APC compensation mechanisms aren't being used is because they are simply too much of an unknown for generators. They’ve only been used in anger once – back in 2010 when direct costs were awarded to Synergen power for the operation of several peaking units during an APC event. So its possible generators are either unaware of the provisions, or aren’t confident to utilise a framework that has been so rarely activated.

Generators may also be wary of the fact that APC compensation is determined by the AEMC, with each application assessed on a case by case basis, rather than being subject to a strict formula as per the Directions compensation. As evidenced by the Synergen claim, assessment of a generator’s claim may take some time to be completed – the Synergen claim took from Feb 2009 until September 2010 to be finalised – hardly a speedy turnaround (though pls see caveat below).

Its telling that the AEMC has recently published a notice that advised that “it will be a priority for the AEMC to process these claims as quickly as possible, as we understand the cash flow pressure businesses are facing”. To be fair, its also important to recognise that the Synergen claim was assessed under an old regulatory framework, which was significantly overhauled in 2016 to speed up the compensation assessment process.

So…what is to be done? Again, LinkedIn is awash with suggestions. I'm not going to get into commentary around brinkmanship and strategic behaviours - others do this far more effectively. Proposals for domestic gas reservation and capacity mechanisms are also missing the point - this is little more than a poorly applied bandaid. Similarly, any kind of ‘capacity mechanism’ is likely a fools errand – as has been pointed out time and time again, a traditional capacity mechanism such as that being considered by the ESB would not have delivered a different outcome in this current crisis, given that it has in large part been driven by coal generator failure.

We need to think about more sensible solutions to prevent this kind of thing happening again.

In the short to medium term, we could start by looking at the level of the APC. The last time this number was assessed by the Reliability Panel in 2018, it was noted that relatively few generators were likely to face fuel costs in excess of this amount, suggesting that a $300 cap was appropriate for the bulk of the generating fleet, with bespoke compensation appropriate for the small number of generators with SRMC in excess. As current gas prices demonstrate, this logic may no longer hold.

Its possible the current issues with gas supply - and therefore prices - are not structural. This suggests the massive gas price spikes we are currently enduing may recede in time, and an APC at $300 may return to being well in excess of the SRMC of most players. Certainly this appears to be the Reliability Panel’s position in its current assessment of the level of the APC. I'd question whether this is necessarily the case, if for no other reason than the level of the APC hasn't been increased for many, many years. Even if the current price pressures subside, it appears likely that an APC of $300 is likely to bite an increasing number of participants.

Another approach could be to reassess the compensation frameworks that can be applied in this circumstance, in the context of the full suite of incentives faced by participants. As noted above, generators can effectively select from either the Directions compensation, or the APC compensation provisions. Generators will logically go with the compensation mechanism they consider is more likely to see their losses returned expeditiously.

This suggests the APC compensation frameworks should be reassessed. While the frameworks were overhauled in 2016 to streamline the APC compensation process, they remain untested. The AEMC also remains the assessing body, a role that sits awkwardly alongside its main regulatory function of rule making. Standardisation of the claim assessment process, perhaps by reference to set formulae in the NER or in guidelines, may go some way to addressing generators concerns and apparent hesitancy to utilise the APC compensation frameworks.

Clearer guidance may also be required as to what is expected of generators during an APC event, in terms of required bidding behaviours. This could come in the form of a rule change, potentially in the Chapter 3 market rules. Equally, the AER could issues guidance as to how these rules will be interpreted in the context of an APC event and looming supply shortfalls.

The ultimate solution is to wean ourselves off fossil fuels. The current price crisis we are enduring is the direct result of a wasted decade – a decade we could have spent building the renewable capacity we need to replace ageing, expensive and increasingly unreliable coal generation. Changes to compensation frameworks or the level of the APC might partially alleviate some of these pressures, but at the end of the day, the only real solution is to increase the supply of renewable generation, transmission and storage.