Act early on energy market design or risk uncertainty

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In unreformed developed markets, the mix of electricity generation types – coal, gas, renewables - is often determined by the vertically integrated monopoly, with these decisions ultimately setting the market’s average price of generation.

In these cases, most generation is either owned by the monopoly or contracted through independent power producer arrangements whereby new entrants sign long-term power purchase agreements (PPAs) with the generation business of the monopoly.

For most governments, a main aim of market reform in developed markets is to attract new generators that will bring any or all of the following:

·         More efficient plants

·         A different mix of fuel sources

·         Better operating practices and innovation

 

At the same time, governments also want to ensure that market design changes are long-term and sustainable to realize the full benefits of competition.

The challenge is that delivering the desired change in the energy mix over the long term requires careful design. The natural profit-seeking behaviour of market participants will test a market design and sometimes yield unintended consequences (e.g., the UK’s “Dash for gas” in the nineties).

In addition, raising finance for new generation requires both certainty of returns and the identification of revenue risks. These can be difficult to achieve during a reform process, given that dispatch and purchase rules are often only one part of the overall framework being designed by government and these unfold dynamically.

Three market design options

Designing a new energy market can take significant time. In my experience, this critical phase of reform can often take more than a year, as governments grapple with variants of three design options:

 

1.     Bilateral trading, where contracts between retailers and generators (in a PPA) exist as the sole method for selling energy

2.     Net pool, where residual capacity (after bilateral contracts) is traded in the market

3.     Gross pool, where bilateral contracts either co-exist in the pool or risk management derivatives are used

None of these design options is right or wrong. Each requires a great deal of consideration around issues such as market power, how to deal with existing contracts in the market, and how to respect past investment decisions made by existing participants without continuing to pass onto customers any inefficiencies contained within these decisions.

Investors seek revenue certainty first

Whichever option is chosen, there will be major implications for those already in the market and for those planning to enter. How to attract finance, plan an effective entry strategy, engage around and invest in the new market design, and interact with fellow participants – all these areas will be significantly affected, both organizationally and contractually.  Each proposed market design will need to be considered, not in terms of intellectual curiosity or economic purity, but on the basis of impact and cost.

Above all, it is certainty, rather than a particular market design, that utilities and potential new entrants will seek before they decide to invest. Revenue certainty is a core objective for any business, and more so in a decreasing cost industry where capital costs are high. Equally important is an ability to identify and price risk. But reforms can undermine both of these objectives if policy considerations are not communicated effectively and decisions regarding design elements are not made as promptly as possible.

It is therefore critical that governments do not prevaricate unnecessarily over selecting the new market design. They should avoid investigating models that could not possibly work and take care to remove ambiguity around critical details.  For example, in a market with dominant government-owned generation held within a single entity, and where there is excess capacity, investigating pure merchant pool arrangements makes little sense.

Communicating a preference for these models, or at least refusing to acknowledge the financial unworkability of these models, will only frustrate new entrants, who may well decide not to engage any further in the process. By contrast, statements that provide comfort at the outset of market reform discussions – for example, that existing contracts between market participants will not be impacted by the resultant market design – will help assure financiers of continued returns. In turn this will enable the costs of engaging in the process to be justified internally by prospective new entrants, and allow consultation of more detailed elements to occur more constructively.

At the end of the day, attracting investment requires governments to step into the shoes of the new entrant, understand the requirements of project financiers and work with them both to unlock the benefits of competition.

Matthew Rennie is EY’s Global Energy Reform & Unbundling Leader. He is based in Brisbane. For more insights on energy reform and unbundling, please visit www.ey.com/energyreform and follow us on twitter @EY_EnergyReform.

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