Unhedgeable – the rise of ancillary service costs

A key theme of the energy transition is a rebalancing of overall system costs away from energy costs (which can plausibly be expected to fall over the long term as more zero marginal cost renewable energy enters the system) and towards ancillary service costs. Ancillary services is a catch-all for the range of essential system services that keep the grid secure and contribute to reliability over and above the energy market. The number and nature of these markets is changing rapidly, but the table below gives a sense of them.

ServiceOld New
Frequency control (FCAS)Provided through FCAS markets co-optimised with the energy marketSimilar but quantity required has increased to keep frequency within normal band.
Fast frequency response (FFR)N/aNew market proposed by Infigen
InertiaProvided automatically for free by traditional generationNo specific proposal for new market, but flywheels being added in SA due to low inertia. Overlaps with FFR
Reliability reserveVery occasional procurement through the Reliability and reserve trader (RERT)Reliability standard increased and three year procurement allowed. Could be common feature in SA/Victoria.
Operating reserveN/aNew market proposed by Infigen. Would replace or at least reduce need for reliability reserve. Also overlaps with FCAS
System strengthProvided automatically for free by traditional generationSynchronous condensers being installed by transmission network in SA. May need similar in parts of Victoria and Queensland.


Unfortunately, it is impossible to tell at this stage how much these markets will cost until they are set up. As the table notes, some are (partial) substitutes for others, so in some cases a new market may reduce the cost in other, existing markets. They will also reduce the need for directions by the market operator, where a plant that is otherwise uneconomic to run at the prevailing price is told it is required. This is an inefficient approach that needs to be minimised over time.

If there is a trade-off between lower energy costs and higher ancillary services costs, does it matter? After all, they all end up in our electricity bills right? Well, there is one critical difference. While the energy spot market can be very volatile, this volatility is hedged away by the contract market. This allows retailers (or sometime large users directly) to manage energy costs and deliver a fixed price per MWh to their customers. However, there are no hedge markets for the ancillary services, which are procured by the market operator (AEMO) and charged out to market participants – mostly retailers. Because they can’t manage them, retailers pass them through directly to larger customers – who of course also have no way of controlling them. Retailers don’t pass-through to small customers, but they are likely building in a risk premium to small customer retail prices as a consequence.

This never mattered when the ancillary service costs were immaterial. But they are gradually growing. The first quarter of 2020 saw record FCAS costs, although a big part of this was driven by the forced islanding of South Australia for three weeks. The chart below shows how the quantity of reserves (primarily for FCAS) procured by AEMO has increased.


Source: AEMO

In principle some of these costs could be hedgeable. Providers of FCAS and even RERT could see some value in obtaining a more stable revenue stream for these services and be willing to do deals with retailers accordingly. And the more these costs grow, the more likely the demand for hedging products will grow. But, in the meantime, large customers especially, need to keep a close eye on these costs and their underlying drivers.