Is the Energy Security Board proposing to introduce a coal subsidy?

Controversy has reigned over the Energy Security Board’s recent suggestion that the best way to ensure reliability in the NEM is via a physically-backed version of the existing Retailer Reliability Obligation (RRO). Many of the opponents of the proposal have sought to portray it as a subsidy to coal plants. Is this a fair description?

Part of the problem in assessing this claim is that there is scant detail around exactly how the physical RRO might work and consequently what sort of resources would qualify. The existing RRO is based purely on retailers having sufficient financial contracts in place to cover their customers’ peak demand. At the time of its creation, the logic behind this scheme was that financial contracts in turn create a very strong incentive to have physical generation backing them. It can be an expensive business to sell cap contracts and then have to reimburse your buyer up to $15,000/MWh when the spot price hits the market price cap if you don’t have a generator on that’s earning that same $15,000/MWh.

The main tweak required to turn the RRO into a physical RRO is that instead of buying financial contracts, retailers would have to buy certificates from an actual generator that would be accredited by AEMO to sell certificates up to the maximum capacity it could provide at peak times. The ESB have indicated that this approach may be similar to the French capacity mechanism. Under this, the market operator nominates a day ahead up to 15 days a year during the potential winter peak (November-March) for which obligated parties (retailers and large users) must have enough certificates to cover their share of demand on that day. The qualifying generators need to be available to run on those days and up to ten further nominated days. Demand response can also sell capacity and small capacity providers (<1MW) can participate if they are aggregated. The ESB have not confirmed if the same provisions will apply to the NEM version, so these are merely indicators of how it could work.

With that in mind, is this a subsidy? There’s a tendency to call all capacity payments “subsidies” because they don’t necessarily result in the recipient having to deliver any energy. This is a rather limiting definition, which ignores the fact that in the NEM we already pay for some services that aren’t “energy”. Some frequency control (FCAS) services entail a reduction in the delivery of energy and system strength services are not predicated on supplying energy.

In Europe, when governments want to introduce some form of capacity payment the EU runs the rule over the proposed mechanism to check it is not illegal state aid (i.e. subsidy). The fact that some capacity mechanisms, including the French one are permitted in Europe indicates that capacity payments are not subsidies per se, the devil is in the detail. Another way of thinking about whether it is a subsidy is whether it is something the market might pay for without being required to by regulation. In this respect, it looks somewhat like a typical cap contract. This allows peaking generation, such as gas to earn revenue without necessarily ever running. For example, in the first quarter (Q1) of this year the price in Victoria never rose above $300/MWh for a half hour period, and so any Victorian generators who had sold Q1 caps would not have had to turn on to defend their caps. Finally, the long-notice RERT, which AEMO has used in recent years to procure emergency reserves, pays for availability (essentially a capacity payment).

Aside from the issue of whether it’s a subsidy there is another question – is it specifically a coal subsidy? For sure, coal plants are expected to qualify for the capacity certification. However, so are gas, hydro and batteries. Demand response may, too, although the interaction with the soon-to-be-launched wholesale demand response mechanism will need to be considered. And if the capacity only needs to be certified for a few peak summer days, coal plant, whose strength is running consistently year round, may not be especially competitive against these more flexible technologies.

So, providing all technologies that are capable of providing capacity when required are able to participate, it’s not a coal subsidy.

The objection seems to be that it might mean some coal plants stay open a little longer. But this will only be the case if we actually need them on the system enough for them to earn enough revenue to stay open. And if that’s the case, wouldn’t we rather have them open a little longer than risk blackouts?

None of this is to suggest that the physical RRO is a great policy proposal. It puts the onus to underwrite physical capacity onto retailers. It’s not clear that retailers are the best party to do that. Many of them are small and have limited balance sheets, especially if they can’t persuade their customers to commit to long-term contracts. The largest ones own generation as well, as a way of managing wholesale market risk, so they are better placed to take on this role. But the ACCC takes a dim view of these businesses and the recent “big stick” legislation crimps them. To be fair to the ESB, they are going down this route to avoid a centralised capacity market, which has its own set of issues, and to try to get governments to step back from the market. But unless governments can be persuaded to stop their chronic intervention and funding of preferred projects, any attempt to use markets to shore up reliability will just be undermined.