An Environmental objective in the NEO: Good Policy or Good Politics?

Last week energy ministers agreed to the introduction of an emissions objective to the National Electricity Objective (NEO) with much commentary supporting this as overdue.

Debate on introducing this element to the NEO is not new and has been the subject of discussion over many years. It has previously been rejected because of the added complication it introduces to decision making for market bodies.

The AEC understands the impetus for introduction of an environmental clause and strongly supports the overall intent of achieving emission reductions both within the sector and in the broader economy and has endorsed both net zero by 2050 and an interim target of a 55 per cent reduction in emissions by 2035 . But equally we have always argued that achieving emission objectives are better done outside the NEO through clear policy and regulation to avoid creating additional complications in decision making.

The Australian Energy Market Commission (AEMC) in a 2019 paper on applying the energy market objectives, makes it clear it already explicitly considers whether its decisions are robust to the impacts of climate change. It also comments that:

Lowering emissions requires governments to make value judgements using information on the economy as a whole and the welfare of the population. Therefore, governments should decide what a particular emissions reduction target should be… We ensure we consider the impacts of mitigation and adaptation risk manifesting through climate change in our analysis of the impact of rule changes on security, reliability, price, security and quality.

So, what are the arguments for and against the introduction of an environmental objective? Energy consultants Engevity have outlined what they see as the potential benefits and challenges to the introduction of an emissions objective. They identified benefits as including aligning the market with state and federal carbon ambitions and reducing ambiguity in strategic planning, while some of the challenges noted include what are the baseline and projected emissions reduction targets for the sector and what is the cost of carbon abatement that will inform future cost benefit analysis, as well as the fact market bodies aren’t equipped to set interim targets.

To take a closer look at the debate and implications below we are republishing analysis undertaken by the AEC in 2016.  The arguments and points, we feel, remain relevant today.

Objecting to the Objectives 

(originally published 15 December 2016)

An emerging theme in the Australian energy policy debate is the value of adding an environmental objective – essentially a recognition of the driver to reduce carbon emissions - to the National Electricity Objective (NEO)[i]. Proponents argue that this will assist with the integration of energy and climate change policy. But could it really work in practice?

Where are we today?

The current NEO states that:

“the objective of this Law is to promote efficient investment in, and efficient operation and use of, electricity services for the long term interests of consumers of electricity with respect to:
(a) price, quality, safety, reliability, and security of supply of electricity; and
(b) the reliability, safety and security of the national electricity system.”

In other words the goal is efficient energy services (taking a long-term perspective) with reference to a range of other characteristics: price, quality, safety, reliability, and security of supply. Some have interpreted these multiple characteristics as an illustration that satisfying the NEO means that several factors must already be traded off and that adding one more factor does not make the role of the energy market bodies any more complex.

The Australian Energy Market Commission (AEMC) recently released a paper in which they explain how they interpret the NEO for the purposes of their decision-making[ii].  While the AEMC is only one of three energy market bodies - the others being the Australian Energy Regulator (AER) and the Australian Energy Market Operator (AEMO), because they are the rule-maker, their understanding of the NEO is particularly pertinent.

“The analysis of a particular rule change could therefore be considered as an assessment of a number of possible outcomes and determining which outcome could deliver the greatest efficiency benefit, giving due consideration to each of the relevant variables”[iii]. In other words, these other characteristics act as side constraints to the pursuit of efficiency, which is still the primary goal.

Notably, the other characteristics typically manifest as static thresholds at any given point in time, with the thresholds defined by bodies other than the AEMC. For example, reliability is determined for the wholesale market by the Reliability Panel and for networks by jurisdictional governments. Safety is determined by jurisdictions or their regulatory agencies. Service qualities are often derived from technical standards, developed through Standards Australia (though these are only binding to the extent that jurisdictions adopt them). So the AEMC, (and as relevant the AER and AEMO) do not necessarily seek to further the goal of, say, safety per se, in their decision-making, but they avoid undermining the goal.

Conversely, there is no clear threshold at the level of the NEM for emissions reduction. There is a national target for 2030... based on the Paris Agreement, but this is economy-wide. Similarly, several jurisdictions have adopted long term goals for achieving net zero emissions. Given emission reduction is a progressive goal, it is also a more dynamic metric compared to most of the existing side constraints. This makes it a more challenging reference point.

What about gas and retail?

The NEO is not the only key objective that governs energy market body decision making. There is also a national gas objective and a national energy retail objective, which are couched in broadly similar terms. Presumably it would be equally appropriate or not to embed an environmental component into these objectives, although it might be even less clear how to apply it.

The benefits of simplicity

The question of changing the scope of the energy market objectives was explicitly contained in the Review of Governance Arrangements for Australian Energy Markets. The expert panel (Michael Vertigan, George Yarrow and Euan Morton) considered the matter and argued that “Focus (that is, limited scope) means that regulators are not asked to resolve major policy trade-offs that, in a democratic system, are the proper responsibilities of parliaments…pursuit of the long-term interests of consumers does not in any way imply that other policy objectives are unimportant and to be set aside or given low priority”[iv].

International experience – Great Britain

One of the expert panel, George Yarrow, spent some years on the Board of Ofgem, the British energy regulator, which may have influenced his desire for simplicity. Ofgem began with a simple statutory duty, much like the NEO, “to protect the interests of consumers, present and future, wherever appropriate by promoting effective competition”. Over time governments added various riders in the form of “having regard to” seven different factors (including the interest of four specified types of consumers) and in a manner calculated to achieve three (now five) other objectives[v]. Several of these sub-clauses referenced environmental impacts or sustainability goals. The overall effect of these riders was obfuscation rather than clarification, as it was not obvious how trade-offs or conflicts between these goals and the overall primary duty should be resolved. While the full range of duties were taken seriously, demonstration of this often amounted to careful presentation of the overall decision, with a few bolt-on regulations or incentives to acknowledge the additional duties. The lesson was that multiple objectives do not necessarily deliver fundamentally different outcomes.

The main objective has since been expanded to specifically reference the need to achieve greenhouse gas abatement, security of supply and fulfil EU energy directives. The list of duties spans a full page of a document, meaning that Ofgem is now moved to offer a 1-paragraph “interpretation” of its duties in an attempt to provide greater simplicity and clarity[vi].

Governments hold the trump card

As noted above, most of the other side constraints are set by governments or their agencies. Moreover, government decisions are not bound by the NEO and can over-ride efficiency concerns. For example, some years ago, the New South Wales Government legislated prescriptive reliability standards following a series of blackouts in Sydney, and the Queensland Government adopted a similar policy. These in turn drove significant network investment. If the AER, which set the revenues that allowed recovery of this investment had been able to evaluate the standards against the NEO, they might have concluded that the gains in reliability were not worth the additional costs and thus were not in the long –term interests of NSW customers. But because it was a legislated requirement on the networks, they had to accept the investments.

The point is that for better or worse, governments have the ability to set policy, including environmental policy,  that may or may not meet the NEO. The AEMC and the AER must then operate within the constraints of government policy. If governments set clear national policies for emissions reduction, then this will inform the work of the energy market bodies, regardless of whether the NEO references them. Multiple state policy settings, on the other hand will not help energy market body decision-making, given that they are operating against national rules.

The call for an environmental objective in the NEO reflects the ongoing frustration of many parties in the lack of stable climate change policy to drive efficient emissions reduction in Australia. But changing the NEO is not an effective substitute for sound policy settings and if we can achieve these, it’s likely that energy market decision making will internalise those policy settings and the driver of decarbonisation in any case.

[i] For a recent example, see Our Energy Future, November 2016, or the CEC’s Power Shift

[ii] A further paper, Applying The Energy Market Objectives, was published by the AEMC on 8 July 2019

[iii] AEMC, Applying the Energy Market Objectives, November 2016, p7.

[iv] Energy Market governance review – final report, p24

[v] See https://www.ofgem.gov.uk/sites/default/files/docs/2014/12/corporate_strategy_0.pdf, p4 for a recent iteration of Ofgem’s duties.

[vi] Ibid, p5.