Government-initiated contracts-for-differences: How stable are they?

The key driver of growth in renewables in Australia has been the Federal Government’s 20 per cent by 2020 Renewable Energy Target (RET). The RET has been successful and is expected to be easily met. By 2018 the National Electricity Market (NEM) had 8000MW of new renewable energy plant and a further 5500MW was under construction at the beginning of this year, according to a new paper.[i]

The paper, by Professor Paul Simshauser of Griffith University’s Business School, indicated that on-market transactions had delivered more than $20 billion of investment without the need for government intervention or involvement beyond selling the policy framework.

But the lack of a post-2020 policy for achieving long-term carbon emissions targets has seen state and territory governments take unilateral action using contracts-for-difference (CfD).[ii]

While these approaches have also succeeded and can play a legitimate role in dealing with market failures relating to policy gaps, missing markets and incomplete markets, they can have serious unintended consequences, which this paper investigates.

Diversifying

As a policy mechanism CfDs represent a means to deliver generation capacity that “for whatever reason, the market is failing to deliver. Government-initiated CfDs have the effect of diversifying buy-side forward market liquidity and in doing so bring about certain short-run benefits”.

Aside from carbon emission reductions these benefits include state and/or regional economic development and reducing spot prices in the short term.

“Used modestly, the impact of government-initiated CfDs on an energy-only market is likely to be benign at worst,” the paper notes. The kicker is that a wide-ranging program of CfDs “whereby material levels of on-market transactions (i.e. between generators and retailers) are crowded-out by off-market CfD transactions (i.e. between government and generators) is likely to give rise to unintended side effects.”

When renewable plant enters with CfDs and displace on-market transactions, when coal plant leaves, the forward market experiences progressively rising shortages of “primary issuance” hedge contract capacity, Prof Simshauser writes. This, he says, has important implications for policymakers.

For an imperfectly interconnected, energy-only market (think NEM) with an extremely high market cap price, policy induced hedge contract shortages present problems.

“A poorly functioning forward market in an energy-only market setting may increase operational risks of incumbent market participants, produce excess contract price premiums, force the most price-elastic (industrial) customers into unwanted spot market exposures, unintentionally foreclose non-integrated 2^nd tier retailers, and ultimately drive investment activity above efficient levels to address hedge shortages – all of which must ultimately harm consumer welfare.”

The paper says that long-dated contracts are typically a pre-condition for the timely entry of project financed plant and while the NEM is noted for having a favourable forward market liquidity, the majority spans 1-3 years. “One reason liquid forward markets have failed to calibrate beyond 3 years is because competitive retailers cannot afford to hold hedge portfolios dominated by inflexible long-date contracts when large components of their customer book switch supplier every 2-3 years.”

Meanwhile high levels of renewables shielded by CfDs and priority-dispatched will initially place downward pressure on price.

“Given negligible marginal running costs, these so-called merit-order effects arising from policy-induced VRE[iii] plant entry became apparent in markets such as Germany as early as 2008 and had been prominent in the SA region of the NEM,” the paper says. (The latter was also noted by Deloitte Access Economics in its report on SA[iv].) The merit-order effect eventually unwinds when thermal plant is forced to exit. “This set of market dynamics has implications for a wide-ranging program of government-initiated CfDs,” Prof. Simshauser writes.

Motivation

In considering the motivation and application of CfDs, the paper says that they “have the effect of bringing forward future power projects to today with the benefits, costs and risks of doing so allocated to electricity consumers, taxpayers and incumbent rivals”.

Government-initiated CfDs also reorientate policy and credit risk away from buy-side energy market participants and passes this to taxpayers.

The paper outlines three reasons why government-initiated CfDs undertaken at scale would adversely affect the efficiency of an energy market. This is because:

1. Government is remote from power system operations and power system contract and risk management requirements. Government-initiated CfD auctions are typically based on simplified metrics such as minimising the levelized cost of energy (LCoE), which can introduce an inefficient pattern of plant entry. “In contrast, broad-based market schemes like the National Energy Guarantee or a well-designed renewable portfolio standard require market participants to focus not on the LCoE, but on the timing, location, and market value of new plant output.”

2. They introduce quasi-market participants that are almost completely sheltered from the NEM’s energy-only short and medium-run locational, spot and forward price signals. These are “the primary signals relied upon by market institutions and policymakers to regulate system performance, system reliability, investment patterns, and long-run consumer prices”.

3. There is the potential to distort forward markets and market efficiency more generally. This is considered by far the most adverse implication.

Conclusion

Prof. Simshauser’s paper finds that in an energy-only market setting, government-initiated CfDs must be used judiciously because “they introduce ‘quasi-market participants’ who do not respond to spot market signals, and do not participate in forward markets at all.

“Quasi-market participants are indifferent or substantially immune from future outcomes in spot and forward markets. This can result in plan entry that is poorly timed, poorly sized, poorly located, and above all, poorly motivated to respond to the electricity and frequency control ancillary service spot price signals, which keep the power operating in a stable manner.

“A wide array of policy instruments exist to deal with the market failures which CfDs are intended to remedy; renewable energy policy objectives can be achieved by an emissions obligation or well-designed renewables portfolio standard; the need for emergency capacity can be (and in the NEM recently has been) dealt with by establishing minimum exit notification periods for plant intending to exit the system; resource adequacy … can be maintained by ensuring the level of … [market price caps] remains appropriate or by pursuing reliability obligations if this become necessary. All these options work with an energy-only market design, including the forward market for contracts.”

[i] On the Stability of Energy-Only Markets with Government-Initiated Contracts-for-Differences, Energies 2019, 3 July.

[ii] This was led by the Australian Capital Territory (ACT) with its wind auctions in 2015. Queensland (solar), South Australia used what is described as a semi-CfD for its battery storage project and finally Victoria (both wind and solar).

[iii] Variable renewable energy

[iv] Energy markets and the implications of renewables. South Australian case study, Deloitte Access Economics, 26 November 2015.