Is there a better way to manage AEMO’s costs?

The Australian Energy Market Operator (AEMO) performs a vital role in managing the electricity and gas systems and markets across Australia. In Western Australia, AEMO recovers the costs of performing its functions via fees paid by Market Participants, based on expenditure approved by the Economic Regulation Authority (ERA).

In the last few years, AEMO’s costs have sky-rocketed in Western Australia driven in part by the amount of market reform and the challenges of budgeting projects that are not adequately defined. However, there also appears to be evidence of AEMO underestimating costs and then spending funds above the approved limit.

Here we take a look at how AEMO’s costs have escalated in Western Australia, the proposed amendments to the allowable revenue framework, and what can be done to keep a lid on costs.

What’s causing the jump in AEMO’s costs?

In Western Australia, AEMO is required to submit its allowable revenue and forecast capital expenditure proposal to the ERA for review and approval every three years, with the current allowable revenue period – known as AR6 – ending on 30 June 2025.

AEMO must provide a range of supporting financial information to the ERA in its proposal. The ERA assesses this information and conducts interviews with representatives of AEMO. Following consideration of AEMO’s proposal, the ERA releases an issues paper seeking comment from interested parties. After that, AEMO publishes a draft determination with revised allowable revenue and forecast capital expenditure. Stakeholders are again invited to make submissions on the draft determination. 

After the ERA receives submissions from stakeholders and a revised proposal from AEMO, it releases a final determination that may fully or partially approve costs, reject costs, or fully or partially substitute costs. The ERA may also recommend that AEMO considers some of its costs in subsequent review periods.

In December 2021, AEMO provided market participants with an indicative view of its forecast expenditure for AR6. The ERA then engaged The Lantau Group (TLG) in 2022 to compare AEMO’s operational costs to other jurisdictions. While Western Australia is not directly comparable to any other market due to its specific and unique design, functions, size, and the timing and direction of impending reforms the comparison prepared by TLG is a useful benchmarking exercise.

The Lantau Group found that AEMO’s costs in Western Australia are higher than almost all other jurisdictions around the world on a megawatt-hours of consumption basis, with the exception being ISO New England in the United States.

Source: AEMO Benchmarking, The Lantau Group[i]

Since then, AEMO’s already significant costs have jumped even further during AR6 due to a series of in-period submissions.

AEMO initially proposed allowable revenue of $156.2 million and forecast capital expenditure of $69.4 million for AR6. The ERA’s final determination approved $142.3 million of allowable revenue and $61.5 million in forecast capital expenditure.

But while the Allowable Revenue period spans three years, AEMO must also make an in-period submission to the ERA for the reassessment of AEMO’s funding where AEMO forecasts a shortfall of at least 10 per cent or $10 million over the period.

AEMO lodged its first in-period submission in 2023. AEMO requested an increase in forecast capital expenditure of $47.11 million and the ERA approved an additional $46.94 million in forecast capital expenditure.

In March 2024, AEMO lodged its second in-period submission. This proposal was for an increase in forecast capital expenditure of $39 million and additional operating expenditure of $59.2 million. AEMO’s proposal estimated that these costs would increase market fees by $1.04 per megawatt-hour (MWh) in 2024/25. This increase in market fees would result in the cost to operate the WEM increasing from $56.4 million in 2023/24 to $96.0 million in 2024/25.

Source: AR6 In period CapEx and OpEx Final Determination, ERA [ii]The forecast annual operating cost of $96.0 million to operate the WEM in 2024/25 would more than double AEMO’s costs for 2022/23, which was the first year of the AR6 funding period.

This is a staggering jump in costs and the ERA was at times scathing of AEMO’s second in-period submission. In one case, the ERA estimated that at least $17 million, just under a third, of the additional operational funding requested in the second in-period proposal related to costs already incurred in 2022/23 and 2023/24. In other words, AEMO spent money it didn’t have and now had to recover those funds.

The ERA’s final determination approved $58.29 million in allowable revenue and $37.9 million in forecast capital expenditure.

In making the determination, the ERA had to juggle its important role of regulating AEMO’s expenditure with the need to keep the lights on in Western Australia:

“The ERA is aware that the additional funding will flow through to WEM fees, with likely increases to the costs for consumers. Although this is unwelcome in the context of other rising costs in the WEM, minimising costs needs to be balanced against the risk of underfunding AEMO and rendering it unable to operate the WEM or to deliver critical market reform projects.

AEMO cannot demonstrate, nor can the ERA fully determine, that the level of funding requested reflects that needed by a prudent and efficient market operator in the current market reform landscape. Components of AEMO’s funding proposal have not met the standard set out in the ERA’s proposal guidelines, and its project management processes continue to raise concerns.”

What’s causing this problem?

AEMO performs a vital role and should be sufficiently funded, provided it can demonstrate that it is acting efficiently to achieve the lowest practical cost of performing its functions. The ERA also has an important responsibility in assessing whether a project and its related costs need to be incurred (prudency) and whether those related costs represent a low-cost option (efficiency). Transparency in AEMO’s costs is achieved through a regulator like the ERA providing oversight and using its powers and resources to interrogate AEMO’s proposed budget.

However, the challenge in regulating AEMO within the existing framework is that it operates as a not-for-profit organisation which is not incentivised to reduce costs in the same way as a profit-driven network service provider. The in-period submissions also highlight that the current regime lacks the teeth to constrain AEMO from spending funds above its approved limit or from stopping it using allocated funds for other projects (for example, AEMO has proposed to delay the implementation of the Relevant Level Method changes to the 2028 capacity cycle despite having already received $16m in funding).

A key part of the problem is that AEMO is required to prioritise the delivery of reform and transition activities to deadlines set in the WEM Rules and by the State Government and Energy Policy WA. These early-stage reforms are given to AEMO to implement, usually without policy makers having sufficiently considered whether the reforms generate a sufficient benefit for the cost. Far too often the result has been that the cost of new projects blow out. To compound the problem, while AEMO is delivering the reforms, there seems to be little way to undertake a re-assessment of costs and timeframes to determine whether it’s prudent to continue delivering the reform or if it is better to terminate or delay the activity.

All of this has led to widespread acknowledgment that the existing allowable revenue regulatory regime has problems: the pace of energy reforms and lack of budget certainty causes costs to escalate; AEMO needs to make regular in-period submissions; and Market Participants and end customers don’t get any certainty of forward-looking costs and fees.  

AEMO has responded by proposing to the Market Advisory Committee that the current Allowable Revenue framework be replaced with a new regime for determining AEMO's business priorities, budget and fees.

AEMO’s preference is to do away with the existing approach of full regulation and instead require consultation with stakeholders. In the below spectrum, AEMO has identified option B or a combination of options B and C as their ideal approach.  AEMO state this could include these key components:

• Requirements for AEMO to consult with stakeholders annually on its priorities and draft budget, along with annual reporting.
• Requirements for AEMO to consult with stakeholders on major projects, both as they are being initiated and during their lifecycle, to enable stakeholders to provide input into the scope, sequence and prioritisation of projects.
• Consideration of the effectiveness of these mechanisms in achieving the Wholesale Market Objectives as part of the WEM Effectiveness Review.

To see larger image of this spectrum, click here

Source: mac_2024_07_25_meeting_papers.pdf (www.wa.gov.au), page 15.

AEMO is now preparing a rule change proposal to amend the Allowable Revenue framework and this is expected to be released in the coming weeks.

A new approach to regulating AEMO

Stakeholders are sympathetic to the vital role that AEMO performs in Western Australia. They have delivered a reliable and secure supply of energy while dealing with the challenges of implementing a large number of reforms driven by the State Government and Energy Policy WA. While many of these reforms have some value, there is no gate in the process requiring a cost/benefit analysis. A better assessment of whether a reform provides sufficient benefit for the cost may result in reforms being screened, prioritised and better budgeted before AEMO even starts trying to implement them.  

AEMO should be commended for engaging with stakeholders on the challenges of the existing Allowable Revenue framework. It’s clear that they are genuinely trying to find a solution to a new problem. Nonetheless, AEMO’s preferred approach of focusing on consultation is a major shift, and it is hard to envision how less regulation would deliver a better outcome for AEMO, Market Participants and end customers. Stakeholders simply do not have the resources or regulatory weight to interrogate AEMO’s proposed expenditure and compel them to operate more efficiently. After all, if the ERA can’t stop AEMO from spending funds it doesn’t have, then it will be a tough ask for stakeholders sitting in a consultation forum to convince AEMO to operate more efficiently.

[i] p3 - https://www.erawa.com.au/cproot/22674/2/-AR.6---Consultant-Report---Final-report-from-The-Lantau-Group---AEMO-Benchmarking.PDF

[ii] https://www.erawa.com.au/cproot/24147/2/AR-6-2nd-In-period-CapEx-and-OpEx-submission-Final-determination.PDF