Lessons from the NEM: Missing policies and random interventions

A new Cambridge University paper has assessed the strengths and weaknesses of energy market reform in Australia over the past 20 years.

The paper[i], by economics Professor Paul Simshauser from Griffith University’s Business School, considered the centrepiece of energy market reform, the introduction of the National Electricity Market (NEM), and the lessons it offers. 

Its assessment? By “virtually any metric” for most of the past 20 years the NEM has been “a marvel of microeconomic reform”, but missing policies have produced outcomes that are now testing “political tolerances” and have led to “piecemeal and random interventions that are likely to inflame rather than resolve matters, at least over the near term”.

Below we look at what are identified as the critical missing policies and the strengths and weaknesses in Australia’s energy reforms.

Weaknesses

The paper lists, “with the benefit of hindsight”, seven weaknesses that have led to the current energy situation in Australia. These are:

1. The lack of a clear gas market and LNG export capacity policy architecture prior to LNG investment commitments in 2010-2012. “With the benefit of hindsight LNG export licencing should have restricted to the availability of “booked” 2P Reserves above that required to service the domestic market for natural gas”. This missing policy needed to be coordinated at a national level. Gas shortages, the paper finds, remain an unresolved problem. The answer though is prospective new supply measures, rather than “retrospective policy intervention which may inflame perceptions of sovereign risk”.

2. Policy discontinuity, poor design, and a general lack of an integrated climate and energy framework. This missing policy has adversely affected investment continuity in the NEM and remains a live problem. Other policies that were introduced such as the expanded Renewable Energy Target were incompatible with the NEM design, with investment disconnected from forward markets and driven by side-markets. “This problem risks being further compounded by the rising use of government-initiated CfDs” (Contracts for Difference). These CfDs have been introduced to support state-based renewable ambitions (and were the subject of this EnergyInsider piece), and while effective they are “incompatible with the NEM design”.

3. Plant exit policy. According to the paper, this could have been better managed in the NEM if the gas market was functioning properly. Regardless, transparency around exit timing needed to be greatly improved. This has now been “semi-resolved” through the three-year closure rule change. “However, looking forward, each State Government should have a well-rehearsed plant exit policy; the closure of the 1600MW Hazelwood Power Station (20 per cent VIC market share) over 6 consecutive trading days with 5-months’ notice did not represent an orderly exit.” In hindsight, some component of Hazelwood’s required $400m capital expenditure program could have been taxpayer (or electricity consumer) funded, on a cost-plus basis so as to ensure an orderly exit and provide the market with more time to adjust given predictable entry lags.” Such a policy “should be a contingent policy, used judiciously to facilitate orderly exit, and only applied in critical circumstances”.

4. Competition policy. Federal, State Governments and the Australian Competition and Consumer Commission (ACCC) prioritised ownership (i.e. privatisation) over competition, and allowed an excess of horizontal merger and acquisitions. The ACCC also “over-diagnosed vertical integration, and under-diagnosed more adverse horizontal aggregations”.

5. The over-diagnosis of price discrimination by various agencies and governments. This is likely to adversely impact a component of NEM reforms “that has generally performed well”. The paper argues that a policy of re-instating a regulated price cap will not solve the underlying problem of affordability” and will leave consumers as a class no better off, while some consumers will be materially worse off as deep discounts contract.

6. In the absence of a formal binding agreement to meet certain policy objectives, the COAG Energy Council ultimately becomes a weakness of NEM governance because it needs multiple State and Territory Governments across different political parties, as well as the Commonwealth to reach agreement on material policy changes.

7. Network regulation. This had proved to be a weakness from 2004-2015 with critical errors made by State Governments.

Strengths

The strength’s cited in the paper include:

1. The NEM’s energy-only, gross pool market design, high market cap price and the associated market for forward derivatives. This has delivered resource adequacy and withstood an array of economic and technical conditions.

2. The NEM’s core governance approach and approach to “open-source” rulemaking had minimised misguided political interference. “It is however noteworthy that random interventions by the Commonwealth Government has been rising, ironically due to market failures associated with the missing policies and the misdiagnosis of price discrimination”.

3. State Governments and the ACCC have allowed (or been forced by the courts to allow) capital markets to determine vertical business boundaries.

[i] “Lessons from Australia’s National Electricity Market 1998-2018: the strengths and weaknesses of the reform experience”, Paul Simshauser, University of Cambridge Energy Policy Research Group, July 2019.