Tackling growing costs of energy reforms

The Australian Energy Market Operator (AEMO) recently submitted a rule change proposal in Western Australia that would amend the way its budget is set. The changes would have resulted in a shift from a fully regulated model to a National Electricity Market-like unregulated approach. Stakeholders raised concerns the proposed rule change would reduce transparency and accountability, and Energy Policy WA rejected the rule change proposal last week, suspending AEMO’s current Allowable Revenue Framework (ARF) and establishing a full review of the ARF.

At the same time AEMO lodged its rule change proposal, the Australian Energy Council engaged Rennie Advisory to identify the root causes for what have become AEMO’s unpredictable and steadily rising costs, assess the extent to which AEMO's rule change proposal does or doesn't address those issues, and consider what options may be available to reform the ARF.

Here we take a look at AEMO’s rule change proposal, the issues identified by Rennie Advisory and some options that Energy Policy WA could consider in its review of the ARF.

Why did AEMO lodge a rule change proposal?

In Western Australia, AEMO is required to submit its allowable revenue and forecast capital expenditure proposal to the Economic Regulation Authority (ERA) for review and approval every three years. Once the budget is set, AEMO can recover its costs from electricity and gas market participants through market fees. This process received little attention for many years as costs only marginally increased, but that all changed with the start of the Wholesale Electricity Market (WEM) Reform program. The current three-year allowable revenue period – known as AR6 – has seen a sharp increase in costs caused by two in-period submissions triggered by regulatory reforms plus scope changes and cost overruns.

Source: Rennie report

The problem with the fast growth in AEMO’s costs and the frequent in-period submissions is that it’s difficult for market participants who pay the operator’s fees to predict and recover those costs. This creates a double-edged sword: if a participant over-forecasts future costs their retail contracts may be uncompetitive but if they don’t, the participant could be reducing their already slim margins by absorbing the cost increases.

Rennie Advisory unpacked this issue in their newly released report on the ARF. The below graph shows just how challenging it is for market participants to assess the impact of fee projections between AR5, AR6 and then the two in-period submissions. Had a market participant assumed fees set at the AR6 final determination level, they would have been out of pocket over $1/MWh in FY2025.

AEMO points to the pace of the WEM Reform program as having made it difficult for them to forecast costs and schedules with certainty. Exacerbating the problem is the fact AEMO operates as a not-for-profit organisation which is incentivised to deliver reform programs and not reduce costs or find efficiency gains in the same way a profit-driven network service provider is. To put this into context, of the 18 projects that were approved in the previous allowable revenue period, nine projects exceeded budget, five projects were not started, and $5m was spent on projects that were not assessed by the ERA. This unpredictability makes it hard for market participants to get a clear roadmap on project costs and schedules, and the ERA has limits on the extent to which it can keep AEMO accountable for these deviations under the current framework.

To address these challenges, AEMO proposed a rule change in August 2024 that removed the requirement for the ERA to determine AEMO’s budget. In its place would be a new budget and fee design process featuring:

• Early engagement on AEMO’s priorities and activities, including publication of draft annual budget and fees;
• Major project delivery reporting;
• Transparency of performance through annual reporting; and
• Review and oversight of the effectiveness of the new framework by Energy Policy WA’s Coordinator of Energy as part of regular WEM effectiveness reporting.

In short, AEMO in WA was proposing to move towards a NEM-like model where there is no regulatory oversight and instead focus on stakeholder engagement.  

Does the rule change proposal address the problems?

The Australian Energy Council engaged Rennie Advisory to undertake a root cause analysis of the existing problems with the ARF and consider whether the rule change proposal would address these issues. Rennie Advisory tackled this with an issues tree that identified a range of potential causes for further investigation. Starting with 19 shortlisted potential causes, six causes were considered unlikely to exacerbate the problem while five causes were later classed as ‘not significant’ after further analysis. This left eight causes that Rennie Advisory assessed as being potentially significant contributors to the problems with the existing ARF.

Based on this analysis, it appears the problems with the existing ARF centre around a few key issues. Firstly, 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 and too often the result is cost and schedule blow outs for new projects. On the flipside, it’s unrealistic to expect that AEMO can accurately forecast reform-driven costs across a three-year cycle. These factors have resulted in the need for additional projects and funding to be regularly assessed via in-period submissions causing unpredictability in market fees.

Rennie Advisory also points out the current framework provides limited incentives for AEMO to operate efficiently. AEMO must instead prioritise the delivery of the full scope of reform work over reducing costs, and the ERA has limited powers if AEMO spends its already previously approved budget before the end of the allowable revenue cycle and then requires more funds, creating a loophole in the ARF. 

Another issue identified by Rennie Advisory is the systemic underestimation of the costs of externally and internally driven projects, including both capital expenditure (capex) and operating expenses (opex). The ERA has previously suggested this could be improved by AEMO implementing more proactive governance processes.    

Rennie Advisory’s report then considers how well AEMO’s rule change proposal would address the validated root cause issues. The results are fascinating. AEMO claimed in its rule change proposal that a shorter forecast period would improve cost and schedule certainty while transparency would be boosted by shifting external oversight from the ERA to market participants. The Rennie Advisory report instead says the rule change proposal would reduce transparency, accountability and incentives to operate efficiently because of the removal of the ERA’s role. The rule change proposal does offer some minor improvement to forecasting accuracy but that is offset by “little improvement in certainty for market participants due to removal of accountability measures to ensure spending remains in line with budgets.” AEMO’s rule change proposal does not address its tendency to under-estimate project costs, and nor does it consider the merits of better cost-benefit analysis before reforms are given to AEMO to implement.

The message in Rennie Advisory’s report is clear – AEMO’s rule change proposal would not have solved the problems they were trying to address. In fact, the reduced transparency, accountability and incentives to operate efficiently would, on balance, lead to a worse situation for market participants and end customers.

What options are available to reform AEMO’s budget framework?

Energy Policy WA noted in its Draft Rule Change report published last week that there was unanimous feedback from stakeholders objecting to AEMO’s rule change proposal. Energy Policy WA concluded the rule change proposal should be rejected and instead a full review of the ARF be undertaken.

The Rennie Advisory report will now be a useful addition to the review being led by Energy Policy WA. Using the root cause analysis and assessment of AEMO’s proposal, Rennie Advisory’s considered what options might be available to reform the existing ARF. Again, the outcome is insightful. Absent some mechanism that will incentivise AEMO to better manage costs, there are no silver bullets that will instantly solve all of the problems with the ARF. Instead, it will likely be a number of options that combine to edge the framework towards a more optimal design.   

One of the ‘no regrets’ options identified in the report is the creation of a WEM Reform Implementation Roadmap. This could draw on elements of the NEM Reform Implementation Roadmap, taking the form of an integrated timeline showing the stages and status of each initiative and the amount spent against the estimated budget. This roadmap would give market participants better insight into the timing and cost of future projects and help policy makers to identify efficiencies.

The other ‘easy win’ proposed by Rennie Advisory is the establishment of a database of past project costs. This initiative would help to validate early-stage budgets and support policy development processes at a relatively minor cost to develop and maintain.

Among the more interesting options put forward by Rennie Advisory is the potential for the Coordinator of Energy to be empowered to make adjustments to the ERA-approved allowable revenue and forecast capex. This would have the benefit of linking costs to the policy development process and timeframes, but the major drawback is that checks and balances would be reduced by removing the ERA’s role in scrutinising major projects; in effect, this option would allow the Coordinator to approve budget with no oversight and scrutiny which is a major concern  stakeholders had with AEMO’s proposal to eliminate ERA oversight.

Addressing the root cause issues

Rennie Advisory has produced a valuable piece of work that pinpoints the root cause issues with the current ARF and identifies options to be considered as part of Energy Policy WA’s review of the ARF. While a fulsome review of the ARF is welcomed by the Australian Energy Council, it is hoped  the scope of the review is widened to include all of the root cause issues.

Many stakeholders are quite sympathetic to AEMO who in recent years have been required to implement a large number of projects to address the energy transition underway in the WEM. The volume of the projects being given to AEMO is outstripping their capacity to manage them. And to compound the problem, many of these early-stage policies are given to AEMO to implement without a budget being developed, policy makers having sufficiently considered whether the reforms generate an adequate benefit for the cost, thought given to whether the policy is actually a priority, and consideration as to how the reform interacts with other projects, and whether it might create a duplication of efforts.

A review that only focuses on the ARF may miss the biggest problem – that is, the volume of projects that AEMO is being required to implement without decision makers having first put together a budget, undertaken a cost/benefit analysis, or assessed its priority.

You can access Rennie Advisory's report via this link: https://www.energycouncil.com.au/media/3jjhs352/20241210-final-report-aemo-budget-framework-v1-0.pdf