Why WA is not suited to an energy-only electricity market

Designing an effective energy-only electricity market requires several minimum conditions to address issues like market power and to deliver efficient outcomes. The WA electricity market is too small for such a design to work properly and should maintain a market for power capacity as well as energy.

*This is the executive summary of a report published by Houston Kemps Economists.

Designing wholesale electricity markets to deliver electricity to consumers efficiently both now and into the future has been a key focus for economists.

What we have learned is that a pure market-based approach, where electricity suppliers compete to supply consumers within a market where energy price signals are provided to both consumers and suppliers is best, if it were possible to be implemented.

In practice, nowhere in the world has such a pure market-based wholesale electricity market design been adopted.

This is because the specific characteristics of electricity systems, and of each region in which a market is being introduced, mean that compromises to the pure market based approach are needed to ensure that efficiency is promoted. When Western Australia first examined the problem of how to promote efficiency in electricity supply, it adopted a wholesale market design known as a capacity-plus-energy market.

Its principal feature is that signals for investment in generation capacity are created through a separate market for capacity, which is linked to administratively set capacity prices.

This reflected in part the challenge of making a purer market-based design work in WA, where incentives for investment in generation capacity are created only through the wholesale electricity price equating supply with demand over each market price settlement period – a so called‘energy-only market’.

Now, WA is investigating whether changes to its current wholesale market design are warranted to promote more efficient use of electricity, and production and investment in electricity generation – the Electricity Market Review. It is in this context that EnerNOC – a third party demand response aggregator operating in WA – asked Houston Kemp to:

1) outline the necessary conditions for the successful implementation of an efficient energy-only wholesale electricity market;

2) examine how well the south-west interconnected system (SWIS) of WA satisfies those conditions, compared to the National Electricity Market operating on the east-coast of Australia; and outline the possible implications for WA, should an energy-only market design be adopted.

Requirements for an energy-only market to promote efficient outcomes

There are several minimum market design requirements for an energy-only market to deliver efficient outcomes, namely:

– a sufficient number of generators to ensure that no one generator can exercise substantial market power;

– a sufficiently high market price cap to allow incentives for new generation investment;

– no restrictions on generators entering and expanding capacity;

– restrictions on the co-ownership of generators and retailers if the market is sufficiently small such that it limits the opportunity for a liquid hedging market to develop;

– ability for demand-response to be incorporated into the market; and

– sufficient public information to allow for independent forecasting of market conditions.

In our opinion, these requirements need to be carefully considered as part of the design of an energy-only market.

In addition to these design requirements, consideration needs to be given to the specific circumstances in the market.

Specifically, for an energy-only market design to produce efficient outcomes, the market needs to be sufficiently large so that:

– new generation entry does not have such a significant impact on wholesale market prices that it creates a barrier to entry;

– there is scope to create sufficient competition amongst existing generators to prevent market power, while still realising economies of scale; and

– a sufficiently liquid hedging market can develop.

Why the NEM and SWIS market characteristics matter for choice of market design

The SWIS is a fairly small single region, whereas the NEM is a substantially larger and more complex system of five interconnected regions. The SWIS would be the smallest unconnected energy-only market in the world if it switched from being a capacity-plus-energy market. The two principal elements of the NEM that assist in it operating efficiently as an energy-only market are:

– the structure of its market; and

– the reliability settings that apply to the NEM.

The benefit of efficient investment incentives provided by an energy-only market is significant for the NEM because it is a large and complex system.

The benefit of these incentives would be lower in the SWIS because the market size and generation mix in WA makes efficient investment choices less complex.

The large size and interconnected nature of the NEM also assists in preventing firms from using substantial market power. By contrast, the SWIS is much smaller and therefore faces a greater risk of market power being used by generators.

The reliability settings, including high price caps, allow the NEM to provide incentives for efficient investment and electricity prices, whilst ensuring that the risk of blackouts is low.

For an energy-only market to produce efficient outcomes, the structure of the SWIS will need to ensure that generators do not have market power under an associated high price cap.

Implications for WA of an energy-only market design

There is a significant risk that an energy-only market in WA will be unable to provide sufficient limitations on the potential for the exercise of market power, leading over time to higher prices than would otherwise have been the case in the absence of market power.

To address market power concerns in place of a very large generation business there will need to be a number of small independent generators created to ensure sufficient supply side competition, potentially losing the benefits of the associated economies of scale.

To provide adequate incentives for new investment, the market price cap would need to be sufficiently high, and there would need to be opportunities for a liquid market in hedging products to develop.

To ensure efficient investment in new capacity occurs, there needs to be scope for the demand-side to participate in the market.

Overall, in our opinion an energy-only market is not likely to promote efficient outcomes in WA, given the current characteristics and in particular the small size of the market. Certainly, it would not be possible to simply “port” the NEM market design to WA without modification and expect an efficient, or even workable, result.