Mostly working: Australia’s wholesale electricity market

1 Jul 2018

Wholesale electricity prices rose across Australia’s National Electricity Market (NEM) by 130 per cent between 2015 and 2017. The value of electricity traded in the NEM more than doubled, from about $8 billion to $18 billion. Household bills increased by up to 20 per cent in 2017 alone. Consumers are not happy, and politicians are under pressure to fix the problem. But fixes are either non-existent or complicated.

Three issues caused the price increases. First, two big, old, coal-fired power stations closed (Northern in South Australia in 2016 and Hazelwood in Victoria in 2017). Although they were low-cost to operate, they faced big maintenance bills that weren’t worth paying given low market prices as a result of historic oversupply. Their closure reduced supply and pushed prices up. This accounts for about 60 per cent, or $6 billion, of the increase in the value of electricity traded annually in the NEM between 2015 and 2017.

Second, the price of key inputs, especially gas and black coal, rose just when the plants they fuel were needed more often. This accounts for up to 40 per cent of the price increase between 2015 and 2017.

Both these issues are largely beyond the control of governments. In both cases, the market responded efficiently to the changing circumstances. Prices have increased to levels that are expected in the long run, closer to the long-run marginal costs of generation including construction and maintenance costs. But prices have not gone so high as to attract much additional investment in the system, beyond the additional supply from subsidised renewables schemes.

The third issue is that generators ‘game’ the system: they use their power in concentrated markets to create artificial scarcity of supply and so force prices up. Supply in all NEM states (Queensland, NSW, Victoria, South Australia and Tasmania) is concentrated, so a single outage, plant closure or transmission constraint can lead to a supplier having a high level of transient market power. In these circumstances, generators can temporarily force prices up.

Gaming has occurred in Queensland and South Australia, there are signs of it in Victoria since the closure of Hazelwood, and it could appear in NSW as supply tightens with the scheduled closure of the Liddell coal-fired power station in 2022. Gaming has been a part of the market for years and appears to be permitted by the current market rules. It is notoriously hard to identify, but it may add as much as $800 million to the price paid for electricity traded in the NEM in some years.

We draw three conclusions from this analysis. First, wholesale prices are very unlikely to return to previous levels of around $50 per megawatt hour. Over-supply, as a result of historic over-building, is disappearing, and gas prices will stay higher than they were in the past. And new generators, using any technology, including coal, cost more. Additional, subsidised renewable supply could put some downward pressure on prices, but this will be transitory because the ‘intermittency’ of wind and solar energy will ultimately have to be paid for. This is not good news, but politicians should be honest with consumers about the harsh truth: higher wholesale electricity prices are the new normal.

Second, governments and the market operator should consider additional changes to the bidding rules to reduce gaming. But more drastic actions, such as lowering the cap on wholesale prices or intervening in the market to break up private energy companies, should be rejected because they are likely to create bigger problems.

And third, governments must provide stable energy and climate-change policy so there are clear incentives to invest when supply tightens and prices rise. Australian households and businesses could then get low-cost, high-reliability, and low-emissions electricity.

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