Australia: Powering down generators: The proposed Rule change to limit generator market power
Competition and Market Regulation Update

The AEMC will shortly commence Stage 2 of its consultation process regarding a proposed rule change to address potential generator market power in the NEM.

In summary, the proposal envisages:

• Large generators being classified by the Australian Energy Regulator (AER) as 'dominant generators' above individually specified levels of demand.

• When demand exceeds the specified level, the dominant generator would be required to offer all of its available capacity at prices not exceeding $300/MWh.

This article investigates:

• the problem that the proposed rule change is designed to address

• existing regulation of generators, including current proceedings AER v Stanwell Corporation Ltd (Stanwell) and AGL Energy Ltd v ACCC relevant to the interpretation of those regulations

• factors relevant to whether it is necessary to impose further regulations on the market

• likely implications of implementing the proposed rule change.

Summary of proposed Rule change

In April 2011 the AEMC commenced public consultation on a rule change request from Major Energy Users Inc (MEU) in relation to the potential exercise of market power by generators in the NEM.

The MEU proposes that the AER declare generators that have market power during periods of high demand as 'dominant generators'. When regional demand exceeds the level at which a generator has been declared a dominant generator, that generator would be required to offer all of its available capacity for dispatch at a price not exceeding $300/MWh. Other generators would be free to offer any price up to the current market cap of $12,500/MWh and all dispatched generators would continue to be paid at the spot price for the relevant trading interval.¹

The AEMC has extended the period for publication of the draft rule determination until 30 April 2012 and has outlined a three stage consultation process. Stage 2 is scheduled to commence in mid 2011 and includes consideration of:

• whether there is evidence of generators exercising market power in a manner that reduces efficiency

• whether such conduct would fall within the scope of the Competition and Consumer Act 2010 (Cth) (CCA) (previously the Trade Practices Act 1974 (Cth) (TPA)).

Perceived problem

The MEU is concerned that when there is very high demand, large generators are able to cause the wholesale electricity spot price to rise more than it should by offering prices far exceeding their costs.² The MEU states that this is a particular concern in South Australia but that it is also a potential problem in other regions.

Occurrences of very high spot prices, even for a small number of trading intervals over the course of a year, can have a significant impact on the retail price of electricity. In this regard:

• Wholesale electricity costs account for around 37-45% of retail electricity bills.³

• The AER has observed that if prices approach the market cap of $12,500/MWh for just three hours a year, the average annual spot price may rise by almost 10%.⁴

There are a number of ways in which market power in a power pool can be measured. These include the relevant firm's profits, the ability of the relevant firm to withhold supply, the Lerner Index, market concentration and equilibrium analysis using simulation. Set out below is relevant data regarding market concentration and prices. As at 2010, South Australia was the region in which a single private generator had the highest market share. Table 1 shows, for each region, the generator with the largest market share by capacity.⁵

Table 1

The annual average spot price in the various NEM regions fluctuates from year to year, but the trend since 2001/02 is relatively flat except in South Australia, where the volumeweighted average spot electricity price has increased from an average of $37.8/MWh in the years 2001/02 to 2005/06 to an average of $77.8/MWh over the period 2006/07 to 2009/10.⁶ Furthermore, the volume-weighted average spot electricity price in South Australia in 2009/10 of $82/MWh was more than double the average in all other regions of the NEM of $40.25/MWh.⁷

As an empirical matter, the AER has concluded on a number of occasions that for certain trading intervals, the bidding strategies of large generators can have a significant impact on the spot price in a region.⁸ For example, the AER concluded that a contributing factor to high spot prices in New South Wales on 1 February 2011 was rebidding by Macquarie Generation and Eraring.⁹

Existing regulation of generators

There is already a number of provisions that place limits on the behaviour of generators and therefore form important context for the present proposed rule change.Two of those provisions, clause 3.8.22A of the National Electricity Rules (Rules) and s46 of the CCA, are currently the subject of Federal Court proceedings. Set out below is a short summary of each of those proceedings and a brief discussion of the potential relevance of those proceedings to the current rule change proposal.

AER v Stanwell Corporation Limited

In Queensland on 22 and 23 February 2008, the spot price exceeded $9,000/MWh on a number of occasions. Both days were very hot, with the temperature peaking at 39 degrees.

The AER alleged Stanwell did not make some of its rebids on those days in 'good faith', contrary to clause 3.8.22A of the Rules. Clause 3.8.22A provides that generators must make rebids in good faith and that rebids are taken to be made in good faith if, at the time of making the rebid, the generator has a genuine intention to honour the rebid if the material conditions and circumstances upon which the rebid was based remain unchanged.

Specifically, for example, the AER submitted that Stanwell made certain rebids, shifting capacity from low-price bands to high-price bands in the expectation of a positive price/volume trade-off and that, when the dispatch price or forecast price did not increase after the first rebid, Stanwell made a further rebid.

In the relevant instances, the AER alleged that Stanwell did not intend to honour the first rebid and that in determining that question, the Court could consider the making of subsequent rebids and whether there had been any change in material conditions, such as price or forecast price, between the time of the first rebid and the subsequent rebid.

The Court's decision is likely to provide greater certainty as to the circumstances in which generators can make multiple rebids in high demand conditions. If the Court decides that Stanwell's conduct was prohibited by clause 3.8.22A, this could have implications for competition in the wholesale electricity market including, for example, providing greater scope for certain generators, such as slow start and peaking generators, to compete in certain conditions.

AGL Energy Limited v ACCC

In response to a section 155 notice, AGL Energy Limited has brought proceedings seeking a declaration that the notice is invalid and of no effect on bases including that:

• The notice seeks to characterise acts comprising the conventional operation of the NEM as conduct that amounts to a taking advantage of market power.

• The notice does not identify a matter that constitutes, or may constitute, a breach of s46 of the TPA.

• The matters identified in the notice include facts or circumstances that could not, even allowing for undiscovered facts, be a breach of s46.¹⁰

This proceeding is only at an interlocutory stage, but the Court may ultimately consider whether the offering by a generator of electricity at high prices can constitute taking advantage of market power in breach of s46 of the TPA.¹¹

Section 46 of the CCA only prohibits taking advantage of market power if the purpose of that taking advantage is anti-competitive. If this provision can apply to bidding and rebidding in the electricity market, there may be no need to implement a rule change, unless there is a reason for extending that prohibition in the case of the NEM to any circumstances where the relevant corporation does not have a prescribed anti-competitive purpose. In the telecommunications industry, ss151AJ and 151AK of the CCA contain an industry specific prohibition on the misuse of market power in circumstances where the relevant conduct has an anti-competitive effect.

Thus, although the prohibition removes the need to show an anti-competitive purpose, it does not entirely remove the touchstone that conduct will only be prohibited if it has an anti-competitive element.

Is it necessary to impose further regulations on the market ?

In addition to the restrictions referred to above, the proposed rule change would place further limitations on the freedom of participants to compete in the NEM. Whether further regulation is appropriate may depend on factors including whether there exists any market failure, whether political uncertainty has created a temporary barrier to entry, whether there is any incentive for generators to use market power and whether it is necessary to alter the existing balance between price and reliability.

The objective of the National Electricity Law (NEL) is to promote efficient investment in, and efficient operation and use of, electricity services for the long term interests of consumers of electricity with respect to various aspects.¹²

In relation to promoting efficient investment, the NEM is an energy only market. As such, generators only receive payment for energy that is dispatched into the market. It is implicit in this market design that for at least short periods, the spot price may increase to very high levels. For example:

• A framework adopted by the Reliability Panel in its Comprehensive Reliability Review noted that one of the three prerequisites for an effective and robust market was that 'prices must be allowed to rise to a high enough level so that generators have an incentive to build and offer for dispatch sufficient capacity to meet demand, and generators and customers are exposed to a cost that reflects the value of lack of supply to customers if they fail to do this'.¹³

• A market design principle set out in Chapter 3 of the Rules is that market participants be allowed 'the greatest amount of commercial freedom to decide how they will operate in the market'.¹⁴

The AEMC has recognised efficiency as a relevant touchstone, suggesting that conduct may be undesirable if it has a detrimental impact on efficiency in the NEM.¹⁵ While efficiency may be an outcome of the operation of markets, it does not of itself provide any easy answer to the question of whether further regulatory intervention in the market is required.

In the absence of a particular reason for failure of the market, it may be expected that in the long term, high prices for electricity generation would lead to investment in new generation and a consequent reduction in any market power. As such, relevant considerations include not only short-term phenomena such as high prices in recent periods, but also structural factors relevant to likely operation of the market in the long term, such as barriers to entry.

In the present environment, the political uncertainty regarding the introduction of carbon legislation may have had a dampening effect on investment in the last few years.¹⁶ While it is difficult to measure the effect of political uncertainty, it is clear that short-term phenomena such as the temporary delay of investment in electricity generation could result in generators having greater market power in the short term than may otherwise have been the case.

A feature of the NEM is the use of hedge contracts, which can protect generators and retailers from risks associated with fluctuations in price. Hedge contracts can significantly alter the incentives for generators. For example, it could be the case that a generator has a greater incentive to seek dispatch (to cover hedge contacts) than to offer generation at high prices in the hope of influencing the spot price. Although figures are not public, the AEMC Reliability Panel stated in 2007 that some 80% or more of total load is covered by contracts.¹⁷ Furthermore, following the privatisation of electricity assets in December 2010 there is an increasing degree of vertical integration between retailers and generators. In consequence, the existence of market power does not necessarily mean that such market power will be used in an attempt to increase the wholesale spot price.

With effect from 1 July 2010, the maximum price was increased from $10,000/MWh to $12,500/MWh. In its rule change determination, the AEMC concluded that the change would  contribute to the achievement of the National Electricity Objective  (NEO) by promoting efficient investment and that this will further the long term interests of consumers of electricity in terms of representing an efficient balance between the price and reliability of supply of electricity'.¹⁸ Altering the basis on which large generators are permitted to bid could have significant impact upon this balance, resulting in a need to revisit the balance between price and reliability of supply.

Likely implications of the proposed Rule change

The proposed rule would be likely to have significant implications for the NEM, including potentially reducing in the short term the number of trading intervals in which the spot price is above $300/MWh. In the long term, the likely implications of the proposed rule change are unclear and would depend on the approach adopted by the AER in determining the circumstances in which generators are dominant.

1 AEMC, Information Note, Potential Generator Market Power, 14 April 2011, p 1.

2 AEMC, Information Note, Potential Generator Market Power, 14 April 2011, p 1.

3 AER, State of the Energy Market 2010, 15 December 2010, p 98.

 4 AER, State of the Energy Market 2010, 15 December 2010, p 30.

5 AER, State of the Energy Market 2010, 15 December 2010, p 26.

6 AER, State of the Energy Market 2010, 15 December 2010, p 28.

7 AER, State of the Energy Market 2010, 15 December 2010, p 28.

8 The AER has published a number of 'Electricity spot prices above $5000' reports in which it has concluded that high prices were caused in part because of rebidding by generators including reports into the events of 1 and 2 February 2011 (Qld), 31 January to 2 February 2011 (NSW), 19 November 2010 (Tas), 8 – 10 February 2010 (Vic and SA).

9 AER, Electricity spot prices above $5000/MWh 31 January – 2 February [2011] New South Wales, page 1.

10 AGL Energy Ltd v Samuel & ACCC, NSD 1722 of 2010; Statement of Claim, 24 February 2011, paras 63, 64, 86.

11 AGL Energy Ltd v Samuel & ACCC, NSD 1722 of 2010; Defence, 28 March 2011, paras 34.4, 34.5, 34.6.

12 NEL, s 7.

13 Comprehensive Reliability Review, AEMC Reliability Panel, Final Report December 2007, page 38.

14 National Electricity Rules, r3.1.4(a)(1).

15 AEMC, Consultation Paper, National Electricity Amendment (Potential Generator Market Power in the NEM) Rule 2011, 14 April 2011, p 29.

16 It was reported in January 2011 that over $10 billion of electricity investment had been placed on hold as a result of the uncertainty regarding carbon legislation: Matt Chambers ('Uncertainty over carbon pricing puts investment on hold'), the Australian, 10 January 2011.

17 Comprehensive Reliability Review, AEMC Reliability Panel, Final Report December 2007, pages 37-38. 18 AEMC, Final Rule Determination, National Electricity Amendment (NEM Reliability Settings: VoLL, CPT and Future Reliability Review) Rule 2009, page

18. AEMC, Final Rule Determination, National Electricity Amendment (NEM Reliability Settings: VoLL, CPT and Future Reliability Review) Rule 2009, page 18.

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