Discussion with the RCM Working Group 27 March 2012 RCM discussion - PDF document

Discussion with the RCM Working Group 27 March 2012 RCM discussion with the RCM Working Group • W HAT C AUSES E XCESS R ESERVE C APACITY • T HE RCM AS AN A DMINISTRATIVE M ECHANISM • E VALUATING C HANGES TO THE RCM A GAINST THE M ARKET O BJECTIVES E VALUATING C HANGES TO THE RCM A GAINST THE M ARKET O BJECTIVES • T HE E XCESS R ESERVE C APACITY P ROBLEM • T HE R ECENT D OWNWARD R EVISION TO THE MRCP • T HE L INKAGE B ETWEEN THE MRCP AND AN E FFECTIVE RCM 1 The Lantau Group

Options for discussion • A DJUST THE S ENSITIVITY OF THE RCP TO E XCESS R ESERVE C APACITY • I NSTITUTE A Q UANTITY -B ASED C ONTROL M ECHANISM • E NHANCE B ILATERAL M ARKET S UPPORT E NHANCE B ILATERAL M ARKET S UPPORT 2 The Lantau Group Stepping Back • What is the purpose of the RCM? – Incentivise timely addition of capacity – Signal when no further investment is needed – Be compatible with the Market Objectives in the broader context of the WEM • What is the value of reserve capacity? – Administrative value vs economic value – What happens if these two values are not the same? • Who provides capacity? – What “is” capacity? • Putting the RCM in context – Short-term signals versus longer term value management – The RCM as part of the overall WEM context 3 The Lantau Group

Why do we have excess reserve capacity? • On the supply side , investors continuously adjust their Expectations investment plans based on their expectations of future conditions. The amount of excess reserve capacity in the WEM Legacy programmes is also the product of legacy conditions (such as the pre-global is also the product of legacy conditions (such as the pre global financial crisis economic boom), as well as historical RCM programmes (no longer in force), such as the Displacement Mechanism in the original Vesting Contract and the earlier Schedule 7 requirements that required Western Power Corporation to tender for new capacity; and Changing market conditions • On the demand side , current and projected demand will generally not be the same as the level that was previously Global Financial Crisis expected or projected. Market conditions change all the time. The global financial crisis and subsequent global economic The global financial crisis and subsequent global economic Shift towards more energy slowdown exemplify disruptive forces that caused demand to be efficiency and distributed much lower than previously forecast. generation The reasons for excess reserve capacity are complex 4 The Lantau Group The WEM: small, lumpy market – easy to forecast, difficult to get right…. 5 The Lantau Group

The economic value of incremental reserve capacity in the WEM Example from 2009/10 Capacity Year (from appendix to TLG RCMWG paper) 6000 Capacity Credits 5000 Note: 4000 Load Scaled -- Large excess to 10 Percent MW 3000 POE Forecast -- Steep LDC 2000 Actual Load 1000 0 0 1000 2000 3000 4000 5000 6000 7000 8000 Cumulative Hours 6 The Lantau Group LOLP: Based on 2009/2010 Actual Loads 0.0014% 0 0014% 0.0012% Note: 0.0010% LOLP (percent) LoLP w/ DSM -- Few relevant hours 0.0008% LoLP w/o DSM -- Low LOLP 0.0006% 0.0004% 0.0002% 0.0000% 0 4 8 12 16 20 24 28 32 36 40 44 48 Hours Ranked by Load 7 The Lantau Group

Capacity Value based on Actual 2009/2010 Loads 0.18 0 18 0.16 0.14 Capacity Value ($/MW) Note: 0.12 Capacity Value w/ DSM -- Low value 0.10 Capacity Value w/o DSM -- Few hours 0.08 0.06 0.04 0.02 0 02 0.00 0 10 20 30 40 50 60 Hours Ranked by Load 8 The Lantau Group LOLP: Based on the 10 Percent POE forecast for the 2009/10 capacity year 1.4% 1 4% 1.2% Note: 1.0% LOLP (percent) LoLP w/ DSM -- Same story 0.8% LoLP w/o DSM 0.6% 0.4% 0.2% 0.0% 0 4 8 12 16 20 24 28 32 36 40 44 48 Hours Ranked by Load 9 The Lantau Group

Capacity Value: 10 percent POE forecast for the 2009/10 capacity year 160 160 140 120 Capacity Value ($/MW) Note: Capacity Value w/ DSM 100 -- Same story Capacity Value w/o DSM 80 -- Fewer than 50 hrs 60 40 20 20 0 0 10 20 30 40 50 60 Hours Ranked by Load 10 The Lantau Group Observation 1: the RCM over ‐ values incremental reserve capacity relative to its economic value • “…the value of incremental reserve capacity over the year is AUD 253/MW with DSM or AUD 780/MW without it. These values are 253/MW with DSM or AUD 780/MW without it. These values are still much lower than the actual cost of reserve capacity in the RCM.” (p. 20) • The difference between the administrative value and the economic value of capacity credits is extremely high making any transition a value of capacity credits is extremely high, making any transition a cause for potential celebration or alarm – inherently partisan 11

Observation 2: Demand Resource (MWs) by class 24 ‐ 48hr 48 ‐ 72hr 72 ‐ 96hr 96 ‐ all Capacity Year Capacity Year (Class 4) (Class 4) (Class 3) (Class 3) (Class 2) (Class 2) (Class 1) (Class 1) 2010/11 116.5 20 17 0 2011/12 152.1 108 2012/13 414.5 40 As of mid 2011 Note: all of the demand resources are in classes that (currently) align with the number of hours that a resource needs to be available to contribute materially to the provision of valuable reserve capacity 12 The number of capacity credits is not linked to the actual reserve requirement • Under the RCM, any resource that can establish itself as “committed” and declares itself as intending to trade bilaterally can secure Capacity Credits. • The RCM does not require facilities that have declared their intent to trade bilaterally to actually do so. • By stating an intention to trade bilaterally and becoming a committed facility, a new entrant can enter the WEM and earn the administered RCP without ever entering into a bilateral contract, or necessarily intending to operate at all. • As a result, the number of Capacity Credits can decouple (as it has) from the actual reserve requirement. This is not an inherent flaw of capacity markets – investors are supposed to take risks, including the risk that they have entered a market that is prone to oversupply The Lantau Group

Trend in excess reserve capacity 14.6% 14 6% The trend is concerning 14 The Lantau Group Trend in “uncontracted” capacity credits 60% 50% 50% Note: -- Recent reduction 40% in investment activity. Why? 30% -- RCM review? -- MRCP revision? 20% -- Perception of risk? -- Impact contracting 10% behaviour? behaviour? 0% Sep 2006 Nov 2006 Jan 2007 Mar 2007 May 2007 Jul 2007 Sep 2007 Nov 2007 Jan 2008 Mar 2008 May 2008 Jul 2008 Sep 2008 Nov 2008 Jan 2009 Mar 2009 May 2009 Jul 2009 Sep 2009 Nov 2009 Jan 2010 Mar 2010 May 2010 Jul 2010 Sep 2010 Nov 2010 Jan 2011 Mar 2011 May 2011 Jul 2011 Sep 2011 Nov 2011 1-%RCR contracted Why? 15 The Lantau Group

Why the trend in uncontracted capacity credits? • The upward trend in the uncontracted reserve Uncontracted Capacity Credits 60% capacity requirement suggests that – generators prefer to contract with the IMO or 50% – that retailers prefer not to contract with 40% generators. 30% • Is it easier to deal with the IMO (e.g., lower transactions costs) or is there a disconnect in 20% the market (e.g., the IMO sets a floor price when the actual economic value of credits is 10% lower)? 0% p 2006 v 2006 n 2007 ar 2007 y 2007 ul 2007 p 2007 v 2007 n 2008 ar 2008 y 2008 ul 2008 p 2008 v 2008 n 2009 ar 2009 y 2009 ul 2009 p 2009 v 2009 n 2010 ar 2010 y 2010 ul 2010 p 2010 v 2010 n 2011 ar 2011 y 2011 ul 2011 p 2011 v 2011 Ma Ju Ma Ju Ma Ju Ma Ju Ma Ju Se No Ja Ma Se No Ja Ma Se No Ja Ma Se No Ja Ma Se No Ja Ma Se No 1-%RCR contracted This is the most concerning evidence of an administrative cause to the mismatch between supply and demand 16 The Lantau Group MRCP review • The RCP is a function of the MRCP, which is, in turn, based on the estimated cost of connecting a 160MW gas turbine to the WEM. • The recent changes to the MRCP included significant methodological and definitional adjustments: – The basis for the estimate of transmission connection costs was changed; and – The specification of the generation technology was altered to incorporate inlet cooling. • Together these specific changes reduced the MRCP by over 20% The significant reduction in the MRCP due to methodological or definitional changes is a crucial factor to consider when evaluating the RCM 17 The Lantau Group

Economic implications of the MRCP revision • The MRCP is a hard cap to the value of a capacity credit in the WEM – The value of a capacity credit can be lower than the MRCP, but not higher • The expected value of a capacity credit is therefore below the MRCP The expected value of a capacity credit is therefore below the MRCP Is this a problem-in-waiting? 18 The Lantau Group What next? 19