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Energy & Utilities

Marginal loss factors – a barrier to clean energy investment?

13 Dec 2019, by Amy Sarcevic

Over the past few years, the Australian Energy Market Operator (AEMO) has caused quite a stir when setting its marginal loss factors (MLF) – the annually-updated figures it uses to calculate the value of power lost through transmission in a choked energy grid.

The draft figures for 2020-21, released in November, show a steep year-on-year drop in new committed projects and experts say the unprecedented MLF variability will be a major deterrent for clean energy investors going forward.

Ahead of Informa’s Energy & Investment Series, we explore why the MLF methodology is a threat to renewable energy investment and what can be done about it.

Subject to volatility

Though designed to provide a fair way of settling the market when the grid is congested, the MLF methodology is limited, in that its figures can fluctuate dramatically from year to year. And, unlike power prices, this variation is impossible for investors to hedge against.

With the recent volatility, experts like Robert Grant, Chair of the Clean Energy Investment Group (CEIG) say there will be serious financial and economic implications.

“It is already causing a dramatic supply-side effect and may even result in recent wholesale energy price declines reversing,” Grant told Informa.

“The volatility will have to be priced into all investment decisions, which will come through some sort of risk premium attached to the investment case.

“The AEMC is currently going through a survey process at the moment to try to quantify that. We [CEIG] are doing our own analysis and survey and I think the Clean Energy Council (CEC) will do the same. But it’s likely to be in the order of, probably, two per cent on – on top of the cost of equity.

“Which across the entire fleet – to build out AEMO’s Integrated Service Plan (ISP) – is going to cost consumers around another $430 over the term of the ISP delivery.  Across 9 million customers, it’s a very substantial number.”

Favours thermal generation

An additional problem with MLF methodology, generally, is that it tends to favour baseload generators.

Australia’s transmission network was designed many decades ago to serve thermal plants. Geographically, it isn’t positioned to easily transmit power from the many wind and solar farms that are beginning to crop up throughout the country.

This means that wind and solar generators are, inherently, more likely to incur greater transmission losses; and, for the same amount of power generation, will be subject to higher MLF volatility.

Though Australia is beginning to embrace distributed energy resources, particularly in areas of high resource intensity, a consequence of this has been significant volatility in the loss calculations. In fact, the more generation that is put into the AEMO MLF model, the more volatile it becomes.

In summary, unstable MLF figures reduce the attractiveness of the energy asset class in general; but – even if stable – the very nature of MLF methodology makes, particularly, renewable energy assets less attractive to investors.

Hungry for clean energy investment

In our global bid to reduce carbon emissions and provide an alternative energy source for our nation’s ageing coal fleet, this presents a significant challenge.

It is estimated that investment capital to the tune of $70 billion is needed to meet the additional 35 gigawatts (GW) of renewable energy generation and 15 GW of storage Australia needs, as per AEMO’s Integrated Service Plan. At the same time, the AEMC and CEC are showing a dramatic slowdown in investment.

As such, there have been calls to replace the MLF model with a more investor-friendly alternative.

“If we keep AEMO’s MLF model, one of two things will happen: either people do keep investing and the cost of equity will increase to compensate for the risk premium of MLF volatility, or investors will altogether give up and find stronger, more reliable, asset classes,” Grant said.

“Unfortunately, at the moment, the latter appears to be happening. And who can blame them? Let’s not forget that investors can’t hedge against unstable loss factors.

“We are already seeing a 25 percent increase in capital costs – fueled by political and regulatory uncertainty. I fear that the investment needed to replace our ageing coal fleet will not be there unless the power grid is better managed,” he said.

Proposed rule change

The AEMC is currently exploring the possibility of two rule change requests which directly consider the issue of MLFs and how they are calculated, among other related reforms.

These proposals will be assessed against the national electricity objective, and will need to be seen to be acting in the long-term interest of energy consumers; as is the case for all rule change requests.

Dynamic regional pricing – an investor-friendly alternative?

The AEMC’s review on Coordination of generation and transmission investment (COGATI) –access and charging proposes changes to the way generators can access and use the transmission network; also a review on charging arrangements.

These will provide an alternative means for transmission companies to recover the cost of building and maintaining transmission infrastructure within and between regions.

One of the reforms being considered is dynamic regional pricing. This provides an alternative to MLF and a fairer way to settle the market and ration transmission constraints. Unlike the MLF model, it isn’t subject to sharp year-on-year variability.

Within the dynamic regional pricing model, large scale generators will receive a local price that more accurately reflects the marginal cost of supplying power at their network location, whilst retailers will continue to be charged at the regional price.

In doing this, it incentivises generators to more reflectively bid their underlying costs and, in turn, aims to improve dispatch efficiency and associated costs. This is unlike the current model, which the AEMC says incentivises disorderly bidding.

Grant agrees that generators’ concerns about volatility and a lack of ability to hedge could be resolved by the COGATI dynamic system pricing.

But he says the framework being proposed by AEMC is very complex and needs “further analysis and consultation with a whole range of stakeholders”.

“It may be a suitable solution, post the 2025 National Energy Market review, but until then we are all sat here twiddling our thumbs,” he said.

“We can still do the COGATI stuff down the track, but first we need to fix the current rules to keep investment flowing and putting downward pressure on wholesale prices to benefit consumers by having more and cheaper clean energy.”

Average loss factors (ALF) – a potential interim solution

An alternative proposed solution, and one favoured by the CEIG is to move from MLF to average loss factors (ALF). Promoted by Adani, this option focusses on the averaging of losses across a reference mode.

Grant believes making the switch to ALF could save consumers $100-125 per year in their energy bills and provide, at least, a good interim option until other major market assessments.

“We can’t see any reason why moving to an ALF wouldn’t be, at least, a good interim solution as we decide what to do post-2025 in the review that’s currently under away with the ESB; and also to dovetail into whatever happens with COGATI into the future.

“We have made the case for that quite strongly in our submissions. It’s not perfect at providing certainty for investors, but it does continue to provide dispatch efficiency; something the AEMC thinks is important,” he said.

However, Grant argues that “nowhere near enough” analysis has been completed by AEMC in its draft determination.

“Not enough quantitative economic analysis has been included in a draft determination for us to be able to weigh up the benefits of MLF that AEMC believes are important versus the ones which CEIG has calculated to be worth more than $100 per year per customer,” he said.

What next?

The rule process kicked off in July this year and the draft determination was published on November 3rd. Submissions on the draft determination are due around mid-January 2020 and from there the AEMC will make a final determination.

Against this backdrop of development in the NEM, Informa’s Energy & Investment Series will be held on 25-26 February at the Swissotel, Sydney.

This year’s event includes three co-located conferences: Large Scale Solar, Off-Grid & Stand Alone Power and Pumped Hydro and Battery Storage.

Robert Grant is to present at the Large Scale Solar conference where he will talk more about the proposed rule change and implications for clean energy investment in Australia.

Other insights will be heard from the likes of The Hon. Malcolm Turnbull, The Hon. Matthew Keen MP, AEMO, AEMC and the Clean Energy Regulator.

Learn more and register.

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