Analysis of the Victorian power market

The analysis presented in this note was undertaken on an unpaid basis for Liberal Victoria to assist in
the development of energy market policies that are effective in delivering consumers more reliable,
secure, lower priced power.

Introduction
At the COAG Energy Council meeting in Sydney on 26 October 2018 the Ministers agreed that “… the
Energy Security Board will progress development of draft National Electricity Law amendments that
would give effect to a Retailer Reliability Obligation, including undertaking any further necessary
stakeholder engagement. ESB will return to Council with a final draft Bill for decision in December
2018.”1

COAG claimed the Retailer Reliability Obligation would “..ensure enough of the right resources will be
available to meet demand in the National Electricity Market (NEM) particularly in regions with limited
access to dispatchable generation.”

The fact that such an add-on to the NEM is seen as necessary to ensure consumers receive a reliable
supply suggests that there is a more fundamental problem with the way in which the National Electricity
Market and the associated institutional, regulatory and political settings bring forth new generation
investment, or otherwise.

The Victorian government has recently laid out a climate change framework that aims to transition
Victoria towards a net zero emission reduction target by 2050.2 This target is consistent with that implied
by the Federal Government’s commitment under the Paris Agreement.3 A key plank of the Victorian
Government’s plan to reduce emissions is to increase the quantity of renewable energy generation in
Victoria. Indeed, it is not practically possible with current technology to achieve the government’s aim
of being net zero emissions by 2050 without a vast increase in renewables and almost total shut down
of almost all existing fossil fuel generators in Victoria over the next 30 years.

The obvious challenge will be to ensure this emissions reduction goal, or any meaningful emissions
reduction goal can be achieved without sacrificing reliability and energy affordability. Unfortunately the
Victorian Government’s Climate Change Framework does not set out how it intends to manage these
objectives. In light of the clear difficulties in managing system security and reliability that are emerging
across the NEM as more of the aged synchronous generators are being shut down, as evidenced by
COAG recognition of the need for the Retailer Reliability Obligation, it is important for the government
to be certain that it has arrangements to avoid reliability, security and affordability problems emerging.

1
COAG Energy Council Communique, 26 October 2019, Weblink:
http://www.coagenergycouncil.gov.au/publications/20th-energy-council-ministerial-meeting-communiqu%C3%A9
2
Victoria’s Climate Change Framework, Weblink:
https://www.climatechange.vic.gov.au/__data/assets/pdf_file/0021/55254/DELWPClimateChange_Framework.pdf
3
Climate Change Authority (2016), Towards a Climate Policy Toolkit: Special Review on Australia’s Climate Goals and
Policies, p. 2. Weblink: http://climatechangeauthority.gov.au/special-review/towards-climate-policy-toolkit-special-review-
australias-climate-goals-and

frontier economics
Analysis of the Victorian power market 2

If the government does not manage these important aspects of achieving lower greenhouse gas
emissions then the public will resist any further emission reductions.
The aim of the analysis presented in this note is to:
 show how significant a problem the disorderly shut down of another coal fired generator in Victoria
is likely to be in terms of price effects
 show the extent to which this effect can be ameliorated by the development of a new dispatchable
synchronous generator. This option can be used to simultaneously lower the Victorian government’s
expenditure on electricity, lower prices for all consumers compared to what they would pay
otherwise, and improve system security and reliability.
This note also sets out a more general scheme that Victoria can put in place to provide long term
generation security to ensure the challenge of achieving a cleaner energy sector is not lost because
there is no plan to manage the legitimate expectations of consumers to be able to have access to
reliable, secure and affordable power.

Impact of disorderly generator shutdown in Victoria

In the past 6 years the NEM has seen the closure of over 5,000 MW of older (mostly coal fired)
generators. The average notice period of the closure of these plants was about 5 months. In the past
the closure of these power stations did not attract much notice because there was excess generation
capacity and new power stations were being built and planned by the private sector. Nowadays, there
is much less spare capacity and the only new power stations being built are those being sponsored by
governments and these are dominated by intermittent renewable generators. The quantity of new
renewable generation being commissioned and planned for exceeds the growth in the demand for
electricity. This means that these subsidised renewable, usually intermittent, generators will displace
the existing stock of generation. It is this process of displacement that results in total emissions falling.
Unfortunately, the vast majority of new renewable generators cannot produce electricity on demand –
that is, they are not fully dispatchable. Moreover, these generators, by and large, do not provide the
power system the electrical services (although some of them can be designed to do so), supplied by
the power stations they displace, to ensure the power system is secure. This means that, in almost all
cases to-date, that an older style fossil fuel generator is which is replaced by a cleaner, renewable
generator will result in the power system becoming more fragile, less resilient. This trend cannot
continue without steps being taken to ensure the power system has the security services that are
essential to operate a power system Australian consumers have had in the past and expect to have in
the future.

In an effort to slow up this process of change and to give the market time to respond to the transition to
a cleaner generation sector, Finkel recommended that government put in place a restriction on power
stations closing. More specifically, Finkel recommended that power stations provide three years notice
of closure.4

Consumers should not be comforted by Finkel’s recommendation accepted by all States that generators
should provide advanced warning of impending power station closure. A generator can more or less
cease production without closing. Indeed, this is what usually happens in the lead up to the closure of

4
Australian Energy Market Commission, Generator three year notice of closure, Rule change application, Weblink:
https://www.aemc.gov.au/rule-changes/generator-three-year-notice-closure

frontier economics
Analysis of the Victorian power market 3

a power station – it just stops producing electricity because it is uneconomic and it takes a long time to
undertake repairs and maintenance. Generators have many opportunities to game Finkel’s proposal.
For example, they can bid a price too high to be dispatched. They can confect fuel supply problems.
They can go-slow on maintenance. They can experience “unforced outages” that require extended
periods of investigation to determine the root cause and solutions. The list of reasons for not producing
are endless.
Given the inability of government to prevent private power stations from closing in response to the influx
of newer generation (short of nationalising them) government needs some mechanism for ensuring the
power system has all the infrastructure necessary to ensure a secure, reliable power system that is
affordable.

NEG Retailer Reliability Obligation

In the past the NEM has delivered sufficient generation capacity to meet base and peak electricity
demand. Due to the uncertain investment environment new generation investment does not occur
unless it is supported by the taxpayer. The Energy Security Board (ESB) has now laid out a complicated
eight-step central planning process for bringing in new generation capacity. The ESB’s eight step
process is the “reliability limb” of the ESB’s failed National Energy Guarantee.5

The philosophy behind this complicated scheme is that market information is provided regarding the
likelihood of generation reliability shortfalls and the market is given the opportunity to invest in response
to this information. If the market does not respond within three years of an expected shortfall then the
regulator – the Australian Energy Regulator - comes in with a ‘big stick’ to force the retailers to buy
reliable capacity. If the ‘big stick’ doesn’t work then AEMO intervenes in the market to acquire reliable
capacity, the costs of which will be forced on to consumers.

For the same reasons that investment in new generation has stalled in general in the NEM, retailers
are very unlikely to respond to the ESB’s market information about the need for new reliability
generators. In fact, investment in capacity for reliability purposes is even more risky than capacity
designed for high levels of ultilisation. This is because capacity that is designed to run infrequently tends
to produce widespread reliability benefits for the entire system and its value is much harder to predict.
It is harder to predict because these events are driven by highly volatile weather events and in any case
the AER’s wielding of a ‘big stick’ to manipulate the market means that it is very unlikely that any
generator will recover the costs of investing in peak generators.
Given these difficulties, it is hard for a single participant to capture enough of the benefits to justify the
costs of investing in peak generation. This means that investors are very unlikely to respond to AEMO’s
forecast reliability shortfall. At best, there will be a delayed response from the industry to see if someone
else will invest in new, highly risky, reliability generation capacity. It is difficult to imagine that NEM
governments will sit idly by and patiently wait for investors who have been subjected to years of the
AER’s ‘big stick’ to eventually respond to the ESB’s predicted shortfall. Inevitably, the Energy Minister
in the region facing the shortfall will be pressured into acting sooner rather than later. It is more likely
than not that the relevant Minister will agitate to have the RRO activated, or some other mechanism in
place to build new reliability capacity, well in advance of the expiration of the three year waiting period.
This ‘early’ intervention will then begin a cycle of further interventions as investors will be certain that

5
Energy Security Board (2018), National Energy Guarantee, Final Detailed Design, 1 August, p. 36, Weblink:
http://www.coagenergycouncil.gov.au/sites/prod.energycouncil/files/publications/documents/Final%20Detailed%20Design%20-
%20National%20Energy%20Guarantee_1.pdf

frontier economics
Analysis of the Victorian power market 4

governments will act before the market and this risk intensifies the risk that other investments will be
exposed to financial stranding. This means that under the ESB’s proposed reliability arrangements the
market will be in a constant state of AEMO intervention. While AEMO embraces intervention, this is not
conducive to improving the long-term stability of the NEM investment environment nor to long term low
price outcomes for consumers.
NEM governments need a better, longer term solution to these investment risks. One interim solution
is for States to directly sponsor the development of reliability capacity to secure their own power
systems. While this interference is not ideal the alternative of system insecurity and, at worst, system
failure, is even less appealing.

Modelling framework and approach

Modelling questions

Frontier Economics has conducted modelling to answer the following questions:

1) What would the likely Victorian wholesale electricity spot prices be between 2020 and 2030

2) What would happen to Victorian wholesale electricity spot prices if Yallourn Power Station
closed

3) What would Victorian wholesale electricity spot prices be if the State kept Yallourn in the power
system and also invested in additional dispatchable capacity equal to the State government’s
load?

Modelling approach

The modelling was undertaken using Frontier Economics’ suite of the power systems models. These
models can predict the impact structural changes, such as a big power station being shut down, can
have on the bidding behaviour of the remaining generators and, hence, prices. In general, when a large
power shuts down and an equivalent source of competition does not replace it then the market power
of the remaining generators will rise. The remaining generators will eventually use this market power to
offer their production for higher prices and consumers will have little choice but to pay these higher
prices.

The modelling took account of all latest market arrangements and State based schemes, including
Victoria’s VRET scheme. We were asked not to include the recently announced enhancement to
household solar subsidies.6 Demand forecasts are based on those produced by AEMO and this
modelling is based on the average demand forecasts for each region.

Modelling results

The Victorian government’s Climate Change Framework which involves a significant increase in
subsidies for renewable generation. This will result in an influx of new capacity and this will initially bring
down spot prices in Victoria and, possibly, associated hedging contract prices. This depressing effect
on spot prices is often used to support even greater supplies of renewables. Unfortunately this so-called
‘merit order effect’ is short lived as inevitably the competition from subsidised renewables, which have
very low variable costs, will mean that existing thermal generators will not be able to recover their fixed

6
Solar Victoria, Weblink: https://www.solar.vic.gov.au/Solar-Panel-Rebate

frontier economics
Analysis of the Victorian power market 5

and, ultimately, their variable costs. This will result in the exit of the most marginal generator first and
then the next and so on. As this exit of these older power station occurs two things will happen. Firstly,
the remaining thermal power stations will have greater market power because there will be times where
intermittent renewable generators can’t supply the market and these remaining generators will bid
accordingly. This will drive prices up as occurred when Northern Power Station closed in South Australia
and when Hazelwood Power station closed in Victoria. Secondly, the loss of large older style power
stations reduces the availability of critical electrical services, such as inertia. Inertia is crucial for the
secure operation of the power system. While batteries can be used to reduce the requirements for
inertia they do not, currently at least, provide inertia. Wind generators do not generally provide inertia,
or where they can, not much inertia. Solar plants provide no inertia. There are some specialised pieces
of equipment that can be used to provide inertia but these are expensive and they are not presently in
the market, or at least there are no significantly sized machines. There are dispatchable renewable
generators that can provide these critical security services, such as hydro and concentrated solar power
plants that use steam turbines. These plant types are already being planned for the development in the
NEM. Most large scale thermal generators can provide these services too.
While EnergyAustralia have indicated that Yallourn is planned to operate until 2032 7 this is very unlikely
to be the case in reality. This is because it will become very difficult for Yallourn to make sufficient
revenues in the face of the influx of subsidised renewables expected in the Victorian market in the
coming years which will reduce their output at the same time as lowering prices, thereby diminishing
Yallourn’s revenues. This decline in revenue, together with higher coal royalties imposed by the
government, and the prospect of ever higher renewable targets, will inevitably drive EnergyAustralia to
a decision to close Yallourn power station in the next few years.

The modelling presented below in Figure 1 shows three lines:

1) Blue line – this shows the effect of the influx of subsidised renewables entering the Victorian
market from the government’s Climate Change Framework as it applies to the stationary energy
sector. These renewables initially causes prices to fall significantly. This is because the existing
generators have enhanced market power following the closure of Hazelwood Power Station.
The subsidised renewables results in greater competition and this causes prices to fall.

2) Red line – this line shows what happens to Victorian spot prices if Yallourn Power Station closes
in response to the expectation of ever declining prices from ongoing subsidised entry of
renewables, at the same time the costs are increasing (e.g. higher coal royalties, higher
maintenance costs as the power station ages).

3) Grey line – this line shows what happens to Victorian spot prices if the State works with Yallourn
to ensure the power station stays online until its design life of 2032 8 and the State invests in a
500MW dispatchable power station (the modelling reflects the operation of a high efficiency,
low emission gas turbine but the competition and security effects on the market would be similar
for all other dispatchable technologies, including dispatchable technologies such as
concentrated solar thermal power, or an equivalent hydro power station or coal fired
generation).

7
Energy Australia, Yallourn Power Station, Weblink: https://www.energyaustralia.com.au/about-us/energy-
generation/yallourn-power-station
8
This is consistent with AEMO’s objective to sweat the existing coal assets as much as possible, see AEMO
Integrated System Plan, p 6. Weblink: https://www.aemo.com.au/-
/media/Files/Electricity/NEM/Planning_and_Forecasting/ISP/2018/Integrated-System-Plan-2018_final.pdf

frontier economics
Analysis of the Victorian power market 6

Figure 1: Transition of Victorian wholesale spot prices (2020 to 2030)

Low spot prices and declining output

140 and higher coal royalties pushes
Yallourn out of the market causing
prices to jump
120

100

80

60

Initial fall in spot

prices from influx Spot prices with Yallourn
40 kept in system and 500
of renewables
MW of new dispatchable
capacity
20
With Yallourn Without Yallourn With Yallourn and new 500 MW of dispatchable capacity

0
2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030

Source: Frontier Economics modelling

Customer impacts
The sustained reduction in wholesale price that results from keeping Yallourn operational for its design
life to 2032 and the commissioning of 500 MW of dispatchable generation capacity can be directly
translated into savings for consumers.
Table 1 shows the annual savings (in nominal terms) by broad household type, in terms of size of annual
power consumption – Large family home, Typical Household and Small unit.

Over the period from 2020 to 2030 households with high levels of consumption can expect an annual
savings of $645 on average. Households with above average consumption can expect annual average
savings of about $355, while households with average consumption can expect savings or around $215.

Table 2 shows the potential annual savings for two representative sized businesses – Small and
Medium SME (as defined by annual consumption levels of 20,000 kWh and 40,000 kWh, respectively).
Over the period from 2020 to 2030 small businesses can expect to save $860 p.a. while double the
savings would be expected by a business double that size, that is, $1,720 p.a.

frontier economics
Analysis of the Victorian power market 7

Table 1: Electricity price savings by household type (2020 to 2030)

YEAR SAVINGS P.A. BY HOUSEHOLD SIZE - NOMINAL

Household category Large family home Typical household Small unit

Average consumption p.a.

15,015 8,269 5,008
(kWh)

2020 $962.31 $530.00 $320.99

2021 $653.80 $360.08 $218.08

2022 $619.63 $341.27 $206.69

2023 $682.68 $375.99 $227.72

2024 $345.59 $190.34 $115.28

2025 $576.84 $317.70 $192.41

2026 $461.58 $254.22 $153.97

2027 $586.41 $322.97 $195.61

2028 $610.88 $336.44 $203.77

2029 $804.80 $443.25 $268.45

2030 $800.73 $441.01 $267.09

Average (nominal) $645.93 $355.75 $215.46

Source: Frontier Economics, Consumption data from:

https://www.mountalexander.vic.gov.au/files/Environment/What_is_a_Typical_Energy_Consumption_Presentation.pdf

frontier economics
Analysis of the Victorian power market 8

Table 2: Electricity price savings by broad business type (2020 to 2030)

YEAR SAVINGS P.A. BY BUSINESS - NOMINAL

Business category Small SME Medium SME

Average consumption p.a. (kWh) 20,000 40,000

2020 $1,281.82 $2,563.63

2021 $870.87 $1,741.74

2022 $825.36 $1,650.72

2023 $909.35 $1,818.69

2024 $460.33 $920.67

2025 $768.37 $1,536.73

2026 $614.83 $1,229.67

2027 $781.11 $1,562.22

2028 $813.70 $1,627.39

2029 $1,072.01 $2,144.03

2030 $1,066.58 $2,133.17

Average $860.39 $1,720.79

Source: Frontier Economics

In addition to these direct savings, consumers can expect significant security of supply benefits that
come from having a high efficiency, flexible, dispatchable generator in the system, especially in the
absence of Yallourn. This type of generator can allow the system to absorb an increased quantity of
renewable without sacrificing reliability and security, and ensure power supplies are affordable. If
governments do not have an effective plan for effectively managing system security then they will not
be able to achieve ambitious greenhouse gas reductions in the future. If governments allow, or even
encourage greater insecurity, by forcing more intermittent renewables into the power system without
also ensuring there is adequate infrastructure (such as dispatchable sources of power supply) then this
will drive prices higher.

frontier economics
Analysis of the Victorian power market 9

Supporting generation investment

Given the reluctance of investors to commit to large scale, long term generation investments State
governments can play a in supporting these investments for the benefit of system security and ensuring
affordable prices for consumers. There are a range of ways the government could support large scale
generation investment, for example:

1) The government could use its own electricity consumption for things like hospitals, schools and
transport to underpin a long-term contract with a generator who invests in a dispatchable power
station. The Victorian government load is approximately 500 MW. The government could hold
a competition to supply this load and the winning bidder must also commit to building further
capacity that they would sell in the competitive market. The bidder that commits to build most
capacity, and also having regard to the price offered to supply the State’s load, should be the
successful bidder, all other things being equal. This approach would actually save the
government money as it has to currently buy electricity in the current, expensive market so if
the State purchased power, effectively at cost from the investor, rather than paying prices
inflated by the market power of the remaining generators, magnified by the closure of
Hazelwood.

2) The government could issue a tender to invest in a larger than 500 MW dispatchable power
station. The government could allocate the first 500 MW of capacity to meet its own load and it
could hold regular 3-5 year auctions to sell the capacity rights or hedging contracts for the
remaining additional capacity. The sale of these additional capacity rights and/or contracts can
be used stimulate more competition in the retail market. The selling of these capacity rights
and/or contracts would result in revenues that would be used to defray the costs of acquiring
the additional generation capacity on a long term basis.

frontier economics
Frontier Economics Pty Ltd is a member of the Frontier Economics network, and is headquartered in
Australia with a subsidiary company, Frontier Economics Pte Ltd in Singapore. Our fellow network
member, Frontier Economics Ltd, is headquartered in the United Kingdom. The companies are
independently owned, and legal commitments entered into by any one company do not impose any
obligations on other companies in the network. All views expressed in this document are the views of
Frontier Economics Pty Ltd.

Disclaimer

None of Frontier Economics Pty Ltd (including the directors and employees) make any representation
or warranty as to the accuracy or completeness of this report. Nor shall they have any liability (whether
arising from negligence or otherwise) for any representations (express or implied) or information
contained in, or for any omissions from, the report or any written or oral communications transmitted
in the course of the project.

frontier economics
BRISBANE | MELBOURNE | SINGAPORE | SYDNEY
Frontier Economics Pty Ltd
395 Collins Street Melbourne Victoria 3000
Tel: +61 (0)3 9620 4488
www.frontier-economics.com.au
ACN: 087 553 124 ABN: 13 087 553