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The role of Capacity Mechanisms in managing the transition of energy to renewables – Renewables

As part of the post-2025 market design reforms that aim
to develop a long-term, fit-for-purpose market framework to support
reliability in the National Electricity Market (NEM), the Energy
Security Board (ESB) has been tasked with progressing detailed
design work on a mechanism that specifically values capacity in the

Recently, the ESB released a High-Level Design Consultation Paper regarding
a new capacity market, operating parallel to the NEM, whereby
capacity providers would be paid to keep capacity available in case
demand overtakes supply.

As noted in our previous article, capacity mechanisms aim to ensure
there is a sufficient energy mix to maintain reliability at lowest
cost. This is in contrast to the current design of the NEM, whereby
generators are only paid for the electricity they produce, not the
energy they store or are able to generate.

Why is a capacity mechanism needed?

The proposed capacity mechanism aims to address reliability
concerns brought on by the anticipated transformation of the
generation fleet. As forecast by the Australian Energy Market
Operator (AEMO) in its 2022 Integrated System Plan
(ISP), all coal-fired generation is expected to
cease by 2043, while electricity demand could double by 2050.

The transition from ageing fossil fuel plants to clean energy
resources needs to be carefully managed, as coal currently accounts
for over half of the NEM’s generation output. As the majority
of new investment in the coming decades will be in variable
renewable energy (VRE) sources, including solar
and wind generation, the risk is that the current market design
will not be able to deliver resource adequacy and effectively
respond to unexpected outages. Accordingly, the new market must be
complemented by dispatchable capacity providers that can generate
electricity on demand. The consequence of not getting this energy
transition right risks high prices and poor reliability outcomes
for consumers.

The introduction of a capacity mechanism would also help address
the tension between the risk appetite of governments and investors.
The ESB notes that, while governments are increasingly investing to
manage risk on behalf of consumers, investors face a number of
risks, including the falling cost of new technologies, uncertainty
around generator closure dates and demand uncertainty. A capacity
mechanism would provide consistent market-based signals across the
NEM jurisdictions to allow existing resources to exit the system at
the end of their useful life and facilitate timely investment in a
favourable mix of new capacity.

Proposed high-level design


The ESB proposes that all capacity-contributing resources be
eligible to participate in the capacity mechanism, as opposed to
only new resources. Eligible resources would include thermal
plants, batteries, hydro, pumped hydro, and demand-side

Some commentators have questioned whether the
inclusion of existing generators such as coal would be more likely
to delay investment in new, fast-start, dispatchable technologies,
rather than accelerate them. The ESB has stated this is necessary

  • increase efficiency in the mix of resources to ensure

  • avoid over-building capacity before it is required; and

  • ensure efficient coordination of entry and exit decisions of
    capacity resources.

The ESB also voiced a preference that States and Territories
retain the final say on which generators are eligible for payments
in their jurisdictions. However, there is some concern this could
reduce the efficiency of the overall proposal.

The ESB has proposed minimum criteria for participation in the

  • capacity providers must pass a technical assessment performed
    by AEMO to confirm the amount of capacity they are eligible to
    offer in the capacity auction;

  • providers must participate in the auction on a unit-by-unit
    basis; and

  • the auction clearing process will incorporate network


The ESB proposes a centralised approach to forecasting and
procurement of capacity needs on the basis that this approach is
most likely to increase public confidence in the NEM, as well as
ensure that sufficient capacity is available when demand overtakes
supply. This process would be underpinned by AEMO procuring
capacity from providers in competitive, sealed-bid auctions ahead
of a delivery year. The core procurement auction will allocate
capacity certificates for one delivery year at a time.

Concerns have been expressed that a centralised scheme could be
more likely to over-insure the NEM if AEMO takes a conservative
approach to forecasting and procurement. To address this, the ESB
is exploring potential hybrid models, where retailers take on some
role in forecasting and procurement, as well as in initial capacity
auctions. To this end, the ESB is considering the following methods
of retailer participation:

  • AEMO purchases all capacity certificates in the initial auction
    and retailers then purchase certificates from AEMO to meet
    projected requirements; or

  • retailers participate in the capacity auction as buyers
    alongside AEMO.

In line with most capacity markets in other jurisdictions, the
ESB considers that AEMO should procure capacity as an annual
product related to a specific delivery year. The ESB is considering
the frequency and timing of auctions, and whether only one initial
auction is to be held, or whether supplementary auctions need to
occur closer to the delivery date. These considerations relate to
the trade-off between the provision of forward investment certainty
and the accuracy of capacity forecasts.

De-rating methodology

Capacity has a physical and deliverability dimension which must
be adjusted for weather and outage events. Most capacity mechanisms
therefore define a capacity unit in terms of a resource being
continuously able to provide 1 MW to meet demand during certain
at-risk periods during the year.

The ESB recognises de-rating – the process by which a capacity
provider’s nameplate capacity is scaled down to the level of
expected output during reliability compliance events – and the
period over which it is de-rated as another essential element of
the forecasting process. De-rating translates each MW of capacity
into a single deterministic number for each resource, which enables
the capacity across the system to be considered interchangeably.
De-rated capacity is an input to AEMO’s reliability forecast
and determines the maximum amount of capacity certificates that
could be awarded to each capacity provider in an auction.

The alternative approach is to treat the capacity from each
resource separately. However, this would create many challenges for
the optimal technology mix, competition in procurement and
differing capacity prices.

A key issue to be considered in the detailed design is the
period over which technologies should be de-rated as this can have
a material impact on different resources’ expected performance,
and network congestion.

The ESB is seeking feedback on the most appropriate approach to
de-rating, whether that be a pre-defined de-rating period, a model
based on the occurrence of reliability events, or a hybrid

Capacity provider obligations

Capacity mechanisms can involve a change to the sources of
revenue and incentives for capacity providers to perform when
needed. As the ESB is proposing a mechanism with centralised
forecasting and procurement, there will need to be obligations on
successful capacity providers to ensure they deliver the benefits
in the market they have been contracted to deliver. These
obligations will prescribe what capacity providers must do on the
day capacity is required.

The ESB proposes the imposition of performance obligations on
capacity providers to meet the requirements of their capacity
certificates in order to receive associated capacity payments and
be considered compliant. The ESB has focused on a model for
performance obligation that is based on capacity provider
availability all year round, with additional requirements to be
available during actual lack of reserve events that may be
triggered at any time. This model of availability during all
periods of system stress throughout the year was preferred over
performance obligations for only peak or pre-determined periods of
the year. In the preferred model, the capacity payment can be
awarded in two parts for availability throughout the delivery year
and for being bid available during periods of system stress.

The ESB recognises the introduction of a capacity mechanism may
significantly impact the incentives that drive market decisions,
and the scale of monitoring and compliance required to facilitate a
culture of performance and compliance. Therefore, the proposed
performance obligations require further stakeholder consultation
regarding detailed design. Specific issues which need to be
considered include the:

  • structure of performance incentives to ensure capacity
    providers are available during times of system stress;

  • definition of availability during the year;

  • methodology for defining system stress events; and

  • interactions between performance obligations, capacity payments
    and existing market design.

The ESB is also considering and seeking feedback on other
compliance obligations concerning the role of retailers in
procurement, and requirements for new entrant capacity in building
assets or participating in capacity auctions.

Transmission capacity

The consultation paper primarily focuses on inter-regional
transmission capacity, and recognises that transmission constraints
limit the ability of capacity providers in one location to meet
demand in another location. The ESB emphasises that a failure to
appropriately reflect transmission system capacity in the design
risks the capacity mechanism underestimating available capacity in
a given location, which would lead to higher costs to consumers and
reduced remuneration for providers. This would also lead to
overestimation of available transmission transfer capacity during
scarce periods.

The ESB is considering two approaches to account for
transmission constraints, through either:

  • expected interconnector flows during periods of system stress
    informing the amount of capacity purchased in a single region, with
    no explicit participation in neighbouring region capacity actions;

  • capacity providers and market interconnectors participating in
    neighbouring region auctions.

The ESB supports the second option in principle, but recognises
the considerable complexity it adds to the overall design. The ESB
is seeking feedback on the most appropriate approach to realising
the benefits of an interconnected NEM in the capacity mechanism.
The ESB is also considering the viability of including a transfer
rights or transfer limits approach to ensure interstate capacity
sales are aligned with interconnector capacity.

Cost allocation

The ESB proposes to allocate the costs of capacity auctions,
contract awards and capacity provider payments to consumers either
through networks or retailers. The ESB considers that cost
allocation through retailers using actual demand is the preferred
and most transparent approach.

Next Steps

The ESB is seeking stakeholder submissions on its proposed
high-level design and the issues raised in the paper.

A draft detailed design paper is forecast to be released in
December 2022 with the aim of producing a final design and draft
legislation to Ministers in February 2023. The draft detailed
capacity mechanism design will be put to stakeholders for further
consultation. The ESB aims to implement the capacity mechanism by 1
July 2025.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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