Delivering the right capacity to decarbonise the power system: managing the exit of fossil fuel generators

This is part one of a two-part series by the Clean Energy Council's Director Energy Transformation, Christiaan Zuur, on the suitability of a capacity mechanism in managing the transition of the energy system from fossil fuels to renewables.

One of the perennial debates in the Australian energy sector is whether to stick with our current ‘energy-only’ market or to move towards a ‘capacity market’. This debate has traditionally been based around which of these two models delivers greater economic efficiency. While this remains relevant, the bigger question is which of these two models better delivers reliability, low-cost power and ultimately, a safe and rapid decarbonisation of the Australian economy.

A few quick explainers. In electricity markets we distinguish between capacity (measured in megawatts (MW)) and energy (measured in megawatt hours (MWh)). Capacity is how big a generator or battery is. Energy is how much they actually produce over a given timeframe.

The difference between capacity and energy is demonstrated in the following chart.

In this example, a generator has a maximum capacity of 100 MW. It runs at half its capacity (50 MW) for four hours, generating 200 MWh (50 MW x 4 hours). It then runs at full capacity for another four hours, generating another 400 MWh (100 MW x 4 hours). We refer to the capacity as the value on the y-axis, while energy produced is the total area under the curve.

The current National Electricity Market (NEM), which services the eastern states, is an energy-only market. This means that generators are paid only for the energy (MWh) they produce. The energy price in any five-minute trading period can go very high – over $15,000 per MWh – so generators can make a lot of money if they are able to deliver energy at that time.

In contrast, a capacity market pays generators not just for the energy they provide, but also for investing in the generating asset in the first place. This means generators are paid for their energy (MWh) as well as their installed capacity (MW). This payment can take various forms, but it’s usually a ‘dollar per MW’ value. Capacity suppliers typically sell capacity certificates, equal to a certain number of MW, to capacity buyers who are obligated to purchase them and then surrender them to a central authority.

Although we don’t have a capacity mechanism in the eastern states, Western Australia operates one – the Reserve Capacity Mechanism. Outside of Australia, jurisdictions including the UK, France, Ireland and California all use some variety of capacity mechanism to firm up supply by paying for investment in generation capacity (as well as payment for the energy delivered).

The Energy Security Board (ESB) is currently considering whether to introduce a capacity mechanism in the NEM. As part of this process, the ESB recently published a project initiation paper to obtain stakeholder views on the proposed design of a capacity mechanism in the NEM. The clean energy industry has argued that the ESB must first do its homework, and properly consider the physics of the changing power system, before it introduces an entirely new capacity market mechanism.

The pace of physical change in the NEM is remarkable. In the last few months, we have seen an acceleration of the exit of large coal generators, coupled with huge investment in renewable generation and storage. At the same time, the record-breaking rollout of rooftop PV and residential batteries is turning the way we use electricity upside down. The growth of the hydrogen economy also brings with it the promise of further structural shifts.

We therefore need to carefully examine the underlying physics and the real case for reform in the context of these structural changes. Perhaps the most pressing of these is how to deal with the rapid exit of thermal coal and gas generation.

How do we deliver a controlled and steady exit of thermal coal and gas generators?

It’s a physical reality that our market and power system has been built around thermal coal generation. Most of the coal generators in the NEM have supplied ‘baseload’ electricity for years and have also helped to keep the physics of the system stable. Putting politics aside, these assets have played a central role in delivering cheap, secure, reliable power for many years.

It’s also a physical reality that this cannot continue for much longer. Aside from the fact that we need to phase out fossil fuel generation rapidly to meet our national net-zero commitments, the economics and the physics are simply stacked against coal and gas.

The economics and physics of renewables means that old coal generators are increasingly uncompetitive. Rather than running 24/7 as ‘baseload’ generation, as they were designed to do, coal generators now need to fit in around cheaper and more flexible renewables. This means that they need to ramp their output up and down each day, rather than running flat out. This is uneconomic for many coal plants and is very demanding physically, resulting in greater wear and tear on units and increasing the risk of catastrophic failure.

All of this means that the exit of coal is inevitable, probably sooner rather than later. It’s also highly desirable, as it’s one of the lowest cost ways to meet our 2050 emissions reductions targets. However, this exit must occur in a controlled and organised manner. Failure to do so could potentially create issues on the power system. We therefore need a process to ensure this exit is controlled and stable.

Why can’t markets deliver a controlled exit of coal?

It’s true that energy-only markets can facilitate the exit of coal. However, these energy market-driven exits may be sudden as they are driven by the commercial imperatives of the owner. As we saw in 2017 with the rapid exit of the Hazlewood brown coal generator, this can create price spikes for end users. If these exits occur in a disorganised manner, they can also potentially make it harder to provide energy and could even destabilise the system and increase the risk of blackouts.

It’s often suggested that a capacity market might help to control, or at least slow down, the exit of coal generation to avoid the aforementioned risks. By providing a separate payment to coal generators (which are often large and therefore have a lot of MW capacity to sell), the theory goes that coal will become more competitive and therefore face lower economic and physical pressures, delaying exit.

Of course, this approach is subject to the same weakness of any market-based solution in that the decision to exit remains solely with the owners of the assets. Even with high-capacity payments, as well as harsh penalties and time limits applied for early exit, the magnitude of the external political and economic drivers faced by the boards of fossil fuel generation companies are increasingly likely to trump the power of a capacity market. This can easily lead to a disorganised and uncontrolled exit of coal generation.

A disorderly exit of coal brings with it significant risks for the transition. Price spikes are (unsurprisingly) unpopular with energy users and governments. Too many of these kinds of shocks can reduce social and political appetite for the transition, slowing down the process of overall decarbonisation of the Australian economy. A staged, rapid and controlled exit of coal is essential to a safe and secure energy transition and decarbonisation.

However, a capacity market is not the way to do this. Rather, governments should play a central role here and consider direct intervention to deliver a safe, rapid exit of coal. There are several possible approaches that governments could take to deliver a controlled, but rapid, exit of coal.

Firstly, this could include targeted contracts with specific assets that are identified as critical, with governments leveraging their countervailing power to ensure a fair deal for customers. This option was flagged by the ESB in its 2021 paper, where it identified ‘Orderly Exit Management Contracts’ as a possible mechanism to stage a controlled exit. Although the ESB did not develop this mechanism in further detail, it acknowledged that state governments would likely be the appropriate counterparty in these contracts.

There are some risks associated with this approach. The countervailing power of state governments versus incumbent coal generators can shift over time, potentially resulting in customers getting a bad deal. Although it’s true such mechanisms could be designed to provide transparency and limit the amount paid out to exiting generators, this must be done very carefully to ensure the best outcome for end users and taxpayers.

Alternatively, state governments can also play a lead role in actively replacing coal generators with new renewables, preferably before the coal generators retire. As we have recently seen in NSW, governments can strengthen their position by engaging directly in capacity replacement. The NSW Government recently responded to the bringing forward of the exit date of the Eraring coal generator with a multi-pronged approach, which included funding new storage and transmission assets to increase supply, as well as targeted support for the local community. This kind of approach strengthens the bargaining position of governments and directly addresses the core problem.

More generally, the NSW Electricity Infrastructure Roadmap is also supporting a planned and rapid rollout of replacement renewable capacity, purposefully timed to match the expected exit of the NSW coal generating fleet. If coupled with incremental changes to the NEM, these state-based schemes can support the provision of cheap, emissions free energy to end users while avoiding the potential shocks associated with a disorganised exit of coal generation.

A controlled exit of coal generation is central to NEM decarbonisation. We must approach this phase out in a clear-headed manner, acknowledging the central role coal generation has played while pushing for its rapid replacement with zero-carbon, renewable generation and storage. The next article in this series will explore how that replacement might be enabled, at the lowest possible cost to customers.