Summary of the Finkel Review

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1. Executive Summary

The Finkel Review into the Future Security of the National Electricity Market was released on 9 June 2017 (“the Review”) after eight months of investigation and consultation.  The Review makes 50 policy recommendations to address Australia’s ‘energy trilemma’, defined as providing affordable, reliable and low emissions electricity for the country.

The Review is detailed and comprehensive, identifying the range of issues confronting Australia’s National Electricity Market (“NEM”) as well as setting out a blueprint for policy, legislative and rule changes required to meet its objectives.

Whilst the Review is receiving significant media publicity, it is likely to be months or possibly years before these recommendations are implemented as law, with much of the practical detail of implementation being deferred to politicians.  Whilst the Review limited its recommendations to policy or structural changes, and will need the support of Australia’s major political parties to be enacted, the initial response from a broad cross-section of industry, both suppliers and users, is positive.

The centrepiece of the Review is the recommendation for the introduction of a Clean Energy Target (“CET”) to assist Australia in achieving its Paris COP21 emissions reduction target (28% on 2005 levels by 2030).  The CET is designed to operate in similar fashion to the existing Renewable Energy Target (“RET”), with all new eligible generators, regardless of technology or fuel type, incentivised to produce electricity below a set emissions intensity threshold.  The proposal is for the CET to replace the RET in 2020.  Whilst not as direct as an Emissions Intensity Scheme (which was rumoured to be an option), the CET would operate in a similar fashion to the existing RET, but with all ‘low emission’ generators (not just renewables) eligible.  This would allow for ease of implementation, but the key question of at what emissions threshold a generator qualifies for CET certification was not stipulated and will be left to politicians to determine.

Other key recommendations of the Review can be categorised as follows:

  • Orderly transition: in addition to the CET, the report identifies the need for advance notice of plant closures and the role of gas as essential to the transition away from carbon generation;
  • System planning: increased grid-wide planning and regional reliability requirements; and
  • Stronger governance: improved data availability, increased roles for the AEMC and AEMO, and establishment of a new Energy Security Board.

Although the Review has focused on policy and structural recommendations with limited detail on practical implementation and process, our view is that the Review provides a sound set of fact-based recommendations.  It is a very important and positive first step towards the changes that need to occur in the Australian energy sector to address the energy trilemma. Further the report directly addresses the need for a long-term stable policy framework, aligned across State and Federal governments, to ensure investors can make long-term investments with confidence of which we are also very supportive.

The Federal Government is expected to provide their response to the Review by the end of July 2017.

2. background

At an extraordinary meeting on 7 October 2016, Energy Ministers from the Council of Australian Governments (“COAG”) tasked Australia’s Chief Scientist, Dr Alan Finkel, to develop a national reform blueprint of the National Electricity Market (“NEM”), to maintain energy security, reliability and affordability. The independent review was initiated by COAG through its Energy Council shortly after a ‘black system’ event that left the entire state of South Australia without power on 28 September 2016, the first state-wide blackout since formation of the NEM.  Without any immediate understanding of the root causes, State and Federal politicians were quick to blame each other’s energy policies, including South Australia’s high level of intermittent renewable generation, its reliance on power from other states via interconnectors and a general lack of understanding of operational settings on new technologies, particularly wind farms. In the following months, vulnerability in the NEM was further highlighted with instances of load shedding in the eastern states, as well as apprehension over possible blackouts in parts of New South Wales and Victoria. Further the peak system redundancy forecast by the Australian Energy Market Operator (“AEMO”) has dropped to an all-time low with significant risk of energy shortages in 2018 for Victoria and South Australia in particular. These events emphasised the urgent need for reforms to national energy policies, rules and regulation.

The speed of transition in Australia’s energy sector has taken the market and regulators by surprise.  This is largely due to rapid technological change, increasing penetration of renewable energy, an increasingly decentralised generation system, early withdrawal of traditional baseload generation, gas supply shortages and fast changing consumer demand. Governments, operators, investors and consumers have all been vocal on the diverse issues arising from this transition and its associated vulnerabilities. Key issues emerging from the nation-wide debates include the impact of increasing renewable energy, domestic gas shortages, and a lack of national policy cohesion (as detailed in our March 2017 Client Memorandum).

With little cooperation and agreement amongst governments and policy makers on the best way forward, energy market participants have long awaited the final recommendations of the Review. It has increasingly been viewed as a key path way for crystallising how Australia will effectively manage the scale of transition underway in its energy market.

3. overview of finkel review

3.1      Objectives

The key objective of the Review was to find a balanced solution to the energy trilemma – that is, developing policies and a system which simultaneously provides a high level of energy security and reliability, access to affordable services and reduced emissions.  There is tension between these three objectives and it is ultimately consumers who will pay the price on how balance is achieved between security, affordability and environmental objectives.  On advice from the COAG Energy Council, the Review commenced with security and reliability as the fundamental consideration, with emissions reduction and affordability secondary.

In formulating its blueprint, the Review panel members consulted widely, including meetings with international energy market bodies, roundtables with various energy market stakeholders across Australia, and through a public submission process on its Preliminary Report which was presented at the COAG Leaders’ Meeting on 9 December 2016.

The final blueprint put forward by the Review is largely based on principles, with the practical implementation left to governments and policy makers. While market participants are broadly supportive of the recommendations, politicians have not yet committed to implementing them.  The Review is likely to be viewed in the context of other energy market reviews currently being undertaken.

It is envisaged that by committing to the blueprint, governments will be able to restore investor confidence and reshape the NEM to be secure, innovative, responsive and affordable.

3.2      Vision for the NEM

The report focusses on four key outcomes for the NEM, being increased security, future reliability, rewarding consumers and lower emissions. It recommends achieving these outcomes through three key pillars, being an orderly transition, better system planning and stronger governance.

Key Outcomes

Increased Security

  • Obligations on new generators to provide essential security services
  • More conservative operation in each region through maintaining system inertia and tighter frequency control
  • A stronger risk management framework to protect against natural disasters and cyber attacks

Future Reliability

  • Obligations on new generators will ensure adequate dispatchable capacity in all regions
  • New generators incentivised to enter the market
  • Existing low-cost generators don’t close prematurely

Rewarding Consumers

  • Large and small consumers rewarded for reducing their demand when needed
  • System upgrades and new generation will be achieved at lowest cost
  • Better access to information to support consumer choice

Lower Emissions

  • A continuous emissions reduction trajectory delivering certainty
  • Emissions reduced by 28% below 2005 levels by 2030, heading towards zero emissions in the second half of the century

Key Pillars

Orderly Transition

System Planning

Stronger Governance

To provide certainty through an agreed emissions reduction trajectory

  • Clean Energy Target adopted to drive investment and reduce emissions
  • All generators will be required to provide three years’ notice of closure
  • Gas is essential to the transition requiring more support for exploration to increase supply and more visibility of supply

To help make the transition to an innovative, low emissions electricity system:

  • A system-wide grid plan informs network investment decisions
  • Regional security and reliability assessments, including Generator Reliability Obligations for new generators (re dispatchable load and fast frequency response)

To drive faster rule changes, overcome challenges and deliver better outcomes:

  • A new Energy Security Board to deliver the blueprint and provide system-wide oversight
  • Strengthened energy market bodies
  • Increased data provision to regulators
  • “Last resort” power to AEMO to procure gas-fired generation capacity for security of supply

3.3      Key Themes and Recommendations

The Review contains fifty recommendations, all targeted at strengthening and evolving the NEM. It does not suggest a major reform of the NEM, but rather focusses on a series of progressive recommendations to address the emission reduction targets and future proof the current system to the ongoing changes in technology and consumer behaviours. Below is a summary of the key themes and recommendations that are most likely to impact future energy investment decisions in Australia.

3.3.1     Low Emissions Future

The introduction of a CET by 2020 has undoubtedly been the most publicised and widely debated recommendation emerging from the Review. It is designed to operate in similar fashion to the existing RET, which is proposed to remain unchanged but not extended.  A CET, in conjunction with the current RET, is intended to restore investor confidence and assist Australia reach its Paris COP21 emissions reduction target of a 26-28% reduction in emissions by 2030, based on 2005 levels.

Under a CET, all new eligible generators, regardless of technology or fuel type, would be incentivised to produce electricity below an emissions intensity threshold, a level that remains up for debate. Eligible generators would receive certificates in proportion to how far their emissions intensity is below the threshold and these certificates would then need to be purchased by electricity retailers, to ensure a pre-determined share of their electricity comes from low emissions generators. The interaction of the CET with the RET needs further consideration, but it is proposed that the RET is replaced by the CET in 2020.

The CET was considered alongside an emissions intensity scheme (“EIS”), which received strong support from many stakeholders. Under an EIS, generators with an emissions intensity below a pre-defined baseline would receive credits and those above the baseline would be required to purchase and surrender credits. Economic modelling commissioned by the Review concluded that an EIS would achieve similar outcomes compared to a CET.

The CET was recommended on the basis that it would be easier to implement and has greater likelihood of being accepted by the current government, which has firmly rejected an EIS. Whether the CET receives bipartisan support remains to be seen, particularly after reports that members of the current government view the CET as effectively a tax on coal, whilst the opposition claims it cannot accept a policy that may designate coal as a clean emissions source. The risk that timely action is not taken on emissions policy is an undesirable outcome that would increase investor uncertainty and increase volatility in power prices, according to the Review.

3.3.2     Increased Security and Reliability

The NEM was built to transport electricity one way, from large power stations to homes.  It is now undergoing a profound transition through an increase in distributed energy resources, transforming the NEM into a new two-way electricity system, scattered over millions of connection points.  Coupled with the introduction of new (largely intermittent) generation and storage technologies, security and reliability have been compromised.  Without any action, demand and supply will become more uncertain and operating the system will become more challenging.  Given the importance of security and reliability, the Review recommends significant changes to how generators and network providers should operate and interact.

To increase system security, the Review recommends that the Australian Energy Market Commission (“AEMC”) introduce a package of Energy Security Obligations (“ESO”).  Amongst other things, the ESO would require transmission network service providers to maintain a sufficient level of inertia for each region and require new generators to have fast frequency response capabilities.  A market-based mechanism for procuring voltage and frequency control services should be implemented only if there is a demonstrated benefit.  Historically, these services have been a plentiful by-product from fossil fuel generators and therefore not explicitly valued in the NEM.  Other measures to improve security relate to higher technical operating standards, improved connection standards, regular testing of black start equipment, and increased preparedness for abnormal events.

Furthermore, the Review recommends that all types of large-scale generators should be required to provide three years’ notice of closure, to assist planning for replacing lost capacity.  This is largely targeted towards coal power plants that have historically closed premature to market expectations, resulting in increased price volatility.

To increase system reliability, the Review recommends both the AEMC and AEMO develop and implement a Generator Reliability Obligation (“GRO”), designed to ensure adequate dispatchable capacity is present in each region. Under the GRO, if there is a risk of inadequate dispatchable capacity, new variable generators (such as wind and solar) will be obliged to bring forward new dispatchable capacity to that region. This new capacity does not need to be located on site and multiple projects can partner with storage providers or gas fired generators to meet the requirement. This potentially introduces numerous commercial and regulatory issues.  Furthermore, the introduction of a GRO may result in increased costs for new intermittent renewable generation projects.

In the short to medium term, the NEM is likely to require higher levels of flexible gas generation to maintain security and reliability. Storage technologies will be able to play a role to support reliability once they are economically able to be deployed at scale.

3.3.3     Efficient Gas Markets

There is an increasing interdependency between gas and electricity. Gas generation has a pivotal role to play in moving towards a lower carbon future, given its synchronous nature (i.e. provides essential security service) and its low emissions intensity, being less than half that of coal generation. Therefore, the combination of low domestic gas availability and associated high gas prices is arguably the single biggest issue undermining Australia’s energy security. This has primarily been the result of an expansion in Australia’s LNG export industry, state-based drilling moratoria and reduced capex spending from upstream developers amid weak market conditions.

The Review recognises that gas generation contributes to a secure and reliable NEM and therefore long-term gas supply is essential, but higher gas prices are likely to remain. It recommends that AEMO have access to generators’ gas supply information so that it can better predict potential supply shortfalls and be given last-resort power to enter into commercial arrangements with generators to make them available during emergency situations. Further details behind these recommendations or what constitutes an emergency have not been provided by the Review.

The Review notes that effective government policy and regulatory settings are vital and should encourage investment and development of Australia’s vast gas resources, but at the same time address environmental concerns associated with unconventional gas extraction. It is recommended that governments should remove blanket state-wide bans and rather adopt evidence based methods to manage the risk of gas projects on a case-by-case basis. To increase fairness and ease community safety concerns, there should be better access to scientific data on gas drilling and improved landholder compensation schemes.

3.3.4     Strong Governance

Strong energy market governance is essential for managing the transition that is currently underway in Australia’s energy market.  Differing and inconsistent renewable energy policies between State and Federal governments has compromised energy security and increased investor uncertainty. It has been widely agreed that there should be a co-ordinated and national approach to carbon abatement and renewable policy.  The Review recommends the COAG Energy Council endorse a national strategic energy plan which would lead to faster processing of rule changes, better funded regulators, enhanced market monitoring and more informed bodies that will help drive better system outcomes.

The implementation of the blueprint lies in the hands of governments and policy makers.  It is recommended that a new Energy Security Board (“ESB”) be established to implement the blueprint, provide whole-of-system oversight, and co-ordinate action on behalf of the COAG Energy Council. It is envisaged the ESB will draw on the expertise of other market bodies and coordinate how they exercise their separate accountabilities to keep pace with the rate of change. It is also recommended that the ESB provide an annual report to COAG on the “Health of the NEM”. When establishing a new body such as the ESB, it is important to clearly define the scope and objectives as more regulatory bodies does not necessarily translate into effective outcomes.

3.3.5     Other Recommendations

The Review contains several other recommendations, which as a package, are designed to further strengthen the NEM. This includes increased data collection and sharing, improving cyber-security, demand management and encouraging distributed energy participation.

Consumers are driving change and are at the core of the transition taking place. The uptake of new technologies by consumers, such as rooftop solar photovoltaic and battery storage systems, provides an opportunity for consumers to contribute to network security services such as frequency control. The Review recommends several measures that retailers and policy makers should adopt to help unlock the benefits consumers can provide to the system.

On the innovation front, the Review notes that the transition currently underway provides an opportunity for governments and policy makers to create a world leading energy system. The successful deployment of new technologies and integration of renewables needs to be supported by high quality data, early testing of new technologies, cyber threat awareness and workforce preparedness. Furthermore, as the mix of renewable generation in the NEM increases, AEMO must have strong weather forecasting capabilities. Data transparency, strong information management and better system planning will help foster innovation.

4. market reaction

Whilst there is disappointment from discrete corners of the market on various aspects of the Review, on the whole and across a diverse cross-section the market has broadly welcomed the recommendations.  It has viewed them as the catalyst for the long-overdue reform of Australia’s energy system and the first step towards greater certainty.  Of most concern is how the political process will now play out and how the implementation of the recommendations will be undertaken.

In an unprecedented move, a few days prior to the release of the Review, the CEOs of Australia’s largest energy utilities and users penned an open letter to Australia’s political leaders.  Published in the Australian Financial Review, the letter emphasised the importance of the Review and urged political leaders to not pre-emptively rule out the recommendations delivered in the report before the community and industry have taken the time to fully digest the content and provide a considered response.

We await the Government’s response to the Review, expected in July, and remain hopeful that the process has commenced to deliver much-needed reform to Australia’s NEM.

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