On the stability of energy-only markets with government-initiated contracts-for-differences

Abstract

Rising levels of variable renewable energy (VRE) in Australia’s National Electricity Market have been driven by a 20% renewable energy target by 2020. This certificated renewable portfolio standard has successfully driven new investment, allocated risk amongst buy- and sell-side market participants and met overall policy objectives. But a policy vacuum for achieving long-term CO2 emission targets post-2020 has led to sub-national and, potentially, national governments initiating contract-for-differences (CfDs) to drive further investment activity in new plant—with virtually no coordination between the jurisdictions. In a gross pool energy-only market setting, replacing on-market transactions between retailers and generators with off-market transactions between governments and generators may have unintended side-effects vis-à-vis market stability. In this article, an energy-only gross pool is modeled with rising levels of off-market government-initiated CfDs, with a specific focus on spot and forward contract market outcomes. Model results show that as VRE plant enters, coal plant exit, and on-market firm hedge contracts historically supplied by coal plant are progressively replaced by off-market CfDs. In the event, while a tractable equilibrium can be maintained in the spot market, shortages of “primary issuance” hedge contracts emerge in the forward market. Any shortage of hedge contract capacity is likely to raise forward contract price premiums above efficient levels, force price-elastic customers into accepting unwanted spot market exposures and may unintentionally foreclose non-integrated (2nd tier) energy retailers, all of which harms consumer welfare. A wide-ranging program of government CfDs may therefore not be compatible with an energy-only market design.