Some thoughts (part 1) about the design paper for the implementation of the proposed Capacity Incentive Scheme

This is the first of a two part discussion on the Capacity Investment Scheme (CIS) Implementation Design Paper (The Paper) released on 1 March 2024. This part will cover its broad objectives and implications. The second part will discuss some details of its design that are open for consultation until 25 March (next Monday).



Last November the commonwealth announced that its CIS will become the prime investment driver of Australia’s electricity transition for the rest of this decade through two enormous underwriting streams:

  • 9 GW of Clean dispatchable capacity (read grid-scale batteries), and
  • 23 GW of renewable generation (read large-scale wind and solar).

Most of this will go in the NEM, but Western Australia and Northern Territory will receive pro-rata shares, consistent the Australian constitution’s expectations of equal treatment. Consultations on how the non-NEM CIS will be managed are promised for the near future.

The Capacity Investment Scheme Agreements (CISAs) will be rolled out with six monthly tenders in each jurisdiction, with the next (6 GW of Generation CISAs) to occur late next quarter. Two clean dispatchable tenders have effectively already occurred:

  • The completed New South Wales roadmap firming tender round 2 of last November is counting 480MW of batteries against the CIS, and
  • The South Australia-Victoria early CIS tender round that closed on 23 Feb, targeting 600MW of dispatchable capacity.

The underwriting is a 15-year revenue collar, where the government de-risks investments by sharing extended periods of low or high revenues. The structure is broadly drawn from the New South Wales roadmap’s work on Long-term Energy Service Agreements (LTESAs) floors, except that CISAs are two-way collars. As well as providing protection from periods of low revenue periods (floor), periods of high revenue are shared with government (cap). The government’s liabilities are on the commonwealth’s budget so it is funded by taxpayers, unlike the New South Wales roadmap which is funded through consumer levies.

Tenderers bid this floor and cap. The modelled cost to government is then divided by the significance of the project to the power system and becomes the main selection criterion.

The government wants the assets to participate within the spot and contract markets as if they were merchant plays. In a nutshell, the government still wants investors to build assets for market returns, but by de-risking investments cases from the most adverse scenarios, their required rates of return will presumably be lower and so plant is built sooner.

Yet there is a trade-off between de-risking finances and distorting operations. The design engages with this tension, for example the floors and caps are not 100% revenue transfers. Even when triggered, assets retain some market exposure.

Energy companies operate integrated portfolios, but that’s a problem when it includes an asset with a revenue collar. Therefore, the design requires the assets to be run at arm’s length, in a Special Purpose Vehicle (SPV), to inhibit the company transferring value to gain access to the government’s floor or avoid the cap.

With respect to New South Wales projects, the government will instead leverage the existing LTESA design, underwriting support for additional capacity beyond the Roadmap’s targets, as New South Wales’ share of the CIS kitty.


How did it come about?

The Capacity Mechanism

Minister Bowen entered government in May 2022 just as the Energy Security Board (ESB) was concluding several years’ work on a NEM capacity mechanism, which, like those used in Western Australia and overseas, was neutral to plant age and technology type. At the time, the new minister was very supportive of the ESB’s work.

With the optimism of a new government, he also sought commonwealth-state consensus decisions through the National Energy Transformation Partnership. Perhaps cynicism may have served better as the capacity mechanism soon foundered upon state ideologies, with Victoria vetoing any fossil-fuelled technology from the mechanism, whilst other states and AEMO continued to see gas and diesel playing a significant backup role.

The commonwealth ultimately solved the impasse with an entirely different approach of underwriting new investment in “clean dispatchable capacity”. They may have different ideologies, but one thing states can agree on is having federal money spent on them, which is what the CIS promises, and as a result it has survived the Partnership.

Whilst underwriting new zero emissions technology may have been necessary given our federation, it is not the sort of approach that economists, like those at the ESB who developed the capacity mechanism, would recommend:

  • Firstly markets, rather than government, should determine how much and what should be built in response to market signals that express customer needs. Indeed, the CIS’ geographical split seems likely to be determined more by the Australian constitution than need.
  • Secondly, all technologies should be treated equally according to their ability to contribute to reliability. Environmental policy should separately target actual pollution. For example, a diesel peaking plant provides excellent reliability support with trivial emissions due to how rarely it runs.
  • Thirdly, existing capacity contributes equally to reliability as new capacity, so it should be similarly rewarded. Otherwise, there are perversely different incentives depending on plant age. And by only supporting new entry, previous market investors are undermined, which is sending a very poor message.

The Clean Dispatchable CIS

The federal government had decided that it would roll out dispatchable capacity of a form that appeased all the states, i.e. zero emissions, underwritten in a way that also appeased all the states, i.e. by the federal budget. As a centre-left government, it had no ideological problem with a government auction replacing market investing and looked for ways to do it at least cost to government and to hopefully keep something of a market working after the investment.

A common approach to shore up reliability is standing reserve, i.e. backup capacity that is purposefully held out of the market to step in as a last resort before load shedding, like AEMO’s existing Reliability and Emergency Reserve Trader (RERT). By sitting idle during high prices, it is loss-making, but in doing so avoids discouraging market investors. Government dislikes this because it involves measurable costs that can be used to criticise it, and precisely because it doesn’t suppress prices.

Another approach is with government grants. Investors could tender for a government handout, for which the only strings attached is that a working asset must get successfully built in a timeframe. After that it is left to run in the market like any other plant. This lowers new entry costs for otherwise market investors, and in the short-term at least, should lower prices. The cost to government is fixed and known up front, which appeals to their treasuries, but not necessarily to ministers, because explicit costs are readily weaponised against them.

More politically attractive was the New South Wales roadmap’s LTESA floor structure. It is intended that in most years LTESA assets are left alone as market players. However, to win a LTESA, the asset bids a revenue floor, and if conditions in an operating year prove unfavourable, it can ask to have its revenue topped up to that floor. Whilst the investor still must run a business case estimating market returns, it can at least rule out adverse revenue scenarios. LTESA costs are unknown up front, but this is not a problem to the New South Wales treasury, because in the LTESA, customers cover the payouts.

The CIS was inspired by the LTESA. It however chose a collar rather than a floor, where a revenue transfer can to government in good years. This seems driven mostly by a superficial appearance of fairness and avoiding the embarrassment of a government supported asset occasionally earning super-normal profits. It however complicates dispatchable assets’ role in contract markets as a provider of insurance against high prices, when it need high revenues to back the insurance it has sold. The CIS allows contract payouts to be deducted from the revenue trigger, so this can be avoided by selling long-term contracts ahead of high price years.

In December 2022 the government announced that its CIS collar arrangement would become the tool by which reliability would be maintained through the transition. It will help build many large-scale batteries, complementing a power system where energy mostly comes from variable renewable sources. However, at that time the CIS was not suggested to build the renewable energy itself.

Eighty-two percent

Although it was never an election promise, and by accident rather than design, achieving an 82 percent share of renewable energy in national (not just NEM) electricity supply by 2030 has become the government’s firm commitment. This gave the government a self-inflicted headache. Due to a host of practical constraints the target seems almost certain to be missed, although possibly by only a year or two, which, in a decades-long transition, is inconsequential beyond the political beltway.

Whilst no amount of money will accelerate some of the constraints, such as community acceptance, some more cash would help developers in the worldwide competition for equipment and engineers. The government therefore looked for a way of topping up what wind and solar investors receive, the “black” electricity spot price plus the “green” Large Generation Certificates (LGCs).

Ways to get more renewable business cases over the line

Expanding the Renewable Energy Target (RET) was considered as it would raise the price of LGCs. But this would be costly for consumers as both the volume and price of mandatory retailer surrender increases. It would create a very large value transfer from customers to existing renewable energy. Already, thanks to the growth of voluntary markets, LGC prices have held up much longer into this decade than most legacy renewable investors would have expected.

Contracts for differences (CfD) have been used by many European governments, as well as Victoria and the Australian Capital Territory as a way of fully de-risking renewable generation from the market. The government absorbs all price exposure. Or, in other words, having created a market, the government creates an instrument to nullify it! This makes an investment case very straightforward indeed and enables ministers to announce what appear, up-front, to be very cheap contracts indeed. However, CfDs have many downsides:

  • Their true cost is unknown and can be quite enormous if the actual volume weighted price realised by the apparently cheap asset becomes unfavourable.
  • Valuable operating signals from market exposure is lost. For example, in the Australian Capital Territory’s case, the government absorbs negative price risk, with the result that some assets keep running during extreme negative prices, creating a security problem and large losses.
  • The government becomes the contractor to much of the industry. It has a “long” exposure to price which is of no use to it but could have been to retailers. Once CfDs have material volume, they create imbalances between spot and contract markets.

Having rejected the above alternatives, and enthused by the CIS it was designing for dispatchable capacity, in November 2023 the government went all-in and extended the CIS collar concept to also drive the rest of the renewable energy build out. By any measure, 23GW of Generation CISAs in half a decade is an enormous proposition.

Details of how the CISAs work is provided in Part 2.


Some high-level implications

Future Investment

Whether it intended it or not the federal government has given the industry a clear message that from now on it will be the prime determinant of new upstream electricity supply and storage. Forget market signals, it is hard to see how any private investor would now enter without a CISA and/or state-based support. As such, there seems not much point in picking up the ESB’s stalled task and re-exploring market designs to enhance incentives for new investment. Governments have taken on this job themselves, at least for this decade.

Yet thanks to the many state schemes that were already in play, this state of affairs may already have been the case before the CIS. Perhaps the CIS just sensibly recognises that reality. And if investment must now all be government driven, the commonwealth has the deep pockets to underwrite a transition on this scale.

Some parties have modelled that even this 23 GW of CIS generation will not get Australia to the 82 percent target, correctly recognising there is now no prospect of other large-scale market investments. Their implication was a call for yet more ambition in it or other schemes. But it would be more sensible to ignore or relax the target a few years, as it can’t be met anyway.

Impact on the existing market

With de-risked new entry, and no capacity mechanism, premature retirement of coal plant seems a risk, however all the privately owned plants seem likely to get individual contracts to underwrite their final years. Meanwhile the Queensland and Western Australian governments will have the final say in their owned plants’ closures.

For existing gas and diesel-fired peaking plant, 9GW of underwritten dispatchable competition may sound unfair but will be more than offset by capacity lost through coal retirement. And as this 9GW will be mostly storage, energy unlimited peaking plant will realise new value as seller of last resort energy insurance. Indeed, Victoria’s insistence that no gas or diesel capacity participate may ironically prove a boon to exactly that technology.

Things seem more challenging for the existing wind and solar fleet. The Generation CIS will favour diversity in renewable energy output, but has WattClarity has demonstrated many times, this can only be at the margin. The negative correlations between price and wind and sun that we already see will get ever stronger. There will be some relief thanks to the batteries themselves, loss of coal minimum generation levels and interconnector strengthening, but these will be far outweighed by the sheer scale of new wind and solar.

There will be a large fleet of legacy renewable assets exposed to this negative correlation, but without a revenue floor to call upon. So, could they become so financially impaired that they risk early closures? It seems unlikely, as their on-going operating costs are of a different order than coal. The CIS also provides an interesting option, perhaps unintentional, to rebirth legacy plant. A no regrets play for an existing windfarm is to put in a CIS repowering bid. If it wins, it upgrades its turbines and gets a revenue floor. And if not, it keeps the old turbines running and tries again at the next auction.

It seems likely that the CIS generation stream revenue floors will be frequently called upon as the market correctly signals it has just got too much energy when the weather is sunny or windy. Paying out on these floors will then become a large ongoing burden on the commonwealth budget but will not become apparent until after the agreements are committed, perhaps not until the 2030s. From aluminium smelters to feed in tariffs, we have seen this story play out many times before.

More detail from the design paper is discussed in Part 2, which will come soon.



About our Guest Author

Ben Skinner is an energy industry veteran, beginning as an electrical engineer in Victorian power system control, including on shift as a generation dispatcher. As the NEM started he was heading up the spot trading desk of a generation portfolio, but in time moved to market design and regulation. From 2008 he spent a decade as a specialist within NEMMCO/AEMO, principally engaging with government on environmental policy. In 2017 he returned to industry representation with 6 years as GM Policy for the Australian Energy Council, which he concluded in late 2023.

You can find Ben on LinkedIn here.

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