Unintended consequences CIS?

The government recently released its design paper for the Commonwealth Capacity Investment Scheme (CIS), which will be used to deliver 82% renewable energy by 2030. While new policies for renewables are always welcome, the latest CIS paper includes a significant change from previous consultations which risks increased costs and reduced retail competition. But it also highlights the need to consider what the future of retailing and contracting in the NEM will look like.

Background

The CIS design is an "all in" $/MWh revenue collar: if revenues are below the floor or above the cap, 90% of the pain and 50% of the gain will be shared with the government. Projects must be in a single asset company, so that all revenues or costs in or out are tracked, including spot revenue but also PPA contracts (if you've sold your energy at a fixed price). This was not an unreasonable approach from an accounting perspective – it's easier if an asset is fully isolated.

However, the government now proposes that related body corporate contracts are not counted towards your net revenues. This means that vertically integrated companies cannot use their own assets to hedge their retail customers. For example, say you had sold firmed renewable energy to customers at $80/MWh, backed by your wind farm, and then spot prices jump to $200/MWh (e.g., Russia invades another country). If your ceiling price was $150/MWh, you will have to pay 50% ($25/MWh) to the government. Even though your customers aren't exposed to high prices – the point of a retailer!

“Penalising retailers for contracting, as the proposed CIS would do, doesn’t seem to align with benefits to consumers”

Effectively, retailers are already doing one better than a revenue collar for consumers – they provide a fixed price. Penalising retailers for contracting, as the proposed CIS would do, doesn’t seem to align with benefits to consumers.

How could retailers respond?

One option is retailers could bid a very high cap, say the APC price of $600/MWh, just to be safe, effectively removing the payback requirement – which defeats some of the purpose of the scheme.

More likely, vertically integrated retailers (i.e., most of the NEM) just won't be able to build assets under the CIS – they'll have to buy energy from third party developers. But then they can't benefit from the CIS risk management, so PPAs will have to be at low prices - increasing CIS costs to government. This will also exclude many large, experienced industry players, reducing competition.

“A worst case outcome is that retailers start passing through spot price risk – which works fine when prices are low, but is pretty catastrophic when prices are high”

A worst case outcome is that retailers start passing through spot price risk – which works fine when prices are low, but is pretty catastrophic when prices are high (as 2022 showed). As Simshauser has shown vertical integration reduces costs and risks for all parties.

All this is on top of the liquidity risk if the CIS projects require floor prices at their LCOE, such as if governments continue to keep coal in the system. If wholesale prices are too low, there’s no incentive for third parties to contract energy in the market – which puts retailers in a tricky spot.

To be clear, while horizontal integration (reduced competition) can be problematic, vertical integration is a sensible approach to risk management. Retailers provide value to energy consumers by providing certainty over the cost of supply, whether that’s for a year or a decade. This risk management becomes particularly critical for firming variable renewable generation with batteries (itself optimised across 11 spot markets), PHES, and gas.

Unfortunately, the CIS design as it stands is incompatible with the vertically integrated firming model currently adopted by most retailers (the “gentailers”).

So what should be done?

The basic ideas of shared risk management in the CIS are still sound, and we should of course celebrate a policy that aligns with our climate targets.

“What you really want is a market where the CIS is only about risk management, not revenue support.”

From a policy perspective, the optimal strategy is still to pivot to contracts on the green certificates (LGCs/REGOs). This leaves the energy market signals intact, and also makes it much easier for governments to compare the net benefit of different technologies. What you really want is a market where the CIS is only about risk management, not revenue support.

This approach is why the RET has worked so successfully to deliver renewable investment. Retailers had a strong financial incentive to procure certificates at least cost – with LGC prices reflecting the gap between market revenues and project costs. Retailers could target high-cost/high-value projects, or low-cost/low-value projects. In comparison, it is more challenging to pick high price projects. Private investors rushed to build projects – meeting and exceeding policy targets.

This project underwriting could be done through the CIS contracts. Alternatively, the CER could become a central buyer of certificates on behalf of all consumers.

Failing that, we might all need to think about how the CIS can be tweaked to support vertical integration and encourage rather than penalise retailers and aggregators that seek to manage risk on behalf of consumers.