Energy Market Prudential Readiness Review
On 22nd May 2010 the Ministerial Council on Energy (MCE) requested AEMO to carry out a review of energy market prudential and settlement arrangements (the Energy Market Prudential Readiness Review), to identify risks and issues with the current arrangements, and initiate or recommend improvements to address the issues. Terms of Reference for the Review are available below.
The MCE’s intention to request AEMO carry out this review was foreshadowed publicly on a number of occasions during 2009 and early 2010. Consistent with this, AEMO established the industry based Settlement and Prudential Reference Group (SPRG) in late 2009 to support the identification of issues and options for improvement and to contribute to AEMO’s analysis. The SPRG comprised 5 nominees of the Energy Retailers’ Association of Australia, 3 nominees of the National Generators’ Forum, and the AEMC (observer). A list of SPRG members is available below.
Decision Making Framework – recommendations arising from the review that require a change to market Rules will be subject to the AEMC Rule change process, in which proposals will be assessed against the National Electricity Objective or Gas Objective, as appropriate. To inform such assessments, AEMO has commissioned economic advice from the Competition Economics Group (CEG). The CEG advice is available below.
SPRG members have helped AEMO to identify a number of Issues and Options related to energy market settlement and prudential arrangements. The primary focus in that process has been on identifying material improvements to electricity market settlement prudential arrangements, due to the greater transaction amounts in that regime. Material improvements to gas market prudential arrangements will also be considered. In considering the issues and options raised, two themes have emerged:
- A desire to reduce prudential obligations wherever possible, but without eroding the prudential standard delivered to credit providers; and
- As there is unlikely to be a single change that addresses the full range of issues experienced with the current arrangements, the range and flexibility of options available to participants for meeting their prudential obligations should be increased where possible to allow them to select an approach that best suits their particular business model.
In the review, a number of specific areas have been investigated, such as the options for improvement identified in conjunction with the SPRG, which are listed below:
- Clarification of the NEM Prudential Standard – the current “reasonable worst case” criterion for prudential management in the NEM has proven difficult to interpret in practice, and is not readily applied to a shorter settlement cycle. The AEMC has also raised concern about adequacy of the current Prudential Margin calculation in their “Review of the Role of hedging contracts in existing NEM prudential framework”. AEMO is seeking advice on more clearly expressing a prudential standard, using performance of the current mechanism as a reference point.
- Shortening of the NEM settlement cycle – the merits of reducing the NEM settlement cycle from 4 weeks in arrears to 1 week in arrears is being investigated. Relevant factors include credit support reduction due to earlier settlement of spot and OTC positions, assessing whether there are potential reductions in the cost of guarantees and security deposits, and cost implications of early payment.
- Swap and option Offset Reallocation mechanism – procedures for this new form of reallocation were published in 2007, and are available here. Commencement of the mechanism is subject to AEMO receiving ASIC exemption from the need to hold a clearing and settlement licence in respect of the mechanism.
- Reallocations Addendum for ISDA documentation – a standard ISDA addendum is being considered in conjunction with AFMA to facilitate the use of Swap and Option Offset Reallocations. Progression of this facility is also subject to AEMO receiving ASIC exemption from the need to hold a clearing and settlement licence in respect of this particular reallocation arrangement.
- Alternative forms of collateral to bank guarantees – the option of allowing cash to be lodged with AEMO as collateral in lieu of bank guarantees is being considered.
- Single arrangements for related business entities – consideration of a mechanism that might allow a group of related business entities to have a single settlement arrangement or single prudential arrangement with AEMO, based on their net position.
- MCLs for new entrant retailers – AEMO currently sets a default Maximum Credit Limit of $100k for new entrant electricity retailers. A survey of second tier retailers carried out in 2009 by an MCE task force raised this as a concern. AEMO is considering revision of this process.
- Reduction in the “reaction period” following default – if the reaction period could be reduced while maintaining the prudential standard, then the amount of collateral required could also be reduced.
- Management of payment shortfalls to generators – in the unlikely event that there is a need to short-pay generators due to a lack of funds, consideration is given to whether the shortfalls could be large enough to cause systematic risk.
For further information please contact Murray Chapman, Senior Manager Market Policy.
Consultancy advice from Seed Advisory and Taylor Fry (actuaries) regarding the NEM Prudential Standard, and two accompanying consultation papers containing a range of findings and proposals on energy market prudential arrangements were published in August 2010 for stakeholder comment.
AEMO published its Draft Report for consultation in October 2010. Copies of stakeholder submissions received in response to this second round of consultation are available here.
AEMO submitted the Draft Report to the MCE for consideration in November, as required by the review Terms of Reference. On behalf of the MCE, the Standing Committee of Officials (SCO) has now agreed to the public release of the Final Report. The Final Report is now available here.
AEMO now intends to progress the initiatives identified in the review It is anticipated that a Rule change will be proposed to implement a clear prudential standard for the NEM prior to mid 2011, and substantial progress is also being made towards meeting the regulatory requirements for commencement of the swap and option reallocation mechanism.
Any questions or feedback in respect of the Final Report should be sent by email to Murray Chapman, Senior Manager Market Policy at the following email address: murray.chapman@aemo.com.au.