Energy market regulation and its discontents


Why the ETS is a dud

by Simon Pockley PhD (last updated 22/11/2009)

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First in - best dressed
Leaving it to the market to implement policy objectives
Emerging markets in Australia
1. Market size and lack of standards
2. Lack of homogeneity and dead koalas
3. Phantom RECs
4. A market for lemons
5. Pricing RECs


The theoretical attractiveness of using market instruments to assist the Australian energy sector meet lower green house gas emission targets won't work if the market does not operate efficiently. Factors working against an efficient market relate to size, lack of homogeneity, inaccurate baselines, phantom commodities, convoluted levels of abstraction, and a level of complexity that point to using simpler, more direct forms of regulation that can be easily understood and aligned with community aspirations.

First in - best dressed

Climate change is one of the most urgent and fundamental problems facing energy market regulators. Yet the extent and impact of global warming is hotly contested and there is public uncertainty about appropriate responses. In many countries the electricity sector is one of the largest contributors to greenhouse gas emissions and is therefore a target for regulation. The Australian electricity industry currently contributes more than 50% of Australian greenhouse gas emissions. Policy failure, over the last 10 years, has resulted in the highest growth of emissions in any sector.

There is a widespread (but not universal) belief that an effective way to significantly reduce greenhouse gas emissions is to encourage the development of a clean, renewable energy sector. The attendant benefits of energy supply security, increased employment and improved public health have not, of themselves, been major drivers.

It is difficult for electricity consumers to know who should be accountable for adverse environmental impacts of fossil fuel generation because there is no transparency about where electricity comes from. Furthermore, the operations of Government regulatory policies have been so convoluted, as to be incomprehensible.

The tenacious competitive advantage of fossil fuels over the last century can be attributed, in part, to the largely hidden subsidies supporting the incumbent production and distribution infrastructures (e.g. coal transport, oil and gas pipelines, national electricity grid, roads); in part, to the failure of market prices to reflect the true costs of the consumption of fossil fuel energy (e.g. water shortages, public health, environmental damage, oil wars); and, in part to the immaturity of the renewable energy technologies that have yet to reach a competitive scale.

It is not because a particular technology is efficient that it is adopted, but rather because it is adopted that it will become efficient.

[Arthur 1989]

To imagine a renewable energy future (e.g. David Mill's Photon Economy), it is worth privately speculating on what might have happened if we had adopted some of the electricity generation alternatives available a century ago.

1839 photovoltaic effect was first recognized
1839 fuel cell principles first demonstrated
1859 first anaerobic digester was built by a leper colony in Bombay, India
1881 first electrical power plants
1888 first windmill for electricity production built in Cleveland, Ohio
1895 anaerobic digester used to generate gas for street lighting in UK
1885 first petrol powered engine car made by Karl Benz
1908 first wind farm 72 wind turbines from 5 kW to 25 kW in the U.S.A.
1954 first solar panel made by Bell Laboratories

Table 1. Key dates relating to the invention of electrical generation technologies

Leaving it to the market to implement policy objectives

Historically, environmental regulation of electricity industries has focussed on air, water, solid waste pollutants and planning issues - not on greenhouse gas emissions. What are known as technical or command and control approaches have been the main methods of addressing the direct causes of environmental impacts.

More recently, financial approaches to environmental regulation, attempt to manipulate the effective 'price' of different energy alternatives by direct and indirect incentives. Such approaches do not make distinctions between solutions (renewables, electricity savings). Instead, they attempt to take advantage of competitive pressures to reduce costs and maximise returns. The effectiveness of such incentives is usually assessed by the extent to which they:

Over the last 20 years the range of financial instruments used in Europe to promote the development of renewable technologies falls into 4 main categories:

The attraction, for regulators, of using one or more of these financial instruments is that they believe they can simply set environmental objectives, and then leave it to the market to resolve how these objectives are actually achieved. In theory, such instruments can also help avoid clashes between different policy measures because the regulated parties can weigh up separate pricing signals.

Australia has been an early adopter of both electricity industry restructuring as well as the tentative development of market-based environmental instruments. However, when it comes to implementing market reform processes of sufficient scale to enable significant change, Government Departments, with an environmental focus, have experimented with a complex array of theoretical instruments without the benefit of proven examples to guide their choices, and usually without much experience in the design and performance of financial and major commodity markets.

Putting aside the factional politics of climate change, the development of effective markets for these instruments is likely to be a process fraught with unexpected difficulties and perverse outcomes.

The market forces that these instruments rely on, even those associated with prescient strategic positioning rather than public good (clean air, climate stability), have so far failed to assist the development of renewable alternatives rapidly enough for greenhouse gas emissions to be reduced to meet, even low, emissions targets.

The theoretical benefits of using markets to implement policy rest entirely on the assumption that these markets are efficient. An efficient market requires (at least) sufficient size to be actively traded, good design, good regulation, and effective surveillance and monitoring.

Emerging markets in Australia

The current structure of the Australian electricity market was shaped by the industry reforms of the early 1990s. Vertically integrated, state-owned utilities were disaggregated into separate generation, transmission, distribution and retail supply components, and the electricity businesses were either corporatised or privatised.

A major element of these reforms was to set up the National Electricity Market in 1998, linking the Australian Capital Territory, New South Wales, Queensland, South Australia and Victoria (Tasmania joined in 2005). Power was then allowed to flow across state and territory borders to meet demand in other jurisdictions.

The National Electricity Market is comprised of a wholesale market and a competitive retail sector, which is intended to promote competition and efficiency in the production and provision of electricity and allow for a choice of supplier. Most electricity retailers purchase electricity from generators on a contract basis. Additional electricity can be purchased through the spot market.

Emerging markets in Australia include GreenPower schemes and the Federal Government's Mandatory Renewable Energy Target (MRET) underpinned by the market for Renewable Energy Certificates (RECs).

The Renewable Energy (Electricity) Amendment Act 2009 was passed in September 2009. As part of the expanded Renewable Energy Target (RET) scheme, related State-based schemes will now be phased out. This legislation requires all electricity retailers and large direct consumers to source additional energy from new renewable energy sources. The key components of the RET Amendment Act include:

To demonstrate compliance, electricity retailers have to purchase (or self generate) Renewable Energy Certificates (RECs) to the value of their compliance burden and then (annually) account to the regulator. A REC is proof of the generation of 1 MWh of electricity from an eligible form of 'renewable' energy (as defined in the act and certified by the Office of the Renewable Energy Regulator (ORER)). If the retailer is still not compliant, a financial penalty (currently $65/MWh) is applied to any shortfall. This is not subject to tax deductions and represents a real cost of close to $93/MWh.

Retailers and generators negotiate (through one of a small number of brokers) to purchase the RECs. Both supply and demand of RECs are variable and uncertain. The supply of RECs includes supply from generators with variable output, such as wind turbines. While aggregate demand as specified under the Act, is unknown until the share of electricity sales by individual retailers is known (after the 31st December each year).

There are several structural flaws and inconsistencies that should raise concerns about the operation of the market for RECs.

1. Market size and lack of standards

Total turnover of Over the Counter (OTC) financial markets in 2000-2001 was around Au$31Trillion. Foreign Exchange (56%) was the largest component, whereas the Electricity market was a mere 0.35%.

The largest environmental market currently trading in Australia is the Mandatory Renewable Energy Target (MRET) market. It has a turnover of around 3% of the size of the National Electricity Market (NEM). This means that the largest environmental market in Australia has a market share of around 0.01% of the overall volumes of trade in the financial markets. Other markets would be an order of magnitude smaller and could be reasonably expected to be very 'thin' or 'boutique' with infrequent trading. Thinly traded markets do not operate efficiently and are at risk of manipulation and even failure.

Globally, environmental markets can be characterised as 'boutique' and 'bespoke' (in the sense that no two are identical). Furthermore, the market design principles that are applied have not yet adopted any commonly agreed set of standards.

2. Lack of homogeneity and dead koalas

Renewable Energy Certificates (RECs) were originally conceived in the U.S.A. in the 1990s as an instrument to be used to meet a regulatory quota. The model for a REC was an emission allowance for a sulphur dioxide (SO2) trading program (acid rain) under amendments to the Clean Air Act. The concern at the time was that competitive electricity markets would drive renewable energy generation out of the market. Since then, renewable energy markets and emissions markets have developed in parallel. This has led to different applications of RECs within two types of tradable commodity instruments:

a. Quota instruments: RECs serve as a tradable commodities and the quota creates a scarcity. Entities with a quota (e.g. cap) are required to submit a certain number of RECs to comply with the scheme. Their allowance is a transferable commodity that confers the legal authorisation to take some action (e.g. to emit a unit amount of a pollutant) without facing a penalty. Each REC functions as proof that an entity has either taken this action (e.g. purchased a unit of electricity from a renewable generator) or has the right to sell the REC representing that action.

b. Offset credit instruments: Voluntary emission offset markets are focused almost exclusively on GHG emissions. These voluntary GHG offset markets are generally unregulated and lack standard protocols and terminologies. Consumers in these markets include both organisations and individuals who voluntarily commit to offset their GHG emissions from their operations, events, travel, products, concerts, or other activities. They can directly participate in renewable energy markets by purchasing generating equipment and installing it on-site, purchasing accredited GreenPower from a retailer, purchasing renewable power directly from generators in competitive electricity markets, or by purchasing RECs.

Assuming that a MWh of renewable electricity displaced electricity from a coal-fired power plant, which emits 1 metric ton/MWh, then implicitly, the retirement of the REC offsets about one metric ton of CO2. Despite such claims, RECs have failed to prove that they convey any legal rights to emission allowances allocated to fossil fuel-fired generators.

Offset projects favour cheap methods of reducing carbon emissions rather than renewable energy projects. 'Green Carbon' offsets are problematic. First, the Carbon Accounting Model (FullCAM) for calculating how much carbon is temporarily taken up by growing trees is yet to be fully developed and tested. Second, trees may release their carbon early when disease, catastrophic fire, prolonged drought and illegal logging become more frequent. Third, there is no credible or sustainable system in place for long-term monitoring.

RECs created by the generation of power from native forest waste have been controversial and labelled 'dead koala' RECs. These trade at a discount to RECs from other sources. The legislative separation of wood waste and biomass sources from wood waste from native forests would go some way towards helping to realise the potential for bioenergy in Australia.

Legislation requires that an energy crop 'must be grown as an energy source for the primary purpose of energy production'. However, a biomass refinery usually produces a range of products including energy, fuels, biofertilisers, and chemicals. The relative proportions of products are varied to meet market conditions. In response, the market has directed its attention to other technologies, in particular wind projects.

3. Phantom RECs

The wide variation in the language used to define RECs results from their use for applications with quite different characteristics.

In Australia, Renewable Energy Certificates (RECs) are promoted as a form of currency. The Office of the Renewable Energy Regulator (ORER) refers to a REC as a commodity that can be bought and sold.

A renewable energy certificate (REC) is a commodity in the REC market. RECs are created by eligible parties and sold to liable parties via the REC Registry to meet their liability under the Renewable Energy Target (RET).

SGU owners-guide

The Renewable Energy Target (RET) was originally intended to ensure that an additional 2% renewable generation was translated to a fixed 9500GWh target for 2010 in order to increase market certainty. When this was expanded to 20% and translated into projected 60,000GWh target by 2020, whatever certainty existed, was lost. Some stakeholders are campaigning for a significantly increased GWh target, while others are saying that the target has lost credibility due to the existence of 'phantom' RECs being generated by the Solar Multiplier.

The Solar Multiplier negates this 'positive impact' by actually reducing the amount of newly installed renewable energy compared with annual targets under the expanded RET. Had the Solar Multiplier been in existence in 2008, the share of RECs generated from SGUs could have accounted for more than 19% of the total REC pool, resulting in 15.5% of all RECs created (i.e. up to 1.48 million RECs out of a total of 9.5 million) not representing actual renewable generation.

ATA Submission REC Multiplier 2009

There is also debate about whether solar hot water heaters should be included as renewable energy sources, since many solar small generation units (SGUs) are not actually replacing electrical power.

Setting inaccurate baselines can also create phantom RECs. Appropriately defined baselines are vital to the effective and efficient operation of a market developed on top of existing arrangements. For each renewable generator that existed before 1997, a baseline is calculated before it is rewarded for additional renewable generation. The default baseline is annual generation averaged over the period 1994 to 1996. Alternative baselines can be negotiated with ORER if this average doesn't represent 'normal' power station output. These baselines are confidential.

The Clean Energy Council (formerly BCSE) has identified that the low level baselines for some of Australia's large-scale hydro generators allow them to create large quantities of RECs that are essentially zero-cost because no additional investment or operational changes are required. Hydro Tasmania has revealed that it had generated more than three times as many RECs as it had registered for the first year of the scheme. The BassLink interconnection between Tasmania and mainland Australia may add to this REC windfall.

All renewable generators with non-zero annual baselines can also benefit from the variability in their annual energy production, as they are eligible to earn RECs in the years when their output is above the baseline, but are not obliged to return RECs in years where their generation falls below it. The Clean Energy Council estimates that 35% of the MRET target to 2010 can be met by existing large-scale hydro because of these baseline problems. The baseline challenge is even greater for low-emission gas-fired generation in Australia because unrelated developments in the NEM seem likely to facilitate a growing role for such generation.

4. A market for lemons

Economist George Akerlof maintained that if buyers in a market are unable to verify the quality of what they are buying then sellers of 'lemons' are encouraged to enter. Cautious buyers then aren't prepared to pay the high prices required to cover the cost of 'high quality' products. Lemon market effects can be easily observed in markets such as used cars, computers and online dating - and now RECs.

...there is incentive for sellers to market poor quality merchandise, since the returns for good quality accrue mainly to the entire group whose statistic is affected rather than to the individual seller. As a result there tends to be reduction in the average quality of goods and also in the size of the market.

[George A. Akerlof 1970]

A REC is really just an abstract idea in as far as it is just a record in a registry database. Transacting a REC is, in fact, an act of information management. But if one REC is not reliably interchangeable with another because of the lack of homogeneous consistency necessary to be treated as a commodity, then market efficiency is compromised.

Phantom RECs not only erode the credibility of the Renewable Energy Target but also reduce the opportunities available for new forms of renewable generation because competitive pressures drive participants towards the lowest cost ways to create RECs.

5. Pricing RECs

Large buyers and sellers of RECs trade through the wholesale market with minimum parcel sizes of 5,000 RECs. The price for a parcel of RECs is called the spot price. In theory, the price for RECs is determined largely by supply and demand. The key factors influencing supply and demand of RECs are:

The graph below shows the fluctuation in the REC price in the wholesale market since June 2003.

RECs prices graph

Fig 1. Source:

In the short term, the supply of RECs is relatively inelastic in so far as RECs are being generated from renewable sources with a variable output (e.g. wind farms or solar power). Hydropower, biomass and certain other forms of 'renewable' energy enjoy the advantage of controllability. Having such producers in the market is a key element of ensuring that the market has an achievable equilibrium position. However, many of the previously mentioned factors will work against establishing an equilibrium price as the correct incentive for new sources of renewable energy, that is - not too low (so that insufficient investment occurs), and not too high (driving over-investment).

A core issue is that adverse environmental impacts are as yet unpriced in current competitive electricity markets and therefore unlikely to influence decision-making.

The failure of Australian electricity restructuring to deliver reduced greenhouse emissions can be seen as a more fundamental outcome of the restructuring process itself. The market for RECs is a form of derivative market for an electricity market that is more of a 'designer market' in as far as electricity is not a natural fit to commodity style competitive markets.

MRET applies only to electricity generation and not thermal energy production, the potential for gains in this important stationary energy sector will not be stimulated until the effects of a cost for carbon are felt.

The present regulatory uncertainty in climate change policy adds greatly to the risks faced by market participants. These abstract 'designer' markets are not constrained by the physical realities that shape many commodity markets. Instead, they represent an environmental policy that may change dramatically and hence lead to changes in the rules that impact markedly on market viability.

An efficient market is also an informed market. In spite of various Government policy interventions designed to reduce greenhouse gas emissions, emissions have increased. Significant factors that have been neglected and that impact heavily on the model for an Emissions Trading Scheme include:

Unfortunately, it is often easier to be guided by historical arrangements and the preferences of incumbent participants than it is to create level playing fields for different possible arrangements and new participants.


The idea of using financial instruments that get the market to resolve how environmental objectives are achieved may be theoretically attractive but doesn't work very well if the market does not operate efficiently. In practice, the factors working against an efficient Australian energy regulation market include:

The poor historical performance of Australian energy regulation schemes should serve as a warning that a piecemeal approach to addressing greenhouse gas emissions is destined to fail. That the murky politics of Climate Change should have become characterised by inaction, clean-coal spin, denial, and impenetrable complexity is cause for alarm.

The greatest uncertainty facing the energy sector is the likelihood that an overly complex and severely compromised Emission Trading Scheme (ETS) will soon replace the current ineffective schemes. This corrosive uncertainty has not only damaged the prospects of numerous renewable generation projects but also the credibility of this or any Government's ability to achieve lower greenhouse gas emissions.

An ETS in Australia is likely to see the price of electricity and manufactured goods rise steeply as generators pass on the costs of permits and offsets to their consumers. But this is no guarantee the market will invest in low emission alternatives. The proposed ETS protects dirty industries by allowing them to buy emissions permits or cheap offsets rather than meet environmental standards.

Prudent regulatory choices should not favour incumbent centralised technologies and supply-side participants against new, distributed generation technologies, and possible 'new entrant' demand-side initiatives.

Under the proposed ETS scheme the community is effectively barred from participating in Australia's response to Climate Change. Whatever the attractiveness of the base theoretical model, the flaws in the operation of the RECs market, the manifold compromises and handouts, and the stain of political double-talk, render the scheme so convoluted - as to be unworkable.

Australians appear to want action and strong leadership. It might be more palatable to replace the complex ETS scheme (that most people can't understand) with something simple and direct where the price of electricity begins to reflect the real costs of the environmental damage resulting from fossil fuel combustion.

This can be achieved simply and directly through imposition of a universal carbon tax and emission charges, or indirectly, as a result of ensuring compliance with properly conceived targets and other environmental standards. Either way, it is important to move away from the levels of public disengagement with the problem.

If we are to seriously attempt to revert to a safe climate, the long-term social and economic transformations needed to overcome the inertia of our dependence on fossil fuels will need to concentrate as much on innovation and energy conservation as developing a cleaner energy sector.