Gradually then suddenly: how energy markets failed and what happens next

“How did you go bankrupt?” Bill asked. “Two ways,” Mike said. “Gradually, then suddenly.”

These lines from Ernest Hemingway’s novel The Sun Also Rises may have echoed in the heads of energy market regulators last week as they struggled to keep the lights on.

Over the past few months risks to the energy system have been piling up. Flooded mines creating a shortage of coal. More coal-fired power plants out of service for repairs or maintenance. Delays to these repairs because of global supply chain issues. More gas generation while coal was out of action. Warnings about prolonged high gas prices stemming from the war in Ukraine. Cloudier weather reducing solar generation. Constraints on transmission lines meaning some states had too much energy while others had too little. Cooler weather than usual throughout May and a cold snap at the start of June.

Taken individually, each of these risks were manageable within the current market rules and shouldn’t have affected the energy system. Taken together, their effects were compounded, and as a result, wholesale electricity prices started to rise. And rise. And rise. Between the beginning of January and the end of May, the NSW wholesale electricity price leapt from an average of $77 per megawatt-hour to $320 per megawatt-hour.

The market rules have a safety valve to limit the impact on our bills of prolonged high prices. Last week the Australian Energy Market Operator (AEMO) invoked it, and imposed a price cap on the wholesale market, so that no generator could sell energy at more than $300 per megawatt-hour.

Three hundred dollars was too low for some generators; it would have meant selling at a loss. They withdrew from supplying the market. With these generators not supplying, others undergoing repairs and maintenance, and yet others with shortages of coal or gas to keep running, plus the colder weather, we suddenly had a crisis: a gap emerged between the amount of electricity consumers needed, and the amount that generators were willing to supply.

When gaps like this emerge, AEMO has the power to direct generators to supply electricity and compensates them for doing so. It can also call on consumers to reduce their demand. This rule was designed to fill small, occasional gaps, but earlier this week one-fifth of all electricity demand was being met by AEMO directions. AEMO did the best thing it could do in the circumstances: it suspended market operations and began directing generators when to supply, paying them a flat rate for doing so. Barring any unforeseen events, this should keep the lights on, although the balance between supply and demand is still tight.

Suspending the wholesale market created a few moments of breathing space. But it’s obvious that the current rules haven’t kept up with the market and aren’t delivering what we need. After a few deep breaths, ministers need to plunge into major market reforms.

There’s no single solution. The former energy minister Angus Taylor was right when he said we need a “capacity market” to ensure there’s always power in reserve to deal with fluctuations in supply. The current Energy Minister Chris Bowen is right when he says we need more interstate transmission lines and more new renewable energy capacity, and he’s right when he says that 10 years of uncertainty about climate policy have chilled investment in the energy system. NSW Energy Minister Matt Kean is right when he says AEMO needs more visibility of individual generators’ capacity to supply. Many people, including my Grattan Institute colleague Tony Wood, are right when they call for more gas to be made available for the domestic market, including a windfall-profits tax on gas exporters if necessary. Others are right when they say more investment in batteries, storage, and energy efficiency are needed. It’s all of the above.

What is critical is avoiding quick-fix market reforms and ad-hoc government interventions that respond to the problems in front of us right now but leave the market unable to respond to future challenges. This decade will be one of the most challenging the energy system has faced, as it transitions away from coal and gas to meet the government’s target of 82 per cent renewable energy in less than eight years. Ministers (on behalf of us voters, citizens, and energy users) need to be clear what they want. Promises of cheaper electricity aren’t enough: it has to be clean and reliable, and the system that delivers it has to be able to withstand shocks and anticipate and respond to risks.

Ministers then need to decide the best way to deliver. The next decade involves a lot of risks, and these need to be shared equitably between governments, consumers, generators, fuel suppliers, renewable energy developers, and energy network owners and operators. Sometimes markets will be the best way to do this, sometimes regulation will do the job, and other times it will require governments to carry risk as well. Sharing information about risks, who is carrying them, and whether they are increasing, will be key.

Hemingway also observed that “everyone behaves badly – given the chance”. It will be very tempting – but counterproductive – for politicians and commentators to jump into blame games and restart the climate wars. It will be tempting for state ministers to go their own ways. But the energy system operates better when they all work together.

How it started is less important than making sure it ends well.

Alison Reeve is the Grattan Institute’s deputy program director, energy and climate change.