Is marginal pricing approach still fit for purpose in the NEM wholesale market?

4 Decemember 2024

The Australian Government has recently initiated a review of the National Electricity Market (NEM) wholesale market settings (the NEM Review) to promote investment in firmed renewable generation and storage capacity.

For this review to drive meaningful outcomes, it must support continued investment in the NEM, address supply needs without increasing costs to consumers, and align with Australia's renewable energy and decarbonisation objectives. A critical aspect of this effort will be examining the application of marginal generator pricing in the spot market.

Marginal generator pricing in the NEM

The NEM operates as a gross pool market where wholesale electricity prices are determined every five minutes based on the marginal generator dispatched to meet demand. This is the generator that sets the "market clearing price" by being the last, most expensive unit needed to satisfy demand during a given interval. All dispatched generators receive the same market price, which is set by the marginal generator.

This design is based on the economic concept of marginal pricing, where the cost of supply is determined by the most expensive unit of electricity generation required to meet demand. It was intended to signal whether the market had excess or insufficient generation capacity over time. In a market dominated by thermal generators with high operational costs, this approach worked effectively, providing clear investment signals when wholesale market clearing prices exceeded average costs of generators being dispatched. Although short-term price fluctuations occurred during events such as droughts or extreme weather, the mechanism generally performed as intended.

However, the growing integration of near-zero marginal cost renewable energy sources, such as wind and solar, has undermined the effectiveness of marginal generator pricing in achieving its intended purpose. These changes raise concerns about this design feature’s ability to guide investment decisions and maintain stable market operations. The initiation of the NEM Review reflects a recognition that aspects of the current wholesale market design require reassessment.

Three key challenges for renewable energy investment have emerged as a direct result of the marginal pricing design feature.

Generators in the NEM now face significant revenue uncertainty. Renewable generators often set lower market prices due to their minimal operational costs. This reduces revenue for all generators, eroding the financial viability of new projects and deterring future investments.
There is significant spot pricing volatility. Renewable energy variability has led to frequent price fluctuations, with price surges during scarcity events and low prices during periods of high output. This volatility makes financial planning for projects more difficult and undermines investor confidence.
The marginal pricing design mechanism does not adequately incentivise investments in dispatchable generation or essential system services, both of which are critical for managing maintaining system security and reliability.

Implications for the NEM Review

The NEM Review must determine whether the marginal pricing design feature of the NEM remains suitable for a renewable-dominated energy system. This includes evaluating alternative pricing mechanisms to provide equitable revenue outcomes for renewable, firming, and transitional generators, ensuring all can achieve reasonable returns and support ongoing investment.

The review should how more certainty in the delivery of transmission infrastructure can support renewable generation investments. Delays or uncertainty in transmission development can disrupt project timelines, increase costs, and pose broader risks to the energy system.

In addition, clear strategies must be developed to incentivise investments in resources that enhance grid reliability such as dispatchable energy and essential system services.

The review should prioritise linking the timely and guaranteed delivery of transmission infrastructure to renewable investments. Delays or uncertainty in transmission development can disrupt project timelines, increase costs, and pose broader risks to the energy system.

The NEM Review expert panel faces a complex and critical task. Substantial reforms will likely be needed to address the challenges of integrating renewable generation while maintaining reliability, affordability, and investment confidence. A well-designed market framework is essential to meeting Australia's energy transition goals and supporting a reliable and affordable electricity future.