John Thwaites outlines how changes to the National Electricity Objective (NEO), among other regulatory changes, could help Australia achieve its emission reductions targets, in this edited extract of a speech given to the Australian Competition and Consumer Commission (ACCC) and Australian Energy Regulator (AER) Regulatory Conference in Brisbane on 4 August 2022.

Economic regulation of energy and water was largely established in the 1990s and early 2000s in circumstances that were quite different to today.

Water and energy were seen as relatively simple commodities.

Climate change was not a dominant global concern.

The main purpose of economic regulation was to promote efficiency in service provision and protect consumers from monopoly pricing.

The priority of efficiency can be seen in the National Electricity Objective (NEO), which was embedded in the regulatory framework and states the national electricity law exists ‘to promote efficient investment in, and efficient operation and use of, electricity services for the long term interests of consumers of electricity’.

The NEO and similar objectives for gas and retail govern the three national energy market institutions the Australian Energy Market Commission (AEMC), which makes the rules for energy markets, the AER, which regulates the industry and the Australian Energy Market Operator (AEMO) that manages the energy systems.

Climate change has changed the game

The economic impacts of climate change are now well recognised. Economists, Nick Stern and Ross Garnaut have advised that the benefits of strong early action on climate change far outweigh the costs of not acting.

The Paris climate agreement in 2015 increased climate ambition and set a new target to limit global warming to 1.5° Celsius above pre-industrial levels.

Most importantly we now have a consistent policy stance at a federal and state level. The Federal Government and all States have net zero by 2050 commitments.

And the new Albanese Government has committed to boosting Australia’s emission reduction target to 43 per cent reduction from 2005 emissions by 2030.

The Climate Change Bill 2022 before the Parliament legislates this target and importantly provides a mechanism to ratchet up ambition in the future.

The energy system itself is the major contributor to climate change. Energy regulation needs to reflect this.

Electricity alone represents 34 per cent of Australia’s emissions.

Climateworks’ Decarbonisation Futures report based on modelling with CSIRO found Australia needs a 70 per cent reduction in electricity emissions by 2030 to meet a 2° pathway.

This is because electricity emissions have to get to zero faster than other sectors because it is much harder to reduce emissions in agriculture, transport and industry.

The Climateworks report found that decarbonisation relies on three pillars:

  1. Ambitious energy efficiency (IEA 4 per cent improvement per year)
  2. Making all electricity zero emissions
  3. Electrification ie using the zero emissions electricity to power transport and industry

Electrification means we are going to need much more electricity than now. This makes electricity regulation that supports low carbon emissions even more important.

What problems have been caused by the failure to include a climate objective in the NEO?

The AEMC has made it clear that the national electricity objective does not require the Commission to have regard to the long-term interests of consumers with regard to climate change or the environment.

In my view, we would have acted on climate change with more urgency if it had.

A good example is the lack of demand management in the electricity market for many years. When I was Minister responsible for Climate Change more than 15 years ago, I met with businesses wanting to set up demand response.

Yet it took more than a decade to set up a demand response mechanism in the wholesale market.

And we still don’t have a system of demand management that aggregates demand management saving from households – unlike California.

I compare this to demand management and water conservation when I was Water Minister. We reduced water use per head by more than 30 per cent in five years.

The water industry has also changed and become more complex as result of climate change and environmental factors

Climate change has huge impacts on the water industry.

The increased risk of drought and reduced rainfall threatens water supply particularly in south-east and Western Australia. At Melbourne Water the streamflow into our dams has reduced nearly 30 per cent this century.

And water authorities are having to cope with severe weather events and flooding.

As a result of climate change, water supply has become more complex to manage and now water authorities need to have a portfolio of water sources to maximise resilience: desalination, recycled water, stormwater harvesting as well as traditional dams.

Regulation of water needs to take account not just of the impacts of climate change but also the need to maximise resilience against its uncertainty.

Water and energy face the challenge of uncertainty. How should regulators accommodate uncertainty?

In an uncertain environment, economic regulation should include resilience as a goal so that today’s consumers and future consumers are prepared for future shocks.

Regulators need to consider longer timeframes where there is uncertainty. The timeframe for consideration needs to be longer than the next price path. It may need to be longer than the life of the asset, which has often been used as the basis for considering the long-term interests of consumers.

Scenario testing different climate and environmental scenarios should also have a role.

In the face of uncertainty, energy and water corporations will need a portfolio of assets and processes to reduce risk. This will require them to try new ways of doing things and to be more innovative. Innovations like stormwater harvesting of water or new aggregated distributed energy systems may cost more in the short term while they are getting established. Regulators need to be willing to allow some extra costs in the short term to support these innovations in order to provide longer term benefit.

How can we ensure the regulatory framework is ‘fit for purpose’ to meet the climate crisis and increased complexity and uncertainty?

The current interpretation of the NEO is not ‘fit for that purpose’.

The approach of a narrow targeting of ‘one goal with one instrument’ is not suited to a world in which climate and energy policies are interdependent

One option would be for the energy market institutions to change their interpretation of the current NEO and include impact on emissions as relevant to the long-term interests of consumers.

Arguably AEMO has already done that implicitly with its 2022 Integrated System Plan, which provides a roadmap for the National Electricity Market that supports a rapid transformation to net zero emissions.

However it would be better if all market institutions were on the same page and for the NEO to explicitly require regard to be had to carbon emissions and government policies on climate change.

A relatively simple change would be to include in the NEO a requirement that in seeking to achieve the objective the market institutions should have regard to the Climate Change Act 2022.

John Twaites in suit and tie, smiling. Green background..
Climateworks Centre chairman Professor John Twaites AM

Alternatively, it could be rewritten to include environmental, climate and resilience objectives.

A change to the NEO requires agreement of the Commonwealth and the states. But surely now is the time to make the change when all states are acting on climate and the new Albanese Government is legislating for stronger action.

There are many international and state examples where broader climate and environmental objectives are included in economic regulation.

In the United Kingdom, the regulator is required under legislation to have regard to the effect on the environment and the interests of consumers are interpreted to include the reduction of greenhouse gases.

And the NSW IPART is required to consider ecologically sustainable development.

As well as a change to the NEO, there are other things that should be done.

I would recommend the Victorian Essential Service Commission’s PREMO approach which has provided an incentive for water corporations to prioritise customer views and deliver outcomes that customers value. I can tell you as Chair of Melbourne Water that it has really focussed the boards attention on customer views and what they value.

The cost of carbon in economic regulation and cost benefit analysis needs to be based on the new, more ambitious abatement policy of the Australian Government.

This is higher than the cost currently used in some Regulatory Impact Statements.

And it is not just about climate. Biodiversity is the next carbon and globally governments and companies are realising the need to also focus on nature related risks and disclosure.

Finally, the capacity and understanding of regulators about climate change and sustainable development is important. Changing the wording is not enough. Regulators need support to increase their capacity and understanding of climate and environmental impacts.

I’m not suggesting economic regulators lead policy.

But – Economic regulation should evolve to enable the achievement of existing government policies and global climate agreements. It need not be the driver of change, but it should “do no harm” to existing government policies.

So long as the NEO fails to ensure that the market rule maker and regulator are not required to consider the carbon emission impact of different investments it will be harder to meet government policies to reduce emissions.

It is in the long term interests of all of us that they do.