New Energy Expert Insights: 5MS: The Early Bidder Catches the Worm – Part I

This series is part of our broader New Energy Insights series from our New Energy team. Stay tuned for regular updates and commentary on topical issues across the sector.

In this two-part series, Hamilton Locke sat down with Quintas Energy and Fluence Digital to discuss one of the biggest changes to the National Electricity Market in years – the switch to 5-minute settlements.

In Part I, we consider the implications of 5MS, how it is likely to change the energy market as we know it and some of the risks that could well materialise should renewable generators fail to act. In Part II, we explore some of the strategies owners and generators should consider implementing to get ahead in the new 5MS world.

Part I

On 1 October 2021, the National Electricity Market (NEM) will be shifting from 30-minute settlements (30MS) with the dispatch price averaged over six separate 5-minute intervals, to 5 minute-settlements (5MS) with the dispatch price calculated on each 5-minute interval.

The single settlement period promises to spur investment in large scale battery storage by removing market conditions that allow large incumbents to game the system and by cultivating market conditions that favour fast-response technologies like battery storage. However, the new conditions created by 5MS will also bring about their own risks for renewable generators.

What are the benefits of 5MS?

The new market dynamics of the switch to 5MS should – in theory at least – more accurately reflect underlying demand and supply conditions and therefore result in a much truer price signalling. Under 30MS, peaking generators could observe a price spike that they had not foreseen, and then belatedly rebid to ‘pile in’ for the remainder of the settlement period. Such market gaming prevents there actually being a true reflection of underlying supply and demand. 5MS will go a long way to removing this market distortion and in the process incentivise investment in capacity and demand response technologies to balance supply and demand. To the extent this is more accurately matched, consumers should ultimately be rewarded in terms of lower energy prices.

Batteries are well placed to benefit from 5MS in comparison to some other types of dispatchable generation such as gas peaking plants. Due to their fast response time, batteries are better suited to capturing immediate price spikes and are therefore arguably better suited to the new 5MS market dynamic.

Whereas today, the primary revenue streams for batteries come from their participation in the frequency control ancillary services (FCAS) markets, 5MS will ensure that the business case for batteries is truly enhanced by sharpening the incentives to participate in the energy market and undertake price arbitrage, responding to (more accurate) energy price signals.

Currently, under 30MS, large generators can strategically use short-term supply fluctuations to push prices temporarily higher, while also undermining the participation of fast-response technologies like battery storage and demand response. 5MS will make it much harder for traditional incumbent generators to “game the system” to their own advantage.

How does 5MS alter the current landscape of the NEM?

Bidding and pricing dynamics

In the short term, 5MS is likely to introduce additional uncertainty into the NEM resulting in some incremental volatility in the energy market, both in terms of pricing and risk. Whether this translates into a long-term change in pricing trends remains to be seen. The more dynamic nature of 5MS bidding could also mean that the old days of reliable price spikes happening at particular times of the day may no longer be the case. Market pricing will be significantly more fluid with the corollary of this being that generators are going to need a much more dynamic bidding approach.

In practice, this will mean that active forecasting and price monitoring will have to be implemented in combination with dynamic rebidding capabilities. Any participants that are using machine learning models to forecast prices will need to retrain their models following the introduction of 5MS as novel pricing dynamics emerge.

The static bidding strategy implemented by many generators in the 30MS world will no longer be financially viable. In the short term, renewable generators are likely to adopt and implement a risk-averse trading strategy. However, slowly but surely as the market settles and participants gain experience and comfort with the new market dynamics and bidding strategies, predictable pricing dynamics will emerge.

Impacts on existing commercial agreements

For projects that are already in operation, whether 5MS actually changes the scope of work to be carried out by contractors (O&M Provider, asset manager, etc) becomes particularly important. Projects which commenced prior to the proposal for the 5MS rule change will likely field questions from contractors as to whether a change in law is triggered under the relevant agreement (PPA, O&M Agreement, Asset Management Agreement, etc).

Where contractors take the view that their scope of work has been sufficiently changed due to 5MS, they may consider submitting variation of scope claims pursuant to these agreements which may potentially result in extensions of time and additional costs. For example, for an asset manager whose scope will usually include data management, not only will market operator data have to be recalibrated to align with 5MS, but so too will the huge databases of the relevant site’s equipment data (ie trackers, inverters and meteorological data more broadly).

Emerging technologies

In terms of market players, big batteries and ‘virtual power plants’ are likely to win out in this new system over old coal generators. 5MS should act as an enabler for future battery projects due to fast response energy sources being better able to respond to negative price periods as they can stop and start supply more readily than the large incumbents. This raises the distinct possibility that incumbent generators might see batteries as part of the solution to the risks associated with 5MS.

What are the market risks to renewable generators following the introduction of 5MS?

Effect on bidding strategies

One of the biggest implications is that static ‘set and forget’ bidding will no longer be a feasible strategy and there will be a much greater need for accurate and dynamic price forecasting. Simply put, renewable generators that do not have dynamic bidding strategies in place, risk being left behind once 5MS comes into effect.

Under 30MS, both traditional incumbents and renewable generators could compensate for incorrect price forecasting by rebidding in the back half of the trading interval. However, this advantage is lost under 5MS – generators must stick with their forecast price for that interval. As such, generators will need to ensure that their price forecasting is on the money (no pun intended) and can no longer take a hands-off approach to the bidding process. The main risk being that under a passive bidding strategy, not being in the market at all will hurt the revenue line but equally, simply leaving a static bid at the market floor could ultimately lead to exposure to negative pricing and potential losses. This is especially so taking into account the ramp rates and generator performance standards that need to be adhered to.

Effect on existing contractor scope of works

As outlined above, another material risk for owners is whether the introduction of 5MS is a change in law relating to a change in their contractor’s scope of work. Relevant questions include whether contractors are entitled to a variation to the scope of works and whether there is additional work required especially in the case of monitoring market data in 5MS. EPC Contractors will also undoubtedly be considering their budgets for testing and commissioning plans in light of 5MS.

Effect on PPAs

An interesting divergence in incentives arises in the effect that 5MS may have on PPAs. PPAs are fundamental to the bidding strategy that the owner will implement as they affect the break-even price and what makes a competitive strategy for both parties (which may differ) yet they do not go into the minutiae of the bidding strategy that 5MS may require.

Thus, there is a split incentive for owners in a post 5MS world: PPAs will usually only specify minimum generation requirements and this may come into tension with the need to reduce Contingency Raise FCAS costs. The situation can arise where the energy price is high, but the asset is bid out of the market because of the need to balance this against FCAS costs. In a project finance context, financiers and lenders will be particularly concerned that assets are not on when prices are high.

According to Chris King, Director of Business Development at Fluence Digital, “an issue that will remain for renewable generators post-5MS is the inherent split incentive around FCAS costs and generation requirements”.

“Sometimes, the asset owner’s desire to reduce FCAS costs can conflict with minimum generation requirements set out in PPAs, however, the level of curtailment to avoid FCAS costs is usually not high enough to jeopardize any minimum generation requirements”.

What are the market risks that will remain post 5MS?

Existing market risks must also not be overlooked. Failure to forecast FCAS prices and to account for expected Contingency Raise FCAS recovery costs in a bid price may result in an asset being dispatched to generate at a loss.

5MS will result in renewable generators rebidding more frequently leading to an increase in compliance risks. Generators will need to continually ensure that their rebidding process complies with regulatory requirements to avoid disciplinary action from the Australian Energy Regulator.

What will happen to renewable generators who don’t change their bidding strategy to incorporate 5MS?

Renewable generators typically face a trade-off between bidding at the price floor to minimise opportunity costs from being constrained off, versus bidding at the break-even price to minimise financial losses from generating below break-even. Currently, a generator might bid at the market floor and use the remainder of the trading interval to compensate for any unforeseen events. This ‘safety net’ will disappear under 5MS. Some renewable generators will choose to manage the new risk of 5MS via bidding at break-even to avoid negative pricing, risking incurring opportunity costs due to constraints in the process.

For renewable generators that continue to bid at the price floor to minimize constrained-off energy, there are two key risks:

  1. generating during negative prices due to a “missed prediction”: the failure to predict negative prices when setting dispatch targets means that the generator will be required to generate through a negative price interval;
  2. getting constrained off (i.e curtailed) due to “false positive prediction”: generators may predict a negative price that did not eventuate. Under 5MS this will be a more common occurrence as negative prices will correlate with high wind and high congestion. Constrained assets must be very confident with their predictions of negative prices if they want to step off the break-even price to the price floor.

For renewable generators that elect to bid at their financial break-even price to protect against the possibility of negative settlement prices, there are risks that also come with this approach. Some of these include:

  • getting constrained off (incurring opportunity costs);
  • being cycled on & off frequently, as the Regional Reference Price (RRP) bounces around the break-even price; and
  • being constrained on during negative prices. This is rare but renewable generators will need to detect the positive local price adjustment and move bids up accordingly to avoid losses.

Notwithstanding the above, there are various strategies and mitigation measures available to owners and renewable generators to address some of these key risks under 5MS. In Part II, we will explore some of these to enable owners and generators to get ahead and avoid the potential pitfalls which await those who sit on their hands and fail to act.

The Hamilton Locke team advises across the energy project life cycle – from project development, grid connection, financing, and construction, including the buying and selling of development and operating projects. For more information, please contact Matt Baumgurtel.