The ESEM is coming

Key Takeaways

The Department of Climate Change, Energy, the Environment and Water (DCCEEW) released the draft regulatory package to establish the Electricity Service Entry Mechanism (ESEM) and the Market Making Obligation (MMO) on 14 September 2026.

The ESEM will replace the Capacity Investment Scheme for long-term investment in the energy sector.

In this update, we consider where DCCEEW and the ECMC have taken the development of the ESEM under the Draft Bill and Draft Rule.

It will have the following features:

• the ESEM Administrator will run a 3-6 monthly auction process to procure ESEM contracts for bulk energy, shaping, or firming services for volumes determined by an anticipated entry trajectory (yet to be developed, but a process has been suggested in the regulatory package);
• the ESEM contracts will be firm, fungible, and non-asset linked;
• the Financial Management Entity (FME) will be counterparty to the ESEM contracts, with its costs "covered" by a right of recovery from Market Customers under the NER;
• a developer can participate in the ESEM if:
  • it has a substantial interest in the proposed project;
  • its project is new capacity, is an expansion of existing capacity, or is a refurbishment project, and does not involve a committed project;
  • it meets competition thresholds; and
  • it meets jurisdictional pre-qualification criteria.
• successful bidders would sign a project development agreement committing to a Notice-to-Proceed Date (within 12 months of contract award) and a target Commercial Operations Date that occurs before the relevant ESEM in-market period
• the FME will recycle the ESEM contracts in accordance with a risk management guideline (yet to be developed, but a process has been suggested in the regulatory package).

However, key uncertainties remain, including:

• how exactly the ESEM will work and how will volumes be determined, as there are multiple guidelines yet to be developed and they will not be developed until mid-2027;
• what the FME's trading strategy will be especially for recycling contracts;
• how the ESEM works with recent Commonwealth data centre policy announcements; and
• whether Queensland will participate – the draft legislation allows it to opt in at a later date.

The National Electricity Market wholesale market settings review (NEM Review) began in November 2024. The Final Report was published on 16 December 2025 (NEM Review Report). The Energy and Climate Change Ministerial Council (ECMC) noted the Final Report and agreed in principle to its core recommendations (Queensland reserved its position) (see our report).

The NEM Review Report made 12 recommendations for improving the national electricity market in the short, medium, and long term. A key recommendation was (in summary):

• Energy ministers should establish an Electricity Services Entry Mechanism (ESEM) within the NEL to facilitate investment in the NEM – utilising the contracts developed through an industry-led contracts co-design process

Implementation of the recommendations is being managed by DCCEEW.

In September 2026, the ECMC, excluding Queensland, agreed to release a draft regulatory package for the ESEM and the MMO for consultation (National Electricity Market Wholesale Market Settings Regulatory Reforms - Department of Climate Change, Energy, Environment and Water). The package consists of:

• Draft National Electricity (South Australia) (Wholesale Market Liquidity and Investment) Amendment Bill (Draft Bill); and
• Draft National Electricity Amendment (Wholesale Market Liquidity and Investment) Rule (Draft Rule)
• National Electricity Market Wholesale Market Settings Regulatory Reforms Consultation Paper.

Consultation closes on 13 October 2026.

The ECMC will reconsider it in December 2026, with the aim of legislating in the first half of 2027.

In this update, we look at where DCCEEW and the ECMC have taken the development of the ESEM under the Draft Bill and Draft Rule.

Clause 4AA.C.6 of the Draft Rule provides for the ESEM to apply to:

• bulk energy service – a service that can generate electricity (measured in MWh) from an eligible renewable energy source under the Future Made in Australia (Guarantee of Origin) Act 2024 (Cth), section 69;
• shaping service – a service that can consume or generate electricity from one or more bidirectional units or voluntary scheduled resources, or consume and cease to consume electricity from one or more voluntary scheduled resources (measured in MW of capacity and MWh of storage or availability);
• firming service - a service that can provide production capacity dispatching electricity continuously for at least 8 hours (measured in MW of capacity).

Clause 4AA.C.6 of the Draft Rule also provides for sub-services – for essential services, strategic reserves, and special purpose procurements.

ESEM will facilitate lowest-cost investment to meet reliability and emissions targets

The NEM Review Report left open one key ESEM design element: how to establish the volume of contracts required for each ESEM service on a periodic basis.

Clause 118AAH of the Draft Bill sets out the ESEM’s purpose: to facilitate investment delivering ESEM services that promote the entry objective.

Clause 118AAI defines the entry objective as meeting the following at the lowest cost to electricity consumers:

• at a minimum, the reliability standard specified by the Rules;
• any targets nominated by the Minister of a participating jurisdiction for the purposes of the electricity services entry mechanism, being 1 or both of the following:
  • emission reduction targets related to the electricity sector;
  • reliability targets 

Clauses 4AA.C.1 – 4AA.C.4 of the Draft Rule set out a two-yearly cycle involving:

• nomination by the Minister of each participating jurisdiction of targets for the entry objective and scheduled generator exits;
• AEMO undertaking modelling of ESEM Scenarios as part of the Integrated System Plan process;
• the ESEM Administrator to develop the anticipated entry trajectory for a designated forecast period (being at least 15 years) having regard to the AEMO modelling and other inputs;
• the ESEM Administrator developing the tender plan having regard to the anticipated entry trajectory and expected lead times for developments.

Comment: The ESEM (General) Guidelines (see clause 4AA.C.36 of the Draft Rules) will set out how the anticipated entry trajectory is determined and translated into the tender plan. The ESEM Administrator will develop these guidelines, but not until 2027.

Two entities will manage the ESEM

The Draft Bill (clauses 118AAL and 118AAM) establishes two entities:

• the ESEM Administrator, which will manage the ESEM; and
• the Financial Management Entity (FME), which will be the ESEM contract counterparty and undertake contract recycling.

Under the Draft Bill, the ESEM Administrator and the FME could be the same entity (to be determined by the ECMC).

Questions persist about the FME’s financial strength and risk appetite for recycling ESEM contracts.

Financial Strength

The Draft Bill (clauses 118AAR to 118AAZ) and the Draft Rule (clauses 4AA.C.27 to 4AA.C.33 and 4AA.C.37) establish a cost recovery process aimed at enabling the FME to achieve an investment-grade credit rating.

The key outcomes in the process (on a region-by-region basis) are:

• the FME will estimate ESEM costs or rebates on a year-ahead basis;
• AEMO will recover ESEM costs from Market Customers using the weekly NEM settlement system and pay them to the FME; and
• the FME will pay ESEM rebates to AEMO, which will then pay them to Market Customers using the weekly NEM settlement system.

Because AEMO will recover ESEM costs, it may draw upon prudential and credit support arrangements of the Market Customers under the NER (including where the Market Customer has been suspended from the NEM).

The accompanying DCCEEW consultation paper says:

"The FME will have a statutory right to recover costs from Market Customers. Appropriate cost recovery arrangements (see Section 2.3.1) will support the FME to achieve an investment-grade credit-rating, giving market participants confidence in their counterparty."

Trading and Risk Management

Under the Draft Bill and Draft Rule, the FME will warehouse exposure from procured ESEM contracts and sell them as electricity derivatives to offset its exposures. The FME may sell products using exchanges, running auctions, or over-the-counter trading (which is expected to be its principal method).

This process will require the FME to be the enduring counterparty to both the ESEM contracts awarded to meet the anticipated entry trajectory and the offsetting trades.

A Risk Management Framework will govern these processes (see clause 118AAQ of the Draft Bill and clauses 4AA.C.21 – 4AA.C.26 of the Draft Rule). The Draft Bill and Draft Rule include the machinery for its establishment, but the broad statements do not seem to significantly restrict the types of trades and recycling by the FME.

Comment: The FME’s market-facing functions and risk appetite will remain unclear until the ESEM Administrator prepares the Risk Management Framework in 2027. This document will be key in determining the FME’s financial capacity to support ESEM contracts.

Clause 4AA.C.8 of the Draft Rule details the ESEM project criteria.

The project must be:

• newly constructed capacity;
• an expansion of existing capacity, or investment to make existing capacity dispatchable; or
• an end-of-life refurbishment that extends an asset’s life for at least the sum of the relevant ESEM in-market period and ESEM contract period.

It must not be:

• a "committed" project; nor
• the subject of any other revenue underwriting or previous ESEM contract.

The target Commercial Operations Date must be before the relevant ESEM in-market period (which includes the period before the commencement of the ESEM contract period).

Comment: Our separate review of the draft ESEM Contracts highlighted risk mitigants, including a portfolio approach relying on backing from existing assets (consistent with the ESEM’s purpose). This proposed ESEM project criteria seems to limit the possibility of portfolio based bids – clarification on this approach would be very beneficial.

ESEM related contract – Project Development Agreement

Clause 4AA.C.18 of the Draft Rule provides important guidance on this contract’s form. Parties must enter into it at the time of the ESEM contract.

It must:

• include a material commitment to commence construction or implementation of the relevant project by a date (called the Notice-to-Proceed Date) – this date cannot be more than 12 months after the award of the contract;
• include a financial disincentive not to meet the Notice-to-Proceed Date, which must be secured by a form of financial bonding (to be permitted under clause 4AA.C.13 of the Draft Rules); and
• provide for automatic termination of the contract and any related contracts if there is a substantial delay in meeting the Notice-to-Proceed Date.

Clause 118AAZF of the Draft Bill excludes the common law doctrine of penalties for damages payable under an ESEM contract or ESEM-related contract for missing a project milestone or other deadline.

Comment: Projects awarded contracts under the Capacity Investment Scheme have often failed to proceed. The bonding requirement on the Notice-to-Proceed Date, combined with the statutory exclusion of the common law doctrine of penalties, seems intended to address this issue.

Data centre operators and large load customers may receive ESEM cost relief

Under clause 118AAX of the Draft Bill, a Market Customer can receive partial ESEM cost relief where it has supported or underwritten the construction or development of a project or facility that:

• has reduced the need to procure ESEM services to meet the anticipated entry trajectory; or
• would otherwise have been identified in the anticipated entry trajectory.

Clause 4AA.C.34 of the Draft Rule includes the machinery to give effect to this concept.

Comment: These provisions attempt to provide complementary relief for Market Customers required to establish new generation or energy storage systems to support large loads. They clearly respond to recent Federal policies on data centre build-out.

The DCCEEW consultation paper recognises this is an early draft of the cost relief content – there are a number of features that need refinement, so watch this space.

Queensland may opt in later – ESEM can commence without it

The Draft Bill allows non-inaugural participating jurisdictions to opt in.

Comment: Queensland has not agreed to the ESEM. However, the ESEM can commence without Queensland, and Queensland can join later.

What this means for you

The ESEM will fundamentally reshape how new generation and storage projects are sponsored by government in the NEM, replacing the Capacity Investment Scheme with a more structured regulatory framework. Key considerations by stakeholder type:

• Developers and project proponents: The ESEM creates a regular 3-6 monthly auction cycle for bulk energy, shaping, and firming contracts. Consider how ESEM contracts could complement your PPA strategy for project financing. The eligibility criteria (substantial interest, new/expansion/refurbishment capacity, not committed) and jurisdictional pre-qualification requirements will shape which projects can participate. The bonding requirements on Notice-to-Proceed Date and statutory exclusion of penalties doctrine signal a stricter approach to project delivery than the CIS.
• Data centres and large energy users: The cost relief provisions under clause 118AAX are directly relevant if you are planning new data centres or large industrial loads. Where you support or underwrite generation or storage that reduces ESEM procurement needs or would have been on the anticipated entry trajectory, you may receive partial relief from ESEM cost recovery. This aligns with recent Federal data centre policy. The provisions remain in early draft form – monitor refinements during consultation.
• Retailers, generators, and traders: The FME’s contract recycling function will create a new source of wholesale market hedging products through exchanges, auctions, and OTC trading. The FME’s financial strength and risk appetite for warehousing ESEM contract exposure remain key uncertainties until the Risk Management Framework is developed in 2027. Monitor this closely as it will determine how effectively the recycling market operates.
• Queensland stakeholders: The ESEM will commence in inaugural participating jurisdictions (likely NSW, Victoria, SA, Tasmania, ACT) without Queensland. Queensland can opt in later. If you operate across jurisdictions, consider the implications of Queensland projects being outside the ESEM framework while the mechanism develops.

Key dates and next steps

The DCCEEW consultation on the Draft Bill and Draft Rule closes on 13 October 2026. Key milestones:

• 2026: Consultation on Draft Bill and Draft Rule; legislation expected to pass
• 2027: ESEM Administrator to develop ESEM (General) Guidelines, Risk Management Framework, and tender plans
• 2027/2028: First ESEM auctions expected (subject to guideline development)

Authors: Dale Gill, Partner; Paul Newman, Consultant and Isabelle Jardine, Graduate.