22 November 2023 saw a massive announcement in the history of Australia’s electricity markets with Chris Bowen announcing an intention for the Commonwealth to procure 32GW of new wind, solar and storage capacity for delivery prior to 2030. Given there is currently around 20GW of existing utility scale wind and solar in the NEM, this would more than double renewable generation supply. This is a massive task to be completed in just seven years, considering it has taken around 40 years to get to our current capacity of wind and solar (the first wind farm in Australia began operating in 1987!).
While some of what follows may come across as negative – it is important to understand that Team Infradebt is composed of debt investors. We can see the downside in anything! 😊Any intervention in the market, however well intentioned, will have both intended and unintended consequences.
First, it is important to recognise Minister Bowen needed to do something. In the absence of a significant change in policy settings, Australia was on track to massively undershoot the government’s 82% renewable by 2030 target (see chart below). If growth rates in GWh continue at rates consistent with recent times we would still miss the mark by at least 20%!
In electricity infrastructure terms, 2030 is incredibly soon. When it takes 5+ years to approve and build transmission upgrades and 2-3 years to build wind farms (plus up to 5 years before hand to get development approval), 2030 will come in the blink of an eye. By contrast, in political terms, 2030 is at least two general elections away, a long time in politics!.
To get to 82% (or even close) Australia needs a massive wave of wind and solar projects to reach financial close in the next 3-4 years. The Commonwealth Capacity Investment Scheme (CIS) is intended to make this happen.
This is a great goal. It is good for the planet because the quicker we can achieve decarbonisation, the lower the cumulative CO2 emissions (which is what matters from here on out) and, hence, dangerous warming potential. It is good for electricity reliability because Australia’s legacy coal fired power stations are, in general at the end of their operating lives, and need to be replaced (and are likely to have lower reliability until they are replaced). The longer we spend thinking about the optimal long-term solution (and we have wasted a decade already) the more risk we take that these plants suffer unexpected breakdowns prior to their retirement.
The CIS is an unequivocal signal from the Commonwealth that the long-term future of Australia’s electricity supply will be provided by wind and solar firmed with storage, and that this is going to happen quickly and at scale. This helps clarify the outlook for the myriad stakeholders in the electricity sector. Hopefully it assists in driving a change throughout the sector from endless discussions of what we should do (what about some Nuclear 😊?) to a discussion of “how do we do it?” and “how do we do it quickly?”. Note we’re not anti-nuclear per say, it’s just that we’ve never seen a compelling case in terms of both cost and/or time – it may well be a solution for countries with poor renewable resources – but that’s not Australia.
What is the Commonwealth Capacity Investment Scheme?
It is a scheme which will allocate revenue support agreements (CISAs) to successful projects through a series of six-monthly auctions starting in 2024 and running to 2026 (for wind projects) and to 2027 for solar and storage projects. It will be seeking to support 32GW of new capacity (23GW of wind and solar and 9GW of storage). Projects will compete against each other to bid a floor revenue (which indicatively will apply for 15 years).
Once built, if the project revenue falls below this floor level, then the CISA would kick in, topping up project revenues. Similarly, if revenues exceeded a ceiling (also part of the auction process) then the project would pay the Commonwealth some of these windfall high revenues (see below).
Source: DCCEEW briefing presentation
Importantly this floor/ceiling would still incentivise the project to enter into offtake agreements with electricity retailers/users and, if not contracted, to maximise the market revenues of the project. The project would also still be incentivised to optimise market revenue as x% of revenue (perhaps 25%) would remain exposed to market outcomes, even if the floor or ceiling was binding.
The Commonwealth believes that these revenue floor arrangements will reduce the risk of greenfield wind/solar/storage development and, hence, encourage new capacity into the system (and importantly new capacity that would not otherwise get built).
The reverse auction nature of the process and the competition between projects and proponents would be expected to drive revenue floors to the minimum. This will reduce the cost to the Commonwealth (compared to a system where it procured capacity outright or, god forbid, chose to build on Snowy 2.0 and tried to deliver the projects itself).
What are the Implications?
It is early days and there is a lot of detail yet to be announced. It will also be very interesting to see how the first few auctions go and what the market clearing level of revenue floors will be. While the current policy design claims that these auction price outcomes will be secret – the reality will be that each project will have a myriad of advisers, investors and lenders, all of whom will need to know what the revenue floor locked in under the CISA is. Thus, while it may not be publicly announced, the outcomes of tenders will be widely known.
Here are four early implications from the CIS:
electricity and LGC prices will be lower. The CIS is all about providing incentives outside of existing market revenues to encourage new entrants (and a massive amount of new entrant capacity). This will result in lower electricity prices. This will be directly negative for existing wind and solar projects – who will earn lower revenues. Compared to an extension of the RET as a mechanism for driving investment – this is a big difference.
the early 2030s will be interesting. The CIS is all about driving capacity into the market in the very late 2020s. At the same time, a disproportionate share of existing wind and solar projects have PPAs that end in 2030 (ie aligned with the end of the RET). Thus, just when prices will potentially be low due to a surge in supply, existing projects are likely to have above average exposure.
reverse auction prices will rise over time. The auctions will be open to any project that wasn’t committed prior to the CIS announcement (22 November 2023). Thus, it is quite possible that early CISAs will be awarded to projects that were already under construction (and projects that were happy to proceed on a merchant basis can afford to bid low in the CISA). Infradebt’s expectations is that as the auctions progress – and the sheer volume of projects required to hit the 32GW bites – that auction prices will rise. It is also possible that a meaningful share of early CISA winners fail to reach financial close for their projects (in this context, it is noteworthy to look at the experience of the Victorian VRET2 auction).
CISAs will deliver much more value to lenders than equity investors. CISAs are a limited revenue floor for a limited period (15 years compared to project lives of 25-35 years). Our expectation, at least in early rounds, is that auction prices are likely to be set on the basis of covering opex and a significant component of debt service, but won’t actually be set at a level that provides a meaningful return to equity. Thus, the impact of the CISA is a modest capital structure change – somewhat higher somewhat cheaper debt – rather than something that necessarily changes the equity base case operating cash flows. The equity base case for wind and solar projects has always been highly sensitive to post PPA merchant revenue forecasts. This will still be the case, it will just be post the end of a 15 year CISA floor rather than a 10 year PPA term (ie longer term, lower price, same overall dynamic).
In conclusion, the CIS will have significant implications for the Australian electricity sector that we will continue to be discussing for years ahead (7 at a minimum 😊). The CIS, like any major public policy announcement, will have its winners and losers – but it is unquestionably better than doing nothing.