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Energy wars – The final showdown

Infradebt has been closely following the renewable energy sector since our inception more than seven years ago (or 28 editions of this quarterly newsletter). In our view, the next two or three years will represent the final showdown in the battle between renewables and fossil fuel based generation. This isn’t going to be a smooth friendly transition. It is going to be a fight and there will be casualties on both sides. Investors in any part of the electricity supply chain need to be prepared for the volatility that will come with this final shake out.

While the last seven years have been anything but plain sailing for participants in Australia’s electricity markets, the experience to date have been the preliminary skirmishes. The inevitable shadow boxing and testing of defences prior to the real battle getting started. Over this period, renewables have averaged well under a quarter of the energy mix. This means, from a coal plant’s perspective it has been reasonably easy to just ease back a bit during the middle of the day or when the wind is blowing and not be too affected by these pesky renewables. For example, the chart below from OpenNEM provides a colour coded view of the supply mix in NSW over a recent week. Black is coal fired generation, the two shades of yellow are rooftop and utility scale solar and the green is wind. The colour coding says it all. The NSW market is currently one dominated by coal where renewables operate at the margin.

NSW Supply Mix

But change is a foot and NSW is the market least affected by these changes. Take Queensland, for example, over exactly the same period. Note the dips in black coal production around lunchtime each day as the rampant solar segment (and it is worth noting that rooftop solar is a much bigger player than utility scale solar) forces coal to cut back.

Queensland Supply Mix

And the same story in Victoria. Note in Victoria, when the wind is blowing (green) it is forcing brown coal to step back (or to export to other states).

Victoria Supply Mix

But the key story – of which the previous slides were just a prelude – is that all markets are likely to end up much more like South Australia. That is, the black and the brown is going to disappear.

South Australia Supply Mix

The rise in renewables to a 25% to 50% share of the market at certain times of day – notably peak solar times – has fundamental implications for how coal plants operate. Coal plants are base load. They are designed to run at near full capacity 24x7 with periodic shutdowns for major maintenance. They are not designed to cut their output to 50% just because it is the middle of the day and rooftop solar is going bananas or because a cold front is passing through South East Australia and wind generation is at its peak. When renewables were small - coal plants could ignore renewables – but now they can’t. Renewables have got big……..too big to ignore.

Coal is going to be forced out and it isn’t going to be pretty. We know who is going to win. This is a battle between zero marginal cost (renewables) and medium marginal cost (coal $20/MWh to $40‑60/MWh depending on whether its brown coal or black coal and for black coal depending on coal supply arrangements).

Zero wins this war.

But before supporters of renewables gloat too much – and Infradebt falls into the supporter camp - it is important to remember that renewables will win through low prices …. which hurts everyone (just renewables slightly less). This is not an agreed exit or a negotiated truce. For renewables plant owners (and this goes to the Winston Churchill reference) what matters is the length of the war. Renewables investors today are vulnerable because whilst they’re zero marginal cost, they are still trying to recover their capital cost, whereas coal plant has been written down to near zero (and thus simply need to recover the operating cost). To use a car purchasing analogy – take the situation of a small business verses the backpacker. The small business (renewables) buys a vehicle with the intention of replacing it in time (operating margin has to cover this future outlay/return of capital), the backpacker (coal) buys the car and will drive it until it doesn’t work (the cost is sunk on day one)….leaving it on the side of the road when it stops working with no intention of replacing it.

This will be a battle to insolvency.

Coal plants and their supporters will fight. They will fight as if their very existence depends on it. Because it does. Likewise, renewables investors will fight, they hope the battle is short and energy prices recover close to their breakeven price (earn their WACC) before they themselves are outcompeted by cheaper forms of energy generation in time.

Electricity prices will be low and volatile. There will be lots of periods where prices are lower than the cost of coal. There will be significant periods, particularly in Spring, where prices are zero or negative.

There will also be periods of higher prices – most notably in the evening peak (and increasingly in winter – rather than in summer). Coal plants will need to make hay during these windows … but they aren’t going to be able to extract enough profit in these windows to offset the march of low prices during the rest of the day.

Prices will also tend to shoot up after each coal plant closes (or its closure is announced). These spikes will be short lived, with the continued entry of renewables a constant downward force on prices.

More batteries will enter and they will compete with coal and gas in the evening peak – limiting the extent of prices at these times.

In short, investors need to buckle up. We are in the final showdown, renewables are going to win, but there are going to be plenty of casualties on both sides.


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