A quick article to follow-up on the more detailed discussion of the National Electricity Guarantee (NEG) in last quarter’s newsletter. Since then, the proposed design of the NEG has become clearer (although there are many details that remain to be resolved) and it also seems likely, in our view, to garner sufficient support to pass through the COAG process.
The NEG has been framed as a solution to three problems:
1. to drive down wholesale electricity prices – which rose sharply following the closure of Hazelwood power station (although there were a number of other factors in play as well);
2. to promote reliability within the electricity system and, in particular, to provide a framework for ensuring sufficient ‘dispatchable’ generation; and
3. to provide certainty to investors regarding the path for carbon abatement requirements for the period 2020 to 2030. That is, for the period from the target date for the Renewable Energy Target 2020 to the target date for Australia’s Paris commitments.
In reality the NEG is a political solution – designed by a team of technocrats – to the political problem of the climate wars that have consumed Australian politics.
In private conversations with market players, my experience has been that the NEG has limited support. However, there is a feeling of exhaustion, and much of the focus of the past six months seems to have been on trying to fix the most objectionable or unworkable components of the initial NEG proposal, rather than to fundamentally oppose it. This has seen material changes, for example, as discussed in detail in last quarter’s newsletter article on the operation of the reliability guarantee (which has been substantially diluted). However, it is very much a debate that has focused on how to limit the potential harm from the NEG rather than to fundamentally reshape it.
In our view, the NEG does little for the three problems it is supposed to solve.
It won’t reduce prices. It is new low cost capacity (in physical cost, operating cost and cost of capital terms) that will drive down prices. Any moderation in wholesale prices over the next couple of years can be entirely sheeted home to the new supply encouraged by the RET (much of which will come on line in the next two years). This fall in prices has nothing to do with the NEG.
Locks in a target for emissions reductions for electricity that is inconsistent with the lowest cost approach to meeting Australia’s Paris climate goals. Electricity represents around a third of total emissions in Australia – with the next two largest sectors being road transport and agriculture. There is broad agreement that the electricity sector offers lower cost, and higher speed, reductions in emissions than transport (where a transition to electric or other low emission cars will take decades) or agriculture. Thus, by only having a pro rata reduction in emissions for electricity it forces these other sectors to also achieve an equal reduction over the same time period. In my view there is no sign that the road transport or agriculture sectors have signed up to emissions reductions of anything like this magnitude and the political will to push through such changes is completely absent in any political party. Thus, the NEG “consensus” on emissions abatement path is fundamentally just a shifting of the position of disagreement (i.e. rather than within electricity sector, it is now in other sectors). From an investors’ perspective we still have the same fundamental dissonance between the bipartisan 26-28% reduction targets of the Paris climate goals and the policy settings at an individual sector level. This dissonance will be resolved either by failing to meet the goals (and the reality is that we probably need to do more, not less) or by yet another change in policy settings. Hardly a foundation for investor certainty.
It doesn’t provide a clear plan for the replacement of aging coal plants (see chart below). Rather, we will now have a complicated eight step process that would only be triggered relatively close to the retirement of these plants (leaving us highly exposed if retirements were unexpectedly brought forward). These plants represent a massive share of total NEM output (more than 78 TWH of production or around a third of the NEM). In our view, it is a very risky strategy to contemplate replacing all this capacity in a five to six year window in the early 2030s. The NEG has missed an enormous opportunity to put a plan in place to replace this capacity in a staged and orderly manner over the 2020s and 2030s – which is likely to be a much lower risk and lower cost approach.
As investors, we take a pragmatic view, with a focus on “will” and “could” rather than being locked on “should”. With this in mind, we think it is quite likely that the NEG will get up, but it is not the bi‑partisan panacea that will resolve the future challenges of the electricity sector.
Having got that off my chest – you ask – but what would you do instead?
If I was in Minister Frydenberg’s position, I would change the focus to an explicit plan for the orderly replacement of the energy and dispatchability currently provided by the aging coal fleet (and an important acknowledgement on this, this isn’t my idea, others have suggested this over the past six months). This could be achieved through a sequence of reverse auctions implemented over the next 20 years. These auctions could be staged, with relatively small amounts in the near term (which allows the potential testing of different generation technologies) and larger amounts as we get closer to the expected shutdown dates.
The advantages of this approach are:
It delivers a clear plan for ensuring reliability through the replacement of the aging coal fleet;
It promotes competition and low-cost solutions through an auction process. These auctions could be structured to allow a broad range of technologies to compete.
It spreads the construction activity of replacing a large portion of the NEM generation capacity over a longer period. In our view, this is very important. One of the lessons from the development of the various LNG trains in Australia, is that building multiple very large similar infrastructure projects at the same time, results in intense competition for resources and workers. This drives cost blowouts that permanently inflate the cost of those infrastructure assets. If the LNG train development had been staged – I would claim that the cost of each would have been 20% plus lower (and, possibly we would have also figured out that we didn’t need as many as we ended up building).
It has the by-product of bringing a range of new generation capacity into the market that is not controlled by the big-3 vertically integrated “gentailers”. Restoring the separation between generation and retailing markets is likely to be a positive for competition and consumers.
However, this approach is not without its own downsides:
It inherently involves bringing forward the replacement of the coal fired plants and, hence, effectively creating subsidised excess capacity prior to the closure of the coal plants.
It risks government misestimating the ultimate amount of capacity required and the construction of more capacity than required. Electricity demand may end up lower than we think – for example, due to the take-up of embedded generation. This is a genuine issue – the history and incentives for regulators (such as AEMO) is that they overestimate demand (mainly because the political consequences of a shortfall (and, hence, high prices and maybe even blackouts) are much worse than the alternative (excess supply).