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Super funds and the Capacity Investment Scheme might not be compatible.

The Commonwealth Government has set a target of 82% renewables in the national electricity market by 2030.   Achieving this target will require massive investment in new utility scale wind and solar generation as well as dispatchable firming assets such as batteries.  While estimates vary – the 32GW+ of additional capacity is likely to require a $50 billion wave of investment.

While policy makers haven’t been explicit on who they think will finance this new investment, my guess is that they would expect Australian superannuation funds and similar institutional investors (for example, offshore pension funds and sovereign wealth funds) to be major investors in new renewable generation capacity in Australia over the next few years. 

I wouldn’t be so sure.

The key policy mechanism that is intended to drive this wave of investment is the Commonwealth Capacity Investment Scheme (CIS).

What is the Capacity Investment Scheme

The Capacity Investment Scheme is a competitive government run process that 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 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 a bid parameter in 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 the minimum percentage of revenue would remain exposed to market outcomes, even if the floor or ceiling was binding (DCCEEW has indicated this could be 90% on the floor and 50% on the ceiling).

What are the likely competitive outcomes

While CISA will be assessed across a number of criteria (sponsor credibility, project readiness, community engagement and support as well as first nations involvement) it is likely that a key differentiating criteria will be the financial criteria in the CIS bid.   That is, what the level of the revenue floor the project requires - the lower the better. 

In Infradebt’s view, the level of the floor price is likely to be the most important bid variable (with the government strongly incentivised to select projects with low floor prices).

The $64,000 question amongst renewables market participants is “What will be the clearing floor price under the CIS auction?”.

In our view, clearing floor prices are likely to be around 50-70% of the levelised cost of projects.   That is, if the stereotypical windfarm requires a levelised revenue of $80/MWh (nominal) over its 30 year operating life to cover its capital and operating costs, it might bid a floor price of $40 to $55/MWh.

Why this range?

I don’t expect CIS floor prices to be below 50% of levelised cost – because at this point the floor is genuinely valueless.   If a project proponent (or their financiers) thought there was a meaningful probability of a 50% of levelised cost floor binding – then they wouldn’t proceed with the investment – CIS floor or not.  In particular, at sub 50% strike prices, given the floor is only for around half of the project life (ie probably covers well under a quarter of project NPV), it means that the floor would only kick in in a scenario where equity and debt had been eviscerated.

Conversely, it will be a competitive process, with the Commonwealth likely to take 3-4 times as many projects through to final round of the bidding process as actual CISA offtakes will be granted. Thus, it seems very unlikely that the winning bids for CISA floors will be at or above levelized costs. 

This is consistent with market outcomes for PPAs, where pre-financial close 10 to 15 year offtakes are usually struck at a discount to project levelised cost.  Put it another way, the experience with other offtakes is that market participants are willing to discount the PPA price for upfront certainty ­- effectively punting that revenues after the offtake period will be higher.  We expect that this dynamic will apply for CIS processes as it does currently for PPAs.  In fact, given that under the CIS the project has the opportunity to earn revenue above the CIS floor (but below the CIS ceiling), prices for CIS contracts are likely to be materially lower than the equivalent PPA from a retailer (where there is no upside opportunity).

What does this mean for likely capital structures

For the sake of argument, let’s assume that a project successfully obtains a CISA at 60% of levelised cost based on 100% of its capacity.  This is a 15 year offtake – it probably only locks in around 30-40% of the NPV of project cash flows.   The diagram below illustrates a potential capital structure for this transaction on a very stylised basis.


If you ignore the CIS in the first instance and imagine the project was fully merchant (uncontracted), the typical capital structure you will get is:

  • Around 30-40% debt.  With debt service front-ended, where lenders can have more confidence about revenue forecasts.   Lenders usually assume project lives shorter than equity and so debt fully amortises prior to the end of the project life.

  • Around 60-70% equity.  Equity gets the balance of the cash flows after debt.  This means that equity returns are inherently back ended.

How does this change with the benefit of a CIS floor?

The CIS floor gives more locked in revenues and so debt financiers can safely lend more. However, the impact of the CIS is reasonably muted (see triangle in diagram above).  The CIS can’t increase debt post year 15 and so the CIS doesn’t make any difference then.  Likewise, if the CIS floor is below revenues that a bank would otherwise lend on a merchant basis then it won’t boost debt.

All of this is me saying that a CIS at 50-70% of evelized cost will modestly increase the amount of debt available and might also modestly decrease the margins banks charge.  However, it is not a game changer.  The likely capital structure is still going to be circa 40% debt and 60% equity.   Mathematically a 15 year CISA on a 30-35 year life project just can’t make much difference unless it is at a very high price (which in turn is unlikely due to the competitive nature of the CIS process).  Thus, in order to drive a higher debt size still requires a high price, long-term PPA from a highly rated offtaker.

Furthermore, it is important to recognise that the equity in a CIS project will have a high exposure to merchant price risk – particularly in the back-end (i.e. post the term of the CIS).  This structure will deliver high returns and high dividends when merchant outcomes are high, but will also be quick to shut off dividends and have substantial capital value write-downs if long-term merchant expectations are revised down.   In scenarios where the CIS floor actually binds (and this is the point that any Commonwealth government subsidy actual gets paid), equity will be taking large losses and be almost certain to be receiving no dividends.

Fit with Superannuation Funds

Infradebt’s comment is that this capital structure and risk return profile doesn’t actually align with what the typical Australian superannuation fund is looking for in their infrastructure equity assets (and while my comment is focused on Australian super funds, the attitudes of offshore pension funds and sovereign wealth funds wouldn’t be that different).   A typical super fund infrastructure equity investment has 60-70% debt and 30-40% equity.   They typically are structured to give stable equity distributions.   That’s not what a CIS backed generation asset is likely to look like.

Rather, the capital structure and overall risk profile from CIS generation assets is more likely to match the generation assets of the gentailers.   The generation assets of the gentailers do have cyclical returns (and that cyclicality can be absorbed in part by balancing the generation owned assets against the profitability of the gentailers’ retail business).  The typical gentailer actually has a two thirds equity, one third debt capital structure.

That said, it is hard to see Australia’s big 3 retailers mobilising $30bn plus of equity capital that would be required if they were to be the principal funders of the generation investment required to hit the 82% target.

Ultimately, funding CIS backed generation investment will require equity investors with a good understanding of short and long-term electricity price dynamics and a willingness to back their own view of the likely trajectory of electricity prices (and, hence, the returns on these assets).

The Gentailers probably have good insights – but don’t have enough money.  The super funds have the money – but historically haven’t been comfortable taking strong positions on long-term electricity prices.

We at Infradebt don’t have the answer to this conundrum – but it will be a key point of dissonance that will affect the execution of the CIS over the years ahead.


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