Last quarter we elected to not make comment on the proposed NEG. We did this because far too little information was publicly available – with policy makers stating conclusions, but policy detail being completely absent other than the broad mechanisms (e.g. reliability guarantee, renewables mandate). Since this time, we’ve spoken with numerous market participants (retailers, regulators, generators and investors across the supply chain) and reviewed material released by various regulators and market commentators, and whilst our views will continue to evolve, from an investment standpoint our modelling and approach to new investments in the sector now incorporates the NEG.
At the core of the NEG are two new obligations on retailers as part of their licencing conditions:
Reliability Guarantee. Retailers would be required to contract with dispatchable generators in for a ‘certain’ amount relative to their customers’ forecast load.
Emissions Guarantee. By contracting with a mix of renewable and traditional generation sources, retailers would be required to meet a maximum emissions intensity level. This level would be set to achieve the targeted 26-28% reduction in emissions for the electricity sector.
Reliability – what is it? This term has broad meaning generally, but in energy markets (and under the NEG) it has very specific meaning. Reliability is defined as having sufficient generation capacity to meet demand. Reliability does not cover the operation of the distribution and transmission network (that is, being able to get that energy to customers) or issues with the stability/frequency/voltage of supply
Based on material released lately by the ESB – it is clear that the concept of the reliability guarantee has evolved a fair way from the initial announcement. It seems that retailers will only be forced to buy capacity if there is a reliability gap forecast by AEMO in a particular NEM region. It’s important to note that at present there is no reliability gap in any NEM region (see chart later). At the moment it would appear that the reliability guarantee – announced with much fanfare – would not require anybody to do anything.
However, assuming there was a gap, it could be met through a range of mechanisms including:
Investing in capacity (e.g. new gas-fired plant, pump hydro, storage);
Demand response (e.g. during peak events contracting with large clients/users to lower demand so as to meet reliability standards); or
Use markets to trade capacity so as to hedge against reliability shortfalls.
In many ways, whilst complexity and compliance requirements may increase, the change under the NEG from the operation of the market today is small. Essentially participants in the market will meet their requirements (reliability and emissions) through physical capacity (i.e. retailer owned generators or contracted capacity) and trading through ASX energy derivatives. ASX traded derivatives, or OTC equivalents, are where the bulk of hedging occurs.
So does Australia have a ‘reliability issue’ (using the definition employed by the NEG)? The facts:
Yes just 0.24% of all network outages for the last 10 years related to generation. Of that 0.24%, the vast majority of interruptions related to old coal and gas fired plants tripping. Ok so you might look at the above chart and say, that’s nice, but we know there are issues in individual states. The existing rules and the NEG set the reliability standard at 0.002% of forecast demand – this equates to 10.5 minutes per annum of unserved load. The next chart dispels the myth that we have a reliability issue in individual states.
So noting that reliability is not an issue, what does the NEG give us (especially as investors)?
It could be argued that the NEG is a solution in need of a problem. But by far and away the biggest problem we have in energy markets relates to narrative. If the NEG has bipartisan support, it will hopefully remove the political grandstanding and create a basic framework where the nation can begin to address the real issues in our electricity supply chain. This more than anything, is the most important thing to unlocking investor capital and lowering the cost of doing business in Australia.
So what are the real issues that are effecting energy markets, and more than anything affecting our industry competitiveness (think Portland aluminium smelter), that the NEG doesn’t address?
The NEG mandate specifically excludes a review of the exiting market structure. However, we have three dominant retailers (AGL, EA, and Origin) controlling a huge share of the market. Competition is a big issue.
Vertical integration of the big 3 retailers also creates further issues - the NEG as specified implicitly assumes that generators and retailers are separate entities competing in an efficient market – this is not the case. In particular, we are sceptical of the ESB’s claims that the NEG will act to bring down wholesale prices. Wholesale prices are likely to fall due the wave of new renewable supply on the back of the RET – but the NEG in our view will have limited impact on pricing.
The NEG will likely have increased compliance requirements (NEG enforcement occurs at the retailer level) and thus smaller retailers will be at an even greater disadvantage. Here there are parallels with Australia’s banking market.
Transmission/Distribution – the elephant in the room
Network costs make up circa 40-50% of the household bill - it varies widely based on the type of customer and network location. Generation, which is the focus of the NEG, makes up only circa 20%-30% of a customer’s bill. Even if generation costs were halved under the NEG, the reality is that the average consumers energy bill will only benefit at the margin. Network costs as a proportion of the average bill have accelerated far faster than any other cost component over the last 10 years.
Looking forward, as Infradebt has previously noted, we see network costs as a very big issue for the efficient operation of the market. Embedded solutions are really beginning to move forward (many projects have approached Infradebt seeking debt finance, a number are under due diligence). Embedded technologies (e.g. solar, storage, control systems) operate in a deflationary environment, the faster costs fall, the greater the network arbitrage. As more users switch at the margin, it forces more cost onto a shrinking base of consumers (as network costs are largely fixed and spread across users). It should be noted that energy consumption has been, and is forecast to be, flat into the future. Some say that fixed and demand charges solve this problem – but really this simply solves the network assets owner’s problem, the total cost of supply to users remains very high.
You may reflect on the pie chart above (99.76% of outages relate to the network) as a demonstration that we need more, not less network investment, but by world standards reliability is a non-issue – Australia’s electricity system is very reliable. The real question is are we overpaying for reliability relative to what we actually need? Energy Australia estimates that $11 billion (13% of total network assets) of Australia’s grid infrastructure is used only 1% of the time.
What is often missed in the media is that targets for CO2 emissions are fixed. We have a budget to reduce our emissions by 26-28% over 2005 emissions. Every year we miss this target, we need to outperform the target (that is, be below target) in a subsequent year. This means deferring action imposes a steeper adjustment path in the future.
The stated target of the NEG matches the Paris commitment. But electricity emissions only make up around a third of emissions (see chart below). So either we will not meet our Paris commitments or we expect the transport, mining and agricultural sectors to carry a much higher burden into the future.
Our fleet of generation assets is rapidly aging (see chart below). Irrespective of whether replacement assets are renewable, this renewal needs to start now. To put the change in perspective, the replacement of Hazelwood’s capacity – requires 4GW of solar capacity (approximately twenty 200MW plants – which is typically as big as farms go in Australia).
Storage will be an increasingly important component of the electricity market as we move forward, but we’re yet to be convinced on the merits of projects like Snowy Hydro 2.0. We just can’t see how under the NEG the project has revenue certainty. As we’ve demonstrated above, capacity today is not an issue. With plant retirements and increasing intermittent generation, capacity could become an issue – but the project is enormous, has a long lead time and is exceptionally expensive. The question we have is who will absorb this much capacity at a price that recovers costs. We’ll likely have another piece on Snowy Hydro 2.0 in the future – but suffice to say we question whether this project will go ahead when it is apparent there are cheaper, more fit for purpose, alternatives.
The stated objective of the NEG is to deliver Australians cheaper, more reliable, and cleaner electricity – but in many ways, and linking it to the title, if this is the objective – we wouldn’t be starting from here (generation). The NEG may not hurt, but nor is it really a solution to the real structural issues affecting electricity markets. That said, we are supportive of the NEG, especially if it creates a base (with bi-partisan support) by which policy makers can move forward, because the uncertainty of the status quo only increases costs into the future.
As investors we urge caution irrespective of where you play in the electricity supply chain. There are definitely value accretive opportunities, but it’s very important that you contemplate a wide range of potential outcomes.