Why Aren't LGC prices zero?

The Renewable Energy Target (RET) Scheme was initially introduced by the Howard government in 2001 with the goal of renewable energy reaching a 20% share of generation by 2020. In 2011, the RET target was split into two parts – the Large-Scale Renewable Energy Target (to incentivise construction of large-scale renewable power stations) and the Small-scale Renewable Energy Scheme (to incentivise rooftop solar for households). As part of this change the Large-scale RET was changed from 20% of generation to a fixed 41,000 GWh. This target was to be achieved in 2020 and held constant until 2030. The fixed target was revised down to 33,000 GWh as part of a bipartisan compromise post the Warburton review.

Under the RET one Large-scale Generation Certificate (LGC) is granted for each MWh of renewable generation. Liable parties (mainly electricity retailers) have an obligation to surrender LGCs in proportion to their customer load. This is the main source of demand for LGCs. State governments and private entities also voluntarily surrender LGCs as a contribution to the RET target. Liable parties can purchase LGCs on a spot market, directly generate LGCs by owning renewable regenerators or through buying LGCs and power together as part of a bundled power purchase agreement. There is an effective cap on LGC prices as failing to surrender enough LGCs results in a non-tax deductable penalty charge of $65 per LGC. This implies a cap of LGC values of around $90.

Each LGC is additional revenue for renewable generators over and above the value of energy. It is effectively a subsidy that is funded by an obligation on retailers (borne by electricity users). While an LGC is a green premium for generators, it is not equivalent to a carbon credit. One LGC unit represents one MWh of green electricity rather than one tonne of abated carbon. The carbon abatement value of LGCs is dependent on carbon intensity of the displaced generation.

History of LGC Prices

The chart below shows the history of LGC prices since 2014.

2014 was a low point for LGC prices since the establishment of the scheme. The Abbott government commissioned a review of the RET scheme by Dick Warburton which recommended the scheme be abolished. LGC prices crashed during this period (as did the pace of new renewables construction).

In late 2015, LGC prices rebounded along with confidence in the scheme. This reflected the compromise 33,000 GWh target adopted in June 2015 (which was a rejection of the Warburton review recommendation). The rebound also reflected the shift in outlook for the renewables sector after Malcolm Turnbull became Prime Minister. At this point it was clear to market participants that the industry was going to struggle to meet the 33,000 GWh target by 2020 and, hence, LGC prices exploded to near the price ceiling between 2016 and 2018.

This, combined with a spike in energy prices following the closure of the Hazelwood and Northern power stations, drove the biggest boom in renewable energy construction Australia has ever seen (see next chart).

Many projects have suffered commissioning delays. However, in calendar 2020 the CER registered 33,152,980 LGCs. That is, there were enough LGCs registered to meet the RET target (only just).

It is possible to use the CER registration data (see chart above) and stereotypical capacity factors of renewable projects, to estimate the run-rate supply of LGCs based on current operational projects (see chart below). Current capacity implies a 2021 supply of LGCs of around 40 million LGCs. This is well above the 33,000 targets. With around 2-3GW of new projects reaching financial close per year, this supply of LGCs is be expected to grow at around 4 million LGCs per year.

This raises the question, if we are already 8 million LGCs per annum above the target and growing at 4 million LGCS per year, why haven’t LGC prices fallen to zero. They have declined from the heady days of $80-90 but at $35-38 are still very valuable. Depending on the region of the NEM, LGCs are worth as much as energy – effectively doubling the revenue of projects.

Why aren’t LGCs worth zero?

There are a few factors supporting LGC prices – some short-term and others ongoing.

One wrinkle in the design of the RET is that retailers have the option of paying the shortfall penalty ($65 not tax deductable) and then if they surrender sufficient LGCs to meet their obligation in the two subsequent calendar years, they can get this penalty refunded. In an era of low interest rates, and with LGC prices expected to fall, this provides a mechanism to meet the RET obligation at a lower cost. However, a side effect of retailers applying this strategy is that it increases demand for LGCs in future years above the 33,000 GWh target as retailers need to acquire additional LGCs to catchup the shortfall from previous years. The CER expects this to be 3,400 GWh of LGCs in 2021 (i.e. an extra 10% over and above the base target). This has the potential to continue for a year or two – the incentive for retailers exists while ever forward prices for LGCs are much lower than spot prices. However, in the context of LGC prices over the next decade, this is only a short-term phenomenon and will inevitably by swamped by the ongoing increase in supply of LGCs. This is part of it, but not the real reason prices aren’t collapsing.

The key driver is demand over and above the RET. That is voluntary surrender demand.

The first element of this is state based schemes. For example, the ACT government has a 100% renewable energy target and as part of this has entered into long-term contracts for difference under which it acquires LGCs from wind and solar farms in SA, Vic and NSW. The LGCs acquired under these offtakes are voluntarily surrendered (and, hence, are not available to retailers to satisfy their RET obligations). This is approx. 2,200 GWH of LGCs a year (i.e. another 7% above the RET target).

The second element is private sector voluntary surrender. For the 2020-21 financial year this was 1,835 GWh of LGC demand. Data on this is patchy, but CER data suggest this represents a tripling of voluntary surrender activity compared to calendar 2018.

Within this voluntary surrender activity, one of the most rapidly growing segments is renewable energy commitments. That is, corporates which have entered into PPAs to acquire renewable energy voluntarily surrendering the LGCs acquired through these PPAs. This has grown from nothing (or at least not recognised as a category in the CER data) to approximately 300 GWh in 2020-21. However, based on the Energetics corporate PPA tracker (see chart below), this category is likely to explode over the years ahead. The chart below tracks PPAs based on when they are publicly announced. This is usually at financial close, prior to the start of construction, and so there is probably a two year lag between a PPA being announced and registration of LGCs. It is also not clear if all corporates intend to surrender their LGCs and so not all of this represents incremental demand over and above the RET.

For corporates looking to purchase power on long term contracts, renewable energy PPAs have offered attractive prices compared to the spot market. It has allowed corporates to effectively acquire LGCs for no/limited incremental cost. Thus, entering into corporate PPAs can be a low cost source of carbon abatement.

In Infradebt’s view, interest in carbon abatement and, hence, voluntary surrender demand over and above the RET, is likely to remain strong. This will arise both through international/national climate targets (and in this context the pressure will be on Australia to lift its ambition) as well as from corporates unilaterally adopting net zero goals (and, effectively, adopting a higher target than the minimum implied by Australian law).

LGCs are not directly analogous to carbon abatement or emissions. Carbon abatement of renewables will depend on what is displaced – if one extra MWh of renewables displaces one MWh of coal then this saves approximately one tonne of carbon. If one extra MWh displaces 1MWh of gas fired generation then this saves 0.4-0.6 tonnes of carbon.

However, in simple terms, in a world of $25+ carbon prices it is not internally consistent to expect LGC prices to fall to zero. There should be some on-going consistency with the implicit price of carbon in electricity markets – which is what LGC prices are signalling – and the economy wide (or international price of carbon). This has the potential to act as a floor on LGC prices in the second half of the 2020s.

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