A renewables hedge against gas price gouging

For a small additional cost Australia could develop significant wind and solar assets that would shield us from the energy security risks posed by a gas-powered future.

While energy security has historically been thought of as a safeguard against abrupt supply disruptions, it can also apply where there is the potential for sudden, unexpected high prices over which there is little domestic control or ability to respond. This is consistent with the International Energy Agency (IEA) definition that energy supply is “secure” if it is adequate, affordable and reliable. 

Energy price security has not typically been an issue for electricity production in Australia, given our abundant domestic fossil fuel resources. However, by the IEA definition, two distinct developments in the Australia market have the potential to threaten Australia’s electricity price security. 

Firstly, east coast domestic gas markets are likely to become linked to international gas markets in the near future via the development of a large Liquefied Natural Gas (LNG) export industry. This creates a growing degree of domestic gas market exposure to the uncertainty and volatility inherent in international markets. 

Secondly, there is expected to be a strong trend towards investment in gas‑fired generation in Australia. If investment is in plant designed for bulk energy production from gas (combined cycle gas turbines, rather than gas peaking plant), electricity prices are likely to become increasingly linked to domestic gas prices, passing through gas costs to electricity consumers.

These two factors mean that Australian electricity prices could become exposed to the possibility of sudden, unexpected high international prices over which we have little domestic control or short-term ability to mitigate. Electricity markets are composed of long lived assets with long development timeframes. This means they respond to fuel price volatility by passing on higher electricity costs to consumers for extended periods of time before new generation assets that are more competitive under the prevailing pricing regime can be installed.

These factors have translated into material uncertainty over future domestic gas prices, as illustrated in Figure 1. Even in the near term, forecasts vary significantly, and by 2030, forecasts range from as low as $4.50/GJ to as high as $15/GJ.

Figure 1 – Recent domestic gas price forecasts from a range of sources in real 2012 Australian dollars

This degree of uncertainty over future gas prices is material, as illustrated in Figure 2. This graph shows the combinations of carbon and gas prices at which the long run marginal cost (LRMC) of combined cycle gas and wind generation are equivalent. At higher carbon and gas prices (above the line), wind is anticipated to be less expensive than combined cycle gas for bulk energy production, and vice versa. 

The magenta points indicate gas prices forecast by the Bureau of Resources and Energy Economics (ACIL Tasman, 2012) with carbon prices forecast by the Federal Treasury (Treasury, 2011), and remain below the line until after 2020 (indicating that combined cycle gas is the lower cost generation option in this scenario). However, this is only one possible economic outcome; the high degree of uncertainty over gas prices at present means that price projections vary widely. 

The range of gas price projections forecast in each year is illustrated by the magenta “uncertainty bars”. It is clear that the degree of uncertainty is material, compared with the relative costs of the two technologies. Carbon price uncertainty is not illustrated, but is similarly large. 

Figure 2 – A comparison of the long run marginal cost (LRMC) of wind and combined cycle gas turbines (CCGT), indicating the combination of carbon and gas price at which they are equal. 

Notes and sources: The points in magenta illustrate carbon prices from the Treasury modelling (Treasury, 2011) and the most recent available ‘medium scenario’ gas price projections from the Bureau of Resources and Energy Economics (ACIL Tasman, 2012). Uncertainty bars indicate the range of the highest and lowest gas price projections forecast for that year from the selection of recent gas price projections listed in Figure 1.  The CCGT is assumed to operate at a capacity factor of 80%; other technology costs for LRMC calculation are from reference (AEMO, 2010).

In addition to exposure to gas price uncertainty, Australia’s electricity price could become exposed to international fuel price volatility.  ]

This has been observed in the UK, where the price of gas is identified to be the main driver of household electricity bills. Following the Fukushima incident and conflict in Libya, international gas prices rose significantly. Despite the remoteness of these events to the UK, they directly acted to significantly increase consumer electricity bills. 

The potential rise in electricity price volatility and uncertainty can be addressed by the development of a diverse generation portfolio. Renewable power, in particular, has been recognised internationally for its value in mitigating fuel price volatility in electricity markets. Continued investment in renewable generation in Australia allows bulk energy production from renewables rather than gas.

With increasing quantities of energy being supplied by renewable sources, a larger proportion of new gas-fired plant can fulfil a peaking role (rather than bulk energy supply). Thus, achieving a significant penetration of renewable energy in our market has the potential to de-couple electricity prices from gas prices, increasing energy price security.

It is recognised that there is an additional cost premium associated with portfolio diversification, since by definition it requires investment in technologies that are not the lowest cost. We propose that the additional cost of diversification can be thought of as a type of ‘insurance premium’, since diversification towards a protective portfolio insures our electricity market against volatile fossil fuel prices. 

The insurance premium that we should pay in order to develop this protective portfolio will be dependent upon the likelihood of adverse events, and their consequences. In this case there is evidence that volatility is likely and could have severe consequences, suggesting that a high insurance premium could be justified.

Given the anticipated increase in gas prices over the coming decades, the premium required is likely to be small. At gas prices of $11-$12/GJ, wind generation becomes competitive with a combined cycle gas turbine (CCGT), even in the absence of a carbon price and RET support. With a carbon price of $23/tCO2-e, wind competes at only $9-10/GJ. 

This indicates that the additional premium required to develop significant quantities of wind generation over the next decades could be small, and likely to be justified by the reduction in risk and exposure to volatility. Similarly, recent and continued cost reductions in solar photovoltaics put this technology at only a small additional cost.

Dr Jenny Riesz is AECOM senior consultant in Energy Strategic Advisory.

For the complete analysis, please refer to:  http://www.aecom.com/deployedfiles/Internet/Geographies/Australia-New Zealand/DeliveringEnergyPriceSecurity_DrJennyRiesz.pdf

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