Putting energy policy under the microscope

Energy policy is in the spotlight as it has been for quite some time, so I turned to David Leitch, who for 10 years was an analyst at UBS and then for 18 years before that an analyst at J.P. Morgan. 

He's one of the top rated analysts in Australia and now runs his own business called ITK Services Australia as an energy consultant.

In my view, he is one of the best informed people on this subject and knows exactly what's going on in terms of renewable energy being built.

Here's David Leitch, Principal of ITK Services Australia to explain what is going on with energy in Australia.

David, perhaps we could just start by taking us through what’s going on with building renewable generation in Australia.  How much is actually underway at the moment?

Broadly speaking, about 7 gigawatts of new renewable energy is being built, depending on whether or not you include the behind the meter power.

You mean rooftop solar?

Rooftop solar, which is increasingly becoming commercial rooftop solar and a little less emphasis on just residential.  But even in the residential sector, the average size of the units is getting larger and so we’re seeing about between 700 megawatts and 1,000 megawatts/1 gigawatt behind the meter a year at the moment, but we’ve also seen about 6 gigawatts depending on exactly when you start counting of new renewable power being introduced on top of that.  We’ve also got two new gas powered stations, one in South Australia and one to be built in New South Wales and those are using what I call the ‘lawn mower technology’, reciprocating engines, which means they have a very fast start. 

They’ve been put in by AGL so they can start up within 10 minutes or 5 minutes and deal with fluctuations in wind and solar.  We also have 100 megawatts of new coal fired generation in New South Wales with an upgrade to the Bayswater Power Station owned by AGL, which will replace about 10% of what’s been lost at Liddell.

Could you put that 6-7 gigawatts of renewable energy being built into context.  What sort of proportion of existing demand would that represent?

That’s a good question, Alan, and you can overstate renewable energy’s impact by focusing on those gigawatts.  The better measure I think really is to focus on the energy that they will produce, the electricity over the course of a year.  I think that’s about 20 terawatt hours which broadly speaking you could say is about an increase of 10% in supply in the current market.  That is why futures prices are forecast to decline in the market from about $80 dollars this year, a bit over $60 dollars if you look at the three-state average of New South Wales, Queensland and Victoria, so a 25% decline in prices and that’s occurring at a time when the gas price is still around $9, a dollar higher than last year.  The thermal coal price in Australian Dollar terms is up around $160, over $100 US. 

And so this is why if you were an AGL shareholder you would see those famous jaws closing very hard because they’re having to be coal price actually being paid into the March quarter.  The one useful thing Rod Sims did in his ACCC report was to put some actual numbers and coal prices for electricity generators in New South Wales are up 70% over the past two and a half years.

Before we get into more detail on that, just back to the 10% - it’s a 10% increase from what to what?

That number I actually have to think about.  Right now, over the past 12 months renewable supply, that is wind and solar, has been about 11% of total supply in the market, so about 18%.  It’s essentially a doubling, more or less.

Right.  The price coming down, apart from obviously flowing through to some extent to retailers, to household bills, also as you say, closing the jaws, the jaws between revenue and cost for retailers like AGL.  What will that do to future building of generation of any sort?

Well, it will slow it down.  It’s pretty obvious.  In the first instance – this is where it comes back to policy and reliability, Alan, and I think it’s important for people to understand this.  There are eight thermal power stations in New South Wales and Victoria...

Coal, you mean?

Coal, yes, coal stations that still carry the bulk of the energy produced.  The AEMO has just sort of doubled their outage risk in its modelling, if I can put it that way.  It said that they’re twice as likely to be unreliable as it thought last year.  The low prices will probably, if the coal prices stay high, will put some of the profits of those coal stations under pressure and the renewable supply has a zero marginal cost and we’ve seen all around the world, if you introduce enough of that, it tends to reduce the revenue available for the coal generations and they stop operating. 

When that happens, because there are only eight of them, it’s a major reduction in supply every time one of them closes.  This makes the price pop up again and this is reasonably foreseeable in my opinion and it’s going to occur extensively over the next 10-12 years and it’s going to make the electricity price quite volatile, go down and then up and then down again.  It’s also going to put some pressure on reliability as we get down the track.  Before we all start blaming AGL, I want to point out that Origin has two years in a row now put prominently in its annual report that it plans to close the Eraring Coal Station in New South Wales, the second biggest supplier, by 2032.  It plans to be out of coal by 2032.  The utility industry has a completely different perspective on what’s going to happen to policy.  

The utility industry is getting out of coal, right?

Correct.  By and large.  Not every player in it, I mean it’s a market, everyone has a different view but by and large it’s getting out of coal.

The proposition from the pro-coal people is that renewable energy can’t be dispatchable, so does getting out of coal by the utilities mean that we’ll have less reliable supply?

That’s a good question.  That of course has been the argument, when the wind doesn’t blow and the sun doesn’t shine – I should write a song about it – has been the argument since day one and so far the renewable industry has been able to rise to that challenge.  It does help, Alan, if you have cheap gas and/or cheap hydro.  For instance, in California, which has an electricity market that’s about 50% larger than Australia, they are already at 30% for wind and solar.  They have an average electricity price of US $32 a megawatt hour.  The same is true in Texas more or less which has 20% wind and an average price of $32 a megawatt hour and they’re able to do that because they’ve got cheap gas to actually come in and do the firming.  In Denmark, which has one of the highest renewable percentages in the world and one of the most reliable suppliers in the world.  They’re able to do that because they have the hydro from Norway to come along and help them.  In Australia, we don’t have that and you do see that prices in South Australia are higher than in the rest of the national electricity market.  They’ve always been higher because Australia, in electricity, has already had to rely on gas that has been more expensive than alternatives and now is vastly more expensive. 

I attended a presentation on ‘Twiggy’ Forrest’s new LNG proposed import terminal at Port Kembla.  My understanding is from that presentation is that he wants to do the gas at Australian $9-12 a gigajoule, you just can’t run an electricity business off that.  So the bottom line to your question is that I’m convinced we can do a very high percentage of renewables, 50-60% without any threats to reliability.  Over time, we will need to reduce more forms of dispatchable energy which I think will be a combination of pumped hydro, batteries, with a little bit of this reciprocating engine gas for some of the very – half a per cent of times where they’re extended unavailability of wind and solar.  Not just every night, but a time when you have a flood or something and it goes on for two or three weeks. 

Obviously, there’s the Snowy 2.0 pumped hydro scheme for storage.  I don’t know what’s going to happen to that under Scot Morrison’s leadership but let’s assume it goes ahead.  But what about large scale batteries?  Is that going to be a viable business given the growth in, as you call it, behind the meter solar?

Well, I think we’ve already seen what’s growing up in Australia, the emerging trends.  I think the individual installations are getting quite a lot bigger.  We started for instance with 50 megawatt solar farms and we’re up to 200 megawatt solar farms.  We started with 60-70 megawatt wind farms.  Origin is now building a 500 megawatt wind farm and AGL a 400-something megawatt wind farm and I’m aware of very commercial proposals to build a 1,000 megawatt wind farm.  Increasing size is one feature in the market and that helps to lower costs.  The capacity factors are getting bigger.  Solar capacity factors on an AC basis are up to 30% at the moment and wind capacity factors are up to 45% to even 50% at the very best sites.  That means you need less dispatchable energy.

The second trend that’s going on is these hybrid wind farms where you’ll take advantage of the very constrained – your access to the constrained transmission network and you are putting wind and solar together.  When you do that on the one site and when you do that and add in the battery your capacity factor goes up to 70% or higher.  Windlab, a public company, a small one started by Roger Price, has been the great innovator in this area but it’s been copied more and more.  The answer to your question is, Alan, that we’re seeing more and more of these batteries popping up in Australia at quite a fast pace. 

Again, if we look in The United States, California proposes to replace three gas plants with essentially batteries.  That’s what the California Public Utility Commission is calling for, 2,000 megawatts in power terms of batteries.  In economic terms I would say batteries are the most economic way of doing dispatchable renewables up to one or maybe two hours.  Beyond that, other forms get cheaper like pumped hydro.  It’s complicated, but if you look at the average daily consumption curve, what you can see is that there may be a chance for batteries to do quite a lot of peak shaving for that two hours in the evening peak and they may well turn out to be the most economic on day to day use, backed up by pump hydro for longer term use.

Well, in fact, it seemed to me that that large-scale battery business is an arbitrage one where you buy it cheaply during the day when the sun’s shining and you’d sell it more expensively at night when the demand is there.

Well, a utility solar farm, they don’t really want to compete with lunch time PV, all those households…  AEMO’s latest forecast show that the minimum demand every day is already at lunch time in South Australia.  Historically forever it’s been in the middle of the night or very early morning, but forecasts as early as 2019, daily minimum demand will be at lunch time.  No utility wants to be competing with that so the incentive for them is to put a battery in and just shift the price out to the right. 

But to come back to one of your earlier points about price, the price has fallen, so there’s much less of an investment price signal whether you’re a coal generator, a gas generator or a renewable generator to build new capacity.  But there’s already enough new supply to come on to cause profit problems.  This is where I think policy has to look beyond the price signals and say what we need in this transformation is a steady supply of new generation and it’s up to state governments – the federal government won’t take the lead and we’ve seen this in Victoria and Queensland to have renewable targets and to run these reverse options. 

Another thing that I think investors don’t fully appreciate is that bond rates in Australia are 2.5% now, they’re actually 30 basis points less than in the USA and bond rates in Australia are lower than a year ago.  The Federal Government’s low cost of capital could drive lower electricity prices.  This is one thing Rod Sims understands but he just made a focus on coal instead of on renewables.  When you look at renewables, the cost of capital and revenue certainty is an absolute major driver of the final price that that supplier needs.  If you’re a bank and you can lend 70% to a project because its revenue is fully contracted, you can get the weighted average cost of capital down to 6% or below if you look at current rates.  That should produce us much lower electricity prices.

New wind will be at $45 a megawatt hour within a couple of years and new solar probably at $50 Aussie or lower within a couple of years.  A new coal plant can hardly compete with that on a fuel cost basis, let alone on a total cost. 

The Labor Party has a renewable target of 50%.  This is the Federal Labor Party.  Presumably they would have to achieve that, they would have to run those same kind of reverse auctions that Victoria is now running.

If I was them I would certainly advise that, because in my opinion if you ran a steady three-year rolling program as those auctions where you could adjust the horizon every year and have a new three-year horizon, the great thing about renewable energy as compared to nuclear plants or LNG plants or even gas or coal plants is you can build the bloody things within a year or 18 months.  So, if you find out you’re making mistakes, it’s pretty easy to fix them up within a year or so.  I think with some careful planning at the federal level could really assist the overall transition and produce the lowest price.  The fact is, for the Australian market we do stand at a cross-roads. 

There’s absolutely no question the New South Wales coal stations and some of the ones in Queensland are going to close over the next 10 or 15 years.  The question is, what are we going to replace them with and how much damage or otherwise are we going to do to Australia’s manufacturing in the process.  I’m very firmly of the view that if we make a smooth transition, go with where we’re inevitably going in the future to a high renewables future where Australia has good competitive advantages with lots of sun and wind.  We can keep industries like aluminium and data centres very competitive globally.  It just needs everyone to push in the same direction.

If you wouldn’t mind just explaining what we’re talking about with the reverse auction, what exactly takes place there?

A reverse auction could be described as a tender, or in financial terms it’s a contract for difference.  Essentially, the government says that it would like to invite bids for say, 1,000 megawatts a year of renewable energy in this case, but it could just as easily be dispatchable electricity.  It says it will take the lowest bid and it will guarantee the price for that supplier.  But in the market, the wind plant once built sells into the market and takes the spot pool price and the federal or other organisation pays the difference between the agreed price or receives the difference between the agreed price and what price is received in the market by the generator.

Right, so it’s a guarantee and then the builder of the generation can go to the bank and in a sense, raise money on the basis of that guarantee?

That’s right, the risk is being shifted from the builder of the generation capacity to the dollar.  That’s essentially what it does.  Risk is best born – a truism I’m sure you know very well, Alan.  Risk is best born by the party best able to bear it and in this case, I think in an era of big transitions, this is big companies and big business is the best able to bear this risk and that’s why I think it’s the right place to put it. 

David, are you able to take us through the investable companies that are engaged in renewables?

I can.  The utility market generally is shrinking, with CKI making a bid for APA, the gas pipeline company.  The stock market companies largely consist of two giants after that, AGL and Origin, about which a fair bit is already known.  I point out that the consensus EPS forecasts for AGL are flat and I personally think that is the best forecast that they can achieve.  If you look at the AGL futures price and you look at the now ex CEO Andy Vesey’s comments at the investor briefing for the results.  He said that results were likely to be down over time but consensus was flat, so I think consensus is optimistic there. 

Origin is going to go up in EPS terms because their LNG business is doing well at the moment.  That business was financed on the basis of AUD$100 oil which is right about where it is now and their balance sheet is improving but they don’t really have, in my opinion, a good long-term strategy around their electricity retailing business and just sort of maintaining their incumbency position.  They have to figure out how to lever that some more.  Then we drop right down, if we leave out the light and poles companies which are regulated and have been loved by investors in times of low interest rates, we drop right down to a bunch of very small companies, Infigen, Windlab and Tilt. 

Tilt has just been privatised by its major shareholder, Infratil in New Zealand, so we can take it out of the category and that really only leaves us with Infigen and Windlab, so not much choice there.

There’s Carnegie Clean Energy which is very, very tiny indeed and has been a shocker too.

It’s been a shocker, Alan, and without offering formal investment advice, I would advise people to look at what an extremely bad job that company did with one of its businesses over the last couple of years.  For a very small company, they dropped $19 million in 18 months, buying and selling the business and had in my opinion, fairly minimal disclosure, to put it kindly, around the whole thing.  No one’s been sacked over it, I think it’s a disgrace to put it bluntly.  If I was recommending stocks, which I’m not, it wouldn’t be up on my list.

What do you think of Windlab and Infigen?

Well, I think they’re okay and look, I like Windlab, it’s a lumpy company.  At the moment its main problem is it’s just starting to get new windfarms financed and write PPAs.  I’m reasonably well disposed towards it.  Infigen has some difficulties with its debt.  About six months ago it tried to refinance or did refinance debt, but it had to pay a very high price through a deal led by Goldman Sachs and there is still, particularly as electricity prices come down, some questions around how all that will play out over the longer term.

We better leave it there.  Thanks very much David, it’s been fantastic talking to you, I really, really appreciate it.

Thanks very much for the opportunity, Alan.

That was David Leitch from ITK services.