The competition twist to a bigger AGL

AGL Energy has announced that it has secured Macquarie Generation from the NSW government for $1.505 billion, contingent on approval from the Australian Competition and Consumer Commission.

The replacement cost of MacGen’s Liddell and Bayswater coal generating capacity would lie at about $2000 per kilowatt, and AGL has just paid about $300 per kilowatt. While the power plants are hardly spring chickens, this looks like a good deal even if you just ran these plants for a small proportion of the year let alone as the baseload generators they’re designed to be.

Indeed, AGL could mothball the older Liddell station potentially reflating prices for Bayswater, and still have only paid a price per kilowatt for Bayswater lower than a gas-peaker lucky to run 10 per cent of the year, let alone as baseload.

While the ACCC has reserved its final judgement until March 4, its preliminary view is that the acquisition shouldn’t proceed because it believes it is likely to result in a substantial lessening of competition in the supply of electricity hedge contracts. In addition, the watchdog believes the deal may also lessen competition in wholesale generation of electricity across NSW, Victoria and South Australia.

Overall, the ACCC has a tough case ahead of it if it wishes to block the transaction. That’s because the overall electricity market is already heavily concentrated and this single transaction, when viewed in isolation and at the present point in time, doesn’t appear to make things much worse.

ACCC’s set of concerns about the transaction tend to centre on the provision of hedge contracts for smaller, new entrant retailers. Hedge contracts allow power retailers to cover their exposure to times when wholesale electricity prices occasionally hit extremely high levels exceeding $10,000 per MWh. That is when they typically offer their customers fixed prices for electricity below $100 per MWh (excluding network costs).

Yet it may be that the ACCC is barking up the wrong tree.

Ben Burge, chief executive of one of the better resourced new entrant retailers, Powershop, explains an approved MacGen deal could allow AGL to provide enhanced competition against Origin and Energy Australia, which dominate the state’s retail market.

He notes:

“There are genuine consumer benefits (via reduced hedging costs) to be derived from large retailers having a balanced portfolio in the markets in which they operate. AGL does not have a significant generation position in NSW and is growing its retail base. As long as there continues to be a range of generators in NSW (enhanced by the injection of wind under the Large-scale Renewable Energy Target) which enable smaller retailers to access the market, there should not be any negative impact on retail competition per se.”

Instead, AGL’s acquisition of MacGen may be more problematic because of how it affects the availability of long-term power purchase agreements to support new entrant generators. In the ACCC’s statement of issues surrounding the transaction it notes:

“There has been a trend towards vertical integration of generators and retailers to form ‘gentailer’ structures throughout the past decade ... These three major vertically integrated retailers (AGL, Origin and Energy Australia) control 45 per cent of new generation capacity commissioned or committed in the NEM since 2009. Investment by entities that do not also retail energy has been negligible, except for the case of wind generation.”

When the Kennett government in Victoria kicked-off liberalisation of Australian electricity markets a decision was made to establish retail businesses separate from generators. The thinking behind this was that by keeping these separate it would enhance competition in each respective section of the value chain. Retailers without generation assets would want to encourage as many generators as possible to ensure competitive prices, and generators would be more than happy to provide contracts to new entrant retailers because it wouldn’t undermine their own profits. 

However, once a retailer owns a substantial amount of generation capacity it is likely to see the entry of a new generator much less favourably as it may make little difference to the profit of its retail arm, while undermining profits from its generator.

New entrant independent power project developers regularly complain that Origin, Energy Australia and AGL pretty much have a stranglehold over entry of new generation capacity. Between the three generator-retailers they have 77 per cent of mass market customers in the NEM, leaving a series of rats and mice electricity retailers with the remaining 23 per cent.

They also hold a large proportion of the customer load outside the mass-market (big energy consumers). None of the smaller retailers have a big enough customer load or the financial strength to provide much in the way of long-term, large scale power purchase agreements required to support bank financing for an economically-sized power plant (which tends to be 100 megawatts or more). 

Now, there are a number of very large power consumers – not retailers – who could provide such power purchase agreements. However to date they have shown a reluctance to engage in such power purchase agreements for renewable energy projects as they are seen as too distant from their core business.

In response, a number of the independent power project developers have consequently established their own retail arms in order to try to bypass the big three. Infigen, Pacific Hydro and Meridian (with Powershop) are significant renewable energy power project developers that have obtained retailer licenses. However, gaining the number of customers required to support more than just one or two power projects will take considerable time and lots of marketing dollars. It is not something you can do without serious amounts of resources.

AGL acquiring MacGen will mean they represent a more capable retail competitor to Origin and Energy Australia in NSW. But it further skews the incentives among the big three to withhold provision of power purchase agreements to support new entrant generators, in particular renewable energy power plants.

With the very large oversupply of conventional power generation at present and the real possibility that Alcoa’s Point Henry smelter will shut, it is very difficult for the ACCC to argue this represents a serious problem for effective competition. 

But in a few years’ time it could look quite different. The federal government may well have slashed the level of the Renewable Energy Target and capacity from some of the older generators could have been withdrawn by the gentailers in an effort to reflate prices (something the Queensland government managed to do with spectacular success by consolidating its three generating businesses into two).

At such a point, it will be very hard to unscramble the egg of a market dominated by just three companies.