Why Australian renewables might be getting riskier

The government’s recently announced National Energy Guarantee could shorten contract duration, creating a risk-return profile closer to fossil fuel merchant generation, argues Maven Libera’s Mark Gemmola.

On 17 October, the Australian Federal Government announced its new energy policy to establish a dual reliability and emissions guarantee (the National Energy Guarantee), which aims to address the risk of electricity blackouts while simultaneously ensuring that emissions are reduced to meet Australia’s international commitments. The National Energy Guarantee was a recommendation made by the Energy Security Board (ESB), established by the government to provide advice on how these goals could be met at the lowest overall cost.

The National Energy Guarantee will place a requirement on electricity retailers to meet their load obligations with a portfolio of resources which include a minimum amount of flexible dispatchable capacity at an emissions level consistent with Australia’s international emissions reduction commitments. Retailers will fulfil their guarantee through the contracts they enter into with generators, or through the type of generators they invest in and operate directly. The incentive is for the retailers to achieve this at the lowest cost.

While the rules and operating parameters of the National Energy Guarantee are yet to be determined, we have reviewed the information provided to date to assess the potential implications for investors in renewable energy, particularly wind and solar generators.

To understand the implications for investors, firstly we provide a brief description of the current arrangements for renewable energy generators. The Large-Scale Renewable Energy Target (LRET) provides financial incentives to ensure that there is 33,000 GWh of renewable energy generated in Australia by 2020. Under the RET, renewable energy generators earn revenue from the wholesale energy market and from the sale of Large-Scale Generation Certificates (LGCs). The RET is legislated to operate until 2030, which means that renewable generators are able to earn revenue from both the wholesale energy market and LGCs until this date.

The design parameters of the LRET has created certainty for investors in renewable energy and for retailers required to purchase LGCs. This has led to most renewable energy generators (typically wind farms) contracting their output with retailers for long periods, typically 15 or 20 years, up until the end of the RET in 2030, since there was a known level of demand for renewable energy generation up until this date. The long-term contracts, which fix the combined price of energy and LGCs, provide stable cashflows to investors – which has attracted investors from outside the traditional energy market, such as pension and superannuation funds.

Shorter contracts

If the National Energy Guarantee is implemented, we expect that the length of contracts that renewable energy generators have with retailers will decrease and be determined primarily by the length of the customer contracts held by the retailer instead of the remaining period of the RET.  That is, contracts between retailers and renewable energy generators will, in the future, mirror the contracts currently reached between retailers and ‘black energy’ (i.e. fossil fuel) generators. The AEMC report on retail competition in 2016 noted that the period over which retailers are contracting has decreased in recent times. Currently, contracts can be as short as one to three years compared with three to five years historically. These are significantly shorter than the 15 to 20 years historically enjoyed by renewable energy generators under the RET.

Post 2030, renewable energy generators will no longer earn revenue via LGCs; instead, revenue will be determined by the wholesale energy and contract markets. This, combined with the shorter duration of contracts, will potentially provide greater variability and volatility in revenue to renewable energy generators.

The pricing of contracts may also become more complex, given the demand for a generator’s output capacity will be determined by the emissions profile of the generator; the emissions profile of each retailer’s mix of contracted generation and, therefore, the emissions intensity that the retailer needs to contract with to meet its emissions guarantee; and whether the generator is able to provide dispatchable capacity.

“These higher risks are likely to lead to required returns for renewable energy generators being similar to those required for current merchant generation”
Gemmola

Therefore, we expect that the contracted price received by each generator will vary according to its offering and the requirements of each retailer to meet its emissions target. For example, renewable energy generators would only be able to receive premium pricing over ‘black energy’ generators if the demand for contracts with zero-emissions generators is high because of retailers’ need to meet their emissions targets.

Also, given the level of required dispatchable capacity will be determined on a regional basis, generators able to provide dispatchable capacity in regions where there is a shortage (e.g. South Australia) will likely be able to contract at premium prices compared with regions where there is a surplus (e.g. New South Wales). The demand for dispatchable capacity may also lead to battery storage coupled with wind or solar generators becoming more viable in regions where there is a shortage.

The need to manage both the level of emissions and the level of dispatchable capacity in each National Electricity Market region may also lead to the retailers, especially the three-largest companies – AGL, Origin Energy and EnergyAustralia – having a greater incentive to own and manage their own portfolio of generation assets rather than being exposed to wholesale over-the-counter contract and spot-market prices.

An additional uncertainty is how the National Energy Guarantee will operate in conjunction with the RET between 2020 and 2030. Renewable energy generators meeting the 33,000 GWh RET will still be able to earn revenue from LGCs during this period. However, depending on the annual emissions level legislated into the National Energy Guarantee, there may be a need for greater than 33,000 GWh of zero-emissions renewable energy. In such a scenario, not all renewable generation will be able to earn revenue from LGCs. For any additional renewable generation to enter the National Electricity Market, wholesale contract prices will need to be sufficiently high to make any renewable energy generation not receiving LGCs economically viable.

Merchant risk profile

As a result, if the National Energy Guarantee is implemented, we expect investors in renewable energy to face higher risks than under the current RET system because of shorter contract durations and more uncertain pricing. These higher risks are likely to lead to required returns for renewable energy generators being similar to those required for current merchant generation. This has potential implications for the type of investor that will be willing to invest in renewable energy generators.  Also, if the retailers have a greater incentive to own their own portfolio of generators, this may further reduce the opportunity for independent investors to own renewable energy generators.

Those investors with opportunities to invest in renewable energy generators that are seeking low-risk, stable cashflows may need to develop innovative structures to achieve their goals. One possible option would be to invest in the tangible assets of the renewable energy generator and hold a contract with a retailer such that all of the generation output is ‘owned’ by the retailer. In return, the retailer would pay the owner of the renewable energy generator a fixed offtake payment, which would resemble an asset lease charge. The retailer would also be responsible for asset maintenance and therefore would assume all major risks, including availability risk, production risk and price risk.  Such an arrangement would leave the investor only facing counterparty credit risk, thereby leading to a stable, low-risk investment. This is similar to the current investment structures in the Hallett group of wind farms.

In conclusion, we see the proposed National Energy Guarantee as increasing the risk for investments in renewable energy and treating renewable energy generators more like traditional ‘black energy’ generators. Investors, such as pension and superannuation funds, that have historically been drawn to renewable energy because of the long contract periods and, therefore, low risk, may need to develop new and innovative structures to consider renewable energy investments in the future.