Energy transition: valuing Australian renewables

The country’s renewables sector offers potential for above-average returns, but this high-growth story is not without risks. Megan Raynal, Australian infrastructure and renewables valuation specialist, reports

Australian renewable generation is growing rapidly and is supported by an abundance of natural resources, such as wind, sunlight and now, sadly, waste. There is, however, significant uncertainty related to energy pricing and energy regulation.

Energy prices are a key driver of renewable energy value. To understand pricing in Australia it is important to understand what is happening in the country’s energy market.

Australia is experiencing significant increases in renewable energy supply, together with (primarily) age-based retirements of coal generators. While gas-powered generation is a key element of the energy mix, high gas prices and long-term international contracts have reduced the contribution of gas-powered generation. The rapid growth in intermittent renewable energy supply has put considerable pressure on existing distribution networks and led to increased caution by the Australian Energy Market Operator (AEMO) when connecting new renewable generators.

According to AEMO’s Q4 December 2018 report, compared with Q4 2017, large-scale wind and solar generation in the National Energy Market (NEM) increased 50 percent, rooftop PV generation increased 25 percent and storage charging, or pumping load, increased 79 percent.

The fourth quarter of 2018 recorded the lowest quarterly average gas-powered generation on record. Gas-powered generation has declined steadily from Q4 2017, influenced by increased penetration of variable renewable energy, rising domestic and international gas prices, and comparatively high hydro output in 2018.

Although renewables have increased, there has been a reduction in coal-fired capacity. Capacity decreased by approximately 4,000MW between 2013 and 2017. The generators expected to retire by 2040 produce around 70,000GWh of energy each year, close to one-third of total NEM consumption.

AEMO forecasts an energy mix with 46 percent renewable energy by 2030, and 78 percent by 2040, under a technology- and policy-neutral scenario. If more rigorous government-mandated technology and policies were applied, the fast-track scenario forecasts 60 percent renewables by 2030, and 90 percent by 2040.

According to AEMO, NEM average operational demand has been declining since 2009, influenced by the decline of energy-intensive industries, uptake of rooftop PV, and energy-efficiency improvements. As more solar comes online, demand increasingly reflects the ‘duck curve’, with peaking later in the day. This is demonstrated by the demand change over time in South Australia, which currently has the highest rooftop PV penetration. Prices at peak solar generation times can therefore be low.

Because of rooftop PV and distributed storage, AEMO expects that economic and population growth will no longer result in significant growth in the overall demand for power from the grid. AEMO does, however, expect increases in electric vehicles to have a moderate impact on demand.

VARIABLE ENERGY PRICES

A combination of factors has led to high black-energy prices in the short to medium term, together with high but declining green-energy prices.

According to the AEMO Q4 2018 report, quarterly average NEM spot electricity prices were A$82 ($58; €51) to A$96/MWh, which is the highest Q4 on record in all regions except Tasmania. These high electricity prices were notable because they occurred despite average mainland demand for the quarter falling to its lowest level since 2002 – and a lack of high spot prices above A$300/MWh. According to AEMO, a combination of factors has contributed to these electricity price outcomes:

• In the shorter-term, the reduction in output from gas powered generation has contributed to higher prices;
• In Q4, gas-powered generation set the price 25 percent of the time in the NEM compared with the long-term average of 15 percent;
• Other contributors include the structural shift of offers from black coal-fired generators to higher prices between 2014 and 2018, as well as the progressive closure of coal-fired capacity.

Calendar year 2019 swap prices are also looking robust.

Australia’s Renewable Energy Target (RET) scheme creates a market for renewable energy generation certificates. The significant increase in renewable energy generation in 2018 contributed to a 34 percent decrease in spot large-scale generation certificate prices in Q4. The price of large-scale generation certificates traded around A$63/MWh in 2018. According to trading service Demand Manager, they are likely to trade at A$57/MWh in 2019, declining to A$28/MWh in 2020 and A$19/MWh in 2021, as more projects come online.

If the current government remains in power, it is expected that any shadow-carbon price will effectively fall to zero from 2020-30. This is because the current government has set an emissions-reduction target of 26-28 percent by 2030. With growth in renewables spurred by higher state-based targets, no further abatement will be required.
However, the opposition Labor party has set an emissions target of 45 percent. A federal election will be held in May 2019. If Labor wins, there may be more upside to the shadow-carbon price, although this is not certain.

NETWORK ISSUES

AEMO applies a Marginal Loss Factor (MLF) annually to generation for the purposes of calculating how much revenue a generator will receive for its electricity. A lower MLF means lower spot electricity revenue. Currently, AEMO sets MLFs one financial year in advance. The MLF is intended to encourage more generation in less power-congested areas and less generation in more power-congested areas.

Following the installation of several large solar farms in the northern Queensland region, the loss factors in the state as a whole have declined. This has come as a surprise to many of the investors as, historically, the MLFs have been reasonably stable.

As the Queensland example demonstrates, MLFs can change as supply changes and the annual setting of MLFs can make it difficult for investors to forecast revenue over a longer period.

CONNECTION CONCERNS

To manage the network system security, AEMO issues Directions (mandatory instructions to generators and network service providers for system security purposes). Directions may include curtailment instructions. Curtailment is a direction to stop generation to prevent the technical limits of the network being exceeded.

Curtailment in Australia has happened primarily in South Australia. Curtailments of wind generation in the state in Q4 2018 amounted to 4 percent of available generation for the quarter, down from 10 percent in Q3. While curtailment reduces revenues, it does so at times when prices are typically very low, thus moderating the impact.

At the Clean Energy Summit in Sydney in July 2018, an informal poll in a session hosted by Kane Thornton, chief executive of the Clean Energy Council, identified connection issues as the chief concern for more than 80 percent of those present.

Because so much renewable generation has been built recently and more is in the pipeline, connection requests have increased significantly. According to AEMO chief executive and managing director, Audrey Zibelman, where once AEMO might be dealing with 20 connection requests, it is now dealing with around 300, and many are looking to build in weak parts of the grid.

Zibelman says the system is now dealing with a new phenomenon, where solar projects could go from conception to construction in less than a year, but grid augmentations still take five to seven years. The current grid was designed to deliver power predominantly from coal-fired plants near three big mining areas. However, wind and solar farms generate intermittent power from more remote sites, where network capacity can be limited.

To keep the grid stable, equipment such as synchronous condensers or batteries may need to be added, which can increase costs significantly. In addition, AEMO often requires additional studies to measure the impact of the new generator on the grid. This can cause delays or unanticipated costs. To prevent unexpected costs and delays due to grid connection issues, it is important that developers engage with AEMO early.

REDUCING RISK

The Australian renewables industry is growing rapidly, and the energy landscape is changing. Above-average returns are achievable, but there are also risks that need to be managed.

Understanding the Australian energy landscape and future trends is critical. In our experience, a key value driver (and risk moderator) for Australian renewables is optionality/flexibility, which allows investors to take advantage of opportunities and mitigate risks.

For example, the Kiamal wind farm synchronous generator provides network stability, allowing the wind farm to scale up if demand grows.

For renewable investments with uncertain cashflows, it is important to understand and map out the potential cashflow impact of different scenarios. Cashflow scenarios should also aid in understanding what flexibility/optionality is available to mitigate risks and maximise opportunities.

Diversification is also important. The right diversification strategy increases value by more than the value of each asset in isolation. This is recognised by credit assessors too. In Fitch’s Renewable Energy Project Rating Criteria paper, published in February 2018, the agency noted that “for a well-diversified set of wind projects, the portfolio effect may result in an increase in the aggregate P90 estimate by 2-5 percent, compared to the sum of the P90s of single projects”.

Using a portfolio approach can therefore maximise risk-adjusted returns.

In conclusion, Australian renewables are in growth mode. For renewable-energy investors, it is important to understand the potential range of outcomes and how risk and opportunity can be managed along the way.

Waste not want

It is worth mentioning developments in waste-to-energy in Australia, as there is currently significant interest in this form of generation. Australia’s first large-scale waste-to-energy plant is under construction in Western Australia and others are being planned.

Following China’s decision not to import waste, Australia is looking for solutions to manage waste, with most states considering some form of waste-to-energy strategy.

Waste-to-energy plants have the potential to provide strong returns because they should be able to obtain reasonably cheap (or free) waste input and generate power at times when prices are high. However, waste-to-energy plants typically deal with councils and large waste operators, and the development model is still immature. Input quality and input costs remain a significant challenge, as do project technicalities, environmental control requirements and local community perceptions.

Stamp duty is also a consideration for waste-to-energy (and pumped hydro) assets in Australia, as these are considered fixed to land (and therefore liable for stamp duty), unlike wind and solar.