The Australian power sector is going through a period of exceptional market volatility. A perfect storm involving high fossil fuel prices driven by the Russian invasion of Ukraine, power unit outages at major aging coal fired generating stations and supply issues caused by regional flooding, caused a spike in power prices and uncertainty over the market’s ability to meet power demand which led to the Australian Energy Market Operator (“AEMO”) temporarily suspending the National Electricity Market (“NEM”) in June 2022. AEMO has since lifted its suspension but the power market continues to experience significant volatility.
While the current crisis in the Australian power market was caused by multiple short-term events, it has highlighted long term trends and risks related to the Australian power sector that will continue to be present even after the current crisis passes. Recent events have highlighted the need for structural reforms to enable and accelerate the energy transition, and the potential for market volatility if there continues to be policy uncertainty over the replacement of the coal fired power fleet.
The energy transition in the Australian power sector remains a large source of investment activity for infrastructure investors, with significant investment required going forward to support the transition towards renewable energy and the buildout of transmission and distribution infrastructure. As infrastructure investors consider future deployments into the Australian power sector, these are the key issues highlighted by the current crisis that we think that investors should consider:
- Merchant power prices are volatile and infrastructure investors should limit their merchant price exposure: Spot power prices rose significantly above their long term averages during the current crisis and hit regulatory price caps in multiple states, and this spike in power prices was one of the reasons for AEMO’s regulatory intervention in the market. The average spot price in NSW in June 2022 was c.$400/megawatt hour, compared to $160/megawatt hour in June 2021. Power prices were impacted by multiple factors such as increased fossil fuel prices, weather, and unit outages.Spot power prices are ultimately a market traded commodity. They can exhibit pricing volatility just as any other traded commodity and are challenging to forecast over the long term, particularly given the structural changes expected in the power market. While there can be periods of high power prices like the current environment, there can also be sustained periods of low power prices and the NEM has been through such periods of low pricing. For example, while the average power price in NSW in FY19 and FY20 was around $80-90/megawatt hour, average prices in FY13 to FY16 were around the $35-55 range. Wind and solar generation assets with merchant power market exposure can be particularly sensitive to power price volatility due to the intermittency of renewables, their inability to choose when to generate power due to their reliance on weather and solar patterns, and price dynamics such as the increasing deployment of rooftop solar placing downwards pressure on power prices for utility scale solar. A degree of appropriately sized merchant price exposure in power generation assets is reasonable but infrastructure investors should be wary of assets that rely on the power spot market for most of their returns.
- The structure of the electricity market is likely to change and this could materially impact the economics of power generation and storage assets: While reforms to the power market have been debated for a long time, reforms to market structure have come to the front of the discussion and taken on urgency after this crisis. Structural reforms being discussed include capacity markets that incentivise power generators to keep flexible generation capacity available to ramp up power production when the grid requires it, targets for energy storage that can complement the intermittency of renewable generation, and faster buildout of renewable generation capacity and transmission lines.Currently, there seems to be significant debate among Australian power sector participants, regulators and policy makers around the direction of future market reforms. Key points of debate include whether capacity markets should include coal and gas fired generation, and the impact of reforms on the renewable energy buildout. Structural market reforms have the potential to impact the economics and attractiveness of current and future power generation and storage assets and this is an area that should be tracked closely by investors.
- Regulatory uncertainty continues to be a headwind, however there is now increased certainty on the broad policy direction due to the change in federal government: Regulatory and political uncertainty around market reforms is usually one of the main reasons given by offshore infrastructure managers during conversations with JANA on why they were being cautious on investing in Australian power generation assets. The current crisis has brought to the fore the debate around the reforms required to allow for an efficient transition towards clean energy and lower carbon emissions. While most market participants are broadly in agreement around the long-term energy transition, there continue to be varying views on the structural reforms and policies required to enable this transition while ensuring security of power supply.While regulatory uncertainty has been a major issue, the new federal government is more supportive of the energy transition (by proposing a 43% reduction in domestic emissions on 2005 levels by 2030 which projects renewables reaching 82% of the NEM by then), and there seems be greater alignment now between state and federal policymakers. It remains to be seen what, if any, reforms are enacted after this crisis, but the direction seems to be positive. An improvement in the regulatory and policy climate will not only improve the return profile of Australian power assets but also reduce the policy risk premium and increase the sector’s attractiveness to offshore capital.
- Maintaining social license remains a critical requirement for infrastructure assets: Regulators and government policy makers have raised concerns during the recent crisis that certain electricity generators were potentially deliberately holding back supply in order to influence the market and improve their profits. The Australian Energy Regulator and the Australian Competition and Consumer Commission recently announced that they will be looking into market bidding behaviour by electricity generators during the crisis, including looking at potential anti-competitive behaviour.Infrastructure assets by their nature provide essential services and often have monopoly or quasi-monopoly characteristics. Maintaining the social license to operate is hence critical for any infrastructure asset and should form a key part of its ESG strategy or risk inviting significant regulatory scrutiny.
- Longer term trends around energy transition and need for capital investment remain intact: While the last few weeks have seen exceptional volatility and regulatory intervention for the Australian power market, the crisis has not fundamentally changed the sector’s long-term trends and investment thesis underpinned by the energy transition, and instead has highlighted the more urgent need for change.AEMO recently released their 2022 Integrated System Plan (“ISP”), which is based around continued decarbonisation of the grid supported by large investments into renewable generation, storage, transmission capacity and energy efficiency. Structural trends around electrification of end user demand are expected to continue, such as uptake of electric vehicles, and green hydrogen, while currently commercial unproven, provides upside. All these are expected to provide significant capital deployment opportunities, though investors will need to continue carefully evaluating individual assets.
Conclusion: The massive quantum of capital required to finance the global energy transition is one of the key investment themes over the coming years, particularly for infrastructure investors as a significant part of the energy transition will be through new renewable energy, transmission and other power infrastructure assets. The crisis in the Australian power market has highlighted underlying trends relevant to long term infrastructure investors looking at the Australian power sector. Merchant price volatility, capacity markets, regulatory uncertainty and social license are key takeaways from this crisis in our view. While the sector is currently seeing exceptional volatility, the long-term trends around energy transition and the shift towards renewable energy however remain intact.