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AGL Energy squeezed by the merit order effect

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AGL Energy, one of the first companies to articulate the “merit order” benefits of renewables, is now threatening to withdraw from activities in South Australia, the state with the highest penetration of wind and solar in the country, if it is forced to pass on some of those benefits to consumers.

A big brawl has erupted between AGL  Energy and the Essential Service Commission of South Australia (Escosa), over the pricing regulator’s recent draft decision to force AGL Energy to pass on the benefits of lower wholesale prices to consumers on standing contracts.

Escosa argued that the wholesale price component had been too high, because it had been set according to energy industry estimates of the long-run marginal cost of energy. However, it said wholesale prices have fallen and recommended a change that would reduce the wholesale price component by $27/MWh, which would result in savings of around $160 a year for consumers in South Australia.

AGL Energy, however, says if the decision is upheld, then not only will it scale back its marketing activity in the state, including cessation of all door knocking, it will also suspend any further investment in power generation, including renewable energy, in South Australia.

“ESCOSA has effectively put up a sign saying do not invest in South Australian power generation,” managing director Michael Fraser said in a statement issued ahead of the company’s annual general meeting.

The “merit order” effect is a well documented impact that wind and solar energy has on the price of wholesale energy. Because these energy sources have a very small short-run cost of energy, because their fuel is free, they get priority in the bidding order of national electricity markets, bringing prices down.

AGL Energy was one of the first to sing the praises of the merit order impact when it was advocating for a higher renewable energy target before the election of the Labor government. However, it has been a bit quiet on the merit order impact lately, particularly in its recent campaign to have state-based feed-in tariffs for solar cut back.

Escosa, surprisingly, did not cite the impact of green energy in its draft finding, pointing only to a reduction in demand. But, as Dylan McConnel from the Melbourne Energy Institute pointed out, the amount of wind energy and even rooftop solar in the state – both the highest in the country – are clearly having an impact. He said it was possibly the first instance where the merit order was passed on in a regulatory ruling.

Certainly, the impact of wind and solar on wholesale energy prices is well established in international markets, and has been behind the argument of most of the major Australian utilities in diluting the renewable energy target. They say too much wind and solar will make coal- and gas-fired generation uneconomic. On the other side, most pro-renewables companies have said the merit order impact is a benefit.

AGL Energy straddles both sides of the argument, because apart from renewables investments, it has coal-fired generation, and is a retailer. It has been the only major utility to support the LRET as is, despite its equivocation on solar PV. However, this attack on Escosa’s ruling is as much about defending its retail margins, and it’s “gentailer” business model. It says the combined impact of regulatory rulings in South Australia and Queensland on retail prices could be $60 million on an annualised basis.

As one energy analyst noted: “It is actually quite well documented in the merit order effect literature that in cases of strong vertical integration (or weak competition), that firms are able to internalise the merit effect – which is perhaps what AGL has been able to do in SA – until now.”

But while AGL Energy is keen on pocketing the increased margins, it is also highlighting an uncomfortable reality for the renewables industry – that is, that if the wholesale price continues to be set by the short-run marginal cost, then eventually it could dissuade investment in renewables as well.

These are some of the issues being confronted in Germany at the moment. And they promise to be some of the most critical and fascinating regulatory arguments into the future – if they can be heard over the short-term rhetoric, and some of the nonsense, that is said and written about energy prices in the political arena. As another analyst pointed out, having a market based on the lower short-run marginal cost (which is what Escosa is arguing) has proved to be efficient in the National Electricity Market since its inception more than a decade ago. It was considered a really good thing, until wind and solar came along to spoil the party for the coal-fired generators.

Now, AGL Energy is arguing that if the regulator sets the retail price below the long-run cost, power purchase agreements become uneconomic and so does investment in utility-scale renewables, since renewables are long-dated investments and need long-run pricing.

AGL Energy’s position is also a calculated part of a broader campaign on price regulation in the industry across the country, particularly in Queensland where AGL Energy and other utilities are fighting against artificial retail price caps. AGL Energy says it has stopped marketing activities in that state, and is also considering doing the same in NSW, where that state’s market regulator has also been instructed to build in market prices into its estimate for the wholesale price component of retail bills. It has been pushing, along with other utilities, for a deregulated market, particularly in time-of-use tariffs.

But the response to Escosa, and its apparent wish to pocket gains of the merit order impact, is not the only mixed message sent out by AGL Energy in recent months. The company that built a reputation for creating the cleanest energy portfolio in the country, with the largest investment in renewables, earlier this year bought the country’s largest single emitter, the Loy Yang A power station.

AGL justified that decision by saying it was too good an opportunity to miss, and that earnings generated by Loy Yang A were better in its hands, as they were more likely to be directed towards green energy. The earnings power of Loy Yang A, which AGL Energy has refinanced using its own balance sheet, was underlined in its latest update, which included a significant upgrade to its earnings this year – to around $590 million to $640 million, compared with $482 million in the last fiscal year.

However, company chairman Jeremy Maycock,  said the regulatory decisions, combined with the uncertainty around the future of carbon pricing and the LRET, meant that “no one should be surprised to see new investment in the NEM (National Electricity Market) evaporate, with all the consequences that would follow.”

He said the continued regulation of retail prices and overlapping state and federal regulatory structures “creates a real risk of systemic failure” in the NEM. But this is part of AGL Energy’s problem, it is effectively arguing for deregulation in one part of the market, and reinforcing regulations in another. The one thing that has been consistent in all this energy debate: everyone has been talking their book.

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  • Tim

    Why don’t they take one for the team and shut down Loy Yang A for most of the year? That should push up wholesale prices.

    • Chris Fraser

      My concern is that running Loy Yang pushes up wholesale prices. I think that’s why they bought it from a distressed vendor. It out-competes other coal so it sits near the base of the AEMO stack, its energy always desirable.

  • Warwick

    AGL is not getting squeezed by the “merit order effect” rather by arbitrary price caps set by regulators or governments. I believe you are also misquoting them when you say AGL “was one of the first to sing the praises of the merit order effect”. As an example, earlier this year they said ” “our analysis and those from international studies (make it) clear that, while the merit order effect may well be real, any consumer benefits are at best transient and the overall effect on (social) welfare is adverse.

    “The notion that suppressing wholesale prices and adversely affecting the profitability of existing producers (of whom of course AGL is one) by subsidising a sub-economic technology through a premium FiT and distorting an otherwise properly functioning competitive market is somehow desirable policy is simply not correct.”

    Note, that not only wind and solar create a merit-order effect so to be consistent, one should be arguing for the return of recently mothballed coal fired plant because they will suppress spot prices. People need to understand that contract prices not spot prices are the significant driver of wholesale costs. Contract prices have not dropped significantly as spot had earlier done and spot price are now roughly twice as high as they were last financial year. Generally speaking, fossil fuelled plants offer wholesale contracts not renewable generators and their input costs after carbon have gone up significantly not down, so their contracting costs are not cheaper.

    Can someone please explain how a company can “pocket gains of the merit order impact”? and in particular how you would quantify this?

    I’d suggest AGL is simply pointing out that regulators setting a market price cap for retail customers may make the mistake of setting a sub-economic level. Look at Western Australia and California as an example… Alternatively, if AGL is making bigger profits then surely there is an opportunity for other retailers to hop in to the market with a more competitive offer.

    • http://energyinachangingclimate.info Martin Nicholson

      Well said Warwick. At least someone who reads this blog actually understands how electricity markets work.

      Any investor will tell you that you need to get a satisfactory return over the life of an investment or you shouldn’t invest. I suspect this is exactly what AGL are saying. If the wholesale prices in the NEM today are insufficient to cover the LRMC (the long term return from a new generator divided by the total energy sold discounted back to today) then you won’t build new generators be it wind, solar, gas or even nuclear.

      If demand in the NEM returns to previous levels and older generators are retired then we may well create a real risk of systemic failure in the NEM if no one is building new generators because they can’t get sufficient return.

      • Geoff

        Exactly right, Martin. Isn’t this what their paper a few weeks ago on the broken merchant model was talking about?

        http://www.aglblog.com.au/2012/07/new-working-paper-no-32-available/

        If the wholesale price is not high enough for a generator to recover their LRMC, then they can’t be expected to invest in the market. Dispatching at SRMC is fine for short periods, but it should be expected that for market stability (i.e. generators to remain operational) wholesale prices should be trending towards the industry LRMC.

        Frankly, I find this discussion on the “merit order effect” tiresome — after all, it only accounts for SRMC which is not the metric applicable for investment decisions. I’d love to see more renewables in the market, but if a wind generator is consistently bidding their output at their SRMC (~$0/MWh), they will never recover the costs of their investment (which could be around ~$95/MWh, but I’ve not got much idea on wind LRMC).

        So then, and I believe AGL might have said something like this in another paper of theirs, pricing at SRMC is transient at best. The generators would experience financial hardship and be forced to recover costs through bidding at higher than optimal prices and increasing volatility in the wholesale market.

        • Warwick

          Geoff,

          Good to hear another voice of reason. The so called “merit-order effect” is nothing more than observation of periods of low spot prices caused by high reserve levels and/or the bidding in of low SRMC plant (it’s so last fin year!). It does not mean that energy bills for consumers will be lower principally because it ignores the price of contracts. Unfortunately, many are perpetuating the myth that energy prices are lower whilst in fact they are higher than last year. Spot prices are no longer near zero either, they have roughly doubled this financial year. Any withdrawal of plant is simply any attempt by existing generators to optimise their economic return by increasing spot revenues and contract prices.

          The other great myth is that generators earn the majority of their revenue through just a few hours each year. The risk of prices like that compels retailers to contract rather than risk being wiped out in a single day such as has happened to some smaller retailers. It makes it sound dramatic by quoting $12,900/MWh that generators are profiteering but they pay much of it back in contracts. So it may be observed that spot prices are low for a period of time but generators will only sell contracts so low…i.e. unlikely to sell significantly below LRAC.

          Renewables such as wind and solar are good as they reduce emissions but claiming that some instances of low spot prices equate to lower electricity bills is not telling consumers the whole truth.

    • Michael

      Hi, Mr.Warwick,
      Could you shed me briefly more info on the situation in WA and California you mentioned in your comment. Thanks.

  • CZ

    Hi – Giles I think it somewhat misleading to only consider the low SRMC of wind and solar without acknowledging that both the wholesale price and the REC price is what is ultimately felt by customers.

    As I’m sure you aware, the actual per/MWh cost of most rebewables are higher that traditional fossil generators. This is because their spot price revenue needs to cover not just their SRMC costs, but also their capital costs.

    RECs provide the necessary secondary stream of revenue to fill this gap between the wholesale spot price and their actual costs. So, the lower the wholesale price, the REC price must increase accordingly.

    The end result of this merit order effect on customer bills is therefore ambiguous – the higher REC price will still be passed through to customers, so any reduction to wholesale costs through the merit order effect may very well be cancelled out through muich higher REC prices.

    AGL have writen about this “wedge effect” a number of times – might be worth acknowledging this in future commentary on the merit order effect.

  • glen

    As a householder AGL is selling me power at about $250 per megawatt hour, this price is rising. I make electricity (solar pv) at about $160 per megawatt hour, this price is falling. From my point of view buying power from a coal plant, 1000’s of kilometres away, is subsidising sub-economic technology.

  • steve the sparky

    AGL’s behaviour in South Australia is laughable…. Don’t forget Giles, they have effectively paid for a big chunk of customers here twice…. Firstly when they brought them from the state governments ETSA and then they had to buy back all the profitable SME’s again with the purchase of Powerdirect.

    AGL would be well and truly underwater in SA… the brought Torrens Island Power Station an aged gas fired clunker that is well past it’s used by date.

    An ex-AGL renewables engineer told me the company was shiting itself with it’s exposure to wind as it was experiencing huge cost blow outs in maintenance and going to offload the risk to other institutions.

    AGL have creamed retail customers for years…. especially all those poor sods that did not go on market contracts…

  • Robert Johnston

    Good luck being a retailer and taking on the incumbent one in a market where the incumbent (AGL) has a massive market share AND owns most of the generation…. you will be broke in under a month unless you have very good wholesale supply contracts (not easy with a very small market share).

    Anyone remember the ACCC looking at AGL’s use of rebidding of Torrens Island PS at high demand periods and the spot price being at $10k/MWh for many many hours a couple of summers ago?

    The reality is AGL wanted no more generation in SA BEFORE ESCOSA decided to move away from the LRMC method – this is just a tool they are using to press the issue.

  • Ewan

    Aren’t we in a situation where energy use in the NEM is going down and we don’t need new investment in generation capacity anyway?
    This is clearly a simplistic argument, but as coal generators become uneconomic and are closed down, supply drops and wholesale prices rise stimulating further (hopefully renewable) investment.
    Isn’t this how the market should work?

    • CZ

      Ewan

      Total energy demand use has decreased in the NEM over the previous 3-4 years, both in terms of total energy and peak demand growth.

      Although there is no consensus as to what is causing this, its likely that the relatively mild summers we have experienced over the previous few years have contributed. Also likely is the effect of the GFC, increased solar PV etc. IES has done some work on this (available on their website I believe), indicating that there are multiple possible drivers of this decrease).

      However, this doesn’t necessarily translate into a permanent decrease in demand. While there are many factors at play, I think its safe to say that a return to very high temperatures (and hence very high demand) we will see a return to the kinds of demand spikes we saw in SA in 2008. Coupled with a return to drought, this could see some of the water cooled baseloaders in the NEM constrained in terms of output.

      This potential outcome means that shutting down large volumes of coal fired capacity now, when levels of demand are low, may result in problems down the track.

      Given the very long lead times necessary to build new generation units, we could be left in a situation where we no longer have sufficient capacity to maintain the levels of reliabiltiy we have gotten used to.

      This could not only result in reliability shortfalls, but also increased scope for dominant generators to exerxcise market power and drive the wholesale prices back up.

      • CZ

        So yes, prices may increase – but whether this will translate into further investment is another question. Hopefully so – and hopefully renewables.

        • Ewan

          Interesting, and good points, many thanks CZ.
          It will be interesting to see what the peak and overall demands are in the NEM this summer (assuming we get a warmer drier summer again). I’ll see if I can dig out that IES report.