Another wild ride for LGC and STC markets as Covid takes the wheel

Categorising 2020 as an extraordinary year has become anything but extraordinary, yet in the market for large scale generation certificates (LGCs), despite all the noise brought by the COVID-19 crisis, there have been some very significant similarities with 2019.

The year 2019 was heralded as the last supply-demand choke point in a market whose demand peaks in 2020, with no restrictions on the entry of new projects being able to create LGCs thereafter.

While a healthy surplus was initially forecast for 2019, a combination of project delays, curtailments, interconnector and other issues conspired to see the projected surplus shrink across the year to the point that many were forecasting a deficit before shortfalls were taken into consideration.

What followed in the second half of the year was a wild ride in which the spot/Cal 19 market climbed from the low $40s to the low $50s in volatile conditions, before softening dramatically in the final months of the year to reach the high $30s.

The final days before compliance then brought even more volatility – in illiquid conditions – with last minute buyers and sellers causing the market to gap multiple dollars on each trade.

Fast forward a few weeks from compliance, the projected surplus for 2020 looked likely to be in the 7-8 million range before any shortfall would occur; a healthy figure for a market that would only grow in surplus in subsequent years.

Yet again, familiar issues have reared their heads to obfuscate. A combination of project delays and persistent curtailments across a range of locations combined with below average wind outcomes across winter to shrink projected LGC supply significantly, with the estimate of a pre-shortfall surplus of circa 2m LGCs outlined by forecasters Green Energy Markets.

With the spot and Cal 20 LGC markets sitting in the low $30s in May, the dawning realisation of the impacts on supply began to be felt across the middle of the year, with the spot market surpassing the $40 mark for the first time in June before briefly softening in July and then bouncing in August.

Though not quite at the levels of volatility seen in 2019, the market moved quickly in this period with the Cal 20 contract briefly reaching the $50 mark in mid-September, before commencing a rapid descent across the latter part of the month that saw liquidity dry up and the spot price close at $42.25.

It is still possible that the aforementioned supply issues will continue to reduce expected supply and could even result in further shrinkage of the projected surplus to the point that it becomes a deficit.

Beyond that though, the major question of participants’ shortfall strategies remains. Under the scheme rules, a liable party can opt to pay the $65 penalty price instead of surrendering LGCs and defer the obligation for up to three compliance years, when the LGCs can be purchased and acquitted with the $65 received back from the government. Such an approach is only appealing when the curve is in backwardation, i.e. future vintages are valued lower than the current one.

If participants decided today to pursue such a strategy, they could purchase Cal 23 LGCs at $13.25 and acquit them to make good on their Cal 20 shortfall, thus achieving a circa $30 saving once the certificates are ultimately surrendered and the penalty repaid. A very appealing return for those who can fund the cashflow burden over the next three years.

The days of the Clean Energy Regulator threatening to name and shame those that adopt this strategy are long gone, with the Regulator instead actively encouraging it on the basis that the overall target has been met with projects that are in the pipeline.

The short-falling behaviour of participants is important because it leaves additional LGCs that were otherwise expected to be surrendered available in the market and thus, as was the case in 2019, may ultimately determine whether the market is short or long.

There have been some interesting arguments made as to whether the COVID-19 crisis would make liable parties more or less likely to shortfall. One the one had there are those who believe that the cashflow burden of paying $65 upfront (or the aversion to taking on more debt to fund it) might dissuade some participants who would otherwise be attracted to such a strategy.

On the flip side, there are those who believe that some entities who have previously been reluctant to pursue such a strategy might this time around be more inclined to do so, with the return on such a strategy helping to improve profits in future years at a time when they are genuinely needed.

Yet COVID-19 will have another impact on LGC market fundamentals. Whilst there was some early concern about the potential disruption of project rollouts, this does not appear to have been a major factor in the end. More significant however will be the overall impact the health and economic crisis has had on electricity demand across the year.

The LGC target is listed in the legislation in a nominal figure (33.7m LGCs in 2020). In order to inform liable entities precisely how many LGCs they must purchase each year, a percentage is derived based upon a forecast of electricity demand for the coming year. Those forecasts are usually very accurate and hence the number of LGCs surrendered is usually close to the nominal target before any shortfall activity is considered.

In 2020 however, the impact of restrictions and lockdowns has seen actual electricity demand deviate from the forecast significantly, with the ultimate variation potentially as large as 5%. If this is the case then the crisis could leave an additional 1.7m LGCs unsurrendered, further impacting the surplus/deficit. While this outcome is less than what some of the bleaker outlooks were at the time, it is not insignificant.

Dire economic forecasts as well as a massive hit to consumer confidence from the onset of the pandemic appeared likely to impact the market for photovoltaic installations in early 2020, with STC prices reacting accordingly. Yet these concerns proved ultimately unfounded with solar installs rebounding dramatically and the STC price softening over time.

With the spot STC market sitting around the $38 mark in March and supply continuing to significantly exceed the weekly rate required by the target, it seemed Q1 would not contain any major surprises. Yet the emergence of the coronavirus pandemic and the panic that ensued changed all that.

With the entire country facing restrictions unseen before in modern times and millions of jobs being subsidised by the federal government to avoid mass unemployment, the initial anxiety surrounding a cliff-face reduction in PV sales in the early days of the pandemic was palpable. With apocalyptic scenarios playing out in the minds of many installers and the phones no longer ringing, STC selling seemed to dry up.

Indeed with the coincidence of this situation with the increase in demand in the lead up to Q1 compliance (28th April), the spot price climbed as high as $39.95 at one point, despite the presence of a sizable surplus of STCs.

While the spot price did ease late in the quarter, the market remained above $39.00 across the early part of Q2, with the spot reaching a high of $39.65 in early June with the persistent expectation that a sharp drop in sales (and hence STC supply) was just around the corner.

With the solar industry having previously been so busy, the existing pipeline of sales kept installers in work and STC submissions strong, while sales were tough to find. And then came the interesting part. Perhaps unsurprisingly, with an enormous proportion of the workforce now operating from home and millions of children doing the same, householders rationally sought to cover the increase in their daytime electricity consumption by getting solar. Far from a steep reduction, solar installations and hence STC submissions grew across the winter months, which is typically their quietest time.

As can be seen in the chart above, weekly submission figures remained considerably above the 706k figure that is required to meet the 2020 target and, in late June, the penny finally dropped. It turned out STC supply was not going to decline sharply, it was consistently strong. Those who had been holding out for the typical rise in prices in the last month of the quarter were disappointed, with the spot price softening into July.

Right across Q3 the spot had been stable in the low to mid $38s with large volumes going through to match the persistently strong STC supply numbers observed, despite installations being halted in metropolitan Melbourne for over 2 months. A brief spike in late September up to $39.00 was short lived, with the price returning promptly to its previous levels.

Looking forward, with the surplus of STCs continuing to grow by circa 200k per week, all eyes are on Q4. With its nominal weighting of 15% of the annual obligation, Q4 has the smallest surrender of the year. Yet Q4 is also the time when liable parties reconcile their actual electricity consumption with the forecast they used for the first 3 quarters.

And this year this is more significant than in other years because, as outlined previously, actual electricity demand will be materially lower than the forecast figure used to estimate the 2020 Small-scale Technology Percentage. What this means is that the surrender in Q4 rather than totalling 5.5m, may end up being more like 3.7m STCs, making the surplus of STCs even larger than previously expected.

Marco Stella is Senior Broker, Environmental Markets at TFS Green Australia. The TFS Green Australia team provides project and transactional environmental market brokerage and data services across all domestic and international renewable energy, energy efficiency and carbon markets.