“It’s a disgrace:” Snowy Hydro to use government subsidy for market dominance

The manner of the federal Coalition government’s decision to provide $600 million of taxpayer funds to Snowy Hydro’s proposed gas generator at Kurri Kurri is a disgrace.

The 660MW Kurri Kurri open gas project, assuming it will go ahead, will reinforce Snowy’s dominant position in the long duration firming market, and it will give it dominance of the NSW, Victoria and South Australia markets.

But it also flies in the face of developments in battery storage. Snowy Hydro is the only major “gentailer” not doing batteries, and its strategy seems to be based around the assumption that battery storage is not happening.

Some further observations from this analysis:

+ An open cycle gas turbines such as Kurri Kurri will earn its cost of capital if the output is contracted in a traditional way as a “cap” at the current NSW price around $11/MWh. However, we don’t think traditional caps are how things will be done going forward. We do think that Snowy does its homework and knows what’s it talking about.

+ The way in which this investment has been forced into the market is a disgrace. No up-to-date study has been produced to suggest it’s needed. Even if one accepted the very dubious conclusions of the Commonwealth/NSW taskforce, as opposed to the more authoritative work from AEMO, the fact is the NSW policy and investment landscape has changed materially since the task force reported, in a way that increases reliability without needing this capacity to be built.

+ In our opinion Snowy will, post Snowy 2.0 and Kurri Kurri, and post EnergyAustralia’s investment in Tallawarra B, have about 63% of the capacity of the traditional peaking (gas and hydro) market in the combined NSW, Victorian and South Australian market. We expect the ACCC to look into this and cannot understand why the ACCC’s hasn’t already commented.

* Post Snowy 2 and Kurri Kuri
Figure 1 Source: AEMO, ITK

 

Despite all the advantages of market power that Snowy has, we nevertheless wonder if it will earn its cost of capital because we expect batteries to capture at least half and probably more of all the firming market.

We expect batteries to capture the majority of average daily firming demand (typically less than four hours) and expect that, for batteries, this firming service will only be one of the services they offer. Batteries are the enabling technology of the 21^st century grid that Australia’s world leading power engineers are about to build.

The grid of the 21^st century will be the inverter and battery run grid(s) control system. It will be the modern power electronics’ engineering triump. The role of non battery firming is still being sorted out. There will be a role, but how big?

The rough guess is about 10% of demand can’t be firmed by batteries or demand response. But in saying that if aluminium smelters started thinking of the opportunities that demand response offers, instead of complaining about the problems, much more might be possible.

Organisations such as the Hunter Alliance and the NSW Govt are contemplating diagrams such as the one presented by Simon Holmes A Court at the Smart Energy Conference. No-one underestimates the challenges. But it’s a long way ahead of what the three stooges, Angus (Taylor), Keith (Pitt) and Michael (McCormack), running Federal policy have offered.

Figure 2 Hunter Industrial renewable precinct. Source: Simon Holmes A Court

As far as Snowy itself goes we think it has put itself in a bad position. Whatever the truth of the matter, the perception now is that it’s now just a tool of the Federal Government.

As such it is tarred with the poor opinion the vast majority of the industry has in regard to Federal Policy. In my opinion the CEO does a poor job of communicating to stakeholders and frankly appears to take the public, politicians and analysts for fools, and this only feeds the increasingly negative perception.

We’d argue a more open discussion such as the strategy days run by AGL and ORG would at least let stakeholders understand the company’s point of view and strategy.

If Snowy were to be a listed company, as it so nearly was:

a) Investors would question its balance sheet.

b) They would question its ability to run significant capital expenditure projects at multiple sites simultaneously.

c) There would be incredible doubt about the return on capital of Snowy 2.0. ITK supports Snowy 2.0 on the basis that we do need longer term renewable firming and the benefits outweigh the impact on the National Park. However, at the moment I am not aware of a single person I’ve spoken to outside management that thinks it will earn its cost of capital. Of course, management may be right and everyone else wrong.

d) Investors would question the wisdom of having as chair a person who, when he was CEO of Santos, saw that company’s share price go  from $17 when he started to $4 when he left in 2015, and who caused  two LNG trains to be built when there was only enough gas for one.

e) Finally, undertaking a heavy capital expenditure program at a time operating profits are going to the toilet would be bad for the share price. Board members Knox and Karen Moses (ex Origin) will understand that well.

EnergyAustralia’s brownfields expansion and Snowy’s 660 MW Kurri Kurri plant mean that Andrew Forrest’s Squadron Energy will almost certainly not proceed with their combined cycle proposal at Pt Kembla. In turn and more speculatively, ITK thinks this makes the whole Squadron Energy Pt Kembla LNG import terminal less likely.

Despite lots of talk, and very strong commitment signals from Squadron management, there is very little pubic announcement of customers signed up to the terminal. One might theorise that the gas plant could have provided a foundation load. We suspect that customers have been told by Santos that they can get a sharper price from the proposed Narrabri gas field once that gets the final go ahead.

About Snowy

Snowy’s Annual Report for the year to June 2020 contains the following extracts, with ratios as calculated by ITK. This information although still barely enough (eg retail revenue is not disclosed) is a big improvement on years prior to FY19 where the only management clues were the disclosure of the non statutory impact of derivative accounting, a vexed area for utilities.

Figure 3 Source: Company annual report

Snowy’s results have been quite volatile over time depending on electricity market and to an extent weather conditions. As reported, the retail business at say10X Ebitda per customer is worth about $1.2 bn. This business is the 4^th largest mass market retailer by customer numbers in the NEM.

Note that in 2019 Snowy changed a number of accounting policies. Most significantly they changed the policy regarding when revenue and expenses of LGCs were recognized. The policy change lifted the ebitda reported in FY18 by $82 million (about 10%). I

It’s likely applying the policy would also have changed reported ebitda in years prior to FY18 but there is no way to know. As such in the graph below ebitda for FY15, FY16 and FY17 would be different and in all likelihood higher, making today’s results still worse in comparison.

Figure 4 Snowy ebitda, Source: Company, ITKe

Given that Snowy sells volatility protection, and not energy, it’s extremely likely that profits will fall further for so long as energy prices are depressed. The leverage may be less than that faced by AGL or EnergyAustralia but it’s still there. If you were in a mood to hand out strategy compliments, which in Snowy’s case we are not, you would say the Lumo retail acquisition has helped stabilize profits. That’s the standard retailer/generator operating model.

Regarding generation, Snowy is primarily a provider of firming or peaking services. As such the pool revenue is in the first instance largely irrelevant. Nevertheless, the FY20 numbers were:

Figure 5 Source: NEM Review and company

Note that in FY20  generation results were down over FY19 and will certainly be well down again in FY21.  Also the NSW Gas results are those for the 660 MW Colongra gas station, a very similar open cycle gas turbine asset to the proposed Kurri Kurri plant. Colongra pool revenue in FY20 was $50 million but that was due to high prices caused by the NSW bushfires.

In the previous two financials years Colongra received pool revenue of $2.5m and $3.2m respectively. But that doesn’t mean it was an unprofitable asset in those years.

Peaking generators traditionally provide insurance

The traditional value of a high variable, low capital cost open cycle gas generator is to provide insurance services. The owner of the asset traditionally sold “caps” to retailers.

The vanilla product, traded on the ASX exchange, is the $300 cap. The owner of the gas generator essentially promises that for the insured quantity of MWs the retailer won’t have to pay more than $300/MWh during the period insured.

If the price of electricity goes above $300/MWh the seller of the cap uses its gas generator to generate sells the output to the pool thereby covering its risk. If the price is between the fuel cost and $300 so in the range of say $120-$300 the gas generator may run for its own benefit, that’s the “cream” on top of the cap revenue.

If the price never exceeds $300 and particulary if the price is below the fuel cost the gas generator may not run at all but still collects the cap = premium revenue.

NSW FY24 caps last traded at $10.86. So for a 660 MW asset, the annual cap revenue if 100% of output was sold as caps would be around $63 million, and if that was all there was to it, Kurri Kurri would look pretty good. The more it runs the worse the results would be because fuel and maintenance costs have to be subtracted from revenue.

Perhaps that’s an exaggerated statement, but that’s sort of how it works. In addition, the $600m cost shown in the table below may well turn out to be less than the actual capital cost when supporting gas infrastructure etc is also taken into account.

Figure 6 Source: ITK, ASX

 

In Australia, peaking gas generators particularly in NSW, require storage

One of the myths of gas generators is that they can provide an unlimited amount of dispatchable power. After all you just run gas through the pipeline and away you go.

In reality, the pipeline system is limited. Typically all the gas generators want to run at the same time, because the electricity price is high, and so the gas transmission system starts to empty out. For this reason most gas generators put in enough gas storage for some hours of operation at the plant.

As we saw recently in Texas the gas generation system is vulnerable to the fact that gas pipelines often use electric compressors. Still, we don’t need to go there, it’s enough to point out that gas supply to a NSW gas peaker is typically a bit limited.

The market is evolving and traditional caps have become yesterday’s story

As a result of several trends ITK believes the market is moving away from traditional caps. Specifically, we think the trend is towards selling “firmed energy”.

For instance, the NSW technology road map envisages supporting “fixed volume/fixed shape” structures. And indeed both Infigen/Iberadola and Snowy itself have talked about selling “firmed renewables”.  We think this trend plays into the hands of battery suppliers.

In the US batteries are subsidised, as they qualify for the Investment tax credit. Australia doesn’t have the policy smarts to do that. Still ,even ignoring the subsidy batteries are a great firming product at least in the daily market. The following chart show the averaged daily price and the quantity of mainland gas and hydro generation supplied on the average day over the past 12 months.

Again averages are not really where Snowy aim at but they are a target for batteries. Leaving aside that price leads demand in this chart it looks as if there is about a 3 hour evening peak price interval where the price goes from $60 to $120 and back again. You could charge in the middle of the day at $20.

The margin is not enough to justify a battery on its own but if you are doing a battery anyway it’s a great contribution to cost, may justify the extra duration and will take market share from gas and hydro.

A battery needs $100/hour margin if arbitrage is all it does

We assume:

• 20-year life. More specifically 7500 cycles. We think this is controversial, but our understanding is that warranties over 20-year life can be obtained, albeit surely with some maintenance capex.
• WACC 5%
• 4-hour battery cycled once per day
• MLF 95%
• Annual degradation of 1.9%
• $25 m of grid connection costs
• Efficiency 90%

We then use Excel solver to find the daily gross margin ($/MWh) to earn the specified WACC (weighted average cost of capital).

Figure 8 Source: ITK

To compete with existing gas and earn cost of capital the margin needs to be less than $100/MWh, which we project is achievable around 2026.

To compete with new gas the battery is arguably just about competitive now. Using a hydrogen price of A$2/kg, which we are still far from achieving, the SRMC (short run marginal cost) of a gas generator is in excess of $150/MWh for open cycle gas.

Batteries are going to reduce the cap price, or the firming reward

So this the crucial point, leaving carbon to one side, there is an increasingly wide spread view that batteries are going to be able to undercut open cycle gas generators in the up to 4 hours market.

Nextera’s May 2021 investor presentation states at slide 22:

“Increased capacity and technology improvements have resulted in energy storage cost declines and the ability to creaste low cost near firm wind and solar”.

The Nextera slide extract below assumes “ 4 hour battery at 25% of nameplate solar capacity; total battery system costs calculated as 2X BNEF battery pack cost”. Nextera’s is the world’s best utility as measured by long term shareholder value accretion and they know what they are talking about.

Figure 9 Source: Nextera

There are numerous studies of gas vs batteries as peaking suppliers. Most of the analysis is from parties talking their book:

For instance, here are the results of a study sponsored by leading battery producer Fluence:    https://blog.fluenceenergy.com/fluence-energy-storage-solar-storage-mid-merit-utility-scale-asset for the USA as far back as 2019 and here is a report prepared by the Clean Energy Council for Australia just a couple of months ago https://www.cleanenergycouncil.org.au/resources/resources-hub/battery-storage-the-new-clean-peaker.

Also talking its book, but from the point of view of the owner of an actual battery, and representing some of the most fact based analysis I’ve seen in Australia, is this article from Andrew Wilson (University of Queensland at the time).

https://wattclarity.com.au/articles/2020/10/batteries-vs-peaking-plants-a-case-study-from-13-october/

Additionally ITK has its very own numbers and views, and summarised are:

1. Batteries are going to proliferate in the NEM because they are vastly better at providing system services than any other technology. They operate at time scales 100s if not 1000s of times faster than gas peakers, can provide virtual inertia, fast frequency, voltage and currency. Batteries are quick to deploy, have small physical space requirements, no environmental issues etc, etc. The value that batteries provide as “peakers” is on top of their guaranteed role in running the grid.
2. Batteries are locked in. If you don’t believe me just look at what all the big players are doing. Snowy is the only major gentailer not doing batteries. It’s Snowy’s attitude to batteries that most demonstrates the backward looking nature of its corporate culture driven by a Board that with one exception is much more driven by gas than anything else.
3. Once a battery is installed it can undercut gas on variable cost anytime the electricity price is less than say $100/MWh.