The “Let’s bully and force AGL to sell Liddell” legislation

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Morrison government’s big stick forced divestment legislation clearly an attempt to force AGL to sell Liddell and not close it. It is revenge, bullying and stand-over tactics.

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Lake Liddell with power stations
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The big-stick, forced divestment legislation as originally proposed is clearly an attempt by the federal government to force AGL to sell Liddell and not close it. It is revenge, bullying and stand-over tactics  by the government because AGL stood up for its right to manage its assets in the way it saw fit.

Words that Josh Frydenberg has spoken in support of the legislation will stand as a permanent mark on his career. This from someone who many see as a future leader of the Liberal party, and hence as a potential Prime Minister.

This is a man who supports the NEG for a year or two, to the extent of personally ringing journalists who write something bad about it, and then without a single word of explanation abandons the policy in favour of “let’s bash business and force prices down below their natural level.”

Governments of many persuasions in many economies have tried to control prices many, many times; as if economic laws, as powerful as any law of science, can be changed because they don’t suit the politics of the day. In the end supply and demand will win.

If you force down price, you encourage over-consumption, reduce substitution and block out new investment.

The fact that the media have reported that the Greens are contemplating voting in favour of legislation that would seek to prevent a coal-powered station from closing suggests a detachment from their core principals. It’s no wonder they are getting isolated. The Greens, it seems would rather be populist than green.

Legislation borne out of a bully boy culture

The worst thing about the legislation is that it’s borne out of a desire of the government to leg over AGL. Make no mistake about it, this legislation had a single purpose. AGL wants to close Liddell. Arguments and debate over AGL’s motivations for closing it can go on but in the end a coal fired power station in NSW is scheduled to close in 2022 and will be replaced by largely renewable energy.

Elements in the government don’t like that AGL has a right to manage its own business. But more, they don’t want another coal station closed, and so under the pretext of forcing prices down they tried to get legislation passed that would enable a minister to order done what the Law at the time did not permit. Let’s not get into the bullying culture that seems to have developed in government.

The proposed legislation is reprehensible on many grounds that should be self evident. But perhaps they need to be spelled out. It’s born of revenge and bullying, developed in haste and secrecy, is inconsistent with the underlying basis of society and will have negative consequences.

More specifically:

AGL and Origin and electricity gentailing is not an especially profitable business on average. See section below. Many companies in many industries do far better than AGL and Origin. Why pick on AGL? The government will say electricity is a core service but in reality it’s the pro-coal thing that is driving them.

The cyclical profits in the business are close to a peak in any case; All the coal stations in NSW are getting old and will need to be replaced by largely renewable energy. Two recent conferences I have attended have made that same point repeatedly.

The NSW government, including energy minister Don Harwin and opposition energy spokesman Adam Searle, made the same point yesterday. Unreported of course.

Speaking of which, it is astonishing the fetish mainstream media have with Malcolm Turnbull. Important comments about NSW Energy policy were made at yesterday’s  Smart Energy Conference by Harwin and his opposition counterpart, Searle, and yet none of the mainstream media, that is the SMH, the Australian, The Financial Review, the ABC carried a single word of those comments.

Mainstream media are almost as much to blame as anyone for the sorry state of energy political debate There is wilful ignorance and negligence to the underlying policy issues and an overwhelming focus on optics.

– The proposed legislation was borne out of spite and a grossly cynical appeal to populism;

– The legislation seeks to pick on one sector that the Government doesn’t like;

– The legislation was rushed and drafted in secret;

– The legislation sought to give dictatorial powers to the Minister of the day.

Contrary to another myth, regularly repeated without sufficient checking by the SMH, Australian and the AFR, there is plenty of new investment in electricity. More new investment dollars than at any time in the past 30 years.

At the utility level there’s around 8GW, which broadly is about $16 billion, perhaps the biggest wave of investment in 30-40 years in the industry.

This investment has been produced by high prices including the short term revenue boost from RECs.

It ignores another $6 billion plus from Snowy 2. It ignores the transmission investment that is coming. It also ignores about say $8 billion over five years of behind-the-meter, that is rooftop investment. High prices in front of the meter provide the incentive for that investment.

I hope the Greens, if they have any brains at all, can remember that.

Frydenberg’s comments

The AFR, which can at least do its quasi-Hansard function, reported Mr Frydenberg as saying:

“It’s industry specific, it’s targeted, it’s sunsetted and it’s based on a judicial order”

This is the point really. You can imagine that’s more or less how the Inquisition operated. Lets imagine those words in, say, a religious context. “Its religion specific, we are only going to apply the pain for a specific period of time, and we will get some religious authority to approve”.

And the inquisition might have gone on to say, “Of course, we aren’t punishing you for not doing our will, we aren’t standing over you threatening more if you don’t co-operate. You should know we are doing this so you can finally see the light. You haven’t broken any law but we want to remind you about the benefits of seeing things our way.”

Legislation like this is the thin edge of the wedge.

AGL has only moderately acceptable profitability and the market doesn’t think much of its growth prospects

What is the appropriate measure for profitability at a point in time?

Is it the “margin”?  No it’s not the margin. The margin is one input, but only one, into a proper profitability measure.

Is it the “Reported net profit,” i.e. bank x reports profit of $y billion, cue feeling of horror shock about greedy banks. But actually the absolute net profit is not an appropriate measure of profitability either.

The appropriate measure of net profit according to every economics textbook in common currency is Return on Capital. That is the profit relative to the funds invested to earn the profit. It really shouldn’t be necessary to point this out, but only yesterday at the Smart Energy Conference I heard complaints about retailer margins being high (at the moment), as if that was the end of the story.

It is true that properly measuring return on capital from reported accounts is not always that easy. Professional analysts spend a lot of time correcting for one-off adjustments to profits and adjusting invested capital for write downs. Also we are interested in the segment profitability and many large business have several segments each of which has its own profitability Nevertheless the objective is crystal clear.

The appropriate way to measure how a business has performed is to look at its return on capital. The appropriate way to decide whether to undertake a new investment is to see whether it is expected to earn its cost of capital.

And another obvious but amazingly, or conveniently, overlooked point by politicians and the mainstream media alike is that profitability is both cyclical and self correcting. The cure for high prices is high prices.

AGL’s reported return on equity (net profit after tax and minorities adjusted for one offs/book shareholder funds) is shown below. I prefer a measure NOPLAT/FFE but I’m satisfied that the numbers AGL presents are not materially distorted.

Figure 1 AGL return on equity. Source: company

A 13% return on equity is a good number, I guess, at the top of the cycle. But it is very, very far from setting any records. The likes of Amazon, Apple, Facebook or even NAB, CSL are hardly going to be moving into the electricity industry on the back of that return. I mean AGL’s is Australia’s largest carbon emitter.

Factset reports 102 companies out the ASX 200 index with a reported return on equity over 15%. Unfortunately this is an unadjusted number but I can be fairly confident that probably at least 20% of ASX 200 companies did better than AGL and for that matter Origin Energy in terms of profitability in FY18.

What about looking forward? For that we turn to earnings per share [EPS] growth

Figure 2 AGL consensus EPS. Source: Factset

It can be seen that the market does not expect any earnings growth in financial year 2019 or 2020 over the 2018 level. On average consensus estimates tend to be optimistic.

We’d add that in our view, assuming Liddell does close, AGL earnings are more likely to go down than up.

Remember there is a 10 per cent increase in energy supplied across the NEM compared to FY18. That’s on what is already under construction. More will surely be announced even without policy support. But policy support probably is coming one way or another. So flat EPS will be a good achievement.

That’s why the price earnings ratio for AGL is just about 12X for the next three years, well below the market average. That is investors don’t rate AGL’s prospects all that highly.

In short a broader view of the prospects for AGL and indeed all coal fired electricity generators in Australia, including those of the Queensland government is very mixed. In my mind risk heavily outweighs return prospects.

David Leitch

David Leitch is a regular contributor to RenewEconomy.com.au. He is principal at ITK, specialising in analysis of electricity, gas and decarbonisation drawn from 33 years experience in stockbroking research & analysis for UBS, JPMorgan and predecessor firms.

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