Will AGL have to choose between green and brown gold?

AGL Energy managing director Michael Fraser finds himself in an intriguing position as chairman of the Clean Energy Council, a role that should put make him pivotal to the push for the fastest possible deployment of renewables in Australia.

Fraser’s commitment to an aspirational goal for renewable energy has been virtually unquestioned for much of the past few years, as AGL Energy sought to position itself for the “clean energy future” with the lowest emissions profile of any major energy utility, and the biggest investment of any Australian company in renewable energy development. Fraser has been one of the strongest public advocates for both a carbon price and a strong renewable energy target, particularly among the ranks of the major listed companies on the Australian Stock Exchange.

The perception of Fraser as a clean energy warrior may have changed, however, with the announced purchase last month of the country’s largest brown coal generator, and single biggest emitter of greenhouse gases, the Loy Yang A power station and mine in Victoria. Many in the clean energy industry are wondering how Fraser can now argue both sides of the energy equation – more renewables, and more options for brown coal, such as exploiting the 1.3 billion tonnes of brown coal that will remain untouched by generation needs. At the very least, it has put some ambiguity into his position.

Analysts note that the purchase is a “clear divergence” from AGL Energy’s previous renewable energy strategy, but they do applaud it. For a start, the price is good – just $448 million in equity for the 67.5 per cent stake it does not already own. It values the facility, sold by the Victorian government for around $4.7 billion in 1997, at $3 billion, including debt. It allows it to better match generation with its retail operation, and therefore hedge its electricity costs. And, notwithstanding its high debt levels, Loy Yang A is a cash machine.

At first blush, the potential for ambiguity about AGL Energy’s position on public policy was in the carbon price. But Loy Yang A is hardly affected by the carbon price at all. It gets a $254 million up front payment, and another $1.05 billion in free permits over the next four years.

It is currently the cheapest of any of the coal-fired generators (it produces electricity at a short-run cost of $2/MWh) and, as the graph below shows, even at a carbon price of $38 a tonne/Co2e in 2021, it is predicted to remain one of the cheapest generators in the NEM. In fact, AGL Energy has said it will still be producing positive cash flow at a carbon price of more than $50/t. But it would, as Fraser himself noted, be even more profitable if the carbon price were repealed, as Tony Abbott has promised to do.

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The biggest threat to Loy Yang A, and other generators, appears to be falling wholesale electricity prices. We highlighted this briefly on Friday, where we pointed out that Loy Yang A, like other generators, is heavily in debt and highly exposed to falling revenues from lower demand and lower prices. Revenue was the key swing factor that took Loy Yang A from a profit in 2010 to a loss in 20111

AGL says the on-recourse debt situation at Loy Yang A, as it currently stands, is not sustainable, and should the ACCC approve its move to full ownership – that decision is due on May 24 – it plans to redress this situation by carrying less debt for Loy Yang A, and having what remains re-financed and brought on-balance sheet, so as to carry AGL’s own higher credit rating (partly by way of the recent issue of $650m of 2039 AGL Subordinated Notes).

Even so, Loy Yang A’s sensitivity to electricity costs was highlighted by leading energy analyst John Hirjee, of Deutsche Bank, who said in a report issued Friday that just a 3 per cent fall in wholesale electricity costs would render the transaction “earnings neutral.” Given that wholesale electricity prices fell 5.6 per cent in 2011 from 2010, according to Loy Yang A’s own accounts, this appears to give the transaction little margin for error.

There are several factors that could lead to a fall in electricity prices, notwithstanding the impact of the carbon price. One is lower demand. Already, the Australian energy industry has had to throw its prior demand growth assumptions out the window, because instead of growth, demand has peaked and fallen, and is now 10 per cent below where it was predicted just a few years ago.

The second factor leading to a fall in electricity prices is the incursion of renewables into the National Electricity Market, and its “merit order” impact on prices (because wind and solar has virtually zero short-run marginal cost, it displaces more expensive generation when it produces energy, and leads to an overall reduction in wholesale electricity prices).

Loy Yang A was among a group of brown coal generators that successfully lobbied the Victorian government to slow its renewables ambitions so that their earnings could be protected. Achieving a 20 per cent renewables target, plus the expected enthusiasm for solar, could make the impact of the merit order effect even more significant, and an even bigger threat to future earnings. This is certainly the case in Europe, where generators have complained loudly about the impact of solar on their returns.  They have successfully pushed, not just for reductions in incentives such as feed-in tariffs, but also for implementing absolute caps on solar installations, in an attempt to protect their position.

The third factor that could cause a price reduction is energy efficiency. The government has been slow to take up measures recommended by the Prime Minister’s task force, and utilities have been arguing against such measures because they adds costs – and, of course, reduce demand.

This is why the proposed contracts for closure are so important for the coal-fired generation industry. To many of the brown coal operators, their survival depends on this controversial proposal, because by removing 2000MW of capacity, there will be greater tension to the wholesale price.

So where does this leave Fraser? And how does he balance the interests of being head of the peak renewables lobby group, owner of the largest single emitter, and head of one of the three vertically integrated energy utilities that dominate the Australian industry? Will Fraser simply respond to the policy boundaries now in place, or will be push for more ambition?

Despite his strong advocacy for the renewables industry, circumstances dictated that his shareholders may have wanted to kipper his entrails had he not seized the unique opportunity of buying Loy Yang A from a distressed seller – the Fukushima nuclear reactor owner Tepco – and now those same shareholder obligations means he is duty-bound to protect that asset. The members of the CEC may want to do the same if he backs down on his renewables advocacy (and the controversy over AGL’s position on feed-in-tariffs has raised concerns).

AGL has said it will be able to use the considerable amount of cash being spun off from Loy Yang A to support its planned $5 billion investment in renewables in coming years, but the question for an industry which wants to progress from a political indulgence to a substantial $30 billion competitive industry, is does he still have the fight to push for ambitious targets – particularly in the current context, where defending even the status quo seems challenging enough.

Fraser has largely dodged the media since the purchase, so the question about whether the purchase of Loy Yang A has caused him to change his stripes, or simply just to hedge his bets, has not been put to him.

The opportunity to do so may not come until the Clean Energy Council’s Clean Energy Week in Sydney in July, where Fraser is due to speak with the newly appointed CEO David Green about the importance of the RET. What better opportunity to reassure his clean energy constituents, perhaps with a remark along these lines: “By golly, I love brown coal. But I like solar and wind even better.”

AGL sells Hallett 5 wind farm

Meanwhile, AGL Energy says it has sold the 52.5MW Hallett 5 Wind Farm in South Australia to Japanese renewable energy investor Eurus Energy. AGL Energy says it will recoup its $129 million development costs from the transaction and realise a development fee of $30 million. The development and sale continue a familiar model used by AGL Energy for other projects.

The wind farm, which came into production in March this year, will deliver electricity to AGL Energy at an effective off-take price of $93/MWh until mid 2014, and at $110/MWh from then on. AGL Energy will continue to operate and maintain the facility, while Eurus and AGL Energy will share the risk of generation volume within a certain “collar.” The facility has a stated capacity of around 36 per cent.