More is better
The deregulation of the Australian electricity industry and its
partial privatisation saw many industry assets become acquisition
targets for both local and offshore companies.
Australia offered offshore electricity companies a unique opportunity to compete in a deregulated market before being forced to confront competition in their primary home markets. Arguably, operating in Australia would provide them with trading and risk management experience, a test-bed for the refinement of corporate trading rules, culture, risk tolerance and the like.
Other investors, and potential investors, saw their first investment in the Australian electricity industry as a means of gaining a foothold in the Asia-Pacific region. Australia was seen as a comfortable stepping-stone to more attractive, but sometimes volatile jurisdictions in Asia.
Conversely, blanket legal barriers on cross-ownership thwarted those looking to develop a portfolio of assets in Australia itself. The premium extracted by government vendors in the initial asset sales also acted as a disincentive to portfolio acquisition.
As new ownership opportunities have emerged ?
? From the secondary sale of assets by the original acquirers;
? From the extension of privatisation (or pseudo-privatisation) into new jurisdictions such as South Australia; and most importantly
? From green-fields development,
? there has been a noticeable shift in aspirations of the remaining investors to portfolio rather than single asset ownership.
The weakening of the restrictions on cross-ownership have made this goal more attainable. Instead of a blanket prohibition, cross-ownership is now examined on a case-by-case basis using a test of the effect on competition, applied largely as it would be in other industries.
Single versus portfolio benefits
The benefits of portfolio ownership (as opposed to a single asset) vary depending on the style of portfolio that is preferred. Regulator sensitivity is highest in the case of horizontal integration. Common ownership of a large slab of one stratum of the market such as generation or retail supply will always raise the spectre of undue market power. In fact, other than through the (illegal and untenable) exertion of market power, the benefits of scale offered by a horizontal portfolio are unlikely to be compelling.
The synergies are greater for vertically integrated portfolios, comprising complementary assets. The businesses of generation and retail supply involve offsetting exposures to wholesale electricity prices. Similarly, peaking capacity complements a base-load generation portfolio, enabling the leveraging of a base-load position. Renewable energy has a valuable role to play as a component of a portfolio, able to deliver good citizen benefits and image-building opportunities that may exceed their relative size.
A recent trend encouraged the separation of merchant (market-sensitive) businesses such as generation and retail supply from the regulated businesses of transmission and distribution. The concept was that investors were market-risk averse and could be attracted to pure ?pole-and-wires' businesses, resulting in a lower overall cost of capital.
In the last couple of months this trend has reversed. Losses from the merchant electricity activities of National Gas Corporation in New Zealand, have put AGL's separation plans on hold, as the company is reminded of the value of complementary revenue streams in a portfolio.
Interestingly, common ownership may not be a prerequisite for the attainment of the benefits of having a portfolio. Where two companies have perceived strengths in complementary areas of the electricity business, joint ventures or other creative ownership and control structures could be used to ensure that each is able to obtain the effect of a vertically integrated portfolio without the need to own or operate assets across multiple business areas. There is a challenge ahead in the formulation of these structures in a fashion that fairly rewards each contributor for their participation, though the incentives are sufficiently large to suggest that a satisfactory resolution to this problem will be found.
As the market continues to rationalise, the emergence of portfolios will continue. Those unable (or unwilling) to expand their holdings in Australian electricity will find it increasingly hard to compete in the absence of the synergies that their portfolio-owning competitors enjoy. Over time, they can be expected to offer their single assets up for sale, for purchase by the portfolio players.
Whilst the benefit of operating complementary assets as a portfolio is clear, the extent of that benefit is not universally understood. The following hypothetical case study illustrates how substantial the synergies could be.
Hypothetical case study:
How SupplierCo benefits from being part of a portfolio
SupplierCo is a retail supplier of electricity operating in the National Electricity Market (NEM) of Australia's Eastern states. SupplierCo buys power in the volatile wholesale pool market at the reigning spot price, and sells it through fixed price contracts of varying terms to end-use consumers. Because the spot price has a propensity to spike upwards dramatically with little warning (though generally only for very short periods), SupplierCo chooses to mitigate its exposure using a financial hedge. SupplierCo may purchase a series of call options exercisable in any period when the spot price exceeds some threshold (the ?strike price', say $300 per MWh).
The following diagram illustrates how the call option provides an effective hedge for SupplierCo:
SupplierCo pays an option premium to the Generator. In return, the Generator indemnifies the SupplierCo from losses arising from the Spot Price exceeding the Strike Price threshold.
Were the Spot Price to reach, for example, $4,900, the payment from the generator would be $4,900 minus $300, or $4,600 for each MW covered by the option. After accounting for the Spot Price legs of the transaction, SupplierCo would have an effective wholesale purchase price of $4,900 minus $4,600, namely $300.
The likely provider of the call option would be a peaking generator, who would in effect, exchange the opportunity to benefit from irregular and unpredictable price spikes, for certain, albeit modest, option premium revenue.
If SupplierCo's expected aggregate customer demand is 1000MW (1000MWh per hour) for the period that it wishes to cover with the hedge, then it would need to purchase call options for this capacity if it is to cover its risk in full with this instrument.
A complication arises for SupplierCo, from the variability of its customer load size. If it purchases call options for some 1000MW, it may still be partially unhedged if should its aggregate customer demand actually turn out to be 1050MW at the time of a spot price spike. Significantly, spot price spikes are more likely to coincide with greater than expected demand, so this is not an unlikely possibility.
Of course, were SupplierCo to purchase options to cover the full 1050MW of potential (rather than expected) capacity it is likely to be paying for extra, unused protection, if demand is consistent with expectation at 1000MW.
This is the critical dilemma faced by electricity retailers, those in the business of SupplierCo. And the stakes are high.
But there is a way of making the hedge go further. Buying 50MW from a peaking generator will hedge 50MW of customer demand (in SupplierCo's case, only 5%). Buying the generator itself may have a vastly different result!
Consider how the spot price is set through the reverse auction mechanism: Generator bids are stacked in order of price, from the lowest to the highest. Dispatch commences at the bottom of the stack and continues, with each generator dispatched in order of price until the prevailing aggregate system demand is satisfied. The spot price is designated as the price bid by the last (most expensive) block of power that is dispatched.
In the circumstances when the spot price spikes, it is usually due to the dispatch of (often small) blocks of peaking capacity bid strategically by their owners to maximise revenue. Even if they have exchanged upside potential through the sale of call options such as those described above, the owners of peaking plants retain an incentive to ensure that spikes do occur in order to protect the price of hedges covering future periods. They are motivated to prevent the occurrence of lengthy spike-less periods enabling the retail suppliers to become complacent and eschew hedges.
Conclusion
It is commonplace for a modest amount of demand to act ?as the straw that breaks the camel's back' resulting in the dispatch of only a small amount of expensive strategically bid peaking plant, to push the price into the stratosphere. Where a market might comfortably meet demand of 11,000MW from moderately priced capacity, an extra 50MW might require the dispatch of an entirely different plant type bid at near to the market cap. The market structure ensures that the entire 11,050MW is traded at the inflated price, not just the extra 50MW.
But, if the owner of the peaking plant that is to be dispatched to meet that extra 50MW of demand has a broader agenda, the outcome might be different.
What if it is SupplierCo that actually owns the peaking plant? If SupplierCo offers its peaking capacity of 50MW at a modest price of $100 per MWh, the full 11,050MW of capacity might well be available for no more than this price. In that case, SupplierCo can effectively cap the price at $100 for the entire 11,050MW.
The extraordinary result is that through the control of only 50MW of peaking plant, SupplierCo appears to have secured a hedge for its full customer demand. Provided that its 50MW of peaking capacity can be relied upon to ensure that other peaking capacity is not required, SupplierCo can rest assured that its purchase price for its entire (and uncertain) demand of around 1,000MW does not exceed $100 per MWh.
Importantly, the benefit flows equally to SupplierCo and its competitor retail suppliers. The others are also saved the impact of a price spike, receiving a ?free-rider' advantage without even having to own the peaking station. Their relative disadvantage is that relying on SupplierCo's bidding strategy to protect them from high prices may be leave them in a precarious position.
Another beneficiary of SupplierCo's strategic use of peaking capacity is the consumer who must gain indirectly from the depressing of wholesale prices.
However, the losers could be the base-load power stations that will miss the bonus revenue opportunities associated with spikes. It may be essential for the owners of base-load power stations that they develop peaking capacity in order to ensure that the value of their base-load investments is not squandered.
Australia offered offshore electricity companies a unique opportunity to compete in a deregulated market before being forced to confront competition in their primary home markets. Arguably, operating in Australia would provide them with trading and risk management experience, a test-bed for the refinement of corporate trading rules, culture, risk tolerance and the like.
Other investors, and potential investors, saw their first investment in the Australian electricity industry as a means of gaining a foothold in the Asia-Pacific region. Australia was seen as a comfortable stepping-stone to more attractive, but sometimes volatile jurisdictions in Asia.
Conversely, blanket legal barriers on cross-ownership thwarted those looking to develop a portfolio of assets in Australia itself. The premium extracted by government vendors in the initial asset sales also acted as a disincentive to portfolio acquisition.
As new ownership opportunities have emerged ?
? From the secondary sale of assets by the original acquirers;
? From the extension of privatisation (or pseudo-privatisation) into new jurisdictions such as South Australia; and most importantly
? From green-fields development,
? there has been a noticeable shift in aspirations of the remaining investors to portfolio rather than single asset ownership.
The weakening of the restrictions on cross-ownership have made this goal more attainable. Instead of a blanket prohibition, cross-ownership is now examined on a case-by-case basis using a test of the effect on competition, applied largely as it would be in other industries.
Single versus portfolio benefits
The benefits of portfolio ownership (as opposed to a single asset) vary depending on the style of portfolio that is preferred. Regulator sensitivity is highest in the case of horizontal integration. Common ownership of a large slab of one stratum of the market such as generation or retail supply will always raise the spectre of undue market power. In fact, other than through the (illegal and untenable) exertion of market power, the benefits of scale offered by a horizontal portfolio are unlikely to be compelling.
The synergies are greater for vertically integrated portfolios, comprising complementary assets. The businesses of generation and retail supply involve offsetting exposures to wholesale electricity prices. Similarly, peaking capacity complements a base-load generation portfolio, enabling the leveraging of a base-load position. Renewable energy has a valuable role to play as a component of a portfolio, able to deliver good citizen benefits and image-building opportunities that may exceed their relative size.
A recent trend encouraged the separation of merchant (market-sensitive) businesses such as generation and retail supply from the regulated businesses of transmission and distribution. The concept was that investors were market-risk averse and could be attracted to pure ?pole-and-wires' businesses, resulting in a lower overall cost of capital.
In the last couple of months this trend has reversed. Losses from the merchant electricity activities of National Gas Corporation in New Zealand, have put AGL's separation plans on hold, as the company is reminded of the value of complementary revenue streams in a portfolio.
Interestingly, common ownership may not be a prerequisite for the attainment of the benefits of having a portfolio. Where two companies have perceived strengths in complementary areas of the electricity business, joint ventures or other creative ownership and control structures could be used to ensure that each is able to obtain the effect of a vertically integrated portfolio without the need to own or operate assets across multiple business areas. There is a challenge ahead in the formulation of these structures in a fashion that fairly rewards each contributor for their participation, though the incentives are sufficiently large to suggest that a satisfactory resolution to this problem will be found.
As the market continues to rationalise, the emergence of portfolios will continue. Those unable (or unwilling) to expand their holdings in Australian electricity will find it increasingly hard to compete in the absence of the synergies that their portfolio-owning competitors enjoy. Over time, they can be expected to offer their single assets up for sale, for purchase by the portfolio players.
Whilst the benefit of operating complementary assets as a portfolio is clear, the extent of that benefit is not universally understood. The following hypothetical case study illustrates how substantial the synergies could be.
Hypothetical case study:
How SupplierCo benefits from being part of a portfolio
SupplierCo is a retail supplier of electricity operating in the National Electricity Market (NEM) of Australia's Eastern states. SupplierCo buys power in the volatile wholesale pool market at the reigning spot price, and sells it through fixed price contracts of varying terms to end-use consumers. Because the spot price has a propensity to spike upwards dramatically with little warning (though generally only for very short periods), SupplierCo chooses to mitigate its exposure using a financial hedge. SupplierCo may purchase a series of call options exercisable in any period when the spot price exceeds some threshold (the ?strike price', say $300 per MWh).
The following diagram illustrates how the call option provides an effective hedge for SupplierCo:
SupplierCo pays an option premium to the Generator. In return, the Generator indemnifies the SupplierCo from losses arising from the Spot Price exceeding the Strike Price threshold.
Were the Spot Price to reach, for example, $4,900, the payment from the generator would be $4,900 minus $300, or $4,600 for each MW covered by the option. After accounting for the Spot Price legs of the transaction, SupplierCo would have an effective wholesale purchase price of $4,900 minus $4,600, namely $300.
The likely provider of the call option would be a peaking generator, who would in effect, exchange the opportunity to benefit from irregular and unpredictable price spikes, for certain, albeit modest, option premium revenue.
If SupplierCo's expected aggregate customer demand is 1000MW (1000MWh per hour) for the period that it wishes to cover with the hedge, then it would need to purchase call options for this capacity if it is to cover its risk in full with this instrument.
A complication arises for SupplierCo, from the variability of its customer load size. If it purchases call options for some 1000MW, it may still be partially unhedged if should its aggregate customer demand actually turn out to be 1050MW at the time of a spot price spike. Significantly, spot price spikes are more likely to coincide with greater than expected demand, so this is not an unlikely possibility.
Of course, were SupplierCo to purchase options to cover the full 1050MW of potential (rather than expected) capacity it is likely to be paying for extra, unused protection, if demand is consistent with expectation at 1000MW.
This is the critical dilemma faced by electricity retailers, those in the business of SupplierCo. And the stakes are high.
But there is a way of making the hedge go further. Buying 50MW from a peaking generator will hedge 50MW of customer demand (in SupplierCo's case, only 5%). Buying the generator itself may have a vastly different result!
Consider how the spot price is set through the reverse auction mechanism: Generator bids are stacked in order of price, from the lowest to the highest. Dispatch commences at the bottom of the stack and continues, with each generator dispatched in order of price until the prevailing aggregate system demand is satisfied. The spot price is designated as the price bid by the last (most expensive) block of power that is dispatched.
In the circumstances when the spot price spikes, it is usually due to the dispatch of (often small) blocks of peaking capacity bid strategically by their owners to maximise revenue. Even if they have exchanged upside potential through the sale of call options such as those described above, the owners of peaking plants retain an incentive to ensure that spikes do occur in order to protect the price of hedges covering future periods. They are motivated to prevent the occurrence of lengthy spike-less periods enabling the retail suppliers to become complacent and eschew hedges.
Conclusion
It is commonplace for a modest amount of demand to act ?as the straw that breaks the camel's back' resulting in the dispatch of only a small amount of expensive strategically bid peaking plant, to push the price into the stratosphere. Where a market might comfortably meet demand of 11,000MW from moderately priced capacity, an extra 50MW might require the dispatch of an entirely different plant type bid at near to the market cap. The market structure ensures that the entire 11,050MW is traded at the inflated price, not just the extra 50MW.
But, if the owner of the peaking plant that is to be dispatched to meet that extra 50MW of demand has a broader agenda, the outcome might be different.
What if it is SupplierCo that actually owns the peaking plant? If SupplierCo offers its peaking capacity of 50MW at a modest price of $100 per MWh, the full 11,050MW of capacity might well be available for no more than this price. In that case, SupplierCo can effectively cap the price at $100 for the entire 11,050MW.
The extraordinary result is that through the control of only 50MW of peaking plant, SupplierCo appears to have secured a hedge for its full customer demand. Provided that its 50MW of peaking capacity can be relied upon to ensure that other peaking capacity is not required, SupplierCo can rest assured that its purchase price for its entire (and uncertain) demand of around 1,000MW does not exceed $100 per MWh.
Importantly, the benefit flows equally to SupplierCo and its competitor retail suppliers. The others are also saved the impact of a price spike, receiving a ?free-rider' advantage without even having to own the peaking station. Their relative disadvantage is that relying on SupplierCo's bidding strategy to protect them from high prices may be leave them in a precarious position.
Another beneficiary of SupplierCo's strategic use of peaking capacity is the consumer who must gain indirectly from the depressing of wholesale prices.
However, the losers could be the base-load power stations that will miss the bonus revenue opportunities associated with spikes. It may be essential for the owners of base-load power stations that they develop peaking capacity in order to ensure that the value of their base-load investments is not squandered.
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