Modernising Electricity Sectors: a Guide to Long-Run Investment Decisions ENERGY REPORT HERE’S the STATS the FACTS the KEY POINTS • Energy Carried by Wires 1
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Modernising Electricity Sectors A guide to long-run investment decisions Discussion Paper - June 2019 About Industry Super Australia Industry Super Australia (ISA) is a research and advocacy body for Industry SuperFunds. ISA manages collective projects on behalf of a number of industry superannuation funds with the objective of maximising the retirement savings of over five million industry super members. The views expressed in this discussion belong to the authors and do not necessarily reflect those of ISA. Please direct questions and comments to: Stephen Anthony Professor Alex Coram Chief Economist (Emeritus) 03 9657 4354 University of Western [email protected] Australia Twitter @SAnthonyMacro [email protected] ISA Pty Ltd ABN 72 158 563 270 Corporate Authorised Representative No. 426006 of Industry Fund Services Ltd ABN 54 007 016 195 AFSL 232514 ACKNOWLEDGEMENTS Thank you to Matt Saunders, Gary Lui, Sandhya Dhaliwal, Jo McNaughton, Debi Bruce and Herianto Lim, from ISA, for their assistance in producing this document. We are indebted to Greg Combet and Gary Weaven, the current and former chairs of the ISA board for their insights on the topic. The authors also benefited from discussions with other experts in the fields of energy policy, financial analysis, portfolio construction and economics. Thank you to Colin Sutherland, Tony Wood from the Grattan Institute, Professor Ross Garnaut from Melbourne University, Grant Mitchell from Port Jackson Partners, Daniel Cass from the Australia Institute, Elizabeth O’Leary from Macquarie Infrastructure and Real Assets, Lachlan Creswell from Macquarie Capital and Mary Delahunty and Peter Siapikoudis from HESTA and numerous anonymous referees who provided valuable insights. In addition, this paper could not have been produced without investment team support from AustralianSuper, CareSuper, Cbus, FIRST Super, HESTA, Hostplus, LUCRF Super, Media Super, NGS Super, REI Super, TWUSUPER, REST Super, Sunsuper, Mine Super, MyLife MySuper, EquipSuper, Australian Catholic Superannuation & Retirement Fund, Statewide Super, Maritime Super, BUSS(Q), Tasplan, VicSuper, UniSuper, IFM Investors and ISPT. 1 Modernising electricity sectors: a guide to long-run investment decisions ENERGY REPORT HERE’S THE STATS THE FACTS THE KEY POINTS • Energy carried by wires 1. Prosperity, safety & security is used for heating, 2. Underpinning economic cooling & lighting homes & competitiveness workplaces. 3. Driving productivity and jobs • 35% of energy used today. 4. Supporting growing • Replace 13 GW of Antique population coal-fired generation by mid-2030s. Source: AEMO, Dept. of Environment & Energy. SO WE’RE FACED WITH A TRILEMMA... HOW DO WE BALANCE THE GENERATION OF CHEAP ENERGY RELIABLE ENERGY LOW EMISSION ENERGY ST CO2 EMISSIONS STILL RISING, NEED ZERO EMISSIONS BY LATER IN 21C Achievable by reforming the electricity sector NEED BOLD PLAN & ACTIONS KEY FACTORS DRIVING PRICES POWER PRICES TRIPLED OVER 10-YEARS Whole markets Intermittency, 42% Network Infastructure, 35% Retail Market Dynamics, 23% 1 2 3 ON ENERGY MIX MUST PIVOT TO RENEWABLES & NEW FIRM CAPACITY Last Decade Today More intermittent supply = higher prices w/o offsetting changes in the grid INTERNATIONAL EVIDENCE INVESTORS’ PROBLEMS • Price spikes should drive investment • Not in absence of robust policy • So market ‘gamed’ by speculators • Risk to invest in firm capacity Source: EuroStat, BP Statistical Review of World Energy & AEMC NEED SIGNIFICANT NEW FIRM CAPACITY INDUSTRY SUPER CAN HELP Need 15GW of new firm capacity by 2037. Framing long-term vision Drive short-termer’s out market Assisting govt. with policy frameworks Making strategic investments in energy grids Investing in new technologies and start-ups Contents Executive summary 5 Overview 7 1. Australia’s electricity sector 19 1.1 Electricity 101 19 1.2 Electricity supply 19 1.3 Regulation 21 1.4 Electricity demand 22 1.5 How electricity drives Australia’s competitiveness 24 1.6 Projections – starting at the end 25 2. Australia’s emissions – history and future 27 2.1 Emission empirics 27 2.2 Recent history of emissions policy 28 2.3 Current emissions policy 29 2.4 State and territory policies and targets 30 2.5 Future emissions 30 2.6 Where to from here? 32 3. Energy and emissions – politics, economics and uncertainty 33 3.1 General uncertainty and ratcheting 33 3.2 Political uncertainty 34 3.3 Economics of uncertainty 36 3.4 Policy lessons for dealing with political and economic uncertainty 39 3.5 Policy lessons from the discount factor 40 3.6 Appendices 40 4. Energy and emissions – technological capacity, costs and uncertainty 41 4.1 Basic concepts 41 4.2 Difficulties in comparing technologies 43 4.3 Technologies not compared 44 4.4 Plant level cost comparisons using levelised costs 44 4.5 Cost comparisons including grid costs 46 4.6 Cost comparisons including value of emissions 47 4.7 Comparing capacities and costs for zero emissions: back-of-the-envelope calculations 48 4.8 Comparing capacities and costs: potential energy and battery storage 50 4.9 Carbon capture and storage 53 4.10 Grid design and distribution 54 4.11 Technology and electricity production in Australia: some lessons 55 5. Take-outs for investors 57 5.1 The adjustment tasks 57 5.2 Two broad approaches 58 5.3 Other considerations 64 2 Modernising electricity sectors: a guide to long-run investment decisions 6. Take-outs for policy makers 69 6.1 Policy approach 69 6.2 Policy suggestions 69 6.3 Summing up 75 7. Conclusions 77 7.1 Future states 77 7.2 Remarks on possible futures 79 7.3 Equity investments 80 Appendix A. Game theory and co-operation 81 A.1 The main questions 81 A.2 A simple model 81 A.3 Emissions reduction where payoffs depend on the number of contributors 82 A.4 Model of emissions reduction with political costs 83 A.5 Model for altruism and dynamics 84 A.6 Positive altruism with c > 0, r > 0 84 A.7 Conditional co-operation with c < 0, r < 0 85 Appendix B. Discounting 86 B.1 The discount problem 86 B.2 The discount rate as a function of expenditure on emissions 86 Appendix C. Optimal trajectories with hard constraints 88 C.1 Hard constraints 88 C.2 Details 88 C.3 Results 89 C.4 Penalties for weak technologies 90 C.5 Remark on discounting 90 Appendix D. Historical investment analysis 91 D.1 Return performance 91 D.2 Correlation matrix 95 D.3 Duration premia 96 D.4 Diversification 96 D.5 Concluding remarks 97 References 98 Figures Figure 1. Generation mix in the NEM in 2016-17 20 Figure 2. NEM electricity demand (TWh), 1999 – 2018 22 Figure 3. Average electricity spot price ($ per MWh) in the NEM 23 Figure 4. Change in average residential electricity prices, real $2016-17, excl. GST 24 Figure 5. Australia’s total greenhouse gas emissions (Mt C02 equivalent) 27 Figure 6. Australia’s total emissions (excl. LULUCF) per capita and per GDP 27 Figure 7. Emissions contribution by sector in Australia, Dec 2017 28 3 Modernising electricity sectors: a guide to long-run investment decisions Figure 8. Australia’s emissions – history and projections 32 Figure 9. Total systems costs of electricity 42 Figure 10. Lazard’s levelised cost of energy ($US/MWh) in 2018 45 Figure 11. The California ISO ‘duck curve’ 62 Figure 12. Possible growth trajectories under (a) high road (b) low road responses 63 Figure 13. The basic model 81 Figure 14. Pay off table for player one 82 Figure 15. Payoff that depends on the number of contributors 82 Figure 16. Example of a payoff function depending on contributors 83 Figure 17. Political costs 83 Figure 18. Dynamics of the system with positive altruism 85 Figure 19. Conditional co-operation 85 Figure 20. Example of a discount rate 87 Figure 21. Optimal controls for high terminal stock (a) and low terminal stock (b) 89 Figure 22. Annual returns of energy, utilities and others, 2002 – 2018, selected regions 92 Figure 23. Index of total returns: energy, utilities, and others, selected regions 93 Figure 24. Comparison of investment risk-returns across asset classes, 2002 – 2018 94 Figure 25. Portfolio impacts of utility investments, Australia, 2002 – 2018 97 Tables Table 1. Generation capacity (MW) in 2016-17, by state and technology 21 Table 2. Summary of state’s and territory’s renewable and emission targets, 2018 30 Table 3. Cost summary ($US per MWh) for advanced nuclear reactors 46 Table 4. Composite total grid-level costs ($US per MWh) 47 Table 5. Brookings’ net benefits ($US per MW) of different technologies 48 Table 6. Comparison of technologies: back-of-the-envelope calculations 53 Table 7. Matrix of electricity assets and ownership, 2019 64 Table 8. Industry super fund holdings of energy assets, selected funds, 2018 66 Table 9. Investment returns volatility, 2002 – 2018 94 Table 10. Correlation matrix for energy and utility equities, 2002 – 2018 95 Table 11. Comparison of duration impacts across asset classes, 2002 – 2018 96 4 Modernising electricity sectors: a guide to long-run investment decisions Executive summary Societies around the world are facing high levels of uncertainty about energy and emissions and this creates unprecedented problems for investors. The aim of our discussion paper is to help industry superannuation funds build the capacity to understand and deal with uncertainty in the context modernising the electricity sector. It is an attempt to provide a general overview of the issues and clear principled guidance on investment and policy. It is not intended to be another set of middle-of-the-road investment hints. In fact, one of the themes is that a good deal of mainstream thinking may be misleading. We aim to assist industry superannuation fund thinking about decision making under uncertainty and how to assess the alternative technological options and costs.