Slow is smooth and smooth is fast for the NEM transition

Reporting season is all but over for the energy majors in Australia and that has left us with a bevy of takeaways on the sentiment for the not-so-distant future. A key thread among reports has been the current low-price environment in the NEM. This is a topic that we have explored in previous weeks, however, the significant write-downs and revised guidance from the energy majors should start raising red flags – or at least serve as a cautionary tale of the speed of the transition underway.

There has been significant commentary that the current market prices are ‘unsustainable’ and may lead coal generators to close much earlier than anticipated as their financials are squeezed. It is no surprise why this is happening through. The significant growth in variable renewable energy (VRE), with marginal costs close to zero, are displacing higher priced offers from coal, gas and hydro in the market.

However, while the introduction of VRE into the supply mix has (and will continue to have) a suppressing effect on market prices, these effects dissipate as the market share of VRE output decreases and these displaced high-priced generators are required to meet demand.

This effect is most prevalent in South Australia where the proliferation of VRE is comparatively highest. When VRE contributes as much as 70% of local generation, the prevailing market price is on average lower than $20. However, as this percentage falls the market prices increase, reflecting the need for higher priced offers to be dispatched.To better illustrate this, the chart on the right visualises dispatch prices and generation mix over 2020 across different price bands. The bars show the number of dispatch intervals which fall within the price bands while the lines highlight the average contribution of VRE generation to the supply mix within the price band. Put simply, the chart shows the correlation of VRE output to market prices – the higher the percentage of VRE is, the lower market prices tend to be.

Evidently, the future of NEM pricing will be increasingly linked to the contributions of VRE and the other regions of the NEM will likely soon echo the trend seen in SA. However, the inherent variability and somewhat correlated output of VRE means that small changes in VRE output can have significant impacts on the market and by extension price.

It is important to remember that these trends are being suppressed by coal generation (which still contributes ~70% of energy), hence the significant number of dispatch intervals with prices around $30-60/MWh. Once coal exits then prices are likely to show more volatility as periods with lower VRE output will be settled closer to the SRMC of gas which is likely to land above $100/MWh (markedly higher if their running hours are significantly reduced).

Coal’s exit is certain. However, disorderly exits from coal before sufficient replacement is installed is likely to cause Hazelwood-like ripples in market outcomes. Therefore, to the greatest extent possible, we need ensure a smooth and measured transition. Otherwise, NEM prices are likely to fluctuate between two conditions – very low prices when VRE percentage of total generation is high and very high prices when that percentage is low.