As this year’s power shortages and unsavoury national energy debate resolve into the federal government’s new National Energy Guarantee (NEG) scheme, we can now give a view on what energy retailer and generator AGL is worth. After a six month-long share price downtrend from a peak of $28.47 in April to a low of $22.60 this month, driven by concerns about political risk, the subsequent rerating to ~$25 at the time of writing correctly reflects less earnings uncertainty and the better outlook for large incumbents like AGL. We think AGL is worth $26.50 as a base case and $28+ if the NEG enables AGL to reinvest a larger proportion of earnings to grow faster at the same rate of return on equity (profitability). This means the share price decline this year has created an entry point where potentially a double-digit return, including dividends, can be earned.
There were concerns a Clean Energy Target (CET) or Renewable Energy Target (RET) would increase energy prices at the additional cost of less reliability. Instead the government opted for a policy that, rather than explicitly targeting a set proportion of energy production from renewals and offering incentives to that end, shifts the responsibility to retailers. The NEG comprises two guarantees: reliability and emissions. The reliability guarantee requires retailers to make available a proportion of electricity from “dispatchable” sources like coal, batteries, hydro or gas. The precise level will vary by state. The emissions guarantee, instead of extending the existing renewable energy certificates scheme from its expiry in 2020, requires retailers to reduce emissions by 26% on 2005 levels after 2020 but by 2030, the deadline for Australia’s Paris emissions reductions targets.
The difference between the CET/RET and the NEG is the government has concluded retailers are in the best position to forecast and acquire the supply necessary to meet consumer demand. It is therefore retailers which must determine the mix of energy sources to supply energy that is affordable, reliable and meets emissions targets.
The NEG policy is curious in light of the ACCC’s earlier preliminary report into the electricity markets, which suggested the markets are too concentrated. Our read is the government’s reliability and emissions policy will entrench that concentration and allow large incumbents like AGL to leverage it. The ACCC was concerned about vertical integration but the NEG’s rule changes increase demand for dispatchable power controlled by the majors (AGL, Origin Energy, Energy Australia and Snowy Hydro), which weakens the position of smaller retailers. The majors currently have the most dispatchable energy in coal-fired power, the strongest ability (access to funding, lower cost of funding, ability to invest, build and operate) to replace obsolete coal plants over time with new systems of distributed renewable (less emissions) generation and batteries, and the most gas capacity now to meet peaks in demand when the industry’s remaining coal-fired power is insufficient.
The initial policy announcement is only 12 pages long so there is little detail on implementation yet. The general implications for investors are however clear. Existing coal generation and the ability to develop a portfolio of dispatchable, lower emissions solutions over time just became more valuable with the launch of the NEG. Risk reduction for consumers and industry will transfer value from specialist retailers and renewable generators to more reliable power providers like AGL. This will mitigate any detraction from AGL’s margins in its own retail business from retail price declines over time or retail price regulation by Victoria.
Further, the burden on retailers to meet the emissions target after 2020 increases the buying power of the largest retailers because they will be able to get the best deals on internationally sourced carbon credits/offsets.
We note the government has stopped criticising AGL for planning to close its obsolete Liddell coal-fired power station in 2022. This could signal the government now thinks the plan AGL reiterated at its AGM last month can support the reliability and emissions guarantees in the NEG. AGL plans to replace Liddell with 8TWh of energy primarily from renewables and 1,000MW of firm capacity including up to 750MW from new gas peaking. We think AGL can deliver on this plan within its existing $800-1,500 million capital expenditure range provided at the FY17 results. There was also the good news of up to $60 million of extra earnings from an efficiency upgrade its Bayswater power station.