Energy prices Part 2: Why is this happening?

In the second instalment of our three-part Blog series on energy cost increases, Tennant Reed investigates the causes of recent price hikes in both electricity and gas.

Businesses and households across eastern and southern Australia are starting to see a new wave of energy cost increases. These will be painful for many, and a serious blow to the competitiveness of some trade-exposed industries. Many want to know: what’s happening? Why is it happening? And what can we do about it?

Here, in the second of our series of three Blog posts, we address part two of the equation: Why is this happening?

The causes

  • Electricity prices have been driven up by several generation closures, increased demand from the Liquefied Natural Gas (LNG) industry, the rising price of gas and the increased role of gas generators to replace coal and back renewables.
  • Gas prices have been driven up by the LNG export industry, which has increased demand, brought on more expensive supply, and linked an isolated market to international influences. Restrictions on gas production will seriously impact the ability to ease the current tight market.

The rises of electricity and gas prices are connected, since gas is an increasingly important fuel for electricity generation.

Wholesale electricity prices have risen for several reasons. Prices have been deeply depressed for several years (particularly when the impact of the former carbon tax is stripped out) due to major excess supply. Demand declined in absolute terms and fell vastly short of projections. Investors and governments had assumed for many years that demand would grow indefinitely, and had over-invested in generation capacity; the Federal Renewable Energy Target (RET) added modestly to this excess.

The balance in the National Electricity Market (NEM) has been shifting on both the supply and demand sides. The takeoff of the Queensland LNG industry has created a substantial new source of electricity demand to underpin the extraction, transport and chilling of gas. And multiple generators have either mothballed capacity, such as part of Pelican Point in SA, or closed it permanently, such as Northern in SA and soon Hazelwood in Victoria.

These closures in turn have many causes: oversupply and weak prices now and into the future; ageing plants with substantial costs for maintenance, refurbishing, or remediation; declining fuel reserves (in the case of Northern); and an electricity market increasingly shaped by renewables’ intermittent abundance and zero short-run costs, where flexibility is valuable and inflexible coal generators struggle to participate.

Gas-fired generators already play an important part in the NEM, with ‘baseload’ gas plants especially important in SA and Queensland, and ‘peaking’ gas plants helping balance the market everywhere. Gas-fired plants are often the marginal generators which set the prices for the whole market. The substantial increase in their fuel costs means they must bid higher prices in the electricity market. And gas-fired generators’ role is growing further as they replace some of the retired coal capacity, and play backup to renewables.

What is the relative contribution of these causes? Most attention has focused on the role of Hazelwood, which is a substantial identifiable change to the market. However, Hazelwood played no role in the 2015-16 spot price increases, where the plant was bidding as usual; most of the increase in futures prices came well ahead of the confirmation of Hazelwood’s closure; and futures prices in NSW and Queensland have followed very similar paths to Victoria, despite the more limited significance of Hazelwood to their regions. It is likely that the Hazelwood closure is a significant contributor, but one of several.

Retail prices and futures contracts also reflect the risks of guaranteeing supply, particularly in South Australia where generation is so variable and the connection to other grids so vulnerable. While wholesale spot prices are often low or negative there, due to the high share of wind and solar with zero short run marginal costs and an additional source of revenue through the Renewable Energy Target, extreme prices can result at other times of low supply and high demand.

Gas prices have been driven up by the takeoff of the LNG export industry in Queensland. But that influence has been felt in several ways. Eastern Australia used to have a modest domestic gas market underpinned by substantial reserves of easy-to-produce conventional gas with no customer except the domestic market. This supported globally low prices. Very large reserves of “unconventional” coal seam gas were then identified in Queensland that were moderately more expensive to produce. These were developed to underpin three large export terminals that, combined and at full capacity, will demand twice as much gas as the rest of the eastern domestic market put together.

Initially it was expected that the availability of the export channel would mean that gas producers would expect as good a price from domestic customers as from export, leading local gas prices to rise to the higher East Asian price level. But in East Asia gas is priced against oil, and two years ago oil prices collapsed – and with them the spot LNG prices that were meant to shape Australian prices.

While the long-term contracts that underpin the LNG export terminals are confidential and complex, and do not fully or rapidly reflect spot prices, the enterprises appear to be worth much less than investors hoped.

Whether they are worth what was spent on them or not, the terminals are there and have contracts that are still worth fulfilling. That has required an enormous increase in gas production. That in turn has raised prices in two ways: first, more expensive fields have had to be developed, lifting production costs and the floor under future prices. Secondly, Queensland production does not seem to have increased as fast as producers hoped, leading exporters to buy additional gas in the domestic market. Some of that was sold by gas-fired electricity generators with low-cost long term contracts, who are now more exposed to the vagaries of local spot prices.

With supply barely keeping up with demand, local prices have soared even as Japanese spot LNG prices hit record lows (though it is not Queensland gas that is being sold on spot in Japan).

The other variable in gas is the clampdown on gas production from state governments in response to community fears about hydraulic fracturing (“fracking”) and coal seam gas. Multiple independent inquiries have found that the only substantiated risks from these techniques, essentially around management of produced water and total water extraction levels, can be managed with good engineering and firm regulation. Communities remain unimpressed and partial or complete bans have been introduced in NSW (which is now signaling case-by-case flexibility), Victoria (where the ban currently extends to conventional onshore drilling as well), and the NT (where the ban on fracking will last at least until an inquiry is complete).

The SA Opposition recently announced it would support a ban on fracking across much of the state, though the Government is offering new incentives for gas exploration and development. Queensland is consulting currently on a round of responsible reforms to lower the cost of gas development while increasing community confidence in the regulation of gas.

These State regulations have probably had a limited effect on gas price and supply to date; small identified economic resources, the timeline for development, and retrenchment in an oil and gas sector with global and local financial woes mean that little gas may have flowed from NSW and Victoria even without bans. But over the longer term a failure to develop further gas reserves will be very serious.  Conventional reserves are dwindling; expansion or even maintenance of gas supplies will require unconventional gas.

With local prices soaring due to overinvestment in gas exports and weak prospects for increased local production to resolve this, bizarre options become worth considering. AGL recently announced a major feasibility study for an LNG import terminal on the east coast, which could secure gas supplies from overseas to keep homes warm, industry humming and the lights on in what is purportedly a gas-rich energy superpower. These are strange days.

Watch this space on Monday for the third and final post in this Energy Prices Blog series: What can we do about it?

What has been your recent experience with energy costs in your business? Have you had to make significant adjustments to budget for increased costs moving forward? Please share your thoughts and experiences by leaving a comment below.

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Tennant is Principal National Adviser – Public Policy at Ai Group. He has worked heavily on climate and energy issues, advising Ai Group’s Leaders’ Group on Energy and Climate Policy and developing reports on natural gas supply, energy prices and energy efficiency. He also works on a range of issues related to manufacturing and innovation. Previously he was an adviser in the Department of Prime Minister and Cabinet, working on fiscal policy, stimulus and infrastructure.

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