Managing NEM volatility

What are the most urgent challenges facing the transition to clean energy? How are corporates planning for future uncertainties?

At the recent All Energy Australia Conference and Exhibition 2024, ERM Energetics’ Gilles Walgenwitz, General Manager, Energy and Carbon Markets was a guest speaker as part of a panel discussion run by Smartest Energy. The topic was “Can Australia solve the renewable energy puzzle?”. The discussion encompassed the issues around financing, building, and contracting renewable energy projects in Australia.

In this article Gilles shares his insights into the challenges, trends and outlook.

Challenges facing end users engaging in the NEM

The first challenge that we see in the National Electricity Market (NEM) is a typical time-to-market risk when considering securing a renewable electricity contract. There are two factors at play:

• ERM Energetics forecast a more than doubling in renewable energy demand from large commercial and industrial customers by 2030.
• In parallel, we are experiencing delays to final investment decisions of new renewable energy projects. Current supply of uncontracted volume is limited, especially from wind, and electricity retailers are short renewable electricity.

The first challenge is therefore about appreciating these market dynamics and defining an appropriate time to:

1. engage the market for Power Purchase Agreements (PPAs) under sufficient competitive tension to ensure adequate pricing is achieved,
2. engage sufficiently early to avoid the “2030 cliff” (when a number of currently active renewable PPAs will be ending) and implement a renewable electricity contracting structure that supports long term risk management in the volatile market conditions expected over the next few years.

The second challenge relates to the effectiveness of renewable PPAs as hedging instruments against the end-users’ load. Entering into a renewable PPA is not just about the provision of LGCs or Renewable Energy Guarantee of Origin certificates, and a notional linkage to a renewable energy asset. It is much more whether a PPA helps to mitigate the impact of market volatility in the long term.

The basis risk between the cash settlement of renewable PPAs and the electricity derivatives market against which retail contracts are priced, has been increasing:

• There is a material disconnect between the dispatch weighted average price of renewable electricity projects and the end-user’s load weighted average price - especially due to production-price covariance risk that is increasing with higher penetration of coincident solar or wind generation.
• We are also observing higher spot-to-futures forward premia, reflecting an increased market perception of market risks. These include the heightened potential for scarcity pricing in tight reserve margin capacity conditions, rising forced outage rates of ageing coal fired power stations, growing concerns about domestic natural gas supply, and the impact of wind droughts.

The challenge is therefore to design and secure a cost-effective hedging structure between the load and these renewable PPAs that aligns with the end-users’ risk tolerance and operational capabilities.

What strategies are we developing and implementing with our clients to tackle these risks?

Standard retail hedging structures of the past were about:

1. the price of baseload futures or forward contracts,
2. the expected load shape cost, and
3. an additional component to reflect the expected covariance between load and price.

Hedging with variable renewable energy introduces volumetric and shape risks as well as the production-price covariance risk of the hedge. This makes the management of residual dollar spot exposure and the valuation of the balancing power more complex.

Market factors include:

• Today, the load shape of the residual spot exposure matters much more in retail contracts. We have seen very high load shape factors applied to end-users with material behind-the-meter solar generation. It is only fair, but it comes as a surprise to some end-users. Pay special attention to load shape flexibility when negotiating your retail electricity supply agreements.
• When contracting with a solar hedge, continuing to purchase baseload futures/forward or a retail product indexed to such an instrument does not allow for leveraging the benefits of this solar hedge. It is worth considering the purchase of other products that better tackle the residual dollar spot exposure such as complementary shaped OTC products, the new ASX peak futures contracts, firming with standard cap contracts, or a hybrid PPA with the inclusion of a battery storage asset.
• ERM Energetics has negotiated for our clients a range of structured retail products that are underpinned by renewable energy assets or that sleeve a renewable PPA executed by the end-user. There is a spectrum of pricing models which allocate risks differently, especially those related to price, volume and shape. Corporate offtakers have different levels of risk appetite around spot exposure, project performance exposure, and pricing models, including price reset mechanisms, leading to tailored long term structured products.

Because of the extreme uncertainty around how the clean energy transition will unfold in the Australian power markets over the next decade, there is certainly interest in products that combine a mix of a long-term renewable PPAs acting as a hedge, complemented by the short-term book build of other complementary products whose prices follow the market.

What trends do you see in the medium to long-term?

In the medium to long term, we anticipate the following trends:

• There is a greater emphasis on the price of managing shape risk. What we see is the value of dispatchable capacity increasing. On the other hand the value of energy may decrease if the build out of renewable energy follows the trajectory needed to bridge the gaps left by the progressive closure of ageing coal-fired power stations. Also, as the value of firm capacity increases, dispatchable assets such as battery energy storage systems and curtailable loads (demand response resources) will increasingly become a source of revenue (wholesale demand response market, off-market emergency response services) as well as act as physical hedges to manage residual spot exposure - if valuable under the contract model adopted by the end-user
• We can expect renewable energy generators to offer fixed shape products to capture the value premium of taking volumetric and shape risks that they can manage at a portfolio level instead of selling pay-as-produced contracts-for-difference. This means that renewable energy generators, rather than selling generation-following, pay-as-produce output from their projects, will be selling products with a fixed volume. For the buyer, because volumetric and shape risks are now transferred to the generator, but price risk is not, the value of the product will be higher, and they will be willing to pay a higher price. For the generator taking these volumetric and shape risks, this means more residual spot exposure to manage. This will typically be done by applying a portfolio approach to product structuring, using wind, solar and storage assets, complemented if needed, by financial instruments (such as cap contracts) purchased over the counter or on the exchange
• We may evolve to even more ‘synthetic’ products to support retail hedging structures:
  • renewable flat swaps (rather than generation-following swaps)
  • shaped hybrid (solar + BESS) PPAs
  • virtual storage agreements increasing the standardisation of 2-hour to 4-hour storage products.
• Electricity retailers may apply new and more granular time-of-use periods, especially with the introduction of new peak products by the Australian Stock Exchange, and offer more dynamic pricing to their customers interested in partially managing their residual spot exposure through their own physical hedges. This, in turn, would facilitate the use of flexible demand and behind-the-meter dispatchable capacity, such as storage assets, to self-hedge.
• With more complex hedging structures and opportunity arbitrage in shallow and illiquid market for electricity derivatives, we can expect a growing number of intermediaries to enter the market. These intermediaries would adopt a portfolio approach to hedging, while also supporting improved liquidity and price discovery.

You can capture opportunities in the energy markets

ERM Energetics can derisk your engagement with the energy markets. Our team has advised some of Australia’s largest corporates to develop tailored strategies to support long term risk management in the power and renewable energy certificate markets. For investors, we leverage our knowledge of market dynamics and our quantitative risk analytics to advise on targeting and derisking investments.

We are the commercial risk advisors and transaction manager to Tomago Aluminium, NSW’s largest electricity user, and have supported corporate renewable PPAs that total more than 25% of the volume contracted in the NEM between 2020 and 2023.

Please reach out if you have any questions or would like advice.