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AGL Reaps, But Sows Change In Oz Power

Australia | Sep 28 2017

This story features AGL ENERGY LIMITED. For more info SHARE ANALYSIS: AGL

AGL is at the centre of a political storm, intending to close the coal-fired Liddell power station by 2022, while benefitting from the surge in electricity and gas prices.

-Maintaining Liddell coal-fired power station beyond 2022 considered costly and unlikely
-AGL's market power considered intact and, perhaps enhanced, despite government confrontation
-Retail electricity margins may come under further scrutiny, providing some potential negative for AGL

 

By Eva Brocklehurst

French company Engie closed Victoria's ageing Hazelwood brown coal-fired power station earlier this year, triggering a debate on electricity supply across the country amid surging prices at both the wholesale and retail levels.

The announcement of Hazelwood's definite closure, just six months before it occurred, opened up a hornet's nest in political circles, while power shortages last summer across the grid in Victoria/South Australia underscored a lack of government planning to ensure reliable electricity supply across the country.

Australia's coal-fired power stations, which generate the bulk of electricity, are old and in need of substantial maintenance to reliably provide power into the future.

Enter AGL ((AGL)), owner of the Liddell coal-fired power station in the Hunter Valley, which has been slated for closure in 2022. After Hazelwood's closure seared political nerves, AGL is now confronting a federal government which is calling for Liddell's operations to be extended beyond 2022, or for the plant to be sold to those who will. The company, at its recent AGM, highlighted the costs associated with making the power station reliable and the issues associated with selling the asset.

Liddell

The company has indicated that additional generation capacity can be obtained to offset the closure of the plant, including new renewable energy infrastructure that is already being built. As well, a 100MW upgrade to the adjacent Bayswater power station, a 250MW battery at Liddell and up to 750MW of potential new gas capacity (similar to the company's new 210MW gas-fired peaker under construction in South Australia) are to be brought on line from 2019.

Ord Minnett notes Liddell had improved since the company bought the asset in 2014 partly because it was downgraded by 15% to 1700MW. Now, as the plant gets to the end of its life, this has become an issue, as it is more likely to experience unanticipated outages.

AGL has stated that while it is not impossible to extend operations beyond 2022, the costs to ensure the plant is reliable are likely to be substantial, revealing a 2013 desktop study on extending Liddell’s life to 2032 which found it would cost an estimated $900m. Moreover, sale to another party would be complex and require that party to stump up considerable costs.

Liddell is linked to AGL's other NSW coal assets and physically to Bayswater. AGL is preparing a report for the federal government regarding the options for Liddell by October 12. Brokers suspect AGL is unlikely to suggest the plant continue to operate beyond 2022.

Gas Shortage

As Australia's electricity prices soar, the country is also facing a gas shortage, as the bulk of LNG production is directed towards exports and the federal government is forced to find a way to ensure domestic supply. Recently, the government announced an Australian Domestic Gas Security Mechanism (ADGSM), whereby exporters would be forced to divert gas for domestic consumption if a shortfall ensues.

Credit Suisse suggests the domestic gas & electricity industry is at a point of "peak risk" but, as there is limited change to the market structure, AGL's market power remains intact and arguably enhanced in the long run. The broker takes this opportunity to upgrade AGL to Outperform from Neutral.

Overall, the risk from gas export restrictions and electricity retail regulation in Victoria remain real and the broker does not dismiss the potential impact but, rather, suggests the downside risk is contained. Credit Suisse considers both measures will serve to suppress prices even if the mechanisms are not triggered.

Moreover, barring an incident in operations, the broker expects electricity market to avoid the blackouts of the previous summer because the market and the Australian Electricity Market Operator are better prepared.

Aside from the existing electricity market, Credit Suisse also notes the threat of oversupply in generation, as new wind/solar and storage projects are developed, has been reduced with the federal government's lower priority for carbon reduction targets. This has enhanced incumbents in the renewables industry, such as AGL.

Deutsche Bank believes potential re-regulation of retail electricity prices in Victoria and the tighter scrutiny of the gas market will have minimal implications for AGL's FY18 earnings. The 2018 wholesale electricity forward curves in Victoria and NSW have been flat since August and point to tightness in the market, particularly as the summer gets underway.

Deutsche Bank continues to believe FY18 will mark the first year that AGL delivers earnings growth above 25%, from the rise of over 100% in the Victorian wholesale electricity forward curve that occurred from mid-2016 to March 2017. This reflects AGL's lagged exposure to rising wholesale electricity prices.

The ACCC is on the verge of releasing its preliminary report into the electricity market. Macquarie acknowledges retail margins will come under further scrutiny and this carries some negative potential for AGL.

The broker believes the company's reiteration of guidance at its AGM confirms confidence in the outlook. Growth year-on-year reflects an absence of cash issues as well as the ongoing re-pricing of higher energy prices. This is mitigated slightly by retail margin pressure and normalised eco-market earnings.

At this stage, with the company expected to generate $6m of surplus cash, Macquarie considers it has ample flexibility to fund its expenditure on maintenance works and upgrades, and still support a 100% pay-out policy.

FNArena's database shows four Buy ratings and three Hold for AGL. The consensus target is $27.10, suggesting 16.0% upside to the last share price. The dividend yield on FY18 and FY19 forecasts is 5.0% and 5.7% respectively.
 

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