New Zealand Professional Investment Services Firm

Forsyth Barr

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New Zealand Professional Investment Services Firm, Forsyth Barr

Equity Bottom-Up

<h2>Electricity Sector<br>Smoking Gun Missing, But Risks Remain</h2>
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<p>Surprisingly, the Electricity Authority's (EA) main concern from its wholesale electricity market review appears to be the discounted NZAS contract price, with other aspects&nbsp;of the review inconclusive. However, whilst the suggested&nbsp;solutions to prevent a repeat discounted price are less concerning than&nbsp;we thought may be suggested;&nbsp;the door is open to greater structural change, in particular limiting&nbsp;generator size. The political response to the&nbsp;EA's&nbsp;report reinforces our&nbsp;view that regulatory/political risks remain elevated, with Meridian Energy (MEL) most at risk from any structural changes. We retain our negative stance on the sector, with regulatory/political risk and rising interest rates the main&nbsp;headwinds.</p>
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<h3>Short-term concerns alleviated, but longer-term political and regulatory risks remain</h3>
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<p>The EA's report has alleviated short-term concerns that it was going to advocate significant structural change to the sector. Instead, its issues paper lists eight possible options to solve, in our view, a non-issue. If implemented none of the options will have a material impact on sector value, in our view. That said, the EA is canvassing opinions on more significant structural change such as, 1) limiting the size of generators, 2) splitting Manapouri from MEL's generation assets, or 3) virtual asset swaps. The EA has not analysed these structural options in any detail but notes input is likely required from other branches of government. The political response to the EA's reports also highlights political/regulatory risks are heightened, with Minister Woods indicating she has asked officials to investigate options proposed, but not recommended, as part of the Electricity Price Review.</p>
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<h3>The surprising key issue is the discounted NZAS contract price</h3>
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<p>Given the wholesale electricity market review was supposed to be about the performance of the wholesale electricity market, we are surprised a one-off contract has become the main focus of the report. The EA argues that the discounted NZAS contract price is potentially below the opportunity cost for electricity and that NZAS increases electricity costs for the rest of the country. Suddenly removing -13% of demand in any industry will lower prices for other market participants — so the latter statement is hardly news. The EA's main issue appears to be that NZAS should not be supplied if it does not get sufficient value from the electricity sold and if there are higher value uses (which is ironic given where aluminium prices have subsequently moved to). We struggle with the EA's analysis for many reasons, including 1) it appears to ignore the fact Manapouri was built to supply NZAS, not the marginal producers of electricity, 2) it appears to believe there are other buyers of electricity chomping at the bit to access electricity. We're certain MEL would not have contracted with NZAS if that were true. In reality, the time frames involved (MEL only had six months to do a deal) precluded MEL going to market. There is an irony that one of the purposes of the discount price is to provide MEL time to find alternative, higher value uses for the electricity — in essence MEL is currently putting the 5TWh of lower South Island electricity generation out to tender, which is one the EA's proposed options. 3) it appears to downplay NZAS having significant market power as the consumer of 13% of NZ's electricity, and 4) it appears to ignore the unique set of circumstances that gave rise to the discount price, the fact that the contract is for a relatively short period of time and the fact that contracting for 13% of New Zealand's demand brings its own challenges.</p>
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<h3>Wholesale electricity market review into elevated prices post-2018&nbsp;Pohokura&nbsp;gas outage inconclusive</h3>
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<p>The EA is careful with its wording regarding the core wholesale electricity market review saying some of the wholesale electricity price increases since the 2018 gas outage may not be explained by underlying conditions. In our view there is barely a smoking gun in that statement. Of the 20 indicators the EA looked at it concluded four indicators showed there are competition issues, two showed no issues and the remaining 14 were inconclusive. Furthermore, the EA's qualitative assessment appears to err on a negative assessment. It is not clear to us what the EA intends to do next, which again is surprising given the performance of the wholesale electricity market was the main focus of the review. There does not appear to be any additional work planned at this stage, other than monitoring whether there is an improvement in conduct following the amended trading conduct rules.</p>
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Electricity Sector Smoking Gun Missing, But Risks Remain


Surprisingly, the Electricity Authority's (EA) main concern from its wholesale electricity market review appears to be the discounted NZAS contract price, with other aspects&nbsp;of the review inconclusive. However, whilst the suggested&nbsp;solutions to prevent a repeat discounted price are less concerning than&nbsp;we thought may be suggested;&nbsp;the door is open to greater structural change, in particular limiting&nbsp;generator size. The political response to the&nbsp;EA's&nbsp;report reinforces our&nbsp;view that regulatory/political risks remain elevated, with Meridian Energy (MEL) most at risk from any structural changes. We retain our negative stance on the sector, with regulatory/political risk and rising interest rates the main&nbsp;headwinds.


Short-term concerns alleviated, but longer-term political and regulatory risks remain


The EA's report has alleviated short-term concerns that it was going to advocate significant structural change to the sector. Instead, its issues paper lists eight possible options to solve, in our view, a non-issue. If implemented none of the options will have a material impact on sector value, in our view. That said, the EA is canvassing opinions on more significant structural change such as, 1) limiting the size of generators, 2) splitting Manapouri from MEL's generation assets, or 3) virtual asset swaps. The EA has not analysed these structural options in any detail but notes input is likely required from other branches of government. The political response to the EA's reports also highlights political/regulatory risks are heightened, with Minister Woods indicating she has asked officials to investigate options proposed, but not recommended, as part of the Electricity Price Review.


The surprising key issue is the discounted NZAS contract price


Given the wholesale electricity market review was supposed to be about the performance of the wholesale electricity market, we are surprised a one-off contract has become the main focus of the report. The EA argues that the discounted NZAS contract price is potentially below the opportunity cost for electricity and that NZAS increases electricity costs for the rest of the country. Suddenly removing -13% of demand in any industry will lower prices for other market participants — so the latter statement is hardly news. The EA's main issue appears to be that NZAS should not be supplied if it does not get sufficient value from the electricity sold and if there are higher value uses (which is ironic given where aluminium prices have subsequently moved to). We struggle with the EA's analysis for many reasons, including 1) it appears to ignore the fact Manapouri was built to supply NZAS, not the marginal producers of electricity, 2) it appears to believe there are other buyers of electricity chomping at the bit to access electricity. We're certain MEL would not have contracted with NZAS if that were true. In reality, the time frames involved (MEL only had six months to do a deal) precluded MEL going to market. There is an irony that one of the purposes of the discount price is to provide MEL time to find alternative, higher value uses for the electricity — in essence MEL is currently putting the 5TWh of lower South Island electricity generation out to tender, which is one the EA's proposed options. 3) it appears to downplay NZAS having significant market power as the consumer of 13% of NZ's electricity, and 4) it appears to ignore the unique set of circumstances that gave rise to the discount price, the fact that the contract is for a relatively short period of time and the fact that contracting for 13% of New Zealand's demand brings its own challenges.


Wholesale electricity market review into elevated prices post-2018&nbsp;Pohokura&nbsp;gas outage inconclusive


The EA is careful with its wording regarding the core wholesale electricity market review saying some of the wholesale electricity price increases since the 2018 gas outage may not be explained by underlying conditions. In our view there is barely a smoking gun in that statement. Of the 20 indicators the EA looked at it concluded four indicators showed there are competition issues, two showed no issues and the remaining 14 were inconclusive. Furthermore, the EA's qualitative assessment appears to err on a negative assessment. It is not clear to us what the EA intends to do next, which again is surprising given the performance of the wholesale electricity market was the main focus of the review. There does not appear to be any additional work planned at this stage, other than monitoring whether there is an improvement in conduct following the amended trading conduct rules.


Electricity Sector: Smoking Gun Missing, But Risks Remain