Death of an (energy) salesman

AGL has been an important company in Australia’s energy market. It was a pioneer of large scale renewables development and is still the largest renewables investor in Australia. It is the biggest generator and seller of electricity. And it now appears to be in serious commercial trouble.

As the biggest coal generator, AGL is also the biggest single greenhouse emitter in Australia. It’s acquisition of Loy Yang A brown coal power station in Victoria in 2012 and Macquarie Generation in NSW in 2014 were seen as commercial bargains at the time. These massive generators have delivered billions of dollars in revenue to AGL and have already paid for themselves. They also continue to play a critical role in electricity reliability. The renewables transformation has been moving at pace, but has not yet evolved sufficiently to operate without these large, dispatchable and polluting machines.

It’s an environmental, investment and operational conundrum. Someone needs to run Loy Yang A and Bayswater power stations for at least another decade as more renewable generation and complementary firming generation are put in place to replace them fully. Trouble is, these generators become less profitable as more clean generation is brought on line, while the continued high emissions mean their owner’s reputation will keep taking a beating.

It is a problem that keeps getting worse. Because AGL is long on generation, its share price is closely linked to the wholesale electricity price. Short term incidents aside, there is little confidence wholesale prices will recover because governments are now so invested in funding new generation to keep it down. That crimps a critical revenue stream for AGL.

Selling off the coal generators is possible and would mitigate reputational damage. But their value is diminished because of low returns and a small market of private capital buyers. They will only purchase at a significant price discount. The sale of these generators would then expose AGL’s remaining retail business to significant market risk.

Vertical integration – matching large retail businesses to large generation businesses – has been the most successful way of large retailers to manage this price risk and electricity market volatility. Selling or splitting the generators means AGL retail will need to buy a lot of electricity from the market and will be highly exposed to price risk if the prices do recover, say as a result of the rapid closure of older coal generators.

The effect of vertical integration was to keep the risks faced by the entire AGL business low enough to be able to borrow and invest. The plan to de-merge into two – a variation of selling off the coal generators – countermands this. Neither of the two split out AGL businesses – clean retailer AGL Australia and  dirty generator Accel – have demonstrated to investors how they can manage better alone than inside the safety of the larger entity.

AGL’s share price fell fell by around 6 per cent when the demerger was first announced, and by a further 10 per cent this week when new AGL CEO Graeme Hunt provided more details of the new commercial structures. Investors remain concerned not only about the loss of value this demerger seems to create, but also ongoing structural uncertainty about how AGL’s $2.8 billion of debt will be allocated, and which financial institutions will continue to underwrite it.

AGL’s shares have fallen from around $20 when it launched a buy-back of 32 million shares in what looks like commercial lunacy now. It is currently trading just above $8. As investor doubts about the demerger remain unresolved, things could get a lot worse yet.