Australia’s largest electricity market, the east coast’s National Electricity Market (NEM), is undergoing a rapid shift from traditional fossil fuels to clean, renewable energy generation and storage. The Australian Government’s emissions target of 62% to 70% below 2005 levels by 2035 relies heavily on the decarbonisation of electricity generation, with the goal of 82% renewable electricity by 2030 significantly underpinning the country’s early emission reductions.

As the electricity system transitions from an aging and increasingly unreliable coal fleet to renewable generation and storage, volatility in the NEM is increasing significantly. The past few years have seen a large increase in price volatility – as the coal fleet is gradually replaced by renewable generation, times of high sun and wind result in low prices. However, when demand peaks or renewable resource is low, more expensive technologies such as gas are increasingly required to take coal’s place, elevating prices and driving volatility.

This transition to renewable energy and storage is creating opportunities for strategically positioned portfolios to capture added value from higher prices.

The need for a new way forward

Whilst predictions on the speed of the energy transition differ within the industry, the Australian Energy Market Operator’s (AEMO) ‘Step Change Scenario’ contemplates all coal being out of the system by 2038. This scenario has been identified by the operator as the most likely future scenario in its 2024 Integrated System Plan, where coal will be replaced by wind and solar for bulk energy generation, and batteries, pumped hydro and gas will be used for ‘firming’. Firming addresses the gaps in supply due to the variability of renewable energy production.

The retirement of the coal fleet also reduces the supply of essential hedging products traditionally available to the NEM’s market participants. Market participants, both customers such as energy retailers and generators, utilise hedging products to manage the risk that comes with their exposure to wholesale prices by contracting to lock in prices in the near, medium or long term.

Historically, the main provider of these hedging products were coal plants, able to run reliably throughout the day at low cost. The retirement of coal means other technologies must take the place in offering the hedging products required by the market. With increasing environmental targets, market participants are not only conscious of hedging their market exposure but also minimising their environmental impact.

The solution: Firmed renewable energy contracts

Investment in renewables in the NEM is underpinned by long-term renewable electricity offtakes in the form of power purchase agreements (PPAs). For a project to achieve financial close, power producers must generally secure a long-term offtake with a customer in the NEM (such as retailers, large industrial users, corporations and governments), which fixes a level of revenue for the project and provides the price certainty required for debt financing and long-term equity investors.

As volatility in the market increases, energy customers are becoming more conscious about protecting themselves from exposure to high prices, and at the same time are aiming to increase the procurement of renewable energy to meet sustainability targets and net zero goals.

Ultimately, customers want a product which provides renewable energy at all times of the day.

To effectively manage these requirements means going beyond the traditional single asset renewable PPAs that have dominated the offtake market to date. Enter ‘firmed’ green off-take products. These innovative solutions cater to the specific demand of energy customers by offering more than just renewable energy; they provide a guarantee of firm supply and price certainty.

This dual benefit effectively mitigates the risks associated with price volatility, provides for appropriate risk-adjusted returns, whilst ensuring customers’ sustainability goals are met.

Firmed PPAs are made possible through a mix of renewable generation and storage assets (batteries, pumped hydro), which when combined can substantially underpin the supply of firmed, clean energy that energy consumers are seeking.

A Portfolio Approach

It’s no longer an effective strategy to invest in single renewable assets.

A portfolio approach to development and contracting is emerging as the key enabler of firmed renewable offtakes. The diversity of a portfolio comes through both technological and geographical diversification - wind and solar have typically complementary generation profile, and when coupled with storage of the appropriate size, can provide a physical position to support bespoke customer demand profiles.

The geographical spread of wind and solar resources across different regions within the NEM offers another layer of diversification for investors and allows contracting with customers throughout the NEM. By investing in geographically diverse projects, portfolios can hedge against regional imbalances and weather events, further mitigating risk and smoothing returns compared to a single asset.

The Investment Opportunity

Balancing the level of contracted and merchant revenues across a portfolio can further increase returns, with the merchant or uncontracted portion of the portfolio assets – in particular storage – able to take advantage of the volatility and provide additional upside.

A diversified portfolio of renewable generation and storage is a compelling investment opportunity for investors seeking to capitalise on the concerns over growing volatility and the drive for net zero. By diversifying portfolios across technologies and locations, power producers and their investors can provide an increasingly in-demand product, generate attractive risk-adjusted returns and contribute to Australia's clean energy future.

Learn more about Octopus Investments Australia

For more information on Octopus Investments Australia and their funds and strategies visit their website.