I. Sector Landscape and Outlook

Companies within the utilities sector are primarily involved in providing electricity, gas, water, and sewage services to the community and businesses. Queensland, New South Wales, Vıctoria, South Australia, Tasmania, and the Australian Capital Territory have interconnected electricity and gas networks. Electricity in this interconnected region is sold through a wholesale spot market that is managed through the National Electricity Market (NEM). Australia’s Eastern and Southern states have one of the largest interconnected grids in the world, spanning over 4,500 kilometres.  The energy network in Australia handles more than 11 million electricity customer connections and five million gas connections.  

Renewable energy generation is growing rapidly in Australia – about 21% of electricity generation was from wind, solar, and hydro in 2019 as per the Australian Energy Statistics by the Department of Industry, Science, Energy and Resources. This was the highest since levels were recorded in the early 1970s. Australia met its 2020 Renewable Energy Target with Solar PV addition to reach over 3.5 GW in 2020. 

Electricity Generation:

With rapid industrialization and growth in population, energy productivity (represented by GDP dividend by energy consumption) has grown by 19% over the past ten years. The nation now creates $304 million in GDP for every petajoule of energy consumed, almost $50 million more than a decade ago. Australia continues to see expansion in mining activities and exports resulting in increased energy consumption. The Transportation sector remained the largest user of energy. An increase in the number of diesel vehicles and increased freight demand for light commercial vehicles resulted in higher consumption.

Generation from coal-firing plants has been declining and was slowly replaced by renewable energy sources. Renewable energy generation increased by 17% in 2018-19 over the last year and it accounted for about 21% of total electricity generation.  Wind generation make-up 34% of renewable energy, followed by hydro with 31% and solar contributing 29%. Large-scale solar PV installations gained momentum. Tasmania (for hydro) and South Australia (for solar and wind) accounted for sizeable renewable energy generation.

Figure 1. Renewable Energy Displacing Fossil Fuel Sources:

Data from the Department of Industry, Science, Energy and Resources, Chart Created by Kalkine Group

Australia added ~2.2GW of new large-scale renewable generation capacity to the grid in 2019 with 34 projects representing $4.3 billion in investments. About two-thirds of this addition came from large-scale solar projects, while wind generation had the best year ever with 837MW of new capacity installed in eight new wind farms. The Victorian government froze rebates under its Solar Homes Program in 2019. This halted the rooftop solar installations, but the program was reopened in July 2019 with a monthly limit on rebates. However, with the pent-up demand, rebates were exhausted in less than an hour after it was reopened. The energy storage segment also saw momentum with 22,000 small-scale batteries installed in 2019 taking the household storage capacity to reach above 1 GWh for the first time. Australian Capital Territory has delivered its ambitious target of generating 100% of its energy needs from renewable sources. It is setting-up zero net emission target by 2045. South Australia’s Home Battery Scheme to see 40,000 battery installations in four years. The scheme covers roughly one-third of installation costs through a subsidy of up to $6,000. Tasmania’s Battery of Nation project is on the cards to build pumped hydro infrastructure in Tasmania with a total outlay of $4.5 billion.

Figure 2. Roof-Top Solar Installations Gained Momentum:

Data from The International Renewable Energy Agency, Chart Created by Kalkine Group

Residential Electricity:

There were 52 retailers in Australia supplying electricity to 6.42 million residential customers in 2019-20. NSW had the most active market with 46 retailers supplying electricity. AGL Group and Origin Energy hold a significant market share of 37.0% and 27.3% respectively. All tier-1 retailers lost market share in 2019-20, while tier-2 retailers gained market share from 9.6% in 2018-19 to 11.2%.

Electricity prices in South Australia stood the highest, where wholesale and network costs are above the average NEM price. Prices touched historical high in 2018 and 2019 but started to ease from June 2019 following the introduction of price caps in Southeast Queensland, NSW, South Australia and Victoria. The government has introduced the cap on electricity prices offered by retailers through Default Market Offer on standing offer contracts. The gap narrowed between standing and market offers, but significant differences remain. A customer moving from the median standing offer to the cheapest market offer in June 2020 can reduce its annual electricity costs by ~20%-25%.

Figure 3. Introduction of Price Caps Narrowed the Pricing Difference:

Data from the Australian Energy Regulator, Chart Created by Kalkine Group

Electricity prices at the wholesale market started to show a decline as large volumes of renewable energy entered the market and fuel prices begun to fall. The Australian Energy Regulator (AER) has approved two electricity transmission projects in Queensland and South Australia to meet the increased volume of renewable energy. Wholesale prices at Victoria peaked at $126 per megawatt-hour early in 2019 due to high fuel costs and periods of high demand (weather dependent).

Update on Residential Gas:

Gas production surged in 2019 as Asian LNG demand over the 2020 Northern Hemisphere winter. Spot prices averaged $7-$8 per gigajoule (GJ) in the fourth quarter of 2019, as compared to $10 per GJ a year-ago due to weak LNG prices following demand contraction owing to the pandemic and falling international oil prices.

Gas consumption at Norther Territory posted robust growth in 2018-19 which had lifted the overall consumption by 2.0% to 41.123 Mcm. Gas use in LNG plants increased to equate with a higher output of LNG for exports. Gas prices were relatively lower in Victoria due to scale economies in the pipeline network. Queensland has low gas penetration and hence the highest cost. Standing offer prices continue to mount across distribution areas in 2018 and 2019, while market offer prices eased in 2020 in Queensland and Victoria.

Index Performance:

The ASX 200 Utilities Index generated returns of ~+46.49% in the last 10 years vis-à-vis ASX 200 Index returns of +42.65%. Rapid industrialization, increased population growth, and wide adaption of renewable energy spurred the sector growth.

Figure 4: ASX 200 Utilities Index outperformed ASX 200 Index by 3.84% over the last decade

Source: Refinitiv (Thomson Reuters) as on the close of 21 January 2021

Key Risks and Challenges:

The sector is dependent on grants and government support for growth, particularly in renewables such as Solar Homes Program in Victoria. The imbalances in the wholesale market with renewables displacing coal-firing plant inflates the prices at the retail market. Lower yields to gas producers as the wholesale gas market witnessed excessive supply over relatively flat demand. AEMO warned supply gas in Southern States from 2024 as Victorian gas production is expected to fall sharply in the coming years. IEA expects utility-scale solar PV additions to shrink due to delay in grid connection approvals, lower project output, and oversupplied market. The sector is highly regulated by the Australian Energy Regulator (AER) and the Australian Energy Market Commission (AEMC) with price movements being closely monitored by National Electricity Market (NEM).

Figure 5. Key Risks Affecting the Energy and Utilities Sector:

Sources: Chart Created by Kalkine Group

Outlook:

The Australian Energy Market Commission is expecting average residential electricity prices will fall by 8.7% in 2022-23, generating savings of ~$100 annually to households. For South Australia, the reduction is expected to be at $200. The government aims to bring down the electricity costs through monitoring and intervention. The industry is expecting an additional 1,000MW of electricity to be added following the closure of the Liddell coal plant in 2023. As per the recent news, New South Wales (NSW) attract private investment of $32 billion to move away from coal-fired plants. It is expecting to close four of its five such plants in the next 15 years. Through the plan, the government intends to bring 2GW of storage, such as pumped hydro by 2030. To make gas prices affordable, the Australian government will work with state governments through programs worth $250 million in accelerating three projects - the Marinus Link, Project Energy Connect, and VNI West interconnectors. The Queensland government has earmarked $500 million for the development of renewable energy projects in its 2020-21 budget.  

II.Investment theme and stocks under discussion (APA, AGL, CEN, IFT)

After understanding the sector, let us now look at four companies listed on the ASX. The price potential of the companies under discussion has been analysed based on the ‘Enterprise Value/ Sales’ method.

1. ASX: APA (APA Group)

 (Recommendation: Buy, Potential Upside: Low Double Digit, Mcap: A$11.22 Billion)

APA Group operates as a natural gas infrastructure company. It owns and operates gas transmission and distribution assets whose pipelines span every state and territory in the mainland Australia.

Valuation

Our illustrative valuation model suggest that stock has a potential upside of 24.52% on 21 January 2021. For the said purposes, we have taken peers such as Origin Energy Ltd. (ASX: ORG), Santos Ltd. (ASX: STO), Beach Energy Ltd. (ASX: BPT). The stock delivered annualized yield of 5.36%.

2. ASX: AGL (AGL Energy Limited)

(Recommendation: Buy, Potential Upside: Low Double Digit, Mcap: A$7.38 Billion)

AGL Energy sells and distributes gas and electricity. The company retails and wholesales energy and fuel products to customers throughout Australia.

Valuation

Our illustrative valuation model suggest that stock has a potential upside of 32.41% on 21 January 2021. For the said purposes, we have taken peers such as Genesis Energy Ltd. (ASX: GNE), Contact Energy Ltd. (ASX: CEN), AusNet Services Ltd. (ASX: AST). The stock delivered annualized yield of 8.26%.

3. ASX: CEN (Contact Energy Limited)

(Recommendation: Hold, Potential Upside: Low Double Digit, Mcap: A$5.70 Billion)

Contact Energy generates, trades in, and retails electricity, natural gas, broadband, and other products, and services in New Zealand. It generates electricity through hydro, geothermal and thermal sources.

Valuation

Our illustrative valuation model suggest that stock has a potential upside of 18.95% on 21 January 2021. For the said purposes, we have taken peers such as Genesis Energy Ltd. (ASX: GNE), Meridian Energy Ltd. (ASX: MEZ), Mercury NZ Ltd. (ASX: MCY). The stock delivered annualized yield of 4.36%.

4. ASX: IFT (Infratil Limited)

(Recommendation: Hold, Potential Upside: Low Double Digit, Mcap: A$4.92 Billion)

Infratil Limited is an infrastructure investment company with portfolio in airports, energy such as renewable and waste-energy, and public transportation.

Valuation

Note: All the recommendations and the calculations are based on the closing price of 21 January 2021. The financial information has been retrieved from the respective company’s website and Refinitiv (Thomson Reuters).

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