In this month’s market update, we will focus on a developing issue closer to home and skip another update on the on-off US-China trade deal and the Brexit shambles. More specifically, we’ll discuss Rio’s strategic review of the Tiwai Point Aluminium Smelter. In our view the outcome of this review could have wide-ranging implications for NZ.
The outcome of this review is not only important for the 1,000 people employed by the Smelter in the deep south, but also the NZ electricity industry. The Smelter consumes a staggering 13% of NZ’s electricity production and so closure would have significant implications for this market. The supply-demand balance would tilt towards excess supply, which would likely see prices decline until the generators reduce production and/or demand increased to absorb the excess supply.
Rio has a track record for hard-nosed negotiations, using the threat of closure as leverage. In 2013 it secured significant reductions in the price it paid for electricity and a $30 million hand out from the then National Government. However, it seems that this time may be different. This is the first time Rio has opted to carry out a strategic review. In the past it only used this as a threat.
This suggests that there is a non-trivial probability of a significant change. Specifically, a change of ownership or closure. While Rio does not provide accurate financials for the Smelter it looks like it is at worst at cashflow breakeven. Add to that the significant cost of remediating the site, should they choose to close the Smelter, and closure does seem unlikely.
Notwithstanding this, the impact of the Smelter's closure is large enough to make it worth reviewing. If Rio were to close the Smelter at the end of its 12 month notice period there would not be sufficient transmission capacity to export all of this surplus electricity up to the North Island. Consequently, we would expect the impact would initially be concentrated in the South Island. More specifically, South Island electricity prices would tumble, and the large hydro generators would have to spill water. The two large South Island generators, Contact Energy and Meridian, would bear a disproportionate amount of the headwind. North Island spot electricity prices would likely also be lower, which would probably see some early closures of inefficient thermal (think gas and/or coal) plants.
It would take between three and eight years for Transpower to increase transmission capacity of the network and cost upwards of $600 million, and so the South Island generators are likely to have to spill water for at least a portion of that time. This seems almost indefensible in a world where global warming is becoming a key concern.
The other option is to find other uses of the electricity. At this early stage, one leading option is to bring forward the electrification of dairy processing plants. There is a strong argument that this is one of the key changes necessary for NZ to meet its Paris commitments. More specifically, to reduce our carbon emissions by 30% by 2030 on a 2005 baseline.
Again, this is not an overnight solution. It seems unlikely that an alternative use for all the electricity currently consumed by the Smelter could be developed in 12 months, which suggests that the electricity generators have strong incentives to negotiate a staged exit (i.e. a lower price is better than a zero price for the electricity in question).
On balance, our analysis indicates that the Smelter will not close. If Rio is indeed focused on only owning the world’s lowest-cost smelters another owner will be found that is more pragmatic. If Rio closes the Smelter, we would expect a period of lower electricity prices, which will be beneficial for all energy users at the expense of the gentailers. Longer-term the market equilibrium will be restored through a combination of a reduction in supply and demand growth.