Smelter deal: a lot to like, but Meridian is taking a gamble

Saturday, 8 June 2024

Southlanders say they are relieved to learn the Tiwai aluminium smelter near Invercargill will stay open for another 20 years.

ANALYSIS: Many Southlanders are understandably jubilant that the Tiwai Point aluminium smelter looks set to remain open for another 20 years after striking new power-supply agreements with three of the country’s four largest generators.

But how should other Kiwis feel about it?

And what would the smelter’s reprieve mean for Meridian Energy’s Great Southern Hydrogen Project, which envisages electricity from its nearby Manapouri hydro scheme being used to produce green hydrogen fuel from water?

The agreements announced between the smelter’s soon-to-be-sole owner Rio Tinto and power companies are all but done deals.

The Electricity Authority (EA) in 2022 granted itself the right to veto any very large, new power supply contracts that electricity users struck with generators, doing so with the smelters’ power agreements specifically in mind.

The EA has already cleared Mercury’s new contract with the smelter and, while it has yet to sign-off the new agreements it has signed with Meridian and Contact, it seems implausible it will throw any spanners into the works.

The regulator’s concern has been that it could be in the interests of the generators to sell power to the smelter at an artificially low price, if that avoided flooding the market with excess generation, and that could push up prices for other customers.

In 2022, it estimated that consumers’ average household power bills could be up to $200 a year cheaper on average if a short-term deal hadn’t been done that saw the smelter able to buy power at the knock-down price of 3.5 cents per kilowatt-hour.

Broker Forsyth Barr believes the new power-supply agreements will see the smelter pay Meridian and Contact the more respectable price of 6c to 7c per kWh for electricity, and Mercury between 8.5c/kWh and 10c/kWh, from next month.

None of the generators have disclosed the actual prices to investors through their NZX disclosures.

But Meridian chief financial officer Mike Roan says analysts’ forecasts “tend to be reasonably accurate”, so probably take it as read Forsyth Barr is on the money.

The smelter delivered a $103m underlying profit to its owners last year, according to accounts newly published by holding company Pacific Aluminium.

If the EA had any concerns, it would most likely be with the smelter’s contract with Meridian, which is set to continue to supply the lion’s share of the smelter’s power.

Roan says the price the smelter pays Meridian will go up with inflation each year from the start of 2028, but only if the price of aluminium has risen in the previous year.

Over recent times, it hasn’t been at all uncommon for the price of aluminium to decline from one year to the next, despite trending marginally higher in nominal terms over the period as a whole.

Between 2012 and 2023, for example, the price of aluminium rose in only five years and fell in six, despite edging up from US$2023 (NZ$3265) to US$2300 from start to finish.

There are a lot of years between 2028 and 2044 and if history were to repeat during that period, Meridian could find itself receiving a much reduced price for its electricity in real terms as the contract progressed.

It may be worth bearing in mind, though, that there is little reason to think power firms’ own generating costs will rise at the rate of inflation over the period, given that the price of new generation from wind and solar is forecast to decline in real terms.

Kevin Hart, chief executive of the Wind Energy Association, says that based on Australian research, he expects the price of wind generation to fall by about a third by 2050.

Roan is unwilling to speculate how many years Meridian could realistically expect to forgo any inflation-adjustment in its pricing, but thinks it’s unlikely the price it receives from the smelter “could drop materially in real terms over the contract term”.

“While the future’s far from certain, the best insight we have into future aluminium prices is the London Metal Exchange. This shows increasing nominal aluminium prices over the next three years,” he says.

“Global demand for ‘green aluminium’ gives us further confidence that this will happen – and hold.”

The positive trade-off for the risk Meridian is taking is the durability of the contract it has negotiated, he says.

“If you look at the reaction from the market and shareholders, I think unquestionably people think that the transaction is a good transaction for us to have written.”

Perhaps all that can be said for sure is that while Meridian appears to be taking a big bet on aluminium prices not being as volatile in the future as they have been in the recent past, it appears to be doing so with its eyes wide open.

None of that looks likely to trouble the Electricity Authority, anyway.

Its rules make clear it will approve large contracts if the customer — the smelter in this case — has the right to on-sell the power it buys.

That’s because even low-ball pricing shouldn’t in theory distort the wider market, if the power can be on-sold.

The fact the aluminium smelter could in theory close down and sell the power it has bought to other customers means the Electricity Authority should clear its contracts.

Meridian’s agreement with the smelter does allow the smelter to on-sell any “unused megawatts”, so looks to be in the clear regardless of whether the EA thinks Meridian has negotiated a good price or not.

There is no question also that the “durability” Roan refers to has value, not just to Meridian but also to the wider power sector and consumers.

The huge cloud the smelter has cast over the power market up to now is simply the repeated threat of its imminent closure.

That has dissuaded power firms from making timely investments in new generation, in case it closed and they were left with a big supply overhang.

Although Rio Tinto has negotiated an exit clause in the power agreements that would let the smelter terminate the power agreements at the end of 2034, it would then need to pay a hefty $180 million penalty to Meridian.

That suggests its intention to keep the smelter open until at least 2044 is entirely genuine.

Gary Holden, chief executive of Lodestone Energy, lauds the positive impact the smelter’s survival should have on renewable generation.

Lodestone appears on track to build about half of the grid-connected solar power plants that the electricity system can easily absorb and that could soon be contributing about 8% of the country’s electricity supply.

Holden says the new-found certainty over the smelter should assist its plan to raise an additional $150m for eight more solar farms.

“The stability is tremendous. It helps to have that big variable taken off the table.”

Mercury Energy has made clear it was no coincidence that a week after its smelter contract was announced it gave the green light to a $486m expansion of its Kaiwera Downs wind farm near Gore.

Mercury’s wind farm at Kaiwera Downs near Gore will become the country’s second- largest, assuming all the smelter’s power deals are approved.

That will make Kaiwera Downs New Zealand’s second-largest wind farm, after its recently-commissioned Turitea farm in the Tararuas, capable of producing about 1.5% of the country’s power.

The investment is contingent on the EA clearing Meridian and Contact’s smelter contracts.

The icing on the cake for the power sector and consumers, is that while the smelter has long played a “balancing role” in the power market by cutting back on production to free up electricity when it is in short supply, it is now set to step up that contribution.

According to Forsyth Barr, the smelter has agreed to cut its production by about a third up to four times if needed before 2044, to free-up just over a terawatt-hour (1TWh) of power in times of tight supply, with lesser amounts available on a more regular basis.

To put that in context, the country’s entire electricity demand is about 43TWh a year.

When developing the business case for the proposed Lake Onlsow pumped hydro scheme, government officials assumed about 5TWh of power storage would be needed to ensure the lights always stayed on during drought years, following the retirement of gas and coal generation.

The smelter’s “demand-response” agreements would reduce that requirement by about a fifth.

Alone, they are a not solution to the problem Lake Onslow was designed to address. Neither are they “free”, given the smelter would be entitled to a reward for cutting production.

But they nevertheless could be a material part of any cobbled-together alternative fix.

Deborah Hart, chairperson of the soon-to-be-disbanded Consumer Advocacy Council, which lobbies on behalf of consumers and small businesses in the power sector, says it hasn’t yet had time to form a view on whether the smelter deal is good for them.

The smelter deal should also see more solar farms built faster.

But John Harbord, chairperson of the Major Electricity Users Group, has no doubts where the interests of industrial power users or consumers lie.

He said soon after the power supply agreements were announced that they would provide “crucial flex” for the power market.

The benefits of the smelter’s demand-response agreements far outweigh any short-term sugar hit consumers would get in the form of cheaper power prices should the smelter close suddenly and flood the South Island with excess electricity, he argues.

While it was having to face up to the real possibility the smelter might close, Meridian put its foot down seeking other potential buyers for electricity from its Manapouri hydro scheme.

In 2022, it announced a partnership with Australian oil and gas giant Woodside that envisaged Southland would be the base for the world’s largest plant that used electricity to produce hydrogen from water through electrolysis.

Roan says the hydrogen project is “still on”.

“It is complex and it has moved slowly, but we’re still committed and working towards agreement with other parties,” he says.

Forsyth Barr notes that Meridian would be supplying 377MW of power to the smelter from next month, versus 472MW previously, as Contact steps up its contribution and Mercury becomes a new supplier.

That means Meridian should still have some extra capacity to play with, to encourage new industrial developments in the South Island.

But, clearly, the hydrogen project would be more important to Meridian if the smelter had closed.

To the extent that it is “either, or”, using power from Manapouri to smelt aluminium may deliver more “jobs for the megawatt”, given that electrolysis isn’t a labour intensive process.

It has been an irony that even businesses in Invercargill, including aluminium boat builder Stabicraft, tend to import aluminium rather than use aluminium made in Bluff.

Stabicraft explained in 2020 that was because there was no aluminium rolling mill in New Zealand from which it could buy finished product.

The smelter reported an underlying annual after-tax profit of $103m for its owners for the 2023 calendar year on Friday.

If the certainty that it will be around for another 20 years is enough to persuade Rio Tinto it should reinvest more of its profits in deepening its integration with the local supply chain and unlocking more opportunities for manufacturing businesses, that might be the cherry atop the icing on the cake.

No imminent sign of that though.

“There have been no approaches, and nor are there plans, to establish a rolling mill facility on site or adjacent to Tiwai,” a spokesperson says.

“The recent announcement securing the future of Tiwai will see the premium export of high quality, low carbon aluminium the world needs for the energy transition continue into the next decade and beyond.”