The much touted Snowy 2.0 pumped hydro scheme appears to have suffered another blowout in costs, just weeks after the Coalition government shovelled $1.4 billion into its wholly owned energy utility Snowy Hydro to support the project.

Details of the contract announced by Italian group Salini Impreglio late last week reveal that with the main construction “mega contract” now comes to $5.1 billion for the civil works and the electro-mechanical component, essentially the drilling of the tunnels and the construction of the power station.

This covers most, but not all, of the total project costs.

And Salini’s junior Australian partner, the listed engineering firm Clough, warns in its own press release that the timeline of the project’s completion is also pushed out, and is now an eight year project that will not be completed until 2027 at the earlier (assuming it begins in 2019), rather than the 2025 previously advertised.

Analyst David Leitch, a contributor to Reneweconomy and head of analyst firm ITK says the “book value” of Snowy 2.0 will likely reach $6 billion when all is done and dusted (see his full note below), which will roughly reflect the cost and investment in the project.

This does not include the $2 billion estimate for the poles and wires to deliver its services, which Snowy wants consumers to pick up the tab for.

Snowy Hydro’s own rather short press release – on the awarding of the contract of what will be Australia’s biggest ever electricity investment – did not even mention the $5.1 billion number at all.

But it said: “The estimate for the project’s construction costs remains in-line with the figures from the 2017 Feasibility Study of $3.8 to $4.5 billion (December 2017 real).”

As Leitch points out, while some companies use the cover of “real” to hide rising costs, most project cost estimates are simply reflected in nominal numbers.

The fact that Snowy Hydro chose not to mention the $5.1 billion number reflects the sensitivities around the budgeted cost, which has already more than doubled once from the original $2 billion price tag, and amid ongoing concern from many in the industry that it will struggle to make money and may not be the most efficient and cost effective choice.

We sought comment and clarification from Snowy Hydro, but was informed by its media manager that: “We get no objectivity in your reporting, so no comment from us.”

We gather that’s a reflection of our decision to publish articles, such as this from ACIL Allen’s Paul Hyslop, Is the reward worth the risk? that question the economics of the project, and for daring to publish graphs and conclusions from Snowy’s own reports – Modelling suggests Snowy 2.0 will lift prices, defend coal, kill batteries– that were not included in the company’s media kits.

You can see all our stories on the subject here.

Hyslop is not the only expert to question the economics of the project, or even its need. As Leitch notes below, the “amazingly high margins” to be enjoyed by the lending syndicate may reflect banker views about the economic risks of the project.

Here’s the analyst note from ITK’s Leitch in full:

A consortium of Salini Impreglio (65 per cent including its US unit Lanes), and Clough Engineering (35 per cent) has been awarded the an $A5.1 contract for the civil and electromechanical works for Snowy 2.0.

The Clough Engineering press release states that the value of the contract includes escalation of prices through the eight years of the project. Almost as much as the price, it’s the eight years to completion that caught this analyst by surprise.

The $5.1 billion compares to the 2017 real $3.8-$4.5 billion quoted in the business case. In our view it is one of the many ways proponents have of disguising project costs to quote in real $. If only household mortgages were quoted in real $!

ITK expects that the book value of the project at completion will certainly be materially higher than $5.1 billion, probably closer to or over $6 billion. In addition to the contract, which no doubt includes a 10 per cent contingency, we expect the book value to include other costs such as preliminary works and capitalised interest. And that’s assuming it’s completed on time.

Still, eight years (2027 if Jan 1, 2019 is the starting point) seems long enough, even for this project. We have never heard of a project where the contingency wasn’t used, but no doubt there is a first time for everything.

The federal government has contributed $1.4 billion of equity, but the remainder of the project will be financed from internal cash flows and debt. Internal cash flows can be regarded as additional equity.

The business case as reported on the Snowy site stated that the cost of debt would be 5.7 per cent and with a tenor of 3-7 years. Management states that the credit rating is expected to be A – and no worse, even in downside case, of BBB – .

Basically, to operate in the National Electricity Market at all requires a BBB – credit rating. Any worse than that is considered junk debt and completely unimaginable for the fourth largest retailer by customer numbers, and supplier of something like 9 per cent of the energy used in the NEM.

In my experience, companies will bust a gut to avoid even one downwards notch in their credit rating. The behaviour, for instance, of Origin Energy during construction of APLNG project, is instructive.

Looking further at the debt, 10-year corporate bonds in Australia are currently quoted at 1.9 per cent. This debt has, in our view, an implicit government guarantee, and yet the 5.7 per cent estimated final debt cost represents a margin 380 basis points.

If accurate, this is an amazingly high margin and, in the absence of any other comment has to be taken as a view that lenders have as to the riskiness of the project. Alternatively, Snowy needs a new corporate treasurer.

It seems clear that the government also took a more conservative view of the balance sheet, in that Snowy’s original proposal was to finance the entire equity contribution out of retained earnings. It’s hard to imagine a private sector company taking, or being allowed to take, such a cavalier view of its balance sheet.

Snowy has been paying about $250 million ($265 million in fiscal year 2018 and $227.5 million in 2017) a year of dividends. Over the next eight years, at that rate, foregone dividends will be about $2 billion.

The federal govt thus has $6.1 billion of investment for the 87 per cent of Snowy bought from NSW and Victorian governments, plus $1.4 billion of direct equity, plus $2 billion of foregone dividends, or $9.5 billion of direct investment in Snowy plus another $1 billion from its original 13 per cent equity stake.

We note that Richard Sheppard, former CEO of Macquarie BanK, is chair of the Snowy Board’s portfolio risk committee and could certainly be expected to understand the balance sheet and cash flow requirements of Snowy. There is no shortage of Board experience.

As at 30 June 2018, Snowy had $786 million of interest bearing debt and was rated BBB +. Call me left wing or conservative just as you like, but it’s a rare company that improves its credit rating during a major capital program where the cost has already increased significantly.

Snowy’s 2018 balance sheet showed total assets of $3.5 billion and property plant and equipment [PPE] of $2 billion. No doubt these assets are heavily depreciated, but it can be seen that Snowy 2.0 will more than double the balance sheet. Any bank is going to see that as highly risky and to require conservative financing.

The idea of doing it all out of retained earnings would, in my view, only be even half way plausible on the premise that the government stood ready to contribute at the first sign of a problem.

For instance another 20 per cent cost blow out is another $1 billion of debt.

This is entirely possible over the life of an 8 year project.

ITK roughly estimates the project to have a book value of $5.9 billion at completion and Snowy to borrow $2.1 billion to finance it. It should go without saying that this includes numerous hard to verify assumptions but it’s entirely consistent with the approach I would take in talking to fund managers if Snowy was a listed company.

The following table sets out the assumptions.

At the risk of making enemies, my personal view is that Snowy management take an arrogant view of the public. If not arrogant, then certainly very thin-skinned.

The company claims “it gets no objectivity in reporting by RenewEconomy”. Fair enough, but RenewEconomy, to which I contribute on a voluntary basis, is far from the harshest critic of the project and, in fact, to my understanding is on balance supportive.

Senior and well-regarded people in the industry have questioned the economics and the process is obviously inappropriate. For instance, here is an article originally published on Linkedin and yes reproduced at Reneweconomy from Paul Hyslop, CEO of a major electricity consultancy regularly employed for major market analysis by say the ESB and the AEMC.

For the record ITK’s view, in a nutshell, is:

Snowy 2.0, a more than $5 billion plus project when completed, did not go through any selection process. Although there is now, eventually, a detailed business case, it was a Captain’s pick.

We regard this as highly inappropriate, compromising the investment from the start. It should have been selected on merit in competition with other projects wanting to provide renewable dispatchable generation.

That said, it will be great to have it, even if it’s bad value for money. In comparison to money being thrown away on 12 submarines that wont be fully delivered prior to the 2050s (yes, you read that right, the 2050s) the Snowy 2.0 money is just an accounting footnote.

We think the duration of its storage 175 hours means that much of it will be needed only very rarely, and therefore have low value.

We think the project crowds out other projects, and in turn runs significant risk of having to compete with massively lower-cost brownfield projects such as 570MW Wivenhoe (operating independently from the end of this year) or a 200MW Shoalhaven brownfield expansion. Wivenhoe, already built, only has to focus on covering variable cost.

We also think batteries may be very competitive in the daily two-hour peaking market and batteries will completely dominate FCAS services. Look at how fast deployment batteries are already eating up gas peakers in the USA. Batteries beat out gas in a competitive tender in Arizona recently, although its true that gas had one arm tied behind its back there.

Bloomberg’s recently published battery price survey shows:

See Bloomberg’s full, careful battery article here.

These are automotive battery costs in $US and stationary energy batteries cost more. Even projecting those costs forward at a 7.5 per cent rate per year gets you to $A0.14 million/MWh. You can earn an annual return of 10 per cent with a net spread (energy revenue -energy cost) of $A40/MWh running for 1 hour a day on those prices, although real world costs may be higher.

Snowy will need more than that, even allowing for 40 per cent of revenue coming from “caps”. That’s our view today, but we might change our mind. It’s the analyst’s privilege.

The NSW government received $4.1 billion from selling its share of Snowy to the federal government, but in contrast to the Victorian government hasn’t put much, if any of that back into the NSW electricity sector. That’s another story.

Editor’s note: An earlier incomplete version of this story was published earlier. We apologise for any confusion.