Fonterra's boiler electrification - is it good business?

Breaking down Fonterra's North Island boiler electrification plans.

I’m a dairy farmers son, and many of my close friends are dairy farmers.

The dairy industry is New Zealand’s biggest export earner, bringing in about 25% of our total export revenue, by inference as New Zealanders we are all dairy farmers.

It is for these reasons that I pay close attention to what Fonterra is up to.

Last year I wrote on merits of their plans to use wood pellets for their South Island factories in Cow Farts and Wood Boilers.

In the latest news this year Fonterra announced a $121 million investment plan to electrify much of its North Island steam plant.

Fonterra’s company constitution does not give the shareholders (the farmers) the ability to vote on the allocation of capital for plant upgrades. However, this is a big investment, and if I were a share holding dairy farmer, I would want to understand better the risks and value proposition that this presents because it could affect dividends.

Let’s take a closer look and dig deeper to see if this is a good idea on behalf of Fonterra’s farmers and the wider NZ public concerned for the future of NZ Inc.

The Context:

Fonterra’s plants are energy hungry (like all heavy industries) and use around 12 PJ of gas annually. Which is a lot, equivalent to around the electricity consumption of 460,000 homes annually.

Natural gas is only used in the North Island. In the South Island the primary fuel is coal (soon to be wood pellets). This is due to the lack of a natural gas reticulation system in the South Island.

Fonterra ultimately want to reduce their gas use by around 5.7PJ, or 47% of today’s figure. The strategic motivation for this we will explore below. Essentially, they state it’s for reduced emissions, however the decisive factor might be continuity of operations and availability of a fuel source

If they stop using gas and replace 5.7PJ with electricity, this will result in about 1.5TWh of annual baseload demand being added to the country’s electrical grid. A grid that’s already under pressure in a dry year. This is about a 4% demand increase for baseload electricity on the grid.

(These calculations are assuming that gas has an efficiency of 95% in a boiler application and electricity is ~99%.)

It is also important to note the energy usage pattern of Fonterra’s processing facilities. During the August to December period these plants run 24-7 and need power available all the time, not just when it’s sunny or windy. (Baseload is the “always on” type of power)

Boiler Electrification:

The plans center around installing 2 x 35MW boilers at Whareroa (Hawera, Taranaki) and 1 x 30MW boiler in Edgecumbe (Bay of Plenty).

Industrial electric boilers are a proven technology that work well across a range of steam pressures and temperatures, so technically I would not expect there to be any issues, other than the supply of electricity (more on that later).

The motivation:

Fonterra’s stated motivation is to reduce emissions from their operations. The electric boilers are expected to reduce CO2 emissions by 51,000 tonnes at Whareroa and 28,000 tonnes at Edgecumbe.

I however suspect it is a twofold motivation and there is also a more pressing security of supply concern regarding the availability of natural gas. This is a valid concern given the depletion rates we are seeing from our domestic gas fields.

So, that said let’s look at the positives and negatives of these plans. With the caveat that detailed analysis, without detailed data insights, is a pretty course estimation.

OPEX:

Negative - Electricity is expensive in NZ and has seasonality issues. The chart below shows the wholesale electricity prices across the last year. The average is in the range of $250-300 MWh in the spot market. I would however expect Fonterra to be able to secure a power purchase agreement that is better than the wholesale spot market rate. For the purpose of this analysis let’s assume it’s in the order of $150 MWh.

Noting that this would have some degree of variability that will follow the market somewhat, and that the start of Fonterra’s season in August coincides with the last gasps of winter when prices are elevated as we see in the chart below.

This works out to be an annual estimated electricity cost of about $225 million to supply the three electric boiler units with electricity.

Wholesale electricity prices for the past year.

Wholesale gas prices again are very hard to estimate and in Fonterra’s case there should be significant purchasing power given the volumes they use. I am going to guess that as a big industrial user with a supply contract they are probably purchasing gas for something like $10 GJ. (*equivalent to $0.04 kwh)

For 5.7PJ of gas this is an annual estimated cost of $57 million.

However, we also need to include the Emissions Trading Scheme (ETS) in the gas pricing which is currently trading near the lower limit at $63.17 tonne. This would add ~$5 million to the gas supply costs.

So, in summary we have a very rough estimate of:

• Electricity annual supply cost = ~$225 Million.

• Natural gas annual supply cost = ~$62 Million.

Fonterra will have done very a comprehensive economic impact analysis on this with all sorts of longer-term projections and price sensitivities. There’s will be much more accurate than mine.

However, on face value this looks to be a very large increase in Fonterra’s ongoing operating costs, which ultimately eats into the margins, and by association, dividend to farmers.

SECURITY OF SUPPLY:

Positive - In the longer-term outlook for New Zealand’s domestic gas supply is tenuous and Fonterra will have been acutely aware of this worsening situation.

I think it is for this reason alone that it is necessary to change energy supplies which is why I see it as net positive in terms of security of supply over the longer term.

However, in the short term this is somewhat akin to jumping out of the pan and into the fire. Electricity as we saw in the recent winter is not guaranteed or abundant.

Fonterra will need “baseload” generation which is electricity that is available on demand, night or day, regardless of the weather. In the NZ context this is essentially hydro, geothermal, or thermal (gas or coal). All of which are at full capacity in the event of a dry year, low lake level scenario. You can read more about this in my previous article “eating the seed corn”, where I outlined that the lakes were permitted to go below consented levels just to meet electricity demand, with no certainty that they will refill.

The risk here for Fonterra is that they get pulled into demand management provisions in a similar fashion to other heavy industrial consumers on those cold, dark and still winter mornings. (Fonterra could be asked to shut down production to keep us warm in our homes on cold winter mornings. August can get pretty cold after all and there’s a lot of milk that needs to be dried at that time).

Further complicating this issue is that the aluminum smelter has recently gone to the market with the RFP (Request for Proposal) to procure an additional 100-200 MW of baseload supply to increase their production.

This would suggest we will now have Fonterra competing for a limited supply of “baseload” with the aluminum smelter.

This is not a good picture because two major exporters, that contribute significantly to our economy, are competing for electricity. This will impact our GDP growth potential and ultimately improving the standard of living for New Zealanders

COMPLEXITY:

Negative - our electricity market is becoming increasingly complex and fragmented.

This will only increase as the percentage of the generation from wind and solar increases. The spot market pricing becomes increasingly volatile with large swings in generation and firming capacity becomes increasingly important.

Firming capacity is quickly dispatchable energy such as Gas Turbines (which as you’ll know by now… there are less of.)

The volatility also impacts the viability of businesses because of the inability to budget energy costs due to the increasing frequency and size of the price swings.

New Zealand’s current direction of travel in terms of generating capacity is onshore wind and solar. The problem being, that for industrial applications with a large and relatively constant demand, trying to modulate their processes to meet supply availability is expensive and can result in loss product and days of dowmtime while they get restarted. The variable generation profiles of wind and solar simply aren’t fit for purpose if not backed up 100% by rapidly dispatchable firming capacity.

These intermittent generation sources also add complexity to the electricity market. They introduce wild swings in the pricing and also introduce an array of new market products like renewable energy certificates and Huntly firming options for example.

These concepts deserve a post onto themselves. In short however, renewable energy certificates are fancy accounting that when the sun is shining or it’s windy, they record the unused power and then later take it from the grid, even if at that later day it was generated from coal. Huntly firming options are “coal as a service”. They store the coal for you and burn it as and when you need it. As you can see, you’ll need an entire department or some whizzy AI (which will ironically use up all the power you generate), to figure the commercials of all this out.

The days of just buying electricity at a fixed rate that you can draw down anytime day or night, winter or summer, and budget for accordingly, are long gone.

Fonterra will need to deploy some smart people and smart tech to manage this complexity and optimize their production vs cost profile.

EMISSIONS:

Negative - This is a much more nuanced question.

Will it reduce Fonterra’s emissions - Yes.

Will it reduce New Zealand’s emissions - No, this is a highly unlikely outcome, and it will probably increase them.

Why?

Because the gas market is constrained and as such the gas that Fonterra doesn’t use will be readily taken up for other users in the market. The emissions will just come from somewhere else.

I would expect companies like Balance Agri Nutrients, who operate an ammonia urea plant in Taranaki will only too readily welcome this supply, or commercial green houses as I have previously noted are struggling to secure gas supply contracts in Gas Powered Vegetables.

This is a Jevons Paradox scenario where efficiencies inevitably lead to more consumption.

I also suspect that this will lead to an increase in coal burn rate at Huntly whenever the grid needs firming capacity, which is increasingly often, and an addition 100 MW of load at Fonterra will only make the situation worse in the near term.

Incidentally as I write this, I note that Genesis is now considering extending the life of its coal fired units, citing the need to improve energy security.

Conclusion - Is this good business?

Yes, but only on the basis that this is a hedge against the potential for a loss of domestic gas availability, and as such is a necessary business continuity risk mitigation.

It is an interesting case study in the complexities of business in New Zealand as we enter the era of energy scarcity.

With so much that is negative about this proposal, particularly the increased operating cost, I suspect this decision has been a while in the making.

The board was likely waiting anxiously for the illusive flood of renewable generation, with mythical baseload properties, to eventuate in the market. In an act of desperation, I suspect the board finally moved to an investment decision under duress as they nervously watched the gas production rates decline rapidly.

This is in essence the horse and cart debate about energy infrastructure that I wrote about in Field of Dreams. Essentially having an oversupply of cheap, abundant, baseload electricity available in New Zealand would make these sorts of decisions obvious and easy. It would also make a wider decision of investing in NZ Inc in the form of value added manufacturing and industrial processing much easier. This is the pre-requisite for industry.

Fonterra do get some marketing upside from this decision with lots of positive news about emissions. However, as I have stated before if this was all about emissions in the dairy industry the obvious solution for Fonterra is to use the same biogenic emissions accounting that they use for wood pellets and apply it to cows. Because the logic is the same, but cows do it faster.