A moat is a sustainable competitive advantage. The imaginary of moat as a body of water to protect a castle is apt as a moat protects a company from competition. To offer effective protection the moat must be sustainable. We no longer believe that AGL’s competitive advantage is sustainable.

Read more about moats here.

What has changed at AGL

We downgrade AGL Energy’s (ASX:AGL) Morningstar Economic Moat Rating to none, from narrow. The firm’s low-cost coal power stations bestow a material cost advantage for now. But with their closures scheduled for the early to mid-2030s, the cost advantage won’t last long enough to justify a moat.

We expect AGL to generate returns broadly in line with its cost of capital after closing its coal power stations. Further, renewable subsidies and other government interference depress the medium-term outlook for electricity prices, particularly in Victoria, curtailing excess returns.

AGL owns a valuable generation fleet but cost advantages from coal power stations are unlikely to last long enough to warrant an economic moat. The three largest private generators in the National Electricity Market—AGL, Origin, and Energy Australia—have combined market share of 45%, followed by a few large government-owned generators.

AGL Energy's overall share is 18% but concentration and market power differ significantly by state. Market power can spike during periods of high demand or low renewable output because of capacity limits on transmission lines. With insufficient flows from other parts of the network during these periods, local power stations can demand high prices.

Coal power stations contribute about 80% of AGL's electricity production. Its Loy Yang A brown coal power station in Victoria has the lowest running costs of thermal generation in the Australian National Electricity Market. Loy Yang A owns huge brown-coal reserves capable of powering the plant for decades, insulating it from commodity prices. But the plant is a major carbon dioxide emitter and AGL has agreed to close it early, in 2035, under pressure from banks, activists and government.

Further, profitability in the next few years is likely to be depressed by weak electricity futures prices in Victoria as the government subsidizes higher-cost competing coal power stations to keep them operating until 2028 to allow time for renewable developments to complete. We expect Loy Yang A to make solid profits until Energy Australia’s Yallourn coal power station closes in 2028, and improving thereafter as the market gets back into balance and electricity prices lift.

The outlook is better in New South Wales where futures prices are higher and AGL also produces power cheaply. Electricity futures prices are higher because NSW power stations rely on export-quality black coal, which is more expensive. AGL’s Bayswater power station has cheap coal supply contracts to 2028—we estimate it pays less than half what competitors currently pay for coal—so is well-placed to make outsize profits for at least a few more years. Even after legacy coal contracts expire, we expect the closure of competing coal power stations to support electricity prices and profits until Bayswater’s scheduled closure between 2030 and 2033.

AGL also owns a portfolio of wind, gas, hydro, and solar generation assets. These assets are small in the scheme of things and unlikely to support excess returns given a lack of differentiation from other utilities. Gas generators are costly to run, but flexible output makes them ideal cover for peak demand periods and as an accompaniment to intermittent wind and solar.

Growth in renewable generation in the long term is likely to increase the need for gas generators, unless there's a major improvement in battery technology. Wind and solar are AGL’s least attractive generation assets because of their intermittent output and expected low returns on investment. Regardless, with nuclear ruled out by government, AGL and others must build huge amounts of wind and solar capacity to offset closure of coal power stations in coming decades. AGL reduces risk by mostly building these assets with capital from third parties while using its own capital to fund large-scale batteries, where it can use existing infrastructure to improve returns.

We do not consider energy retailing to have durable competitive advantages. The three largest players—AGL, Origin, and Energy Australia—dominate retail energy markets with a combined market share of over 70% in electricity and 80% in gas. They benefit from scale and vertical integration, which provides a natural hedge to help manage volatile wholesale electricity prices. But the product is commodity-like, switching costs are low, mass market prices are semiregulated, and there are many small retailers offering discounts to win share. The result is a highly competitive market with low returns.

AGL faces material environmental, social, and governance, or ESG risks, particularly from government subsidies to encourage new renewable energy supply that could undermine wholesale electricity prices. However, coal power stations contribute more than 60% of power in Australia and are vitally important for grid strength and stability. An orderly transition to renewable energy likely requires coal power stations remaining in the grid for another couple of decades, and we think this is only possible if they make sufficient returns to cover the cost of capital. AGL is well-placed in the medium term as one of the lowest-cost suppliers of electricity on the grid, although maintainable excess returns are unlikely.