Sembcorp Industries (SCI) and Keppel Corp experienced significant volatility in prices during the week starting June 19.

 

On June 16, the Energy Market Authority (EMA) announced it is introducing the Temporary Price Cap (TPC) mechanism to mitigate extreme price volatility in the Singapore Wholesale Electricity Market (SWEM).

 

EMA has also introduced the market-clearing price, referred to as the Uniform Singapore Energy Price (USEP). This is set based on the marginal energy offer price. If the marginal energy offer price is at or above the TPC, the USEP will be capped at the TPC.

 

&ldquo The TPC mechanism is intended to act as a short-term measure to stop the vicious cycle of volatility and risk aversion, and allow time to identify and address the cause of the extreme price volatility, by temporarily capping the USEP at a level lower than the existing Energy Price Cap, which is at $4,500/MWh in the SWEM,&rdquo says EMA. The TPC mechanism will take effect from July 1.

 

A DBS report dated June 20 says that the TPC should reduce huge swings in wholesale power prices, but the impact on the average power price is likely to be marginal.

 

&ldquo Average USEP can potentially drop by 7-8% assuming 4% activation of TPC,&rdquo the DBS report explains. The DBS report is suggesting that investors take advantage of the wide swings in price to buy SCI and Keppel because the impact from TPC is likely to be limited, in particular for Keppel which has &ldquo only a 1% exposure to the wholesale market&rdquo .

 

Keppel&rsquo s exposure is through Keppel Merlimau Cogen, 51% owned by Keppel Infrastructure Trust A7RU -1% and 49% held by Keppel. SCI owns SembCorp Cogen.

 

SCI has locked in at least two-thirds of capacity under longer-term contracts including an 18-year power purchase agreement (PPA) with Micron of up to 450MWh and a 10- year PPA with Singtel (estimated at 60MWh&ndash 80MWh), leaving only onethird to benefit from market volatility during the expected tight power market, DBS says. In addition, SCI also has leeway to sell gas instead of using it to generate power, if that has higher margins, the report adds.

 

Before the volatility set in, SCI&rsquo s share price had been up by more than 60% this year, and one of the market&rsquo s best performers. The market has been anticipating positive catalysts, including new renewable growth targets, divestments and potential inclusion into the MSCI Index in August or November.

 

Keppel is transforming into an alternative asset investment manager, with a focus on fees, AUM, and an asset-light model. Against this, its earnings are likely to be very diversified.

 

Technically, the likelihood of SCI&rsquo s share price rebounding and gaining strength is probably higher and more likely as prices are in a primary uptrend. Against this background, retreats &mdash though deep at times &mdash are likely to be followed by a resumption of the uptrend. Hence, SCI is more likely to make a new high this year than Keppel.

 

Keppel&rsquo s share price movement reflects investors&rsquo uncertainty over its new business model of focusing on AUM. While this ensures lower writedowns and stabilised cash flows, Keppel may, at times, as a sponsor, need to support its units where the assets are parked, such as Keppel Infrastructure Trust, Keppel REIT, Keppel DC REIT, and possibly its unlisted funds which may at times need to be recapitalised during black swan events.

 

Following news of the impending price cap implemented by the Energy Market Authority (EMA), shares in Sembcorp Industries U96 0.37% and Keppel Corporation BN4 0.00% saw their shares drop in knee jerk sell-offs.

 

On the morning of June 20, shares in Sembcorp fell by 9% while shares in Keppel fell by 5%. The move was seen as overdone by DBS Group Research analyst Ho Pei Hwa, especially for Keppel, which has a 1% exposure to the wholesale market.

 

In her June 20 report, Ho notes that the tightness in the Singapore power market also looks set to persist with the country&rsquo s power reserve margin falling close to the trough level seen in 2011. The power supply cushion also declined to around 10% during the peak periods, well below the 20% market which signals a tightness in supply.

 

&ldquo Adding fuel to the fire, nearly a quarter of Singapore' s power generation capacity ([around] 2.8GW) is approaching the end of its lifespan over the next five years. [A] new investment cycle has just kick-started in 2023 with Sembcorp and Keppel committed to build two units of 600MW hydrogen ready power plants, representing [around] 10% of current total capacity, that will come online by 2026. For now, energy imports from neighbouring countries &ndash [around] 1.3GW import license has been granted - could provide some reprieve,&rdquo she writes.

 

Besides, the elevated power prices look set to stay even with the new temporary price cap mechanism. Ho points out that the Uniform Singapore Energy Price (USEP) shot up to $503/MWh in May 2023, a record high for the average monthly USEP. While she expects the USEP to moderate amid normalised fuel costs, the amount should still be hovering at elevated levels of $300/MWh in the foreseeable future given the tight power supply.

 

She adds: &ldquo The newly introduced temporary price cap mechanism from July 1 should effectively reduce huge swings in wholesale power prices, but [the] impact on average power price is likely to be marginal. Average USEP can potentially drop by 7% - 8% assuming 4% activation of the temporary price cap.&rdquo

 

Considering the relatively limited impact from the temporary price cap and still constructive power market dynamics, Ho reiterates that the sell-off for both Sembcorp and Keppel has been overdone. In a June 21 report, Ho kept her &ldquo buy&rdquo call on Sembcorp with a higher target price of $6.50 from $4.60 previously.

Citi Investment Research has maintained its &ldquo buy&rdquo rating for Sembcorp Industries U96 0.00% despite Singapore&rsquo s Energy Market Authority (EMA) implementing a temporary price cap on wholesale power from July 1, with an unchanged target price of $5.98.

 

In his note dated June 21, analyst Jame Osman says that Citi&rsquo s fundamental view on Sembcorp remains &ldquo intact&rdquo despite concerns over the EMA&rsquo s price cap, which resulted in the energy player&rsquo s share price experiencing a 9% drop on June 20 &mdash a &ldquo knee-jerk reaction&rdquo to EMA&rsquo s announcement on the same day.

 

He adds that some investors took the chance to take profit given Sembcorp&rsquo s strong year-to-date outperformance.

 

The EMA&rsquo s energy price cap is intended to act as a guardrail to restore the orderly functioning of the electricity market during times of extreme price volatility, says Osman.

 

He explains that the temporary price cap does not operate at a fixed rate, but rather is set and refreshed based on the long run marginal cost of combined cycle gas turbine generation, which includes both fuel and non-fuel components. This is then applied to a &ldquo dynamic multiplier&rdquo , which depends on prevailing gas spreads.

 

The price cap is activated when the moving average price exceeds the threshold for a consecutive period of 24 hours.

 

Osman views the policy as a move to protect independent electricity retailers which are wholly reliant on purchasing power from the wholesale market, with the objective of ultimately improving stability of the value chain for the end consumer.

 

The analyst says the energy price cap will potentially limit &ldquo supernormal&rdquo upside to spark spreads for power generation companies, particularly when input costs are lower compared to spot prices.

 

&ldquo Considering that the Singapore power market has been transitioning to an &lsquo Open Electricity Market&rsquo model over the past decade or so, the proposed price cap policy is admittedly surprising as price intervention has traditionally not been an approach, as it perceivably creates a crutch mentality among consumers,&rdquo says Osman.

According to him, the Singapore government has historically deployed subsidies and rebates to help lower income consumers, while establishing a regulatory framework largely to govern &mdash and encourage &mdash market competition. &ldquo We expect the EMA to further fine-tune its approach when the temporary price cap is due for review, likely sometime in 2025,&rdquo he adds.

 

In the EMA&rsquo s simulation studies of the effects of the price caps on spot prices through backtesting against the January 2021 to April 2023 period, the average reduction in Uniform Singapore Energy Price (USEP) due to the temporary price cap was 8.1% between January 2021 and September 2022, and just 3.2% between October 2022 and April 2023.

 

On balance, however, he sees limited downside risk to Citi&rsquo s existing earnings forecasts for Sembcorp, noting that he retains his positive view of Sembcorp&rsquo s fundamentals given current market expectations for normalising electricity prices near term, as well as the company&rsquo s strategy to contract the majority of its capacity.

 

Osman says that while Sembcorp does not provide disaggregated disclosure on country revenues or revenue types, he estimates that an 8% reduction in spot tariffs, assuming all other factors remain equal, would pose an estimated 13% downside risk to Citi&rsquo s FY2023 patmi forecast for Sembcorp and an estimated 15% downside to its target price from lower spot electricity sales.

 

His target price of $5.98 is derived from a sum-of-the-parts valuation given Sembcorp&rsquo s different operating segments. Given current expectations for earnings contribution from its conventional energy segment to normalise over FY2022 to FY2025E, Osman says he is forecasting the proportion of earnings from its renewables segment to increase to 46% by FY2025, compared to 19% in FY2022.