Source: Allens Insights (legal sector)
Financing the next generation of PHES projects 11 min read
Interest in pumped hydro energy storage (PHES) continues to grow as the need for affordable, long-term, firm and weather-independent dispatchable electricity becomes increasingly critical to Australia’s energy transition. However, its high upfront capital costs and complex planning, procurement, and delivery processes, in contrast with its low operational expenses, is prompting debate over its viability as a mainstream asset class and optimal funding strategies.
PHES assets in Australia are predominantly government-owned, reflecting an era when electricity generation was seen as a public utility and a national asset. The privatisation of many segments within the energy sector raises questions about the future ownership and funding of large-scale PHES assets in today’s market-driven environment.
In this Insight, we explore the challenges and opportunities related to the financing of PHES projects in Australia and outline possible offtake structures to ensure a successful project.
Key takeaways
- Government corporations have traditionally owned and procured PHES assets in Australia.
- Significant capital costs, extensive civil engineering, underground works and long lead times have made private sector ownership and access to debt capital markets for PHES challenging.
- Recent advancements seen in the BESS sector underpinned by the development of innovative funding and offtake structures present a potential pathway by which PHES could follow and become a mainstream asset class.
- In NSW in particular, there is significant government support for PHES projects, with the LDS LTESA and the new Energy Security Corporation focusing on investing in long-duration storage, and in South Australia the proposed Firm Energy Reliability Mechanism.
Background
Australia has a PHES fleet of approximately 1.6 GW across the Wivenhoe, Tumut 3 and Shoalhaven power stations, with an additional 2.2 GWs of generation expected to come online with the completion of the Snowy 2.0 expansion project. There is also a significant pipeline of privately procured PHES projects in various stages of feasibility and planning.
The scale, capital intensity and inherent complexities of delivering a PHES project has meant that, to date, every project that has come to market in Australia has been funded using some form of government support. The most recent example is the Kidston PHES, which reached financial close in 2021. Whilst a privately owned asset, the project was funded with a combination of equity capital, a government grant and a concessional loan.
A question therefore arises as to whether PHES should continue to seen as public infrastructure necessitating government investment, or market evolution will result in future PHES being funded exclusively by the private sector.
Could a PHES be privately funded?
In our view, yes, though in the short term, the success of PHES will depend on a combination of both private and public sector investment. The private sector faces a unique set of challenges when it comes to the development and funding of PHES projects.
PHES projects have long lead times and are capital-intensive. Upfront development costs are very high, and the construction period typically ranges between three to four years. Up to 80% of asset-life costs can be on upfront capital expenditure, which typically runs into several billions of dollars. As a consequence, PHES is beyond the investment horizons of many private sector investors and the future success of the sector will be contingent on investors gaining access to debt capital markets.
While the recent $3.5 billion debt financing of Snowy 2.0 is an encouraging example of the willingness of mainstream financiers to lend to PHES, it is a government-procured project backed by an AAA-rated counterparty. Privately procured PHES projects with more limited funding sources will be subject to much more stringent credit requirements. Recent examples of cost and time delays on major PHES projects and the trend towards collaborative contracting and pricing models represent potential challenges from a bankability perspective.
Prospective financiers will focus heavily on the developer’s chosen procurement model to ensure that there is firm pricing and transferred risk to limit volatility and exposure. Where there are elements of flexibility or uncapped pricing (for example as seen with approaches to managing geotechnical risk on recent government projects), we are seeing developers seeking to forward-solve these issues by implementing robust risk mitigation measures, including, alternative contracting methods, highly structured delay and performance liquidated damages regimes and intricate risk allocation arrangements.
In addition to enhanced procurement regimes, prospective financiers to PHES projects have, through market soundings, also indicated that highly conversative modelling assumptions and tighter financing terms will be required. As seen with other nascent renewables assets classes during their ascendancy (such as wind, solar and now BESS), developers will likely be required to also build in large contingency packages, contingent undrawn lines, accept front-ended repayment profiles, more stringent cash sweep and upside sharing mechanisms and lower gearing levels.
Access to debt capital markets will also be contingent on investors demonstrating that PHES as an asset class is commercially viable in the context of private ownership. Traditionally, governments have adopted a model of utilising PHES projects as a form of system support (ie where there has been a shortfall of supply during periods of peak demand). In contrast, private sector investors will need to monetise projects and demonstrate positive price differentials between pumping and generation.
Owing to the capital cost of PHES, the initial wave of privately held projects will be financed utilising multi-source funding structures. At least initially, it is expected that multilateral agencies which are spearheading Australia’s push to net zero, such as ARENA, the CEFC and NAIF, will provide concessional/grant funding alongside mainstream commercial debt. The limited pool of civil contractors with PHES experience in Australia, combined with a lack of a domestic OEM market will likely result in developers satisfying key credibility requirements for international export credit agencies to also participate in the financing of Australian PHES projects.
Unlocking private funding for PHES projects
Despite the challenges in financing PHES assets, recent market developments and potential future changes could pave the way for greater private funding of PHES projects.
The sheer scale of PHES projects means there is a limited pool of available investment-grade offtakes, and as a consequence, many pipeline PHES developers are seeking to underpin project economics through government revenue underwriting schemes such as the Long-term Energy Support Agreements (LTESA) and Capacity Investment Scheme Agreements (CISA).
While initially met with scepticism, these agreements are starting to be viewed favourably by financiers, representing a fixed revenue line against which debt sizing can be made. This has been demonstrated by the successful project financings of the Orana BESS project in mid-2024 (the first standalone financing of an LTESA) and recently EnergyAustralia’s Wooreen BESS project (the first standalone financing of a CISA). Both projects also demonstrate the potential upside these products offer to developers, with the revenue underwrite providing scope to trade all or part of a project’s capacity in the merchant market.
A potential challenge however is whether or not the LTESA and CIS programs are in fact ‘fit-for-purpose’ in the context of PHES, owing to their capital intensity and the quantum that these government support agreements will have to underwrite over the long term. There is a view by some market participants that a more traditional model, whereby the government acquires an equity interest in projects, would be better suited to PHES and would go some way towards solving a number of the key bankability concerns pipeline developers are currently grappling with.
The NSW Government has sought to address this issue through the Long Duration Storage (LDS) LTESA, which provides a tailored agreement for LDS projects (including PHES) to account for the fundamental differences in their operational and market context.
Key features of the LDS LTESA that benefit PHES projects are:
- an underwriting mechanism that grants the operator a series of two-year options to access a variable annuity payment in the form of a top-up to net operational revenue – rather than short-term swaps, which are granted under the generation LTESA;
- a minimum availability threshold of 97% rather than a minimum generation guarantee; and
- a contract term of up to 40 years for PHES projects, compared to 20 years for a generation LTESA and 10 years for firming LTESAs.
The ACEN Phoenix PHES project was recently awarded an LDS LTESA, marking the first time a PHES project has been awarded an LTESA. AEMO Services has indicated that the next LDS tender round will open in the second quarter of 2025 and is encouraging projects with short lead times to participate in order to meet the 2030 minimum objective. This directive does not rule out PHES projects, with many of the PHES currently under development in Australia having expected completion dates of 2030 or earlier. PHES projects with longer lead times are encouraged to participate in future LDS tenders to help meet the 2034 minimum objective.
While there is no active mechanism in any other jurisdiction, the South Australian Government has announced its proposed Firm Energy Reliability Mechanism (FERM), which is similar to the NSW LDS LTESA tenders and Federal Capacity Investment Scheme, providing a revenue underwrite for long-duration capacity projects. All existing and new generators in South Australia with long-duration firm capacity >30MW (excluding coal) and that can dispatch for a period of at least eight continuous hours must participate in the FERM process, but are not required to bid for financial contracts. The South Australian Government is considering responses to the FERM and is expected to release an update in 2025. With NSW as the frontrunner in supporting LDS projects and SA proposing some support, other jurisdictions may consider similar regimes based on their progress.
In June 2024, the NSW Energy Security Corporation (ESC) was established to accelerate the state’s renewable energy transition. In February 2025, the government announced the first Investment Mandate for the ESC. The Investment Mandate sets out how the ESC will invest in renewable energy projects where private sector investments alone are insufficient. The ESC has been allocated $1 billion and will co-invest with private investors on PHES, as well as large-scale batteries, community batteries and virtual power plants.
The Investment Mandate did not provide a breakdown of how the $1 billion would be allocated amongst these projects. However, with a clear mandate to invest in PHES projects, there is hope that the ESC may be able to help address some of the challenges faced by private investment as set out above.
PHES is often referred to as a ‘water battery’. It is therefore unsurprising that revenue models which have underpinned the recent meteoric rise of the BESS market are similarly being adopted by PHES developers who are currently in the planning phase.
In particular, the rise of virtual offtake arrangements (ie where the offtaker makes virtual nominations that are effectively separate from the physical operation of the asset). These structures (and the significant capacity size of PHES) allow a developer to retain day-to-day control over the underlying PHES asset, split capacity across multiple offtakers, provide potential for greater equity upside (although also give rise to greater risk on the downside), and importantly can be treated off-balance sheet from an accounting perspective.
We are anticipating a further evolution of the virtual offtake market, particularly if storage projects can secure an underlying LTESA or CISA, which can give them a base level of security to trade the remaining capacity. Revenue sharing, caps and firmed supply (or a mixture of a number of structures) could be possible, and we expect the PHES market to take inspiration from the BESS market.
Actions you can take now
If you are considering entering the PHES space and exploring funding options, it is important to:
- engage with financiers (both private and government, and concessional providers) early;
- engage external counsel early and seek guidance on key bankability issues throughout the planning and feasibility phases;
- develop your revenue stack during the planning phase (in consultation with financiers) and take into consideration the quickly evolving offtake market in the BESS sector;
- for those projects in NSW:
- prepare for the next LDS LTESA round which is slated to be undertaken before the second half of this year;
- engage with the ESC to explore how it will invest its $1 billion in the context of a PHES project; and
- for those projects in South Australia, engage with the South Australian government and monitor for updates on the FERM process.