The Clean Energy Finance Corporation will invest $125 million to connect Snowy 2.0 to the national energy grid, in a bid to share the benefits of the project across Australia.
Network operator TransGrid - which manages the high voltage poles and wires in NSW and the ACT - will use the finance to build and operate a new 330kV switching station and transmission lines to connect Australia's largest renewable energy project to the National Energy Market.
Energy Minister Angus Taylor said this would ensure the entire market would benefit from the $5.1 billion project.
"It's all part of our strong action to stabilise the grid and get the energy generation balance right to deliver affordable, 24/7 reliable power," Mr Taylor said.
The National Energy Market currently supplies around 10 million customers with electricity in NSW, Queensland, South Australia, Victoria and the ACT.
Around 7.12 per cent of the power generated at present comes from pumped hydro.
Clean Energy Finance Corporation chief executive Ian Learmonth said Snowy 2.0 would be the largest energy generator to connect to the NSW grid in 30 years.
"Investment in new storage, transmission and related infrastructure is essential to support the security and reliability of the grid during Australia's clean energy transition," Mr Learmonth said.
Snowy 2.0 will link two existing dams, Tantangara and Talbingo, through 27 kilometres of tunnels and include a new underground power station.
From 2025, it will generate an extra 2000 megawatts of dispatchable energy and provide 350,000 megawatt hours of large-scale storage.
This will be enough to power 500,000 homes for more than a week during periods of peak demand.
The project will also support new renewable energy zones in southern NSW, where 1900 megawatts of renewables projects are in construction or under development.
The investment is the first the Clean Energy Finance Corporation has made in major grid infrastructure from its $10 billion fund.
Legislation is currently before the parliament to allow the corporation to invest in new energy generation, storage and transmission infrastructure through the new $1 billion Grid Reliability Fund.
However the proposal has attracted criticism over concerns it would be used to prop up fossil fuel projects.