The European electricity market is facing probably its most challenging period, both structurally and financially, since Michael Faraday first generated current. Indeed, he may well be spinning in his grave.
The progress of privatisation and de-bundling since the early 1990s was relatively smooth, built on a foundation of stable generation assets, predominantly coal and nuclear, clustered along national transmission grids mapped on the backbone of coalfields and nuclear sites.
However, the industry has been hit by the perfect storm. Hands on the rudder are many, pulling slowly in different directions, while the lifeboats are few.
The causes are clear and at risk is the future of stable and secure power generation across Europe:
• Renewable generation
The growth in subsidised renewable energy, now becoming a significant percentage of the generation mix, has had an impact in a number of ways:
– The intermittent nature of renewable, but with guaranteed grid priority, causes balancing issues;
– The virtual zero marginal cost disrupts market pricing;
– The geographic dislocation between generation and consumption (e.g. North to South Germany).
• US shale gas boom
The exceptional growth in US shale gas has impacted Europe. As the US moved rapidly to replace coal generation with cheap gas, there was oversupply in global coal which flooded into Europe. This, coupled with a collapse in carbon prices (worth a dissertation on its own), meant that coal could compete with cleaner gas-fired power generation in the merit order – both squeezed between subsidised nuclear and renewables.
• The European debt crisis
The banking and sovereign debt crisis crippled growth and put the cost of renewable tariff support clearly in focus. Political sentiment has turned against the cost of renewable energy in many European Union (EU) countries, and opened many opportune ears to climate change scepticism. It appears that a pair of euros today beats a full house of CO2 tomorrow as we play a game of poker with the Earth’s climate.
Many governments are revising their renewable energy support legislation, with tariff reductions evident across Europe. This period of uncertainty is significantly impacting the immediate investment climate for renewable energy. However, it should be superseded by a more stable and balanced market where renewable projects, well sited with good resources, can offer an acceptable return.
Renewable energy will need to compete on a more level playing field in the future, and undoubtedly it can because the cost of wind and solar will continue to fall through efficiencies and innovation. However, the immediate future will be challenging for developers and Original Equipment Manufacturers (OEMs) with short term over-capacity likely to lead to consolidation.
• Nuclear policy
The aftershocks of the Fukushima nuclear disaster are evident in national policies towards new nuclear plants and the accelerated decommissioning of ageing nuclear assets. Even those states that are pro-nuclear will face major challenges in planning approvals which will delay by many years plant construction. Decommissioning and spent fuel processing costs are also becoming clear. For example the cost of cleaning up Sellafield, the UK reprocessing plant, is estimated at over £67 billion (€77 billion; $100 billion). You could replace the UK’s entire generation capacity for this.
• Ageing generation assets
In most regions of Europe the generation asset base is ageing, and most new capacity has been wind or solar. This is particularly evident in Central & Eastern Europe (CEE) as indicated in the charts below.
• Utilities investment constrained
The last five years have been difficult for European utilities – traditionally the main investors in European generation capacity – with an average decline in share price of over 60 percent since 2008, as evidenced by the ESTX Utility Index below.
Many utilities have been divesting assets to rebuild balance sheets and focus on their core territories. Additionally, the project finance debt market remains constrained, compounding the shortage of capital for new energy projects, particularly in the CEE region. Unlike the US, to date private equity has not been a major factor in the power generation industry in Europe.
The investment necessary to replace ageing generation assets in the CEE region alone in the next 10 years is in excess of €20 billion. In current market conditions, the proposition for investment in base-load power generation in many Western European markets is not favourable, with operating hours curtailed between renewables, nuclear and competitive coal. Without payments for capacity, which are being considered, investment in electricity-only generation is currently challenging.
So are there investment opportunities arising from these disruptive conditions in electricity generation infrastructure?
The growing focus on energy efficiency
Europe cannot afford to be wasteful with energy. Security of supply, climate change, long-term energy price trends and the need to be competitive in global markets, requires that Europe must embrace a more efficient energy future. It could be reasonably argued that it was erroneous global policy to prioritise renewable generation ahead of efficient use and generation.
The tide is turning. Political sentiment is favouring emphasis on energy efficiency, as a more cost-effective way to reduce carbon emissions. The Energy Efficiency Directive 2012/27/EU (EED) is intended to reduce net energy consumption by 20 percent by both more efficient energy use and generation. A cornerstone of the Directive is to increase the utilisation of Combined Heat and Power (CHP) where waste heat in the process of producing electricity is utilised in heating or industrial processes, significantly increasing overall energy efficiency. As shown below, typically 60 percent of energy consumed in an electricity-only generation plant is lost to the atmosphere.
Currently, approximately 11 percent of Europe’s power generation is from CHP. The CEE region has substantially more, as a positive legacy of central communist planning. For example, in Poland approximately 50 percent of the population is connected to district heating systems which are commonly supplied by CHP plants. Much of the infrastructure is aged and requires substantial investment. The EU EED mandates that CHP must be the default solution for all power generation above 20 megawatt thermal (MWth) input, and that existing CHP/district heating plants must be maintained.
The secure additional revenues from long-term heat sales contracts arising from modern highly efficient gas-fired (or biomass) CHP plants provides an attractive proposition compared with an electricity-only power plant. Most countries provide subsidies for high-efficiency cogeneration, which will be sustained or strengthened under the EED. The critical difference is that CHP returns are enhanced by these subsidies but the industry is not solely reliant on this support, as is the case with most renewable generation. Supporting CHP is a far lower-cost route to carbon reduction compared with renewable subsidies.
Flexible generation improves returns and provides long-term security
Modern gas-fired CHP plants, engines or turbines provide a high degree of flexibility in operation. In particular, their ability to start and stop quickly is becoming increasingly important in balancing electricity grids to offset the intermittency of wind and solar energy. A plant can follow the heat supply demand and also provide valuable balancing and ancillary services to the grid. For example, in the summer season, when heat use is low, a large portion of the plant’s electrical capacity can be contracted for ancillary services (e.g. fast-start response).
As electricity markets evolve over the life of the asset (25+ years), this flexibility enables the asset to perform optimally according to market conditions. This will be significant as capacity payments and fast-response balancing services are likely to increase in value.
Efficient and flexible power generation: an attractive asset class
The complex changes impacting the European power sector has provided an opportunity for private equity infrastructure investors to capture secure, long-term, income assets, in what is in our view the emerging sweet-spot in the European energy sector. We believe the CEE region offers exceptional potential in this regard, benefitting from its extensive district heating infrastructure, and where most countries have maintained throughout the debt crisis higher GDP growth and lower sovereign debt than most Western states.
Having identified the opportunity, as a CEE regional energy specialist, EnerCap Capital Partners is launching the EnerCap Efficient Energy Fund (E3F1). It will target €350 million to invest in a series of pre-screened projects serving this strategy across the CEE region. The E3F1 fund will invest in 8 to 10 high-efficiency energy projects in the CEE region which will deliver low-cost, clean energy to consumers while providing investors with a stable source of predictable cash flows.
*Jim Campion is a partner at EnerCap Capital Partners, a Czech Republic-based fund manager investing in clean energy projects across Central, Eastern and South-Eastern Europe