The European power market is in a state of flux, driven by a mixture of market fundamentals and resulting competitive pressure, political influence and regulatory mandates. This is creating major opportunities for infrastructure investors.
A proper understanding of the current situation cannot be achieved without first examining the underlying market fundamentals. Power demand in many European countries has been subdued in recent years. Recession-induced falling industrial demand has been compounded by the impact of energy efficiency policies and the growth of small-scale renewable generation, particularly solar. Across the European Union (EU), power demand is set to grow slowly, but demand in the key German and UK economies is declining.
Coal has re-emerged in the EU as the conventional fuel of choice ahead of gas, driven by relatively low coal and carbon prices. This combination has resulted in coal-fired generation running hard at the expense of gas.
THE SUBSIDISED RISE OF RENEWABLES
In addition, the contribution of renewable energy has grown significantly, fuelled by EU targets and resulting government subsidies. As such, by the end of the decade, renewables are predicted to be the second-largest component of the EU energy mix, accounting for around one-third of total generation. Increasing volumes of intermittent generation, such as solar and wind, present challenges for the industry, as conventional plant must flex and the network expand to accommodate it.
This large growth in subsidised renewable generation has had a dramatic and paradoxical impact on the market. More renewables increase overall generation capacity and lower wholesale prices, thereby signalling an apparent reduction in demand for conventional generation. More intermittent renewable generation on the system needs highly responsive and predictable capacity to support it. Only gas-fired generation can provide the responsive capacity support needed. However, the combination of increased renewable capacity, and low coal and carbon prices, is squeezing gas from the market.
In a market characterised by subdued demand and low prices, it is odd that renewables continue to flourish – and so further compound lower prices. In a normally functioning market, as capacity leaves, prices will respond. However, the market entry of renewables is not driven by underlying fundamentals, but by politically-induced subsidy support.
This perverse situation is compounded by electricity's uniquely difficult storability characteristics, and the need to have the right sort of responsive capacity to accommodate increasing volumes of intermittent renewable generation.
The market has evolved into two distinct streams:
Conventional thermal generation influenced by market fundamentals.
Low carbon generation – with very low marginal costs whose returns are driven by government policy subsidy support.
E.ON has responded by announcing plans to split in two and spin off its power generation, energy trading and upstream businesses into a separate entity, leaving E.ON to focus on renewables, distribution networks and energy efficiency services.
Fellow German energy giant RWE has not yet announced similar plans, but it is clearly feeling the same pressures and has predicted a further decline in profits during 2015.
Meanwhile, Danish power company Dong Energy, the world's largest operator of offshore wind farms, is also considering restructuring and selling parts of its offshore renewables interests as it seeks the right balance between its operations in wind, thermal power and oil and gas. A spinoff or sale of its oil exploration and production unit may fetch as much as $8 billion, according to Bloomberg Intelligence estimates. The Danish government, Goldman Sachs and the other owners of Dong are currently reviewing potential options.
RENEWABLES – EXPANSION CONTINUES?
Although the growth in renewables has been consistent in much of Western Europe, the recession and resulting age of austerity has raised questions around continued affordability.
In the UK, concern over affordability and the impact on customers' bills has led to the introduction of an annual cap on the subsidy support for renewables – the Levy Control Framework (LCF). In a drive to improve the cost-effectiveness of renewable subsidy support, the UK has also introduced contract auctions for new renewables – with projects now competing against each other to secure a contract.
Inevitably such competition will favour those nearer to market technologies and larger developers, and so potentially reduce the unbridled growth rate of renewables.
THE RIGHT KIND OF GENERATION
Focus will instead shift to the need for responsive plant that can make an economic return operating on fewer overall hours, to operate in tandem with intermittent renewables. In the UK this has led to the reintroduction of a capacity market in an attempt to provide the right sort of generation with an additional income stream. Opportunities for reconfiguring existing plant and its contractual arrangements to provide the right type of capacity in the short term will arise.
In addition, the role of new gas-fired generation is likely to change – hitherto, new more efficient plant have displaced older plant to run as base-load generation, now the higher returns for new plant will be to operate flexibly. Marrying the engineering technicality of flexible operation with the economic requirement of optimum dispatch will be the challenge for many operators to exploit.
REGULATORY RISK AND REWARD
Given that the returns of renewables and networks are dependent on policy developments and regulatory decisions, any change in policy sentiment and emphasis can have a profound impact, as witnessed by the Spanish government's withdrawal of subsidies for solar energy, and by Japan's apparent U-turn on re-introducing the use of nuclear power following the Fukushima disaster.
Where next? While the cost of renewables has fallen, some technologies such as offshore wind will not be cost-competitive with conventional generation by 2020. Others, such as wave, remain far from the market. If governments have met their targets, will they continue to subsidise costly renewables and the relatively expensive electricity network expansion to support it? For investors, picking the right project will require an understanding of the regulatory drivers underpinning it, and an appreciation of the fact that the rules of the game can change.
Such change can also provide opportunity. In the UK, energy regulator Ofgem is looking at putting out to tender large transmission projects post 2021, in an attempt to secure more efficient delivery. Whether competitive tender will actually secure more efficient delivery is questionable – but opportunities for investment will arise.
To adapt to the combination of increasing volumes of small-scale generation and differing electricity use, such as electric vehicles, distribution networks will no longer be just a passive one-way route for electricity. As such, smart grids will emerge as a key technology over the next decade. Major players such as General Electric and Siemens are already investing to make distribution grids smarter. Opportunities to exploit distribution network management will also be high, with regulatory returns increasingly geared towards rewarding the more innovative companies.
THE ROAD AHEAD
What does the future hold? Despite deregulation it is clear that electricity is not just like any other commodity – the risk of power failure has profound economic and social impacts. Therefore the electricity market will remain highly influenced by policy makers and economic regulators. The era of unbridled expansion of high-cost, low-carbon generation will slowly come to an end and only the most competitive projects will be developed. Project versus project competition will increasingly influence the market, with subsequent developer/backer risk/reward.
Capacity markets will come back into fashion as power markets (and policy makers) adapt to cope with increased volumes of intermittent and variable renewable generation – with an additional market signal for flexible, conventional plant to enter the market/stay in it. Balancing the technical and economic parameters driving the operation of conventional plant will be essential here to maximise return on investment.
Networks will also offer increasing opportunities, with short-term expansion of transmission to accommodate renewables, followed by smarter operation of distribution.
Fundamentally, the current state of the market shows us that things move very quickly and, while this can present huge opportunity, it can also signal increased risk. The ones to benefit will be those who diversify, adopt a multi-generational strategy, and garner a thorough understanding of not just how things are likely to evolve, but the resulting implications.