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The growth of renewable energy and its impact on power markets

Gerard Reid, founding partner of Alexa Capital, and Jochen Kreusel, head of ABB Smart Grids Industry Sector Initiative, discuss renewables and new business models in the energy sector in an interview with ABB Review.

Part 1 – The drivers of renewable energy growth

ABB Review: The renewables transformation is advancing at dizzying speeds. What are the drivers of this development?

GR: We really wouldn’t be seeing renewables rolled out across the world without a government mandate. Particularly in Europe this has been the major driver. There are two other important factors. One of them is cost. We’ve seen very rapid reductions in costs, especially in solar but also in wind. Renewables are rapidly becoming too cheap to ignore. The other factor is strategic advances in technology. And I don’t mean just the renewable technologies themselves, but how they are integrated into the system. Ten years ago most people in Germany would have said that it would be impossible to integrate 10 percent of renewables – today they are at 30 percent. In my own country, Ireland, it’s 25 percent. Those drivers are going to remain, but their balance will shift. I think we will be seeing a move away from the importance of the government mandate and toward costs and technology.

JK: And both technology and the cost of that technology is where industry is flexing its muscles. Electricity demand is growing rapidly and CO2 emissions have to be reduced. These two counter-trends can really only be addressed by technology – front-end renewable technology per se and the associated technology that supports it. In-depth knowledge of renewable power generation technologies and experience installing these around the world are required to serve the renewable energy industry. This comprehensive approach will become ever more significant as the renewable business continues its rapid evolution.

ABB Review: Where is the government mandate coming from? Environmental concerns?

GR: Yes. If you take the case of Europe, there would never have been such a massive build-out of renewables without a green movement that pushed in terms of legislation on pollution and emissions.

ABB Review: With the new technology becoming so affordable, do we still need continued government support in Europe?

GR: The power markets as we know them are broken. No generation of any type can be built without some form of very clear regulation in place. The reason is that, in Europe, you are not going to get your capital expenditure back, except maybe in the United Kingdom. Without that return, there is going to be no investment in power generation. This is why renewables – and energy in general – will need a support or market mechanism.

From the power-market perspective, there is a new phenomenon that renewables have brought about, namely that they have zero marginal costs. They don’t have fuel costs and the running costs are very low. A gas- or a coal-powered station needs fuel for every kWh generated and needs a lot of people to make sure that the power station just keeps working. With renewables you have the exact opposite. If a utility has a whole range of power generation assets available, when it has to decide what it’s going to take as part of its generation mix, it’s likely to use the renewables preferentially – based on the variable costs.

As we keep putting more renewables on the grid, eventually what will happen is that the wholesale price of power will tend toward zero. That can be seen in particular in Germany. The German power prices are at 30 to 35 euros/MWh (about $33 to $39/MWh). Nobody will build conventional generation at those prices because they can’t recover the variable cost, let alone the investment cost. And that’s the big opportunity that renewables have brought to the market.

Part 2 – The importance of cost of capital for renewables

GR: In terms of CAPEX, people might say the costs of solar are $1 million/MW and say the figure for gas is about the same, and so assume they are at parity. But that’s not true because what you really have to look at is the CAPEX per MWh. If a gas generator is going to run 60 per-cent of the time and a solar park is going to run 15 percent of the time, the CAPEX cost per unit generated is going to be four times higher for the solar park. If we want to get renewables onto the system, we have to get the cost of capital down.

Capital costs are going to be determinant in getting renewables onto the grid. This can have different implications across regions. For example, the cost of capital in India is almost twice as high as in Germany. However, as India has nearly twice as much sun, the cost of electricity production is more or less the same in both countries.

We’ve never had this scenario with conventional generation because we recovered CAPEX through the power price, and the power price was determined by the marginal cost. So if fuel costs went up, they went up for everybody, and so the power price went up.

With renewables, we don’t live in that world anymore. Based on the low marginal costs of renewables, a utility or power producer can offer consumers a power purchase agreement with a set price for the next 20 years. No utility would do this with gas or coal. However, with competition in the market, a consumer can switch suppliers quickly, and thus sign only shortterm contracts. This does not align to renewables
as investors need the security of power prices to recover the capital costs. This requires a fundamental change in the way we look at power markets.

ABB Review: How must the power market be reformed to support this different way of looking at things?

GR: I think that the best way to do it is to allow the power price to determine everything.
Rather than 15-minute pricing we will need one-minute prices. If you price on a minute basis you get a lot of volatility in the power price, but that would mean power suppliers can recover their cost through that volatility.

JK: In my opinion, this approach may indeed help to give incentives for demand response or other dispatchable types of generation, but I do not see how this will help the renewables. The reason behind the current market mechanism in which the power price is determined by the marginal cost is that it delivers the lowest operational cost to run a given group of power plants. The task of particularly spot markets is to determine the optimal load dispatch. This task is becoming obsolete in a system with zero marginal cost.

Therefore, short-term markets will not be an adequate tool anymore. We already see different market approaches in other fixed-cost dominated markets, such as telecommunications. We see flat rates and incentives to sign longer-term contracts – admittedly two rather than 20 years. In this case, competition is indeed strongly determined by the cost of capital.

GR: Another approach to the market is that you give a regulated return to the owners of renewable assets, which in some cases is happening already. But one way or the other, radical changes are required. Recent attempts at reforming the market have just been about tinkering. We need far more radical restructuring.