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Why renewables is disrupting the financing of power generation

Increased competition and transparency in the power markets have led, in recent years, to a fall in wholesale power prices across much of North America and Europe.

One of the primary beneficiaries of these lower power prices has been heavy industry which are not able to only benefit from the low power prices but also to engage in the power markets in a way that was never possible. In Europe, for instance, increasing numbers of heavy power users are trading power on the wholesale power market and using that market to hedge power price risk. The liberalisation of the power markets has also led to a whole range of next generation utilities which do not own power generation; instead they buy and sell it on a highly liquid wholesale power market. However there is one huge issue with this market based approach and that is thatcurrent wholesale market prices are now so low in both Europe and North America that they do not cover the total cost of supplying power.

This “missing money problem” comes about because the building of power stations requires significant upfront capital expenditure which needs to be financed through future revenues from power sales. With declining power prices and utilization rates thanks to lots of renewables in the system, there is little or no financial incentive to build new capacity. Now if you have a fully paid for power station, the only costs you are interested in is the incremental costs of producing power which are basically fuel costs. These costs for a modern coal or gas plant are at or above €30/MWh, and so when rival owners of similarly aged plants bid into the market they are happy do so at or above these prices, and if there is lots of competition in the market the wholesale prices tends to move towards this level.

This was not a problem in the past as utilities would simply close old and inefficient capacity, the market would tighten and prices would go up. However, now we have a huge amount of renewables in the system (much of which is not owned or controlled by the utilities) which may have high upfront costs but have no fuel costs which means that their marginal cost of producing a MWh of power is effectively zero. Renewable suppliers will thus supply this power at any price greater than zero, and what this means is that the more renewables you put in the grid the more likelihood that the price will go towards zero. We are seeing the first steps towards this in Germany at weekends where renewables often supply over 50% of weekend power needs with prices averaging €20/MWh.

In theory, there would be no problem, if power prices were allowed to rise to extremely high levels in the hundreds or even thousands of euros per MWh, when wind and solar power are unavailable. That is the level that gas and coal power plants would now require to cover their costs, given the new lower-priced environment. However, utilities doubt that policymakers would allow such price extremes.

As a result, utilities are becoming reluctant to invest in new generation under this market only system.  The average total cost of a new coal or gas power station (including upfront investment) is now higher than US or European power prices at at least €70/MWh and to make matters worse most power stations will not run at full capacity in the future (due to renewables) which means the breakeven point will be even higher!

The impact is threefold:

1. It will lead to underinvestment in power generation assets and thus increase the likelihood of power cuts and quality problems.
2. New power plants despite being more efficient than old ones could be closed. We are already seeing this in Germany, where E.ON announced their wish to closure the Irsching 4 and 5 gas plants in Bavaria, both plants of which are under four years old.
3. It may cause governments to look at other methods such as capacity payments to incentivize new generation. This however is not easy to do, as can be seen from the recent UK capacity market auction under which capacity payments totalling £1bn were given to generators to meet power demand in 2018. The issue is that only 5% of payments will actually go to new generation with the some 95% of payments (for 46.5GW) going to existing generation which would have probably kept running anyhow.

What this all means is that we are going to have a cold, hard look at our power market systems in the next years, and it is not clear what the best way to finance and pay for new generation is. Certainly, the gradual elimination of support for renewables will help reduce the continual addition of new capacity. But question remain for the situation we have now.  Will we see more market or less?  Will we see more regulation or less? Will we go continue to liberalise our markets or monopolise them again? Interesting times ahead whatever the answer.

This blog first appeared in the Energy and Carbon Blog