UK Electricity Market Reform Gas finally comes into focus

Transcription

1 UK Electricity Market Reform Gas finally comes into focus JULY 2012

2 UK Electricity Market Reform Gas finally comes into focus Introduction A complete turnaround by the UK government on gas-fired generation since the beginning of its EMR process In early May 2012, the UK government called for evidence to help build a new gasfired power generation strategy that would set out the role of gas in the electricity market, attract investment in gas-fired generation and ensure energy security. The request for submission by the Department of Energy and Climate Change (DECC), which closed on June 28, 2012, breaks over a decade of substantial silence on gas and represents a complete turnaround by the UK government on gas-fired generation since the beginning of its EMR process. This saw the publication of the Electricity Market Reform (EMR) consultation document in December 2010, followed by the White Paper in July 2011 and a Technical Update in December 2011 among which gas was conspicuously absent. The call for evidence was the first time a UK gas-fired strategy had been explicitly mentioned as part of EMR, beyond brief remarks made by energy ministers indicating their intention to consider a role for new gas-fired power generation. Despite having initially side-lined gas in favour of nuclear and renewables, DECC has gradually come around to the important role that gas will have to play in an industry struggling to handle the cost of renewables and unable to set out a clear agenda for nuclear. Opposition to gas-fired power generation was mainly due to rapidly rising gas and hence power prices which triggered security of affordable supply concerns as the UK becomes more dependent upon gas imports. But it is becoming increasingly clear that gas-fired power will be essential for keeping the lights on. Industry participants believe that gas will play a vital contingency management role for base load supply as the government works out and implements its new zero carbon energy construction programme. As a current base case, investment in gas-fired generation will be vital for: replacing coal-fired power generation as it is phased out as part of the Large Plant Combustion Directive (LPCD) by 2016; filling the gap created as investment in new nuclear is further delayed; and making up the shortfall in offshore wind that is not forthcoming due to uncertainty over policy and operational challenges. Gas is also widely expected to play an operational risk management role in the future generation mix, providing backup supply when wind power generation fails to deliver during windless periods assuming significant investment in wind gets made. A year on since the July 2011 White Paper was published, details of how the EMR will work including key specific components such as the capacity mechanism, feed-in tariff through Contracts for Difference (FiT-CfD) for low-carbon generation, and the carbon floor price are still extremely sketchy. And crucially, industry still has no clear direction or confidence to invest. It is understood that the Treasury has now stepped into the process and raised serious concerns with DECC over the cost of low-carbon generation to the economy and to UK industry competitiveness. This seems to have brought about the focus on the role for gas in providing lower cost low carbon power generation. 2

3 UK Electricity Production by Source for Major Power Producers 40 Old coal-fired power plants used only in winter periods will come offline in 2016 what can fill the gap? 35 Electricity Supply UK TWh Jan-00 Jul-00 Jan-01 Jul-01 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Coal Net imports Oil Other Nuclear Hydro Wind Gas Chart: Gas Matters Source: Gas Strategies, DECC Over Q1 2012, supply from coal increased by 20% (6.5 TWh). Coal supply accounted for 46% of total supply, its highest level for 6 years. Supply from gas fired stations fell by 32% (-11 TWh). Gas generation in March was at the lowest level recorded since May EMR uncertainty causes investment hiatus Industry is still waiting for real details, causing a notable hiatus in investment and pushing investors away across the board EMR may be causing more short-term harm than benefit, generating confusion and skewing the industry away from practically realisable goals. But what s clear is that gas still has a strong role to play in the future energy mix, will outlive coal by a clear margin and may be a more secure proposition for keeping the lights on than both renewables and nuclear especially given the latter s controversial status globally following the Fukushima crisis in Japan, and the recent withdrawal by RWE and E.ON from the Horizon nuclear project in Wales due to significant ongoing costs in keeping the project alive as the government works out the investment agenda for new nuclear. Even clearer is the fact that industry is still waiting for real details, causing a notable hiatus in investment and pushing investors away across the board not just for new gas-fired power, but also new renewables. Capacity margins risk being lower than 10% as early as 2016, and if it doesn t act fast, government will have to either delay coal and nuclear being taken offline or risk having black outs. The government needs to encourage new build quickly and given the much shorter lead times, this can really only be met through new gas-fired plants. People are wary of investing money in the electricity market at the moment because no one can model what the world s going to look like, says Elisabeth Blunsdon, Of counsel at law firm Hogan Lovells. We ve got people looking to buy gas-fired assets at the moment and struggling to get anything beyond three years look forward, and they re buying on the chance that the medium to long-term doesn t look as bad as it does now. Blunsdon adds that investment in the gas market, as in any other, needs certainty for the future, visibility as to what the market will look like, and the ability to model pricing: all of which are currently absent. 3

4 Indeed, buyer interest is at present muted due to ongoing uncertainties over the future industry playing field, despite various UK gas-fired power stations being up for sale. The other problem gas has is that EMR and CfDs are fine, but we don t know how much of the whole market is going to be taken up by CfDs. Non low-carbon generation is going to be selling into the part of the market not covered by CfDs, and that is going to get smaller and smaller on current projections. We ve already got liquidity problems, and there doesn t seem to be any real solution to those at the moment, Blunsdon says. There is a real risk that we end up with a hotchpotch rather than a market. If we want market forces to set prices there needs to be a properly functioning wholesale market. Richard Tyler, partner in the energy and natural resources team at Hogan Lovells, notes that the current approach to energy reform is still being driven by the politically popular green agenda, which is at the heart of government policy. But trying to deliver low-carbon energy at an affordable price for the consumer is going to be a tricky equation to balance, he says. From the perspective of affordability, it is important to think about carbon-saving policies from the point of view of getting the most carbon reduction for the least money, Tyler says. Investing in gas-fired power may only be economical for portfolio players those that have wind and possibly nuclear positions i.e. the Big Six Some of the policies that we ve been following in the last five years made no sense to me if you were looking at the carbon abatement curve Presumably there will be life extensions on nuclear plants, possibly life extensions on coal plants. It s not only UK energy policy that s a mess the EU Emissions Trading System (ETS) doesn t work, it s created the wrong price signals that have led to Europe using more coal rather than less. Developing a commercial scale solution on CCS would be important, but how expensive is that going to be? Why invest in gas? Amid the confusion, mixed signals and lack of clear direction at present, the question arises as to why people would wish to invest in gas-fired generation. Investing in gas-fired power may only be economical for portfolio players those that have wind and possibly nuclear positions i.e. the Big Six. But this is not ideal for creating more competition in the power market. Independent Power Producers (IPPs) cannot justify investing in new gas-fired generation at a time when more confidence in policy and an understanding of the implications on the market is needed to encourage investment. Spark spreads, or the margin made by gas-fired power generators, are low or even negative, as power prices have been pulled down by more competitive coal-fired generation given the current low international coal price and very low carbon emissions price. Looking ahead, it is still uncertain how margins will evolve especially with the government influencing the market by setting the level of FiT for low-carbon generation, which will impact on market prices for power. Vice president of strategy and regulatory support at Statoil s natural gas business unit, Rannveig Stangeland, points out that market conditions, the regulatory framework and gas, power and carbon prices have all increased the uncertainty associated with new gas-fired generation. Financial and operational risk, particularly for independents without a customer portfolio is high, and it is likely to become more difficult for potential generation projects to take an informed view on when and at what price level they will be operating in, she says. 4

5 Confidence in the availability of supplies and infrastructure is key in the decision-making process of power station developers, therefore a stable investment environment along with liquid wholesale markets in gas and power is essential. Stangeland adds that, in Statoil s view, natural gas has all the features needed for the UK to reach its long-term energy policy goals of affordability, security of supply and carbon emissions reduction in conjunction with CCS. Further, as a proportion of gas-fired plants are coming to the end of their life following the dash for gas in the 1990s, there is a significant volume of new plants already consented although they are still waiting to be built if or when economics allow, she says. New gasfired power generation can be the solution to managing the investment, construction and commissioning risks of new nuclear and wind Increased regulatory and operational certainty, more robust spark spreads and liquid gas and power wholesale markets which support longer-term contracting will all help improve the investment environment and support the role of gas generation going forward. David Porter of Energy UK formerly the Association of Electricity Producers, says there needs to be a clearer understanding and articulation of the interactions of the gas and electricity markets at all stages in the project lifecycle. This includes securing connections and capacity, daily operations under normal and stressed conditions and contracting for additional services by the grid/network operator. A more holistic consideration of the gas and electricity markets and networks is needed to ensure efficient interactions and that the reforms work as expected with unintended consequences being avoided, he says. Transition fuel or destination supply? So what else is holding back investment in gas-fired power? How should gas-fired plants be viewed as a bridge to a low-carbon world, or a long-term piece of the puzzle? The UK cannot make the transition to zero carbon overnight or even in a decade, but with government s apparent scattergun approach to bringing on as much low-carbon generation as quickly as possible, there is a risk that it will fail to do this affordably and effectively. New gas-fired power generation can be the solution to managing the investment, construction and commissioning risks of new nuclear and wind, buying the government more time to work out how to optimally transform the industry. Furthermore, simply replacing coal-fired power with new gas-fired generation is already a big step towards reducing carbon emissions. Gas should be considered as both a bridge to a low-carbon future and as a destination fuel in achieving a zero-carbon generation target by With closure of existing coal and nuclear plants over the next decade, new gas-fired generation can fill the gap while also reducing the overall level of carbon emissions. Post 2025, when new nuclear and more renewables can eventually come online, new gas-fired plant will be more important for peak power generation. Throughout the period to 2050, Carbon Capture and Storage (CCS) technology will allow gas to remain part of the solution in a zero-carbon generation mix. However, at present, given the potential for serious delays to investment in new offshore wind and nuclear base load generation, the role for gas-fired power generation may be wrongly focused on providing back up for wind intermittency. These delays are caused by uncertainty in policy, and the government needs to take more time to think through how investment in offshore wind and new nuclear can be made. 5

6 It depends how successful we are at getting other generation capacity in place, says Tyler. As to whether gas is just a transition fuel or also a destination fuel, or whether the transition period is going to take longer than people think managing an electricity grid with much greater levels of intermittent generation ultimately requires a commercially scalable solution to electricity storage that must be the key to it. The risk around changes to government mechanisms and policies, coupled with the uncertainty in power prices levels, creates a lack of a secure revenue stream Tyler adds that a key question for encouraging new gas-fired generation and maintaining existing gas fired capacity and the question that the Capacity Mechanism is supposed to solve is what the business case might be for a CCGT working on a 30% load. Gas-fired plants currently run 60-70% of the time to provide base load power, but if CCGTs are reduced to mitigating peaks when the wind is not blowing and as part of the Capacity Mechanism then the economic justification for running those plants is similarly reduced. Statoil s Stangeland emphasises that investment in gas-fired generation is currently unattractive, not only because of the low spark spread, but due to uncertainty relating to the environment in which they are expected to operate. Clearly, investors need certainty of revenue and this is extremely difficult to predict in the current economic and regulatory environment, particularly when looking to the future, Stangeland says. There is an expectation post-emr that gas-fired plants will provide a peaking, rather than a base load service, which limits its ability to generate revenues. It is currently an unknown how often and at what price level plants will be called upon to generate. The capacity mechanism, still in its development stage, and the level of financial support it will provide gas-fired plants, is currently a bit of an unknown, but is key to the economics of gas power plants going forward. Capacity Mechanism And Flexibility in gas supply Detail for DECC s proposed capacity market remains thin on the ground. Though not explicitly mentioned by DECC, one of the key requirements for the capacity mechanism will be to finance and sufficiently compensate stand by capacity in new, more flexible, gas-fired power generation required for mitigating uncertain output from wind power generation. Given that the requirement for this backup capacity increases as more investment in wind power gets made into the future, the capacity mechanism will need to be adjusted to account for the increasing backup role that gas will have to play. The risk around changes to government mechanisms and policies, coupled with the uncertainty in power prices levels, creates a lack of a secure revenue stream and may mean gas-fired plants will not readily receive financing. The flexible backup role that gas-fired power generation is expected to play raises questions on the volatility in gas demand and whether gas can be supplied to the plant at short notice, and on a within-day basis. As the role of gas changes, plant operations and hence gas supply and power off-take contracting will have to change as well. However, the UK has unresolved issues of an illiquid power market, the lack of an hourly traded gas market, an inflexible gas supply network and insufficient underground gas storage, which will all require significant investment. However, there is currently no mechanism for guaranteeing that the secure gas supply required for backup generation capacity will be provided in the necessary timeframe and questions arise as to how a back-to-back mechanism or an obligation for ensuring power generation as well as securing the required gas supply at short notice may work. What is clear is that investment in underground storage and even additional LNG receiving capacity and storage will be required before significant wind power starts to come online. 6

7 Underground Storage Capacity compared to Import Dependency and Demand Storage Capacity/Demand % 80% 70% 60% Hungary 50% Austria Czech Rep 40% Germany Italy 30% Romania 20% France 10% Spain UK Poland Belgium 0% 0% 20% 40% 60% 80% 100% 120% Imports/Demand % Size of bubble is developed storage capacity (UK =4.4Bcm) Chart: Gas Matters Source: Gas Strategies, National Grid With rapidly declining indigenous production, UK import dependency is expected to increase from 50% to over 75% by Investment in seasonal and fast acting storage complimented by LNG will be important for managing seasonal prices and in providing flexibility in supply at short notice. The full details of the capacity mechanism are not yet known, nor are the final proposals of Ofgem s significant code review of gas security of supply. We hope that these will both provide an understanding of the market interaction under stressed conditions. Clearly we would wish to avoid a situation where the capacity mechanism rules have the potential to precipitate a gas deficit emergency, Porter of Energy UK says. As the role of gas changes, plant operations and hence gas supply and power off-take contracting will have to change as well Additionally, as Blunsdon points out, there are practical limitations to consider with the functioning of CCGTS. CCGTs are not designed to be switched on and off frequently. They can t start quickly from cold, so if we are going to use CCGT for back up, the machines will have to be on standby keeping warm, but of course keeping them on standby burns significant amounts of fuel and produces CO2. Stangeland says it is difficult to envisage how a capacity mechanism could be back to backed by a gas mechanism not least because gas plants are likely to ramp up for only a short period to respond to peak demand, with gas balanced on a daily basis. Then there is the question of how CCGTs will come to rely on the kind of responsive gas supply required to meet peak demand at short notice. Tyler notes that the UK has some short-term storage, with the potential for more fast-acting storage to be built with the right incentives but that these projects have found it hard to justify the business model. Gas contracting is going to have to change, because it s often been done on the basis of long-term contracts with a stable and high take-or-pay regime, and that s clearly not what a CCGT power plant s going to need in future. They re going to need to be able to trade their gas flexibly, and there s a question of how many of the gas suppliers who have upstream gas supplies will find that interesting, says Tyler. If we have intermittent demand for gas, we probably don t have enough underground storage to be able to cope with that. Although we have been getting increasing amounts of gas from LNG, that s not a fast reactive source of gas. The logistics of the LNG trade mean that it can take days to divert LNG ships in response to increased demand (and price) in a particular market. 7

8 Porter meanwhile points out that whether or not the UK has sufficient gas storage is a big question with no simple answer. Ultimately this will depend on, amongst other issues; the penetration of intermittent renewables in the generation mix and development of other means of meeting low-carbon generation shortfalls. Improved forecasting of wind generation will also help to make gas requirements more predictable, with longer lead time changes in gas demand easier to manage than short lead time ones, he says. Blunsdon meanwhile points out the additional concern that the National Transmission System (NTS) is not designed with intraday flexibility in mind. Physically and contractually gas is supposed to flow flat throughout the Gas Day. If everyone who s generating from gas is generating to cover gaps in intermittent renewable output the chances are they re all going to be generating at the same time, Blunsdon says. Reducing the cost of gas in winter periods through firm or counterseasonal LNG imports and seasonal storage will be key At the moment flow balances itself out, but if we find ourselves in a situation where CCGTs are providing backup generation and all switching on at once, the current system will struggle with that. Contractually it will be difficult as well. Whether that means moving to a shorter balancing period I don t know, but physically the NTS was not designed to run that way. Stangeland echoes Blunsdon s comments, pointing out concerns about whether the gas transmission system is fit for purpose in a post-emr world with more flexible generation on line, a greater diversity of supply and a greater need for within-day flexibility to meet variable gas demand. It is clear there will be a need for significant investment in certain areas of the network. In terms of process, it is for National Grid to put forward a case as part of their new price control discussions, Project RIIO, to ensure that the appropriate level of capital expenditure and rates of return are assured, she says. There may also be locational issues related to the siting of storage facilities being remote from the area of demand. Ultimately, National Grid is responsible for designing a system within the framework of a commercial daily balancing regime. A UK Security of Supply gas report and possible intervention measures are currently being undertaken by Ofgem for DECC and we wait with interest to see DECC s conclusions on the way forward. Who will carry the costs? As with any new government initiative, EMR will only truly stand up if it is able to keep the British public happy. Is there any way to prevent high gas and power prices being passed down to consumers? And can we better manage gas and power prices? The government needs to invest in reducing future gas prices by encouraging more conventional and unconventional gas exploration. Reducing the cost of gas in winter periods through firm or counter-seasonal LNG imports and seasonal storage will be key, as the UK increasingly competes with mainland Europe and global markets for supply. Encouraging more competition in the power markets by providing incentives for more IPPs to invest will create more power market liquidity and may serve to bring down power prices. What s clear is that the cost of new CCGTs, including commodity costs, is likely to be lower in the short to medium term than investing in low-carbon alternatives without a well-calculated financing and cost recovery plan that doesn t involve the hand out of large subsidies. Gas-fired generation has a clear advantage over renewables and new nuclear in terms of affordability of supply, due to the proven nature of the technology, lower capital costs, and shorter construction 8

9 period relative to other technologies. This makes gas-fired generation particularly attractive to financiers as long as policy and market uncertainty do not provide obstacles to funding. As Porter points out, the prices paid by consumers are made up of a number of elements including network and environmental charges and tax. Wholesale costs, including supplier cost and margins account for around 54% (power) and 63% (gas) of the total bill. The role for new (and existing) gas-fired generation can be clearly written as a primary contingency management instrument for mitigating risks to electricity supply Suppliers will have a range of strategies to procure the power/gas to meet their customers needs. These will include procurement from different suppliers for different durations to mitigate the impact of shortterm price spikes. Suppliers manage the risk of short-term price spikes such that they are not immediately reflected in customers tariffs. However, over time customers bills must reflect general movements in wholesale costs, else suppliers would not be able to finance their business, he says. Stangeland says it is clear that significant investment is needed, with figures quoted by Ofgem in the region of 110 billion for new generation, transmission and distribution assets to support EMR. But she adds that, with gas playing a critical long-term role in the UK energy mix with a wealth of infrastructure already in place, along with a liquid wholesale traded market projected investment costs to support UK energy requirements will be significantly lower. Gas is an economically attractive option in that technology is proven, gas reserves are large and increasing, there have been a number of recent new discoveries and we agree with both DECC and the IEA that the global outlook for gas is good. Tyler, meanwhile, says it is inevitable that the consumer will pay a lot more for electricity. What it s going to have to pay for gas depends on global supply and demand, and it s probably a more complicated question, he says. Shale gas in the US for instance is helping to keep gas prices down somewhat, although the Japanese nuclear problems are pulling them back up the other way so there are some global factors that relate to gas. Gas as contingency management After a number of wilderness years for DECC, when many industry commentators consider it to have lost its way, the call for evidence for a new gas-fired power generation strategy gives welcome cause for hope. Without necessarily compromising the low-carbon agenda, the role for new (and existing) gasfired generation can be clearly written as a primary contingency management instrument for mitigating risks to electricity supply arising from the construction and commissioning of wind and nuclear. Contingency management against the risks inherent in such large-scale transformation of an industry is a legitimate investment over the next 10 to 15 years. The role of gas as a destination generation fuel will inevitably become clearer over that period. UK Government policy now needs to be quickly brought forward in a manner that accepts this uncertainty as part of the investment in industry transition that must be supported if it is to be an investment that parties other than the Big Six portfolio players can absorb. The openness and attractiveness of UK generation for investment may now be as much at stake as capacity margins. 9

10 In the coming months Gas Matters will be discussing the issues raised in this article in more depth with the UK power and gas industry, considering the respective interplay of physical gas supply flexibility, changing financing challenges, gas contracting, developments in CCGT plant flexibility and reliability, and incentivisation on the future role for gas fired generation. We d be delighted to get your feedback and any specific views on EMR that you may have. If you d like to be contacted by our journalists to share your or your company s point of view please contact Mark Selby (M.Selby@gasstrategies.com) on If you like to find out more about the advisory services that Gas Strategies provides including in the UK gas and gas to power sectors contact Mitun Patel (M.Patel@gasstrategies.com) on or Peter Thompson (P.Thompson@gasstrategies.com) on