Anyse Sabuncu, Global Energy Decisions, UK

Higher prices, potential blackouts, missing targets for carbon and renewables. Is the outlook for the UK power wholesale market really as gloomy as this?

The electricity market is rarely out of the news – whether because of concerns about security of supply or individual power stations being affected by flooding. Additionally, there is the impact of electricity generation on the environment. Politically, there are statements on the latest government thinking on nuclear and carbon policies, and new offshore wind farms under construction – the range of topics is at times truly bewilderingly.

To provide an outlook on where the market is heading requires detailed analysis and modelling of each of the complexly inter-related major factors that affect the market now and in the future. Global Energy Decisions has just launched its latest Power Market Outlook for the British Power Market, which provides a 25-year electricity and fuel price outlook for the wholesale electricity market. It makes uncomfortable reading for those wanting a sunny forecast.

New capacity is needed as early as 2010 to prevent blackouts as old plant, including nuclear, closes. Although significant volumes of new generation are in the planning stage, this is not committed, and even if sufficient capacity comes on-line in time, significant price rises are expected as the plant mix will be more expensive to run than now.

The Large Combustion Plant Directive (LCPD) will have a major impact on the market, resulting in power price rises of over 50 per cent as relatively cheap flexible coal plants are restricted in how they operate. Power prices will be increasingly linked to continental and world gas prices as over 60 per cent of peak prices are forecast to be set by gas plant by 2015 (over 90 per cent by 2025). Current upward pressure on gas prices is likely to feed through into higher power prices.

Global Energy Decisions’ stochastic analysis of power price volatility shows that peak prices are likely to become increasingly volatile as new gas plant competes to recover its investment costs.

Carbon targets are unlikely to be hit – indeed, emissions are likely to increase over the next ten years as carbon-emitting gas plant comes on-line to replace zero-emitting nuclear plant.

The carbon allocations given to large electricity producers (LEPs) are not expected to be sufficient to cover emissions. Additional allowances will need to be bought and their cost passed on to consumers.

The UK market will be 2.6 per cent (3.5 GW) short of renewables capacity to meet stated government targets in 2010. Based on a Global Energy forecast for renewables build, this shortfall increases to 5.8 per cent (8.7 GW) by 2020.

Old versus new thinking

The underlying message forecasting tight reserve margin filled mainly by new gas plant is not a new one for the UK market. Indeed, it is an almost comforting reminder that we still operate in a traditional capacity cycle (or the more extreme boom-bust) environment, although this time it appears different as there are reduced degrees of freedom in which the market now operates. The LCPD, carbon and renewable targets, emissions ceiling directives, and other government policy initiatives all limit the options the market has with which to respond and also the speed of response. As these constraints are generally set separately by different organizations, with little prior analysis of how they interact, it perhaps is not all that surprising that some (maybe all) of the targets appear unachievable. Given the current market conditions, this is especially true when they are all analysed together.

We discuss below some of the expected market outcomes as players try to meet their obligations while maximizing their profit. Prices will rise and security of supply remains an issue.

Is the margin really that tight?

Reserve margins are about 20 per cent in the UK market – relatively high, measured against a traditional ‘planning margin’ target of 15 per cent. But this margin is expected to decline quickly because of planned closures of nuclear and old coal plant to zero by 2015 with no additional capacity. Of course, some new plant is already under construction and committed for this period – over 2 GW, including 1.3 GW of wind – and there is other plant in the pipeline (Figure 1). Global Energy estimates that an additional 6.5 GW of conventional generation is needed by 2015 and over 35 GW between 2015 and 2025 to replace closing plant. Figure 2 summarizes forecast reserve margin.

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This analysis may lead the reader to wonder whether there really is a problem with reserve margin. Fast-track planning (already mooted by the government) should solve any issues. But this standard reserve margin calculation does not tell the whole story about available capacity. Figure 2 shows the reserve margin rising above current levels from 2009 to 2015. This is necessary to maintain security of supply in the system as the LCPD will mean that affected coal plants will not in practice be fully available during this period. Indeed, by 2015, they are expected to generate only 30 per cent of their 2006 output, mainly in the winter peak periods (Figure 3). This leaves a shortage of flexible, mid-merit and peaking plant, a role that extra gas generation plays. The result is higher prices and, paradoxically, given the intention of the LCPD, increased emissions from oil stations.

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What is the impact of the LCPD?

In the UK, 9 GW of coal plant have opted-out of the LCPD rather than meet its more stringent emission restrictions, so this plant will close by 2015 and run for at most 20 000 hours until then. Our analysis shows that the impact of this restriction is surprisingly high – resulting in an increase in average yearly wholesale peak price levels of 58 per cent between 2008 and 2015 (Figure 4).

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Convergence of power and gas

The main reason for this price rise is that the LCPD affects which plant is ‘at the margin’, i.e. the plant setting the market price, particularly at peak times. Figure 5 shows the fuel at the margin during peak hours in the market. In the early years, oil plants are at the margin for 7-10 per cent of peak time, gas plant for 50-60 per cent and coal plant for the rest of the peak hours. Over time, as nuclear and coal plants retire, gas will be the main determinant of market prices, setting an astonishing 95 per cent of peak prices by the end of the period.

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Despite a forecast rise in renewables and even nuclear build in this period, none of this plant is in a position to set price as they are essentially price takers. The result of this shift in plant mix towards gas is a greater correlation between gas and power prices, and, as more and more of this gas is imported, an issue for security of supply. This is further exacerbated in winter peaking power markets such as the UK’s. Higher winter gas heating loads will mean even higher generator fuels costs in peak months.

Will new entrant plant be profitable?

Power price levels are closely related to the profitability of the underlying plant, particularly the new entry cost of the marginal plant – in this case a combined-cycle generating plant (CCGT). An analysis of new entrant CCGT plant for the UK market going forward under the Global Energy assumptions reveals that while clean spark spreads (i.e. after carbon costs) can outturn as high as £60/MWh ($120/MWh) on peak and £15/MWh off peak, a deterministic analysis of the forecast CCGT gross margin is not sufficient to cover fixed costs in the short term (£15/MWh in 2008). However, once a stochastic analysis is performed, taking into account the volatility (extrinsic value) of the underlying market and the flexibility of the asset to respond under many different market outcomes, the expected gross margin is £47/MWh in 2008 – sufficient to cover most costs.

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What are the impacts on carbon?

The UK government has committed to reduce CO2 emissions by 26-32 per cent by 2020 and 60 per cent by 2050 compared with 1990. In the context of a long-term market outlook, it is difficult to see how these targets are achievable. The UK government is committed to the closure of existing nuclear plant, which will be replaced with some renewables but mainly carbon emitting gas plant, so probably until 2020, carbon emissions from the electricity sector are likely actually to increase. The Large Electricity Producers (LEPs) will be short of the carbon allowances and will have to purchase addition allowances from the ETS scheme, which puts more upward pressure on power prices. Beyond this period, Global Energy’s analysis shows that significant carbon reduction is only achievable with 5 GW or more of new carbon-free nuclear and the fitting of carbon capture storage on coal plant.

Are renewables the answer?

Renewables are central to the UK government’s strategy of reducing carbon emissions by 60 per cent by 2050. The government has set ambitious targets of 10 per cent and 20 per cent generation from renewables in 2010 and 2020, respectively. But Global Energy’s analysis shows that despite 6.5 GW of wind on-line by 2015, we are likely to miss these targets by far. Only 5.4 per cent of UK generation is from renewables. Global Energy predicts this will rise to 7.4 per cent in 2010 and 14.2 per cent in 2020. Figure 7 breaks down how this could be achieved.

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A gloomy outlook?

There are challenges ahead for the UK power market – upward pressure on prices, tough targets getting tougher and security concerns from an increasing reliance on imported gas. Is it really gloomy? No. Viewed in a historical context, it is just part of the natural upswing in a boom-bust cycle.