Complexities grow with liberalisation

The deregulation which is sweeping the EU`s energy sector has opened up opportunities for players old and new, particularly in industrial generation. Yet this is a complex market with many pitfalls and it is not getting any easier.

The liberalisation of the EU`s electricity market was always thought likely to damage the volume of industrial power generation equipment sales. Liberalisation brings generation and supply competition, which in turn lowers electricity prices and reduces the requirement for self-generation as a cost saving initiative. But, as shown in Figure 1, there are a host of factors that influence this basic model.

Regulation

Regulation on industrial power, and in particular sales of surplus electricity to the grid, vary considerably across the EU. The ability to sell excess electricity to the grid has been the primary driver behind on-site industrial power projects throughout this decade. Although regulation is not geared towards this in all countries, for example when industrial generators are forced to pay high prices for electricity from utilities when they suffer a shortfall, the 1990s has clearly been the decade of industrial power.

Most excess electricity prices are based on an avoided costs calculation, which means the industrial generator is paid on the basis of how much the utility would have spent on generating the amount of electricity sold. Although this sounds like a rough deal for industrial generators (i.e. they get the cost of sales, but unfortunately no margin) this is generally not the case. Many of the European utilities are relatively inefficient and have to run expensive plants, especially in the case of nuclear power.

If this were compared to the running costs of a small gas-fired cogeneration plant, the cost comparison would be quite different, especially when the benefits of process steam and lack of transmission losses are taken into account. Although in France prices are based on the avoided costs of a CCGT, this is generally not a common practice in Europe.

The development of price is therefore set by regulation rather than market conditions, but certain developments are more or less sure for most countries:

•Avoided costs prices will fall as utilities become more efficient

•Utilities will continue to fight what they see as benefits to their competitors

•Regulation is likely to become much less generous as competition bites.

This all points to one conclusion: surplus electricity prices will fall. This will impact on the industrial power plant industry because much of the current business relies on excess power sales. Certainly many industrial generators have invested in power plants bigger than they otherwise would due to the possibility of excess power sales, and some industrial generators have now reached IPP status due to the size of their generating operations.

This will have to be scaled down if excess prices fall, or even if there is uncertainty about how they will develop, unless the industrial generator intends to move into the electricity generation market wholesale.

Excess prices are not expected to fall as fast as utility prices in most markets as they ultimately depend on regulation rather than competition. But utilities such as Enel and Endesa, which are forced to buy excess electricity, are putting severe pressure on their governments to ensure they get a fair deal.

Energy management

Contract energy management (CEM) has emerged as a market of growing importance in liberalised energy markets such as the UK. Many industrial companies have benefitted from the provision of low cost power and steam, whilst leaving the CEM company to handle the excess power sales – a complex process in even the most deregulated of markets. The CEM company will source equipment suppliers, cogeneration packagers and engineering contractors to construct the plant, handle the operations in addition to helping with the financing.

Cogeneration packagers can either supply packaged units to the end-user who, if they have the technical expertise, will install them. Alternatively, the companies may install these units themselves or sell them to CEM companies. Generally, in the small-scale market there is little evidence of CEM and in most cases the unit is bought outright, although the cogeneration packager company may provide help in arranging finance.

Although CEM is generally more popular in the large-scale market, it is a useful way of gaining business in the small-scale market. Not all companies will necessarily want to invest in cogeneration equipment outright and the opportunity to make savings without this initial capital expenditure will be attractive to some users.

In the larger scale market, cogeneration units are tailored to suit the needs of individual clients with the result that there is little room for intermediary packagers. In this market, CEM companies have gained a lot of ground. They are able to conduct feasibility studies on demand profiles and then design and implement tailored packages. They source equipment from a variety of suppliers and will also subcontract the engineering work to specialists.

Their real advantage comes with the negotiation of electricity and heat supply contracts. These contracts will take various shapes. Typically the client purchases the fuel and receives the heat output for free. The electricity is purchased from the CEM company at a price related to, but lower than, the pool price. Some contracts will also include a factor for inflation as, although pool prices may not rise in line with inflation, the CEM company`s return on investment is linked to price change.

If the CEM company purchases the fuel, it will link the heat tariff to the fuel price. In addition to knowledge about these contracts, the CEM may also have the ability to provide the gas to the site and top-up power from the grid. This is particularly important as, in some cases, investment in cogeneration has been halted as a result of the problems associated with sourcing electricity from the grid on a requirement basis.

Contract energy management is less popular elsewhere in Europe than in the UK, but there are signs that the market is picking up. The development of an electricity pool in some European countries is an important step towards this as it allows the CEM company to provide power to its client on something other than a fixed power purchase agreement.

New market entrants

Liberalisation of the EU electricity industry has led to a flood of new market entrants into the power generation industry. From the EU`s leading IPPs to large industrial players and fuel suppliers, the market has become a battleground for some of the world`s largest companies. This affects the industrial power market in two major ways:

•Some large industrial companies are entering the generation market wholesale

•On-site projects are becoming sponsored by generating companies rather than industrial companies.

The electricity generating market is viewed by many industrial players as an attractive way to diversify their concerns. It has lower competition and higher margins than the core industries most companies operate in and can be entered with relatively low risk. The industrial power plant is no longer just a vehicle for cost savings but for revenue gains and a number of companies have been quick to spot this opportunity.

Although large investments are required, entry into the market can be considered relatively low risk as industrial electricity prices would have to fall to cost levels before the cost savings element of an on-site plant is lost – a situation that remains unlikely. Players such as Shell in the UK and Akzo Nobel in the Netherlands have already set up generation subsidiaries to handle this transition and other possibilities.

The second factor follows a shift in utility strategy. How utilities will deal with competition and demands for lower prices from their customers will be crucial to how the equipment market will develop over the next five years. One thing is certain, however: in order to offer electricity at significantly lower prices, lower cost generating capacity will have to be invested in, whether it be utility or on-site.

To support the price falls expected in markets like Germany and Austria, utilities will have to build cheap, probably gas-fired, generation of their own or help their major industrial clients to build on-site plants capable of taking the excess electricity. IPPs will also come into the equation, and will therefore build plants in conjunction with major industrial clients.

This will enable them to obtain a guaranteed outlet for some of their power and sell the excess under whatever regulatory regime operates in that country. Italy is one very good example. To build up Italy`s low base of installed capacity excess electricity sales to the utility Enel were generously priced, leading to a swathe of IPP/industrial CCGT projects, supported by the power purchase agreements.

In Germany, RWE announced last year that it would build, own and operate an 450 MW CCGT to serve Bayer. This type of project is expected to provide a large amount of the new build market in the EU`s power generation market, particularly when EU utilities start to encroach on each other`s markets.

This strategy is even more clear in Belgium, where Electrabel has positioned itself as a `cogeneration partner` and is involved in almost all but the smallest of industrial projects. The strategy that Electrabel is undertaking, is to take a leading role in on-site power development rather than trying to prevent it. Electrabel is now positioned to act as an energy partner for industrial companies which require cheaper supplies of electricity and steam.

In this manner Electrabel is better placed to prevent IPP competition, which often depends on some form of on-site takeoff to be economically feasible. By wearing the clothes of the IPP (i.e. helping to finance on-site projects and dealing with the excess electricity sales), Electrabel will present a formidable competitor for project developers like those found in Italy and the UK.

With Electrabel now actively encouraging on-site power generation rather than fighting it, a rush of projects have started to go ahead.

By European standards installed industrial generating capacity in Belgium is very small, and has actually fallen this decade. This, in combination with Electrabel`s new status as a cogeneration `champion`, should give rise to an increase in orders for small industrial CCGTs and cogeneration schemes.

As deregulation and competition develops across the EU electricity market, there will be less `traditional` industrial projects. The standard industrial project has almost died and most projects are now arranged through CEMs or with utilities or IPPs. Although there will still be many utility projects going ahead, many more joint ventures such as the one between Enel and Enron are expected to reduce the importance of `traditional` utility projects.

Cogeneration potential

Cogeneration has many advantages over other industrial power technologies but one in particular has driven this technology to its premier position: beneficial regulation. Most governments across the EU encourage cogeneration in some form or another and most countries have a body that represents cogenerators, equipment and service suppliers, and lobbies on behalf of technology.

Cogeneration has long been recognised as a technology that makes highly efficient use of the different fuels it uses. Over 90 per cent global efficiency can be obtained if the heat generated by the combustion process is also utilised. In industrial applications this is generally harnessed as process steam, which has to be produced separately if it cannot be produced by cogeneration, or bought independently.

In countries with advanced district heating networks, it is possible for cogenerators to sell the heat they produce to district heating utilities, although this is a more complex process than selling excess electricity. In industrial applications where process steam or heat is required, this means that cogeneration will provide extra benefits to the investor outside of electricity savings and excess electricity sales – the primary reason behind the prevalence of this type of technology.

Increasing availability of natural gas and the introduction of new generation products has also given the market a boost. Lower emissions from gas-fired generation (coal or oil fired cogeneration is more fuel efficient, but will still produce the same amount of CO2 for the same amount of electricity). Meanwhile, high technology products have combined with improved services from cogeneration packagers and contract energy management companies to give rise to high levels of investment across the EU.

Unlike CCGT technology, cogeneration is almost universally popular everywhere, with all countries in the EU having at least some industrial cogeneration capacity. The same cannot be said of any other power generation technology.

Scandinavia, Germany and Austria in particular all have a large amount of electricity produced by cogeneration in both the industrial and utility sectors.

Furthermore, the use of biomass has been championed in these regions. Biomass produces little in the way of emissions and is often considered to be a renewable energy source, although it is far less energy- intensive than fossil fuels.

About Datamonitor Industrial

Datamonitor Industrial, formerly known as MarketLine, is a global research and analysis company specialising in the power equipment and energy industries. Datamonitor Industrial publishes a wide variety of market information reports on the power generation, transmission and distribution industries based on primary research and significant expertise in the area. Datamonitor Industrial can also offer tailored research and analysis services. Contact:

Michael Jones

Datamonitor Industrial

16 Connaught Street

London W2 2AF, UK.

Tel: (+44) 171 624 2200.

Fax: (+44) 171 372 0130.

mjones@mlint.com

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ƒ Figure 1. Factors affecting the basic model for industrial power

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Figure 2. Regulation indicators for EU industrial power markets

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Figure 3. Industry is a big user of cogeneration