Critical consolidation

Security of supply has become a critical issue in Europe’s electricity markets, helping to cultivate conditions ripe for a new wave of consolidation.

Siàƒ¢n Green

“The key question is clear: the UK faces a profound challenge in the energy field as it moves to a low carbon economy with secure sustainable supplies,” said Malcolm Wicks, the UK’s Minister of State for Energy, speaking at the inaugural Energy Summit hosted by the Engineering and Physical Sciences Research Council (EPSRC) in London. “We face a number of complex issues and hard choices.”

These challenges and choices are not unique to the UK. “Energy is the world’s biggest industry,” commented Professor Sir David King, the UK’s Chief Scientific Advisor. “It is about to undergo the biggest transformation ever seen as it tackles the issues of CO2, price control and security of supply.”

The Energy Summit is part of a new Energy Programme in the UK that will see closer collaboration academics and industry to overcome the challenges that the energy industry faces. Perhaps the most pressing of these is security of supply.

“Security of supply is a major issue [in Europe],” says Bill Easton, head of centre of excellence of utilities market restructuring, Capgemini. “[In the electricity market], spare capacity has been used up and there is a need for sustained investment in new capacity.”

The tight balance between supply and demand in Europe’s electricity market is one of the key findings of Capgemini’s latest analysis of the region’s energy markets. In its report, European Energy Markets Observatory, Capgemini reports that investment levels have continued to decline, leading to huge tension between supply and demand. According to the report, the average generation margin in continental Europe in March 2005 was 5.8 per cent compared with 5.5 per cent in October 2003 and 5.4 per cent in December 2002.

Capital expenditure by European utilities has fallen, adding to tight supply margins in the region
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The lack of investment has been compounded by rapid growth in electricity consumption in Europe in spite of the subdued pace of economic growth. French electricity consumption growth reached 4.3 per cent in 2003 and 2.1 per cent in 2004; in Spain and Portugal the 2004 growth registered at 4.1 and 5.6 per cent respectively. In the UK it amounted to 5.5 per cent.

The current margin is dangerously low, says Capgemini, considering that industry associations recommend minimum margins of five per cent in order to overcome exceptional weather or generation problems. The low margins in electricity are compounded by tensions in gas supply caused by growth in demand and depletion of UK field reserves. In the short term there are fears that the lights could go out in the event of a winter ‘cold snap’, while in the long term, Russia’s strong supply position is of great concern.

Although Norway’s and the Netherlands’ North Sea gas production levels have risen, the stronger integration of Eastern European countries, with a 71 per cent reliance on Russian gas, means that Europe’s reliance on gas imports is growing.

Capgemini’s report notes that although spot electricity prices declined overall in 2004, tight margins pushed prices up on the European exchanges during cold winter periods and in areas where supply is particularly tight. For example, Italian prices were significantly above the continental European price with an average of €50/MWh, and dry weather in Portugal and Spain also pushed prices up.

Overall, there is an upward trend in electricity and gas prices and this will continue in the future, says the report. Contributing to this are tight supply margins, the sharp rise in CO2 prices and high oil prices.

Following a wave of consolidation in the European utilities sector some five years ago in response to the onset of competition and deregulation, the major players have been focusing on strategies to improve performance and profitability. This means that balance sheets are healthy and utilities could be in a good position to invest.

“Most utilities have implemented major performance improvement programmes in order to reduce their cost bases,” notes Easton. Utilities have focused on core activities in European markets by divesting telecom and other business elements, and launched major cost reduction programmes, for example €2bn for E.On and €7.5bn at EDF. Most significantly, they have reduced capital expenditure. According to Capgemini, the investment/turnover ratio has fallen from a peak of 10.3 per cent in 1998 to less than 5.5 per cent in 2004.

Overall state participation in the utilities sector has declined, with only EDF and Vattenfall remaining state owned. This, together with growing competitive forces and healthy balance sheets, mean that conditions are ripe for a new wave of mergers and acquisitions, as illustrated by Gas Natural’s bid for Endesa. Increased M&A activity will challenge regulators, but will not solve the supply problem.

Generation investment decision requires a degree of confidence in the revenues of future plant output. According to Capgemini, although price trends are encouraging, banks will be reluctant to lend to IPPs without some form of PPA. Private investment may therefore be slow to emerge, aggravating the supply situation.

Nevertheless, new capacity is being built. Spain has added 11 000 MW of new capacity and 7500 MW of new capacity will come on line in Italy this year. Capgemini notes that the tight supply margins provide an opportunity for utilities to expand in overseas markets, and many operators are looking to asset management techniques to improve availability. For the long term perspective, the nuclear debate has become a real issue for securing supply, and France and Finland have taken leadership roles here. However, it seems that for now, the real challenge for utilities is to translate the market signals in to strong, long term investment plans.

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