Great Reform act

New risks from EMR equal new opportunities. Jim Fitzgerald and Marc-Felix Otto say Europrean experience shows the market will react to change and new investment potential will emerge

As details of Electricity Market Reform (EMR) continue to emerge, and despite important details still missing, investors are starting to consider how investment in the UK power sector could meet their requirements. The package of measures contained within the Energy Bill includes carbon price support, a capacity mechanism, Feed-in-Tariffs with Contracts for Differences (FIT CfDs) and emission performance standards (EPS). Each of these will fundamentally alter the risk profiles investors face, in some cases increasing and in other cases reducing exposure.

For investors in low-carbon generation, the most important EMR measure is the FIT CfD. New risks are likely to be placed on intermittent generators such as wind and solar, which have not been present in the UK before – namely imbalance and basis risk. A similar payment structure and risk exposure already exists in the German market.

Since 2012, generators eligible for support under the Erneuerbare-Energien-Gesetz (EEG) have had the option each month of earning revenue either through a traditional fixed feed-in tariff or alternatively through selling output directly into the wholesale power market and receiving a top-up to the EEG-levy. Generators are compensated for the additional costs incurred in selling output directly into the wholesale market, and bear the forecasting risk, although the initially generous level of compensation has recently been reduced. More than 70 per cent of all German windfarms have since opted to sell their output directly in the wholesale markets.

The EEG top-up levy pays the difference between the EEG price and the average monthly price of the European Power Exchange. In a similar way, the FIT CfD will pay the difference between the strike price and the Market Reference Price (MRP) when selling their output. The MRP will be an index based on the price of power in the GB Zone of the future North West Europe coupled market.

However, as under the EEG levy top-up structure, the MRP element will be subject to considerable uncertainty. Wholesale market prices are forecast to become more volatile, and low-carbon generators will become responsible for selling their own output into the wholesale markets, assuming long-term power purchase agreements (PPAs) continue to remain unavailable to independent generators. The ability of a generator such as a windfarm to sell all of its output at or above the MRP will be uncertain (basis risk). In addition, generators will be exposed to imbalance risk in cases where they produce too much or too little energy within a half-hour period compared with the nominated volume.

Mitigating basis and imbalance risk will be dependent on three main factors. First, accurate forecasting of the output of the generator up to gate closure (one hour ahead) is required. Second, development of a trading strategy that maximises capture of the MRP for the output, through optimisation of selling the power on forward markets as well as day-ahead and within-day, while also avoiding exposure to Balancing Mechanism costs.

Third, there must be 24/7 control of the asset to actively manage the output of the generator in cases when market prices fall below the CfD top-up component – in effect making renewable generators dispatchable generators. In summary, both the UK CfD and German EEG levy top-up place strong incentives on renewable generators to better forecast their energy output.

Investors are now considering the business opportunities arising from pricing and mitigating these risks. Risk can be mitigated by investment in higher accuracy power generation forecasting software systems, 24/7 trading desks and optimisation of generator outages through operations and maintenance cycle planning. Renewable generators can undertake these activities themselves in-house, or through trading service agreements or short-term PPAs with third party service providers.

New business models are already developing in the UK under CfDs, as they have done for the directly traded EEG in Germany, where existing wholesale market traders provide risk management and market access services to wind generators. These existing wholesale market traders can add the output of renewable generators to their portfolios of gas and power physical and contractual assets. The extrinsic and intrinsic value of these assets can be significant, especially for traders seeking to diversify their energy portfolios from other commodities such as gas. In the coming months, investors can expect a process of price discovery for these services and capabilities, as the Energy Bill is passed and implemented in detail.

Investors are also expecting new business models and opportunities to develop in response to other Energy Bill measures. The capacity mechanism, carbon floor price and emission performance standards are all expected to improve the economics of demand-side management, distributed generation, energy efficiency and smart grids.

A myriad of new business models, services and technological innovation is expected to meet these new opportunities, just as they have done elsewhere in Europe. Combining distributed generation (such as micro-CHP) with flexible demand (such as demand-side management) and energy storage (such as photovoltaics with batteries) can create virtual utilities and micro-grids.

Aggregation and asset optimisation will allow the creation of new revenue streams for energy customers by selling energy back to the grid or altering energy usage patterns in response to market prices. And energy management services, in particular helping customers reduce bills through smarter use of energy through environmental and other measures, will become a key success factor for all players in the market.

Based on their experiences in the UK, Germany, Holland and elsewhere, investors are expecting fierce competition in this new market. Nimble new entrants can be expected to continue capturing market share through offering cost-competitive and innovative new products and services. Incumbent utilities, however, will remain a critical part of the energy sector because they are unique in having the technical, operational and management structures needed to make these new business models a success.

Investors are mindful that speed has been a key success factor in other European energy markets. The experience in Germany under the direct marketing EEG has been that the more complicated – although initially more profitable – new regime has been adopted more quickly by local players who followed the legislative process more closely. With windfall profits of that new regime now decreasing, it becomes obvious that speed was a key success factor. That might also be true for the EMR.

Jim Fitzgerald, associate partner in London and Marc-Felix Otto, partner in Zurich, The Advisory House

CfDs leave marine renewables all at sea

The jury’s out on whether CfDs will increase investment in marine renewables, writes Andrew Williams.

The government’s Electricity Market Reform (EMR) measures (in particular Contracts for Difference (CfDs)) will fundamentally alter the way marine renewable energy is supported in the UK – and hence its ability to attract investment.

Andrew Perkins, partner, lead advisory – environmental finance at Ernst & Young, expects the CfD regime will reduce the risk on energy generation revenue. He says: “We need to ensure that this move takes place in a way that supports the development of renewable technologies – including marine – which have the potential to be cost-competitive over time and play to established UK skills and infrastructure.”

However, rather than nurturing such development, David Krohn, wave and tidal development manager at RenewableUK, argues that the EMR process is “injecting a huge amount of uncertainty” into the wider renewables market and making it difficult for projects to secure investment. He warns that a number of issues relating to contract length, strike prices and a “clear route to market” have not yet been adequately resolved. But he admits that if government addresses the concerns of industry and provides a plan that works to encourage investment: “[The CfD regime] holds the potential to catalyse real growth as it provides a higher level of price certainty than the Renewables Obligation regime, which was variable and prompted investors to use worst case scenarios when making investment decisions.”

Meanwhile, Gaynor Hartnell, chief executive at the Renewable Energy Association (REA), says EMR “poses a great problem for wave and tidal”. In her view, the main challenge to the sector will emerge when competitive price-setting is introduced to the CfD process. Although it is currently unclear exactly how this will work in practice, Hartnell points

out that renewables will begin by competing against each other in “technology bands” before eventually competing against all other low-carbon options.

“Unless marine renewables’ costs have come down to the extent that they are competitive with other options by that time, the prospects don’t look good. The sector may need to convince the government of the day to implement an industrial strategy, if it is to be a significant technology of the future,” she says.

Within the marine renewable energy sector, Hartnell says that the first reaction to the ongoing EMR reforms was an “entirely predictable” aversion to the upheaval process. Most REA members are focused on ensuring their projects are commissioned before the end of the Renewables Obligation scheme – with “few understanding the details of the EMR proposals”.

Krohn agrees that the industry remains “highly sceptical” about the EMR process due to the fact that “very little detail” has emerged about how the whole system will work.

Meanwhile, Andrew Horstead, head of commodities research at Utilyx, points out that while the concept of using CfDs to support investment in wave and tidal energy projects is “broadly accepted”, the chief concern is the level of support these technologies will attract. “This lack of strike price clarity is a common area of concern, and our experience from the developer community indicates an increasing level of scepticism that the reforms will deliver what the government hopes to achieve,” he says.

“With so much emphasis being placed on nuclear, it is the small guys who could be overlooked. The government must urgently agree the rules and guarantee a price for electricity if it is to persuade the private sector to invest in low-carbon and renewable forms of generation,” he says.

In contrast to this relatively downbeat assessment, Ronan O’Regan, director of energy and utilities at PricewaterhouseCoopers, says the marine renewable energy industry is now “broadly behind EMR”, although he admits that some concern remains about the amount of work still required to deliver EMR for mid-2014.

“If an objective of CfDs is to attract investment into both operational and construction stage assets, then for technologies that still have high levels of perceived construction risk, such as offshore wind, where this risk all remains with the developer, these projects will not be attractive to institutional capital until they become operational,” he explains.

Looking ahead, Hartnell says: “The most pressing need for investors is reassurance about the route to market.” Perkins adds that, if EMR succeeds in improving investor confidence on returns in the UK market, there is a “real opportunity” for UK marine renewables to prosper.

Andrew Williams is a freelance journalist

This article first appeared in Utility Week’s print edition of 26th April March 2013.

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