The politics of power and Europe's energy evolution

Simon Hobday, Partner at Pinsent Masons and Advisory Board Member for POWER-GEN Europe considers the complex factors shaping the evolution of Europe's power markets and the operational and commercial impacts seen so far

Simon Hobday, Partner at Pinsent Masons and Advisory Board Member for POWER-GEN Europe considers the complex factors shaping the evolution of Europe's power markets and the operational and commercial impacts seen so far


Market uncertainty has been a given in the European power industry for as long as the private sector has been involved. Significant political uncertainty however, is relatively new to the energy business, and is not only resulting in a degree of reluctance to invest, but raising a number of questions around political risk that many in the industry never expected to see in Europe.

A growing number of banks, for example, are now questioning the market basis on which to model investments and hence what will make worthwhile investments, with the whole mind-set having changed because political uncertainty has altered the dynamics of the industry time and again over the last five or six years. Subsidies, for example, have been introduced, increased, reduced or even withdrawn with limited notice. There have also been numerous changes of policy regarding the type and manner of generation incentivisation.

So while market uncertainty is a given, and markets are adept at harnessing technological change, difficulties have in the past few years arisen from political uncertainty and the framework within which the markets are meant to operate. Stakeholders in many cases aren't clear whether they are going to be playing in the same game tomorrow as they are today, and with limited or no confidence in the business model being invested in, it is not surprising to see a reluctance to invest.

A question of incentives

By their very nature, subsidies are an intervention in the market. The moment you move away from a market driven solution there is a distortion in what the market does and how it operates. The greater the level of distortion (ie subsidies) the more the effectiveness of the market model becomes a question of whether the subsidy is achieving a social/political goal rather than delivery of the underlying product in an economic efficient manner. Thus, where questions start about the affordability of the subsidy, what is actually being questioned is whether the mechanism for achievement of the social/political goal, or indeed the goal itself, is valid given the costs incurred in achieving it.
The experience of Germany is perhaps illustrative of this. The subsidies Germany has over the past decade provided have been incredibly successful in promoting renewable power and increasing the penetration of solar and wind in particular into their generation mix. However, questions are now being asked around the wider consequences in terms of cost of energy for domestic consumers and potential impact for industrial users. The imposition of subsidy costs as well as the effect on the transmission system of the large amount of intermittent generation on the North German coast are also cause for concern. It is not clear that these effects were anticipated at the time the original subsidies were designed. This scenario (and others like it) is now the topic of debate across tracts of Europe. When you promote one particular form of generation, there are inevitably unintended consequences, one of which being that the overall quantum of it works out far worse (or better depending on the point of view) than was anticipated – for example, intermittency.

The cost of intermittency isn't just the subsidy support for the particular intermittent generation in question, it's also the consequential costs around grid reinforcement, congestion, potential maintenance of reserve capacity and the role of storage in the market and how to pay for that; essentially how to keep the lights on when intermittent sources aren't generating power. Although direct costs are associated with a subsidy intervention (i.e. Eur per MWh produced to the generator), these are not necessarily the same as the overall cost of the intervention, and one could argue that this overall clarity as the full economic costs of subsidy has to be fully appreciated.

At the same time, the question of when a subsidy for a specific source of generation should be stopped is purely political. Certainly, it is to my mind essential to manage and reduce carbon emissions, given the detrimental impact of unconstrained pollution has had across Europe over the last 50 years with effects ranging from spanning acid rain to "dead" rivers and worse. But whether or not current incentives are producing the most efficient economic way to reduce carbon is another matter.

Germany's experience

The fact is that if you are moving away from a pure merit order dispatch model for generation and intend to give preference to certain technologies in preference of others, there are consequences. Irrespective of where a plant is in the merit order stack, at an underlying level the cash flows and earnings need to work to support the necessary power generation to meet the demand and/or incentivise demand side response as an alternative to generation.
In terms of the electrical system within Germany, a large number of wind farms have been established across northern coastal areas, placing increasing strain on the transmission systems of Germany and the ‘bootstrap' corridors either side. This strain is due to the way in which the physics of wind power generation works: where wind speed varies in a short period of time in northern Germany, the concentration of wind generation affects voltage control and grid stability, with knock on effects on and fluctuations in pricing.

For example, on Christmas Eve 2012, an unseasonably warm sunny period in Southern Germany combined with moderate levels of wind saw power prices of about minus two hundred Euros per megawatt hour for power. Given the increasing interconnection of European power markets, this type of fluctuation doesn't just affect Germany's power market, but those of surrounding countries, because power prices interact with and flow across neighbouring countries and linked markets.

In addition, Germany's Energiewende has signposted the accelerated end of nuclear generation in the country, although the phasing out of nuclear had been a feature before the announcements in spring 2011. The alternative to nuclear generation promoted through the Energiewende has been a greater deployment of renewables. This has given huge impetus to a range of generation projects which is likely to increase the level of intermittency and has already given rise to questions around the ability to run gas fired plant economically without some form of capacity support. In the meantime, the drive towards renewables is placing Germany (and bordering countries) at the forefront of a number of technological advances in intermittent generation – both renewables and storage technology as well as looking at market design. Although it is still too early for there to be lessons learned, other countries in Europe will be looking to draw reference from Germany's experience.

Capacity markets and interconnection
While Germany is exploring implementation of a capacity market, given the more advanced nature of the market reforms in the UK there will be a natural tendency for countries to first look at how the introduction of the UK capacity market progresses. Capacity market mechanisms are designed to provide payments to cover fixed costs in order to maintain flexible generation sources with the aim of ensuring security of electricity supply through sufficient reliable capacity being retained in place to meet demand.

An alternative to securing MWh through plant supported by a capacity market, is to transport power from one region with a surplus to another which is in need. This is one of the key aims of the move to a single European market in electricity. However to achieve this, two key requirements must be in place: there must be sufficient physical transmission links, known as ‘interconnectors' between member states to for flows of power; and there needs to be sufficient free capacity on the interconnectors to enable power trades across boundaries based on efficient market-based mechanisms or fully integrated control systems and market mechanisms across national boundaries.
Interconnectivity comes down to a mixture of different issues. One is the physical interconnection: if you are looking to have a market that spans areas with limited connectivity between them, say three direct links each of 100 megawatts, with an overall installed capacity of 70 GW you can't get the power flows to allow a proper market price signal over the wider area.

A further issue is that legal and regulatory differences create barriers as do technical standards. Barriers can also arise from localised vested interests which can range from the political and regulatory, right the way through to commercial. For example, if you have a market in which you are particularly strong, a logical business response may be to drive change forward aggressively to get first mover advantage, or fight hard to retain what you've already got.

These types of issues influence behaviour of individuals and entities in the sector, and hence those of the markets themselves. As such, interconnectivity, energy independence or unification all comes down to the same question: where is the line drawn on interconnectivity and independence? At the same time, any answer has both economic and political ramifications, with security of supply also coming into the equation.

Optimising technology

There are a number of elements impacting on the objective of greater interconnection of Europe's power markets while ensuring self-sufficiency and meeting targets on renewables. While hydrocarbons have many uses in today's industrial society, in practice, energy independence is generally viewed in terms self-sufficiency in primary energy production rather than usage of hydrocarbons or other energy products as the base material for products.
Secondly, different power generation technologies have different operating characteristics. Wind as a technology is good in areas where there is an unobstructed wind flow with a degree of wind stability, which tends to mean coastal areas. Meanwhile, gas-fired generation is flexible but the gas has to be piped to the location. Some countries around the North Sea area have indigenous gas, but others in Europe have to import it. Gas is also a much more environmentally friendly technology than burning oil, coal or brown coal.

Interconnectivity provides the ability to optimise the use of renewables in respect of local conditions (e.g. good offshore wind, or high potential for solar PV) and spread the risk posed to security of supply by external events – at a basic level, if the level of interconnection is sufficient in terms of capacity and geographical size, power can be transported to where it is required should there be no wind or if the sun doesn't shine in one particular location.
The ability to draw in power from other areas will be limited in locations with limited or nointerconnectivity. Thus if such areas have significant intermittent renewable penetration, they may need to be proportionately greater additional plant to be built to provide backup. Conversely, in larger well connected areas, the risk is more distributed because alternative sources of supply are more readily available.

On the cusp

With a number of blackouts or grid events in southern Germany, Italy and Switzerland in recent years being linked back to issues with grid stability, it could be argued that the risks posed by renewables have already materialised. As the share of renewables increases, inevitably there are changes in how the grids are being required to operate, because of intermittency and voltage interruptions.
However, the industry is also on the cusp of a technological revolution with the intelligent management of power consumption through a ‘smart grid'. This encompasses the introduction of intelligent management of energy consumption and localised or distributed generation where it is economic to do so.

Control over end-point consumption will enable a form of profile shifting, so that where there is a peak on demand, it will be possible instead of producing more power to reduce demand to maintain system stability in real time and to earn income from the turn down. There is potentially a whole new disruptive model of energy networks and systems on the horizon, enabled by hooking up smarter controls, computing power, and realising the value of power through trading around the greater volatility of power production and hence pricing.

The NINES (Northern Isles New Energy Solutions) project in the Shetland Islands is a good example of how different technologies can work together in this way. The aim of the NINES project is to intelligently manage heat and electricity demand on Shetland so that the planned replacement for the diesel-fired Lerwick power station (LPS) can be reduced in size, while allowing more renewable generation to be connected to the system. And there are other examples where even more radical ideas could be put into action.

To hear more about some of the ideas being considered, as well as the critical issues forming the heart of business and political discussion, the forthcoming POWER-GEN Europe conference being held in Cologne on 3-5 June 2014 is the place for the power industry to meet, share information and do business. Track one of the conference looks at strategy for a changing energy sector, with a session on Wednesday 6 June dedicated to decentralised generation and system integration.

About Simon Hobday

Simon is a partner at legal firm Pinsent Masons and specialises in the regulatory and commercial energy sector. He advises energy companies, regulators, Governments and commercial customers on regulatory issues and projects. He is on the Advisory Board for POWER-GEN Europe a committee of industry leading professionals responsible for agreeing the conference programme for this events.

About POWER-GEN Europe

Being held 3-5 June 2014 in Cologne, Germany, POWER-GEN Europe is co-located with Renewable Energy World Europe and is the leading European conference and exhibition for the power industry to meet, share information and do business. Achieving the balance between affordable, clean and reliable electricity has been the defining challenge of the power industry. The European Union's transition to a low carbon future – in particular Germany's much debated "Energiewende" – has placed this delicate balancing act right at the heart of business and political discussion and become the topic for today's energy experts. Navigating the power transition will be the central theme of this year's event. For more information visit: www.powergeneurope.com

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