GENERATION

GETTING OUT OF EUROPE AT EXACTLY THE WRONG TIME

Just as many U.S.-owned power companies are packing up and leaving the European market, the power sector there faces an investment boom. Over the last 10 years, more than 20 U.S. power companies invested almost $50 billion in acquiring assets or developing independent power projects in Europe. Several more have also invested in establishing trading operations, mainly in London.

It all started in the early 1990s with Enron as an independent power producer and developed rapidly between 1997 and 2001 as U.S. companies looked for opportunities coinciding with the liberalization and privatization of Europe's power markets. U.S-owned companies built up a sizeable market share in generating capacity in England and Wales (rising from 6 percent in 1997 to 28 percent in 2001) and distribution (75 percent of network business in England and Wales in 1997). Using the United Kingdom as a foothold, a number of U.S. companies then looked to expand their operations in continental Europe.

But today almost $20 billion of those assets have been sold to mostly European companies. Many of those sellers have found European markets an uncomfortable place to do business, due to a number of factors.

• There is disappointment with the regulatory and political environment that included tough price controls and a windfall tax.
• Power exchanges are illiquid and volatile for reasons unconnected with potential shortages.
• Transmission operators have yet to agree on a long-term approach to capacity allocation and cross-border charging mechanisms.
• Gas is still sold mainly through long-term supply contracts between producers and national or regional suppliers with only limited trading breaking out at the margin.
• The future path of fuel prices and the relationship between these and the power markets is subject to considerable uncertainty.
• A limited number of incumbent power companies have dominant market positions.
• The market concentration of the European power sector overall is going up.

The rather negative view of Europe has been accelerated since the purse strings of aspiring U.S. entrants to European markets were tightened by the Enron debacle and banks' and other financial institutions' heightened credit requirements for energy companies. U.S. generators have also invested heavily in their home markets, which has contributed to a worsening cash position, both through the direct impact on their cash reserves and through the depressing effect of too much investment on U.S. power prices.

The flow of announcements from U.S. power companies that they are cutting back or winding down their activities in Europe has been steady. Still, U.S.-owned companies currently have an approximate 20-percent market share in generating capacity in the United Kingdom, the Netherlands, and Hungary. In Finland and Poland, they have a market share of around 5 percent—in all other European countries the share is below that. In the distribution sector, U.S. power companies currently own 6 of the 15 local networks in the United Kingdom, although in the supply business, only TXU still has a presence. TXU also has invested in network and retail businesses in Scandinavia and Germany.

But in the end the decisions to withdraw are based on short-term thinking only. With environmental pressure tightening on the European power sector, particularly constraints on carbon emissions, a massive investment in new power stations will be needed over the next few years to meet energy needs. Although the constraints on carbon emissions will mean the closure of coal-fired plants, U.S. companies do not own too much coal capacity in Europe so they do not have the downside of existing plant redundancy. Moreover, they can potentially benefit from opportunities to build new plants.

With more merchant project development and financing experience than European rivals, U.S. companies could be major beneficiaries of this development. They seem, therefore, to be retreating at exactly the wrong time.

Emissions to the Rescue
Although wholesale power markets are still grappling with excess capacity and relatively low power prices, this will change, mostly because of the need to meet greenhouse gas (GHG) emissions reduction goals. These goals will require a significant investment, resulting in higher wholesale power prices as the emission restrictions take effect. In particular, there is great opportunity in some markets for new renewable and gas-fired capacity.

The change to the generation mix will be achieved through a variety of different measures including

• feed-in tariffs (which provide a guaranteed purchase price for power from specified generation sources);
• green certificates (where the environmental benefits of renewable generation are commoditized and traded separately from the power itself); and,
• tradeable emissions allowances (GHG permits granted by the regulatory authorities).

Rise in Volatility
The rise in energy price volatility, too, will be marked as markets move toward supply/demand balance from the current excess capacity position, thus increasing both the probability of supply shortfalls and the influence of portfolio players.

For example, weather patterns in Europe are leading to significant volatility in hydropower and a tightening supply-demand balance. Scandinavian countries saw a doubling of power prices to nearly 24 Euros per megawatt-hour (MWH) from the 12 Euros per MWH average price in 2000. Over time, other European Union (EU) power markets will see volatile peak prices as the markets begin to work and capacity is shut down in reaction to the low earnings of marginal plants. In the shorter term, up to 2005, power prices should rise in Europe by an average of 8.5 percent in real terms, with higher-than-average increases expected in major markets such as France, Germany, and the United Kingdom.

Although cross-border trade in renewables will develop, renewable developers will seek "friendly" locations with high electricity prices and market mechanisms that do not excessively penalize unpredictable generation. This will catch out some developers who fail to stay ahead of legislative changes and wider renewable markets.

The base case assumes that the development of an EU-wide renewables market is a long way off due to the complexities of integrating disparate renewable markets and definitions. Under this assumption, the green certificate price (the difference between the marginal cost of renewable generation and competitive electricity prices) in each market is closely related to the power price. Green certificate prices are expected to fall until 2010 as the cost of renewable technologies declines and as wholesale power prices in a number of markets pick up. Beyond 2010, green certificate prices begin to rise again owing to an exhaustion of opportunities for the development of onshore wind power and the necessity to develop more costly technologies, such as offshore wind, to meet national renewable energy supply targets.

Trading in GHG Emissions
The EU is pushing hard to introduce a carbon emissions trading system with a target date of 2005. The details of the scheme are under negotiation, but as power sector emissions will be specifically targeted, it is clear that such a system would have a significant impact on the value of existing generation and the pattern of development of new generation. In the short term, coal-fired generators in a number of countries may benefit from the forecasted upward trend in wholesale electricity prices arising from the internalization of the value of GHG emissions.

In the longer run, however, inefficient coal-fired assets are particularly at risk, and by 2010 more than 6 gigawatts (GW) of coal-fired capacity in EU member states may be forced into early retirement as a direct consequence of carbon constraints. This figure could rise to more than 20 GW if the electricity sector were subjected to emissions trading restrictions.

Combined-cycle gas and nuclear stations stand to benefit the most from the introduction of carbon constraints, owing to the forecasted rise in electricity prices and, in the case of the former, growth in generation levels.

ICF Consulting's view of carbon trading is that the European power sector will have to achieve emissions reductions consistent with its Kyoto commitments, i.e., a reduction of 8 percent below 1990 levels by 2008-2012. Trading will, however, be open to other industries and, from 2008, non-EU Kyoto participants.
Analyzing the European power markets under this assumption suggests that the internal EU power sector marginal cost of emissions abatement will grow from around 10 Euros/tonne carbon dioxide equivalent (CO2e) to 17 Euros/tonne CO2e in 2010. Comparing power sector abatement costs to current forecasts for emissions prices in an open trading system (generally between $5 and $10/ tonne CO2e in 2010) demonstrates that the EU power sector is likely to be a net importer of emissions allowances from other trading participants.

As a consequence, the future level of emissions prices will have the most significant ramifications for forward electricity prices and the profitability of existing stations. Efforts should therefore be made at the European Commission level to minimize emissions prices by ensuring that any EU emissions trading scheme is as open as possible in terms of both geographic and industrial coverage.

Still the Place to Be
The case for staying in Europe is strong:

• Power prices are set to increase.
• They will become more volatile.
• Excess capacity will be shut until the rewards for marginal thermal generation are sufficient to cover the costs of keeping it going.
• Significant new investment is required in renewable and gas fired capacity.
• Green certificate prices will reflect the higher cost of renewables and the low returns from electricity sales.

In fact, there are substantial opportunities in Europe, particularly in generation investments that do not involve over-paying for existing assets. With their painfully won knowledge of the European markets and trading structures already in place, the timing may be right for U.S. power companies to keep their suitcases in the closet rather than packing up and heading home.

© 2008 Edison Electric Institute