Bold decisions on energy strategy are needed fast. Mark Livingstone of PA Consulting sets out some scenarios for UK companies to consider

2014 promises to be a watershed year for the implementation of UK Electricity Market Reform (EMR). The Energy Bill is now the Energy Act; details are emerging from the Department of Energy and Climate Change (DECC) about how EMR will work; carbon price levels have now been pegged at £18 per tonne; the first Contract for Difference allocation is expected this year and, assuming all goes smoothly, the first capacity auction is to be expected as well.
Yet, despite the euphoria of progress, there appears to be a genuine concern that the powers-that-be in Brussels could stymie UK energy policy. Rarely have energy portfolio strategy decisions for generators been more complex or more crucial, but if these are not made (and made quickly) the security of Britain’s electricity supply could be affected.
The latest update of PA’s Energy Investment Map – an online tool which shows the risks and returns in investing in different energy technologies in various regions – shows an obvious divergence in decarbonisation strategies across Europe. For example, some countries are still very dependent on coal, particularly those in central Europe. Even committed ‘green’ nations such as Germany and the Netherlands make extensive use of coal-fired generation, and the lack of a well-functioning EU emissions market does little to hinder this.
Neither coal nor oil shale are very environmentally friendly, but they represent the best economic options some EU economies have while recognising that national competitiveness in energy is too vital to ignore. Importantly, they also offer a degree of fuel security that cannot be overlooked – particularly given recent events in the Ukraine and new fears over European gas dependence on Russia. Debate across the EU on shale gas, and the impact of newly proposed environmental legislation, also touches on this fuel security agenda. However, it has not hindered efforts to date in ‘fracking nations’ such as the UK and Poland.
With this in mind, we believe that UK energy companies should bear the following in mind while formulating their future portfolio strategy.

Coal – does it have a new future?  While it often seems as though coal is the persona non grata of the energy supply family, it’s worth remembering that it currently provides 40% of the world’s electricity needs (according to the International Energy Agency). Coal use continues to increase globally and, with low prices in the past few years, it has been far more economical in the UK than gas-fired generation. There are certainly challenges ahead over timing, cost for carbon capture and storage, and clean coal technologies. But with questions being asked about alternative energy forms, it makes sense for UK energy companies to analyse coal’s option value now against a set of future scenarios. It may just be that coal will rise again in a new scrubbed-up form.

Nuclear – does it live or die? After years of battling against the odds, there is a chance of a British nuclear renaissance. However, no nuclear facilities have been built anywhere in the world without some form of government assistance, so the State Aid question is hard to ignore. If the Hinkley nuclear power station does not get the nod it is hard to see energy companies Horizon or Nugen stepping swiftly up to the plate. As a result, scenarios with more gas, coal and interconnection start to look interesting.

Gas – will the capacity market restore investment confidence? Decc has now extended the proposed capacity contract from 10 years to 15 years for the new generation of plants, but strangely this makes the difference between continuing to operate an existing plant (with a one-year capacity contract), and building a new one, very different in a risk sense. With the proposed cap on capacity contract prices, a combined cycle gas turbine generator will need to rely on profitable operation in the energy market to justify remaining open. Energy suppliers would do well to scrutinise their relative competitiveness in a fundamental economic sense, including system constraints. Pessimists may point to years of low operating margins, but worldwide gas supply continues to increase and diversify. Therefore, there are many scenarios where gas provides a vital, growing and profitable lifeline for future energy security.

Wind – will politics prevail over economics? Wind generation has been the favourite son in recent years of UK energy policy. But with continued growth of onshore generation facing political headwinds, and offshore wind up against it on cost (witness the £155/MWh strike price), energy suppliers can expect a shakedown in the next few years. The Levy Control Framework (LCF) plays a key part here. Given the £7.6 billion limit imposed by Treasury on the total amount for annual low carbon subsidy, a healthy dose of economic reality is required. Building vast amounts of new wind generation out at sea is simply not affordable. While the LCF may indeed rise after 2020 to allow a new wave of projects, confidence and project profitability will also have taken a knock from the recently announced £18/tonne carbon price support cap.
While wind has a place in most balanced generation portfolios, evidence from markets such as Spain and Australia suggest that wind generation levels consistently over 20% have consequences for system stability and transmission infrastructure.
As if the complexity in these four areas is not enough, the impacts of growth in interconnected, small-scale renewable generation and demand side management are also part of the portfolio equation. Plus, there are fundamental questions around demand growth, such as the potential for electric vehicles.
Overall, there are multi-billion pound decisions that will need to be made every year if the UK’s energy security is to be retained. Appreciating the economic complexities of EMR is tough enough as it is, but the current political complexity from Brussels is a growing challenge that also needs to be factored into risk-based decisions. In this complex environment, UK energy suppliers would do well to analyse a full range of possible scenarios to ensure they have a robust portfolio strategy and remain on a firm competitive footing come what may.

Mark Livingstone, is an energy expert, with PA Consulting Group