POWER PRICE CANNIBALISATION – HOW IS IT AFFECTING YOUR RENEWABLES PROJECTS?
As the rollout of renewables continues, wholesale electricity prices are at risk of a considerable haircut. How is this affecting your project revenues and how are you planning to reflect this in your valuation models?
Simple economics will tell you that electricity generated when either demand is low or supply is high (or both) is less valuable. This is of particular concern if you are in the renewable energy generation industry, which by its very nature is somewhat at the mercy of the weather concerning the timing and quantity of energy production. With increased supply from new projects contributing to the downward trend in power prices, wholesale electricity prices are at risk.
Solar and Wind - the impact of intermittency on revenues
The complementary relationship between solar and wind is very beneficial in terms of continuity of supply throughout the year (wind mainly in winter – sun mainly in summer).
However, in terms of individual project economics, the inherent intermittency of power generated from renewables can create pressures on revenue as periods of highest output don’t necessarily correspond to periods of highest demand. This may be even more problematic if wind and solar conditions are favourable at a time when energy prices are already depressed, and could result in actual revenues being materially lower than those expected in the operator’s future cash flow model.
Why would prices already be depressed?
This could be for a number of reasons, but has its root in the increased availability of cheap electricity generated from renewable sources. Let’s have a more in-depth look into some of the factors behind price depression.
Low levelised cost of energy (“LCOE”)
As the renewables industry has developed so much in recent years, levelised cost of electricity (defined as all costs associated with the production of power) has reduced to the extent that it is now equivalent to - if not lower than - the LCOE associated with some conventional power sources. In other words, renewables are increasingly able to generate power more cheaply than conventional fuel-based sources. This achievement has been promoted through incentive payments from governments keen to develop more sustainable energy systems. There are reports that initial criticism regarding the cost of government incentive schemes is beginning to fade because savings to consumers have the potential to eclipse the cost of these schemes to the taxpayer. For instance, the UK Government’s 6GW capacity auction in September 2019 saw 5.5GW of offshore wind capacity agreed at a cost of around £40/MWh, which was close to the wholesale market electricity price.
Low marginal costs
Marginal cost of electricity (the incremental system cost of increasing electricity generation from one particular source versus another) plays a key role in depressing electricity prices.
Different power sources have varying levels of marginal cost. The availability of a variety of different sources enables the grid to bring generators with the lowest marginal cost online first, in order to meet demand in the most cost-effective way. Generators with higher marginal cost are only used if cheaper sources are not meeting demand or are unavailable, and the absence of fuel costs makes renewable energy a very competitive option. This mechanism is known as the “merit order effect”.
In some locations, the merit order effect has already resulted in lower wholesale prices at the midday peak demand (coinciding with higher solar generation levels).
Low capture prices
The term “capture price” relates to the actual electricity price achieved by a generator in the market, and it’s compared against the wholesale price.
Through our work with clients operating in the wind sector, we have observed that actual capture prices achieved by offshore and onshore wind farms are lower than the average wholesale market prices (baseload price). At times when wind power is generating large amounts of electricity at low marginal cost, the merit order effect is upheld and the grid’s demand is met with a welcome supply of cheap electricity. As subsidy mechanisms typically reward production, the incentive is to continue to oversupply in order to overcome the opportunity cost of not generating. These factors depress the wholesale market price, resulting in an effect known as “price cannibalisation”. This effect is set to increase in prominence as the growth of renewables continues.
As the amount of wind capacity has accelerated over the past decade, various studies have been carried out with the aim of assessing the impact of price cannibalisation in the UK’s electricity market. Although the phenomenon affects all intermittent weather-driven generation, it is more pronounced in the wind sector due to the higher magnitude of output. One study carried out using day-ahead and season-ahead leading price information covering 2011 to 2015 suggested that wind generators appear to have realised sales that are on average 1.4% lower than the average baseload price. Based on our discussions with investors in recent months, it would suggest that price cannibalisation is now higher than this on average. If the downward trend in prices continues, and without a proportionate decrease in development costs, it could cast doubt on the viability of subsidy-free projects in the future.
The arrival and ramp-up of utility-scale battery storage and electric vehicles (“EVs”) however has the potential to alleviate some of the negative effects of price cannibalisation, as excess supply at times of peak generation can be captured by these technologies and stored. It will be interesting to see how the development of EVs and rollout of battery storage changes the electricity system and the economics of electricity generation.
One further factor which must not be ignored is the impact of COVID-19. Electricity prices in the UK were already at the lowest level for a decade in Q1 2020, and the UK Government’s social distancing measures have resulted in a marked decrease in electricity demand. Although the market consensus is that these effects likely represent a short, sharp, shock, the timeline for lifting restrictions and the rebound of demand from commercial and industrial energy consumption is unclear.
As the rollout of renewables and especially offshore wind continues, what are your predictions for the levels of price cannibalisation that could be in store for your projects, and how do you plan to reflect this in your future cash flow models? And at what point do you expect relief from the downward pressure of COVID-19 on power prices? We look forward to the discussion on this increasingly important topic.