Power to Change

Ross McCracken, Editor, Platts Energy Economist

The world's power industry is on the cusp of a new investment cycle, but faces a minefield of risk. Market experiments, environmental and supply security concerns, and a revolution in technology have created an investment environment beset by uncertainty.

ELECTRICITY MARKET OPENING, OR "liberalization," has failed to create one broadly accepted model of market design. After the California debacle, the US has been left with a cocktail of competitive wholesale markets, hybrids and traditional service models. In Japan, the liberalization process has not been as chaotic as in South Korea, but progress has been slow, despite some of the highest electricity prices in the OECD.

In Europe, the European Commission retains an unbridled passion for change. It has unveiled draft proposals for the EU's third package of market liberalization measures and is skillfully using competition and market abuse probes to put pressure on the continent's establishedcalled "incumbent"power producers. And this time the proposals hit right at the essence of Europe's dominant vertically-integrated utilities, threatening to dismember them by unbundling their transmission and generation functions.

But many European Union governments have deliberately created national utility champions that have reinforced the vertical and horizontal market power that the liberalization measures are designed to removethe latest being Paris's renewed support for the Gaz de France-Suez megamerger. And the degree to which EU electricity markets remain fragmented is clearly revealed by prices: In 2006, the EU boasted both the lowest and highest electricity prices for industrial consumers in the OECDFrance at 5.1 US cents per kWh sat uneasily alongside neighbor Italy with 21 cents/kWh.

The EU's unbundling proposals have significant support, but are by no means a done deal. The battle between liberalizers and incumbents remains a source of tension which makes policy direction uncertain. As in the US and elsewhere, the lack of an accepted market model and the inadequacies of existing ones mean that regulatory change remains a risk factor for investment. That risk also inhibits integration at regional and international levels.

Nevertheless, the EU's power sector liberalization is helping to promote international trade in electricity through harmonizing rules and regulations, which allows greater competition. In addition, the growth strategies of national incumbents buying into other EU markets are creating more transnational companies with a better understanding of how the EU's national markets interact. Perhaps the most important experiment in regional electricity integration has been the success of market coupling among the Benelux, French and German markets, where transnational trading has produced a high level of price convergence.

But trade in electricity worldwide remains small in relation to total production. International Energy Agency data shows it expanding but at a relatively slow pace. In Europe, electricity imports grew by an average annual rate of 7.0% in 1973-1990, but slowed to 3.3% subsequently. There was a similar trend in OECD North America, with imports increasing 4.5% annually in 1973-1990 but dropping to 3.1% growth in the subsequent 15 years.

Growth in electricity trade is limited by a lack of investment in the necessary infrastructure; lack of regulatory, legal and technical harmonization between neighboring systems; and by nationally focused structures and mindsets. Where trade does occur it brings substantial benefits. The successful shared exploitation of transborder resources like hydro through trade in electricity can lead to greater regional economic integration. Exchanges of electricity also reduce the reserve margin needed by diversifying sources of supply and are thus an important contribution to supply security.

Global Debate

Liberalizationindeed any change of market structureposes uncertainties for investors, but in the time it has taken liberalization policies to approach fruition, or in some cases to reach fruition and fail, a new set of policy priorities has evolved. Just as the OECD enters a new investment cycle, reflecting both demand growth and the age of plants built in the decades following World War II, uncertainties facing investors have multiplied.

Power provision has become a global issue like no other. Rapid demand growth in developing economies has created new competitors in the search to secure energy supplies. Climate change has focused attention on the carbon emitting proclivities of human activities. Meeting the lifestyle aspirations of both developed and developing nations' populations remains inseparable from growth in energy demand. While there is no such thing as a global power market, there is now a common set of challenges facing energy policy makers that are international in nature.

And as issues have become increasingly internationalized so has the potential for conflict. The preliminary talks on a successor to the Kyoto Protocol underlined the clear division of interests between the developing and the developed world. While the OECD has been responsible for the bulk of past carbon emissions, energy usage trends show that countries like Brazil, Russia, India and China will account for the majority of future growth in energy consumption.

According to the IEA, over the last 32 years, electricity production grew at an annual rate of 5% in non-OECD countries, but at 2.7% in the OECD. While in 1973, the OECD produced 72.9% of the world's electricity, by 2005, this proportion had fallen to 57.1%. But China and other developing countries have made clear that their primary goal is development and that they hold the industrialized world responsible for the current level of carbon dioxide in the atmosphere.

Demand growth is not just a developing world concern. The IEA's 2006 World Energy Outlook estimates that the OECD will require an additional 466 gigawatts by 2015 based on a business as usual scenario. Despite the spread of the environmental agenda, in its September report Energy Use in the New Millennium, the IEA observed that "increased demand for energy services remains deeply rooted in the lifestyle ambitions of consumers." As nations become richer, people tend to consume more electricity per capita, and the billion-plus populations of India and China have legitimate aspirations to follow the industrialized world down this path.

The second phase of the EU Emissions Trading Scheme suggests that a carbon price will become an increasingly important element in investment decisions. The spread of different carbon constraint systems on a state level in the US, despite federal resistance, suggests a similar outcome eventually in the US, and the potential for an intercontinental market for carbon. This market will incorporate risk at almost every regulatory level starting with the clash of interests between developing and developed nations.

Technological Revolution

Energy demand growth, under these conditions, needs to be met without the past reliance on fossil fuels, without generating international conflict, and without retarding economic development. Policy makers are trying to iron out the inherent contradictions in this essentially idealistic outlook, but while they do so, it leaves investors facing a very uncertain policy environment. But other processes under way will have an even more profound impact on the power sector.

High energy prices, the insecurity engendered by dependence on imported hydrocarbons and climate change mitigation priorities have prompted a period of intense technological change. As in any revolution, the outcome is unpredictable, but it is the disruptive nature of renewable energy as much as the development of new means of power generation that may prove most significant.

The changes that carbon, demand growth and security of supply issues have prompted are already enormous. Heavily subsidized wind power has become a global business. Its intermittent nature has focused attention on grid design and on energy storage. The solar photovoltaic industry is growing exponentially, as is biogas in some markets, and wave and tidal power could well follow.

For more established technologies there has been a sea change in fortunes. The nuclear industry is widely seen as experiencing a renaissance, largely predicated on a yet-to-be-realized flood of new orders. Less well advertised is that large-scale hydro is also undergoing a revival. Environmental concerns on a global scale are starting to outweigh local environmental issues. Coal's future, by contrast, is being challenged in areas like Europe and the US, where emission control mechanisms could effectively internalize the cost of carbon, penalizing CO₂-intensive power. Clean coal technology may become a requirement of new coal plant, undermining the investment economics of coal-fired power. In Asia, where developing economies are stretched for energy and coal is plentiful, governments are struggling to balance energy and environmental demands. But countries like China have made clear they will satisfy their populations' energy aspirations before addressing the industrialized world's climate change concerns.

But change in the energy sector runs much deeper than a change of emphasis on the preferred generation mix. The most important energy commodity is oil, and electricity may be about to challenge oil in what is not just its main market, but also its last bastiontransport. PHEVsPlug-in Hybrid Electric Vehiclespromise a mode of transport that relies primarily not on refined oil products, but on electricity from national grids.

The evolution of car power trains neatly encapsulates divergent technological trends. Hybrid cars harness electricity from the braking mechanism of the car and reduce the need for traditional hydrocarbon fuel. They are a decentralized power application. PHEVs go much further in reducing the need for gasoline and diesel by relying on a greater draw of power from a centralized grid. They are "green" only insofar as the electricity that charges them comes from a renewable source.

Solar power, where efficiency breakthroughs are building, is also finding applications that suit both distributed and centralized models. A typical manufactured photovoltaic module currently has an efficiency of 15% or below outside a laboratory. Scientists at the University of Delaware in late July achieved 42.8% efficiency with a combined solar cell tapping sunlight at standard terrestrial conditions, topping the 40% record set by Spectrolab and the US Department of Energy's National Renewable Energy Laboratory in December 2006. Scientists' next goal is to exceed 50%. Solar boosters foresee centralized peaking power plants on a large scale, while "intelligent" building materials offer electricity flow from walls and windows, and small-scale solar panels power laptops, mobile phones and other electronic gadgets that have fueled energy demand growth.

The technology for a more distributed power system is evolving quickly through solar panels, wind turbines and combined heat-power boilers scaled for the home, geothermal heat pumps, heat exchangers and fuel cells. Some even envision the house as a power source rather than as a consumer, and the technological base to support that vision appears to be evolving rapidly.

In addition, measures to restrain power demand might prove more successful than expected. The IEA says, "Since 1990 the rate of improvement in energy efficiency has been about half of what it was in the previous decades. Had the earlier rate been sustained, there would have been almost no increase in energy consumption in the IEA" member countries. Having set ambitious emissions targets, governments are belatedly realizing that demand side management is not just essential, but the cheapest means of achieving those goals.

Factoring in a potential fall in electricity demand, from microgeneration and energy efficiency gains, as one possible outcome over the lifetime of new power plant investment challenges revenue assumptions and increases the possibility of stranded investment. Alternately, if PHEVs prove successful, power could find a large new market dependent on centralized power generation. Just as electricity had by 2004 overtaken natural gas as the second most important energy commodity in the final energy mix, it is not outside the range of possibilities that electricity could one day topple oil from the top spot.

For business, it is hard to imagine a tougher start to a new investment cycle. The level of uncertainty prevalent in the power sector is why organizations like the IEA believe that under-investment is a serious risk. The IEA wrote, "Long project times and high investment costs, particularly for large base-load units, create a need for government action to reduce uncertainty in the very near term." In the absence of such certainty, companies have little choice but to proceed with caution, relying on diversification as a hedge against the future.