The changing economics of energy supply is squeezing profit margins

Dominic Fava, Head of Marketing & Propositions, Origami.

Historically, the cost of feedstock – oil, coal or gas – determined the price of electricity. Today, with a system reliant on renewables and interconnection, wholesale electricity prices are increasingly determined by changes in weather and a complex, interdependent system. For example, electricity costs rise and fall depending on whether the wind is blowing in one part of the country, the sun is shining, there is a heatwave, or any power stations are out of action.

Renewable energy has zero marginal cost, which means that feedstock costs now have far less influence over electricity prices. The dominant and growing determinants of electricity prices are the cost of building and maintaining the networks, reliability of the system networks and the subsidy levels for renewables. Already, less than 50% of business energy bills are directly related to commodity costs.1

Balancing services are key tools that system operators use to ensure that the electricity system is balanced and reliable. Costs for these services are paid by energy suppliers and generators, which they pass through to customer bills. As renewables become a bigger part of the energy mix, there is going to be an increasing need for balancing services provided by assets at the grid edge and on the distribution network. These assets will fill the generation gaps when renewables aren’t available or be used to deal with other problems.

Berkley University2estimates that with 40-50% renewables in the energy mix, the cost of balancing services to the USA electricity system will increase 2-9 times. We expect a similar increase in wholesale market volatility where renewables are deployed at scale.

In the UK, Prof. Goran Strbac, from London’s Imperial College, believes3that the cost of balancing services will increase 10 times by 2030. At the same time, the cost of energy production will significantly reduce, assuming that more electricity must be produced by zero-marginal cost low- carbon generation if we are to meet carbon reduction targets.

1https://theenergyst.com/2018-energy-outlook-can-businesses-expect/

2http://eta-publications.lbl.gov/sites/default/files/presentation_pdf.pdf

3https://www.theccc.org.uk/wp-content/uploads/2017/06/Roadmap-for-flexibility-services-to-2030-Poyry-and-Imperial-College-London.pdf

The changing economics of energy production

The National Infrastructure Commission4points to a similar picture in 2050 where high levels of renewable penetration will depress wholesale electricity markets by £8bn/year on average. This reduction is offset by the need to spend £5bn/year in additional balancing costs, which is up from around £1bn today. At 80% renewables penetration, total system costs are minimised, while balancing and network costs will be greater than energy costs.

These trends point to an overall shift in the value of the commodity towards the shape of the energy; how and when it is used to generate value.

Energy suppliers and asset owners can provide services to help keep the electricity system in balance while benefiting from these new trading opportunities.

Balancing services will change

As system operators become comfortable with more sophisticated market players and markets demonstrate the capability to keep the lights on, more liquid markets could replace some balancing services. For example, wholesale power markets may evolve from today’s 30 min intraday markets. There is already a dramatic shift from long-term contracts to shorter term contracts. We expect this trend to continue.

The growth of zero marginal cost renewables will contract wholesale power market costs, while increasingly intermittent energy generation5and changes in regulation will drive up volatility (perhaps by as much as three times). We see great value in being able to trade and dispatch assets in near real-time, potentially trading the same unit of energy into multiple markets. Optimised trading of this nature is only possible to do at scale with intelligent technology, supported by asset and price forecasts informed by real-time data. Technology enables much better risk-adjusted returns.

In the absence of any concerted action, margins in all areas of utility businesses are going to get squeezed. Only by delivering less extreme, more predictable trading outcomes and becoming more efficient will market players maintain their margins.

4https://www.nic.org.uk/wp-content/uploads/Power-sector-modelling-final-report-1-Aurora-Energy-Research.pdf

5Cornwall Energy