CfDs could threaten link between electricity and natural gas markets

18 March 2013 20:32 Source:ICIS

The UK's looming subsidy model for low-carbon power generation could see wholesale natural gas prices dislodged as the primary driver of the electricity market, distorting existing dynamics, participants have warned.

The Department of Energy and Climate Change is introducing long-term feed-in tariffs with contracts for difference (FiT CfDs), under which generators will be guaranteed a fixed price for electricity sold from low-carbon generation assets.

CfDs will allow generators to sell output from low-carbon generation sources into the wholesale market. The return will be determined by a stable, pre-set value known as a strike price.

Under existing arrangements, a power plant will generate only when its owner deems it profitable. But, as a result of the government's intervention, plants operating with a CfD will always be operating in profit because end-user funded subsidies will remunerate the difference between the market price and the strike price. Some say this mightdistort market dynamics.

"If you get to the stage where low variable-cost generation [volumes are] so high that it's not profitable for thermal capacity gas generation to run, then the gas plants will be shut off and gas will no longer set power prices," independent utilities analyst Lakis Athanasiou said. "A wind farm under a CfD mechanism would still want to produce when prices are negative."

Athanasiou argued that, by issuing CfDs, the UK electricity market could become a two-tier system.

Liquidity drain?

Some traders also anticipate a stifling of liquidity on forward contracts: "The CfDs could kill the wholesale market, " a UK power trader told ICIS. "It is going to take liquidity away from the market and liquidity is already bad. It's a step backwards that could destroy the forward market."

CfDs and the existing subsidy mechanism, renewables obligation certificates (ROCs), are subject to a levy control framework that keeps a lid on subsidy pools across government departments.

This, one equities analyst said, will limit the impact that smaller cumulative newbuilds, such as onshore wind farms, will have on the wholesale market.

The story could be different for new third-generation nuclear reactors, which will each have an installed capacity approaching 2GW.

"Investment contracts issued for nuclear builds will have a bigger influence on the market," the analyst told ICIS. "It will be an issue when the new nuclear plants join the grid [in the 2020s]. It is clear that the dynamics of the market will change."

French utility EDF is in the final stages of negotiations to build a 3.2GW UK nuclear plant, Hinkley Point C. According to recent reports, the strike price agreed by EDF and the British government will settle at just below £100/MWh, adjusted for inflation (see EDEM 4 March 2013).

The strike price is expected to be about twice that of wholesale energy prices. The benchmark front-season contract is assessed by ICIS at £50.10/MWh.

The 'psychological effect'

The UK's terms for its CfD with EDF could also have implications that span Europe.

Czech utility CEZ has told ICIS it is looking to the UK as an example of a funding mechanism for its new nuclear build at its Temelin site.

The central European region, however, is blighted by excess installed capacity, which has driven down wholesale power prices.

An equities analyst told ICIS: "There are no plans in Germany to offer contracts for difference. So, if CEZ builds the new Temelin plant, it will create a negative situation for the German plants. Oversupply will drive down prices."

Ingo Becker, a Kepler Equities analyst, agreed that prices could be driven down as a result of subsidy reform, and said further market distortion could result.

"The CfD or whatever funding mechanism you pick has no direct effect on the market price," he said.

"There is also a psychological effect as soon as the market believes the price for power has been set. Gradually, prices will be less dominated by market fundamentals."

However, it is thought that CfDs will ultimately bring smaller players to the market by allowing them to enter into long-term power purchase agreements (PPAs) not previously accessible by them.

"CfDs will break the oligopoly that the big six have on offering long-term PPAs," Smartest Energy chief executive Robert Groves told the Major Energy Users Council conference on Friday. He said: "The contract-for-difference strike price will allow companies such as us the opportunity to enter the long-term power purchase agreement market."

While it is certain that market dynamics will shift, benefactors of the subsidies also have a clear case in support. And it is up to the UK government to manage the policy in a just fashion. Katie McQue

By Katie McQue