A tough spread environment05 Mar, 2012
The requirement for investment in generation capacity is a key theme across European power markets this decade. Investment in renewable capacity is to a large extent being driven by government support mechanisms which, although similar in design, are specific to each market. Investment in gas and coal plant on the other hand, is driven primarily by expectations as to the evolution of future generation margins. Generation margins differ across markets depending on capacity balance. However market coupling, liquidity development and increased interconnection has resulted in a convergence in generation margin dynamics, particularly across North West Europe. Forward market generation margins for gas and coal plant (clean spark and dark spreads) provide a useful insight into the challenges facing thermal asset owners and investors.
The forward spread environment
Chart 1 is a useful spread chart produced by Reuters which illustrates the evolution of German clean spark and dark spreads over the last 5 years. While there are some domestic factors influencing spread evolution (e.g. the nuclear closure decision last year), the dominant driver of spreads has been the impact of gyrations in fuel and carbon prices.
The clear trend emerging over the last year has been a divergence between coal and gas fired generation margins. The increase in the competitiveness of coal versus gas plant can clearly be seen in the bottom panel of the chart. The main drivers of this have been:
- A tightening in the global gas market since the Fukushima disaster in Japan
- The decline in the EUA carbon price as the debt crisis has impacted European economic growth
- A relatively softening in the global coal market as a result of more subdued developing economy demand.
A recovery in gas prices since the start of 2012, has left gas generators across Europe confronting a situation where the intrinsic value of their plant has been crushed. In other words they are unable to hedge any meaningful spread margin in the forward market.
The impact on asset owners and investment
There can be no doubt that owners of gas fired plant have suffered a tough couple of years. The decline in gas plant competitiveness has coincided with a substantial volume of new capacity coming online in the UK and the Netherlands, plant conceived in times of better spreads. Utilities are pushing hard to emphasise the extrinsic value of gas plant (a view we share), as evidenced in a recent investor presentation by E.ON Energy Trading focused on this topic. But the evidence is mounting that the current environment may lead to a thermal generation ‘bust’ of plant mothballing and closures, the latest being last week’s news that the Barking Power in the UK will take 500MW of CCGT capacity offline due to weak spreads.
Thermal asset investors are also facing a difficult environment, summed up in a speech by E.ON CEO Johannes Teyssen at the recent Energy Roadmap 2050 conference:
We all hear investment is needed… Well present markets don’t give any, any, whatsoever investment signal even not incentivised outside the market…. And if a company would even try to invest in any form of generation its shareholders would immediately fire the management, because you can immediately right it off the day you start.
Teyssen’s comments highlight the inconsistency between market pricing and the political agenda to build lower carbon gas plant to complement the huge projected growth in renewable capacity. If anything, the current market price signal is pointing towards the construction of coal capacity given the carbon market bust and softening global coal prices. But the development of new coal plant is virtually impossible in North West Europe given emissions and environmental planning constraints.
The current forward spread environment is indicating stagnation in new thermal plant investment and the increasing risk of a ‘bust’ to clean out older plant. But as always with the threat of a bust comes opportunity. The increase in intermittent renewable penetration across Europe is driving a structural requirement for more system flexibility. As capacity margins tighten through this decade, it will be the remaining thermal plant setting the price for provision of that flexibility.