CCGT investment in the UK and Germany19 Sep, 2011
In both the UK and German power markets, the development of significant volumes of new thermal capacity will be required to replace retiring capacity and to provide flexible backup for intermittent renewable generation . Policy makers in both countries are actively promoting private sector investment in new gas-fired CCGT plant to facilitate the transition to decarbonisation of the power sector. But in an environment of depressed forward market margins for CCGT, developers are faced with the challenges of lower load factor projects and competition from life extensions of existing plant.
What will the market pay a gas fired generator in the UK and Germany?
Chart 1 illustrates the evolution of the UK forward market clean spark spreads (CSS) and clean dark spreads (CDS), benchmarks for the margins earned by gas and coal fired generators respectively.
It is clear from the chart that CCGT generation margins have continued to fall despite the increasing threat of a tightening UK capacity margin by 2016 when 11.5 GW of capacity is scheduled to retire in response to the Large Combustion Plant Directive (LCPD). Chart 1 only shows forward spreads to 2012 but indicative market pricing out to 2014 shows little improvement in forward generation margins. The key driver of this year’s decrease in forward CSS has been the uplift in gas prices as a result of a tightening in the European gas market post Fukushima (as explored here).
The forward market returns for CCGT in Germany are similar to the UK, also suffering this year from the rise in European gas hub prices as illustrated in Chart 2:
What margin does a developer need to build a CCGT?
The developer of a new CCGT plant needs to be able to convince themselves that they can recover the capital costs, fixed costs, variable costs and tax bill associated with their project. These costs vary according to factors such as plant design, prevailing turbine costs and tax regime. But it is reasonable to assume an average baseload equivalent CSS margin in the range of £12-14/MWh (€14-16/MWh) is required to support a CCGT over a 20 year economic lifespan. Chart 3 illustrates the breakdown of a generic project cost for a new CCGT in the UK (assuming baseload operation for the sake of illustration).
Taking the £13/MWh (€15/MWh) mid-point of this required CSS margin range it is clear that current forward sparks spreads are a long way from supporting CCGT new build. This is the case even accounting for a ‘top of the line’ new CCGT plant efficiency at 53% (HHV) as compared to the 49% benchmark used to calculate market CSS (e.g. as shown in Charts 1 and 2).
While it is useful to consider the baseload CSS as a benchmark for current and required market returns, in reality new CCGT plant are likely to run at much lower load factors. The increase in volumes of ‘must run’ renewable capacity in both the UK and Germany is eroding the market share of thermal plant. Gas fired plant load factors are particularly affected by the intermittency of renewable generation when relative market fuel prices favour coal over gas in the plant dispatch merit order as is currently the case.
The load factor risk around UK and German CCGTs differs as a result of different generation merit orders as shown in Chart 4. The German market in the left hand diagram has relatively large volumes of ‘must run’ renewable, nuclear and lignite capacity which is dispatched ahead of coal and gas capacity. The UK on the other hand has a higher proportion of more expensive thermal capacity. As a result a new CCGT with ‘top of the line’ efficiency will tend to run at much higher load factor in the UK than Germany given its relative competitiveness versus the greater share of thermal capacity in the generation stack. This is not to say that a new CCGT in the UK currently looks like a good investment but rather that a new CCGT in Germany looks to be a very tough challenge indeed.
The CCGT investment case has changed
The project economics of new CCGT have traditionally relied on locking in healthy forward market margins at high load factors, at least in the early years of a plant’s life. However changes in generation mix and the policy environment mean that this is very likely to change. The promotion of renewable capacity with ‘feed in tariffs’ acts both to reduce average CCGT load factors and to push the risks associated with balancing intermittency onto thermal plant. This is a situation that will only become more pronounced as time goes by.
In this environment of lower load factor running, the margins for a new CCGT plant are likely to be increasingly focused into periods of peak system net demand (system load less intermittent output). As a result a new CCGT developer needs to be increasingly focused on the structure of peak and super-peak margins. It is these margins rather than the baseload CSS that are likely to support new CCGT investment as capacity margins tighten. However it is important to note that new CCGT projects face competition in capturing these margins from the life extension of existing thermal plant. While older plant operate at a somewhat lower efficiency, the capital expenditure associated with life extension is small in comparison with building a new plant. It is also important to note the risk to CCGT margins from government policy intervention distorting market price signals, specifically from the Capacity Mechanism that is under consultation in the UK.
Perhaps the largest challenge faced by an investor in a lower load factor CCGT is the complexity around estimating and hedging generation margins. The focus of plant returns shifts from intrinsic value that can be relatively easily hedged in forward markets to the extrinsic value associated with the plant’s flexibility to respond to changes in market prices. Extrinsic value is much more difficult to quantify and hedge than intrinsic value, given its dependency on unobservable parameters such as the volatility and correlation of the underlying power, coal and carbon prices. But if private investors are to deliver new CCGT capacity as the UK and German governments are anticipating, then they will need to become comfortable with the economics and challenges associated with lower load factor running.