The approaching European gas plant bust?08 May, 2012
There has historically been a pronounced boom/bust cycle in the investment market for gas-fired power plant in Europe. The late 90’s dash for gas gave way to the post Enron bust in 2002-03 which was followed by a resurgence in gas plant investment during the 2007-08 commodity price boom. Boom periods tend to be accompanied by stronger generation margins and the easier availability of capital. Busts feature depressed spreads and capital constraints, strong features of the current environment.
Many owners of older gas plant across Europe are currently confronted by forward generation margins that do not cover their fixed cost base. These conditions are consistent with another gas plant bust in the form of development project cancellations, plant mothballing and closures. But the threat of a bust is complicated by a backdrop of a strong structural increase in demand for thermal plant flexibility given the rapid increase in output from intermittent renewable capacity.
Current gas plant returns
A gas-fired plant can be characterised as a strip of options on the clean spark spread (CSS), the margin between the price of power sold and the cost of gas and carbon required to generate it. The strike price of these CSS options is determined predominantly by the efficiency of the plant.
At current price levels, older gas plants have a limited ability to hedge plant value in the forward market (intrinsic value). This has been caused by a growth in low variable cost renewable generation output driving down the power price (particularly in Germany), generation overcapacity (particularly in the Netherlands) and the relative strength of gas vs coal pricing given a tight global LNG market.
But despite limited intrinsic value, older gas plants have significant value associated with their flexibility to respond to changes in market prices (extrinsic value). The challenge currently faced by gas plant owners is how they can quantify and monetise that extrinsic value and whether it is high enough to justify keeping the plant open.
Gas plant lifetime economics
The economics of an older gas plant is driven by the relationship between its market return (increasingly supported by extrinsic value) and plant fixed costs (given capital costs have been paid down). The plant fixed costs can be thought of as the premium paid for ownership of the strip of spread options. Gas plant owners are currently struggling to earn a plant return that covers fixed costs given the depressed level of market spreads, i.e. they are suffering negative cashflow from their plant.
In order not to mothball or close a plant in this environment, the owner needs to be able to convince themselves that the future value of plant optionality outweighs its current inability to earn an adequate return. This is not a hopeless task. There is a strong story around the structural requirement for gas plant flexibility as renewable intermittency increases. Older plant can typically provide this flexibility at a lower cost than that required to develop new gas capacity. There is also the potential carrot of policy measures to support gas capacity value (e.g. the capacity market currently being designed in the UK).
But until this value is realised, plant owners are suffering some very real pain in the form of negative cashflows. So there is a game of ‘prisoners dilemma’ involved in which plant owners mothball and close capacity first, to the benefit of other plant owners. It is difficult to predict the timing and factors that may precipitate another gas plant bust. But the increasing pain being felt by plant owners and the growing queue of gas assets for sale suggests that a ‘clean out’ of older gas plant may not be too far away.