ARE MARKETS DEAD? ARE WE HEADING FOR A REGULATED FUTURE? DOES COMPETITION STILL STAND A CHANCE?

ARE MARKETS DEAD? ARE WE HEADING FOR A REGULATED FUTURE? DOES COMPETITION STILL STAND A CHANCE? RIDING THE WAVE TUESDAY, TALLINN STEPHEN WOODHOUSE

PÖYRY MANAGEMENT CONSULTING ENERGY Pöyry offices (c) grafikdienst.com Pöyry Management Consulting offices Europe s leading specialist energy management consultancy. Offering expert advice from strategy to implementation on policy, regulation, business operations, financing and valuation and sustainability. Providing in-depth market analysis and strategic insight across Europe. Over 200 energy market experts in 13 offices across Europe: Düsseldorf Helsinki London Madrid Milan Moscow Oslo Oxford Stockholm Paris Vienna Villach Zurich 2

CORE SERVICE OFFERINGS Corporate and Business Strategy Market Insights and Modeling Portfolio strategy Growth strategies Business strategies and business plans Business model development Scenario analysis Risk management Environmental strategies Market entry strategies Cooperation strategies Market analysis Market forecasts Demand, supply, and cost analysis Price projections Industry cost curves Market design and modeling Market regulatory frameworks Market scenarios Resource and Technology Strategies Sales and Supply Chain Strategies Resource base valuations and development Technology mapping Technology benchmarking Technology options evaluation Technology strategies R&D portfolio strategies Technology acquisitions Supply/market analysis Pricing strategies Contract negotiations Supply chain optimization Sourcing strategy formulation Supplier assessments Transfer Pricing Performance improvement Operational and organizational benchmarking Corporate restructuring Organizational design Business transformation Operational and Organizational Excellence Change management Post merger integration Manufacturing strategies Energy efficiency Asset Management Maintenance Strategies Acquisitions Divestments Asset valuations Business valuations Project pre-feasibility / feasibility assessments Investments and M&A Due Diligence (strategy, business, technical, environmental) Business valuation vs. Asset valuations WEC-ESTONIA CONFERENCE 3

MARKET DESIGN IS A CORE PÖYRY STRENGTH We draw on our unparalleled understanding of national energy markets across Europe to provide impartial advice to both public and private sector parties on energy policy and market design issues Cutting-edge understanding of practical implications of low carbon futures Highly respected and influential in both Governmental (EU and national) and private sector circles Successful implementation of our market design concepts Irish electricity market South Eastern Europe regional market Ukraine market operator and balancing market Irish gas market opening Quantitative and detailed modelling to back our thinking on market design Approach electricity, gas and carbon markets as a unified system Understand commercial perspective of investors and participants Source: EURELECTRIC 4

Pöyry has completed a new multi-client study focusing on the future direction of electricity markets Decarbonisation and market harmonisation objectives create a policy dilemma between re-regulation and liberalisation. In this context, the multiclient study aims to answer the following question: What are the consequences for future electricity market design? Will the future energy sector be based on market principles or are we returning to regulated investments? How will EU and national policy objectives be balanced in the future framework? How will emissions targets and renewables targets be balanced? How will we ensure that investment is made in a timely and efficient manner? 5

Decarbonisation is driving change to electricity market design The longer term vision must shape the markets in the shorter term Evolution of electricity markets Longerterm vision Mediumterm vision Shortterm vision What is the future of the European electricity system: a market or a centrally planned economy? Can we invest in generation capacity in the face of market volatility? How to defend cashflows in the short-term? 6

What do we mean by decarbonisation? 1 2 3 Pöyry Future Market Design study has defined it as delivering a carbon intensity of 20gCO2/kWh by 2050 within the power sector consistent with EU Energy Roadmap decarbonisation scenarios Carbon intensity targets CO2 Intensity EU RoadMap Scenarios (gco2/kwh) 500 450 400 350 300 250 200 150 100 50 0 1990 1995 2000 2005 EU Energy Road Map Scenarios 2010 2015 2020 2025 2030 2035 CO 2 Intensity, ~80-90 gco 2 /kwh 2040 2045 2050 EURELECTRIC Power Choices Reloaded Scenario 1: Reference Scenario 1bis: Current Policy Initiatives Scenario 2: High energy efficiency Scenario 3: Diversified technologies Scenario 4: High RES Scenario 5: Delayed CCS Scenario 6: Low nuclear CO 2 Intensity, ~5-20 gco 2 /kwh 2030 150gCO 2 /kwh 2040 50gCO 2 /kwh 2050 20gCO 2 /kwh 7

Decarbonisation is a major challenge whichever policy path is chosen Overarching challenge of decarbonisation 1. The cost of decarbonising electricity is high and unevenly shared whichever path is taken 2. Costs vary strongly between technologies, and future capabilities are highly uncertain 3. Deployment of low carbon technologies is bound by political and resource constraints 1 2 3 Total Cost ( trillions) over 2020-2050 10 9 8 7 6 5 4 3 2 1 0 Emissions Target relaxed to 50gCO2/kWh Core scenario High nuclear/ccs costs Used and remaning technology potentials 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 9% 95% 87% 15% 80% 48% 2% 1% 67% Nuclear CCS Coal CCS Gas Onshore Wind Offshore Wind Biomass Indigenous Remaining Potential Used by 2050 Used by 2030 Used by 2012 Reservoir Hydro Run-of-River Hydro Solar 8

Pathways to decarbonisation will depend heavily on policy choices A number of policy scenarios covering carbon pricing, out-of market low carbon support, trans-national coordination and approach to security of supply can be envisaged 1 2 3 Absolute Market Decarbonisation is delivered through pure market solutions Carbon price drives low carbon investment Scarcity rent (linked to system margin) in the electricity price incentivises sufficient generating capacity needed to maintain security of supply Building National Solutions National intensity targets, support payments and electricity market designs Support regimes designed to deliver national carbon intensity targets drive low carbon investment National solutions to maintaining security of supply Coordinated European Planning Targets, support payments and capacity mechanisms are coordinated across EU Low carbon investment via support regimes for EU RES and carbon intensity targets A common EU-wide capacity mechanism exists to ensure security of supply Coordinated transmission build planning Dual Support Delivering decarbonisation through tempered market solutions plus residual low carbon support payments Carbon price drives low carbon investment in first instance, supplemented by support payments if needed Strategic reserve delivers security of supply 9

Challenges 1 2 3 Long term both carbon pricing and support payments routes face challenges The future business model is not yet clear will energy markets continue? Carbon pricing Support payments Credibility gap: balance of risk/uncertainty and profit potential Balancing investor certainty with democracy Required carbon price becomes high, uncertain and sensitive Potential for inefficiency from central planner Subject to political variation and other national policy objectives Central planner inefficiency and market distortion Distributional impacts (producers vs consumers, between markets) Support mechanisms distort price / dispatch, leave volume risk 10

The carbon price needed to bring full decarbonisation becomes high, uncertain and sensitive 1 2 3 Carbon price trajectory under markets Cases and 20gCO 2 /kwh Sensitivities Carbon Price ( /tco2) Narrow range of potential carbon prices up to 2030. Broad range of potential carbon prices beyond 2030. 1 2 Delivering low carbon investment beyond 2030/35 requires a high and rising carbon price, due to diminishing returns from incremental increases as carbon falls out of the wholesale price The spread of potential carbon prices broadens from 2030/35 across the sensitivities, creating uncertainty for investors regarding the anticipated carbon price over the economic lifetime of a project. 11

Wealth transfers can take place both from country to country and between consumers and producers High consumer to producer transfers can be seen under carbon pricing, particularly for nuclear around 2030-2040 when carbon emissions reach around 100gCO 2 /kwh Costs vs. revenues for nuclear (AM) & Relative country wealth change (selected countries) 1 2 3 Nuclear 120 100 2020 2025 2030 2035 2040 2045 2050 AM 114 111 11 14 99 10 86 117 16 100 0% -100% -200% 0% 80 60 40 20 0 49 5 43 27 13 8 5 59 7 51 33 20 8 5 72 9 63 41 27 8 6 88 55 39 9 7 99 71 53 10 8 99 67 11 8 101 78 12 9 The relative country wealth change takes into account both additional costs to end users and the additional profits to producers in each country normalised against the general production cost increase -100% -200% 0% -100% -200% 0% -100% -200% 2012 2015 2020 2025 2030 2035 2040 2045 2050 12

Credibility of carbon regime can be improved by reducing political involvement and pursuing cost reductions for critical technology The range of potential carbon prices required to drive investment widens over time, posing uncertainty and concerns regarding bankability of the trajectory Options for improving credibility of carbon regime 1 2 3 Explicit consideration of inter-related support Project specific contracts locking in an anticipated carbon price trajectory Predefined adjustment mechanisms to provide price stability Pursue cost reductions for critical low carbon technologies Independent carbon bank Improving credibility Carbon revenue recycling 13

All support regimes require central planning to varying degrees and history shows that this is a major issue These inefficiencies can arise through decisions on location, technology choice, and payment levels as well as reduced incentives for efficient plant operation. 1 2 3 End User Energy Cost under the AM scenario the BNS scenarios with different levels of efficiency End User Energy Price (CO2 recycling) ( /MWh) Rising inefficiency in the support regimes can dramatically alter the cost to the end user. When the scheme is shown to be extremely efficient (BNS) then overall end user energy costs tend to be cheaper than the market scenario. However, higher cost assumptions arising from inefficiencies can push the regulated solutions much higher than the Absolute Market carbon pricing solution. 14

Future support schemes must deliver revenue certainty, in the light of price and volume risk Revenue support scheme based on revenue (not price) contracts for difference, with commercial exposure to wholesale market, offers a possible approach Revenue CfD support scheme 1 2 3 An overall revenue requirement for each low carbon technology is agreed up front Wholesale market revenue expectations are determined ex-ante, potentially annually, for each low carbon technology based on fundamentals modelling The revenue support is set based on difference between revenue requirements and anticipated wholesale revenue Payment is not made based on production, which removes incentive to bid below SRMC and so reduces dispatch distortion The generator still trades through the wholesale market and has incentive to beat expectations projects have a commercial interest in wholesale market operation 15

1 2 3 Policy Recommendations: Need action now to reach commitment on a carbon pricing approach to drive next phase of decarbonisation Mitigation measures may be required to boost credibility and acceptability 1 Commit now to a clear carbon pricing framework to deliver the next phase of power sector decarbonisation and pursue policies that support its effectiveness A strong carbon pricing regime can deliver significant decarbonisation through fuel switching and delivery of lower cost low carbon investment options may require improved institutional credibility (e.g. independent carbon bank, pre-defined adjustment mechanisms) may need re-distribution of impacts, e.g. through carbon revenue recycling 2 Build in option for structured transition to incremental support in future Potential tipping point in effectiveness of carbon pricing linked to diminishing returns from incremental carbon price increases and associated sensitivity requires clear triggers for transition to project-specific support regime for higher cost technologies investors will demand stability for projects that straddle the transition 3 Enhance support payments, balancing revenue certainty and short-term efficiency Production based subsidies have distortionary impact and do not provide investor certainty as volume and price risk increase option to switch to revenue support scheme, not paid on output, which improves longer-term certainty while providing commercial exposure to short-term operation of wholesale market 16

1 2 3 Increasing renewable generation has a knock-on effect on thermal plant Falling load factors lead to a decreasing number of periods of cost recovery Thermal load factors Distribution of profits for a CCGT 100% Load factor 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2012 2015 2020 2025 2030 Based on Pöyry North-West European Intermittency Study Profit per MW (2009, thousands) 140 120 100 80 60 40 20 Decreasing periods for cost recovery 0 0% 20% 40% 60% 8 Proportion of year Based on Pöyry North-West European Intermittency Study 17

Security of supply must be delivered alongside decarbonisation 1 2 3 Security of supply 1. Scale of investment needed to deliver security of supply is overshadowed by investment needed for decarbonisation Key issues with scarcity rent approach A. Delivering security of supply in an energy-only market requires high levels of scarcity rent and acceptance of wholesale price spikes Key issues with capacity mechanism approach B. Designing an effective capacity mechanism is difficult. This challenging task falls to regulators to address potential for regulatory risk. Key issues with strategic reserve approach C. Capacity must be appropriately ring-fenced from the market to avoid slippery slope issue and crowding out of market led investment 18

1 2 3 Capacity payments do not appear to be the answer for providers of flexible generation tend to be a market intervention rather than a market-based solution often called for as a thinly-guised support for stranded assets introduce a new set of regulatory risks e.g. regular intervention in SEM to bring down the total payments e.g. will we, won t we capacity payments in GB e.g. separate payment (terms) for new and existing plants tend to bring forward predetermined types of capacity (not need-driven) Do we need MW or flexibility? Over what timescales? How/when will this change? tend to emphasise long-term stability over short term efficiency therefore the pattern of cross border flows can be badly distorted demand-side is usually excluded, or included in a clumsy way tend to be national rather than regional therefore the pattern of cross-border investment can be badly distorted 19

1 2 3 Full trading of flexibility appears to be a more appropriate option? CAPACITY PAYMENTS Unlikely to provide sufficient weight to plants providing system flexibility (e.g. hydro plants) TRADING FLEXIBILITY More appropriate to reward flexibility directly but how can this be achieved? 1 2 3 4 Balancing Intraday responsibility allocation of Energy options and marginal capacity (Explicit prices & Implicit) Cross-border balancing Four steps needed to reveal the full value of flexibility 20

1 2 3 Appropriately ring-fenced strategic reserve as stop-gap pending development of tools to balance volatility of energy-only solution 1 Improve cross-border cooperation in periods of system stress Regional coordination of generation adequacy measures offers benefits in theory but national focus (e.g. through TSO licence requirements) can prevent sharing of capacity at times of system stress pursuing a more regional approach to generation adequacy may help to unlock better cross border cooperation in periods of system stress 2 Promote demand side participation Push for greater active, voluntary participation of the demand side within the market should continue in order to unlock the potential for demand side response must be combined with public acceptance that it is appropriate for customers to reduce demand in response to price signals when they have signed up for this 3 Enhance trading arrangements to sharpen balancing incentives and allow trading of flexibility To create appropriate incentives to balance, imbalance price signals should be sharpened and all parties should have balancing responsibility will help to reveal the value of flexibility close to real-time and encourage the development of flexibility products that can help market participants to manage the risks of the future market 4 Develop strategic reserve approach as a stop-gap Governments should develop a targeted, strategic reserve if required to meet national capacity requirements contracted capacity should be robustly ring-fenced from the wholesale market and only used in exceptional, predefined circumstances, with dispatch prices feeding into imbalance prices to provide signals to the market 21

1 2 3 And meanwhile, European utilities are under pressure to improve financial performance Selected stock indices Source: Thomson Reuters 22

THANK YOU! STEPHEN WOODHOUSE STEPHEN.WOODHOUSE@POYRY.COM TEL: +44 7970 572444