European energy model ‘is broken’

Paul Boughton

The now ‘traditional’ vertical integrated large utility model that exists across Europe, and has resulted in the ‘Big Six’ in the UK, has arisen as it has enabled the large incumbent companies to supply its customers and achieve its margins whilst taking relatively low risk.

The low risk achieved by the large European utilities arose though their ownership of large thermal generating assets, whose economics and margin largely set the overall wholesale price, through possession of a large balance sheet to enable forward hedging of commodity prices and their inheritance of a large customer base with a regulatory system that had a high inertia to customer switching. All of these factors resulted in a steady and profitable business model.

As is now widely reported, this business model now looks ‘broken’ in mainland Europe. This does not yet appear to be the case in the UK. The capacity limitations on interconnectors linking the UK (and Ireland) with mainland Europe means that the UK is, to some extent, isolated from the ‘oversupply’ that can exist at times in Europe and which drives wholesale prices down.

This, however, is not something the UK Government, the regulator and National Grid want to see continue as there is a clear agenda for more interconnection capacity to allow the UK and mainland Europe markets to become one with closer price parity. This indicates that the UK’s ambition is to also see the existing large utility model ‘broke’ but in the UK the safety net of the capacity mechanism currently exists to ensure security of supply and perhaps reduced reliance on Europe in a crisis.

Why is the European large energy utility broken? The core reasons are that the large incumbents’ thermal generating assets are losing money due to a disconnect between the cost to generate using fossil fuels and wholesale prices.

In addition they have to maintain their energy supply to a (slowly) declining customer base but the customers lost represent their most profitable, with new suppliers able to ‘cherry pick’ and provide niche ‘green power’ offers and also purchase power on the wholesale markets at below the cost the incumbents can generate it and pass these savings on. Whilst the utilities could themselves purchase power on the wholesale market, they still have to service the debt and fixed costs on the large thermal generation fleet they own – some of which have only recently been built.

Looking further beyond the core reasons, the underlying causes are an overall reduction in energy use across Europe coupled with the growth of renewable generation. In the case of renewable generation, this has been achieved through subsidising its construction and/or generation.

Renewable growth and demand reduction has created a supply and demand imbalance with a large renewable installed generation base that generates irrespective of wholesale price or demand. The level of renewable subsidies makes generation profitable even if the energy generated is given away and, in some circumstances, even if you have to pay somebody to consume it!

The energy utilities’ response to these pressures in Europe has been to lobby for support of the asset models they have on a platform of energy security and overall cost to the consumer. One of the calls has been for the equivalent of the UK’s capacity mechanism, with all European countries having conducted studies of possible options and undergoing consultation on what such a mechanism would look like.

However, in November 2014 Germany’s energy minister rejected the introduction of a capacity mechanism in Germany and there appears to be a strong European sentiment rejecting the need to ‘subsidise thermal power plants’.

With this sentiment against the financial support of existing thermal power plant – many of which are loss-making – it is no surprise that the European utilities are looking to reduce the cost burden of these assets through retirement, mothballing or locating whole stations to other more profitable countries or regions. It was reported in statistics by the European Wind Energy Association that in 2013, 10GW of gas, 7.7GW of coal, 2.7GW of oil and 750MW of biomass capacity was decommissioned in Europe against a backdrop of 35GW of new installed capacity, with about 27% of this being thermal and the balance renewables.

These new market forces are also seeing incumbent utilities diversify their business to areas outside of Europe whilst within Europe they are also looking to move from being a commodity energy supplier to providing energy services.

Much commentary has been written on this with the entrance of Google (indirectly) into the arena through the purchase of the NEST thermostat and the penetration of ‘smart’ meters, indicating that the margin in energy is perhaps to be made in its customer-side technology and not in the old supply models.

As many commentators have pointed out, the corrective actions of the large utilities have come somewhat late in the day. Many sectors have come under fire from disruptive technology and business models and this could be the new future for energy utilities and supply – but it has perhaps taken a long time for the large utilities to conclude that the old model has broken. This would not be a surprise given the background of the large inertia of the incumbent utilities making it difficult for them to quickly change tack. They may still be hoping that at the eleventh hour the talk of mothballing and retreating from their domestic markets may make governments ultimately think again and support their existing asset base paying for standby generation.

Changes in the companies and structures that ensure the lights do not go out across Europe will introduce new risks and challenges and politically the stakes of failing to manage this could be high. However Europe, in resisting calls to support thermal plants and the general anti-large utility rhetoric that exists, may have signalled that governments and consumers want a more modern business model for energy supply where more distributed generation, niche suppliers and provision of energy services aimed at managing and reducing energy costs are the way forward.

Paul Verrill is director at EnAppSys, an independent energy specialist company that provides electricity and energy market data, systems and consultancy services to parties with an interest in the UK energy market.

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