Is Trouble Brewing in the Electricity Market?

After the series of articles discussing the shale oil industry I received a lot of feedback discussing both shale oil and energy in general, including the following from a reader discussing electricity in Europe:

Chris, Here’s the puzzle I am trying to figure out: Will there be mean reversion with regards to electricity wholesale prices in Europe/Germany and if so, how should one play it?

  • wholesale electricity prices – the main value driver for electricity producers – have been driven down to levels not seen for more than a decade in Europe (currently below EUR 30/MWh for delivery 2016/2017/2018).
  • this is due to substantial overcapacity in production (and sluggish demand due to the weak European economy).
  • this overcapacity in production is coming from Germany, which decided to turn off its nuclear power plants by 2022 and to massively support renewables.
  • so far the business model for operating a renewable power plant (wind, photovoltaics, biomass, water) in Germany (and other European countries) essentially was: you will receive X EUR/MWh for the electricity produced by your renewable power plant for the next 20 years (you don’t need to worry about who is going to buy that electricity or whether actually anybody needs that electricity).
  • the latest data I have shows that Germany (more precisely it’s consumers and households) is paying on average something like 160 EUR/MWh for its renewable electricity (n.b. that is roughly 5 times the price where wholesale prices are now).
  • on average means: there are power plants of different renewable technologies (wind, photovoltaics, biomass, etc.) and of age (the costs of new installations have come down substantially during the past; e.g. during the last 5 years the costs of a turn-key utility scale photovoltaics plant came down from lets say 3.600 EUR/kW to 1.000 EUR/kW).
  • even if one takes the cost reductions of the past years into account total costs per MWh for newly installed wind turbines or photovoltaic plants (the main technologies at work here) are somewhere around EUR/MWh 60-80 for wind and EUR/MWh 80-100 for utility scale PV
  • as of now Germany covers roughly 30% of electricity production from renewables and wants to get to 40-45% by 2025 and 55-60% by 2035.
  • Germany realized that this is going to be rather expensive and tries to redefine the renewable business model as described above and change the design of it’s electricity market.
  • at the same time European utilities are getting killed because of the low wholesale prices (see for example the following article:
  • utilities like Germany’s E.On an RWE are trapped because they can not shut down capacities – which would be good for wholesale prices and profitability of the remaining plants – because they (a) need a business model and (b) need the cashflow to service their debt.
  • the really interesting thing about this technological shift is that conventional power plants need a fossil fuel to burn which comes at a cost – in other words SRMC of conventional power plants are linked to the price of oil, gas or lignite/coal or whatever is burned.
  • the current low wholesale price is due to the low coal prices worldwide.
  • virtually all gas power plants have been crowded out of the European market as those would need a wholesale price of more than 60 EUR/MWh in order to be profitable.
  • renewable power plants (wind, photovoltaics) on the other hand have SRMC of zero, as there is no cost associated with the input (wind or irradiation).
  • so one has a big lump sum up-front investment (sunk cost) with only minor operating expenses during operation.
  • this means that in the short run any price above zero is good enough for a renewable power plant.
  • in the long run renewables need to earn total costs (60-100 EUR/MWh).
  • In a commodities market general competitive strategy dictates that cost leadership is the way to go – one has to be a low cost producer to stay in business.
  • All this leaves us in this rather bizarre situation in Europe (again!? probably the main reason you are investing not in the developed world!?) where renewables are entering the market with total costs of 60-100 EUR/MWh and are crowding out conventional power plants (mainly oil, gas and lignite) with similar or lower total costs.

The really big question here is, what happens:

  1. to all those unprofitable over capacities in the market, or
  2. if RWE or E.On go bust?

Somebody will be there to pick up those assets for pennies on the dollar (Euro) and will hence have a different cost structure (in terms of total cost NOT SRMC) than is prevailing today. I’d say that lots of people in the utilities world like to say that we will see stronger wholesale prices once Germany switches off it’s nuclear power plants – the forward prices for wholesale electricity do not reflect this so far. I have to admit that I see a strong case for rising wholesale prices medium turn (and I am not from the utilities world). The rationale is that if nobody earns total costs at this level prices will have to reflect costs at some point in time. Nevertheless, this whole situation with built over capacities (which are mostly sunk cost) reminds me very much of your point in case about the “dot-com” bubble and the infrastructure that it created and helped to make internet affordable faster than otherwise possible. I strongly believe that one needs to “shoot your darlings” when investing. Which means not to search for the 23rd argument in favour of one’s opinion but to look for arguments that falsify one’s investment thesis. Have you come across this mess in Europe’s electricity market or anybody who has his focus on that? What am I missing here?

I share the above with readers as I found it quite an interesting puzzle with many moving pieces. I’m largely unencumbered by any in-depth knowledge of the dynamics at work in European electricity.

More educated minds may have some insights. Please drop any insights into the comments section below.

Here is what I do know with a caveat that I’m not an expert in this sector. Energy is much more global than ever before. Infrastructure for things such as the transportation and storage of energy has meant that there exists a much closer relationship between energy costs in Europe say and those in South America or Asia. From that perspective I look at some major drivers taking place globally. Drivers which affect energy in general and wholesale electricity pricing downstream. Firstly, the age of oil as the world’s dominant driver of energy has been in decline for the last 15 years. While it is still the largest, with coal close on its heels, its overall share of the energy mix has nevertheless been in decline. Electricity today makes up a larger and larger portion of this mix. However, electricity comes from multiple sources including oil, so it’s a little more difficult to quantify without writing a 30-page report on the topic. We’ve discussed solar previously and alerted readers to this sector last year. Take a look at the cost structure for solar below: Silicon Photovoltaic Cell PriceAs the cost of anything falls, typically the usage grows as it becomes increasingly cost effective, and this is exactly what we’re seeing in both solar and wind. This cost base is bound to collapse even further in the next few years.


China is one answer. We all know what China did to the commodity boom of yesteryear, and while that particular game is over, I believe China is set to change the landscape on solar in the coming years and here’s why. China has a huge air pollution problem, largely due to coal fired power generation. They are aggressively addressing this problem and they’re doing it by building solar infrastructure… lots of it. How much? China will build more solar infrastructure this year (2015) than existed in the entire world in 2008. I find it hard to imagine that this build out doesn’t impact the cost decline curve of solar. From Reuters:

Apple announced Wednesday it will build 200 megawatts of solar energy projects in China and work with local suppliers to source more renewable energy, its latest moves to green its Chinese supply chain amid criticism that its local partners are heavy polluters. As part of Wednesday’s announcement, major Apple supplier Foxconn said it will build 400 MW of solar energy projects by 2018, starting in Henan province.

To put this into perspective, consider that in 2013 China had 11.3 GW connected to the grid, followed by Japan with 6.9 GW connected, and the US in third place had 4.8 GW connected. China is planning on adding a whopping 100 GW by 2020 and Japan already just added a whopping 9 GW in 2014, adding more in 2014 than they previously had in total. As this additional infrastructure build-out in solar, wind and nuclear continues, I think it’s fair to extrapolate that low energy prices on a look-forward basis are in the cards. Additionally, the cost of solar will continue to fall and the quality will continue to rise.

The guy sitting in Ghana may not think it affects him that China is building a ton of solar infrastructure but if he’s even modestly educated and understand economics he’ll be able to understand why the solar panels he’s buying in Accra are falling in price and likely increasing in quality and efficiency. This affects wholesale electricity providers, some more and some less, depending on particular countries. I’m not sure about wholesale electricity prices in Europe or how best to participate (if at all) as per the comments from our reader.

We are however long solar, synthetically short oil by being long the USD across multiple strategies – a trade which we began telling you about in late 2014 and which we believe has a lot more juice left in it. I won’t rehash all the reasons for that as they’re detailed in depth on our site and in reports we’ve sent to those on our mailing list.

– Chris

“China is now the largest wind power market in the world. They have increased their power generation from renewables from really nothing 10 years ago – and now it’s 25%.” – Maria van der Hoeven, Former Executive Director of the International Energy Agency


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