Disaster Scenario Worse Than Brexit Looms for U.K. Power Market

(Bloomberg) --
Away from Britain’s struggles with the European Union over Brexit, there’s another conflict with the bloc that threatens the nation’s electricity supply.

An unexpected ruling by a court in Luxembourg on Nov. 15 to uphold a challenge from a little-known company removed EU state aid approval for a mechanism that pays generators for keeping their power plants available. The 1 billion-pound ($1.3 billion) a year capacity market is at a standstill while an investigation is carried out with payments suspended and uncertainty about when they will be reinstated. The probe may take 12 to 18 months. 

“It was a big shock,” said Phil Hewitt, director at Enappsys, a U.K.-based energy trading consultant. It now looks like there’s “a massive red light over the industry saying it’s not safe to invest in.”

The ruling adds to the darkening outlook for British utilities, including the government’s cap on energy bills and stiffer competition that’s draining customers from the Big Six suppliers. The collapse of a merger involving the U.K. retail units of SSE Plc and Innogy SE’s Npower earlier this week underscored the difficulty of doing business in the U.K. energy industry.

Disaster Scenario Worse Than Brexit Looms for U.K. Power Market

While the capacity market suspension adds to those frictions, generators have been notably silent as they digest how much the mechanism will reduce or delay earnings. They face a gap of 300 million pounds this year and 1.1 billion pounds in 2019 if the ruling is unsuccessfully appealed or offset by a new program, according to Moody’s Corp.

The U.K. government has sought to reassure investors that it and the European Commission are working closely on the necessary steps to complete the investigation. As proof of its confidence, the U.K. will go ahead and hold a “top-up” year-ahead auction in the summer of 2019, with payments made after a resolution with the European Commission.

This auction will only cover 4.6 gigawatts of capacity and is likely to clear at a “low price,” according to the researcher Bloomberg NEF. The EC’s investigation, which hasn’t even started yet, needs to be completed before October when the contracts begin.

Disaster Scenario Worse Than Brexit Looms for U.K. Power Market


That’s the optimistic scenario being pushed by the government. There’s less rosy ones too, where 20 gigawatts of coal and natural gas capacity drop off the power grid and “create serious security of supply issues,” according to Jefferies Group LLC. That’s enough for about 29 percent of Britain’s peak demand.

 

Here’s what else may go wrong:

  • A worst-case scenario is that the EC’s investigation finds that the scheme is inherently unfair and previous auctions are deemed not to have met state aid rules. In this, albeit unlikely scenario, generators would have to return 463 million pounds to the government and miss out on 5 billion pounds of payments agreed for the next 18 years. Older power plants would begin to shut, leaving a supply gap and raising the risk of power cuts.
     
  • A slightly better situation for utilities would be an EC conclusion that past auctions have been unfair, that the contracts are no longer valid, and they all have to be rerun and the rules changed for future auctions. This could result in power plants shutting sooner than expected.
     
  • The most likely scenario, according to Richard Howard, research director at Aurora Energy Research Ltd., is that the EC finds that capacity markets in general and the U.K.’s in particular are fair but there are some rule changes needed to level the playing field between technologies. The important nuance is whether the new rules will apply only to future auctions or previous ones as well.
Disaster Scenario Worse Than Brexit Looms for U.K. Power Market



Timing Slips

The timing of any deal is the biggest risk for power generators.

The mechanism, instated in 2014, was meant to ensure that enough new capacity is built to replace older power plants as they close. Generators need more certainty about how they will get paid to justify further investments, said Lawrence Slade, chief executive officer of Energy U.K., the industry’s lobby group.

“Investors need clarity on what is happening and when,” Slade said. “We need dates. It has put investment and jobs at risk.”

Leaving a question mark over the market revives the debate about whether a capacity market is compatible with broader goals to cut greenhouse gas emissions. Critics have lambasted the mechanism for allowing fossil-fuel plants to keep running. With contracts as long as 15 years available for new facilities, the challenge to the market made by Tempus Energy was on grounds that these deals weren’t available to all types of generation.

Disaster Scenario Worse Than Brexit Looms for U.K. Power Market

One possibility is that the capacity market will be reinstated and payments backdated, according to analysts from Sanford C. Bernstein & Co. LLC to UBS Group AG. But the uncertainty is already causing headaches. Drax Plc modified a deal it has to buy generation assets from Iberdrola SA’s Scottish Power to include a risk-sharing mechanism to cover missed payments during 2019. Further delay has the potential to unravel other projects.
 

The Brexit Factor

Britain’s scheduled exit from the European Union in March may complicate this dispute.

If Britain leaves the EU without a deal, the government has signaled its intention to use the Competition and Markets Authority to rule on the fairness of state aid in the way that officials in Brussels do now. So it’s likely that Britain would still have to uphold the EU Court ruling on the capacity market and continue the EC’s investigation.

Having the CMA at the helm could give Britain more flexibility on the timetable of the investigation. However, the EC probably wouldn’t hand over the paperwork related to the case quickly in the event of a “no deal” Brexit, and that would leave the CMA needing to restart the probe from the beginning.

Britain leaving without a deal, which now seems like a real possibility, will complicate energy trading with the continent but is in itself not a threat to supplies. 


Power Prices

So far, power prices haven’t moved much as a result of the mechanism being suspended. But they may in the months ahead.

Without capacity payments, companies will lose money from coal and gas stations this winter, according to Rob Lalor,a senior analyst at Enappsys. These power stations are usually squeezed out by higher levels of wind generation in November and December and don’t generate much or even at all.

Disaster Scenario Worse Than Brexit Looms for U.K. Power Market

“Generators are being asked to stay in the market and keep the lights on while taking a big financial hit,” Lalor said. “Usually with capacity payments they can get through it.”

National Grid Plc has reassured the government and the market that there are no supply risks for this winter. Part of the reason is it’s not easy to close a power station quickly even when they’re unprofitable. An operator must give notice to National Grid before shutting down.

If the capacity mechanism can’t be restored then old stations will probably be reviewed at the end of the financial year at the end of March 2019, Lalor said. “It will take months to shut a station so it will be next winter when there’s less capacity.”

That coincides with the date the U.K. is due to leave the European Union.

©2018 Bloomberg L.P.