Truflation Deep Dive: Energy & Utilities | Truflation
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Truflation Deep Dive: Energy & Utilities

Published 26 Sep, 2022

Energy prices are driving the current cost of living crisis in one way or another. In 2021, Truflation began building global inflation data by launching our US and UK indexes; utilities are one of the main drivers of global inflation this year, especially in the UK and Europe.

Easing the burden on consumers is a priority: the total energy bill paid by the world’s consumers is likely to top USD 10 trillion for the first time in 2022, hitting the most vulnerable in society the hardest. Governments have announced fiscal support and market price interventions in the European Union and the UK.

Is this the ‘right’ approach? Why is there such a concentration in energy, supply, production, and markets? Today, we deep dive into the data behind utilities to what lies behind energy ‘prices’ and how this affects everyone globally, no matter where you live. We will cover:

  • The production hangover
  • The ‘clean’ energy transition
  • Energy markets’ misallocation
  • Russia’s war with Ukraine
  • Winter is coming

Let’s look at the stories behind the data, how events over the last decade have led us to where we are now, and what, if anything, can be done to ‘mitigate’ the current crisis.

The production hangover

Even before COVID,  electricity has been predominantly sourced from burning fossil fuels, either coal or, more recently, natural gas, because it is cleaner burning.

Source: Hannah Ritchie, Max Roser, and Pablo Rosado (2020) - "Energy"

Although hydropower has been used since the early 1900s, it currently represents only 16% of global electricity generation. However, its contribution is higher than nuclear power and larger than all other renewables combined (including wind, solar PV, bioenergy, and geothermal).  Over the last twenty years, hydropower’s total capacity rose by 70% globally; its share of total generation stayed stable due to wind, solar PV, coal, and natural gas growth. Over the past two decades, only China and India have increased their hydropower generation capacity through large infrastructure projects.

Natural gas for electricity generation has overtaken coal as the fuel of choice for flexible electricity generation. However, natural gas exploration and discovery have not kept pace with the increased global demand for this fuel. Investment in fuel supply has been dropping since 2015 in both oil and natural gas.

You can also see this downward trend in upstream investment in new oil and natural gas fields. Most upstream capital investment is centered on existing fields and shale plays (Source: World Energy Investment 2022).

Before COVID, exploration for new oil and natural gas fields decreased.  The reduced demand for oil products and refining during the pandemic only exacerbated this trend. Although investment is on an upward trend for 2022, it is still below 2015 levels even as demand continues to grow. During the pandemic, due to the demand shock of lockdowns and the low oil prices, investment in refining capacity decreased, especially in Europe and North America. Here older refining capacity was ‘retired’ or mothballed due to the lack of demand for oil products or because the input costs of upgrading refining capacity were higher than refinery margins.

Investment in production capacity after COVID has increased, but most oil and gas development has a long time horizon between discovery and active production.  In many cases, COVID only delayed higher prices by artificially suppressing energy demand due to lockdowns and reduced industrial production globally.  The return to ‘normal’ after COVID saw higher prices for natural gas and electricity in 2021 as demand and energy usage returned to pre-pandemic levels.

The ‘clean’ energy transition

The last decade of under-investment in energy supply and production has been driven by the desire to reduce greenhouse gas emissions and global warming. Governments, businesses, and consumers have been pushing for greater electrification of the economy and acceleration of the clean energy transition.

As advanced economies have focused more on sustainability and the environment, there has been a conscious shift away from burning ‘dirty’ fossil fuels like coal (even in China).  However, coal is still a large part of the electricity production mix globally, especially during episodes of peak demand. Many countries have been ‘trying’ to phase out coal generation capacity.

At the center of the net zero discourse has been natural gas, our go-to fossil fuel with lower emissions than coal and higher flexibility.  It was Plan B: until we build enough renewable electricity generation capacity to meet demand.  Renewable capacity is forecast to account for almost 95% of the increase in global power capacity by 2026.

Increased renewable capacity is driven by effective policy, including PV subsidies and pricing pressures. Both regulatory changes and higher retail electricity prices in markets make self-consumption and net metering more attractive to consumers and businesses. For example, with average base-load power prices trading at more than EUR100 per MWh for Germany and France to 2030, this provides a significant incentive for consumers to opt for renewables even if their variable production incurs a cost in the form of consumption-production mismatch.

Fun facts about renewable energy:

  • In 2020 renewables accounted for more than 43.1% of the UK's total electricity generated, at 312 terawatt hours (TWh). This outstripped fossil fuels over the year for the first time in the UK’s history.
  • The UK has pledged to target power from 100% renewable sources by 2035.
  • The UK had its longest run of coal-free power, with a total of 68 days between 10 April and 16 June 2020.  This was the longest coal-free period since the industrial revolution in the mid-1700s!
  • UK zero-carbon electricity generation overtook fossil fuel consumption in 11 months of 2021.
  • Solar power is the fastest-growing source of renewable energy production in the EU. Across all 27 EU member states, 18 countries broke solar records this summer. In the EU, renewable energy sources made up 37% of gross electricity consumption in 2020, up from 34% in 2019.
  • In the EU, wind (36%) and hydropower (33%) accounted for over two-thirds of the electricity generated from renewable sources. The remaining one-third of electricity came from solar power (14%), solid biofuels (8%), and other renewable sources (8%).
  • By 2026 the European Union’s renewable capacity is expected to reach 750 GW, expanding by 40 GW per year. If this pace continues, the bloc will be on track to not only meet but exceed current renewable capacity plans for 2030.

Regarding pricing effect, long-term contracts are crucial in financing wind and solar PV projects at scale. In Europe and the UK, shorter renewable contracts encourage developers to prepare for market prices at an earlier date while also providing flexibility for other revenue streams (e.g. bilateral power purchase agreements or PPAs) with large consumers over the remaining years of the plant’s operation.

Renewable generation is increasing quickly, but infrastructure monopolies and regional power networks in many countries lack physical network investment.  Often power networks cannot manage peak power generation events because the grid is not designed for higher electricity transmission.  Ageing electricity grids cannot meet the current energy demands on energy infrastructure in many countries, even without further renewables coming online. For example, this summer’s blackouts in Spain resulted from the EU not being able to send enough electricity to Spain to meet their peak demand during this summer’s heat wave.  

Electricity grid management and further investment in transmission are the keys to integrating additional renewables into the energy mix and managing electricity demand better, especially in the UK and Europe. Energy integration in Europe between countries for gas pipelines and electricity grid networks between member states is an urgent priority.

Energy markets’ misallocation

The downside of renewables is their unpredictability, seasonality, and inconsistency. The sun does not always shine, nor does the wind always blow, which makes producing consistent electricity difficult. This means that marginal production is always required to fill the ‘gaps’ in electricity generation, ensuring the ‘on-demand’ supply of electricity we all take for granted. Here is where energy market pricing comes into the story.

Let’s look at European and UK markets: energy prices in both these markets are set through a marginal pricing system. This means the need to meet demand on any given day from the most expensive power plant sets the wholesale electricity price for all suppliers (regardless of how they generate electricity). As a result, natural gas-fired power stations (the most common form of electricity generation in Europe and the UK) dictate the wholesale electricity price for the whole market. As the share of renewables in the energy mix has increased, there was little incentive to overhaul the market (it worked well for the last 30 years!).

Consumers believed they supported green energy by ‘paying’ a higher tariff for renewable electricity through their electricity suppliers. The theory was that higher prices would incentivize and fund the development of ‘clean’ energy by increasing the profit margins for lower-cost renewables and encouraging further investment. In 2022, with hindsight, this looks like wishful thinking on behalf of governments, regulators, and consumers.  

Electricity supply is, in many ways, a monopoly, which is why the marginal pricing system created a fair playing field for electricity generation providers regardless of generation type. The market structure has backfired spectacularly this year as gas prices have soared to record levels, dragging the cost of electricity to record levels as well.  

This dynamic between natural gas and electricity is fueling energy prices. Taxes and levies accounted for 36% of household electricity bills in the second half of 2021. For gas bills, the corresponding share was 30%. There were no significant changes in taxes or levies during the last two years. These levies in most countries fund the grid, the regulator and infrastructure investment regardless of their energy supplier.

For example, the following chart is from Britain’s Elexon, the company which manages balancing and settlement on behalf of National Grid (Britain’s power network). Exelon’s job is to compare how much electricity generators said they would produce and what suppliers said they would sell with the actual volumes and then determine a price for these differences.  This electricity balancing mechanism is how they ‘keep the lights on’.

The chart below illustrates the forward curve for power price assessment for the rest of this year.

Source: Exelon

It’s scary stuff! These numbers illustrate why the EU and national governments are stepping in to cap prices and address the hardship consumers and businesses will face this winter due to prices rising so high, so fast. Governments are stepping into the breach to prevent utility suppliers from going under too. For example, Finland and Sweden have announced capital provisions for their utilities.  The broader question we should be asking is whether the current market pricing structure is fit for purpose going forward?  

Since July, a UK consultation has been underway on decoupling wholesale electricity prices from the price of gas and creating a different pricing system for electricity. This option addresses the cost of power generation and disconnects renewable pricing from the fossil fuel market.  It also recommends a pricing structure build around times of day and household size to make usage predictions more accurate.  

There also needs to be a backstop to prevent energy suppliers from collapsing. We need to ensure that lack of capital provision does not cause a chain reaction among suppliers. Banks should be persuaded to provide reliable working capital for European and UK utilities in partnership with governments during extraordinary price movements such as now.

Russia’s war with Ukraine

Today’s high energy prices are brought to you by Russia’s war with Ukraine and their weaponization of natural gas supplies to Europe in retaliation for Western sanctions.

Even before the invasion, natural gas and wholesale electricity prices in these two markets had increased throughout the pandemic (even as demand weakened due to a decrease in energy usage). You could argue that during 2021, Russia was already reducing its natural gas supply via pipelines into the EU market and driving prices higher.

In the UK, energy prices have risen for the last decade; the average unit cost increased 67% from 2017 to 2021. These are not new COVID-driven supply issues; this is simply the result of electricity demand outstripping generation capacity.

Russia’s invasion of Ukraine has been the ‘Mother of all Supply Shocks’ for energy and commodity prices. Oil, natural gas, and electricity prices have all risen this year due to competition between markets for alternative energy supplies and the race to fill storage capacity before winter 2022/23 in Europe.

Enter Liquid Natural Gas (LNG). Where LNG exports had in the past been headed for Asia, higher energy prices redirected LNG to Europe from both the Middle East and the US.  You can see from this graph that LNG capacity has been growing steadily over the past five years in North America, even before COVID or the Russian invasion. The shale gas era has propelled both the US and Canada to become net energy exporters.

With its LNG terminal and infrastructure, the UK has been reverse supplying LNG via its pipelines to Europe this summer. Norway has also been trying to do its part to provide its EU neighbors with additional natural gas capacity in preparation for winter through its pipelines.  The real question is, have the EU and the UK done enough to avoid rationing and blackouts this winter? We will have to wait and see.

The energy crisis and Russia’s invasion have incentivized new investments in energy, including an expansion of coal in emerging Asian economies. Even in Germany, coal-fired power plants are being brought back online to meet the challenge of Russian supplies being cut off even with their commitment to reducing emissions.  LNG export capacity investment is the one area where natural gas supply production has been increasing, especially in North America and Australia.

Over the longer term, increasing international isolation of Russia following its invasion of Ukraine will place additional pressures on an already tight market for many of the minerals and metals vital to manufacturing renewable energy components like solar PV and wind turbines and battery technology.

These are interesting statistics about Russia that we need to keep in mind for the clean energy transition:

  • Russia is the world’s 2nd largest producer and consumer of natural gas (638 and 411 billion cubic meters, respectively). Only the US produces more natural gas.
  • Russia is the world’s 2nd largest producer of aluminum (6%) and accounted for 8% of EU imports in 2020. High gas and electricity prices have reduced the EU’s aluminum production by nearly half since September 2021.
  • Russia is the world’s largest producer of battery-grade Class 1 nickel, accounting for 20% of the world’s mined supply.
  • Russia is also the world’s 2nd and 4th largest producer of cobalt and graphite, respectively (critical minerals for battery production).
  • Russia is also the world’s largest producer of enriched uranium (for nuclear power).

What do critical metals have to do with energy pricing?  These critical metals and minerals are vital for manufacturing and producing renewable energy components such as wind turbines, solar PV cells, and battery systems for storing renewable energy. Material component prices have remained relatively consistent until recently, which led to greater investment and construction of renewable projects, thus increasing renewable electricity generation. In the long term, Russia’s isolation will result in higher costs for further electrification and generation capacity, which may keep prices higher than they would otherwise be.

Winter is coming

Without a doubt, Russia’s weaponization of natural gas and western sanctions on Russia have increased volatility in energy markets during 2022.  The question is, how can we address energy prices while the war is ongoing? The EU has been hard at work on its strategy for weaning its members off Russian natural gas and oil and the negotiations to hold together EU solidarity over Ukraine in the face of considerable rises in the cost of living within member states. Recalibrating infrastructure takes time, something the EU and UK do not have with colder weather on the horizon.

The IMF has recently published a working paper outlining potential actions to address Russia’s disruption of gas supplies.  The IEA has also outlined ways that governments, businesses, and consumers can reduce their demand for energy by pursuing energy efficiency initiatives and allowing pricing mechanisms to work to a fuller extent than has been the case so far.  

The EU has presented the REPowerEU package to reduce Russian energy import dependency and facilitate progress towards achieving complete energy independence from Russia by 2030. Overall, REPowerEU will focus on (i) reducing energy consumption (via efficiency campaigns); (ii) diversifying supplies; (iii) accelerating the green transition (both through a push on solar PV technology, as well as developing alternatives to natural gas such as green hydrogen and biomethane); and (iv) improved connectivity within Europe.  The EU has also put forward regulations mandating minimum gas storage levels of 80% by November 1, 2022, with an increased target of 90% from 2023 onwards. Preliminary data for the first half of 2022 suggests some demand adjustment is happening.

No one knows how these government energy price caps will affect inflation over the medium term or how much the economy will slow down, given the headwinds that are battering growth. We are currently in uncharted waters, and almost all economists agree that energy price caps will help rein in inflation this year or stop it from rising further. However,  energy rules them all and will continue to drive inflation in 2023 and beyond.  

It is time to focus on energy efficiency, reduce usage and develop new energy storage technologies. Both of these are needed to be able to store and use renewable power better and more efficiently. Increased renewable energy supply will only influence consumer energy pricing when we build a modern ‘smart’ grid that can allocate, distribute and price energy usage based on time of day, the type of energy used for generation and balance always-on supply with ‘green’ energy’s dynamic supply.

We need new and better ways to store and transmit electricity, and we must start building ‘smart’ electricity grids now. This is a mammoth task for both energy pricing markets and power generators. Globally, the era of cheap energy is over, but energy innovation is just beginning.

Written by CeAnn Simpson

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