Cost competitive

A setback for grid parity? By Stephen Nash

The impact of the recent fall in the oil price on O&G investments has been well covered, but what is the impact further down the value chain? What is the impact on the power sector, and on the quest for grid parity for renewables?

In recent years the costs of renewable generation have been falling and the prospect of grid parity has seemed increasingly within reach.

The Holy Grail for the development of renewables has for a long time been the goal of reaching grid parity, that is being cost competitive with conventional power generators on a $/MWh basis. Until a few years ago that target seemed a long way off and to date most renewables capacity in developed markets has been subsidised. This has normally meant receipt of some form of Feed-In Tariff (FIT) or Green Certificates (GCs), with the cost of the subsidy being funded by electricity consumers and/or taxpayers.

More recently, cost reductions have raised the prospect of grid parity becoming a reality. Fig 1 illustrates the rapid fall in installed capex for wind and solar PV since the start of this decade. For solar PV, this has resulted in the Levelised Cost of Energy (LCOE, a measure of the annuitised cost of generating each MWh of energy) falling by c.50 per cent between 2010 and 2014. Solar PV modules have actually fallen by more (c.75 per cent), but the same savings have not yet been seen in balance of plant costs. During this same period the total installed capacity has increased to more than four times 2010 levels. Costs have also fallen significantly for wind generation, although the quantum has been less dramatic.

The LCOE achieved varies widely by project, depending on resource availability, the commercials struck by the developer, and the cost of finance. But, in summary, it is increasingly common for LCOEs of less than 0.1 $/kWh to be achieved. This is below the retail cost of energy in many markets, and below the wholesale cost of power in many less developed markets, where the wholesale cost of electricity is determined by relatively expensive oil-fired generation. However, the correct benchmark, at least for utility-scale renewable generators, is against wholesale prices in more established more liquid markets, meaning that grid parity is still some way off.
Baringa Partners Fig1
As small-scale distributed generation (e.g. rooftop solar) plays an increasingly significant role, the comparison against retail energy prices becomes increasingly relevant. Some network costs can also be reduced through greater use of distributed generation, but on balance the cost of these smaller scale projects is, at least currently, much higher. The International Renewable Energy Agency’s (IRENA) latest analysis of renewable generation costs quotes a LCOE range of 0.14-0.47 $/MWh for residential solar PV projects, versus 0.11-0.28 $/MWh for utility scale projects in 2014.

Power prices are now lower, reflecting falls in the price of oil and other commodities, pushing back the prospect of widespread grid parity.

For grid parity to become common in more developed markets, either further cost savings are required, or there would need to be an increase in wholesale power prices. An increase in power prices has become less likely over the past few months as the price of oil has fallen, and as the market response to the announced withdrawal of European carbon allowances (EUAs) from the market later this decade has been muted. In many power markets it is the price of natural gas that often determines the short run cost of the marginal generation plant, and hence the wholesale price of power. Natural gas pricing, at least in Europe and in markets dominated by LNG, is often indexed to oil, although this is gradually becoming less prevalent. In less developed markets, the marginal plant is often diesel-fired resulting in a more direct link to the oil price.

Fig 2 shows how power prices in GB and Germany have dropped as the oil price has fallen, as a result of this relationship between oil and power prices. For ease of comparison, the power forward curves are presented in $ terms using the spot exchange rate on the quote date. If we were to extend this analysis to other power markets, the impact would vary by country. The fall in oil prices will generally have less impact in markets where coal dominates the generation mix, since coal prices do not always move with the oil price in the same way that gas prices do, especially in domestic coal markets that are not well connected with international hubs. Conversely, the impact of oil prices is more direct in many less developed markets where the marginal power generator is oil-fired.
Baringa partners Fig2
The fall in commodity prices could have a negative impact on the renewables capacity developed in the coming years, and could also have a negative impact on existing investors in the sector.

So what will the impact of this fall in power prices be on renewables? In markets (e.g. in Europe) where renewables are supported by subsidies, and in particular where those subsidies guarantee a fixed price for the power generated by renewables, the cost of those subsidies will rise.

The UK is a good example of this. The amount of subsidy that can be granted under the new Contracts for Difference (CfD) mechanism is capped through the Government’s Levy Control Framework (LCF). The LCF allows for c.£1.6bn in annual funding for renewables supported by CfDs by fiscal year 2018/19. To illustrate, if the power price were to fall from 50 £/MWh to 40 £/MWh then that would increase the subsidy paid to a renewable generator. For example, for a generator with a strike price of 100 £/MWh (in reality the strike price varies by technology) and a load factor of 30 per cent the implied subsidy would increase from 131 £/kW p.a. to 158 £/kW p.a. This in turn could reduce the amount of renewable generation capacity that could be funded within the LCF cap in the period to 2018/19 by 2.1 GW.

In less developed markets, the principles are similar. Even in markets where the wholesale price of power remains very high, a drop in this price may lead to the business case for investment in renewables appearing less attractive. A lower power price increases the risk that an appropriate level of return on up-front capex investments is not earned.

A more immediate concern for existing investors in renewables may be impairment risk (i.e. the risk that the ‘fair value’ of their assets falls below the book value). The decline seen in forward power markets may lead to lower power price assumptions being used in evaluating asset book values. This could lead to those book values being revised downwards, especially where the subsidy received is in the form of an adder to the power price, but also for the equity tail of assets receiving a fixed price subsidy.

In summary, the recent fall in the oil price has a number of consequences for the renewables sector, and could push back the prospect of grid parity. But will these effects persist? Achieving grid parity would require further reductions in the cost of renewable generation and/or a recovery in power prices.

However, there are several reasons to believe that one or both of these requirements could be met. On the former, the very factors highlighted in this article could increase competitive pressure on renewable technology providers, potentially speeding up the rate of cost reduction. At the same time, capital costs could fall as reduced demand brings down the price of key commodities – a factor that has been partly responsible for the decline in the oil price. On the latter, the cyclical history of oil pricing suggests that low prices will not persist forever. It is also possible that a comprehensive agreement at the Paris climate change talks could lead to a more robust carbon price, in turn generating higher power prices. There is no doubt that falling oil prices put pressure on developers of renewables projects in the near term, but in the long run could they be a blessing in disguise?

Baringa Partners
Stephen Nash is a senior manager at Baringa Partners, an award-winning management consultancy specialising in: energy; financial services; telecoms and media, in the UK and continental Europe. It partners with organisations when they are developing and delivering key elements of their business strategy, as well as working extensively with government and regulators providing policy and advisory services.

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Issue 122 July 2015