Electricity disrupted - Part 1

The business model for power generation hasn't changed much in 100 years. Then, as now, electricity was produced in one location and transported, via familiar poles and wires, to another location to be consumed.

The industry depends on generators to produce the electricity, distributors to transport it and retailers to sell it to consumers. These parts of the electricity industry – generation, distribution and retail – have long been stable, reliable business, generating stable, reliable returns. Not anymore.

Changing patterns of consumption and production, particularly the introduction of renewable power, now threaten to turn the power industry on its head. In Europe, utilities that were once stable engines of profit now risk bankruptcy and irrelevance. The very viability of the electricity business is threatened and yet, in Australia, few have noticed the threat at all. Could the same thing happen here?

In this two part series, we'll examine how renewable energy, and particularly solar power, have changed electricity economics and how ASX listed businesses in the generation, distribution and retail parts of the industry will be affected by the change.

Trick question

Which European industry suffered most since the GFC? If you said banking, you'd be wrong. Banks are the highest profile casualties of the Great Recession but electricity utilities in Europe have lost more in dollar terms than even the continent's fragile banks.

Since 2008, more than €500bn in market capitalisation has vanished from European power utilities.

The share price of Germany's largest utility, E.ON, has fallen 75% in that time; its second largest, RWE, reported its first loss since 1949 this year and its third-largest generator, EnBW, has publicly said it expects profits from generation to fall 80% by 2020.

But the problem doesn't just lie with the Germans. Since 2008, wholesale electricity prices across Europe have fallen 35-45%, prompting a mass shutdown of generation capacity. About 30 gigawatts (GW) of gas power alone has been mothballed. The chief financial officer of RWE warns that 'conventional power generation is fighting for its survival'.

What has caused the crisis in Europe's utility market? Renewable energy, mostly. In particular, the growing use of solar power has dramatically altered industry economics. Power generated by solar panels in the EU has increased from 10GW in 2008 to over 80GW today, amounting to about 2% of total generation and 4% of peak capacity. To understand why this has played havoc with profits, we need to understand the economics of generation.

The good old days

Generating power should be a simple business. Base load power plants provide 'always on' generation using coal and nuclear energy and cannot easily be switched on or off. They were therefore built at a mighty size to reduce unit costs and left to run all the time. Traditionally, these plants have been the cheapest and most abundant sources of electricity supply.

Although base load supply is constant, electricity demand is lumpy. It spikes and falls at predictable times. For example, demand increases on hot days and during evening peaks, causing prices to spike and making it profitable to fire up expensive but flexible peaking power plants, usually gas, that can supply marginal demand.

Renewable energy challenges that business model because it boasts two unbeatable traits. Firstly, it generates power at zero marginal cost which means that, when it's available, renewable energy is always the cheapest on the market, displacing both peak and base load power plants. Secondly, it does this just when demand – and hence prices – are at their highest.

Power plants rely on peak periods to generate their profit. In Australia, for example, 25% of all generation profits come satisfying just 36 hours of peak demand.

Renewables account for a small percentage of total generation but, because that volume is supplied at the most profitable period, it is devastating for incumbents: the equivalent of taking Christmas away from retailers.

The solar threat

Incumbents in the Australian electricity market face the same fate as their European peers. About 1.4m households now have rooftop solar (aka photovoltaic, or PV) panels that generate almost 3.5GW of energy – about 2% of Australia's generation, a similar level to Europe (see Chart 3). That number is forecast to double by 2020.

With the price of panels tumbling, the cost of solar power is approaching the cost of conventional energy even without subsidies. The Western Australian market operator says that, by 2023, 90% of commercial businesses could have rooftop solar panels. In Dubbo in NSW, 30% of all households already have solar panels.

The march of solar power is unlikely to stop. But what is a triumph for environmentalists is a disaster for utilities.

Stanwell Corporation is Queensland's largest generator. Last year, it made no money from generating 4,000 megawatts of electricity. That is entirely because solar supply has displaced it on the handful of days in a year when prices peak.

There is more wind power being generated than solar, but solar is by far the more disruptive force. Wind merely replaces one type of energy for another. Power is still generated at one location and sent down poles and wires to another where it is consumed. Solar does away with the entire system of generators, distributors and retailers. Solar threatens the very economic foundations of the industry.

Who needs the grid?

Power that is generated onsite, as by solar panels, doesn't use or pay revenues to generators, distributors or retailers. As this form of energy grows, the number of customers paying for the grid falls. That raises the cost of maintaining the grid for everyone else because network costs are spread among fewer users. That, in turn, encourages more to switch to solar systems. A positive feedback loop thus creates a 'death spiral' for the industry.

The CSIRO forecasts that by 2040, half of all electricity might be generated at the point of consumption. If anything like that scenario emerges, it spells disaster for all. Generators, retailers and especially distributors will need different business models and probably state support. Europe faces that future today because growth in the renewables sector, especially solar, has been strongest there. The EU accounts for almost two-thirds of global solar capacity.

Australia is on the same path and our industry faces a similar reckoning. In the second part of this series, we'll look at how generation, distribution and retail businesses will be affected.