Utility Asset Strategies in a High Price Environment

The European wholesale gas and power markets have become increasingly volatile with prices rising to ever greater levels in recent times. This volatility and high price environment has increased the risk of exposure for utility companies. This brief aims to assess the wholesale strategies utilities can undertake to minimise exposure or to gain an advantage in these difficult times.

Report Highlights
In a volatile and changing market it is not always the best course of action to hedge heavily, as this can result in severe price exposure should the market fall. Key strategies can however mitigate this risk, which in turn can deliver significant competitive advantage.

Following the recent round of mergers and acquisitions, Datamonitor has reviewed the levels of exposure of the major utility companies operating in Europe, giving a breakdown of their projected exposures.

Datamonitor has collected details of the most significant upstream strategies that can be used to mitigate against the risks inherent in a high price environment and assessed these against standard criteria, delivering detailed insight into the possible benefits of these.
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DATAMONITOR VIEW 1
CATALYST 1
SUMMARY 1
ANALYSIS 2
Utilities risk price and commodity exposure as they trade and purchase the energy they need to supply their customers 2
UK Gas and power prices are made up predominantly of commodity costs and so are extremely influenced by the wholesale cost of gas or power 2
As prices fluctuate prior to delivery, it can be either detrimental or advantageous to contract energy in advance 3
To avoid commodity exposure, a utility company must ensure that it has purchased sufficient energy to cover its position 4
The WACOG and WACOE for a utility are dependant on prices arranged for power to cover its position 5
Due to wholesale market fluctuations, when utilities establish a contractual position for a delivery date, they risk price exposure 6
The difference between the weighted average price of the energy bought by a utility and the market spot price defines the level of price exposure 7
High wholesale power prices have continued to be passed on to consumers, with sharp increases seen in the UK 8
As UK wholesale gas prices have begun to climb once more, retail prices have been increased to accommodate them 9
As the market moves into a high price and volatile environment, the potential risk and cost of exposure increases 10
Wholesale European gas prices have continued on an upward trajectory 10
European power prices dropped at the beginning of 2007, but have increased significantly over the last 18 months 11
Coal prices have seen a dramatic surge over the last 18 months, but generation from coal also suffers from associated high carbon costs 12
Despite rising gas prices, potential margins from gas-fired generation have increased as Spark Spreads increase 13
Despite rising coal prices, potential margins from coal-fired generation have increased as Dark Spreads increase 14
Each utility has a different level of potential commodity exposure 15
There is a significant discrepancy between different utilities' exposure to European wholesale electricity markets 15
Most utilities use more gas than they produce, a very different picture to that seen in electricity, as few have upstream capacity 16
The volume of exposure paints a different picture from the percentage of exposure due to the difference in size of utilities 17
While almost all utilities surveyed show considerable wholesale gas exposure, the actual volumes involved vary dramatically 18
Datamonitor assesses the range of strategic options available to reduce the impact of gas exposure 19
Datamonitor assesses possible strategies to mitigate price and commodity risk according to six criteria 19
The 'Going Upstream' strategy entails purchasing gas production assets or even exploration acreage 20
Although 'Going Upstream' can provide guaranteed cover from wholesale price increases, it is a very expensive and complex process 21
'LNG Procurement' strategies present an alternative source of gas to wholesale markets 22
Procuring LNG to feed retail portfolios brings with it certain security of supply advantages 23
The ""Storage Capacity Build"" strategy reduces commodity exposure and also presents opportunities for arbitrage 24
Seasonality in gas prices presents opportunities for arbitrage through storage 24
The 'Storage Capacity Build' strategy reduces commodity exposure, providing a buffer to spikes in the wholesale gas market price 25
Utilities have a range of strategic options available to reduce the impact of power exposure 26
A 'Generation Capacity Expansion' strategy increases a player's existing asset portfolio, thus reducing wholesale market exposure 26
'Generation Capacity Expansion' is an adaptable strategy, but can take a long time to yield returns and may adversely affect public relations 27
'Contractual Purchase' strategies allow utilities to boost supply portfolios without paying for new assets or increasing exposure to wholesale prices 28
The 'Contractual Purchase' strategy offers long-term security of supply and is sufficiently flexible to suit utilities of all sizes 28
The 'Tolling Agreement' strategy sees the utility hire a power generation asset from another player in order to increase its own portfolio 29
'Tolling Agreement' strategies are easy to implement, but in a changing market can increase or reduce commodity exposure 30
Utilities' previous strategic choices to mitigate against exposure have been diverse 31
Centrica's recent activity exemplifies a utility aggressively pursuing the 'Going Upstream' strategy 31
Centrica has been one of the few European utilities to pursue the 'LNG Procurement' strategy, although it has since been retrenched 31
EDF is constructing new plants and regenerating much of its existing asset portfolio, thus reducing wholesale market exposure 32
E.ON recently established a pan-European subsidiary to focus exclusively on increasing storage capacity 32
Smaller utilities such as Statkraft have used PPAs and GPAs to expand, minimizing exposure and investment 32
Centrica's deal with Drax demonstrates the benefits that a 'Tolling Agreement' strategy can bring to both parties 33
APPENDIX 34
Appendix 1: WACOG and WACOE 34
Appendix 2: price exposure 34
Appendix 3: consolidated scores for each strategy 35
Ask the analyst 36
Datamonitor consulting 36
Disclaimer 36
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Table 1: Each strategy is rated against six criteria on a range from 0 (most detrimental) to 3 (most beneficial). 35
Figure 1: A breakdown of gas and electricity bills normalized to percentages of the average UK bill shows the commodity element of gas is 68% and electricity 66%. 2
Figure 2: Commodity markets experience either backwardation or contango, making it essential that utilities anticipate market movements and purchase appropriately. 3
Figure 3: Example exposure for a given gas position. 4
Figure 4: Example of how a WACOG position is calculated. 5
Figure 5: Example of how a utility can become positively price exposed or negatively price exposed. 6
Figure 6: Rising wholesale power costs are passed on into retail costs, with a lag to account for hedged positions. 8
Figure 7: Rising wholesale gas costs are passed on into retail costs, with a lag to account for hedged positions. 9
Figure 8: European Wholesale Gas Prices. 10
Figure 9: European Wholesale Power Prices. 11
Figure 10: European Wholesale Coal Prices. 12
Figure 11: The Spark Spread is the difference in price between the power generated and the gas required to generate it. 13
Figure 12: The Dark Spread is the difference in price between the power generated and the coal required to generate it. 14
Figure 13: Wholesale gas exposure measures production against supplied volume and highlights how few utilities have any upstream position. 15
Figure 14: Wholesale gas exposure measures production against supplied volume and highlights how few utilities have any upstream position. 16
Figure 15: Wholesale electricity exposure measures generation against supplied volume, here shown as absolutes compared with percentiles. 17
Figure 16: Wholesale gas exposure measures production against supplied volume and shows the dramatically different positions between utilities. 18
Figure 17: Datamonitor Scoring Categories. 19
Figure 18: Analysis of the 'Going Upstream' Strategy. 21
Figure 19: Analysis of 'LPG Procurement' Strategy. 23
Figure 20: Month Ahead UK Gas Price against Mean UK Temperature. 24
Figure 21: Analysis of the 'Storage Capacity Build' Strategy. 25
Figure 22: Analysis of the 'Generation Capacity Expansion' Strategy. 27
Figure 23: Analysis of the 'Contractual Purchase' Strategy. 28
Figure 24: Analysis of the 'Tolling Agreement' Strategy. 30
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