The evolving role of interconnectors in European energy markets
The almost complete penetration of gas and power into residential, commercial and industrial energy demand coupled with diverse generation mixes and high gas import dependence, create the conditions for interconnection to play a vital role in obtaining energy balance and maintaining security of supply across Europe. As such, it is important for companies to understand the value dynamics of interconnector capacity and the pivotal role it can play in portfolio optimisation and risk management.
October 3, 2011
The importance of interconnection in the European gas and power markets is perhaps unique in global energy markets. The tight cluster of industrialised countries is connected by a complex web of transmission lines and gas pipelines. The almost complete penetration of gas and power into residential, commercial and industrial energy demand coupled with diverse generation mixes and high gas import dependence, creates the conditions for interconnection to play a vital role in obtaining energy balance and maintaining security of supply. Gas and power interconnector or transportation capacity is a core component of most European energy portfolios. As such, it is important for companies to understand its value and the pivotal role it can play in portfolio optimisation and risk management.
Market Dynamics and Fundamentals
The flow and load patterns of the European gas and power markets have two core characteristics. There are structural patterns that are a function of sources of supply, regional supply and demand balances and the relative costs of supply. For example, in North West Europe there are structural gas flows west from Russia and south from Norway, the two major sources of pipeline supply. Similarly in the European power market France typically exports low cost baseload power generated from it’s nuclear plant to its neighbours. Alongside these structural patterns the direction and level of flow between major markets is very dynamic as companies and system operators adapt their strategies in response to changing market conditions. Access to capacity and regional markets provides a mechanism for companies to optimise their activities in the physical market to manage risk and create value as they respond to market price differentials. Chart 1 compares the inter country flows between countries at 10:00 on two dates earlier this year.
Chart 1: Comparison of pan European power load flows.
Chart 1 highlights the stable exporting status of France but also the dynamic change in direction of some flows and the change of some countries from net exporters to net importers (most notably Germany). The key drivers of the direction of flow are:
- Demand levels and particularly weather sensitive demand
- Plant availability and hydro storage levels
- The relative short run marginal costs of thermal plants, predominantly driven by commodity prices and thermal plant efficiencies
- Prevailing output levels of ‘must run’ intermittent renewable capacity
Interconnectors are set to play an increasingly important role as intermittent renewable capacity grows in Europe. Fluctuations in renewable output, particularly inGermany, will need to be supported by generation flexibility from neighbouring markets. Flows from flexible hydro capacity in Scandinavia and the Alpine region and flexible thermal capacity in the Netherlands and Eastern Europe will be critical to maintaining system balance. We explored the impact of increased levels of renewable capacity on CCGT investments in the UK and Germany in a recent post.
Gas pipeline interconnection between European countries plays an equally important role, with the pattern of gas flows between markets shown in Table 1.
Table 1: Major European gas flows August 10 to July 11 (source: IEA)
In addition to highlighting Europe’s import dependence, the table above demonstrates a number of characteristics of European gas flow patterns. First, it shows the role of Central and Eastern European countries providing a transit role for Russia gas supplies. This role is more pronounced when Eastern Europe is considered using more granularity. Second, it can be seen that several pairs of countries both export and import to each other highlighting the dynamic nature of European gas flows. These are not only seasonal as the import and export status of countries can frequently flip several times a month. Declining domestic production and increases in LNG imports have and will increasingly make European gas flow patterns less certain and more dynamic as cargoes can be delivered to any one of the European regasification terminals. As we explored in a recent article, these changes will increase the requirement and therefore value of flexible gas supply infrastructure.
Non discriminatory access and efficient incentives are key regulatory objectives
Market integration through interconnection between regional gas and power markets offers clear economic benefits. Increased competition, enhanced liquidity and greater diversity of supply will ultimately lead to a reduction in economic rents and risk, as well as enhancing security of supply. As such, over the course of the last few years the European Union and state energy regulators have been working to provide market structures that provide clear incentives for the economic use of existing transmission infrastructure and the development of new capacity. These regulatory change programs have included ring fencing network and system operations, unbundling, non discriminatory third party access, harmonisation of market rules and ultimately formal ownership separation.
The objective of these policy initiatives is to create an environment where companies can contract for capacity over different timescales, facilitating the optimisation and management of both forward exposures and physical balances. Given efficient incentives the collective activities of all market participants should provide the grounds for an efficient outcome for the entire market. These changes have allowed energy companies to construct capacity portfolios that match their requirements as they can now purchase capacity on a locational basis, for a range of periods and on different contractual terms.
Implications for market participants
Given the vital role interconnector capacity plays in the European power and gas markets and the regulatory objective to promote efficient incentives for the use of existing and investment in new capacity it becomes vital for companies to understand the value drivers of capacity. This applies to both investors in new capacity projects and the valuation, hedging and optimisation of capacity in energy portfolios. Both classes of market participants have become more sophisticated in their understanding of the value of flexibility.
Investors in interconnection capacity have historically relied on locking in structural price differentials to finance their projects (as was the case with the gas interconnector between the UK and Belgium which sold long term contracts to cover capital costs). Whereas the recently commissioned BritNed power interconnector between the UK and the Netherlands was financed on the understanding it was going to operate on a purely merchant basis with revenues being generated through a series of rolling auctions.
Gas and power transportation capacity has become a core component of European energy portfolios. The ability to flow gas or power between locations allows companies to optimise and balance their positions and take advantage of location price disconnects. Historically capacity has been treated as an operational expense of doing business and accounted for on accrual basis (i.e. realising cost incrementally through the contract period). But increasingly the market is recognising the value of the embedded optionality in transportation capacity and adapting valuation methodologies accordingly. As a result this value is increasingly reflected in capacity prices and asset valuations, particularly in the case of capacity that connects major trading hubs. The optimisation and valuation of transmission optionality presents some interesting challenges which we explore in more detail in an article to follow shortly.
CCGT investment in the UK and Germany
The value of flexible gas supply infrastructure