UK battery investment 3: building an investment case
The current interest in UK merchant battery investment is supported by some powerful fundamental drivers. The most important of these is a strong case for increasing UK power price volatility as renewable intermittency rises and the supply stack steepens.
Policy changes are also creating tailwinds. Adjustments are being implemented in the Balancing Mechanism (BM) that should increase incentives for flexible response e.g. the PAR1 changes that sharpen cashout price signals. System charges are also likely to be reformed in favour of batteries (e.g. tackling the double cost of charge & discharge).
But an exciting fundamental backdrop is a different thing to a robust investment case. In this article, our 3rd and final in a series on battery investment, we consider some of the key challenges facing investors in building a robust investment case.
Balancing 5 considerations
In order to build a merchant battery investment case, it is useful to start with a broader consideration of the challenges a battery developer is trying to navigate in developing a viable project. These are set out in Table 1.
Table 1: Battery project success factors
|1. Capex||How much do I need to invest over the project life?||Low capex key to economics. Unit costs falling fast but with an uncertain rate of future cost declines. Short duration L-ion batteries currently winning the race.|
|2. Duration||What is my cycling time?||Focus currently on L-ion 1-2 hour duration. This skews investment case towards volatility chasing & extrinsic value. Economics of longer duration batteries more difficult.|
|3. Variable cycle cost||How much does it cost me to cycle?||Variable cycling cost determines the hurdle that must be overcome to capture price spreads. It is driven by efficiency, system charges, transactions costs & degradation allowances.|
|4. Degradation||How does cycling impact my battery life?||Cycling reduces battery life, accelerating replacement capex. Degradation depends on technology and cycling patterns. It needs to be explicitly integrated into the variable cycling cost hurdle.|
|5. Margin stacking||How can I stack interdependent margin streams to make a viable return?||The ability of a battery to generate margin depends on 1. to 4. Margin focus can vary by project. But wholesale/BM value capture is the foundation of merchant battery returns.|
Battery developers are trying to optimise these 5 considerations to structure an investable project. But how do you quantify margins for a merchant battery project to underpin an investment case?
Quantifying battery risk/return
Quantifying battery value is a different challenge to other types of conventional capacity. Building a battery investment case using a traditional Base/High/Low margin forecast approach is a bit like trying to fly a fighter jet without radar. Unless you’re Top Gun there is a fair chance you will get cooked.
Robust battery storage valuation depends on understanding and quantifying project risk/return distributions, recognising the inherent uncertainty of battery value capture.
The first step in doing this is to properly deconstruct battery optionality. This is a costs and constraints problem:
- Cost hurdle: The option ‘strike price’ of a battery is represented by the variable cycling cost hurdle, driven by efficiency, system charges, transaction costs & variable degradation costs.
- Physical constraints: Battery constraints are defined by the physical cycling characteristics of storable energy volume and charge/discharge rates.
The second step in projecting robust battery margins involves probabilistic modelling of the exercise of battery optionality against uncertain market prices. Exercising this optionality involves a complex set of decisions on value capture at different points in time as market prices cascade towards delivery.
Battery optionality can be exercised against various price points, each of which have different liquidity, volatility and risk characteristics. For example:
- Day-ahead – relatively liquid, lower risk (as prices can be secured in the auction), but lower volatility
- Within-day – less liquid, higher risk but increasing volatility
- BM bids/offers – potential for very volatile b/o levels, but with substantial forecast risk i.e. risk of not being dispatched
- Cashout prices – high volatility, but with substantial forecast risk i.e. risk of losses as well as profits.
In addition the battery owner needs to optimise wholesale market & BM value with other interdependent value streams (e.g. ancillary services & embedded benefits).
We set out the practical challenges of monetising battery value in our last article in this series. The main difference between a ‘theoretical’ and a ‘tangible’ investment case is the extent to which these value capture challenges are reflected in battery margin analysis.
The most important challenge in creating ‘tangible’ numbers is incorporating the impact of price uncertainty on battery margin distributions. This involves analysis that captures both:
- Price dynamics: modelling the evolution of the relationship between different prices against which battery optionality can be exercised e.g. the dynamics of day-ahead vs within-day vs BM price distributions.
- Forecast error: accounting for the fact that merchant batteries are optimised and dispatched based on forecast prices, with inherent price forecasting error resulting in losses as well as profits.
A battery investment case should be underpinned by probabilistic analysis of how price uncertainty drives margin distributions and therefore project risk/return dynamics.
Raising capital & route to market
Batteries share some of the challenges that gas engines face when raising capital. This stems from a focus on value capture from price volatility for both types of capacity.
Gas engines have benefited from the relatively secure nature of 15 year capacity agreements to support capital raising (at least until this year’s T-4 auction cleared at 8 £/kW). Shorter duration merchant battery projects do not enjoy that capacity margin buffer (given low derating factors). This means that merchant battery investment cases to date are focusing on equity capital to absorb the market risk around revenues.
It is possible to firm up revenues over the front years of a battery project via signing a contract with a market facing counterparty (e.g. a supplier). But the value haircut from doing so typically outweighs the benefits of reducing project cost of capital.
This leads to the route to market challenge. A battery project needs market access i.e. the ability to execute the trades required to capture value in the market. But more importantly it needs a commercial function to optimise battery optionality. This means hiring traders, developing analytical capability, building systems and implementing risk management processes.
The route to market challenge gives players with an established commercial function a competitive advantage in the battery space (e.g. suppliers & aggregators). There are also clear overlaps with the commercial optimisation of batteries and engines, that result in economies of scale for larger flexible portfolios.
So merchant battery projects may be born from a range of developers and business models. But battery projects (like engines) are ripe for consolidation. Step forward a couple of years and dominance of the battery space is likely to gravitate towards a narrower group of players who have the sharpest commercial functions to optimise the value of flexibility… and manage associated risk.
|Briefing pack: Price dynamics driving asset value
Timera Energy has just published a briefing pack on UK power market dynamics & asset value. This summarises our views on the evolution of price shape & volatility, and its effect on UK power asset risk/return dynamics. This pack can be downloaded here: Price dynamics driving asset value