Monday, 29 June 2015

The economics of electricity generation

The general definition of economic sustainability is the ability of an economy to support a defined level of economic production indefinitely - 
Able to be maintained at a certain rate or level  e.g. "sustainable economic growth" - Definition of Sustainability, Oxford English Dictionary

Traditionally, when you wanted to build a new gas plant, you obtained a bank loan on the basis that the output and hence income of the plant could be determined in advance and was at a price linked to the wholesale cost of gas. There would be a certain amount of downtime for maintenance but your plant would be running for most of the year. This meant that the bank was satisfied that you could meet your repayments.

Total generation capacity in the country was linked to demand for electricity in the economy with some spare capacity for reserve. This meant that the cost of your electricity bill was pretty much directly linked to the amount of electricity you consumed with a few added extras to keep the system running and of course, profitable.

During the last decade, with the advent of intermittent renewables, most notably wind generation, both of the above sound economic principles began to be unwound.

Wind generation requires a subsidy because the output of wind is uncertain and therefore banks would be wary of funding such intermittent generation. The wind might blow, then again it might not. If your 20MW wind farm is only generating at half output i.e. 10MW, the subsidy you receive in effect brings your output up to 16MW (10MW multiplied by € 80 / €50 ). In otherwards you would only have received 10MW * €50 = € 500 MWh but instead you will receive 10MW * 80 =
€ 800MWh. Now the bank will be much happier.

If we now go back to our gas plant that has received bank funding, its output is starting to become more uncertain as intermittent wind is pushed onto the grid. Therefore, its income which was once fairly regular becomes staggered and less certain. Now, the banks will become worried, how certain are the loan repayments ?

So once we introduce alot of intermittent generation such as wind and solar into the system, all forms of generation, which were once dispatchable and reliable, become intermittent. This means that some form of subsidy needs to be introduced for the gas plant either in the form of a REFIT style subsidy on the market price or a capacity payment to ensure the plant remains financially viable throughout periods of high wind and solar penetration. So now, we enter into a new era of electricity generation economics where subsidies are required to maintain all generators, not just the renewables. We reach a stage where the gap between supply and demand is so large that there is simply not enough peanuts to go around for everybody and so subsidies are required for all. This differs from the heavily subsidized farming industry because demand for farming products is always equal to or above supply.

This situation that we then have is the exact opposite of the free competitive electricity market we were promised by the Fianna Fail government, when in 2006 they broke up ESB's monopoly on the market and set up Eirgrid to run the national grid. The fact is that when ESB controlled the electricity market, electricity was much cheaper (and no, I don't work for them).

The housing bubble evolved in exactly the same manner - there was a huge over-supply of houses, developers required subsidies in the form of tax reliefs and cheap credit (we now know that all that cheap credit was in effect a taxpayer funded government subsidy) and there simply was not and never could have been enough demand to maintain that level of supply indefinitely.

So the question is how long will it take for the levels of over investment in the electricity market to begin to become unsustainable and the bubble bursts ? It will most likely happen when the level of electricity bills becomes so high that more and more consumers fail to pay the bills on time or at all. Disconnections will rise. Quite a large proportion of the hikes in energy bills are loaded on industry. When most of them decide to jump ship to more competitive countries, as in the case of Cadburys, we are deep trouble, not just because of the resultant job losses, but because there will be a significant hole in the funding of the electricity bubble. When holes begin to develop at the bottom of a pyramid, the whole pyramid eventually collapses.

When this happens, subsidies to generators will be slashed, loan repayments will no longer be met, and the banks will be facing another hole in their balance sheets. In effect, this means that today, the electricity generation assets on the balance sheets of banks are significantly overvalued. Their current valuation is only as good as the ability of the electricity consumer to continue funding indefinitely the ever wider gap between electricity supply and demand (and the supporting grid infrastructure required to support it).

It may turn out that because electricity is a necessity good, the bubble will continue for longer than the housing bubble. This then means that people will have less discretionary spending in direct proportion to the increasingly higher electricity bills. So there will be a period where the electricity bubble will impact other sectors in the economy, themselves already impacted by the higher bills (e.g. a designer clothes shop will be impacted twofold with less customers and higher bills).

There are alot of industries dependent on discretionary spending in Ireland and along with the water charges (water is another necessity good), the hikes in energy bills will put a squeeze on them. Cold weather will also increase the demand for coal and oil - necessity goods which are now heavily taxed. With government policy, and the majority of investment, focused almost solely on electricity generation and windmills, people have little choice when it comes to heating their homes e.g. the investments into retrofitting and energy efficiency are tiny compared to wind energy.

In this scenario, different sectors in the economy will start to feel the squeeze and we will see another recession. This will be the beginning of the bottom sections of the pyramid collapsing. On top of this will be the disappearance of large industry - another section at the bottom of the pyramid gone. The electricity bubble will have collapsed but, like the housing bubble, will have brought down alot of other industries with it.

But whatever the sequence of events - one thing economists know for certain is that an economic bubble will eventually collapse.


  1. Banks and other investors currently do virtually no due diligence on wind turbine investments or loans. If they did they would be very sceptical of lending and investing in or to wind farm developments. Many studies show that capacity factor fall off in wind turbines can be as much as 50% after 6 year's. Also there are significant technology related issues, with these multi megawatt wind turbines, which can shorten their operational life to as low as 5 years. The impacts of these shortcomings will reduce the ability of wind farms to make a return to investors and/or repay loans. Then there is the looming of issue health damage caused by infrasound , Low Frequency Noise. When the dam breaks on this, all it takes is one successful case,the liabilities for every body involved will be enormous. So this great wind program could be a loose loose situation for us all.

  2. I am unclear as to where you see the bubble exactly? Prices (both wholesale and retail) have been relatively stable over the past few years. Do you mean an increase in the PSO levy due to REFIT payments?
    It is worth mentioning that the oversupply you mention is likely to be tempered by a rise in demand due to data centres - there are many planned to open in Ireland over the next few years

    1. In my opinion, the generating assets are overvalued. This is because demand has fallen while supply has increased. This is not normal market economics. When demand is low, supply should also be low. Demand is now low for bricklayers relative to 2006, hence we have a low supply of bricklayers. We saw the results when Whitegate power plant was sold for a quarter of its cost to build. Eamon Ryan and ESRI forsaw in 2008 a huge surge in demand by 2020 but the opposite has happened. So a normally functioning government would now put the brakes on all new generation plant including wind.

      Demand is unlikely to rise to boom levels again for the next decade - yet we have more capacity than back then.

      And one would imagine that having the third highest electricity prices in the EU would act as a disincentive to industry relocation to Ireland. So its hard to see where this increase in demand will come from. Perhaps the data centres have been offered a special rate ? For every data centre company that does come, how many industries move out e.g. Cadburys ?

      This is from wikipedia :

      "Prices in an economic bubble can fluctuate erratically, and become impossible to predict from supply and demand alone."

  3. Yes there is an oversupply, but i'm not convinced this is a bubble as such, or not one that will burst in the way that you mention. There are a lot of old plant on the system, whose capital costs have been long paid off, and just sit around collecting capacity payments. These may start to close in 2017 when the capacity mechanism changes, however the impact on prices would be negligible imho as they barely run in the market.

    I'm not sure what is attracting the data centres, good internet connection and beneficial tax rates perhaps? Not energy prices as you say - nevertheless they come!

    1. Eirgrid in their recent capacity adequacy statement dont envisage any closures for the next 10 years apart from Tarbert in 2022. Interestingly, in their 2010 statement, Tarbert was scheduled to close in 2013. Presumably, its fast acting response capabilities is useful in times of high wind penetration. So we will see.

      Eirgrid are working under the assumptions that some form of subsidy, whether it be capacity payments or something else, will be required to support these idle generators into the foreseeable future. This is in agreement with the thrust of my article.

  4. I made a submission to the Emlagh wind farm planning application last year and I attended the oral hearing in the Headford Arms hotel Kells on the 23rd June 2015. It was conducted by An Bord Pleanala, the Irish planning appeal board. I asked the developer's representative what capacity factor did he expect for the wind farm being proposed? He replied that the wind farm had been given a connection offer to the national grid as being capable of producing 126 mw of electricity. I pointed out that for the wind farm to provide its rated capacity, the wind would have to blow at 33 mile per hour and for it to produce its full capacity, the wind would have to blow at 33 miles per hour for 8760 hours per year continuously. It's located in the Midlands.

    I pressed the developer to concede that the capacity factor for his wind farm was an entirely different measure to the rated capacity and that it was a very important matter to ensure the project broke even and made some profit. Low capacity factors could mean the enterprise would never make a profit and could be abandoned. The developer's representative continued to insist that the rated capacity was all that was relevant for the purpose of the application. I pointed out that I expect a factor of no more than 20% and the the Mount Lucas wind farm in Offaly is returning a factor of 14.45%.

    I accept that the developer may not want to allow any discussion about the economics of their project, but what if investors and bankers lend on that basis? The balance sheet of a sound credit institution will show a loan book and it was traditionally assumed that due prudence went into the assessment of each loan. Out of 100 loans, 90 should be rock solid, 5 could be a bit shaky, requiring a time extension, the remaining 3 might have to be sell the assets of the borrower and 2 might have assets of little or no value. Europe's banks are already a bit shaky and if the revenue stream for wind farms turns out to be lower than expected, how will they be paid? What effect could this have on the overall survival of the banks?

    It can be seen that if the capacity factor year on year is below break even point, the wind farm is worthless and would make a loss. It's all down to the wind, and my very exact analysis for 2008 and 2009 coincided with the Met Eirean 30 year wind speed record of 24.1% at Kingscourt 144 meters above sea level.. Eirgrid give it at 30.5%. That 6.4% difference is crucial. Any bubble I witnessed resulted from the discovery that the real value of assets is below the balance sheet value of the owner and the owner is often the bank. The wind is all around us, there for all to observe. Wind farming depends on the variability of wind and the variability of subsidies. Subsidies are unlikely to rise, so its over to the wind.