Two of the largest utilities in Europe, E.on and RWE, have drastically changed strategies since 2016. In this post we argue that competition from third parties was the key driver behind this strategic decision. The following is a summary of the key findings from three different research papers that we have published. If you are interested in a more detailed analysis, take a look at our papers in The Energy Journal here, Bremen Energy Working Paper here or the Rutledge Companion on Network Industries here.
The strategic shift of E.on and RWE
Before we dive deeper into the issue of third parties and their role in the electricity sector, let us first take a look at what E.on and RWE did in the last two years. Basically, the companies divided their core business units into two different companies: E.on created Uniper; Innogy is a spin-off from RWE.
In both cases the conventional generation business (with fossil and nuclear power plants) was separated from renewable generation, the distribution networks and retail. While the two companies Uniper and RWE focus on the conventional generation business, E.on and Innogy now focus on the renewable business with network ownership and retail. Additionally, new business areas related to digitalization and new technologies like e-mobility, storage or other flexibilities are part of E.on and Innogy as well. Basically, the result of the restructuring of RWE and E.on is the separation of traditional energy business based on conventional and centralized power generation, from new business models based on distributed generation from renewables, new technologies and digitalization.
Why did two of the largest utilities in Europe change their business structure so dramatically? Some argue that both companies tried to avoid the legal responsibility for the costs of the nuclear phase out and the dismantlement of the nuclear power plants. While this might have been a trigger, the key driver for these developments was competition and the increasing role of third parties in the electricity sector.
We can define third parties as actors in the energy sector that are non-incumbents or incumbents that enter a new business area or market. For the discussion in this post the non-incumbents are especially relevant. Most non-incumbent third parties enter the energy supply chain by investing in distributed renewable generation from solar photovoltaic or wind energy.
The rise of third parties in electricity generation
It is a known story that the diffusion of renewables in Germany have started to reach significant levels since the year 2000, based on the governmental support of the energy transition. The German Government defined in the Renewable Energies Act that renewable electricity supply should provide about 40-45% by 2025, and 55-60% by 2035 of total electricity consumption. To reach this goal the government initiated a Feed-in-Tariff (FIT) mechanism. The FIT was very successful: in 2016 renewables already produced 29% of gross electricity production and 31.7% of gross energy consumption (BMWi 2016).
Third parties own largest share of renewable capacity in Germany
Most of the renewable capacity is owned by non-institutional private investors (households, energy cooperatives). In 2012, these private non-institutional investors provided the capital for approximately 35 percent of all investments in RES in Germany, while the Big 4 (RWE, E.on, Vattenfall and EnBW) only provided the capital for 5% of total RES investments 2012. Resulting from this, private households owned roughly 45 percent of total RES capacity (51 percent of PV, 48 percent of onshore wind capacity) in 2012, while incumbents from the energy sector only own a share of 12 percent of the RES (for further details see here).
Figure 1: Investment in renewable energies for electricity production sorted by ownership in Germany 2012 (total 73 GW) source: own illustration based on data from trend:research 2013
This year, the incentive scheme for onshore wind energy changed from the FIT to a tendering system. The first round in this tendering process was in the beginning of 2017 and 96% of the successful bids came from cooperatives that are financed by private households (BNetzA 2017). In the past, cooperatives were already important investors for wind and solar PV projects. Now, with the tendering scheme, it was anticipated that these private cooperatives would loose relevance, but the opposite seems to be the case: Even in an official tender the cooperatives can successfully compete with utilities and other businesses. Therefore, it seems likely that third party investors will remain the dominant investors for renewables in Germany.
Third Parties invest in distributed generation
Importantly, most private households that have invested in renewables focused on small-scale and decentralized power producers, which significantly alters the supply structure (Brunekreeft et al., 2016). This in turn, resulted in a more decentralized and fragmented generation structure in Germany. Figure 2 illustrates this development by relating the number of power plants to the amount of new capacity installations. The figure shows that starting with the Renewable Energy Act in 2000 each MW of newly installed capacity has corresponded to a growing number of power plants. In other words, the structure of new capacity installations has changed from large-scale to small-scale power generators. This observation corresponds with the increasingly fragmented investor landscape for renewables as we have discussed before: Private households increase investments in small-scale renewable generators, which in turn reduces the average size of the installed generators. This correlation is at the heart of the decentralization process in Germany.
Figure 2: Number of power plants per MW additional capacity (Brunekreeft et al 2016)
Incumbents lose market share in generation business to third parties
Due to the overall increasing share of renewables, combined with the small renewables portfolio of the big 4 utilities in Germany (RWE, E.on, Vattenfall & EnBW), the market share of the Big 4 in the generation market is constantly decreasing. In the period from 2000-2004 the four larger utilities still owned between 80% and 90% of the conventional generation capacities in Germany. However, till 2013, this share fell below 70% (Bontrup & Marquardt, 2015).
The same picture occurs when we take a look at figure 3 that depicts the weighted average values of RES-shares and the concentration ratio of the largest company in a market (CR1) for the European markets in the period from 2004 to 2013, showing a clearly negative relation during that time period: with increasing RES-shares, the largest generator’s market share tends to decrease. In other words, RES development fosters the emergence of third parties in electricity production and thereby affects market concentration and supply structure.
Figure 3: Relation between RES-share in total electricity generation and the market share of the largest generator (CR1) in the market (Brunekreeft et al 2016)
How the incumbents business case is challenged by third parties
Obviously, the increasing number of distributed generators owned by third parties increases competition for the incumbents. However, the more severe effect of this new market structure in generation business for the Big 4 in Germany is the reduced revenue for the conventional generators. Basically, what we can observe is that due to RES the average electricity price at the energy exchange is reduced and at the same time the full-load hours of conventional power plants are falling as well. Together, these two developments significantly reduce the income of gas-fired power plants and coal-fired power plants in the future. Let us take a closer look at what has happened at the electricity spot market since third parties entered the generation business based on renewables.
The Merit-Order effect of renewables
In Germany, electricity is traded at the wholesale electricity market. Before the real-estate and financial crises in Europe the day-ahead wholesale price for baseload was about 70 euros in 2008. Since then this price has been decreasing.
Figure 4: Development of future and spot market prices for base load deliveries on the German-Austrian power exchange, 2003–2015 (Matthes 2016)
While this development is the result of several effects (too high expectations of electricity demand increase resulted in stranded investments etc.), the strongest driver for decreasing wholesale prices are the renewables in Germany. Recently the wholesale prices of base load have fallen below 30 euros. Though peak prices often were quite high in the past, we are now in the situation that we see strong negative price peaks in Germany.
How are renewables effecting the merit order?
Basically, the merit order is the ranking of generators according to their price bids to the market. Thereby, the merit order defines the order in which generators are dispatched and at the same time sets the corresponding market prices. The highest cost generator necessary to meet demand in a given period defines the final price for all generators in that period. To illustrate this, let’s imagine that we need 10 MWh within the next hour to meet electricity demand. 10 generators per 1 MW are needed to meet the demand in that hour. The first 9 generators offer their production at costs below 30€/MWh and generator number 10 produces at 35€/MWh. Then, all ten generators get 35€/MWh. Therefore, the last generator with the highest price that is needed to meet electricity demand is called the “marginal generator”.
Today, renewables enter the electricity market with close to zero marginal costs, which makes them the cheapest generators available (from a marginal costs perspective!). Thereby, renewables reduce the average electricity price and at the same time renewables reduce the need for conventional power plants to meet the current demand. The merit order effect can be observed in different markets, e.g. in Texas. In their article, XX nicely introduce the merit order effect in Texas and provide the following illustration of how the merit order effect works:
Figure 5: The merit order effect in Texas – An illustration of the electricity market bid stack for the ERCOT grid in Texas. Generators line up left to right from the lowest cost to highest cost every five minutes. As demand changes throughout the day, the ‘marginal generator,’ or the last power plant called to provide power, sets the price that every plant providing power (left of the vertical black line) is paid. Power plants to the right of the line are not dispatched and thus do not receive payment in an energy-only market. (NG CC = Natural Gas Combined Cycle; NG Other = NG boilers and combustion turbines). University of Texas at Austin, CC BY
The consequences of the merit-order effect from renewables
Obviously, if electricity price as well as quantity go down, the business case of conventional power plants is at stake. Today, especially the gas-fired power plants with high marginal costs are pushed out of the German market by renewables, while these are the only power plants that can provide the flexibility that is required to balance an electricity system with high shares of renewables. Coal-fired power plants, on the other hand, have gained from the increasing share of renewables in the electricity market over the last years. However, this is only a short to medium term effect that won’t sustain higher shares of renewables above 40-50%.
So we can see two effects that are induced by renewables and summarized under the headline of the merit-order effect: prices and load factors for conventional power plants are reduced, implying that conventional plants suffer from lower revenues. This development is already taking place: Figure 6 shows how the full-load hours of fossil power plants developed in the period from 2006 till 2014.
Figure 6: Load factors lignite, coal and gas 2006 – 2014 (Brunekreeft et al 2016)
While lignite gained from the energy transition in the last years, hard coal- and gas-fired power plants are already facing significantly less full-load hours. And, it is anticipated that this development will accelerate in the future. Figure 7 summarizes the expected full-load hours for conventional power plants in Germany till 2024 and 2034 for different scenarios.
Figure 7: Projection of full-load hours for lignite, coal, and gas plants in Germany (Brunekreeft et al 2016)
In addition to the expected decrease in full-load hours, the wholesale prices are expected to stay low or even below the current level in the future, resulting in a negative gross margin of gas-fired power plants.
How the utilities adapt
In the past, utilities in Germany were quite reluctant to invest in renewables. One main reason for this was the risk of self-cannibalism: If utilities that own and operate conventional power plants invest in renewables, this new investment puts the revenue from conventional generation at risk due to the merit-order effect described above.
Actually, renewables can be considered an example of disruptive developments in the theoretical sense defined by Christensen. But this is an issue for a later post.
However, since 2014 it has become inevitable to shift from conventional to renewable production, at least for a long-term business case. To address this “new” business case the utilities took the step in 2015-2016 to separate the conventional from the renewable generation business. Now, the renewable generation departments are unleashed from the limits defined by the self-cannibalism threat. Still, the new businesses Innogy and E.on now need to prove that they are able to gain market shares in the renewable energy market, a segment in which they are far from being big players yet. Furthermore, the customer market is very competitive and new services are required to meet new demands that evolve from new technologies, e.g. related to digitalization, electric vehicles and flexibility. The question now is whether E.on’s and RWE’s strategic shift was still in time. We will see how the new players, Innogy and the new E.on perform in the future.
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