The summer heat wave has driven Europe's cooling demand, coupled with the lack of renewable energy generation, nuclear power supply and soaring natural gas costs.
Against this backdrop, European countries and power companies are facing some difficult decisions. The continent's current energy crisis is the product of a myriad of factors, but the way it responds to it will shape Europe's energy institutions for years and decades to come.
To cushion the worst effects of the crisis, some have called for greater extraction of fossil fuels in the short term, while others have advocated a massive rollout of renewable energy to drive prices down.
At this moment, however, power plant project owners are faced with a dilemma: whether to increase the proportion of transactions in the commercial electricity market to take advantage of high prices, or insist on locking in long-term power purchase agreements (PPAs) to ensure more stable, predictable revenue streams ?
The key consideration here is where the company and the market think the price will go.
The current price is at the highest point in years – the average spot market price is now over €300/MWh ($327/MWh), up from around €50/MWh ($54/MWh) at the end of 2019, up several times.
Electricity prices soar across Europe since May 2021
Represented by France, the price of electricity in various European countries has soared recently. France's electricity price last week was 383.14 euros per MWh, up more than 64% from the previous week, followed by Italy at 369.07 euros, Austria at 343.94 euros, Germany at 323.34 euros, and Greece at 312.67 euros.
No one expects the situation in Europe to be resolved anytime soon, especially if Russia invades Ukraine, but market expectations and electricity price expectations will be key factors in deal and contract decisions.
Why is the European energy market in crisis?
Europe's current energy crisis is the result of a combination of factors: natural events, geopolitical actions, poor strategic planning, and the Russian invasion of Ukraine. The combination of these factors created a perfect storm that sent prices soaring, governments angered and reshaped energy policy. In the process, consumers are hurt.
The storm started last winter when it was particularly cold in Europe and Asia. Competition in the liquefied natural gas (LNG) space is fierce in these regions, and as economies begin to open up in the wake of COVID-19 lockdowns, competition has intensified, prices have soared, and in the process, electricity prices.
To make matters worse, Europe has low natural gas reserves, which has further pushed up prices and sparked a supply panic. In addition, lower-than-normal U.S. LNG exports to Europe and Asia due to severe winters and chaos in Texas put further upward pressure on prices.
Then, on February 24, Russia invaded Ukraine. Western governments quickly imposed sanctions on Russia and called on companies to sanction their business in Russia on their own. Energy majors BP, Shell, Exxon Mobil, Equinor and TotalEnergies have cut ties with Russia or said they would do so.
Germany also refused to approve the Nord Stream 2 gas pipeline from Russia to the EU, causing the holding company to go bankrupt. This all further constrains natural gas supplies and pushes up prices.
European countries have tried to mitigate the impact of sanctions by finding alternative sources of natural gas. For example, expanding the capacity of the Medgaz gas pipeline connecting Algeria and Spain, Bulgaria connecting the gas network to Romania and Serbia, Poland connecting Denmark, and Bulgaria pushing for further connections to Greece.
Still, most of these projects won't be completed by the end of the year, and by their very nature, they are regional, not EU-wide, meaning the frenzy and turmoil in the market will continue in the short term.
Where will electricity prices go?
Kesavarthiniy Savarimuthu, European power analyst at BloombergNEF, said no one expects electricity prices to fall back to normal levels anytime soon, and the evolution of electricity prices this year and next will depend on several factors, such as coal and gas prices, weather, unplanned nuclear outages, availability of Renewable energy generation and electricity demand, etc.
And, with European gas reserves still low, don't expect any easing trend in resource competition. Werner Trabesinger, head of quantitative products at renewable energy consultancy Pexapark, said: "To reach comfortable storage levels by the fourth quarter of 2022, between gas consumption and storage refills, large quantities of LNG will be required throughout the summer. "
"This will put European buyers in direct competition with players in the Asian LNG market, in a tighter market where Russian LNG volumes have effectively been excluded," Trabesinger said.
"The European Commission has been negotiating to diversify gas supply sources and reduce demand for Russian gas imports," Savarimuthu said. "Scenarios such as increased LNG imports could generate a premium, with a positive impact on gas and electricity prices.
A switch to other fuels, such as coal, could help address a tight gas market. However, the same problem arises here. Much of the hard coal has so far been sourced from Russia, and the competition to find alternative coal will intensify. "
According to ING's forecast, future basic energy prices in European economies such as France, Germany, Belgium and the Netherlands will remain high at around 150 euros/MWh ($163/MWh) throughout 2022, with a drop in summer , but will rise again to around €175/MWh ($190/MWh) heading into winter.
The current situation is very fluid and unpredictable. "The wholesale price of electricity in 2022 will be more volatile compared to the levels of the past decade." Savarimuthu added that the uncertain gas supply will spur more volatility in the electricity market.
"I think we're going to have another very volatile period," said Phil Grant, a partner in the global power generation group at energy consultancy Baringa. "It's affecting how people trade and their expectations of risk."
Grant's question is, "As a generator, do you want to lock in forward prices now, or are you happy to ride the wave of commercial prices?"
PPA long term contract or commercial market trade?
With prices soaring 8.1% in the first quarter of 2022 and up 27.5% year-on-year, the European renewable energy PPA market is "more competitive than ever", according to LevelTen Energy. Before the Ukraine conflict, prices were expected to level off this year and have now climbed for four straight quarters.
LevelTen's European Q1 2022 PPA Price Index noted that strong demand for renewable energy has led to a shortage of off-taker project options. According to a summary of the lowest 25% of solar offers, the P25 index rose 4.1% to now stand at €49.92/MWh ($54.1/MWh), up 20% (€8.32/MWh) year-on-year.
Solar P25 Price Index by European Countries
“This buyer appetite quickly creates an imbalance between supply and demand for renewables, as developers struggle to keep pace with demand.”
"I think the PPA market will continue to rise," said Gregor McDonald, head of trading and PPAs at European Energy AS. "But I don't think it's going to be a one-to-one correspondence with the wholesale market. Obviously, different contract terms need to be considered."
But what does this mean for generator revenue streams, the power generators plan to sell through PPAs, and the percentage of electricity traded in the spot market?
There is no right or wrong answer to this question, "it is a decision based on a portfolio of projects owned by individual developers or independent power producers (IPPs), which is not a simple binary choice given the complex commercial structure of many projects."
At the end of the day, it's a matter of risk and shareholder expectations, and the same portfolio or asset can make wildly different decisions just because of the capital structure that underpins them. "
Grant suggested that if the owner is an infrastructure company, pension fund or publicly traded renewable energy company, it may be prudent to remove risk and lock in a PPA contract of three to five years.
"They're going to be premium contracts, and with current market conditions, the cash value may be lower than commercial alternatives, but it's also a much less risky world."
According to Pietro Radoia, a senior analyst at BNEF, investor appetite for business risk is growing, in part due to a mismatch between sell-side and off-take-side expectations for long-term PPAs.
However, for large institutions, large energy companies and established trading firms that have traditionally enjoyed commercial markets, higher asset risk makes sense given these institutions' ability to effectively monetize their portfolios. Grant endorses this view.
At the same time, Pexapark sees increasing challenges for long-term PPA deals by utilities, with only a small fraction of the recent surge in wholesale prices translating into better PPA pricing as offtakers have begun to price in deals. Including extreme risk buffers, "We expect that extreme price levels on the front end of the current liquidity curve will translate into more, shorter-duration PPA activity."
"In addition to higher wholesale selling prices, shorter liquidity maturities expose off-takers to less unhedable risk, thereby reducing risk buffers and improving competition among off-takers,"
Of course, portfolio managers are unlikely to be fully committed to one or the other, but at any point may be influenced by government-backed products, fixed-price PPAs, floating PPAs, and some commercial market mix. Grant said managers consider future price levels and geopolitical events when deciding on the balance of trading investments.
When it comes to corporate off-takers, Grant said prices are expected to start falling again next year, and given that, these entities are unlikely to lock in long-term (three to five years, he believes) contracts at current electricity prices, before pricing the future In the absence of consensus, the industry has turned to shorter PPAs.
McDonald noted that when it comes to newer projects, "you can make money up front with more market solutions and hedging than with long-term PPAs."
The wholesale market has jumped, but PPA pricing has not kept pace, McDonald said. "In a more liquid market, if you make as much money in the wholesale market in five years as you make in ten years through a PPA, then the PPA doesn't look as good as it used to be."
The biggest advantage of entering the wholesale market over PPAs is that you can trade quickly. McDonald explained that if you move to a standardized benchmark load product and are able to deal with off-take risk, you can execute trades in minutes, and the PPA's closing time is on a monthly basis, which really hinders the market today.
On the other hand, LevelTen said, "In order to compete in an increasingly competitive market, corporate buyers need to thoroughly understand their objectives, be flexible when contracting and close deals quickly."
Also, commercial entities like supermarkets or data centers may want to lock in very long, 10-15 year contracts with generators if they can get the right price.
"If they can lock in contracts at £40-50/MWh ($59-66/MWh) then that would be attractive, but it would be a bilateral contract with a single generator, not in the current market implement a hedging strategy."