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Interview with Jakub Guzikowski  25 listopada 2019

The Winter Package will harm the profitability of Polish coal-fired power plants

Interview with Jakub Guzikowski  25 listopada 2019
przeczytanie zajmie 8 min

The Clean Energy for Europe programme, known as the Winter Package, is a series of legislative changes to the Community energy legislation that have come into force in recent months and will drastically change the European electricity market in the years to come. From the perspective of Polish producers, whose generation is 80%-based on fossil fuels, this means losing a market share, as their energy will be more expensive than energy from foreign sources, in particular, renewable sources. However, consumers will benefit – when electricity wholesale prices in Poland are at the highest levels in the region, the increased liquidity of cross-border markets should lead to an increase in electricity imports to Poland and, consequently, to lower the prices. Paweł Musiałek talks to Jakub Guzikowski (an expert on international regulations in the energy sector) about the consequences of the introduction of the Winter Package.

Late May this year, after almost three years, the last issues concerning the so-called Winter Package – a set of different regulations fundamentally affecting the electricity sector in all EU member states – were resolved in the EU. What was the purpose of introducing new legislation?

The main ideas include a common, single EU-wide electricity market („from Lisbon to Helsinki”), environmental protection and the fight against climate change. To this end, some mechanisms need to be put in place, mainly of a technical nature. For example, to build a common electricity market, individual Member States must establish technical coordination of the operating rules of their electricity systems. To this end, Regional Coordination Centres (RCCs) are being set up to replace the existing Regional Security Coordinators (RSCs).

Will it mean the transfer of competences from the state to the regions, and finally to the EU?

The delegation of powers to direct the operation of the power system to the supranational level is very limited. It is mostly about coordination between Transmission System Operators (TSOs) from different Member States so that they are aware of what other TSOs in their region are doing. Nevertheless, the thesis that directional decisions concerning the development of the power sector will be made more and more often in Brussels rather than in Warsaw is true.

Will these changes be beneficial for Poland?

The national scale seems too general to me. The electricity market should rather be viewed from the perspective of individual groups since each group will be differently affected by the consequences of the changes.

The Winter Package focuses on those clients whose role on the electricity market will gradually change – from passive entities that only consume electricity, paying a fixed price throughout the year, regardless of current wholesale electricity prices, to entities actively operating on the market. Amongst other things, this will be possible thanks to the implementation of smart metering in end users, which will enable them to react to dynamic price developments.

For the recipient, I assume that the changes will be financially beneficial. In a situation where currently wholesale electricity prices in Poland are at the highest levels in the region, we can expect that the increase in the liquidity of cross-border markets will lead to increased electricity imports to Poland, which should translate into lower retail prices. Nevertheless, the implementation of the mechanisms provided for in the Winter Package, including: the need to make 70% of cross-border interconnection capacity available to the market and the installation of smart metering or new solutions concerning power mechanisms, will mean higher operating costs for transmission and distribution system operators, which will be eventually transferred to clients within the framework of the above-mentioned rates. Therefore, the final balance of costs and benefits for the clients, especially in the short term, appears uncertain. At least theoretically speaking, in the long term, this will make it possible to reduce electricity costs, link up national markets, and build a common, low-carbon electricity sector.

That’s the positive side then. And what about the dangers?

For Polish producers, whose 80% of generation is based on fossil fuels, this means that in the medium term a part of the market will be lost, as their energy will be more expensive than energy from foreign sources (especially renewable sources). The Winter Package will, therefore, become a challenge for Polish energy companies that produce electricity from coal. As I have already mentioned, energy prices on wholesale markets in Poland are at the highest levels in the region, so increasing cross-border trade opportunities is, in principle, unfavourable to Polish producers.

You mentioned that the Winter Package is supposed to introduce many smart solutions that should turn the passive receiver into the active participant. What did you mean exactly?

As part of the revision of the Market Directive, part of the Winter Package, Member States were required to implement smart metering for 80% of consumers as soon as a cost-benefit analysis showed that the benefits outweigh the costs. Thanks to this solution, energy consumers are to be activated, as the price offered to them as well as the cost of transmission and distribution of energy could be shaped dynamically, reflecting the current situation in the system, including the availability of sources. This translates into current wholesale prices and operators’ costs. Therefore, it will not have to be (as it is now) fixed throughout the year, but it will be possible to make it dependent on wholesale energy prices. This will give end users natural price impulses, which will shape the way they use electricity.

How should this work in practice?

If the price of energy is high at a given moment, I can wait until the price drops to an acceptable level before switching on energy-intensive appliances. This mechanism makes it possible to flatten the demand profile. At present, we observe clear peaks and falls of demand during the day. Activation of consumers will cause them to be forced to take into account the current operating conditions of the system, as these will directly translate into the price of electricity.

Another tool emphasised by the revision of the Market Directive is the so-called flexibility. The service consists of the execution of an operator’s request for a quick change of the energy generated/collected by the producer, energy storage owner or receiver. The implementation of smart metering will also enable the provision of flexibility services by smaller electricity consumers through Demand-Side Response mechanisms (DPS). In short, customers can be remunerated by the operator for their readiness to reduce their consumption or for the reduction of consumption at the operator’s request. It seems that such solutions will contribute to better management of consumption. There will be economic incentives for this – consumers will be able to save on their energy bills.

Is it possible to indicate an actual date when electricity and prices will start to circulate freely in Europe?

According to the Market Regulation, the 70% level of available transmission capacity on interconnectors (network connections allowing the flow of electricity between countries) will begin to be applied at the beginning of 2020, and if this cannot be achieved, the Member State concerned will have to implement the so-called Action Plan, ensuring that this level is reached by 31 December 2025 at the latest. This is when the wholesale market should be operating smoothly within the EU. Given the low levels currently available at Polish synchronous borders (with Germany, the Czech Republic and Slovakia), it is expected that the target level in these regions will be reached around 2025-2026.

How will these changes affect energy producers?

They will certainly promote energy sources with the lowest variable cost, and so, first and foremost, renewable energy sources. Thanks to a variable cost close to zero, these units will, first of all, conclude contracts on wholesale electricity markets, worsening the financial situation of fossil fuel power producers, in particular, coal. At the same time, due to production controllability, stable conventional units will prove to be crucial to ensure safe system operation with increased coverage of the demand by RES.

The Market Ordinance also introduced additional difficulties for fossil fuel power producers by limiting their ability to participate in power mechanisms, such as the power market, which rewards stable power producers (including coal) for their readiness to produce electricity, so that when there is insufficient wind and sun, demand coverage will be secured by stable but emission units. A producer who has obtained a contract in an auction system within the power market shall be obliged to deliver in a given unit of time, upon request of the TSO, the power in the volume corresponding to the contracted capacity obligation.

Starting from 2020, the Market Regulation in principle excludes the possibility for new generation units emitting more than 550kg CO2/MWh to enter into contracts and obtain payments on the power market. This is a level that no coal-fired power plant or even some gas-fired power plants can reach. Although EU law does not directly limit Poland’s right to shape its energy mix based on fossil fuels, it does introduce solutions whose long-term goal is to reduce the profitability of coal-fired units.

Does it mean that in the coming years, coal-fired power plants will not be economically viable?

The Market Ordinance makes it difficult to maintain the profitability of coal-fired power plants, which at present largely ensure stable operation of the power system in Poland. Due to this fact, according to some estimates, in the coming years, we can expect that even 8-10 GW of the installed coal capacity will be extinguished, as they will be unprofitable in the long term. However, the Regulation provides that existing conventional power plants, which do not meet the 550kg/MWh criterion, can obtain capacity contracts and payments within the capacity market, but only until mid-2025. The Regulation also provides for the application of the grandfathering clause. It consists in the fact that the limit of 550kg CO2/MWh does not apply to power contracts concluded before the end of 2019. This is important for some new and modernised units which have already signed long-term contracts within the power market. They will be able to fully perform them even after 2025.

Can we say, then, that there are justified concerns regarding the financial stability of our energy companies due to the increase in imports and restrictions on the use of power mechanisms?

I wouldn’t draw such far-reaching conclusions. Large groups include not only coal-fired units but also renewable and gas-based sources in their portfolios, as well as commerce, trading and distribution, which enable revenue to be generated independently of energy production. I also assume their economic rationality, which will prevent them from clinging to the coal-fired power industry, which will become less and less profitable as years go by. From such a perspective, one should assess very positively the plans to build offshore wind farms in the Baltic Sea, for example. I am also waiting to see further steps on the construction of a nuclear power plant, which I consider to be an essential element of the Polish energy transformation.

What will be the situation of Polish coal-fired power plants then?

As a rule, it’s getting worse. The most likely increase will be the price of CO2 emission allowances that owners of fossil fuel power plants have to buy. Imports from neighbouring countries where electricity is cheaper will also increase. This will reduce the need for coal-fired power.

However, if the new unit concludes a capacity contract by the end of 2019, it can fully execute it. The permissible period of support for new coal-fired power units is 15 years, which should allow covering most of the capital expenditures for the construction of this unit (CAPEX) from power contracts. On the other hand, entities established in mid-2025 onwards will not be able to obtain support under the power mechanisms, and therefore their revenues will be limited to the sale of energy on the market, where they will have an increasingly weaker position. This is unlikely to allow a return to be made on further investments.

Such a long unprofitable period will have to lead to the extinction of some of the coal-fired power plants. Do we have anything to replace them with?

From a purely market perspective, this may be very difficult, mainly due to the volatility of the cheapest energy sources, which RES are. Apart from coal, there are two stable sources: the atom, which is a very expensive and long-term investment technology, and gas.

Should we then decide to build a nuclear power plant?

I believe so – it is an investment that will provide us with clean energy for decades. The French have built their system based on nuclear power stations, and today they have cheap and clean energy.

Why not put our money on gas?

Gas-fired power plants, although they have low investment costs and can be built relatively quickly, also have high variable costs, mainly related to high fuel prices. Moreover, although they are less carbon-intensive than coal-fired units, they still hurt the environment and climate, and they have to bear the rising costs of CO2 emissions.

From the perspective of investors, the most probable fuel seems to be gas, as gas units are built quickly and relatively cheaply. Unfortunately, due to high variable costs, gas units may have difficulty in maintaining profitability because they will produce at peak demand, in the absence of other available sources rather than within basic production. Therefore, the number of hours per year for which they will be used will be limited.

The scarcity pricing mechanism, which Poland was obliged to implement in the European Commission’s decision approving the Polish power market, can help such peaks. The mechanism consists in the fact that when in a given hour the level of reserves in the system drops below a specified level, an allowance is added to the price of energy and reserves, which may amount up to 50 thousand PLN/MWh. In this way, gas-fired power plants, which are used during peak demand, could not operate within basic productions but would generate electricity for a limited number of hours and remain profitable.

Will the extinction of cheap power plants and the introduction of gas not mean an increase in prices for the Polish customer? 

Not necessarily. Increased investment in stable generation sources will translate into a higher capacity fee, as the power market ensures that the capital costs (CAPEX) of stable producers are covered. At the same time, existing coal-fired power plants do not need such a range of support from the power market as, for example, newly-built units, which must be covered by the entire CAPEX within the power market.

To a large extent, the price of electricity produced will depend on the costs of emission charges. If the price of CO2 emission allowances rises above EUR 30 or 40 per tonne, gas energy production may turn out to be cheaper than coal. The cost of coal power generation will increase, mainly due to the increase in CO2 emission allowances prices, but also due to the growing costs of raw material extraction in Polish mines, which are largely supplied to power companies. Polish deposits are becoming more and more difficult to access, which translates into higher prices and, consequently, increased coal imports to Poland.

Increasingly, the demand for energy will be covered by RES units, whose variable cost is close to zero. With the high availability of renewable sources, the wholesale price will be at a low level. At the same time, we are facing increased price fluctuations, and when RES are not available (lack of wind or sunshine), then other, stable, expensive units will ensure the security of the system. They can be either expensive coal-fired units or gas and nuclear units, which should become increasingly competitive because they are low emission or, in the case of the atom, zero-emission, so they do not have to pay the cost of CO2 emission allowances. I am therefore assuming that the price at peak demand with low wind and low sunshine will rise regardless of whether we stay with coal or switch to gas or atom. At the same time, a change in the structure of generation may lead to additional costs which will be covered by additional charges such as the capacity charge.

When will the coal age end in Poland?

It will probably last at least until the end of the 2030s. Poland will use coal to generate electricity but to a lesser and lesser extent. First of all, we should move away from thinking of coal-fired power stations as working on a peak demand basis when renewable energy sources are not available. Cheaper renewable energy is being developed and more expensive sources will be used at peak demand when RES units are not available. The key question is whether the market will allow coal or gas sources operating for several hundred hours a year to be profitable. The „yes” argument is certainly the price spike that can be obtained by the controllable producers. Although power plants will move from base-to-peak production, their continued operation may be economically justified by the resulting price spikes. The mechanism of scarcity pricing will certainly be useful for this purpose. However, replenishing RES will require more flexibility than coal-fired units, whose start-up and duty point change can take up to several hours. The situation is different in the case of gas units, which can change the current working point dramatically in just a few minutes.

Polish version is available here.

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