The past weeks were unprecedented. The price for a barrel of US oil (West Texas Intermediate = WTI) plummeted to well below zero on 20 April. And for the first time ever, negative electricity prices were seen in the Netherlands for several weeks running. The underlying reasons are broadly the same: abundant supply, sharply lower demand and limited storage capacity. But there are also big differences between oil and electricity.
Global oil demand will not return to its old level for the time being
Alongside the existing ample supply of oil, the demand shock was the primary catalyst of the sharp slump in oil prices. But the effects in the oil market appear to be temporary: once the lockdowns are eased, the economy will pick up and demand for oil will follow suit. That said, the chances of global demand for oil returning to the level seen at the start of the year in the foreseeable future are slim. Now that working from home and using online conferencing and webcasts have become so widespread, we may start to look more critically at the need for daily commuting and business flights. Nor do I expect this new situation to accelerate the transition to electric cars, which has been mainly tax-driven so far. To achieve the next acceleration in this transition, we will need to make the step to a private and second-hand market. All in all, it will be years before the supply and demand balance is restored in the oil market and oil inventories decline to a ‘normal’ level. Until that time, there is a ceiling on the potential price recovery.
Electricity is not a normal market
Demand for electricity, as with oil, has plunged under the impact of the coronavirus measures. In the coming years, however, demand for electricity will recover and even grow further. In a normal market, the supply from electricity sources would fluctuate with demand, leading to a kind of equilibrium price. That is the well-known recipe for every commodity market. Which takes us straight to the biggest difference between these markets and the electricity market. If you leave the balancing mechanism solely to the market, you can have too much supply in some periods and too little in others. And the latter is not, and cannot be, allowed in the electricity market. Sufficient capacity must always be available to safeguard security of supply, even during the ‘dark doldrums’*.
Further innovation and technological advances needed for viable business model
Apart from that, of course, we have our climate objectives. To reduce our CO2 emissions, the percentage of renewable energy must be strongly increased. As long as this overcapacity cannot be stored on a large scale or put to an alternative use (such as the production of green hydrogen) and the supply/demand ratio remains difficult to control (large-scale demand-response), low or even negative electricity prices will be seen more often. If an incidental occurrence, this need not be harmful and the wind or solar farm can still generate an excellent return. Sometimes, however, there is an obligation to continue producing even when prices are low in order to meet contractual commitments or to receive subsidies. If technology fails to provide solutions and low or negative prices become structural, the revenue model of solar and wind farms could be undermined, in which case operators would be forced to switch off production more often.
Need for new price stabilisation mechanism?
The tender for the next offshore wind farm – Hollandse Kust Noord, kavel V – has just closed. The outcome of the previous two tenders (Hollandse Kust Zuid) was that they could be built without subsidy. Provided, that is, the government bears the costs of the seabed survey and the offshore connection to the power grid. Lower electricity prices also make it more difficult to conclude Corporate Power Purchase Agreements (PPAs), i.e. contracts with a fixed corporate customer. Such contracts are taken out by large corporations that want to agree a fixed price for their electricity supply with the wind or solar farm owner. The agreed fixed price is lower than the expected electricity price. The customer is thus effectively given a discount for making a long-term commitment and reducing the wind farm’s price risk. If the wind farm revenue model comes under increasing pressure from lower electricity prices, the need for a different kind of price stability mechanism will become more imperative.
If we choose to rely solely on the Emission Trading Scheme (ETS), the climate objectives for the various sectors – including those of power plants – will still be achieved. But the route towards these goals will be different, with less emphasis on the initial expansion of the renewable energy share. That, however, would clash with the European objectives, which not only stipulate CO2 emission reduction targets, but also the use of an ‘x’ percentage of renewable energy. I therefore very much look forward to seeing which party wins this tender and how this wind farm will be built and financed.
*Dark doldrums = the English translation of Dunkelflaute , i.e. a sunless and windless period. The Dutch term ‘schemerluwte’ was coined in one of my earlier columns.
This column was published earlier in Dutch via Energiepodium.nl