Analysis of 2012 European and Japanese Energy Market Developments and Offshore Wind Pricing

Eye on the Market | October 22, 2012 J.P Morgan The most important energy developments of 2012: how countries are planning for Independence Day adding up, it is unclear how Germany will accomplish all of its goals simultaneously. That’s probably why the ECB has been doing the heavy lifting in the European bailout: that approach doesn’t look like it will cost Germany any money (yet.....) A brief comment on investment opportunities in wind. A recent offshore wind farm project in Germany entailed a fixed sale price contract for electricity at a guaranteed rate of 119 Euros per MWh for 13 years. This compares to 45-50 Euros per MWh for electricity in shorter term German power markets. The investor takes operational and maintenance risks, and the risk of wind’s intermittency. With a large gap between the contract price and the spot market, there may be a “windfall” (sorry) for investors. However, wind investment risks have at times been under-appreciated. In a May 2012 report from Standard & Poor’s, the authors note that they had initially rated 7 portfolio and single-asset wind projects as investment-grade. All but one has since fallen below investment-grade, which S&P states is a result of “wind resource deficiency” (wind levels below what industry experts had cited as lower-bound estimates), and higher-than-expected operating and maintenance costs (repairing cracked foundations, jack-up rigs to fix gearboxes and blades, etc). On the latter point, S&P indicates that U.S. wind project O&M costs stabilized at rates that were 30% to 40% higher than forecast. Ill: Inherit the Wind: Japan’s energy dilemma after Fukushima Among the challenges Japan has faced in the wake of the tsunami and nuclear meltdown, one of the greatest relates to energy policy. Only 2 of its 54 nuclear reactors are now operating. While Japan may turn some back on temporarily, it expects to decommission all of them within 18 years. Like Germany, Japan plans to increase contributions from renewable energy. Japan’s plan entails increases in offshore wind, geothermal power, biomass and tidal power. The government’s preferred plan as described by the METI Advisory Committee in September 2012 is #1 in the first chart, which entails no nuclear power by 2031. Contribution to Japan power generation Japan power plant capacity utilization by fuel type Percent Percent 100% 100% 90% Co-generatio 90% Coal 80% Renewables 80% LNG 10% 9 60% Hydro 70% 50% Pe 60% Oil 40% 50% 30% Coal 40% 20% 30% 10% Nuclear g i<e] land 00 o oO N yy N (9) re tmaeks 2007 2008 «= 2009 = -2010S-2011_~—Ss«-2012 7 Source: Federation of Electric Power Companies of Japan, METI Advisory oe Ai Wore hamulieteoa ofapan2012 Flesiicily Committee. — The first thing to note is that Japan has been able to withstand the reduction in operating nuclear plants through a sharp increase in electricity produced by natural gas plants, and oil-burning plants. However, as shown above in the 2nd chart, utilization rates of plants using LNG are rising close to maximum capacity. Consider as well the fact that Japan pays as much as 5 times more per BTU for its natural gas than the US. Asa result, Japan is facing a near-term decision: turn on more nuclear power plants, import more LNG or suffer the growth penalty from higher electricity costs resulting from less supply. For a country that is already suffering from low growth and declining exports, this would be a steep price to pay. As for Japan’s long-term renewable energy plan, it is starting from a lower base than Germany: in 2011 only 1.25% of electricity came from renewable energy other than hydro (which supplied ~9%). The largest single component of its renewable energy plan relies on offshore wind. Japan’s Institute of Energy Economics estimates that offshore wind levelized costs might be only 35% higher than onshore, but Japan has limited experience in both. What may be more relevant is the experience of the United Kingdom. In a recent auction run by Ofgem (Britain’s electricity and gas market regulator), participants were asked to bid on a contract to build connections to offshore wind farms. Using Ofgem’s estimated transfer values, just the cost of building the connection for offshore wind farms to the grid is ~$1.05 million per megawatt (MW). As in Germany, this is a bit higher than the UK Department of Energy and Climate estimate for an entire new 850-MW combined cycle natural gas plant. For manufacturing-heavy Germany and Japan, a future based heavily on offshore wind and solar will be a brave new world of yet-to-be-determined cost and complexity. According to Vaclav, the “entire green thing is desirable and very much worth doing, but at a measured realistic pace commensurate with overall system conditions and requirements, not guided and propelled by naive, unrealistic expectations and impossible goals”. 5 HOUSE_OVERSIGHT_024198