Key View: The UK’s power sector outlook is set to see upside risks develop to a faster decarbonisation amid the government unveiling of its new energy strategy. We expect to see upside risks to the development of low carbon power generation with non-hydropower renewables set to be the only net growth sector with share of generation rising from 47.6% over 2022 to 71.2% over 2031. We highlight that the wind sector and particularly the offshore wind sub sector will account for 84% and 70% respectively of all new capacity coming into the market. Upside risks to new nuclear projects coming into the market over our forecast period are rising with new SMR technology.
- The UK’s latest energy strategy launched on April 7 2022 has been designed to reduce energy costs, increase low carbon power generation and increase energy security against the backdrop of the Russian invasion of Ukraine.
- While we believe the plan will serve to shore up domestic energy supply and increase low carbon power, we remain sceptical as to whether it will impact energy prices or tackle consumption inefficiencies, with the current strategy focused on the energy supply rather than the management side.
- The plans place a heavy emphasis on increasing offshore wind, solar and nuclear power with a more moderate approach to onshore wind with a new target mix of 95% low carbon technology’s with a reduction of gas-fired power.
- The strategy will also seek to double the hydrogen production capacity target to 10GW by 2030 with at least 5GW of green hydrogen electrolyser capacity, utilising the UK’s expansion of offshore wind to produce the gas. That said, the gas would be used in a wide range of industrial applications which are hard to decarbonise and natural gas-dependent.
- The new plans have put the UK more in line with other European markets which are also seeking to build out multiple GW’s of electrolyser capacity, while leaving room for low carbon blue hydrogen. We believe this move will be able to shelter the gas sector but also enable gas-fired power generation through the use of carbon capture and storage (CCS) as the government targets decarbonising the power sector.
Over Q421, the UK announced its aims to reach net-zero carbon emissions by 2050. Within the strategy, the UK is targeting a fully decarbonised power sector by 2035, with domestic energy generation sourced from a mix of low carbon renewables and nuclear power. This has since been brought forwards with the latest energy strategy to reach a 95% low carbon power mix by 2030.
Under the backdrop of decarbonisation, the UK has been a strong proponent of renewables and in particular offshore wind. We maintain that offshore wind power will be the main investment bright spot in the UK renewables sector, as the government will aim to attract investment in big-ticket infrastructure post-Brexit, and cement the country's role as a sector outperformer. In contrast, the solar and onshore wind sectors have seen support deviate between governments.
In order to facilitate the high levels of new internment power supply, the UK will rely heavily on a series of interconnectors to neighbouring markets. The UK's 7GW of interconnection capacity in the pipeline will allow for increased levels of traded electricity over the latter half of the decade as the market pivots to becoming a major power exporter. Power storage through battery technology will play an equally important role and we expect this to grow in tandem with the renewable sector.
More than GBP112bn of private sector investments across the UK’s power market are driving growth opportunities, while also highlighting the market's diverse competitive landscape. The 2035 renewable energy targets will require investment of between GBP280bn to GBP400bn from a mix of public and private sources, as outlined by the government. We previously outlined that we expected to see the private sector take a much more leading role in delivering the future of the UK’s nuclear programmes, and also become the driving force behind renewables growth as the UK looks to support private enterprise.
We continue to expect that as coal-fired power is phased out, the gas segment will claim total dominance of the thermal sector, accounting for 99% beyond 2024. However, we do not expect large-scale capacity developments in the segment, and see its role diminishing amid a rise of lower carbon-emitting alternatives. While gas plays a vital role in ensuring power supply by offering flexibility, we see the rise of alternative generation sources impacting this position. As markets become more interconnected, grids become smarter and more flexible, and battery storage options become cheaper and more widely available; the need for gas to complement renewables will dwindle, and competition to provide baseload generation will come increasingly to the fore. We highlight that while natural gas capacity will remain in the UK, its output towards the end of the decade will decline, falling from 112.7TWh over 2022 to 74.1TWh by 2031.
Coal On The Way Out
We maintain our core view that the UK government will realise its plan to phase out coal capacity as a component of the UK power mix by 2024. This is because the plan, which was first announced in 2015, largely cements a trend whereby ageing coal-fired power stations are already closing due to unfavourable power plant economics and tightening emissions criteria. With coal generation accounting for 23% in 2015, this figure came to 2.2% over 2020, and will fall to 0.0% by 2025. A total of 4GW of coal capacity was taken offline in 2016 alone, largely due to carbon taxes and unfavourable coal power generation margins. In light of coal closures and strong growth in cheaper non-hydropower renewables capacity, coal did not supply any electricity to the UK for the first continuous 55-hour period in April 2018, as output was eclipsed by generation from other sources.
These coal closures cement a trend that has been firmly in play over the last few years as a result of the impact of the Large Combustion Plant Directive, which has now been replaced by the Industrial Emissions Directive (IED). In the aftermath of Brexit, how strictly the UK will follow the EU directives is open to debate. However, the IED effectively put in place tighter emissions limits for power plants in Europe after 2016, with plant operators given the option of either upgrading to meet the tougher emissions criteria, or closing. In light of the government's plans to phase out coal by 2025, we do not expect coal power plant operators to invest in upgrading coal plants to comply with the directive. To this end, we currently estimate that the UK has less than 8GW of coal capacity - spread across a handful of facilities. In March 2016, for example, both Scottish and Southern Energy's (SSE) Ferrybridge coal-fired power plant in West Yorkshire and Scottish Power's Longannet coal plant in Scotland were shut down. Notably, operations at RWE's 1,500MW coal power plant in Aberthaw, Wales, were decreased from 2017, due in part to challenging market conditions.
Favourable Gas Plant Economics To Accelerate The Switch
Although we expect a contraction, the outlook for gas generation is solid, albeit at a reduced capacity as the UK looks to ensure lights on over the next decade, assuming that investment can be mobilised and channelled into gas capacity. We emphasise that with new nuclear capacity likely to be held up in delay, and the remaining coal plants likely to close earlier than anticipated, the government's options for baseload capacity are limited. We forecast that gas will be supported by oversupply in the global gas markets, which will keep a lid on gas prices over the next few years and keep input costs low for power generators.
This switch in power generation dynamics has led to an uptick in activity in the UK gas power market over the last few years, and the project pipeline has strengthened somewhat with 840MW under construction, and 8.4GW in planning. These projects are important because the extent to which gas will play a role over a longer time frame will depend, to a certain degree, on the construction of new, highly efficient gas generation capacities like some of the facilities mentioned above.
Capacity Mechanism Designed To Mobilise Investment In New Capacity
Should the government decide that it wants to encourage investment in gas-fired power, it may have to reform the UK's capacity mechanism - the scheme under which the government makes payments to providers of back-up power supply.
The capacity mechanism was launched in 2014 to guarantee the UK's energy security. Under the mechanism, power providers will be paid to maintain and invest in new power plants that are needed to provide backup capacity over the next few years. Capacity payments are necessary in the UK because ageing coal capacity is being taken offline to comply with environmental targets, while margins at the remaining thermal power plants are being eroded by an influx of intermittent renewables generation. This means ageing capacity is closing without being replaced, raising the risk of a capacity deficit, and forcing the government to intervene in the market.
The two auctions, which are carried out by National Grid, procure capacity for up to four years ahead (the T4 auction) and one year ahead (T1) respectively. This twin approach is intended to incentivise investment in long-term supply, while also making sure that existing capacity remains online to meet near-term demand over the next 12 months.
However, over the long term, the results of the auctions and the low clearing prices have largely sustained many of the questions over the effectiveness of the system, especially regarding new-build gas plants. In our view, the biggest problem facing National Grid and the UK government is that it is still unclear as to whether the auction system provides the necessary pricing signals to incentivise the construction of new capacity and ensure energy security over the long term.
Questions Linger Following 2018 Auctions
The UK's capacity auctions in early 2018 did not dispel some concerns about the capacity mechanism, after clearing prices in the T1 and T4 auction came in below expectations.
As a consequence, we highlight that the very low clearing price raises questions about the need for the auction in the first place. While the government has argued that the low price represents value for money, critics have countered that the very low price, which is reportedly half the price that analysts expected, indicates that supply is robust. Therefore, it could be argued that the auction has simply subsidised existing power plants that would have stayed online anyway.
Meanwhile, the T4 auction secured 50.4GW of capacity for the winter of 2021-2022 at a clearing price of GBP8.4 per kW-year, with 48.4GW of the contracted capacity coming from existing capacity and interconnectors.
The T4 auction, in particular, had a lower-than-anticipated clearing price, which is well below the GBP18-22/kW year price registered in other earlier T4 auctions. The major winners appear to have been existing power plants, small (but flexible) gas-fired peaker plants, existing nuclear plants and interconnectors. Gas power plants accounted for 29.6GW of capacity, followed by nuclear at 7.9GW and interconnectors, which were included in the auction for the first time, at 4.6GW. Contracts for only 2.6GW of coal were awarded, while pumped storage accounted for 2.5GW, and battery storage for 153MW. A total of 8.3GW of existing coal capacity also withdrew from the auction due to the low clearing price, raising the risk that coal plants may close earlier than expected.
However, as with previous auctions, major questions remain about the likelihood of the mechanism stimulating investment in new greenfield gas projects. In this regard, we highlight that many proposed large- and medium-sized gas-fired power plants, which could be needed to bridge the gap between the closure of coal capacity and the start-up of new nuclear, exited the auction without securing contracts. These included the 470MW North Killingholme gas-fired power station project, which is being developed by C.GEN Killingholme, and SSE's proposed Keadby 2 gas power plant. Drax Group also said that two new open-cycle gas turbine projects participated in the auction but exited above the clearing price.
Low Carbon Gas To Present Upside
We note the increased drive from the government to decarbonise the power sector as taking priority, with the majority of capacity actions being awarded to low carbon alternatives as the market strives for net zero emissions by 2050. We highlight investment in the sector will be aimed at upgrading and prolonging the existing fleet, with a focus on reducing emissions as the progress of hydrogen adoption in the gas power sector is promising and delivering decarbonisation. In August 2020, UK utility SSE outlined that the only major new gas plant project underway in the UK, the 900MW Keadby 3, would be developed with either a CCS, or would be run on hydrogen gas. Given the success in deploying full scale hydrogen gas production systems in the UK and Europe, we highlight this development as an upside risk to the hydrogen gas-fired power sector.
Furthermore, the crossover technologies between gas-fired and hydrogen-fuelled generators are seen as a viable alternative for the technology's developers and operators. Over Q121, the UK government announced it would set aside GBP16bn for the energy transition in the gas sector. Of this, GBP13bn will be allocated to aid the development of the hydrogen sector in the UK, enabling the gas sector to branch into this new sector.
One of the most advanced blue hydrogen initiatives will be led by Equinor, with the firm announcing its intention to develop a 600MW hydrogen facility in Hull - currently the world's largest. The so-called H2H Saltend Project will be developed as a hydrogen hub, a common theme we have previously outlined, producing blue hydrogen through CCS for the region's nearby industries. This will include a natural gas power plant that will be converted to utilise a blend of the gas, another ubiquitous hydrogen theme developing over the decade.
In addition to the role of gas in hydrogen production, we also highlight the potential created by the inclusion, under the Net Zero Strategy, of four carbon capture usage and storage clusters, which will capture 20-30mn tonnes of CO2 by 2030. The HyNet North West and East Coast Cluster projects will be the first to be developed, with the support of the GBP1bn Carbon Capture and Storage Infrastructure Fund. The HyNet project is being developed by ENI and Progressive Energy, and will produce hydrogen from natural gas, while the East Coast project will focus on industrial emissions, and is being developed by BP, Equinor, Drax and SSE.
Over Q321 Equinor said it would seek to triple its hydrogen output to 1,800MW for the additional use cases of hydrogen and potentially more hydrogen power generation. We also highlight that the nascent sector will see significant support from government, with GBP4bn being launched from the country's hydrogen strategy.
At the beginning of 2022, the Energy Networks Association, the gas networks operating body, announced that the UK’s gas networks will look to ensure that up to 20% blends of hydrogen would be possible by 2023. As such, we expect turbine operators and project developers to develop new capacity with this in mind and usher in possible new hybrid gas technology.
Opposition To New Gas Plant
Over Q121, it was announced by Drax that it had cancelled its 3.6GW gas-fired power development. Due to mounting public and political backlash, legal challenges were aimed at the development outlining that the project would undermine the UK's binding carbon targets. The firm aims to pivot its investments towards low carbon generation methods.
We highlight that intense scrutiny will fall on the segment due to the sector's environmental credentials and the locking in of the sector into the power mix beyond our forecast period with the market's long-term ambitions to fully decarbonise power supply by 2035. Given the volatility in fuel prices, an over reliance on natural gas is facing considerable opposition. Over February 2022, the Office of Gas and Electricity Markets (Ofgem) announced that the energy price cap would rise by 54% to reflect the elevated gas prices.