To benefit from the economics of generating electricity most supply companies have developed integrated businesses, which both generate and supply electricity.
Some of these companies have also invested in gas supply. At face value the acquisition of gas supply assets by a generating company makes economic and business sense. If the generator has its own gas supply then it has greater control of its business. Likewise if a gas supply company has generation assets then it has two markets for its gas supply. It can either convert the gas into electricity or it can sell the gas to the end user market. The determinant of which route is taken — sell gas or generate electricity — is the market price of the underlying commodities. If the cost of generating electricity from gas is less than the forward market price of electricity then it makes sense to convert the gas into electricity and recover the margin. The converse scenario whereby the cost of converting gas to electricity is greater than the market price of electricity would make economic sense for the gas to be supplied to the end user and not converted to electricity. This relationship between gas and electricity prices is the basis of “spark spreads”.
Spark spreads recognise that there is an arbitrage opportunity between gas and electricity. This arbitrage opportunity exists because there are imperfections between the two markets. Spark spreads have been popular short-term trading strategy tools in the US and European markets. The popularity of these instruments is expected to increase when the European directive on gas competition comes into effect in August. By using spark spreads, generators are able to assess the available electricity margin based on the price of natural gas. In the UK market, the formula for determining the spark spread is based on 60 MW of electricity, 1 000 therms of gas and a plant efficiency of 50 per cent. In other words, a plant with 50 per cent efficiency would generate 60 MW of electricity from 1000 therms of gas.
Conventional wisdom would tend to suggest that the growing convergence between gas and electricity markets in the UK would lead to a growing correlation between the two markets, with increased gas prices leading to increased electricity prices. However the opposite is true and it has been having a marked economic impact on the UK base load generating market.
At the beginning of 1999 annual base load electricity prices were around £26 per MWh and annual gas prices hovering around 12 pence per therm. But at the beginning of July the October annual electricity base load price was bid/offered at £19.35/19.50 per MWh and the October annual gas price was bid/offered at 19.20/19.35 pence per therm. In other words there has been a total reversal of prices. This reverse is further put into context when looking at the April 2001 annual electricity base load prices, which were bid/offered at £18.20/18.30 per MWh at the beginning of July.
The impact of this price reversal has had pronounced effect on the economics of generating base load electricity. At the beginning of 1999, based on the above prices, the spark spread was over £15 per MWh. At the beginning of July this spark spread had shrunk to just over £5 per MWh. With a typical cost of production for base load plants of between £9 and £11 per MWh the generating margin has shrunk from around plus £5 per MWh to around minus £5 per MWh. In other words, gas-fired base load generating plant is losing money. It should come as no surprise then that some UK generators are keen to sell their base load plant. It should also be little surprise that other companies will almost certainly buy these plants, albeit at a reduced cost, as a way of getting into the UK generation market. But investing in these plants will carry a risk that the disparity between gas and electricity prices will be more than a short-term blip.
Gas prices in the short to medium term are unlikely to fall below 16 to 17 pence per therm based on the marginal backwardation in the market. The value of gas is now strongly correlated to world oil prices, and although OPEC ministers last month decided to increase production to push prices down they would not sanction oil prices falling below $25 per barrel, a level which would maintain gas prices above 16 pence per therm if the correlation between oil and gas prices remains. Similarly electricity prices are unlikely to rally in the short to medium term, particularly with the UK’s New Electricity Trading Arrangements coming into effect by the end of the year. The economic outlook for gas-fired base load plant therefore looks on the bleak side. For a long time the concerns over base load generation have rested with coal-fired plant. But with a government subsidy to RJB Mining, the UK’s largest coal producer, and long term supply contracts being agreed by RJB Mining the coal market looks to be fairly secure, at least for the next few years. The concern though rests with un-contracted gas as the high gas prices and low spark spreads argue against generating base load electricity from gas.
With the UK government’s de facto moratorium on new gas-fired plant due to end shortly those companies without contracted gas supplies looking to invest in new gas-fired plants may now decide to re-think their strategy. The government, by comparison, can afford a wry smile in saving, at least in the short term, the UK coal industry. But at what cost to the environment?