In a politically, economically and environmentally volatile world, energy security is an increasingly important consideration. Paul Murphy of Milbank Tweed Hadley & McCloy explores this idea, highlighting the market structures that would be more appropriate in the current era.
Electricity is a fundamental input in the modern world. Comprehensive studies have previously demonstrated the almost linear relationship between electricity and development, which is only further enhanced by the inexorable progress of technology that underpins society as we have come to know it today. In such an atmosphere, stable and secure electricity is an imperative for national governments, both for basic household needs and for industrial progress and overall economic growth.
Given this critical role that electricity – and, more broadly, energy – serves, it would seem that sovereign actors would have a clear path in addressing this “basic need”. However, a number of factors complicate the process. First, in recent years, considerations about climate change have come to lead discussions on the means by which electricity is generated. Second, energy markets are particularly volatile, both historically and in more recent times, noting contemporary examples of: the dramatic fall in the price of oil over the last year; the impact of US shale oil and shale gas on both US and world markets; and the shutdown of Germany’s nuclear reactors, and the ensuing impact of Energiewende (clean energy transition), which has, interestingly, increased Germany’s net emissions. Third, world events continue to show that energy is highly influenced by political events – from Energiewende in Germany to Saudi Arabia’s decisions not to defend the price of oil, and the state aid debate over the United Kingdom’s Contract for Difference (CfD) and Loan Guarantee approach for the Hinkley Point C nuclear power project. Finally, while electricity markets have been deregulated in many countries in an effort to promote price competition and, therefore, a reduction in electricity prices for end-users, deregulation has had the effect of governments ceding control of electricity markets – in terms of both what is built and how prices are determined.
With such turmoil, unpredictability, and political/geopolitical influence, discussions concerning “energy security” have come to the forefront of thinking, particularly within the European Union, principally in response to the actions by Russia in relation to Ukraine and, in particular, with a focus on reducing European dependence on Russian natural gas under this rubric of “energy security”.
But what does “energy security” really mean and why might considerations of “energy security” impact the way companies choose to assess the merits of a particular infrastructure project?
Starting with foundation principles, electricity constitutes the critical infrastructure of a nation. Together with national security, public safety, food, water and shelter, it is one of the “basic needs” that governments must provide to their people. Therefore, it naturally follows that energy security is put at risk whenever a nation must rely on an external supply of electricity and/or an external supply of the fuel needed to generate electricity. If such reliance exists, as is the case regarding the supply of natural gas by Gazprom to the European Union, client countries are susceptible to supply being unavailable and to pricing being unpredictable, due to reduced availability, market shocks and/or manipulation by the supplier country.
By internalising energy supply, the country doing so can achieve superior levels of price stability, mitigating the unpredictability associated with reliance on external sources. Furthermore, diversifying fuel sources promotes further energy security by reducing the country’s dependence on any one particular type of fuel supply. Interestingly, though, concepts of “energy security” and “energy diversity” are intangible and of indeterminate value when modelling a particular project at the project pro forma level. Generally, a developer will consider the costs and revenue stream tied to the asset, and then look to source both debt and equity to finance the project. In such an exercise, there is no line item called “energy security”; there is no line item for “energy diversity”. Nor is there a line item for “climate change”, unless an external economic valuation (eg, through carbon tax incentives, carbon credits, a carbon trading scheme, etc) is imposed on the project by a government.
These ideas of energy security, energy diversity and climate change are, thus, generally outside the project decision-making process. They are benefits not considered at the project level; instead, they are external to the project itself as the benefit is a shared, a more macroeconomic, benefit, which is of significant, albeit indeterminate, value to the nation and, in the case of climate change, the global community. Now, in regulated markets, these concepts can still be considered by a regulated utility, with such costs passed on to the rate base clientele. Moreover, when such regulated utilities are government-owned or controlled, such national considerations can be directly factored into decisions regarding the overall electricity generation portfolio and national energy strategy. However, in deregulated markets, the “go/no-go” decision always comes back to the project economics, which remains limited to the project level. At a project development level, this presents the first challenge to development of infrastructure projects that might address, among other “soft” goals, energy security considerations.
The second challenge is that the aforementioned deregulation that has occurred across the globe has not really been in full. In an effort to meet climate change/emissions reduction goals, renewable energy has been the focus of subsidies and other preferential treatment, thereby creating market imbalances, which can in turn create market instabilities. Policies in the United States and Europe have led to market extremes, whereby negative pricing has been observed in deregulated energy markets. Such market imbalances have led, or are leading, to the shutdown of nuclear power plants in the United States and advanced technology combined cycle gas-fired power plants in Europe (somewhat ironically in favour of increased reliance on coal-fired power plants).
Why is such market behaviour disconcerting from an energy security perspective? The unfortunate reality is that such preference for renewable energy is favouring an intermittent generating source. If the sun does not shine (which happens at least one-third of the day, regardless of weather patterns) or the wind does not blow, alternative sources of power must fill such gaps. As such, baseload generation (ie, 24/7 generation capacity) is essential from an energy security perspective. Yet traditional baseload forms of power (hydro, coal, gas, nuclear) are either limited in capacity (hydro), disfavoured for environmental reasons (coal), limited by supply (gas, regionally so), or politically challenged (nuclear). While recognising the important role that renewable energy must play in the overall effort to reduce carbon emissions, it must also be recognised that, as renewable energy grows as a percentage of the overall energy portfolio, the inherent intermittency raises new challenges of grid instability, which in turn compromise energy security.
The third challenge, which is more specific to certain countries, is the inability to determine their own destiny when it comes to internal energy portfolios. In the European Union (EU) “subsidy” is a dirty word given state aid limitations. The state aid rules are reflected in Article 107(1) of the Treaty on the Functioning of the European Union: “Any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods, shall in so far as it affects trade between Member States, be incompatible with the common market.” However, by excluding renewables from the state aid construct, baseload generation has suffered greatly.
As a result of the state aid requirements, EU member states are unable to make their own decisions on their energy portfolios in the absence of meeting state aid requirements. Given EU membership constraints and privileges, not only must member states pass muster with Brussels on state aid analysis, but other member states have the ability to raise objections to decisions from Brussels on individual projects. For example, at the time of writing, Austria (possibly joined by Luxembourg) was preparing a case before the European Court of Justice to challenge the European Commission’s state aid determination for the UK’s Hinkley Point C nuclear power project. In its simplest terms, what this represents is the ability of one member state to block the decisions of another member state (and the potential ambitions of other member states as well, recognising the interest that certain central and eastern European member states have given to the CfD structure) regarding what would seem to be a fundamental consideration for a sovereign country: the stable provision of electricity for its people.
If one recognises that energy security is fundamental to national development, it does raise the question of whether the European Union’s rules concerning state aid in terms of electricity generation are appropriate. Returning to the case of Hinkley Point C, if the United Kingdom wishes to make a decision to build nuclear power plants as a source of emission-free, baseload generation – based on its determination that nuclear power is the most rational way to meet the competing goals of energy supply, climate change commitments and energy security – then one must question whether it is appropriate for either the European Union, as an institution, or its member states, in the case of Austria, to be able to challenge such a decision on the basis that electricity should be governed by classic, common market/anti-subsidy principles.
In the case of the present state aid structure, clearly the basis for challenging the UK’s pricing and loan guarantee programme for Hinkley Point C exists. However, if the market was not providing an answer to the needs of the United Kingdom, as determined by its government, then, particularly on the basis of energy security considerations, is it not justifiable, if not the absolute responsibility of the British government, to take whatever measures it determines necessary to incentivise the construction of that form of generation that it considers best serves its national interests?
Of course, not to be outdone, the United States is well on the way to tying its own Gordian knot with the pending (as of the time of this article) release of the EPA’s “Clean Power Plan”, where a federal instrumentality will now impose requirements on individual energy portfolios at the state level. The premise – combatting climate change – is worthy, but the application neglects the aforementioned challenges posed by the combined effects of deregulation and renewable energy subsidies. The result is that large, baseload generation is disfavoured in deregulated markets, and grid reliability concerns have been raised by both FERC and NERC in respect of the planned EPA rules and the speed with which states must comply with carbon emissions targets.
Uncertainty and instability are particularly unwelcome in industry. Commercial unease with instability is no more evident than in the use of hedging instruments that are widely used in large commercial and financial endeavours. Hedging is used for commodities, interest rates and currencies. The idea that industry favours the lowest price above all else for a key input is simply not correct; instead, hedging demonstrates that an entity is willing to forgo (or is unwilling to chase) potential favourable price extremes in an effort to avoid the opposing unfavourable price extremes. In short, stability and predictability are more important in the case of key inputs. With industry being the backbone economic growth, one must question the prudency of any policy that does not promote price and supply stability for a key strategic and social input.
In this era of deregulated markets and climate change priorities, if the market does not get to the desired result (recognising that the “desired result” will vary from country to country), the national government must (from an energy security perspective) have the ability to create the necessary incentives to promote the goals it so desires. In the case of the EU, while consensus on treatment of renewables as a special case has been achieved, the same consensus does not exist for nuclear power. Yet the lack of consensus merely underscores that, in an area as fundamental as energy security, perhaps the law should be tailored in a fashion to put electricity completely outside the state aid rules, especially when one considers the diversity across the membership of the EU at present and the need for individual member states to determine the means by which to achieve their energy security and emissions goals. To think that such a combination of countries can reach consensus on energy decisions in any meaningful way is ambitious in the extreme (consider that the United States – one country, with a common law and government, a common language, and a common market – has yet to develop any sort of effective national energy policy).
Taking this idea further, it must also be considered whether deregulation of electricity was the right decision. With electricity as a key driver of economic development and overall quality of life, it falls to the national government to ensure and protect such supply, as well as to factor in other intangible considerations – all of which are more difficult to do in a deregulated market structure. It also becomes difficult for a responsible government to base the provision of such a need on the unpredictability of external energy markets and supplies, as well as external controls, which, necessarily, change the rules by which governments must evaluate energy projects and the support for them. These considerations then factored into a national government’s merit-based assessment of the project; to do otherwise – only to look at project level metrics and not “value” external benefits like energy security – would short-change the investment decisions of such government, leading, in turn, to incongruous results when viewed from an energy security perspective. We seem to have outsmarted ourselves with electricity markets, and, perhaps, a return to core principles is what is now needed to address energy security in the current era.