Seven Challenges for the Energy Sector
Nothing will have greater significance for long-term energy prices than the energy mix decision, particularly with respect to onshore windfarms and nuclear power
Economic growth requires secure access to energy resources – at a given time and place, and at the correct price. Ten years ago, costs still seemed to be the only challenge. Recent years, however, have shown that physical access is another: a major share of global resources sits in politically unstable locations. Even if we are successful in securing energy sources elsewhere, the timing may not be as expected, and the price might not allow for sustainable development. The energy crisis and its impact on the gas market (affecting the power market, in turn) was an example of this. Once we add climate issues, and the resulting full rolling economic costs, into the mix, the scale of incentive systems thrown in for good measure, we can only conclude that building an effective energy market under such conditions is exceedingly difficult, making regulatory backing necessary.
The current energy transition will require a reformulation of the regulatory trilemma: how to reach something akin to an equilibrium while satisfying energy demand, integrating lower-emission technologies, and securing universal access to energy at affordable prices. The solution will either encourage or discourage investments at certain locations and vital investments are anything but minor. Global energy transition outlays in 2022 have been estimated at around USD 1.1 trillion. In the meantime, reaching zero net emissions – the goal adopted pursuant to the Paris Agreement – will compel the world to spend over three times that amount, or USD 3.5 trillion to 4.1 trillion by 2050. Such exorbitant spending translates into a pessimistic forecast for delivering emission-related targets. While energy transition is rolling along at a faster pace than originally expected, the tempo of change is still insufficient if global warming is to be kept at the targeted 1.5°C level.
Yet finances are not most significant strategic challenge. High interest rates and the rapidly changing economic environment have elevated energy conversion to a high investment position, providing hope for the expected return.
Three Global Challenges
While the global energy sector is facing multiple challenges, I believe three to be crucial. Firstly, a conflict-free shift in resources critical to the energy sector, driven by the abandonment of fossil fuels. Fossil fuel-based technologies are certainly offering a competitive edge to states with access to oil, gas and/or coal today. Yet these states may not enjoy similar positions tomorrow, once new technologies become the foundation of the energy system. This creates tension, but also entails specific regulatory decisions and actions. One might well ask: since energy is to be dispersed, renewable and digital, why should certain states still be given a premium position in the new world energy order? This will tie in with minerals and metals critical to the transformation ahead. Wind, photovoltaic (PV), battery, and electric vehicle technologies all require the use of cobalt, copper, graphite, lithium, platinum, nickel, magnesium, iron, and other minerals and metals. Estimates suggest that over USD 200 billion will have to be invested in the development and opening of new mining operations by 2030 alone. It is incredibly important to determine who will be supplying these future resources and from where.
Mastering electricity (and heat) storage technologies is another challenge. Renewable energy sources (RES) with the highest potential (windfarms and PV) do not guarantee the expected continuity or quality of electricity supplies. They will have to be supported with flexible, weather-independent sources. Regrettably, the potential of such RES (biomass, biogas and hydropower sources) is far from impressive. While fossil fuels (coal, hydrocarbons, nuclear) can provide backup during the transition period, the swift relinquishment of coal and, somewhat more slowly, of hydrocarbons will be a must if climate change is to be curbed. That will, in turn, require assorted energy storage formats. Battery storage and pumped-storage power plants can be put to work in the short term (for hours or days). While relatively expensive, they ought to be developed, primarily as a backup for PV.
Given lengthy periods of sunless and windless days (in wintertime in particular), storage facilities with a capacity several times the current volumes will be needed. For the time being, storage hydropower plants are the only ones with such a solution. Regrettably, conditions in Poland – and in many other countries, for that matter – preclude the option of building aforesaid storage facilities in greater numbers. While green hydrogen and its derivatives (ammonia or methanol, for example) and small modular reactors (SMRs) definitely look promising, we are still in a nascent stage as far as these technologies are concerned. One would be hard-pressed to describe the battery of the future today, or how it may affect power system economics. It is equally difficult to predict the future of solar panels, windfarm components, or batteries once they have reached the end of their economic life.
I believe that market operating rules are the third and final challenge. Europe has opted for a single-segment energy model with a price quotation mechanism based on marginal costs, and transmission and distribution grids kept separate from other activities, energy exchanges, an extremely ambitious climate policy and the flagship ETS (emission trading system). But similar choices have not been made around the world. The energy crisis has rekindled discussions concerning energy market operating rules. Should the marginal cost of the most expensive unit generating energy at a given point in time be the price quoted for the entire market? Even in extreme cases of gas prices skyrocketing from EUR 20 to EUR 350/MWh when all cheaper units were generating surplus profit? Will such a price bring a solid return on equity, especially given an ever-greater share of zero marginal cost sources? Should the market be divided between energy and power, or should the power market be considered a form of state aid, and thus subject to a specific regime? Do we really want a single energy market in Europe? Will we continue to allow individual countries to restrict it by introducing their own regulations, tariffs and support methods? These and other questions are being discussed in the EU today. The outcomes of these debates will certainly affect regulations, which, in turn, will influence the rules that apply on our market as well.
Three Challenges for Polish Decision-Makers
I will now segue to the Polish market, one with its own specificity and challenges. They are abundant, particularly because we have been the most expensive energy and power market in the region for some time. Again, I will only list three challenges.
Firstly, the energy system decarbonisation method will affect the development capacity of other sectors of Polish economy, i.e. its competitiveness. Carbon footprint calculations are swiftly becoming a required market standard. Our business partners are interested in how our carbon footprint will affect their balance-sheet in so-called scope 3 terms. Consequently, an ever-greater number of entities doing business in Poland are estimating the so-called scope 2: their in-house footprint resulting from electricity and heat consumption. They will subsequently demand that scope 2 carbon footprinting be reduced, hence the increasing popularity of green PPAs (power purchase agreements) and direct RES investments. Decarbonisation is an opportunity for Polish energy companies to develop. Will we introduce a measure resembling the German mechanism, based on respective companies separating out coal-related assets pursuant to market rules? Or will we continue the programme of forming and evolving the National Energy Security Agency (NESA)? This decision will have a major impact on the market, its competitiveness, our investment capacity, and future energy prices.
Nothing will have greater significance for long-term energy prices than the energy mix decision, particularly with respect to onshore windfarms and nuclear power. While onshore windfarms are the cheapest energy sources in Poland (in LCOE, or levelised cost of electricity terms), their development has been hampered by administration in recent years. This affects not only energy prices in Poland, but also the effective use of transmission and distribution grids, and the competitiveness of the Polish economy. In the medium-term, power grids will be the greatest energy transition bottleneck, and not only in Poland. The nuclear power-related decision is a much more hefty one, associated with a broad range of potential benefits, costs, and various types of risks. It seems that today’s challenge is all about “how” rather than “if”. A few technologies – LNR and SMR – have been considered, with a concurrent review of several suppliers. Effective nuclear power plant funding is no trivial decision. I will not reference decisions regarding the further development of PV technology or green hydrogen. In the latter case, Poland has many advantages and can achieve greater benefits than other countries developing this technology. Regrettably, we are still stuck at the starting line, while others stride ahead.
Market structure is the third challenge. We have created an enormous energy corporation, making the other three look like much younger, impoverished siblings. Should the decision regarding the separation of distribution grids from today’s energy groups be made to allow greater investment independence, and should the NESA decision be confirmed (even if the Agency’s original structure is altered), one ought to consider further development goals for remaining capital group divisions, or possible continuation of sector consolidation. This brings further challenges regarding our market’s competitiveness, other investors, funding methods, the evolution of the district heating market, etc. Polish energy market conversion will require an investment of over PLN 1,250 billion by 2050 (excluding the district heating, automotive and industrial sectors, within which an electrification megatrend is visibly developing at a swift pace). Now that is serious money. Today’s energy companies will be unable to shoulder the full transformation cost. While PV development over recent years is certainly a reason for optimism, energy consumers will not cough up the full cost of transition either. The market needs other investors, including foreign ones. Should we fail to create solid market structures, we might find it difficult to convince American pension funds, for example, to make Poland their investment choice. Recent experiences – the year 2018 and the current energy crisis – have taught us that the regulator will be aiming for a balance between energy user and investor interests, usually aiding the former at the expense of the latter. The market structure and its operating rules will certainly help attract investors, as will a well-designed regulation mechanism (such as a basic infrastructure access subscription, based on Regulatory Asset Value and designed to cover grid expenses, as well as basic generation costs).
Governments worldwide are making various compromises with regard to economic priorities, geopolitical ambitions and environmental goals, depending on the resources available to them (commodities, equity, capabilities). These compromises impact political decisions, sending out signals to markets, investors and consumers, and, ultimately, determining progress. Policies such as the US Inflation Reduction Act (IRA), the EU’s Green Deal, or the REPowerEU plan all raise emission costs while encouraging cooperation and investment in clean energy technologies. Within a year of launching the IRA, the US clean energy sector attracted USD 270 billion in investment (eight times more than average annual investment projects). Energy transition may well become the Polish economy’s flywheel.
And last but not least: challenge number seven. Many experts believe that the rapid pace is the largest yet. Notably, however, progress is never linear. Since it is best rendered as an S-curve, we can expect the energy conversion tempo to pick up considerably, regardless of the fact that we are only at an early stage of transformation. Our aspirations are hugely important – where we wish to finish in the race might be the most important ambition of all. ©Ⓟ
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