Reed Smith Client Alerts

Authors: Brett Hillis Nicholas Rock Prajakt Samant

Introduction In recent years, the UK power sector has seen owners and/or operators of generation assets increasingly reflect on their commercial strategies with respect to their operations. In the case of power plants, this has involved a consideration of divestment or strategies for optimising these assets. This focus on the efficiency and optimisation of assets has been a key feature for market participants in the past few years, and has also facilitated the increased diversification of market entrants.

One of the primary objectives for an existing owner/operator, or an entity acquiring such an asset (Owner) will be to achieve optimal monetisation – maximising the gross margin from selling a unit of electricity in relation to the available capacity of a power plant. This is more commonly referred to as the “clean dark spread” (in the case of coal-fired generation), or “clean spark spread” (in the case of gas-fired generation).

Therefore, Owners will need to consider the extent to which they need to balance “in-house” capability alongside procuring energy management services from a third party for the purposes of achieving the above.

This article considers some of the key drivers behind this trend in the market and the kinds of services that Owners will need to access in order to achieve their objectives.

Drivers of this trend

Regulatory impact on existing providers of energy management services While the power markets are seeing some new entrants, regulatory changes have led to some of the incumbent market participants cutting back on their energy trading activities.

For example, some investment banks who previously provided, or were able to provide, energy management services have reduced the scope of their capabilities in this area, or have curtailed their involvement in this market.

Additionally, some energy companies have disposed of power plants in the UK to allay competition concerns raised by the European Commission.

This has led to opportunities for other participants to step in and provide these services or for Owners to consider self-provision.

Security of supply Issues concerning security of power supply have seen the emergence of so-called ‘flight to physical’ investment strategies by a diverse range of investors, from pension funds to banks to infrastructure companies, due to the (perceived) investment solidity in owning and/or trading around these assets. Such investment, it is thought, allows participants to arbitrage physical market exposure with appropriate hedging, supply and logistical systems/arrangements in place.

Greater certainty within the domestic regulatory landscape The UK Government’s Electricity Market Reform (EMR) programme represents the single biggest transformation to the UK’s electricity market in a generation. The development of the EMR has been underway for over three years. During much of this time, there has been considerable uncertainty as to the precise scope of the market reforms to be implemented. The past several months, however, have seen numerous significant and long-awaited developments, which have brought more certainty to the EMR, particularly around contracts for differences and the capacity market. This has helped to bring a level of confidence to those in the market who previously had been deterred from new investment.

Energy management services In recent years, increasingly sophisticated trading services have been put in place between energy trading merchants (as Services Provider) and Owners, whereby the Services Provider provides energy management and trading services that encompass fuel input, power offtake, balance sheet functions, emissions allowances, credit functions, banking products and IT systems, often on a 24-hour, seven-day a week basis.

A key driver for this type of strategy has been the ability of Owners to leverage off the sophisticated derivatives trading and hedging capabilities that a Services Provider has. In addition to these trading capabilities, maximising the “spread” will involve a combination of physical and financial trading strategies which it might be difficult for Owners to self-provide.

Owners or Services Providers that are considering monetisation strategies will need to consider (amongst other things) the following issues in determining the level of services to be procured or provided respectively. It is important to involve a party which knows the industry and has appropriate experience from the outset.

a. Trading strategy – in order to maximise the dark or spark spread, the parties will need to agree upon forward looking hedging strategies dealing with fuel procurement, power offtake and how emissions allowances will be dealt with. This should take into account the capacity of the power plant being made available for the optimisation services, and matters such as planned outages. This will include strategies around how much power to sell into the balancing market on a day, week, month and season ahead basis.

b. Route to market services – the parties will need to agree the basis upon which the Services Provider will seek trading opportunities in the wholesale electricity, coal/gas (depending on fuel input), and emissions markets to make the relevant physical and financial trades.

c. Hedging and strategy team and recording – there will be a discussion around which individuals, particularly on the side of the Services Provider, will be engaged to undertake the relevant obligations and responsibilities assumed under the services arrangement. The parties will also need to agree upon how various transactions will be entered into and recorded, which may include some or all of the following types of trades:

i. Optimisation trades, including trades undertaken on a within-day, week ahead, month ahead, or season ahead basis.

ii. Any trades that are required to reduce exposure to imbalances.

d. Communication – processes and policies will need to be implemented to govern the basis on which communications between the control room, representatives of the Services Provider and the transmission system operator are to be made. If the optimisation services are not to be undertaken on a 24/7 basis, then consideration will also need to be given as to how handover to an overnight team is to be effected.

e. Market Information Services – in order for the Owner to establish, along with the Services Provider, trading strategies (as identified above), there will need to be agreement as to the types of data that the Services Provider will provide to the Owner. This data can relate to the physical and financial power markets, the coal or gas markets as applicable, and in relation to the emissions markets.

f. Information control – the Regulation on Energy Market Integrity and Transparency (REMIT) has placed prohibitions in relation to the use of inside information and market manipulation, and introduced disclosure obligations regarding planned outages of a power plant. Therefore, systems and controls will need to be established in relation to the compliant passing of such information to the Services Provider and its dissemination to the wider market, as well as limitations on trading at times when such information has not been publicly disclosed.

g. Other – further areas that will be relevant to structuring an energy management services arrangement will include: how imbalances and other charges will be dealt with; the basis for billing and calculation; IT issues; the treatment of fees; costs and payments (such as hedging payments, trading costs and payments, and profit share payments); and terms that will be applicable to underlying transactions entered into pursuant to the optimisation strategy (e.g. financial trades being governed by an ISDA Master Agreement).

Conclusion: likely prospective trends There is expected to be a continued review of commercial strategies relating to UK power generation assets through a combination of: (1) new market entrants, be it an Owner or Services Provider; (2) the expiry of traditional long term fuel supply arrangements to a power plant; and (3) greater regulatory certainty. There are likely to be increasing opportunities in this area for market participants, but greater regulatory certainty goes hand in hand with greater regulatory scrutiny. Therefore, both Owners and Services Providers will need to ensure that they consider their respective regulatory positions when contemplating structures that involve a convergence of physical and financial trading and route to market services.


Client Alert 2014-211