The new reality of electricity prices?


Power auctions have accelerated the energy transition and the rise of renewables. With ever lower auction results being reported, what are the implications for power markets if the average cost trajectory follows the auction results?

This article was originally published in Smart Energy International 5-2018.  You have access to our digital magazine here.

Power auctions have accelerated the fast-paced energy transition toward renewable energy sources.

In a power auction, the tendering entity calls for the lowest bid to produce electricity in a given location and timeframe. There are countless variations of these power auctions, some being technology specific, some rendering attractive land accessible (e.g., for solar installations). Over the past several years, power auctions have become a popular tool to enhance cost transparency and increase competition – especially in contrast to predefined feed-in tariffs.

Auctions have contributed to driving down margins in the value chain. Auction results have frequently undercut prevailing price assumptions and, thereby, accelerated the ongoing transition. With ever lower auction results being reported, the question arises: what would the effect be on our power markets if the average cost trajectory followed the auction results?

Despite some acknowledged limitations [see sidebar: acknowledged limitations], an ‘auctions-as-reality’ scenario still sheds useful light on the future developments of our power markets.

Using the McKinsey Energy Insights Global Power Model, we have modelled the implications of this auctions scenario and compared it to our 2018 Global Energy Perspective reference case. We focused on three countries: Germany, Mexico, and India.

In the auction scenario, the penetration of renewable sources is accelerated, increasing the pressure on fossil generation and capacity investments. The role of gas as a transitory fuel is reduced, and fossil generation in moderate-growth countries declines rapidly, while investments in new fossil generation capacity in high-growth countries are not required. At the same time, emissions reduce drastically and preparing grids for high RES environments moves to the centre of attention.

Comparing the scenario results with the 2018 GEP reference case, several overarching trends impact market outlooks and investment decisions:

• The penetration of solar and wind power generation in the power sector is accelerated by up to 20 years – varying by technology and geography

• Gas loses its role as a transitory fuel in countries with low demand growth and gas generation capacity becomes uneconomical earlier, e.g., in Germany, ~55% less total cumulative generation from gas until 2050 • Fossil capacities in countries with moderate growth become uneconomical earlier than expected, e.g., in Mexico, annual power generation from gas is already 60% lower by 2030

• Additional fossil capacities currently projected in high-growth countries are not needed, e.g., in India, all additional power demand is provided by RES

• Overall, power grids have to be adapted for high renewables environments much earlier as high levels of intermittent generation levels are reached up to 20 years prior to predictions

• CO2 savings are significant – in the three country archetypes, total cumulative emissions from the power sector between 2018 and 2050 are reduced by ~25% or ~16,000 Mt CO2 e, while annual emissions in 2050 are ~50% or ~1,000 Mt CO2 e lower for the three countries

These trends manifest themselves differently in the three countries:

Germany: faster uptake of solar and wind limit the role of gas as a transitory fuel In Germany, RES penetration levels are accelerated by ~10 years in the auctions scenario: solar reaches similar generation levels to the reference case 8 years earlier.

This acceleration is driven by wind and solar LCOEs becoming cost competitive against existing coal and gas generation. The uptake of RES is then limited by the system’s capacity to absorb new additions.

The accelerated uptake of RES in Germany only slightly impacts coal generation, while significantly reducing the role of gas as a transitory fuel: total coal generation is ~10% lower until 2050 in the auction scenario, while total gas generation is over 50% lower.

The reference case assumes carbon prices within the EU ETS to rise until 2040, which leads to a steady replacement of coal by gas.

In the auction scenario, RES are sufficiently cost-competitive in the 2020s to replace coal generation directly: gas as a transitory fuel is leapfrogged.

The replacement of fossil fuels by more cost-competitive RES also significantly reduces CO2 emissions. As a side effect, the 2030 government target of 180 Mt CO2 e/yr emissions from the power sector are met.

Mexico: wind replaces gas in the short run In Mexico, the accelerated uptake of RES is particularly strong for onshore wind.

Preponed by 20 years, wind generation reaches ~150 TWh by 2030 instead of ~2050.

This is primarily driven by onshore wind becoming cost-competitive with existing gas ~28 years earlier in 2020, instead of in 2048. The uptake of Solar PV is preponed by ~5 years reaching cost competitiveness against existing gas in 2020, instead of in 2032.

As a result, the uptake of wind is robust in the years until 2030, tripling generation compared to the GEP reference case.

Wind generation then stagnates, primarily driven by saturation and solar being better complemented by battery storage which becomes economical by 2030.

Solar generation increases more rapidly post 2030, accelerated by the combination of solar and storage becoming cost-competitive against existing gas post-2034.

As a consequence, Mexico’s predominant gas generation is significantly challenged.

In the auction scenario, total gas generation until 2050 is ~40% lower than in the reference case. In the auction scenario, gas generation drops so rapidly that by 2030 annual generation is ~60% lower than in the reference case, putting significant pressure on the gas generation portfolio.

In the same timeframe, coal generation is reduced by ~25%. However, as coal plays a smaller role in Mexican power generation, this represents a much lower absolute reduction.

With such low costs, RES absorbs all new demand growth and replaces 40% of gas and 25% of coal generation.

The extensive replacement of fossil-based power generation in the auctions scenario yields ~30% carbon emissions reductions until 2050. By 2030, annual emissions are nearly 50% lower than in the reference case.

India: renewable sources can cover all additional power demand growth

In India, the solar uptake is accelerated by ~5 years, as new solar becomes competitive against existing coal already in 2025, compared to post 2050 as in the reference case. Already in the reference case, solar competes primarily against coal newbuild to cover the power demand growth, where solar is competitive against new coal post-2024.

While in the auction scenario, solar is already competitive against coal newbuild in 2020 and the combination of solar and storage by 2025.

The penetration of wind is accelerated by ~15 years, to 2035 instead of ~2050. Wind generation increases more strongly than solar generation relative to the reference case: wind generation in 2050 is more than four times higher in the auction scenario than in the reference case – solar only 10%.

The main reason behind this difference is that wind becomes cost-competitive against existing coal by 2035 instead of post-2050 in the reference case.

As a consequence, both solar and wind become sufficiently cost-competitive against newbuild coal to absorb all additional demand growth.

Compared to the reference case, total coal generation until 2050 is 30% lower in the auction scenario, effectively keeping coal generation stable at current levels.

At the same time, gas generation increases by ~25%, primarily driven by the demand for flexible capacity given high RES shares.

However, in absolute terms the improvement is marginal.

The reduction in coal generation translates directly into reduced emissions: until 2050, total carbon emissions from the power sector are reduced by ~25%. In 2050, annual emissions are nearly 50% lower than in the reference case. The reduction in annual emissions in 2050 of ~1,000 Mt/yr is equivalent to twice the total projected emissions of the EU power sector in that year (~500 Mt/yr).

Modelling the auction scenarios

We built a scenario assuming auction results to represent actual cost trajectories.

Based on an analysis of the auction results, the bids, and expert interviews, we estimated the differences to the GEP reference case for five key assumptions: Capex, Opex, WACC, capacity factor, and lifetime. We then used the identified deltas to scale the assumptions for the different countries, respectively.

We chose three country archetypes based on their power demand outlook: in a high-demand growth context, RES compete against other (fossil) newbuild capacity (LCOE vs LCOEs), whereas in a low-demand growth context, RES primarily compete against existing (fossil) capacity (LCOE vs SRMC). Apart from demand growth, the age of the generation fleet is also relevant, as earlier retirements in an older fleet shift the competition for RES earlier from existing fossil generation (SRMC) to newbuild fossil capacity (LCOE).

Therefore, our analysis is structured into three archetypes distinguished by their power demand growth:

1. Developed market with little demand growth, e.g., Germany

2. Emerging market with moderate demand growth, e.g., Mexico

3. Developing market with high demand growth, e.g., India SEI

Acknowledged limitations:

• ‘Sweet spots’ increase value: Many geographies auction specific RES projects at favourable sites, featuring prime conditions

• Expected future cost declines: Auction bids factor in speculation on a future cost decline. Since projects are auctioned off several years before they are built and go online, bids are based on assumptions of their future cost structures

• Reduced risk: Transparent auction procedures themselves reduce risk, e.g., tendering agencies prepare detailed site assessments or even exclude risky elements from the bid, e.g., connection cables from offshore wind

• Potential ‘winner’s curse’: Auction results might be unprofitable for the bidder. Due to incomplete information, the bidder may only win because they overestimate profitability more than anyone else intentionally or unintentionally – a.k.a. the ‘winner’s curse.’

• Auction design: Different auction types are not always comparable – some auction types only represent price floors – with additional revenue possible – some allow for parts of the possible electricity generated to be sold separately, e.g., to industry clients or in the spot market, and some include special price increases over time that lift the realized auction price

About the authors

This article was written by Frithjof Wodarg, Christer Tryggestad, Bram Smeets, Sebastien Leger, Jerry van Houten and Tristan Swysen, McKinsey.

As head of content for the Global Energy Perspective, he establishes outlooks on future energy systems with a focus on energy demand and power generation. He led the establishment of the power model and serves clients in a broad range of sectors, including power, financial institutions, national governments, and oil and gas. He holds a Ph.D. in energy economics.