The existing Kingsnorth power station. Image source: E.ON.

E.ON’s £1bn plan for a new coal-fired power station at Kingsnorth is waiting for approval from the UK government. Other generators have shifted away from coal. Drax, which owns by far the largest coal power station in the UK, is investing in biomass. Other companies have focused on new gas plants. Why is the world’s largest investor-owned utility pushing ahead with a project to burn coal without carbon capture?

The answer, unsurprisingly, is that burning coal to generate electricity is extremely profitable. Very low prices for emissions permits and tumbling coal costs mean that a profit-seeking management team is highly incentivised to try to push for permission to use coal in power stations. This article provides the background calculations for an estimate that the new Kingsnorth will generate an operating profit of about £300m a year if current fuel and carbon prices persist. Additionally, it also tries to show that the cost of fitting CCS equipment and running the plant to capture the large majority of all carbon emissions is likely to add no more than about 1.5p per kilowatt hour to the cost of generating electricity at current coal and carbon prices. This means that a new coal fired power station with CCS may have operating costs only marginally above gas power plants

Nevertheless, E.ON has just asked for government subsidy to install CCS at Kingsnorth from day one. The purpose of this article is to offer an estimate of the maximum the government ought to offer E.ON in order to get it to invest in CCS prior to opening the new power station.

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As the UK Climate Change Committee’s report of December 2008 showed, generators will generally wish to develop coal, rather than gas, power stations if carbon costs are low. E.ON’s persistence in the face of the widespread opposition to Kingsnorth is testament to the truth of this assertion. Coal is today’s fuel of choice. Speaking to investors on 3 March 2009, Dorothy Thompson, the CEO of the enormous coal power station at Drax, said that in current conditions ‘coal plants tend to be more economic than gas plants’. The company also said without equivocation that ‘coal remains the most attractive fossil fuel’.

The Kingsnorth project
The new Kingsnorth will be a ‘supercritical’ coal plant composed of two 800 mW units. Total output will therefore be about 1.6 gW when the station is running at full capacity. E.ON has entered the competition for a grant to fit CCS on a portion of the new power station. It has said that it will fit CCS on the rest of the plant when it makes sense financially, and not before.

E.ON has a point. It is in business to make money. CCS will always add – probably significantly – to the cost of generating power. So it wants the UK taxpayer to fund the incremental cost. Other generators around the world have made similar requests, though rarely in so bold a way. E.ON’s great rival RWE has proposed a 450 mW plant with carbon capture at Huerth in Germany, and has made pointed remarks to Chancellor Merkel about subsidy for construction costs. US coal-fired generators have proposed an imaginative scheme for encouraging early CCS projects.

The wily folks at E.ON must have noticed the fixed and discomfited smile on ministers’ faces when talking about Kingsnorth. Which politician wants to go down in history as the person who approved a new unabated coal power station just before the Copenhagen climate change negotiations begin? E.ON seems to have offered a tempting political bargain – give us the cash and we will fit CCS from the opening of the plant. It all comes down to money.

The economics of Kingsnorth
Coal stations need maintenance, both planned and unplanned. Drax managed to be available for operation for about 85% of the time last year. Its position as the lowest cost fossil fuel station in the UK meant that its output was actually asked for about 75% of the hours in the year. Other coal stations were similarly busy. Kingsnorth will probably run about 80% of the year, slightly more than Drax. It is newer and will have a lower marginal cost to operate. (Its position in the ‘merit order’ will be behind only nuclear and wind.)

Drax has already sold much of its output for 2011. The price is about £63 a megawatt hour. If Kingsnorth achieved this price its yearly output of approximately 11.2 terawatt hours would be worth about £702m. (11.2 terawatt hours is about 3% of UK electricity use.)

The primary costs of operating Kingsnorth will be coal purchases, carbon permits, coal transport, and operations and maintenance (O+M).

Coal
Kingsnorth will be very efficient for a coal-fired power station and turn about 42% of the heat value of coal into electricity, but to be conservative I have used a figure of 40%. To generate 11.2 terawatt hours, Kingsnorth will need to buy about 3.4 million tonnes of coal. At current spot prices – which may not be representative of levels in five or ten years, or of prices for long-term contracts – this will cost about £163m. (Although coal prices are currently low, they are still above the costs of extracting the fuel.)

Carbon
Kingsnorth will generate about 8.6m tonnes of carbon dioxide. At today’s European permit prices, this will cost about £103m. (I assume that by the time the station is opened power stations will have to pay for their entire allocations of permits.)

Coal transport
The current cost of shipping coal to Drax from non-UK sources is about $17 a tonne. It should be lower at Kingsnorth because the station is on the Kent coast and can receive its own coal shipments by ship. Nevertheless, I have taken the Drax figures. This adds about £42m to the costs of running Kingsnorth.

O+M
Drax cost about £230m to operate last year. This includes the cost of maintaining the station and keeping it running flat out for most of the year. A substantial problem at one of the six turbines probably slightly inflated this figure. I have calculated an O+M cost for Kingsnorth, pro-rated by the respective electricity outputs of the two stations. This is about £101m.

I estimate net operating profit at just under £300m. (Drax operates at an approximately zero net working capital position, so this figure would be approximately the same as the cash generated by the plant before any tax.)

Summary estimate of the operating profit of the proposed Kingsnorth plant

If these numbers are correct, E.ON can expect an annual return of about 30% on its proposed £1bn investment.

The impact of adding CCS
Dr Golby, the CEO of E.ON UK, says that first generation CCS will reduce the efficiency of the plant by 20%. This is a surprisingly low estimate; others have produced much higher figures for the efficiency loss. In effect, E.ON is saying that to produce the same amount of electricity it will need about 25% more coal.[2]

Adding 25% to the cost of coal purchases will cost £41m. This is about 0.36 pence per kilowatt hour. The capital cost of a plant will be much higher if CCS is installed and its operating costs will rise. E.ON has estimated elsewhere that these extra costs total about 2p per kilowatt hour. (See ‘Carbon, costs and consequences’ from the E.ON website – I have estimated this figure from the bar chart on page 9 of the PDF.) So the additional cost of adding CCS is about 2.4 pence per kilowatt hour.

But the plant will save most of its cost of CO2 permits. Most power engineers assume that CCS will cut emissions by 90%. Only having to buy 10% of the existing volume of emissions will save E.ON about 0.83 pence per kilowatt hour.

The net consequences of adding CCS to the Kingsnorth project are therefore approximately as follows:

At current gas and coal prices, the prospective future margins for electricity generation are about 1 pence per kilowatt higher for gas than for coal.[3] (It is fair to note that gas turbine power stations are cheaper to construct than coal-fired plants, which will somewhat reduce the significance of this figure.)

The implication of this is that at today’s fossil fuel and carbon prices, and using E.ON’s own estimates, adding CCS to Kingsnorth leaves this coal power station only marginally more expensive to operate than a new gas-fired power station. Coal with CCS may be only about half a pence a kilowatt hour more expensive than gas.

Why does this matter?
E.ON’s recent announcements have opened a negotiating door. The company is clearly signalling that it wants a deal over CCS. It seems to be asking for a guaranteed price premium. Rather than see Kingsnorth open without CCS, the government might be prepared to agree a deal. The purpose of this note is to suggest that the premium should not be large; analysis seems to suggest it can be well under 1p per kilowatt hour.

To the outside observer E.ON’s tactics do not look pleasant. The government knows that the electricity supply situation looks grim beyond 2016. It may have to accept more coal. So E.ON is offering to make that new coal capacity more environmentally acceptable – provided we all pay the additional cost. In my view, the government should do the deal, provided it can keep the cost below 1p.



Footnotes
[1] Operating profit takes no account of interest payments or depreciation.
[2] If efficiency goes down by 20%, it will fall from 40% to 32%. To get the same daily output, coal use would have to rise by 25%.
[3] The ‘Dark Green Spread’ less the ‘Green Spark Spread’.

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If you were prime minister and faced the need to cut UK greenhouse gas emissions by at least 80%, which policy would you support? Taxing the high profits of the energy companies or obliging them to invest a £1bn in energy-saving measures targeted at the houses with the worst insulation? Put this way, there shouldn’t be much argument. If we are to reduce CO2 output, the government must focus on improving the dreadful waste of energy in British homes. Our houses are far more important emitters of greenhouse gases than our car or even our holiday flights. About 25% of UK emissions come from running our homes, most of them badly insulated and leaky. The scope for improvement is immense.

By contrast, applying an unexpected windfall tax might actually increase emissions. The current profits of the utilities are going to be partly used to make the huge investments in renewable energy that we urgently need. E.ON, for example, faces the need to find at least £500m to build its share of the 1-gigawatt London Array, the biggest offshore wind farm in Europe. A raid on its bank account by the Treasury is not going to help E.ON pay for the new turbines.

If our only interest is climate change, Darling’s focus on energy efficiency is absolutely appropriate. The proposed £1bn home insulation scheme is the nucleus of a set of policies that might start reducing domestic energy use. About 8 million homes in the UK don’t have cavity wall insulation. Almost all households could profitably improve their loft insulation. Full double-glazing would benefit a large percentage of UK homes.

In fact, eco-renovation is probably the most effective and cheapest way of reducing UK energy use. Simple measures will cut 30-50% from the heating bills of most homes. We should welcome Darling’s proposals. In fact, we need to encourage the government to go much further, copying the German government’s commitment to improve the energy performance of its entire housing stock by 3% a year. Backed by grants and soft loans, the German scheme is substantially reducing energy use in over 200,000 homes a year. Many of the most successful schemes have reduced energy use by nearly 85%. We could easily do the same in the UK. It might also pull a hundred thousand people into good jobs.

‘But what about fuel poverty?’ people will say. Twenty thousand more people die in the UK’s winter than in summer, many because of inadequate indoor temperatures. Shouldn’t the government’s real priority be to increase the affordability of gas and electricity above every other objective so that people can heat their homes? No: it actually makes far more financial sense to improve the energy performance for decades to come than to temporarily reduce the price of fuel. A targeted investment of a few hundred or even a thousand pounds will typically pay for itself within three or four years in lower fuel bills. It may seem harsh, but this is far better than a short-run discount on prices.

Environmental groups led by Green Alliance have complained last week that the main political parties have begun to ignore climate change as they focus on the financial pressures faced by householders and business. Darling’s policy of not subsidising fuel costs or arbitrarily penalising the energy companies is a striking counter-example. He should be congratulated for his courage, not criticised for his inhumanity or berated for his obeisance to big business.

This article was originally published in the Guardian on Wednesday 10 September 2008.

Shell backed out of its commitment to provide the financing for one third of the world’s largest offshore wind farm off the Kent coast. The London Array, expected to cost about £2bn, now needs to find a new investor. What about tapping the public? The project has reasonable economics, and private individuals could benefit from 40% tax relief by putting shareholdings into pension plans. Perhaps as importantly, such a move would raise understanding of renewable energy generation among the wider community.

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The London Array is a proposed wind farm, located over 12 miles off the Kent coast in south-eastern England. Up to 340 large turbines will produce up to one gigawatt in strong winds. Actual production, taking into account periods of low winds, will average about 400 megawatts, equating to about 1% of total UK electricity needs. This is by far the largest offshore wind farm in the world.

The project has now finally succeeded in obtaining most of the consents and planning permissions necessary to build the farm and bring its electricity onshore to link to the high-voltage backbone of the grid. The remaining backers, E.ON and DONG Energy of Denmark, still face huge hurdles. Few manufacturers make turbines that can survive offshore conditions. Only a small number of vessels are available worldwide to construct the foundations of the turbines.

Nevertheless, the project should have acceptable financial returns. Much can go wrong, but a simple model shows that dividends should meet the requirements of most individual investors.

First, let’s examine the financial characteristics of the wind farm:

1. Shell was due to put down one third of the money. The costs of this project have escalated substantially, but I assume that Shell’s withdrawal has left a hole of about £700m, including payments to the remaining consortium members for their efforts so far. Wind farms can be partly financed by debt – perhaps in a ratio of £300m debt to £400m shareholders’ investment in this case.
2. If the debt costs 7%, then servicing will be about £21m per year.
3. We cannot know accurately what the annual maintenance charges will be. A small onshore wind farm has operating and maintenance costs of about 15-20% of revenue. Expressed as a percentage of revenue, it seems unlikely that this huge project will have higher costs.
4. Projected electricity generation is about 3,200 gigawatt hours. At typical electricity prices of about £45-50 per megawatt hour, the output from the entire project will be worth about £150m a year.
5. This is less important than the money generated from Renewable Obligation Certificates. New rules mean that the farm will attract 1.5 ROCs per megawatt hour. At current ROC prices of about £50, the value of the output of the London Array will be approximately £240m.

We should be clear: neither the electricity price, nor the ROC value, is guaranteed. The price of ROCs is entirely dependent how much renewable energy is produced expressed as a fraction of the government’s target which rises over the years. The London Array is so large a project that its arrival will affect this ratio and this will push down the price. Nevertheless, forecasts of renewable generation still strongly suggest that the future price of ROCs will continue to be buoyant. In other words, there is little likelihood that the percentage of all electricity derived from renewable sources is never likely to rise fast enough, even with the Array, to cause a crash in the price of ROCs.

If private investors bought a one-third share in the project, the outline finances would look approximately like this for the first year of full operation. I have not included fund raising costs:

† This is not a cash cost, but can be used to generate a sinking fund that repays the debt and then the full investment after 25 years, with interest.

There are many questionable assumptions in this illustrative calculation; but it shows that to a private investor the returns may be acceptable. The income would be more attractive if the individual’s shares were placed in a pension fund. Such an investment would allow the higher-rate taxpayer to reclaim 40% of the cost of his or her investment, raising the effective return to 17.5%.

What does this mean for a 40-year-old investor putting money into the London Array for 28 years (a three-year construction period plus a twenty-five-year operating life) as part of pension planning? My very rough calculations suggest that an investment of £10,000 wrapped into a pension fund that accumulates all the payments from the Array would multiply the investment over 15 times after tax relief. I make the assumption that ROC and electricity prices stay constant and that the cash accumulating in the pension fund only earns 5% return. For the boffins reading this article, this is a real internal rate of return of well over 10% a year.

From the individual investor’s point of view, these figures ought to be reasonably attractive. There are substantial risks, such as cost overruns during construction and falling ROC prices, particularly during the latter half of the project life. But they are partly matched by the possibility of the Array realising higher electricity prices, and ROC prices rising over the next few years. An investment will also act as a hedge for the individual investor against rising retail electricity prices.

This quick look at the economics of the London Array shows why Shell backed out. The returns don’t match what it can hope to achieve getting oil out of the Alberta tar sands or in onshore wind projects in the US. Nevertheless, it also demonstrates that, properly packaged, the Array should be able to attract money from individual investors.

* The idea of using private investors’ money to plug the gap left by Shell was proposed by Phil England, climate change journalist. I am very grateful for permission to write about his idea.