European energy storage: a new multi billion dollar asset class

How we produce and consume electricity is changing fundamentally. In Europe, the capacity of renewable energy sources is growing very rapidly, while traditional power plants are slowly being decommissioned. That's creating a unique new opportunity for investors amid the emerging demand for battery storage, which provides balance to electricity markets.

"With energy storage, there's a new and interesting asset class emerging, and the business model is fundamentally different to that of wind and solar," says Ingmar Grebien, who leads GS Pearl Street and is a managing director in Goldman Sachs Global Banking & Markets. GS Pearl Street is a platform for trading and financing solutions for clean energy technology. Overall, total energy storage in Europe is expected to increase to about 375 gigawatts by 2050, from 15 gigawatts last year, according to BloombergNEF.

We spoke with Grebien about electricity market trends, energy storage technologies, as well as the investment and financing opportunities emerging from these technologies.

What sort of challenges does the rise of renewables pose for European electricity markets?

By 2050, you'll have about 72% of electricity produced by wind and solar in Europe, which is a massive increase compared to the 30% we have currently, according to BloombergNEF data. This is really a profound structural change in the electricity market. And it's here to stay. Now, that's great from a decarbonization perspective. But it also results in issues with regards to the timing and certainty of supply, because renewables are intermittent sources of power. When there's no wind or no sun, there's also no power production. Imagine a world where the light switch only works if the sun shines or the wind blows.

As renewables penetration rises, there are increasing imbalances between consumption and production. That can result in market volatility and in some instances extreme price scenarios. For example, some European markets such as the Netherlands or Belgium have already started to see a significant increase in negative hourly prices directly correlated with the rising share of solar and wind power.

Energy storage is the key to shifting electricity and resolving those structural issues in a low-carbon way.

What opportunities does energy storage offer for investors?

With energy storage, there's a new and interesting asset class emerging, and the business model is fundamentally different to that of wind and solar.

Wind and solar assets generate revenues by selling electricity and therefore depend on the absolute level of electricity prices. The rapid increase in renewable assets that all generate at the same time and with low marginal cost of production means that there's a long-term risk of lower electricity prices, lower capture rates, and lower revenues for those assets.

The exact opposite is true for energy storage. Energy storage is shifting electricity, and it makes money from buying, selling, and trading the difference between low- and high-priced hours in the market. Storage assets therefore depend on price spreads, which tend to be higher with more imbalances. Imbalances, in return, are driven by more renewables. Energy storage is therefore well-positioned for an electricity market dominated by renewables and represents an interesting new asset class. It's also a potential hedge for players who already have classic renewable portfolios.

Compared to classic renewables, energy storage has really only become an investable asset in Europe over the last few years on the back of technology advances, market price signals, and government support mechanisms. Overall, market research such as BloombergNEF predicts that grid-scale energy storage in Europe will increase to about 375 gigawatts in 2050 from 15 gigawatts last year.

Goldman Sachs, through its GS Pearl Street platform, is at the forefront of financing energy storage projects across Europe and provides market leading trading and route-to-market services.

What are the key technologies to watch out for in the storage space?

For short-duration energy storage projects, utility-scale lithium-ion batteries have emerged as the dominant technology choice. The average cost of lithium-ion battery packs has decreased by more than 80% over the last decade due to technological advances and economies of scale. At the same time, the performance and the longevity of the technology has improved. This has resulted in lithium-ion becoming a bankable technology. But the final verdict on energy storage technology has not been made, in particular for longer-duration storage applications

There's a range of other new technologies that could solve the problem. Sodium-ion batteries for example are potentially a hot contender for large grid-scale storage systems, where high energy density is less important. Other technologies such as liquid air storage, flow batteries, compressed air storage, and gravity applications could all solve the long-duration energy storage problem for electricity markets. However, for the moment these alternative technologies tend to be less mature compared to lithium-ion storage systems.

What are the key revenue drivers for storage providers?

For short-duration energy storage assets, there are really three key revenue streams for energy storage assets in Europe.

The first one is capacity payments, which have become a broadly implemented policy measure by governments to support system reliability and incentivize the installation of certain new power asset types. Capacity contracts tend to be bilateral contracts with governments, for up to 15 years. They're awarded by auction, and storage providers essentially get paid to build the assets. They provide a fixed revenue stream, the amount of which varies country by country.

The second revenue stream is ancillary services. These are market mechanisms designed to provide a service to the grid operator, who must ensure that consumption balances perfectly with production at any time and address any resulting frequency deviations from imbalances between electricity consumption and production. To do that, they need to be able to call on assets to perform certain actions such as ramping up or down at very short notice. Ancillary services are procured by the grid operator on a daily basis, with storage assets free to participate in the various auctions the asset qualifies for.

The third type of revenue comes from wholesale markets, and it's really arbitrage trading. You're buying electricity more cheaply in one hour and selling it at a more expensive price in another, thereby making money on the spread between how much you pay for charging the battery and how much you pay for discharging it.

Revenue models can vary significantly country by country. In the UK, the business model relies almost entirely on wholesale trading and ancillary services. There is a capacity market, but it's a relatively small portion of the overall revenue. In Italy, it's the other way around - in some instances your business model can be driven by a capacity market and long-term contracts with the grid operator.

How important are power trading strategies for storage providers?

Absolutely vital. In contrast to wind and solar, where the asset owner simply sells power into the grid when produced, energy storage assets are power trading assets. Different revenue streams can be stacked, and continuous trading decisions have to be made on whether to buy power, sell power, or participate in ancillary services.

The trading of storage assets is often contracted to so called "route-to-market providers" - large utilities or independent trading houses with 24/7 trading teams. Trading strategies are becoming increasingly sophisticated with a strong reliance on technology and big data analytics. In the UK - the most advanced battery market in Europe - there are currently 23 entities trading energy storage assets. Trading results are publicly visible on leaderboards, allowing asset owners to benchmark performance.

Our experience with GS Pearl Street has been that in order to achieve top-quartile trading results for energy storage assets you need to tap into the best of new and old worlds. A state-of-the-art trading technology stack and high degree of automation are extremely important, but we equally value having experienced human traders in the loop.

Is there a risk of cannibalization if installed capacity grows too quickly in one country?

That's a complex topic. To get a better understanding, we should explore the different revenue streams separately.

The parameters for ancillary services are defined by the grid operator, which has finite capacity requirements for each service. While this requirement might vary over time, it's often not a direct function of renewables growth. As a result, ancillary services tend to saturate more quickly. A good example is the UK market, where services for frequency control such as dynamic containment (DC), dynamic moderation (DM), or dynamic regulation (DR) have decreased in value over the last two years due to saturation. At the point of saturation, ancillary service revenues start to converge with wholesale arbitrage - the alternative revenue stream for energy storage.

In wholesale arbitrage, trading storage assets shifts electricity from times with high renewable production to times with low renewable production. How much energy storage capacity is required to shift a country's energy is a function of the total electricity demand, power stack, and renewables penetration. It's therefore important to look at energy storage in the context of the overall market and its flexibility requirement.

In the case of the UK, there is currently around 4 GW of energy storage capacity operational. That's not enough to shift energy across all hours. However, the additional battery pipeline of circa 16 GW committed under the capacity mechanism will get us closer to it.

From an investment perspective it's very important to diversify across countries as well as revenue models in order to mitigate these risks. While headwinds for new projects will likely lead to some consolidation in the UK market over the medium term, other continental European markets are only at the start of the energy storage build out and have different flexibility requirements and opportunity sets.

How do investors know which markets are attractive for energy storage trading?

Spreads, spreads, spreads. We are a big subscriber to the view that margins across the different energy storage revenue streams will ultimately converge as the installed energy storage capacity grows. As described, when ancillary services are saturated, it's the wholesale arbitrage trading - respectively, the price spread between buying power cheaply at a time when there is too much of it, and selling it more expensively at a time when there is not enough supply - that drives the profitability of energy storage assets.

Wholesale arbitrage trading opportunities are influenced by near-term factors such as a country's marginal cost of power production, as well as by longer-term factors such as a country's renewables penetration. In Europe the marginal cost of power production is often still determined by gas, coal, and carbon prices.

Wholesale spreads across Europe therefore were very high by historical standards throughout the energy crisis on the back of high fuel prices and have subsequently corrected and declined. Generally wholesale spreads in most European markets remain at attractive levels for energy storage providers and these will continue to benefit from the trend towards renewables.

How much investment is required to satisfy Europe's energy storage needs?

Given the clean energy targets that we see across Europe by 2050, we in Global Banking & Markets believe that building all that energy storage capacity will take up to $250 billion in capital investment. This will require a mix between residential units and grid-scale energy storage.

The financing landscape for grid-scale energy storage has started to move over the last 12 to 24 months, and we're seeing a broader range of project financing structures being offered. Historically most projects have been financed on the back of so called "floor contracts" - route-to-market agreements with a revenue floor. As the market is evolving, lenders are also starting to become comfortable with merchant battery financing.

But there's a big question mark around whether the market is deep enough to finance all the policy targets and the corresponding energy storage build out in Europe. The financing landscape is also relatively nascent if you compare it to the wider renewables and infrastructure sector. It's important for the energy storage financing market to grow and become more institutionalized, which means a broader involvement from a broader range of financial institutions and funds. Our experience with GS Pearl Street in the context of financing larger energy storage projects has been that there is a great amount of interest among lenders and financing counterparties, but business models and technologies for energy storage often still require explanation.

This article is being provided for educational purposes only. The information contained in this article does not constitute a recommendation from any Goldman Sachs entity to the recipient, and Goldman Sachs is not providing any financial, economic, legal, investment, accounting, or tax advice through this article or to its recipient. Neither Goldman Sachs nor any of its affiliates makes any representation or warranty, express or implied, as to the accuracy or completeness of the statements or any information contained in this article and any liability therefore (including in respect of direct, indirect, or consequential loss or damage) is expressly disclaimed.