Aurora 2024 Renewables & Batteries Summit in Berlin

TLDR:

• The German government is focusing on building out the grid to avoid having to split Germany into different price zones.

• Battery storage will not receive subsidies from the German government.

• More updates regarding the planned capacity mechanism will be published this summer.

• CfDs are needed to reach capacity targets, as PPA prices are too low.

Annual conference about the German Market

Aurora’s annual conference about the state and future of the German Energy Transition took place on 28.05.2025. It included a keynote by the undersecretary Dr. Nimmermann about the strategy of the German government, as well as presentations by Aurora and panel discussions.

Keynote by the permanent secretary

The focus of the German government is on grid/system stability and energy security through:

• building out the grid,

• keeping a fleet of gas-fired powerplants that can be converted to hydrogen use and

• speeding up the permitting and grid connection process

A conference with KfW is planned for July in Frankfurt to discuss with private capital providers what the right framework should be to attract private investment for the build-out and modernisation of the German electricity infrastructure.

Further details about the upcoming capacity mechanism will be published this summer. But no decision has been made so far on whether it will be a capacity market or some form of hedging mechanism.

The government wants to avoid having to split Germany into different price zones and is considering some form of additional grid charges to send locational price signals.

Battery storage deployment is working well and, therefore, doesn’t need government subsidies and is not included in the government’s long-term supply and demand modelling.

The current EEG subsidy tender system must be replaced by a two-way CfD mechanism to comply with EU regulations.

More demand and supply flexibility is needed to ensure system stability, and renewable energy asset owners need to accept curtailment as part of their business case.

Keynote: Rentability of PPA and merchant solar PV

New solar PV projects in Germany that plan to sell their electricity on a merchant basis or via a PPA are currently not profitable if your cost of capital is higher than 5%. This is not forecasted to change until 2036 at the earliest. PPAs will, therefore, remain a niche product that only a few project owners will choose.

To reach the capacity increase targets, the government will instead rely on CfDs, and capacity limitations have been ruled out so far, unlike in the UK.

Government-backed CfDs are less risky than PPAs, and this will lower the cost of capital for renewable energy investments.

Panel Discussion: State of the Energy Transition

The panel broadly agreed that investors and lenders see three critical topics in Germany:

1. PPAs are a niche product and not financially attractive. The EEG and CfDs will drive the capacity build-out.

2. If the government wants to avoid introducing different price zones, the transmission network needs to be expanded, and some form of locational pricing needs to be introduced through grid charges.

3. Germany has a long way to go to encourage demand flexibility. However, supply flexibility is also needed, which will be achieved through more storage capacity and more frequent curtailment of renewable energy generators. This will reduce the frequency of hours with negative electricity prices, but there will be more hours with near-zero prices.

Keynote: co-location in Germany

Whilst co-location would be a logical choice for the German electricity market with its increasing number of hours with negative prices, the current regulations don’t allow for a profitable business model.

Co-located batteries that receive subsidies are only allowed to be charged from the connected renewable energy generator. This will change in 2026, but the government hasn’t published the details yet.

This situation frustrates investors as other countries have more straightforward metering concepts and are more flexible on how the battery is charged.

Panel discussion: Does co-location make sense

The panel mirrored the keynote by expressing frustration around the co-location regulation and that the business case doesn’t work in Germany.

An interesting assessment from one panellist was BESS developers shouldn’t pin too much hope on the future capacity mechanism, as gas-fired power plants tend to win most contracts in other European markets.

Wood Mackenzie London Renewables Briefing 2024

Wood Mackenzie’s annual Renewables Briefing took place on 30 April 2024 in London. They are a consultancy that provides data, analytics, insight, and events around the energy transition.

Events like these are good opportunities to gain insights into the industry’s state, the participants’ moods, and what they expect in the future.

Below are some key takeaways from the event.

European Power Markets (presented by Dan Eager)

Electricity demand keeps falling due to improved efficiencies and demand destruction caused by the Ukraine war. At the same time, more intermittent electricity generators are being commissioned, replacing old coal, gas, and nuclear power plants.

This leads to an increasing number of times of „oversupply“ and hours with negative energy prices. The chart below shows the cumulative hours with negative pricing for several European countries.

Source: Wood Mackenzie

These negative prices open up new arbitrage trading possibilities for energy storage projects (charge the battery when the prices are negative and discharge it when the prices are high).

Wood Mackenzie forecasts that baseload electricity prices will stabilise in the range of €40/MWh (Nordics) to €60/MWh (Germany, Italy, UK) after 2030. However, the capture rates for solar and wind projects without energy storage will continue decreasing.

We have probably reached a turning point for corporate PPA prices, as several projects are no longer viable and will not be built. This will reduce supply and increase prices again.

Electricity demand in Germany will keep falling until 2030, before the full effect of electrification kicks in.

Energy Storage (presented by Anna Damani)

Governments and TSOs support the deployment of more energy storage as more and more intermittent generators are coming online. There is no unified support mechanism in Europe. The slide below shows the systems on a country-by-country basis.

Source: Wood Mackenzie

Wood Mackenzie forecasts the installed storage capacity (excluding pumped hydro) to grow from 9GW to 100GW by 2033, with the UK (20%), Italy (17%) and Germany (15%) becoming the most significant markets.

Ancillary markets are lucrative, but only for first movers and some countries, like the UK, already have an oversupply. This leaves energy trading and government tenders as the most important revenue component going forward.

Currently, the upper limit for economically viable lithium-ion batteries lies around 5 to 6 hours. Beyond that, we will need new technologies to achieve true long-term energy storage.

Long-duration energy storage capacity will only grow significantly from 2030 onwards and will need subsidies to be built.

My thoughts

The days of making money by building a pure wind or solar project are over. Too much intermittent generation is being built, and simply bolting some energy storage solution onto your generator is only a temporary fix. The big winners will be IPPs and strategic investors who hold large portfolios with multiple generation technologies and large energy storage capacities. They can offer (almost) baseload green power levels that are no longer tied to a single asset.

Second REMA consultation: Highlights

The second consultation of the Review of Electricity Market Arrangements (REMA) is open until 07 May 2024. It is part of a wider reform process in the UK to adapt the electricity system for a net-zero future.

The REMA process tries to find solutions for four fundamental problems:

• How do you address that the best wind resources are in the north, but most of the demand is in the south?

• How do you prevent price manipulations?

• How do you make sure that we have sufficient generation capacity?

• How should the government support new renewable energy projects?

Better locational price signals

Most demand is in the south of England, where there is limited room for new solar farms and onshore wind farms are effectively banned. As the existing transmission network has limited transport capacity, we can’t “ship” enough electricity from Scotland to England on windy days. This means that wind farms in the north have to curtail their production while expensive gas-fired power plants in the south are being used to meet the demand.

To solve this problem, you either need to:

1. build more electricity generation capacity in the south of England or

2. reduce the electricity demand through more efficiency or

3. you encourage companies to move their facilities to the north.

This can only be achieved if the electricity in the south is more expensive than in the north.

REMA is considering two alternatives:

1. Split the electricity market into different price zones along the transmission bottlenecks OR

2. Reform the existing transmission charges system by either

3. Using the existing ofgem network charges reform

4. Reviewing the transmission network access arrangements

5. Expanding constraint management

6. Optimising the use of cross-zonal interconnectors.

Central vs Self-Dispatch

Currently, it is up to each generator to decide how much electricity they want to feed into the grid/sell on the market. This system is called self-dispatch and is commonly used in Europe. This system can lead to two problems:

1. Too much electricity is produced, and prices fall or become negative.

2. Generators withhold their production to create an artificial shortage, and when prices spike, they start selling their production.

In some countries (like parts of the USA), central agencies decide who can sell what amounts of electricity at any given time. This is called a central dispatch system.

While the UK government is exploring the option to switch to a central dispatch system, it is unlikely to be introduced because of the high implementation costs. A reform of the existing self-dispatch system is more likely.

Capacity Market reform

The capacity market is another tool for the network operators to ensure that enough generation capacity is available at all times. Contracts are awarded through auctions.

As part of the reform process, the government is considering to introduce new minimum criteria in each auction:

• minimum capacity target per region

• minimum capacity target per technology

These auctions could be used to support the build-out of new generation in regions of high electricity demand and to support new technologies.

CfD Reform

The Contract for Difference (CfD) scheme has become an important tool to support the energy transition. The government wants to future-proof it to include options for new technologies and for retrofitting older wind or solar plants (re-powering).

The options under consideration are:

• Pay generators on deemed generation instead of the actual produced electricity. This would allow producers to reduce their output in times of oversupply without losing income.

• Pay generators a lower fixed amount for the capacity (per MW) and let them sell the electricity on the open market.

• Limit how many MW per plant can be submitted in the CfD auctions. The idea behind this proposal is to provide asset owners with a minimum amount of certain revenue while encouraging them at the same time to sell the rest of the production on the open electricity market.

• Review the formula for the calculation of the reference price.

Provide your feedback

If any of the abovementioned areas impact you or your business model, I encourage you to submit your feedback to the Department for Energy Security and Net Zero (DESNEZ) by 7 May 2024. You have the rare chance to influence the design of the electricity market for years to come.

REMA: Nodal or Zonal Pricing?

REMA and the coming changes of the UK electricity market

The energy transition brings significant changes that require rethinking the rules of the electricity market. That is why the UK government launched the Review of Electricity Market Arrangements (REMA) consultation process.

The UK currently faces a problem: Scottish wind parks are producing the cheapest renewable energy. But the majority of the demand sits in Southern England. And there are not enough transmission lines to transport all the electricity produced in Scotland to England. To match supply and demand, you must curtail (limit) the amount of electricity produced in the North and use expensive fossil fuel generators in the South.

Therefore, one question being asked is whether having a single electricity price across the whole of Great Britain (Northern Ireland is in a joint market with the Republic of Ireland) is still the best option in this situation.

What is Locational Pricing?

Currently, people pay the same price for each electron whether it is being produced in Kent, in the Midlands or off the Scottish coast.

A result of REMA could be that Great Britain gets split into multiple markets to send stronger price signals and to balance the market better:

• If you have lots of demand in one market, prices would increase, incentivising people to consume less or at different times.

• If a lot of electricity is produced in another market, prices would fall (oversupply), and generators would be incentivised to reduce production.

Over the long term, energy-intensive industries would ideally move into markets with cheaper prices. And investors would build more generators in markets with high prices.

Electricity markets can be organised around Nodes or Zones.

What is Nodal Pricing?

According to ofgem (the UK regulator), a node is a single point in the network where wires/cables meet. This could be the substation where a generator connects to the local network. Or where the local electricity lines connect to the wider transmission network.

And each of these connection points would have its own electricity price.

Several countries/regions worldwide use this model, notably Texas, California, New England, Singapore and New Zealand.

The problem with Nodal pricing is that you create tens of thousands of tiny “markets” across the network. And each market has only a few generators and consumers. Therefore, the normal price-setting mechanism through the market doesn’t work in this case.

As a result, you need to introduce a central dispatch system and abolish the intra-day market. The sole responsibility for balancing supply and demand lies with the system operator in a nodal pricing model.

What is Zonal Pricing?

Price zones can be drawn up in different ways. Often, they follow geographic dividing lines or bottlenecks in the transmission network (interconnections between regions).

Within Europe, Norway, Sweden, Denmark and Italy have already split their countries into different price zones.

Source: Wikipedia

As long as the zones are big enough (i.e. enough market participants), electricity prices tend to be more stable and predictable than nodal prices. Consumers and generators can help the system operator balance the network through an intra-day market.

However, you will need some form of locational hedge or financial instrument for PPAs if the generator and the consumer are not in the same price zone.

Closing thoughts

The next government communication regarding REMA is due before Christmas, and industry insiders expect that we will get some additional information regarding the potential introduction of locational pricing.

It would take several years to introduce nodal or zonal electricity markets. Not only would you need to update all the laws and regulations, but also test the system thoroughly before switching away from the current model. We can’t afford disruptions in the flow of electricity.

It will not be a quick fix for the current problems of congested transmission lines and long waiting times for new grid connections.

But splitting the British market into several price zones would create enough pressure to incentivise :

• the build-out of new transmission lines (because people in the South will be angry with politicians due to higher prices) and

• drive the adoption of demand-side responses (smart meters, load shifting, etc.) from consumers.

One open question will be how to integrate legacy PPAs into this new market. The previously agreed price could be significantly lower or higher than a future locational price. Who will carry the financial burden or benefit from these old contracts?

CMS Breakfast Seminar: Co-location of storage and renewable generation

Introduction

The intermittent generation profile of wind and solar farms is one of the main challenges of the energy transition. How do you store green electricity when the sun is shining, and the wind is blowing so it can be used later in the evening or at night?

Stand-alone battery energy storage systems (BESS) try to address this by storing electricity when prices are low (i.e. the sun shines and the wind blows) and selling it later.

Another approach is locating batteries at solar or wind farms and optimising the amount of electricity imported or exported into the grid.

CMS London organised a seminar with industry experts to discuss the challenges and opportunities for the business model of co-located projects.

Panelists

The panel was made up of:

• Charlie Websper, Senior Director, DIF Capital Partners

• Ralph Johnson, Head of UK Business Development, Habitat Energy

• Hannah Staab, Head of Strategy, Natural Power

• Rosalind Smith-Maxwell, Director, Quinbrook Infrastructure Partners

Insights they shared

Why co-location

Co-locating a battery and a solar PV farm has some direct benefits:

• Both projects can share grid connection costs, and having a battery on-site reduces the imbalance charges for the solar generator.

• An on-site BESS can store excess production and help deal with active network management problems and grid constraints.

• The load factor for UK solar PV is only about 10% to 14%, leaving enough room for a battery.

Project setup

Almost all co-located projects in the UK couple the BESS with the solar farm on the AC (alternating current) side of the inverters, requiring one set of inverters for the solar farm and a second set for the battery. This reduces points of failure (i.e. one broken inverter doesn’t take down your entire project) and allows the installation of separate electricity meters.

Coupling BESS on the DC (direct current) side is trickier. You save costs, as you only need half the number of inverters, though this is partially negated by the fact that DC/DC inverters are more expensive than their DC/AC counterparts.

Another factor to consider is that it is harder for DC-coupled batteries to participate in the ancillary services market.

All panellists agreed that DC-coupled batteries only make sense if you significantly oversize the PV farm and use the battery to avoid clipping losses in the current market environment.

As for the contractual setup, having one SPV owning the battery and the solar PV generator is the preferred option. This removes the need for grid-sharing agreements, and the solar cash flow can be used to support the operation of the battery.

Revenue model

Combining a solar generator with a battery gives you a firmer generation profile, which means you can achieve prices above the solar capture prices.

The priority use of the export connection is given to the solar PV generator. This impacts the arbitrage trading of the battery only minimally due to the low load factor of solar PV.

However, optimising a co-located battery is more labour-intensive than a stand-alone BESS project, and you can only achieve 60% of the FFR revenue and 70% of the capacity market payments.

Asset owners, therefore, often use one optimiser to manage the solar farm and the battery, allowing the creation of revenue stacks:

• Solar: submit part of the capacity in CfD auctions while operating the rest on a merchant basis

• BESS: participate in the ancillary services market and pursue price arbitrage through physical or financial trading

Over the next few years, there will be significant changes to the revenue model.

• Ancillary markets are becoming saturated. Arbitrage trading is becoming more and more critical for battery projects.

• The current indication is that the GB power market might be split into different price zones as part of the REMA process.

Financing

Lenders are still uncomfortable taking significant merchant risk exposure and prefer fixed-price contracts. For example, DIF closed a financing for a co-located project earlier this year and had to sign up to a 10-year floor price contract for the battery. This leaves significant arbitrage upside potential on the table.

Another aspect lenders worry about is the interface risk between the ICP, the solar EPC contractor and the battery OEM.

Retrofitting

As grid connection dates for new projects tend to be several years in the future, retrofitting older PV plants offers the opportunity to deploy capital in the shorter term if you can get import capacity. But it is only happening slowly, despite the first project in the UK being completed in 2017.

One panellist highlighted that the battery needs a minimum size of 20MW to make this economically attractive.

Another panellist mentioned that sellers are asking buyers to value the potential for a battery retrofit in recent sales processes for operating solar PV plants.

Differences with US markets

Due to its size and market structure, the US market is seen as more advanced than the UK market.

The West Coast market’s extreme duck curve incentivises longer duration storage (4 hours) for load shifting. In Nevada, for example, evening prices from 18:00 to 21:00 hours are six times higher than power prices at noon.

And US corporate off-takers increasingly demand renewable energy 24/7, incentivising co-location to shift part of the daytime production into evening hours.

Challenges for co-located projects

The seminar concluded with the panellists discussing what challenges they see for co-located projects in the UK.

• Lenders need to get more comfortable with merchant risk.

• Investors need clarity on the potential shift to zonal pricing and other topics in the REMA process.

• Larger price differences between daytime and peak-demand times would encourage the installation of longer-duration storage, as seen in the US markets.

• Increasing costs and falling power prices have reduced the profit margins of batteries.

• BESS have a different risk profile than a solar farm, which can lead to higher costs (e.g. a higher fire risk, and therefore insurance is more expensive).

My thoughts

Co-locating batteries and solar farms allows for a more efficient use of the grid connection and is the next stepping stone towards an electricity network that offers renewable electricity 24/7.

Retrofitting operational solar farms with batteries can be a stop-gap measure to help us reach the net zero targets. But this only works if the existing grid connection allows for large enough electricity import.

When comparing the UK and US markets, you notice that intraday price differences here are not significant enough to make load shifting economical.

Why is Italy the new hot BESS market?

Source: Pexel

BESS = Battery Energy Storage System

TLDR (Too Long, Didn’t Read)

Italy is an attractive market if you enter early and pick the right locations (Sicily, Sardinia, south of the mainland).

Recent Deal Activity

The UK market has long been seen as the most active and advanced of all European countries regarding energy storage. The relatively high penetration of intermittent renewable energy and limited interconnection due to the island location created a thriving market.

But recently, a string of deals and announcements came out of Italy. Here are just some examples:

• Enel secured 1GW in capacity market contracts from grid operator Trena in 2022 and is replacing retiring fossil fuel plants with batteries in Sardinia, using the existing grid connection.

• Aura Power is working on a 1GW plus pipeline in Italy.

• Matrix Renewables has partnered with others to develop 1.5GW of projects.

• Eku Energy partnered with a local developer to create a 1GW pipeline.

What does the Italian market look like?

The country has about 7.7GW of pumped hydro storage projects, mainly located in the Piedmont and Lombardy regions, and energy storage plants are exempt from grid charges.

The country is split into seven price zones with limited interconnection between them. But contrary to the Nordic markets, only generators get paid different prices for their production. Consumers are being charged an average price that is the same across the country.

Italian Price Zones (Source: Terna)

Power Generators and Storage Operators can participate in the wholesale market or the capacity market.

Source: Aurora Energy Research

The national grid operator Trena is running capacity market auctions, with some contracts being awarded to battery projects.

The frequency response market has only been open to thermal generators in the past, but some pilot projects are being developed to open the service to batteries.

The Regulatory Authority for Energy, Networks and the Environment (Autorità di Regolazione per Energia Reti e Ambiente or ARERA) approved new criteria and conditions for large-scale energy storage capacity on 6 June 2023, which will allow Trena to run large-scale energy storage auctions

A consultation is running to get industry feedback on the design of the auction system, and the first auctions are expected for later this year or early next year.

A separate auction mechanism is being developed for long-duration energy storage (LDES) projects with a duration of 6 hours or more. It is expected that the contracts will be awarded for the entire operating life of the assets.

In return, participants must offer projects that can time-shift load and provide ancillary services.

What are Italy’s targets regarding energy storage?

Italy has a national energy plan (PNIEC) and targets a renewable share of 55% by 2030 in the electricity sector.

Based on this target, Terna expects that 15GW of total energy storage will be needed by 2030, of which 9GW needs to be LDES with a duration of at least 8 hours.

What can BESS bring to the table in Italy?

Close to 50% of electricity generated comes from imported natural gas. The build-out of renewable energy generators can reduce this dependency on imports. However, it will lead to grid constraints and a higher price volatility in the intraday markets.

And this where energy storage plants can help with the energy transition:

1. They can help stabilise the grid by absorbing excess electricity production during peak production times and releasing it back onto the grid when the demand picks up in the morning and evening.

2. There is less need to build new interconnections between the different price regions. Batteries can store electricity until it can be sent to another region.

3. Intraday price differences offer BESS operators the chance for arbitrage (buying electricity when it is cheap and selling it for a higher price later on).

Will Italy become the next UK for BESS?

The first large-scale projects have been granted planning permissions, and many investors are rushing into the market in a land grab.

In a PV Magazine interview, Milan-based management consultancy MBS Consulting estimated that trading in the spot market could cover 60% to 65% of the project capital expenditure (CapEx). The remaining 35% to 40% of revenue would need to come from ancillary services.

Italy’s different price zones and their limited interconnectivity will shape the Italian need for energy storage.

1. The two island markets (Sicily and Sardinia) favour a large-scale deployment of energy storage, as electricity cannot easily be exported to or imported from the mainland.

2. The large-scale deployment of solar energy plants in the country’s south will lead to excess generation during the daytime, requiring energy storage to shift the production to the evening peak demand.

These constraints will increase the need for a growing capacity market in these regions, opening up higher revenue opportunities for investors and making Italy an attractive market to be in.

Closing thoughts

Italy has a considerable potential and a significant need for energy storage. But picking the right location is crucial, with the south and the island markets offering more favourable market conditions than the country’s north.

Investors that enter the market will have an advantage over latecomers. As we can see in the UK market, more and more projects compete for the same ancillary service contracts, driving down prices. The earlier your project is ready, the fewer competitors you have.

Taking a long view on the energy cost crisis

The high energy prices are on everybody’s mind currently. Millions of people are getting pushed into energy poverty, and thousands of small and large businesses are being pushed to the brink, just one year after the Covid pandemic. There is even talk about potential blackouts (whole areas getting disconnected from the electricity grid) in winter.

In the search for solutions, it is helpful to remember that most Western countries faced two similar crises in the 1970s. But instead of gas, oil was a scarce commodity. Another war was the trigger back for the first one in 1973 and a revolution for the second one in 1979.

How did politicians, businesses, and society react back then? And what were the long-term consequences?

1973 Crisis

In 1973 several Middle Eastern countries attacked Israel in what became known as the Yom Kippur War. The USA, under President Nixon, quickly started supporting Israel with weapons and financial aid.

The Organization of Arab Petroleum Exporting Countries (OAPEC) placed an embargo on oil exports to the USA and other Western countries from October 1973 until January 1974. During that time, the oil price increased four times from $2.90/barrel to $11.65/barrel. The aim of the embargo was to stop Western countries from supplying Israel with military aid. It only came to an end as the US got involved in the negotiation to end hostilities between the different warring parties in the Middle East

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1979 Crisis

The Iranian Revolution in 1979 didn’t affect oil production noticeably but caused a panic in the market, and prices doubled again over a short period. This was followed by an actual drop in oil production in 1980 with the start of the Iraq-Iran War.

Consequences

Recessions

A perfect storm hit the Western world in 1973, which ended the continuous rise in wealth and quality of life that had followed the end of the Second World War.

The oil shock contributed to skyrocketing inflation which started in 1971 after Nixon removed the dollar-gold link. The resulting stock market crash was the biggest one since the Great Depression.

Effect on everyday life

Most people were directly impacted by higher electricity prices and shortages of petrol. Long queues formed at petrol stations whenever some supply was available. And some governments in the Western world rationed petrol. Several countries like Germany and Switzerland introduced car-free weekends to reduce demand.

These high prices had a lasting impact on the preferences of car buyers. They shifted from large V8 or even V12 engines to smaller, more compact cars. This benefited European and Asian car manufacturers, which traditionally sold more fuel-efficient vehicles.

In the UK, the situation was even worse due to the coal miners’ strike (a significant source of electricity production back then). People were told to heat only one room in their houses, and companies were to work only for three days a week.

Long-term effects

Creation of strategic reserves

The embargo validated the European nations’ effort to build up stockpiles of oil (so-called strategic reserves) which they had started even before the oil embargo. In 1975 the USA followed suit and created its own.

Change in the energy mix

The high oil prices led western countries to stop using oil for electricity production. This led to a renewed interest in building nuclear and gas-fired power stations.

Some countries looked for other forms of energy. Israel introduced solar heaters for residential homes. And Brazil began adding Ethanol to the petrol sold at the pump.

New oil sources were explored in places like the Artic, the Deep Sea, the North Sea and Siberia to break OPEC’s monopoly.

The International Energy Agency was set up to advise governments around the world on energy strategy and to monitor future developments.

Drive to improve energy efficiency

The high petrol and electricity prices made consumers look for more efficient cars and appliances.

A speed limit of 55 mph on highways was introduced in the USA, as well as fuel economy standards for vehicles.

Oil glut

All these efficiency measures mentioned above (plus the production from new oil fields) soon led to an oversupply of oil in the 1980s, which in turn led to a crash in the oil price. This weakened OPEC’s power significantly.

Lessons to be learned for today

What can we learn from the oil shocks that can help us in the short term? And what might be the long-term consequences?

Short-term options

I’m afraid there is no easy fix for the short-term pain. It takes years to develop oil and gas fields. And Europe is competing with Asia for the available liquified natural gas (LNG) on the world market.

All we can do for now is reduce our thermostats, run washing machines either in the middle of the day or at night, and switch off lights when we are not in the room.

Governments can help to ease the pain by subsidising part of the electricity prices that consumers and companies have to pay.

Longer-term changes

The fundamental changes will happen over the medium to long term. If the 1970s oil shocks are any indication, consumers and businesses will invest in energy efficiency to lower their bills. This will likely take the form of better building insulation, heat pumps and roof-top solar photovoltaic installations.

Most Western governments now understand that natural gas can easily be weaponised. And the climate emergency makes a return to coal-fired power stations unlikely.

This leaves nuclear (fission or fusion) and renewables (solar, wind, tidal etc…) combined with energy storage as the only other options.

Nuclear Energy

The old nuclear industry (fission or splitting atoms) has a strong lobby and the backing of several governments. It is expensive to build classic nuclear reactors, and we still haven’t figured out how to safely dispose of the waste. But these reactors can produce electricity 24/7 in constant quantities (baseload).

Nuclear fusion (combining two hydrogen atoms into one helium atom) can produce vast amounts of energy. Our sun works this way. Hydrogen is the most abundant element in the universe, and fusion reactors can’t have meltdowns (without constant pressure, the process stops).

But the big question is if we can develop the technology to handle the extreme heat and pressure required to make fusion happen. So, it is a bit of a wild card when we want to predict the future energy mix.

Renewable Energy

Renewable energy is the cheapest option and can be rapidly built out. But the sun doesn’t shine at night, and the wind doesn’t always blow. And because of space requirements, most solar plants and wind parks are built far away from large population centres.

To switch to a one hundred percent renewable energy mix, we would need to build new power lines and find a cheap and efficient way to store vast amounts of electricity for several months at a time.

Over the long term, we will transition away from fossil fuels and classic nuclear energy (fission). But it will be a slow and gradual process.

Hydrogen

Some of you might ask: But what about hydrogen to store and produce energy? That will solve all our problems.

I’m afraid I have to rain a bit on your parade. Hydrogen is not an efficient medium for electricity storage, as about half of the energy is lost in the process of creating hydrogen. This compares to about 10 percent when storing electricity in batteries.

Hydrogen has a place, but it will be in the chemical industry, in processes that require constant high heat (for example, steel or glass making) or in long-range transport vehicles (lorries, large container ships and long-haul airplanes).

Summary

To summarise things:

- There were two energy crises in the 1970s from which we can learn.

- In the short term, we can only cut back our energy use, and governments can help ease the financial pain.

- In the long term, we will transition away from gas for heating and electricity production. Nuclear energy and renewables will replace gas, but each technology has its own challenges.

- Hydrogen is inefficient for energy storage, as half of the electricity is lost in the process of creating the hydrogen.

The exact shape of our energy future will be decided by governments in the end. Some have a strong preference for nuclear energy (like France), and others prefer wind and hydro-power (like Norway).

And not all countries have the same weather conditions. Spain has a lot of sunshine, Scotland is very windy, and Switzerland is a land-locked mountainous country.

The Math of Finance: Part I - Interest and the Time Value of Money

Photo by Sven Schreiber on Unsplash

What is interest?

Interest is the price you pay for borrowing money. You either pay this price when you take out a loan or, you charge it when you lend money. Let me give you two simple examples:

1. 1. You borrow USD 100 from a bank for one year, and they charge you 5.0% ( 5 / 100 = 0.05) interest. You calculate the interest amount as follows: USD 100.00 x 0.05 = USD 5. So these USD 5 are the price you pay for borrowing USD 100 from the bank for one year.

2. You deposit USD 100 in a savings account. At that moment you effectively lend your money to the bank. They pay you 1.00% ( 1 / 100 = 0.01) interest per years (USD 100 x 0.01 = USD 1). So this USD 1 is the price the bank pays for borrowing your money.

Sometimes interest, fees and dividends get mixed up when people talk about interest. But you have to differentiate between them.

• Fees are fixed charges that you have to pay in case certain events happen like overdrawing your account or a monthly service fee for offering you a bank account.

• Dividends are payments a company makes to its owners based on profit made or how much cash is available.

The History of Interest

Interest has been around for thousands of years. In the Middle East, about 5000 BC, people had to pay “interest” on the number of seeds they borrowed. You borrowed 500 seeds in the spring to plant them. And come harvest you “repaid” 600 seeds.

But over time, many religions including, Christianity and Islam, forbad the charging of interest, at one time or another. And in Islamic Finance, it is still forbidden this day. Islamic law instead expects the borrower to share the risks and rewards with the lender.

For a long time, it was considered morally wrong by society to charge interest, as money wasn’t producing any physical goods by itself.

Only from the 14th century onwards, during the Renaissance, that people started borrowing money to set up businesses. This gradually removed the stigma from interest, and it became more and more commonplace to charge interest on loans.

What is Cost of Capital?

A term you sometimes hear in connection with interest rates is “Cost of Capital”. There is no such thing as “free money”. When a bank grants a loan to someone, they will incur certain cost. One example would be the salary for the bank employees, that need to fill out all the paperwork for the loan. This is a concept that comes from the world of Economics (the science of how nations and large economies work).

What drives interest rates?

According to Economic theory, the interest rate (i.e. how much interest is charged) can be driven by two factors:

• Opportunity Cost: This is a term from Economics for profits you miss out on. Let me explain it with an example: Let’s say you own a bank and have USD 100 in cash that you can lend to clients. Two customers (let's call them Ernie and Bert) come to you and ask at the same time if they could borrow USD 100 from you. So you need to decide: who will get the loan and how much interest you will charge.

  • You could lend it to Bert for 2% interest because you know that he is reliable and will pay you back on time OR

  • You could lend the same USD 100 to Ernie for 6% interest because you’re not sure if he will pay you back the full amount.

But you can’t lend money to both of them as you only have USD 100. In the end, you decide to give Ernie a loan. So you earn 6% interest from Ernie, but you miss out on the 2% interest income from Bert. These 2% interest that you will not earn are your opportunity cost. Think about it this way, if Ernie doesn’t pay you back, you lose the 6% from his loan, and you won't get 2% from Bert either. So when a bank decides how much interest it should charge on a loan, they also need to take into account that they can lend out every dollar only once.

• Supply and demand for debt: In the last article, I mentioned that banks are not allowed to give out as many loans as they want. So if more people want to borrow than the bank can lend to, it will increase the price (I.e. the interest rate) of those loans. And if no one wants to borrow from the bank, it has to lower the price it charges for its money. It is the same principle as the surcharge from Uber. The more people book an Uber ride at the same time, the more you have to pay for it.

What is the time value of money?

We all have noticed in our daily lives that things get more expensive over time. Fifty years ago you could buy a good car for a few thousand Dollar. Today cars cost tens of thousands of Dollar. This increase in prices is what is meant when people speak about inflation. (Don’t worry, I will explain inflation in the next article.)

This means that you can buy a lot more things with USD 100 today than you will be able to buy in twenty years for the same amount. The same applies to borrowing money.

If you borrow USD 250,000 from a bank to buy a house today, for example, the bank will lend you USD 250,000. And you will promise them (i.e. put a mortgage on the home) that you will replay this amount over 20 years. The problem for the bank is that all the amounts you pay in the future will be worth less than they are today.

So if we assume an inflation rate of 2% (i.e. money loses 2% of its value each year) the bank needs to charge you at least an interest rate of 2.0% to make sure it gets back the same value back over those 20 years.

This also affects you and your savings. If you put your money into a savings account that pays you 1.0% interest per year, but the annual inflation is 2.0%, then your savings lose value every year (1% - 2% = -1%).

What is compound interest?

Einstein supposedly called it the eighth wonder of the world. And while there is no proof that he said it, compound interest can either be your best friend or your worst enemy.

Compound interest is essentially interest that is charged over unpaid interest. It is best explained with an example.

Let’s say that you borrow USD 100 on a credit card for 10% per year. So at the end of the first year, you owe the credit card company USD 110. This is calculated as follows:

Interest cost: USD 100 x 0.10 = USD 10

The new amount owed to the credit card company:

Original Balance: USD 100 +

Interest: USD 10

= USD 110

Now let’s assume that you don’t pay the USD 10 in interest cost but let the balance stand on the credit card. After another year, the following will happen:

Interest cost: USD 110 x 0.10 = USD 11

The new amount owed to the credit card company:

Original Balance: USD 100 +

Interest Year 1: USD 10 +

Interest Year 2: USD 11

= USD 121

The extra dollar you pay in interest in year 2, compared to the first year, is compound interest.

I hope this example helps you understand how compound interest can be your best friend or your worst enemy.

• If you have bank or credit card debts and can’t repay them in full, the initial loan will become more and more expensive over time, as the amount that you owe grows faster and faster over time.

• But if you save money and keep the earned interest on your savings account, your money will grow faster as well the more time passes.

Why is the interest on loans higher than on savings accounts?

Above I describe that interest is the price you pay (or receive) for either borrowing or lending money. People that are less likely to repay their loans on time (like Ernie) have to pay higher interest rates than more reliable people like Bert. And the interest rate can change depending on how much money is available and how many people want to take out a loan.

But why are banks paying you always less interest on savings accounts than what they charge for the loans they make?

The first reason is quite simple: they want to make a profit on lending out your money. If you deposit USD 100 into a savings account that earns you 1.0% interest per year and the bank uses your money to give someone else a loan for 3.0%, then the difference between the 3% and the 1% is their profit. So if they would pay you the same interest rate that they make of the loan, they couldn’t pay their staff, rent etc.

The second reason has to do with risk. I already mentioned that “riskier” clients like Ernie have to pay higher interest cost.

Most government programmes usually insure your savings in the bank. This programme will give you back your money, in case the bank goes bankrupt. Therefore you take a minimal risk by depositing your money into a savings account.

But banks lend to people and companies that can go bankrupt or only have the means to repay a part of their loan. This activity carries significantly more risk than putting money into a savings account. So lenders need to earn enough from interest charges to compensate for all their lent money that they will never get back. Hence the riskier the client, the higher the interest rate.

What does the Central Bank have to do with interest rates?

Sometimes you hear people on the news talking about how they expect the Central Bank to lower or raise interest rates.

The interest rate that the central bank charges for lending money to commercial banks act as a floor to interest rates on loans. There is the explicit assumption in Economics that a bank’s cost of capital will always be at least the same rate as the lending rate of the Central Bank. So they need to charge more than the Central Bank if they want to make a profit.

If the Central Bank increases it's lending rate, interest rates on loans and savings accounts go up. And if the Central Bank lowers its rate, debt becomes cheaper, but you also receive less interest on savings.

How does this article help me?

Understanding what interest is and how it works is crucial for getting out of debt and building up savings. Because interest is the price of money, you need to understand how much a loan or credit card debt is costing you and how much you can earn by putting your money into savings accounts. Let me give you three examples:

Example: Mortgage

You need to take two points in particular into consideration when looking for a mortgage.

1. If the interest rate is not fixed, it means that the rate can go up over time, and suddenly you might no longer be able to make your monthly payment because of the higher interest charges. This is what happened during the foreclosure wave in the 2008 financial crisis.

2. Taking out a 15, 20 or even 30-year mortgage will mean that the total interest payments to the bank will be higher than the actual amount that you borrowed. So always get offers from different lenders. Small differences in the interest rate can mean significant savings or extra cost during the term of the mortgage.

Example: credit card purchase

Credit cards can offer excellent benefits. My wife and I have a credit card that gives us points with our favourite airline, which we can exchange for flights. But we pay off our cards every month in full to avoid interest charges.

If you continuously keep a balance on your card, the company will charge you interest on that unpaid amount. And credit cards always have high-interest cost. Just making the monthly minimum payment will mean that the interest charges on your purchase could be higher than what you paid in-store.

Example: savings account

It is essential to compare different offers from different banks. The higher the interest rate, the more they are willing to pay you to be able to use your money. And if the offered interest rate is less then the annual inflation, then your money is losing value for every year that it sits in this savings account.

What will be the next article in the series?

The next article will explain what inflation is and what makes your money lose value faster or slower.

The building blocks of the economy - Part III: Money

A brief history of money

In the earliest societies, the economy was based on the exchange of goods. If you were a hunter, you would trade meat or furs for bread, for example. 

The problem with this system is that you need to find someone who wants your meat and at the same time can offer you bread. 

So, people started using IOUs (I Owe You). The baker would give you a loaf of bread now, and you would promise him to give him some meat later. 

This system required that all people honoured their IOUs and that you kept a good record of all promises.

To solve this problem, people started using tokens (stones, shells, precious minerals or specific grains). As long as everyone agreed what the value of a gold coin or a peppercorn was, you could quickly pay for things with these token. The key here is that these tokens are only worth something if people can agree on their value. Gold, for example, is pretty useless in everyday life. You can’t eat it, heat your house with it or dress in it. But it is valuable because we all believe so.

The next step in the history of money came when bank accounts were invented in the Islamic world in the early Middle Ages. And modern paper money appeared first in China in the 11th century.

States issue most of today's money and we call it currency (US Dollar, Euro, Yen, etc.). The government forces companies and banks to accept the local currency for payments and bank deposits.

Why do we need money?

Today’s money has three main functions:

1. A medium of exchange (i.e. you can use it to buy things)

2. A unit of account and (i.e. you can compare the value of different items easily)

3. A store of value (i.e. you can save your money to spend it later)

The basic idea of our capitalistic system is that the market place (two parties exchanging goods/services for money) is the most efficient economic system. It might be debatable if this is still the case in an age of increasing inequality. But the premise is that you offer your time (work) or savings (money) to others, which in turn pay you a salary or interest. And you can then use this income to buy the things you need and want. This way, we avoid the problems of a barter or IOU system.

What types of money exist?

Two types of money exist:

1. Physical money: Notes and coins that have been printed or minted by the Central Bank. They are the only organisation within a state that has the right to do so.

2. Electronic money: This is the vast majority of the money in developed countries. It encompasses all the money on bank accounts, on credit cards etc.

In the UK, for example, only a small percentage of the total money is actual cash.

Notes and coins only form 4% of the total money in the UK according to the Bank of England.

The vast majority of money in the UK exists only as Ones and Zeros according to the Bank of England.

Source: Bank of England (Retrieved 12 June 2019)

Who can create new money?

As mentioned above, only the Central Bank of a country has the right to create new banknotes and coins.

But the Central Bank also creates electronic money nowadays every time it makes a loan to a commercial bank. If Barclays wants to borrow money from the Bank of England, they receive the money via computer rather than in the form of bank notes.

But the vast majority of electronic money is created by commercial banks like Barclays, Citi Bank or Deutsche Bank. It works as follows:

1. You take out a loan of USD 100 from a bank

2. The bank then creates a record that you owe it USD 100

3. It then adds USD 100 electronically to your bank account

Et voila, USD 100 have been created in the form of the record that you owe money to the bank.

But this also means that every time you repay a loan, money gets deleted:

1. You have USD 100 in your bank account

2. You use this money to repay a loan of USD 100

3. The bank deletes its record that you owe them USD 100

Of course, banks can’t create as much new money as they want to. The Central Bank and various international bodies regulate that the maximum of money a bank can lend to others. It cannot exceed a fixed multiple of the money they hold in deposits and government bonds.

This system might sound strange to you and my wife thought I was joking. If you want to check yourself, just take a look at the website of the Bank of England, for example:

https://www.bankofengland.co.uk/knowledgebank/how-is-money-created

What are the problems with this system?

Our current system, like the previous ones, has some inherent flaws that you need to be aware of:

1. It creates instability

2. It promotes inequality

3. It gives commercial banks a lot of power

INSTABILITY

Banks are neither evil nor good. They are companies that want to make a profit. So, they tend to give out more loans when times are good (economic boom) and fewer loans when times are bad (recession).

So, when prices (e.g. for houses) and the stock market go up, banks give people more loans to buy homes, stocks etc. This drives prices up even further, eventually creating a so-called “bubble”.

But there comes the point when people realise that things are too expensive and prices begin to fall again (i.e. the bubble bursts). Banks then lend less. Therefore less money is available, and prices will fall even further.

INEQUALITY

The business model of banks is to lend money to other people against fees and interest. They want to make sure that they get all their money back.

Banks are doing this by assessing how likely it is that a person or company will repay the loan in full. This is called a credit risk assessment. Your credit score is such an assessment, for example. And the interest rate is the price you pay for being a riskier client.

If a person poses a low risk of defaulting on their loan and have lots of assets (savings accounts, houses, stocks), the bank will charge them a lower interest rate.

But if it is more likely that a person or company will not repay the loan in full, the bank with charge them a higher interest rate. You can think about it this way:

• the bank lends USD 100 each for one year to five people with a high credit risk

• each of these people has to pay USD 25 in interest at the end of the year

• So, if one of the five people can’t repay its USD 100 and the interest at the end of the year, the bank still got all its money back as the other four people paid USD 100 (4x USD 25) in interest

This system is not inherently evil and makes sense from an economic point of view.

The problem is that this means that rich people can borrow money for low-interest costs and poor people have to pay higher prices to borrow money. So, it is more expensive for poor people and creates more wealth inequality.

POWER

The ability to decide who gets loans, how much it costs to borrow money, and for which purposes money can be borrowed gives commercial banks a lot of power over the economy and society.

If, for example, lenders decided to provide new car loans only for electric vehicles, most people would have no choice but to buy an electric car.

How does this article help me?

To quote the International Monetary Fund (IMF):

most people in the world probably have handled money, many of them on a daily basis. But despite its familiarity, probably few people could tell you exactly what money is, or how it works.

Source: International Monetary Fund (Retrieved 12 June 2019)

Money makes the world go round, as the saying goes. It is therefore critical to understand what it is, who can create it, and why it can literally save you money to have a good credit score.

What will be the next article in the series?

The next article in the series will be called “Interest and the Time Value of Money”. I will explain to you:

• What is interest?

• How is interest calculated?

• What is the time value of money?