This article is based on a presentation by Amani Joas at Montel's CSEE Energy Day.
Battery energy storage systems are becoming a cornerstone of Germany's energy transition, driven by the rapid expansion of renewable energy sources. With over 50% of power production expected to come from renewables this year, batteries are increasingly vital for balancing the grid. This article explores the financial opportunities and risks associated with battery investments in Germany’s wholesale and balancing markets, focusing on profitability, market dynamics, and potential hedging strategies.
Profitable market segments for batteries
Batteries generate revenue through multiple market segments, primarily ancillary services and wholesale markets. Ancillary services, such as frequency containment reserve (FCR), are ideal for batteries due to their fast response times. These markets allow transmission system operators to rent battery capacity for grid stability. In Germany, batteries are also moving into automatic and manual frequency restoration reserves (aFRR and mFRR), though these markets are smaller. In Lithuania, mFRR capacity prices are reportedly high enough to recover battery investment costs in just two years.
Wholesale markets, particularly the day-ahead and intraday markets, offer significant potential. The continuous intraday market is especially lucrative due to its high volatility, which batteries can exploit by charging during low-price periods and discharging during high-price periods. A liquid intraday market, combined with extreme imbalance prices, encourages renewable energy producers to trade actively, creating opportunities for batteries to fill supply gaps. Additional revenue streams include imbalance energy management and behind-the-meter optimisation, though the latter is less relevant for traders due to its focus on regulatory arbitrage.
Revenue potential and investment costs
Current revenue estimates for a standard two-hour battery system (one megawatt, two megawatt-hours) are around €170,000 per megawatt per year in Germany. Some backtests suggest revenues as high as €270,000, though real-world data from a competitor’s portfolio indicates slightly lower earnings, likely due to a mix of system types. Investment costs for such systems are approximately €500,000 per megawatt, implying a payback period of about three years at current revenue levels. This profitability explains the surge in battery projects, with 340 gigawatts of grid applications currently in the market, far exceeding Germany’s maximum load of less than 80 gigawatts. However, only a fraction - potentially 10% - of these projects are likely to be realised.
The bull case: renewable growth and volatility
The profitability of battery investments is closely tied to the expansion of renewable energy. Germany’s renewable energy production is over 50%, reducing reliance on coal, gas, and nuclear power. This shift has led to a decoupling of average power prices and volatility. While average day-ahead base prices are declining due to low-cost renewables, the high-low spread - the difference between the cheapest and most expensive hours - has increased significantly. This spread, which reflects market volatility, is where batteries thrive, as they can capitalise on price fluctuations.
The economics behind this trend are straightforward. In traditional energy markets, a stable supply curve, with nuclear and coal at the base and gas at the top, determined prices based on demand fluctuations. In a renewable-dominated system, supply becomes more variable. Wind and solar production can shift supply by 50–60 gigawatts at near-zero marginal cost, leading to negative prices on weekdays, not just weekends. Meanwhile, the exit of baseload technologies like nuclear and lignite has steepened the supply curve, as gas and batteries, with fewer operating hours, require higher prices to remain profitable. This dynamic creates larger price spreads, boosting battery revenues.
Additional factors support this bullish outlook. Germany’s coal phase-out, scheduled for completion by 2038, will reduce flexible supply, increasing the need for batteries. Predicted demand growth from heating and transport, which is largely inflexible due to low smart meter adoption (below 5%), will further amplify volatility, benefiting battery operators.
The bear case: competition and market risks
Despite the promising outlook, battery investments face significant risks. The UK provides a cautionary example, where ancillary market revenues fell from €180,000 per megawatt during the energy crisis to €60,000, rendering many projects unprofitable. While the UK’s market dynamics are unique, the lesson is clear: oversupply and market saturation can erode profitability.
In Germany, the 340 gigawatts of battery grid applications signal intense competition, which could suppress price spreads as more batteries vie for the same opportunities. However, this risk may materialise slowly. A more immediate concern is the potential for declining gas prices, driven by increased LNG exports from Qatar and the US or a resolution to the Ukraine-Russia conflict. Lower gas prices would reduce power prices and compress price spreads, potentially cutting battery revenues by 40% within months. This risk is difficult to hedge in the current market.
Small-scale flexibility, such as home storage, electric vehicles, and heat pumps, also poses a threat. Germany’s largest battery capacity today comes from home storage systems, which currently charge inefficiently during high-price periods. If these systems become smarter, they could compete with large-scale batteries. Regulatory risks, such as grid operators shutting down batteries to manage congestion, could further reduce revenues, with compensation mechanisms still unclear.
Hedging strategies for investors
To mitigate these risks, investors must consider hedging strategies. Traditional tolling or floor price models, which guarantee minimum revenues over long periods (e.g., seven years), are limited by the small number of counterparties - typically large utilities with strong balance sheets. These utilities often lack the trading expertise of specialised companies, reducing their effectiveness as optimisers.
A more promising approach involves standardising power purchase agreements (PPAs) and flexibility purchase agreements (FPAs) to create tradable products. These can be executed quickly, often in minutes, compared to months for conventional PPAs. For batteries, a novel hedging mechanism focuses on the high-low spread, which represents the daily value of flexibility. By fixing this spread at, for example, €110 per megawatt-hour over seven years, investors can secure stable revenues. If the spread falls below a critical threshold (e.g., €90), the hedge protects against losses.
This fix-for-floating swap model allows smaller traders to participate by selling the spread to offtakers, such as industrial customers. These customers, who face risks from high spot market prices during low renewable output, can use virtual battery contracts as a complementary hedge to renewable PPAs. This commoditisation of flexibility could create a robust market for battery revenue hedging.
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Strategic considerations for investors
Timing is critical for battery investments. While current revenues are high, they are likely to decline as the market matures. However, falling battery costs, driven by oversupply from markets like China, may offset this. Grid access remains a bottleneck, with 340 gigawatts of applications overwhelming capacity. Co-location with renewable projects and strategic site selection, considering dispatch risks and additional services like black start, will be increasingly important.
Investors should prioritise partnerships with optimisers who use advanced, automated platforms to maximise revenues across multiple markets in real time. Revenue-sharing models, where optimisers take a percentage (e.g., 9%) of earnings, place performance risk on investors. Instead, models that shift risk to traders, such as fixed spread agreements, offer a more balanced approach.
In conclusion, battery investments in Germany offer strong returns, driven by renewable growth and market volatility. However, risks from competition, gas price declines, and regulatory changes require careful management. Standardised hedging instruments and strategic market participation can help investors capitalise on this opportunity while minimising exposure.