Roller-coaster ride in the generation game

Price falls followed by a sharp rise have plunged Britain's electricity industry into chaos. Clayton Hirst investigates

This week British Energy will miss out on £4.6m of revenue. The stricken nuclear generator will forgo a similar amount next week - and the week after that. In fact, according to calculations by The Independent on Sunday, if energy prices remain roughly where they are today, British Energy will, between now and March, miss out on a staggering £144m. To put it in context, this is nearly six times the company's market value.

It wasn't supposed to be like this. Last winter, when the company was in the middle of restructuring talks with the Government, British Energy sold around two-thirds of its capacity on fixed contracts to companies such as Centrica. The plan was to shield British Energy against further falls in prices. With hindsight, the decision was rotten. Wholesale prices have soared 29 per cent since these contracts were agreed. And while British Energy is forced to sell its electricity at absurdly low prices, the rest of the industry is beginning to reap the rewards.

The three-way bidding battle for Drax, the UK's largest coal-fired power station, is a product of the spike in prices. A few months ago no one would have given the Yorkshire facility a second glance. Its American owner, AES, was earlier this year forced into negotiations with its creditors after Drax lost one of its largest customers, TXU Europe. With electricity prices depressed, the 4,000-megawatt station was suffering large losses. After nine months of talks with 53 banks and bondholders, which were owed £1.3bn, AES threw in the towel earlier this month.

Its timing was poor, as days later, wholesale prices jumped. It was little coincidence that Drax became the subject of a bidding battle between International Power, investment bank Goldman Sachs and mining group BHP Billiton. Creditors have until Wednesday to consider Goldman's offer, and if that is rejected, they have two more days to decide between the other two. All three offers are for Drax's debt, which will give the winning bidder access to a proportion of the facility's equity.

One source close to Drax says: "The bidders are taking a punt on electricity prices going north. Drax is one of the most efficient power stations in the country, so it's the obvious target."

The companies that survived the trough in electricity prices are also betting on further rises. The German-owned Powergen famously branded the industry "bust" last year, and mothballed a quarter of its capacity. But the company is now planning to return some of its power stations to service. The first will be Grain in Kent. Engineers will this week begin to drain the nitrogen from Grain's giant boiler, which has been protecting the facility while it has been lying dormant. Powergen, headed by Paul Golby, hopes to test-run the power station early next month.

Platts, the energy information provider, says that a megawatt hour of electricity can today be bought for around £21. An extra £1.20 will buy a six-month forward contract. Last winter the price was just £17.

Having witnessed a spike in prices, it is no wonder some industry executives are confident that extra demand during the autumn and winter will help to sustain further increases. But this optimism may be misplaced. There is evidence that the recent price increases could be the result of unconnected events.

Under the electricity trading system Neta, the price of electricity is set by the market. The slump in wholesale prices last year was due to a generation oversupply and a relative lack of demand. As a result, companies such as Powergen mothballed generators, which helped to push up prices.

Power stations can't just be switched on and off, however. It takes months to mothball and then bring a station back on line. As a result, companies have to gamble on future prices. This summer, with fewer power stations running, prices went up. But as winter approaches, more stations will come back on line, which could offset the increased demand for electricity - driving prices down again. Patrick Heren, managing director of Heren Energy, a specialist energy publisher, says: "Powergen is bringing Grain back, and I'm certain that other stations will be dusted off. As the mothballed capacity is brought back into service, this will bring prices back in line."

Privately, some electricity company executives are worried that the process of mothballing is making electricity trading more volatile - increasing the risk of the country being heavily under- or oversupplied at any one time. Some companies urged the Department of Trade and Industry to introduce so-called capacity payments in last year's Energy White Paper. This would have encouraged electricity companies to keep power stations operational, even if the market is fully supplied. However, the proposals were thrown out. Many companies, such as EdF, which owns London Energy, are now preparing to urge the energy regulator Ofgem to consider the idea again as part of the forthcoming review of the electricity market.

The record summer temperatures in Britain also placed a strain on generators, helping to push up prices. In searing heat, power stations cannot work at full capacity, but electricity demand is especially high due to the increased use of air conditioning.

This year, however, some of the demand for Britain's electricity came from France - the two countries' electricity systems are connected by an undersea cable. In June, Britain became, for the first time, a net exporter of electricity as France experienced extreme temperatures that claimed the lives of up to 10,000 people. Last week's cooler temperatures brought Britain's wholesale electricity price back in line with that of France.

The recent heatwave and rise in wholesale prices also coincided with a number of British power stations being taken out of service for maintenance. One electricity executive, who asked not to be identified, says some of the repairs were as a result of companies postponing work during the winter. In some cases repairs were delayed because of financial difficulties due, in part, to the low prices.

As Britain's electricity companies prepare for the autumn, the optimism over the wholesale market may be short- lived. Prices may not be about to fall back to a level that will save the blushes of British Energy's executives, but it could make the frenzied battle for Drax look over the top.