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The UK faces some significant challenges if it is to continue to achieve that small miracle of providing everything that we take for granted as citizens of the developed world, from turning on the lights or taking a bath to firing up the central heating. According to a recent report from energy expert Professor Ian Fells entitled A Pragmatic Energy Policy for the UK we will face a massive shortfall in energy production in the next decade if nothing is done.

Addressing the problem will require creative solutions and massive investment. The market is unlikely to be sufficient to provide all the infrastructure needed. Projects such as the Severn barrage – which could provide 10% of the UK’s electricity but at an initial cost of at least £15 billion – will have to be led by government. This is a significant challenge for a country heading into a recession but it could provide opportunities for a number of companies and therefore investors, who should look to pick up stock in Alkane Energy (ALK:AIM) and [BOLD] Redhall (RHL) and hold on to nuclear experts such as Babcock International (BAB).

Reliance on Russia

Professor Fells says if no action is taken there will be a shortfall in UK power generation capacity of 23 gigawatts (GW) by 2020, rising to between 30GW and 35GW by 2027. To put that into context, operating capacity is currently 65GW and peak electricity demand around 60GW.

If the UK does not take sufficient steps to address its energy problems then our reliance on Russian gas is likely to increase. In 2007, 50% of Europe’s gas was imported from Russia, with 29% coming from Norway and 11% from Algeria. Russia’s practice of cutting supplies in order to browbeat states that were previously part of the Soviet Union allows a glimpse of a potentially frightening future for Britain.

The UK’s own North Sea oil and gas resources are either becoming harder to extract or running out. Peak annual production from the UK Continental Shelf (UKCS) was seen in 1999 at 2.6 million barrels of offshore oil production per day – a figure that had declined to 1.5 million barrels by 2007. By 2020 production is expected to have fallen by a third from its peak, and Britain is now a net importer of crude for the first time in decades.

The nuclear option

At present around a fifth of the UK’s electricity is produced by nuclear power plants, but seven facilities are due to be decommissioned in the next decade – removing 7.4GW of capacity from the system. One option is to extend the lives of some of our existing nuclear plants, while another is to commission new ones, although it takes around 12 years to construct a new site. Either way, this should provide opportunities for a number of support services companies, which have ostensibly positioned themselves to pick up work in decommissioning. These include Amec (AMEC), Babcock International, Redhall and Serco (SRP).

At present civil nuclear work represents only a relatively small fraction of what these groups do but that could change dramatically going forward.

Babcock, which has a market valuation of £882 million, confirmed this year it had retained its position as the main supplier to British Energy (BGY), signing a five-year £70 million contract to provide it with ongoing nuclear services support for the seven power stations it operates.

Methane gas

Russia also provides the UK with coal for our coal-fired power stations, which again represents a potential future risk to energy supplies. Yet there are ways of obtaining energy from coal and coal mines other than burning it.

One technique popularised in the US and Australia is to use the methane gas trapped in coal mines to generate electricity. Only now is the UK starting to adopt this approach. There are currently around 1,000 disused coal mines in the UK emitting nearly 80,000 tonnes of methane a year. They will continue to do so for at least another 50 years.

Two UK-listed companies specialise in Coal Bed Methane (CBM) – Island Gas Resources (IGAS:AIM) and Alkane Energy (ALK:AIM). The latter increased its capacity by 17% to 20 megawatts (MW) in the first half while Island is due to start producing its first electricity at the end of this year.

Another important move toward developing a consistent energy supply is gas storage. At present the UK can only store around 4% of its annual gas consumption, compared with Germany and France which have the capacity to cover over 20% of their needs.

Relying on gas imports makes it difficult to ensure a balance between supply and demand that aligns with seasonal and daily fluctuations, such as periods of high demand during particularly cold weather. Portland Gas (PTG:AIM) is one exponent of gas storage in the UK although Shares has yet to be convinced whether the company can successfully find a farm-in partner to help finance its planned £500 million gas storage facility under the Isle of Portland in Dorset.

Something in the wind

Wind power, particularly offshore, is a source of hope for the government although its plans do appear unrealistic. EU targets call for 20% of energy to be produced from renewable sources by 2020. This will be more difficult to achieve in terms of heating and transport so 40% of electricity

is likely to have to come from renewable sources if the target is going to

be met.

The government recently announced a major programme to cut the cost of off-shore wind farms. Under the £30 million Offshore Wind Accelerator scheme, designed by the Carbon Trust, the cost of transforming wind into usable energy should be reduced by 10%.

Major utility groups such as Scottish and Southern Energy (SSE) dominate this area, but there are also some smaller players that are seeking to capitalise on expansion in this field.

They include Novera Energy (NVE:AIM), Renewable Energy Generation (RWE:AIM), Clipper Windpower (CWP:AIM) and also Ramco Energy (ROS:AIM) – a former oil explorer that has re-styled itself as an energy investments company and set up wind power focused subsidiary Sea Energy Renewables. These companies are to be avoided for now. The scarcity of debt financing available for something as capital intensive as the construction of a wind farm means fewer companies will have the means to develop such projects. In a sign of the anticipated slow down in the wind market Spanish wind turbine maker Gamesa announced a halt in production at certain plants last week.

Energy security is a burning issue and will only continue to grow in importance. Not all firms involved will benefit equally and Shares has identified a trio of potential winners and losers.

Alkane Energy (ALK:AIM) 14.3p

The CBM specialist will be exposed to higher prices next year and looks attractive on a long-term view – even if the shares languish at an all-time low of 14.3p. The £13 million market cap agreed the majority of its current contracts in September 2007, when the price of electricity was much lower than it is now, and 50% of next year’s output has now been contracted at prices around 50% ahead of this year’s levels.

Babcock International (BAB) 361p

The company’s focus on providing maintenance on existing infrastructure is a positive in recessionary environment and the recent sharp falls in the share price do not fully take account of the defensive nature of its business. Babcock is now a significant player in civil nuclear services. It has the skill-set to facilitate essential decommissioning work and, while new-build work remains quite distant, the company is also well placed for attempts to extend the life of existing nuclear plants.

Clipper Wind Power (CWP:AIM) 190p

The company – which has a portfolio of wind farm developments as well as a turbine manufacturing business – has struggled to achieve decent margins since floating at the end 2004. Hopes of a maiden profit in 2009 were recently extinguished when the firm cited rising steel prices as a concern and expressed the hope 2010 will see more favourable commercial terms. Broker Kaupthing recently slashed the value it ascribes to the wind development portfolio from 246p per share to 64p per share, arguing the group trades at a significant valuation premium to other players based on that estimate.