When energy transforms, who pays?

Changing business models and an evolving competitive landscape

Historically, state-regulated energy companies owned and operated generation, transmission and distribution systems and earned a return on the investment over an asset’s useful life.

Financial sponsors invested heavily. Pension funds liked the long-term, stable returns and predictable cash flow that matched their long-term liabilities. Private equity (PE) funds focused on growth investments and high returns in key geographies.

More than 95% of power sector investments now rely on regulations or contracts beyond short-term wholesale markets for their main remuneration, as regulators pursue security of supply and environmental aims. Tendering schemes for long-term power purchase contracts play a growing role in driving renewable power investment. And competitive mechanisms now account for around 35% of global investment in utility-scale renewable generation.

Regulated utilities are no longer the hub for energy infrastructure decisions. State legislators are taking a more proactive approach in establishing renewable energy standards. Foreign strategic investors and financial sponsors are actively looking to grow investment in renewables and emerging technology. Several utilities are now setting-up their own venture capital (VC) arms, primarily to target early phase investment in emerging technologies. As the energy transition gets deeper, investment profiles are likely to change with energy companies competing for these prized assets.

Meanwhile, different customer groups are also entering the market. As technology costs fall and as decentralized energy resources increase, new players – prosumers, aggregators and active consumers – are emerging. Business customers are increasingly investing in self-generation and storage solutions or entering into power purchase agreements on their own. Residential customers are also turning to self-generation and storage in pursuit of energy independence.

A new energy world will disrupt the stability of these investments — for better and worse

As energy becomes cleaner, more affordable and efficient, the risk of diminishing returns to traditional investors is real, as energy companies grapple with a retreating consumer base and stranded asset costs. Uncertainty around long-term cash flow and returns may force investors to seek investment opportunities elsewhere.

For clean energy to expand, energy companies need to find new buyers, offering them simpler, lower-risk products. Energy companies have long managed these complexities and it remains to be seen if they will meet the challenge as the market transforms around them. To be successful, they will need to team up with other players in the energy ecosystem and find the investment needed to make infrastructure and networks fit for the future.

Despite these challenges, new opportunities are emerging for a different type of investor. As the energy transition accelerates, energy companies have the chance to develop new business models that favor innovation and leverage new and emerging technologies. Already, they are increasing their investment in technologies that enhance power system flexibility and integrate renewables and new sources of demand. They are also spending more on smart grid technology, including smart meters, advanced distribution equipment and electric vehicle (EV) charging infrastructure.

Forward-thinking energy companies could also offer 100% clean power to customers, including corporate buyers, and in doing this, bring all the complexities around price and supply risk back to themselves. Already, some energy companies have established VC funds that sit outside of their regulated entity to help fund this type of innovation.

And further opportunities are emerging for VC funds and PE firms to finance the growth of new technologies, customer experiences, electricity delivery models and other commercially focused ventures that fit well into their three-to-five-year investment horizon.

That’s not to say, however, that energy companies should stand still and rely on regulators for perpetual protection from market forces.

Protect and prepare

There are five steps energy companies can take now:

1. Create a culture of innovation. Energy companies need to embed innovation into all aspects of the business — from how they organize their business, to how they talk (and listen), to how they energize, incentivize and reward employees. As this is a radical departure from the traditional energy company culture, they may have to acquire these capabilities.
2. Gain senior-level support. Shareholder activism can force a split between companies’ renewable and legacy activities. Energy companies need support from investors and boards of directors to implement their innovation strategies successfully.
3. Establish a VC fund. Energy companies can set up a separate entity outside of the regulated business framework to manage a VC fund. Alternatively, they can partner with VC firms with the experience and appetite to support new energy innovation.
4. Optimize portfolios. To address the rapid disruption and increasing pressure from investors, energy companies must undertake more frequent or continuous portfolio reviews. They should assess the current and future resilience of their assets, building in agility and flexibility to respond to change.
5. Consider leasing models. To help accelerate the transition to renewable energy, companies could consider offering leasing as a financing model to drive customers to adopt EVs and solar.

If not a disruptor, be an agile adapter

As participants in a regulated industry, energy companies are not especially well-positioned to become disruptors. They can, however, become agile adapters.

Working with regulators, they can inform legislation to allow them to pursue new, commercially competitive business models and innovative funding mechanisms. They might team up with financiers and investors to develop funding options that provide win-win returns for both sides.

Energy companies that rise to this new challenge can retain customers and capitalize on the wave of new technologies. Those that do not may be displaced as they lose market share.

Regardless of how they partner, and with whom, the adage that two (or more) heads are better than one holds true. Energy companies have a better chance of generating revenue and delivering favorable returns to investors as part of an ecosystem, rather than doing it alone. If they can’t find a way to justify these emerging investments, other players will undoubtedly step in to fill that gap.