When energy transforms, who pays?

By

Miles Huq

EY Global Power & Utilities Transaction Advisory Services Leader

Strategic Ernst & Young LLP partner in power and utility transactions. Trusted advisor to clients, colleagues, friends and family.

7 minute read 5 Apr 2019

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Despite the disruption occurring in the energy industry, there has been very little innovation when it comes to new funding mechanisms. 

The cost of the energy transition will be immense. In 2017, global energy investment was US$1.8 trillion, making up 1.9% of global GDP. But, according to the International Energy Agency, more than US$20 trillion will be needed to meet electricity demand up to 2040.

The power sector is becoming increasingly capital intensive. Already, the predicted upsurge in electricity consumption, in line with the global decarbonization agenda, means that investment in electricity generation and networks now tops that in oil and gas supply. And, investment in low-carbon energy sources represents more than 70% of global power generation funding.

The success of the clean energy transition depends on incentivizing investment in flexibility – such as demand management and energy storage solutions – to compensate for the intermittency of renewables. It will see a new mix of energy investors emerge, as well as new opportunities and financial vehicles, and changes to the structure of traditional energy companies.

Yet, even as these changes get underway, and as markets and industries transform to reflect the operating characteristics and risk profiles of new and emerging technologies, the same old hurdle remains: how to secure financing.

As markets and industries transform to reflect the operating characteristics and risk profiles of new and emerging technologies, the same old hurdle remains: how to secure financing.

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.

Disruption has yet to breed disruptors when it comes to financing the future of energy

Interestingly, despite the disruption going on within the energy industry, there is very little innovation in funding mechanisms. The primary sources of investment continue to be VC funds, PE, co-financing and partnering with peers in the value chain, and green bond and tax equity financing.

Whether any disruptors step forward will depend, to a large extent, on the role of regulators and the moves they make in the years ahead. Under the current energy model, regulators serve as a barrier to the development of new, more commercially focused business models and, by extension, innovative funding mechanisms.

Overall, regulators seem in no hurry to enact legislation that allows energy companies to invest in the expensive shift from owning legacy infrastructure, to being providers of energy services. And, without incentives, there appears to be little for energy companies or investors to gain by leading a disruptive charge.

Regulators seem in no hurry to enact legislation that allows energy companies to invest in an expensive shift from owning legacy infrastructure, to becoming providers of energy services.

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.

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Summary

There’s a whole lot of disruption going on in the energy sector, but little innovation in funding mechanisms to pay for it. With a US$20 trillion bill to settle by 2040, energy companies need to identify new ways to position themselves as investable propositions. Those that rise to the challenge can retain customers and capitalize on the wave of new technologies. Those that do not may be displaced as they lose market share.

About this article

By

Miles Huq

EY Global Power & Utilities Transaction Advisory Services Leader

Strategic Ernst & Young LLP partner in power and utility transactions. Trusted advisor to clients, colleagues, friends and family.