In my recent post about the dawning of the renewable energy sectorI referred to what I call the “Age of Paradigm Shifts”. Put simply, renewable energy has transformed the global electricity markets in multiple, profound ways over the past several years.
To summarise, the traditional electric utility model is no longer sustainable:
· Electricity generated from wind and solar is now less expensive in more and more countries than the local / national utility’s preferred technology (i.e., traditional thermal power generation technologies, such as CCGTs, nuclear and/or coal).
· Renewables have become a preferred asset class of a new type of investor – an investor that has a much lower cost of capital than utilities
· Utilities are now losing their best customers to renewables
· “Must run” renewables have taken away utilities’ largest traditional profit centre (i.e., peak supply)
· Finally, the simplicity of renewables eliminates the opportunity to “charge for complexity”, a common tactic of large companies that have historically enjoyed high barriers to entry.
Each of the above would be a Paradigm Shift in itself. But taken in aggregate, renewables are now changing the world’s electricity sector as rapidly and as fundamentally as when the steam engine first arrived on the scene; or when petroleum finally arrived to fuel industrialisation; or the internal combustion engine was invented. In fact, I believe the impact of renewables will dwarf these historic comparators.
Only time will tell.
For now, let’s take a closer look at each of these Paradigm Shifts below.
1. Competitiveness: First & foremost, renewable electricity generated from wind and solar PV are increasingly becoming the cheapest form of power in many countries around the world. Auctions have, to a large part, forced the sector to become price competitive. Moreover, and perhaps even more interesting, not only are wind and PV now cheaper than the traditional margin price setter (i.e., a new build CCGT), they are also cheaper than some existing (fully depreciated) thermal power generation.
Think of a Polish coal facility that is 30 years old. Maintenance costs, fuel costs, unplanned outages, etc all add to the cost per kWh of power produced. And increasingly, this cost is higher than a new build wind farm. The current pool price in Poland (which represents all eligible assets bidding in) is ~ 290 PLN/MWh (~€64/MWh). Recent renewable auction results from the latest auction (late 2020) averaged about 220 PLN/MWh (€48/MWh).
Think of a US or French nuclear facility. The inflexibility of the technology (must run 24/7) and the cost to maintain these (typically) 25+ year old units safety is expensive. Very expensive. Reference Exelon, one of the US’ largest nuclear fleet owner (https://www.msn.com/en-us/news/us/without-another-bailout-exelon-plans-to-close-two-illinois-nuclear-plants-next-year/ar-BB18sqDe ) and EDF in France. Both are hurting. And France is projected to be Europe’s second largest wind power market over the next 10 years, according to targets set by the French government.
Additionally, whereas many European coal plants are being shut down for environmental reasons (as well as economic reasons), globally many are being shuttered due to economics alone.
Similar to Peter Drucker so famously stating that a corporate’s “culture eats strategy for breakfast”, I like to say that “economics beats politics every time”. The bottom line is that the renewable sector’s growth is now driven by economic value add, with political support now less important. (sidenote – perhaps my expression is less creative than Mr. Drucker’s … however, it is as relevant!).
2. The Rise of Institutional Investors (IIs): renewables achieving cost competitiveness isn’t just due to auctions and technology improvements, however. As important as these two elements have been, an equally - if not greater catalyst - has been a new uber-optimised capital structure. Put simply, pension funds, insurance companies and the like love this asset class. And since their cost of funds are much lower than the corporate sector, project developers are able to bid more aggressively in auctions as they know they can subsequently sell into this lower cost pool of II capital.
Post the Fukishima nuclear disaster and on the subsequent heels of the German government decision to decommission nuclear power, German utilities were sent into a tale spin. Yet these same utilities were some of the first to realise that the attractiveness of the German (and other European) renewable energy feed-in-tariff regimes could produce a new, more optimal ownership structure. Seeing the emergence of the IIs, they repositioned themselves to play to their corporate strengths - namely, project development, construction and operations – and selling out or selling down to IIs when a project had been de-risked.
Today, all of the major European utilities play this capital compression game. And why not? It enables them to grow their asset base whilst delivering new investment opportunities to the IIs. A true win-win.
But why do IIs like this asset class? Their rationale is quite simple. The very nature of pension funds and insurance companies is that they have capital to invest today in order to be able to fund future liabilities. And there are few better asset classes to meet this need than renewable energy assets. Renewables generate relatively stable, long-term cash flows in any desired currency, all with minimal operational risk. In fact, renewable assets are perfect for IIs and I know, first-hand, that some do not invest with investment return as their most important criterion – rather, they value asset life, stability of cash flows and currency as their main investment drivers.
In support of my above statement, one well-known global pension fund came to me whilst I was in the corporate sector and announced that “if you can bring us de-risked renewable assets that yields a 3% return, we have unlimited appetite”. Imagine that – a wall of institutional money seeking low-risk cash generative assets.
The bottom line is that the emergence of the IIs is a key game changer for the renewable energy sector. In fact, it’s probably the key Paradigm Shift as it’s acted as an accelerator of price competitiveness whilst, in parallel, reshaping a more capital efficient ownership structure.
3. The rise of corporate PPAs: Google, Microsoft, Apple, Facebook, Norsk Hydro and many other leading corporates quickly discovered several years ago that “going green” was not only good for marketing purposes, but it also made sense economically. These companies, and many more, now contract directly with renewable energy asset owners to buy power on a fixed-price, long-term (15+ years) basis to fuel their data centres & industrial activities. Not only does it make sense for the corporate for the aforementioned reasons, but the asset owner secures a credit-worthy long-term buyer for their power, enabling increased and cheaper bank debt to be secured.
And utilities hate agreeing to long term fixed-price supply agreements as it creates contingent liabilities on their balance sheet with little perceived upside (gone are the days of Enron).
And so, another win-win is achieved; except again for the utility, who up until recently had these blue-chip corporate customers as captive customers.
4. The collapse of peak/off speak price spread: historically, utilities would make most of their profits during time of peak power demand (both seasonal and daily). Put simply, aggregate demand for electricity from the general population is higher in the morning, when preparing for the day, and in the evening, when returning from work. A utility would always operate its most cost-effective plants to meet base demand, only utilising more expensive facilities to meet higher demand levels (both “shoulder” and “peak” demand). However, if one looks at utilities’ historical financial statements, one will see that a significant portion of their profits derived from these periods of peak demand supply. In other words, they were able to charge incrementally more for this peak demand than it cost to generate peak supply.
Renewables have turned all of that on its head – at least in countries where renewable generation has reached certain penetration levels. By its very nature, wind power produces electricity when the wind blows. And the sun typically shines for much of the time when human beings are most active. Aggregately, wind and PV compress – even collapse – this peak demand as wind and PV facilities always supply power to the grid when they are operating. Why? Well, once they are installed, wind and PV are the cheapest form of marginal generation cost on a grid as their fuel costs are zero. So, in effect, they always run when the “fuel” is present, shaving off the most profitable peaks for utilities.
5. Simplicity: finally, renewable technology is quite simple & commoditised, regardless of what the OEMs state in their marketing brochures. A ground-mounted PV facility may require an inverter change every now and then but really only needs a “man and a dog” to keep the panels clean. Wind technology is slightly more complex as it involves a tank-sized nacelle unit sitting 100+ meters above the ground, housing a generator, a gear box and other key components. By their very nature, moving parts are always more susceptible to failure than inert technology as found with PV. Yet when compared with the components and complexity of a gas turbine or a coal boiler, a wind turbine is laughably simple. Moreover, wind power is distributed, meaning that temporary downtime of one or more unit(s) in a multiple unit wind farm will not greatly impact a project’s economics (at least when compared with one of two gas turbines going down or the steam turbine that is combined with two gas turbines “running out of steam”…).
So, given that renewable technology is much simpler than traditional thermal solutions, operating wind and PV is much easier; thereby making it much cheaper. My experience in large companies has taught me that when competitive barriers exist, they will seek to monetise that value, charging for delivering and managing complex designs, technologies, etc. With renewables, this is no longer possible.
Whereas many of these Paradigm Shifts have hit at the heart of the utility sector, many leading utilities have adeptly adjusted to this new world order. Many develop projects and sell-down equity to IIs at the operational stage, charging fees to manage the asset long term; thereby playing to their comparative advantages. In addition, utilities are still some of the best-placed players to manage the intermittency of renewable energy by offering “balancing services” and “load profiling” (services that corporate clients often demand).
I close with a well-known Chinese saying: “may you live in interesting times”. Many believe that this saying is meant as a curse, to live in times of trouble and upheaval. I see it both ways:
· the renewable energy “Age of Paradigm Shifts” may have brought some value destruction & disorder to some traditional players
· However, we live in an era of decentralisation, empowerment and innovation in the electricity world, amongst others (think FinTech). And given that the power sector is one of the world’s largest and most strategic, the pluses far outweigh the negatives for society at large.
So, may YOU live in interesting times ... because I sure as hell do!