By Nathaniel Bullard
Director of Content
Bloomberg New Energy Finance Summit
Click here to download the full VIP Comment in PDF.
Our electricity system is a century old in concept and regulation, and in some cases physically as well. Its existence is predicated on solidity. Infrastructure is massive and fixed. Business models are simple and venerable.
Regulation is designed for robustness rather than flexibility. The historical growth relationship is linear: population growth equals load growth; economic growth equals demand growth.
But that solid phase is changing. We are now one decade, and nearly two trillion dollars, into a transformation of the electricity sector created through three vectors: widespread deployment of renewable technologies at increasingly competitive costs; energy efficiency through new products and services; and new business models for distributed generation and services.
What is the result? New futures for the electrical system’s prime movers, of technology, capital costs, investment, risk assessment, the physical environment, and regulation. The phase changes within each are a challenge not only to existing perception, but to existing business structures.
Earlier this month, Toyota Motor Corp issued a recall for 1.9 million of its popular Prius model – more than half of all Priuses on the road – to update vehicle software. Assuming a very conservative 10 kilometers driven roundtrip for recall, this recall will incur 19 million kilometers driven by its owners, or the equivalent of 474 circumnavigations of the globe, or 25 roundtrips to the moon…for a software update.
Tesla Motors Inc, meanwhile, has changed everything from its door handle opening sequence to vehicle suspension heights via over-the-air updates to its vehicles’ telematics system. As Toyota was issuing its mass recall for a software fix, Tesla founder and CEO Elon Musk announced another operating system update with a tweet, promising to make it “awesome”.
For a century, every energy system has been a derivative of its resources – whether fossil fuels or hydroelectricity or even solar and wind resources. Resources determined an energy sector’s functionality and its cost structure. But as clean energy costs come down further, and as hydraulic fracturing opens up vast gas resources that were functionally non-existent prior to new technology, energy systems are becoming a product of their technology.
On this topic, the Bloomberg New Energy Finance Summit on April 7-9 will hear from Tony Fadell, founder of Nest Labs Inc, which he just sold to Google Inc for $3.2bn, and from Jim Hughes of First Solar Inc and Christopher Crane of US utility Exelon Corp., who will both join our “Global CEO Dialogue”. And Jeffrey Immelt of General Electric Co, in conversation with Bloomberg LP CEO Dan Doctoroff.
Most Bloomberg New Energy Finance clients will be familiar with our clean energy equipment experience curves, showing declining costs for distributed technologies with their increased deployment over time. Prices for hardware items such as PV modules may fluctuate from month to month, but the trend in costs is firmly down. Manufacturers have made more than 700 million solar panels so far; curves are proven.
Investors deeply imbedded in conventional energy technologies could look at early high renewable energy costs with bemusement, at later plummeting costs with curiosity, and at today’s lower costs with concern. Clean energy undercuts many conventional options in a growing number of places, without subsidy.
Just as important today is the cost structure for conventional energy assets. Wind and solar have the advantage of deployment in tens of thousands of discrete assets per year; capital costs are visible, comparable, and near-term; fuel costs are non-existent. Conventional assets developed over several years are exposed to commodity prices, to labour prices, and to capital markets and investor appetite for allocation and risk.
In the case of nuclear energy, there is a huge risk in the construction phase – Finland’s Olkiluoto-3 reactor, originally scheduled to be commissioned in 2009, may not eventually start operating until 2015, and its costs have risen accordingly. The phenomenon is not limited to power generation, either. The cost estimate for the Gorgon liquefied natural gas project in Australia was $37 billion in 2009. Last December, project owner Chevron Corp. announced its second cost increase of the year, to $54 billion, and also pushed back its online date.
CLEAN ENERGY INVESTMENT CAPITAL
Capital for clean energy projects has been specialist since its beginning. In many ways, this is only natural; clean energy was an asset class with all the risk of a technology sector, all of the longevity of the power sector, and the sorts of exotic requirements that institutional investors actively flee. It is no criticism to say that clean energy investment capital often came from an investment bank’s “special situations group”, a domestic or international policy bank, or a government. Only the most established of asset types, such as onshore wind and ground-mounted PV, found it straightforward to find commercial bank non-recourse project finance, but even project finance is itself a specialty undertaking. The capital pool was functionally finite.
The capital pool began expanding years ago, though early measures like the Breeze wind bonds in Europe in 2005-07 were not always successful. The global financial crisis, of course, nixed all attempts to widen any capital pool for a while. Change began with the first billion-dollar investment grade solar bond in the US, for the Warren Buffett-owned Topaz PV plant. Last year, rooftop PV asset owner SolarCity Corp. sold its first $54 million bond, and its next offering may reach $200 million.
And, there is another source of capital: direct retail investment via community investment or any of the various mechanisms grouped under “crowdfunding”. When I first analysed crowdfunding, it was as an exotic investment. Today, Mosaic lists its investments by asset, with defined yields, tenors, and total subscription. The velocity of such fundraising is also significant. In 2012, Dutch company Windcentrale spent four and a half months to raise 400,000 euros from 5,200 households to invest in a wind turbine. Last September, the company reportedly raised 1.3 million euros in 13 hours from 1,700 households to finance a 2-megawatt turbine.
On the availability of capital, the Summit will hear from Jim Barry of BlackRock Inc, an infrastructure finance veteran bringing precisely the institutional investment which the sector needs, as well as Francesco Starace, CEO of Enel Green Power SpA, one of the world’s biggest developers and operators of renewable energy projects.
Last year’s Summit struck a chord with the theme of a “New Energy ROI” of resilience, optionality, and intelligence – a framework for thinking of energy assets as something other than least-cost, best-fit financial elements. Resilience is one of the greatest attributes of a smart, distributed energy system, and one which is beginning to be priced in by regulators, utilities, and other investors. There is strength in being distributed, a strength all the more needed as the world feels climate change impacts.
Climate change’s impact on the physical environment is something everyone can relate to, but unfortunately the proportion of CO2 in the atmosphere is an abstract concept. International efforts pinned to this abstraction are necessarily multi-party and complex. This is not to say that climate change is anything less than dire, or that international efforts are doomed.
It is telling, though, that Mayor Michael Bloomberg was recently appointed as UN Special Envoy for “Cities and Climate Change”, not just “Climate Change”. Cities are where climate change comes to ground; where an abstraction becomes concrete in the face of rising seas and polluted air. We breathe out carbon dioxide everywhere. We breathe in 2.5-micrometer particulates in Beijing and Shanghai and New Delhi and Ulaanbaatar. China has been reasonably intractable in climate change negotiations, but it now has the world’s second-largest carbon market (in pilot phase) for its own environmental reasons. The central government has also announced trillions of dollars of spending on cleaner air and water, while already supporting the world’s largest solar and wind project markets.
Who better to brief the Summit on the nexus between politics and the environment than EU Climate Commissioner Connie Hedegaard, Ernest Moniz, US Secretary for Energy, and Maria van der Hoeven, executive director of the International Energy Agency?
For renewable energy technologies, risk assessment has long been a function of the exoticism I mentioned above. But if we take a sober assessment of risk today, where does risk lie?
Renewable energy projects have fixed capital costs, generally well-known operating costs, contractually guaranteed revenue streams (except if the owners are playing in spot markets), and downsides limited to retroactive policy changes and the security of their contracts. When and if they need repair and repowering, new equipment costs and performance follow the experience curves described above.
Conventional power generation projects have variable operating costs thanks to fuel requirements, variable revenue streams based on wholesale markets, uncertain utilization rates due to changing grid demand and renewable energy, potentially open downsides due to emission regulations or carbon taxes, and in some cases, hard-to-predict capital costs. Fuel producers, too, will be heavily exposed to changes in fuel demand particularly as their long project lead times require them to commit investment well in advance of production. Last year, HSBC examined cash flows on five UK-based mining firms and found that if there was no coal consumption growth post-2020, their discounted cash flow from operations would fall by 44 percent. This same set of uncertainties affects 200 fossil fuel companies, with a market value of $4 trillion and debt of $1.5 trillion.
Investors can easily view one side of this renewable-or-conventional divide, but rarely do they do both. Investors may be specialist investors in one technology, or they may have portfolio allocations pre-determined by their investment committee, or they have limited partners who all but dictate their strategy in one direction or the other. But in a sober assessment, which type of asset is riskier?
REGULATION AND RHETORIC
The changes afoot in the electricity business today, and differing assessments of the regulatory mandate and market desires are undermining the foundations of its regulatory structure.
I will start with a quote from David Crane, NRG Energy Inc CEO and several-times Bloomberg New Energy Finance Summit thought-leader:
“First of all, if you are reading this from your comfortable and secure office at a regulated utility, I hope you don’t believe a word of what I have to say. You see, I don’t think utilities can win on the energy playing field of the future, but your continued absence from the parts of our industry that most matter to the future leaves the path to future success clearer for the rest of us.”
I will follow with another quote, from Mark Ferron, retiring commissioner at the California Public Utilities Commission:
“We are fortunate to have utilities in California that are orders of magnitude more enlightened than their brethren in the coal-loving states, although I suspect that they would still dearly like to strangle rooftop solar if they could. Modern utilities are subject to a rapidly evolving business environment, and I wonder whether some top managers at our utilities have the ability or the will to understand and control the far-flung and complex organizations they oversee.”
We have seen early stages of pushback from regulators in Spain and Germany, seeking to stall deployment of distributed solar by introducing fees on those producing their own electricity. This pushback is for many reasons: incurred costs from very high subsidies or concerns about grid reliability, both of which have kernels of justification. In the US, we have also seen regulatory maneuvering, with Arizona’s utility given the green light to impose a fee per kW on new solar customers, a disagreement that will become a skirmish that could become a battle for survival.
As in any revolution, there will be some strange bedfellows. In the US southeast, Tea Party Republicans and the Sierra Club have formed the “Green Tea Coalition”, uniting two groups that are unlikely kindred spirits, in opposition to utility Georgia Power. Their shared goals? To force Georgia Power Co to accept more renewable energy in its service area, and to persuade regulators to reject the utility’s grid access charge for solar. In the words of co-founder Debbie Dooley, “We agree on the need to develop clean energy, but not much else.”
A DIFFERENT WAY OF THINKING
We have always used the dollars invested in clean energy as the proxy for the impact it has on the energy system. The result is a linear growth function: more dollars means more assets means more impact. However that is only one way of thinking about the issue.
US energy efficiency company Opower Inc has received $66 million in venture capital since its founding seven years ago. This seems paltry, roughly equivalent to the cost of a 30-megawatt PV plant, but let’s look at it in a different way, using readily available data.
Since its founding, Opower has saved 3.7 terawatt-hours of electricity for customers (or to put it another way: it has reduced sales of grid electricity by 3.7 terawatt-hours). Annualised, that is the same amount of electricity as the consumption of Côte d’Ivoire.
Those avoided electrons have resulted in ratepayer savings of more than $400 million. If we think of this example in terms of capital impact, it is striking. Some $66 million in investment capital for 3.7 terawatt-hours of electricity savings means that a dollar invested in Opower to date is more than 300 times as efficient at reducing grid demand than is a dollar invested in a rooftop solar system in California.
Netscape creator and venture capitalist Marc Andreessen said that “software is eating the world”. Obviously, it cannot devour our substations and transmission lines, but it can re-arrange their rank order in measuring significance in the electricity system.
While (virtually) leafing through Harvard Business Review recently I read Theodore Levitt’s Marketing Myopia. I smiled at this passage on electric utilities:
“Who says that the utilities have no competition? They may be natural monopolies now, but tomorrow they may be natural deaths. To avoid this prospect, they too will have to develop fuel cells, solar energy, and other power sources. To survive, they will have to plot the obsolescence of what now produces their livelihood.”
That was written, mind you, in 1960. An idea can be true, just very early, and still be true.
Levitt makes a sharp distinction between selling and marketing. Selling focuses on the needs of the seller; marketing focuses on the needs of the buyer. Myopia creeps in when companies sell (pushing their own needs on the market) rather than market (pulling in customers based on meeting customer need). In today’s phase change, energy consumers have the same need as before but also new needs (resiliency in the face of a changing environment, cleaner air, predictable cash flows from self-owned generating assets). For an energy company, meeting those needs requires marketing, not selling; clear vision, not myopia.
THE MELTING ICEBERG
Last month, in his VIP Comment, Michael Liebreich introduced the notion of phase change as he recalled watching the frozen Neva River fracture in St Petersburg’s spring thaw. I will conclude with another version of the analogy of solid ice to liquid water: the iceberg.
Icebergs are stable formations, but they are also peculiar formations – 90% of their bulk, of their matter, is invisible.
In an electricity system, a casual observer sees wires and switches; today, perhaps a wind turbine in the distance or a solar panel on a rooftop. A casual observer does not see a rate structure, a merit order, a marginal price curve, or many trillions of dollars of physical assets. These are the hidden bulk, physical and metaphysically, of the iceberg.
When an iceberg melts, it does so from beneath. The superstructure, with its high albedo affect, is relatively immune to light and heat. The substructure is exposed to the temperature and current, both of which are pervasive, persistent, trend-driven, and ultimately unstoppable.
At a certain point of melting, the substructure cannot support the superstructure. The iceberg rolls over – and only then do the unstoppable forces which were long at work become visible.
As an energy investor, an asset owner, a policy-maker, where do you want to be positioned? Embedded in a superstructure which, however indestructible it looks, may be melting from underneath? Or on a craft alongside, nimble and maneuvering in turbulent seas?
The Bloomberg New Energy Finance Summit 2014 takes place in New York on April 7-9. Click on http://about.bnef.com/summit/ for further details.
Click here to download the full VIP Comment in PDF.