Breaking the chains: Why the utilities sector must be ready for System 2.0

When Rosa Luxemburg famously said that “Those who do not move, do not notice their chains”, she could not have known the relevance of these words to the electricity industry of the twentieth and twenty-first centuries. Indeed, disruption looks set to strike the electricity industry and its 140 year old linear production and distribution chain, in much the same way as it is the transportation and accommodation industries.

Investment shifts signal new energy ecosystem

Over the past 15 years, the technology, consumer products and energy sectors have continued to converge. Now in 2018, investors, management and governments are preparing for the emergence of a new energy ecosystem - a System 2.0 – and anticipating a range of value shifts in the industry which will produce significant winners and losers. These shifts are already underway – albeit hidden among small series A and B capital raisings and synergies between new tech and strategic utilities.

These green shoots can be difficult to spot in a sector like power and utilities. This is an industry of big numbers, and 2017 was another stellar year for mergers and acquisitions (M&A) in the sector. As detailed in EY’s Power Transactions and Trends Q4 2017 report released today, deals hit an eight-year high in terms of both value (US$200.2b) and volume (516), with:

• US$63.3b deal value in networks
• US$55.1b deal value in “others” including integrated and water and waste water
• US$42.8b deal value in renewables
• US$39b deal value in generation
• 35 multi-billion dollar transactions contributing 77% of total deal value
• 10% increase in deal volume from 2016 driven by a 28% rise in renewable energy deals; and
• Corporate buyers investing 1.6x more than financial investors.

In a global marketplace with low (but increasing) interest rates and excess capital, investors are still looking to yield investments delivering long-term stable returns. The easiest ways to deploy capital are still predominantly via network assets and renewable backed by power purchase (PPA) agreements.

The former - transmission and distribution (T&D) and integrated assets - attracted US$100.3b (50.1%) of total deal value in 2017 with US$57.8b of these deals in the Americas (58% of total deal value for that region), US$25.6b in the Asia-Pacific (26% of total deal value) and US$16.9b in Europe (17% of the total deal value). Corporate investors were the dominant buyers of these assets investing US$82.7b, or 82%, of total deal value.

Of interest, T&D assets globally traded at a EV/EBITDA (enterprise value by earnings before interest, tax, depreciation and amortization) ratio of 11.2x, a 13% premium to the two-year forward ratio of 9.9x and an average P/E (price to earnings) ratio of 19.6x, a premium of 42% to the two-year forward ratio of 13.8x. These figures signal overvaluation in the segment. With US interest rates forecast to increase further over the next year – influencing global markets – we expect a new era of caution for regulated assets, given that much of the new technology paradigm is banking its success on arbitraging the peak, upon which so much network value is based. 

Investments in renewable energy assets backed by PPAs increased 1.5x in 2017. Most value was contributed by European deals (US$15.1b), followed by those in the Americas (US$14.2b) and Asia-Pacific (US$13.5b). Financial investors invested 65% (US$27.9b) of total deal value.

A new paradigm - System 2.0

But finding value in 2018 and 2019 will require vigilance. Investors must carefully consider where the markets are going – which means understanding where trends are moving, how companies and technologies will adapt, which technologies will become essential, and who will buy them in the electricity system of tomorrow.

So what does the future hold for the utilities sector? While much is still unknown, we can be sure we are entering a world of change. System 2.0 will require new models for generation, networks and retailing, as well a range of emerging ancillary businesses to support it. Key characteristics of the new system will include:

• A new paradigm for generation:  Baseload and peaking generation, with conventional and renewable generation augmented by storage and open-cycle gas generators, will manage the peak. The era of PPA protection for renewable developments, already endangered presently as the pipeline of permitted projects without funding grows, will be a thing of the past. Just as conventional generation competes on heat rates, placement of projects in good solar areas, and on conveniently dispatched parts of the grid will determine the winners from the losers. Large-scale storage enabled by short-term settlement in electricity wholesale markets will complement open-cycle gas turbines and better ramp rates for conventionals to meet peaks. Availability and pricing of gas will be an increasingly critical factor in determining electricity prices;
• An enhanced role for electricity networks: Networks will be the providers of high-voltage direct current (HVDC) transportation between markets, as well as existing AC and connection asset technologies. Within 10 years, we’ll see a split emerge between the valuation methodologies for regulated transmission and distribution companies, which will increasingly compete with, and be enabled by, storage.
• A new life and model for distribution systems: Discussions around household beyond-the-meter storage will soon be replaced by investment cases for storage within transformers and substations, enabling load flow management across the distribution network and the gradual removal of the peak. Reduced capital expenditure will place pressure on regulated asset valuation methodologies, requiring additional investment in technologies and activities that increase revenue and profit yield from the network. 
• New digitally enabled retail models: We’ll see the emergence of digitally enabled retailers that strive to reach a scale of five million customers, while managing wholesale risk through the financial or physical integration with open-cycle, storage or baseload generation assets. Those retail companies that are used to competing with small-scale, electricity or dual fuel retailers will face new competition from tech-enabled, large-customer-base entrants hungry to deploy scale investments through existing platforms to new users. Margin-selling retailing will largely cease and barriers to entry will rise, with new entry retailers facing pressure to lease digital platforms to compete effectively, and to gain customers from a higher relative cost platform.
• The creation of new secondary markets and technologies: Cyber security, market modeling and load flow, frequency response, ramp rate technologies and system planning using data analytics will enter mainstream electricity markets. New regulatory arrangements will be driven by stakeholders keen to push for lower prices through greater innovation and competition. In generation, settlement arrangements will move to shorter intervals. In networks, regulatory asset values, pricing arrangements, cost allocation and service classifications will change. Retail protections will embrace privacy in a digital age. In short, the system will change, and the way utilities view their parts within it will change too.

Market impact of large-scale storage will drive future investment

We already see evidence of investments in these new areas. 2017 saw US$2.4b deals in energy services and US$4b investment in technology and trading. In 2018, we’ll start to see the market benefits of early investment in large-scale storage to support frequency response which should help demonstrate the commercial business case for future investment. We expect to see regulators and network operators move to address market design issues, including reducing settlement periods to support increased investment in this space.

In retail, a number of start-ups and digital platforms have emerged on the fringes. In 2018, we expect to see an increased focus on digital in retail, with companies looking to acquire small innovative start-ups in this space. During the last two years, new energy-focused start-ups have raised US$746m of funding through series A and B rounds of with US$253m of this focused specifically on energy services.

All of these evolutions will change values in a dynamic way, with returns contingent, not only on technologies and roles, but on regulatory arrangements, revenue recovery, price signaling and counterparties. Knowing which buttons to press, which levers to pull, and the most likely mix of policy instruments necessary to enable them will be essential as financial engineering becomes a distant second priority to deep sector expertise and system understanding. The power and utilities industry will be forced to think holistically about the convergence of sectors, technologies and social drivers that will be essential to picking winners and avoiding losers in a new energy future. How are you placed for System 2.0?