The past five years have been difficult for shareholders of European utilities. An average decline in the share prices of nearly two-thirds as reflected by the ESTX utility index is difficult to digest. Even taking the strong dividend payments into account, the value destruction is still above 50% before inflation.
Is this the end of the traditional utility business model, or just a normal business cycle, where investors should have looked at the timing and overall valuation of utility stocks five years ago?
Let’s have a closer look what happened in the utility sector in Europe in the last 15 years. At the end of the 1990s, the first liberalisation waves arrivedin Europe and the general technology boom reached its heights. Stronger competition on the wholesale market with US traders such as Enron and Dynegy opening operations on the European markets and overcapacity in the electricity generation led to declining wholesale power prices.
Profits of European utility incumbents came under pressure, as the traditional fully integrated utility business model was transformed and split along the value chain into upstream, midstream and downstream activities. European incumbents were reacting to this threat in the first years of the new millennium by growing their own presence on the wholesale, trading and midstream market and by selling all non-core, non-energy related activities, spanning in many cases telecoms to construction and printing.
Utilities transformed into pure energy plays. As wholesale prices were low, new-build activities slowed considerably and the overcapacity diminished step by step. The crisis among US traders, especially the insolvency of Enron end of 2001, first increased insecurity but later enabled the European utilities to regain a strong foothold in the wholesale spot and term market.
The years 2003 to 2008 will stand out as the golden years for European utilities for many decades, as different factors worked in favour of the utilities profits. Wholesale market prices for electricity entered a bull market, and not only were absolute electricity prices on the rise, helping the profits of nuclear and lignite generation, but spark and dark spreads, defining the ability to generate returns by transforming either natural gas or hard coal to electricity,set record highs at above €25/MWh by the end of 2006.
In 2005, Europe launched the European Union Emissions Trading System (ETS) to combat climate change.
The ETS give each ton of emitted CO2 a price in a bid to reduce total emissions in Europe by a cap and trade system. Although a possible threat to the European utilities in the longer run, especially to the lignite and hard coal generation assets, the CO2 price was factored into wholesale prices, pushing up revenues for electricity generation, while power generators, including industrials and utilities were granted most of the needed CO2 certificates at no cost, meaning the cost side increased only fractionally step by step. In fact this grandfathering lead to windfall profits for the utilities.
So if instead of looking at just the past five years we consider the past 15 years, utility stocks are now on the same valuation level as a decade ago. The argument that this has been just a normal business cycle seems to fit the data and the investors that entered utility stocks in 2008 were guilty of bad timing. Or is this time different, as people are speaking about the perfect storm for European and especially German utilities?
Back to the five years since 2008, the record profits were not seen by the utilities managers as an extraordinary positive development, but as the level that should be the standard for the future. As in every traditional boom and bust cycle, major utilities embarked on big investment programmes to strengthen their ageing fleet of largescale power stations around 2005, programmes running five to eight years as planning, permitting and construction of large power generation plants takes time. Although customers and stakeholders of utilities, especially in Germany, had been signalling for more than a decade that renewable generation and CO2 emission reduction was the name of the game, most utilities did they did best historically – invest in traditional conventional largescale power stations.
Negative public sentiment with regards to coal-based electricity generation and the Germanic negative sentiment regarding nuclear generation was taken seriously, not enough to change investment programmes but sufficiently to attempt to diffuse arguments and change public opinion. These efforts led to negative sentiment towards utilities taking excessive profits, increasing electricity prices and threatening the environment. The energy market has become a very emotional place where consensus is unreachable and a balanced energy mix is interpreted as being an enemy to the ultimate 100% renewable target.
As a consequence the utilities’ licence to operate is at risk. But more external shocks contributed to the so-called perfect storm environment for European utilities. The tragic events in Japan lead Germany to shut the oldest nuclear generation plants in the country and phase out the whole nuclear generation in the medium term, the debt crisis and recession in the southern part of Europe lowered electricity demand, and the second pillar of utility incumbents, the natural gas business, is suffering an extraordinary market shock – shale gas in the US and more restrictions in Europe are pushing liquid natural gas volumes at low prices into the traditional pipeline-based gas business in Europe. Long-term natural gas pipeline supply contracts are out of the money, with losses for each cubic metre sold by the utilities.
The traditional split and risk taking, where utilities carry the volume risk and natural gas producers carry the price risk in comparison with oil as main competitor is not working any more. Oil index-based pricing has been criticised for many years, but the current excess volumes on the European gas market are making it impossible to continue with traditional long-term contract structures. Arbitration court procedures are the consequence, and the change of the traditional relationships between gas producers and utilities. Finally the strong renewable capacity build-out in Europe especially in Germany with an unforeseen photovoltaic boom leads to generation overcapacity again. About 17,000MW of photovoltaic capacity was added in Germany in 2011 and 2012.
While overcapacity is threatening utilities, this capacity is also treated with high priority in the grid, with very low variable cost, pushing load factors for newly added large-scale generation down. So a combination of lower prices and lower load factors for largescale electricity assets. The photovoltaic (PV) generation pushes wholesale electricity prices down, especially in the midday peak hours, lower than anybody would have imagined a couple of years ago. Decreasing demand for electricity coupled with strongly rising renewable capacity leads to lower electricity wholesale prices. As a consequence utilities’ cashflows are under pressure and this lead to downgrades of utility ratings. As utilities traditionally run high leverage ratios and are still finishing the large investment programmes started in the middle of the last decade, this development is serious.
The amazing consequence of the renewables success in Europe and the shale gas boom in the US are price signals that counteract what is expected from utilities. Cheaper coal and very low CO2 prices in Europe, well below €10 per ton, are putting newly constructed gas-fired power stations under pressure as the clean spark spread has shown negative readings for months, even though these power stations are perceived as perfect flexible partners for the intermittent renewable generation. Even pump storage is in trouble, as the shrinking peak and off-peak spread is diminishing returns for pump storage. Instead, coal-based electricity production is on the rise, as the clean dark spread is still positive at around €10/MWh. Cheap coal and CO2 pushes utilities to abandon biomass as the real solution provider for carbon neutral non-intermittent renewable generation.
Is this the low point and will utility valuations rebound?
One thing is sure, the current entry level is much more attractive than five years ago. As the incumbents have reacted successfully in the first years of the new millennium to the threats of a new trading business model and the liberalisation of the energy markets, utilities will again change and adapt their business model to the current reality. So long-term investors can start looking at some of the utilities again, the ones that actively tackle the challenges to become a solution provider instead of a problem identifier.
What is the core difference between the changes enacted by the liberalisation in the late 1990s and the current situation? During the late 1990s the value chain was sliced into different pieces, the underlying technologies for electricity generation, distribution and use were unchanged. What we currently see in the European energy markets is a change brought by renewable technology innovation. Is this innovation trend getting weaker due to the shale gas boom, the lower electricity prices and overcapacity on the wind turbine and PV module manufacturing side?
The indication from the patent application front, which is an indicator for research and and development activities, point to the opposite. The Clean Energy Patent Growth Index (CEPGI), published quarterly by the Cleantech Group at Heslin Rothenberg Farley & Mesiti, is showing strong clean-tech patent growth in the US, and this development is mirrored in Japan, Germany, Korea and Taiwan.
And all these patents will be reflected in products only in the coming decades. So this technology-driven change is very likely at its start.
The current technology innovation in the energy market is comparable to what happened to the telecoms market with the appearance of mobile telecommunications in the 1990s, and to the large central mainframe computer market with the appearance of the personal computer in the 1980s.
The traditional central generation-based utility business model with long-term planning and financial modelling of capital intensive assets paying off over the next 30 years is phasing out and it will not return to success in an innovation- driven energy market. This implies that waiting until the new technologies are mature and only then applying them, as utilities have been behaving, is risky. Combining technology conservatism with customers that prefer to generate their own renewable energy and the negative image of utilities of being excessive profit-takers and not customer-oriented is fatal.
The future will be more renewable and more decentralised and distributed than in the past. The energy, telecoms and information technology markets are converging to enable interconnected and smart distributed assets. This trend is further fuelled by fast-increasing data transmission capacities and smartphone success. The smaller-scale energy resources have shorter lead times, fewer permitting needs and more standardisation potential. They can
be realised also in the context of a fast-changing, innovation-driven energy market.
So what are promising opportunities for dynamic fastmoving utilities driven by technology innovation and conclusions? Renewable generation technologies continue their cost down-trend and provide new solutions to industry and end customers:
l PV generation will not stop at the current flat type module installations, but can provide new technology solutions. Organic PV technologies, for example, lead to flexible, lightweight products with a range of transparency and colour options to users.
l Energy services can provide multiple applications, combining renewable electricity and heat generation with, for example, a tailor-made solution for waste disposal, by adopting new technologies. Balancing electricity supply and demand with a high proportion of intermittent renewable generation:
l Intelligent solutions such as wind and PV generation forecasting increases the ability of the decentralised generator to sell electricity on the wholesale market and offer real-time warnings on a smartphone if the asset is not performing as it should given current wind and solar conditions.
l Smart demand-side management based on short-term electricity price signals enable industrials and consumers to adapt their demand to the available renewable electricity supply and even to replace fossil fuels at times of electricity oversupply.
l Upgraded biomass as a natural energy storage can supply dispatchable renewable electricity and heat, when it is needed, where it is needed.
l Small distributed generation assets will be interconnected and managed in virtual power station clusters to optimise electricity and heat markets.
Enable distribution grid to be an intelligent and active connection between distributed electricity generators and consumers:
l Local generation will be supported by small-scale storages at the customer’s home, even enabling load management.
l New control mechanisms for substations will be combined with medium-sized storage to reduce investment requirements for the distribution grid build-up. The electrification trend is nowhere near to its end, as it is driving efficiency gains and new products:
l Whole new sectors still wait to be electrified. One of the most prominent being the automotive sector joining in with plug-in hybrids and electric vehicles in the next decade. All these vehicles will need charging. Data management, data analytics and value-added services to customers, including
security services and quality assurance for the mostexpensive part of the electric vehicle, the battery. Energy, IT and telecoms markets are converging:
l Smart meter, electric vehicle charging and interconnected home appliances will form microgrids pushing the innovation speed at the customer’s home to the next level. How can a utility tap successfully into these opportunities? The reaction to current market distortions by renewable technology innovation will be more regulation, not less.The requirements of the new energy world are very different from the traditional cost efficiency-driven integrated utility business model. This means that the utility business model might have to split into different pieces, managed by different organisational set-ups and targets – the regulated business driven by cost-plus-based benchmarks and the public service idea, the fast changing, decentralised, innovative, technology-driven and customer value-oriented business, And the traditional cost efficiency-driven large scale asset business.
New partnerships can pave the way to success in the new energy world. Between utilities and innovative dynamic start-up companies or between incumbents on the converging energy, telecoms and smart appliance markets.It is probably easier to create new set-ups for the new opportunities instead of trying to transform existing setups. Open innovation can complement traditional researchand development and must be combined with readiness to accept failures.
Not all new technology developments will be a success, but the speed of technology innovation will create some big opportunities. A portfolio approach that survives failures is a possible recipe for success.
So wrapping all this up, the traditional utility business model is under threat and will not survive in its current form, but the current situation is also a trough in the business cycle with additional shocks that have put utilities under enormous pressure from various angles, and this provides a lot of rebound potential, for every utility that accepts the new realities and moves into active and disruptive innovation mode in addition to rigorous cost-cutting and incremental efficiency optimisation of existing operations.