INSIGHT: Utilities have their uses

Utilities are trying to wean themselves off their carbon-heavy generation model

Utilities are trying to wean themselves off their carbon-heavy generation model

“Beware the Ides of March” should be a maxim for the German utility sector, as the annual results of E.ON, RWE and EnBW certainly left a lot of blood-red numbers on the floor.

All three recorded declines in 2013 net income, with E.ON reporting a drop of 4% year on year and EnBW a 90% drop. RWE brought up the rear with a whopping €2.8bn ($3.9bn) loss, its first for 60 years — albeit after a €4.8bn asset impairment charge, mostly on its traditional generation businesses.

The common theme for all was falling profitability in fossil-fuel generation businesses, caused by a combination of weak demand, low electricity prices and underutilised peaking and baseload assets, exacerbated by the arrival on the scene of variable renewables electricity with priority grid access.

Some in the green sector have been cheering loudly to see these traditional fossil-fuel and nuclear behemoths brought to their knees, but in truth the renewables industry cheers the demise of these utilities at its peril.

Nine of the top ten European wind farm owners are major utilities with significant exposure to traditional generation. We can argue the merits and relevance of the traditional utility business model, with its carbon-intensive, centralised generation, in a world where energy efficiency is stifling growth in power consumption and renewables technologies have provided consumers with low-carbon, cheap and decentralised generation.

However, there is no escaping that in the medium term, utilities will remain among the largest investors in renewable energy, especially wind, and particularly offshore.

Untitled-1.jpgGrowth in new generation capacity, even to repower old fossil-fuel and nuclear assets, requires underlying cash-flow generation to provide investment funds. Although the costs of wind and solar installations have dropped in recent years and the levelised cost of energy for wind is now mostly cheaper than fossil-fuel and nuclear newbuild, renewable energy remains at least twice as capital-intensive to build as gas-fired capacity.

Utilities’ cash flow to invest in new renewables assets comes principally from two sources: the underlying cash flows of existing traditional generation and distribution businesses; and capital market funding (whether debt or equity). External funding in the main relies on the power of existing businesses to generate sufficient cash to support debt and equity funding. In other words, all roads seem to lead back to the continuing profitability of the utilities. Therefore underperforming traditional power-generation assets could jeopardise future investments in the renewables sector.

Most utilities now have renewables at the heart of their investment strategy, and as these assets grow, the cash flow from them will support future investments in more green-energy assets. Utilities’ management teams have also been grappling with the challenges of exiting their traditional businesses. Arguably some — for instance, E.ON — have been quicker to adapt than others, such as RWE. Equity investors, who have an eye on future earnings and the future viability of business models, have been voting with their feet, and share prices for these two companies have declined by nearly 70% since their peak in 2008 and are at the level they were more than ten years ago.

Simply put, the utility sector needs to be able to evolve, even if other investors in new generation are coming into the market. Decentralised power generation is growing rapidly, but it cannot yet supplant existing baseload power. Utilities need to continue to be able to earn a sufficient return across all their businesses, including back-up baseload capacity, to generate cash flows for green investments.

The challenge for governments will be to design a holistic marketplace that allows this to happen, while weaning utilities off carbon-intensive centralised generation. This battle is being fought right now, with the Magritte group of utilities banging up against the EU, while discussions about new targets and new energy policy rage on.

Recharge Insight is a new premium subscription service aimed at providing renewables thought leaders and decision-makers with best-in-class analysis of key issues facing the industry. For more information on Recharge Insight, contact Ksenia Burkova at ksenia.burkova@rechargenews.com

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