Investing in energy used to be a safe place to put your money: in times of trouble utilities with their solid dividends were the place to invest. “Defensive” investments as they used to be called. However, that was yesterday. Today, particularly across Europe, nearly all utilities are in some form of strategic review and/or restructuring. The falls we have seen in wholesale power prices have led to “stranded assets”, to unprofitable generation units being closed and to the values of those assets being written off. In total, the major European utilities have made asset write-offs to their asset base worth over €75bn since 2009. Why has this happened? The answer is twofold: regulation and innovation.
Regulatory changes are driving once-in-a-lifetime changes to the world of energy.These changes are varied, but are mostly motivated by environmental concerns. In Europe, for instance, there is the Large Combustion Plant Directive in Europe which requires power producers to comply with tough controls on SO2, NOx and particulates emissions. Or the German government decision to decommission nuclear power plants earlier than generators would have wanted. Or the so called 20/20/20 goals of 20% renewables, 20% less energy consumption and 20% less carbon emissions by 2020, which have led to a wave of far-reaching laws across European countries promoting renewables and energy efficiency.
And the impact can be clearly seen in the world of European power. A massive build out of renewables, most of which are not owned by incumbent utilities, as well as weak demand, thanks to energy efficiency measures, both of which have led to low wholesale power prices. At these low prices, many generators cannot meet the operating costs of their power generation units, let alone the fixed costs of building them, and as a result these assets are becoming increasingly “stranded”.
These regulations have also had another impact, in that they have also driven innovation particularly on the renewable energy side. So for instance, feed-in tariffs across Europe have allowed both wind and solar technologies to benefit from economies of scale, and thus push costs down to levels which are now oftentimes below that of fossil fuel technology. Or LED lighting technology, which has also seen a massive drop in costs in recent years as countries across the world have regulated against energy-intensive incandescent lighting. And we are also seeing a move to electrification across the automobile industry, as manufacturers realise that this is the only way for them to meet CO2 targets. These new regulations are forcing innovation such as stop-start motors, as well as the introduction of new and exciting electric vehicles such as the BMW i3.
And going forward? The risks of stranded assets will only increase. Investments in energy assets (oil rigs, power stations, grids) are expensive with long payback periods, which are often designed to operate for 40 years or more. As uncertainty about the future increases, the cost of capital will rise, and projects that would have otherwise been completed will now not take place. Worse still, there is a risk that existing projects will have to be written off.
New climate change regulation across the world will continue to put pressure on all forms of fossil fuel, but in particular coal, which is not only Co2-intensive, but a big air pollutant and a cause of smog. We are likely to see regulations in China, the US and Germany, in the near term, all of which will be negative for coal. In fact, the pending decision of Germany with regards the future of coal in that country will have a massive impact on the ongoing sales process of Vattenfall’s German lignite power stations. In the worst case scenario, those assets may become liabilities which means that Vattenfall will have to pay someone to take those assets off them … Coal is also increasingly under pressure from investors. We have seen a whole host of investors, in recent months, announce their decision to divest of coal assets, and we are likely to see this trend increase in the coming years.
But it is not just the risk that assets could be stranded by climate change regulation, we are also seeing innovation having a massive impact on the commodity markets of oil, gas and coal. The impact of new drilling technologies has brought about a renaissance in US natural gas and oil production, the impact of which is that we have each of these commodity prices are at five-year lows. And at current price levels a whole pile of drillers and miners are suddenly not able to make money and may close production of proven reserves which means those asset could become stranded.
To make matters there is further innovation coming our way. We will see the costs of solar continue to fall in the coming years. We will see fuel cells and energy storage come down. We will see much more intelligence put into our homes, vehicles and workplaces all of which will curtail energy demand. But perhaps the biggest change will come from the electrification of transport. The increasing hybridisation of the automobile is already driving the costs of batteries down and with new all electric models being introduced my nearly all global manufacturers, the costs should come down even quicker. Give it five years and the cost of an EV and similarly sized combustion engined automobile will be the same and with the lower fuel costs of an EV we could see a substantial move to electric vehicles. And that will have a big impact on the oil market.
What does all this change mean for the investor? It is going to be critical to identify assets that are at risk of becoming stranded. And again this is just not fossil fuel assets. There are huge risks of on the decommissioning side of nuclear assets. There are country risks for renewable assets, and there are risks that CO2 will be priced going forward which will impact all fossil fuels. Energy is becoming a very interesting place.
This post first appeared on the Energy and Carbon Blog: