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Environmental challenges in the electric utilities industry

Environmental challenges in the electric utilities industry

25-11-2015 | Matthias Narr Power generation requires substantial investments and long-term planning by the power generators. At the same time their strategies are greatly affected by regulatory decisions as a substantial part of the market remains regulated or impacted by regulatory decisions (e.g. subsidies). The right balance between security of supply, environmental impact and energy costs must be found for the power system - and its participants; the electric utilities - to be sustainable. For this reason we believe companies should implement proactive and ambitious environmental strategies and, independently of their historical energy mix, focus on de-carbonization i.e. move from coal to gas and eventually to renewables. It also means working towards operational excellence of the existing coal-fired power plants by striving for higher thermal efficiencies, the ability to burn biomass, co-generation and responsible coal sourcing. New opportunities also arise as centralized generation becomes less and less important and we think that companies ought to innovate their business models, diversify their revenue streams and leverage their huge customer base. Finally, the regulatory side of the equation is difficult for companies to influence, however we believe companies should at least be transparent on their lobbying activities and ensure consistency between their positions and the positons of their trade associations.

We believe that the business models of power generators will significantly change by the end of the decade; moving from a centralized generation structure based on burning fossil fuels to a decentralized one based on renewables. Environmental reasons are one of the main drivers behind this development. Decentralized generation through renewables is increasing the existing overcapacity in the power markets. Coupled with low demand due to increasing energy efficiency and modest GDP growth, traditional power generation is being pushed “out of the merit order” and will ultimately need to be shut down or get paid for providing backup power. In this context, companies need to design new strategies and seize investment opportunities elsewhere by focusing on cleaner power generation, customer retention, networks and services. However, the journey is not without risks. With the sector getting more digital, the risk is that new entrants such as Google and Apple will start proposing power management solutions. As investors, we need to know how the electric utilities will deal with this tectonic shift in their industry, how they will address the huge risks and how they plan to profit from the opportunities that arise. This will allow us to pick the winners of this transformation.

Our assessment of the sector translated into the following four engagement objectives:
 
Proactive environmental strategy
We believe companies should have a proactive environmental strategy to position themselves for future changes such as rising carbon prices. Thus we expect electric utilities to have a clear de-carbonization strategy (i.e. from coal to gas to renewables) reflected by decreasing carbon intensity and to have a plan of how to deal with a future carbon price reflecting the reality of the emissions’ impact (about 30-40€/t). We acknowledge that traditional generation will continue to play a role in the energy mix for some years to come; however, we expect electric utilities to shut down aged and less efficient coal-fired power plants.

Operational excellence in thermal generation
Traditional thermal generation from sources such as coal and gas will continue to play a role because it helps to mitigate the increasing volatility related to the integration of more and more renewables into the grid. That is why we expect electric utilities to strive for operational excellence at their thermal generation assets. This includes having quantified thermal efficiency targets, upgrading coal-fired power plants to higher thermal efficiency, creating cleaner plants and sourcing coal responsibly.

Focus on business model innovation
The rise of distributed generation presents a significant challenge to the current business models of electric utilities. It has the potential to substantially disrupt the ability of electric utilities to generate revenues. Therefore, we expect electric utilities to adjust their business models by diversifying their revenues e.g. via energy services, and find ways to monetize their huge retail customer base and capitalize on digitalization (e.g. Smart Home). In addition we believe investments in grid efficiency and flexibility, targeted strategic acquisitions and green marketing and product development are suitable strategic choices.

Public policy
We expect electric utilities to be transparent on their lobbying activities on the national and EU level and on their positions on relevant environmental legislation (i.e. fixing the ETS, or carbon tax). This includes ensuring consistency between the companies’ views on climate change and those which are advocated for on their behalf by their representative trade association(s). This transparency allows investors to see if the utilities are indeed embracing the changes or trying to hold on to the status quo.

In the first quarter of 2015, Robeco commissioned a research report by the utilities team of French broker Exane BNP Paribas. Based on our outline of the issue and definition of engagement objectives, the report analyzed a large number of key performance indicators such as capital expenditure, R&D spending and thermal efficiency across the peer group. Complemented with an in-house report on the public policy activities of the utilities this data set forms the basis for our engagement. Over the next three years we will engage with the following companies on the four engagement objectives above for the utilities sector: Centrica, Drax, E.ON, Electricite de France (EDF), Enel, Energias de Portugal (EDP), Fortum, Gas Natural Fenosa, Engie (GDF Suez), Iberdrola, RWE and Scottish and Southern Energy (SSE). In June we kicked off the engagement with formal letters to the 12 companies, in these letters we outlined our expectations and invited them to start a dialogue.


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