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30/06/2014

Energy utilities: a changing portfolio

A lot has already been written about the increasingly challenging and competitive environment in which EU utilities are currently operating. The latest activities undertaken by major EU energy players, and Dutch ones in specific, triggered Sia Partners to make an impact-analysis of this behavior on their portfolios. This article aims to provide an overview of how EU power majors adjusted their strategies, and how their portfolios have been transformed as a consequence of their strategic moves.

The conundrum

To cut a long story short, the investment climate for the energy sector has been troubled by an increasing concern for energy security, its environmental impact and the economic crisis. Heavy investments in production capacity have been made years ago in order to be prepared for a rising energy demand. However a stagnating growth of consumption, mainly due to the financial crisis of 2009, resulted in the underutilization of existing power plants. In parallel, governments have been pushing for green energy which resulted in a subsidized- growth of Renewable Energy Sources (RES) - especially in Germany. A new mix of base load production coverage appears pushing the existing base load plants out of the merit order. Furthermore, the gas-fired power plants, of which we have many in the Netherlands, have been challenged by the flow of cheap coal from the US as is explained in our earlier article 'Future of coal'. It causes a situation of overcapacity in the Netherlands which is expected to maintain till at least 2016. Also it increases the competition between utilities with margins already under pressure. These low margins in combination with large write offs on the existing underutilized production assets led to a dramatic 59% devaluation of their net worth for utilities since 2008 (Financieel Dagblad, 06-2014). As a consequence there is little room to manoeuver in order to create a more future proof production portfolio.

External drivers influencing production portfolios

The production portfolios of utilities have always been influenced by governments and national energy policies. Their policies center around three pillars. First of all, the economic advantage, where cost effectiveness and competiveness is a key driver as governments strive to facilitate a favorable establishment climate for companies - and energy intensive industries in specific. Secondly, security of supply plays an important role in shaping national and pan-European energy policies, and will have a direct impact on utilities' portfolios. The Ukrainian-Russian situation illustrates this dependency on energy sources. European political leaders wish to decrease this dependency for obvious reasons. Lastly, minimizing the environmental impacts, of GHG emissions and of nuclear exposure which improves the consumer safety, is high on the political agenda. Next to the regulatory drivers consumer dynamics such as the rise of prosumers and of decentralized small-scale production facilities are changing the production paradigm and are responsible for the changing portfolios as well.

A winning strategy?

The above mentioned elements describe a situation in which energy utilities have been forced to adapt to new market conditions and to adjust their strategies. To deal with these elements an analysis of past performance is essential.

During this analysis we have identified some similarities in the behavior of utilities in order to come up with a winning strategy. The resemblance is that utilities reacted in a two-step approach:

  • First action has been to take cost cutting measures through contract renegotiations (mainly gas contracts) in order to survive the market disruptions.
  • A second step has been to consolidate long term streams of income and redefine market positioning in three ways:

1) They enhance their presence along the entire energy value chain, with the launch and offer of innovative energy services and non-power generation activities;

2) They expand their horizons by generating revenues in growing markets (the US, Asia and Middle East) and non-energy related products such as insurance;

3) They increase their investments in (subsidized) RES projects in and outside the EU. In the Netherlands we have seen utilities diversifying their electricity generation mix in order to stay competitive by adding more renewables in their production portfolio as did recently DELTA with the Gemini offshore wind park, or as Vattenfall did last year with the onshore Zuidlob wind farm.

Current production portfolios

The production portfolio of utilities can be seen at the core of the classical utilities business model and will determine the extent to which an energy company is exposed and impacted by mentioned external changes. Those portfolios are the result of historical developments given the long investment cycles associated with funding the very capital intensive power plants. As a consequence, the impacts of changes are not always directly visible. The impact is portrayed in figure 1 which shows that utilities are focusing on a limited set of power generation technologies with one or two core production technologies representing more than half of the total installed capacity. Lastly the technological developments have played a great role in shaping utilities' portfolios, especially when it comes to the development of RES. Within renewables hydropower is by far the most utilized source and utilities are now developing other renewable energy sources - focusing on centralized production units - with wind power being the fastest growing one.

Figure 1 - Relative evolution of production portfolios of EU utilities between 2012 and 2013
(source: annual reports and corporate websites)

Looking ahead

Five years after the financial crisis of 2009, no sign of relief has been noticed and its impact turned into a lasting one. Utilities have taken measures meanwhile. First of all they become more focused. Secondly they structurally reorganized their non-core functions by means of operational excellence programs. Also they, entered into a long-term strategic re-orientation process and chose to diversify their portfolios outside the EU, and outside the power generation business. This in order to become less dependent on pertinent developments like the declining demand driven by energy efficiency, the increased share of RES, and also a negative economic outlook. Building a future proof portfolio is the next step however, even if the utilities wish to successfully implement these strategies there is only limited funds available for investments. Mothballing plants and the potential selling of parts of the portfolio is an obvious step, whereas clever partnerships could provide the short term edge.

The challenge for any utility with its production mix remains to balance the major investments in conventional generation (coal- and gas-fired power plants) with the existing investments in wind/solar and the future investments in Power-to-Gas (P2G), energy storage, Power-to-Hydrogen (P2H) and decentralized generation. Subsidized RES projects have the only publicly accepted viable business case at the moment. However, being heavily dependent on the availability of subsidies makes them a hardly 'sustainable' investment while government budgets have been cut down and integration costs of RES are rising. A key success factor for consolidating incomes in the long-run will be to align corporate and government interests. The corporate interests have to be aligned with a holistic approach where decisions related to production involving multiple business units are made taking the position/interest of the total group into account. This way the portfolio structure is supported throughout the organization and ensures a long term sustainable position. Let us be aware that when the economic downturn will start to disappear, the net demand for power may increase again, despite increased execution of energy efficiency measures.

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