Co-Founder and Chair of 38 North Solutions
Clearway Energy announced today that it will significantly reduce its quarterly dividend “to proactively maintain balance sheet and capital allocation flexibility during this period of uncertainty with one of Clearway’s largest customers.”
The customer in question is PG&E, which declared bankruptcy on January 29. The uncertainty is regarding the status of its long-term power purchase agreement (PPA) contracts. PG&E’s bankruptcy filing automatically triggered default, and the long-term fate of those contracts is an open question. Jarring events like bankruptcy happen from time to time in every industry, but today’s news underscores the risk sometimes associated with concentrated investments.
While the ultimate financial impact of PG&E’s bankruptcy on Clearway Energy and other PPA counterparties—if it impacts those companies at all—will not be known for some time, the magnitude of exposure to risk here is clear. At CleanCapital, a highly diversified acquisition strategy is our way of ensuring that we’re insulated from all types of “event risk”. We own and manage a broad spectrum of small-scale solar projects representing a wide range of geographies, a multitude of off-takers, and various types of contracted revenue. This diversification gives debt and equity providers comfort that the negative impact of any solitary issue will be limited and contained.
Diversification is a tactic designed to minimize risk and optimize returns; investing in distributed assets is one strategy to achieve that objective in renewable energy markets. I guess we’re putting a slight twist on the old adage: ”Don’t put all your electrons in one basket.”
For more insight on how PG&E’s bankruptcy is changing the energy investment landscape, read Four Challenges that will Shape Electric Utilities this Decade from Derek Daly, Director of Investments & Capital Markets for CleanCapital.
CEO of the Leonardo DiCaprio Foundation
Derek Daly is Director of Investments & Capital Markets for CleanCapital.
Electric utilities, traditionally known as defensive investments with below average market volatility, are dealing with several new challenges that not only add risk and uncertainty to the sector, but will dramatically change their business model over the next decade.
As shown below, for the past 20 years, total returns from utility companies in the S&P 500 have exceeded those of the entire S&P 500 for all periods except the 10-year mark. Despite rapid growth in the technology sector, driven by titans such as Apple, Amazon, Alphabet, Microsoft, and Facebook, utilities have dominated the index based on total returns.
Today, utilities continue to maintain their reputation for reduced risk. Leading investors and publications have reported about the “stability that comes from a highly regulated industry,” that “utilities are among the lowest-risk securities available,” and are “companies offering an essential service on an exclusive basis”.
While historically valid, supportive statements like these ignore or significantly underplay four major challenges electric utilities are facing today.
1. Declining Energy Consumption
This divergence of energy use from population and economic growth reflects improvements in both energy efficiency and productivity. The ratio of GDP to energy consumed grew 17% over the last decade, a major shift for an industry founded on the assumption of ever-rising energy demand.
2. Expense of Repairing and Replacing Infrastructure
Even as energy consumption declines, a record amount of new capital has been earmarked to replace aging equipment, improve reliability, and deliver renewable generation. In 2017, Bloomberg New Energy Finance reported that investor-owned utilities and independent transmission developers increased investment to an estimated $22.9B. This is 10% more than 2016 levels and 91% over 2011.
Josh D. Rhodes with the University of Texas estimates the average age of power lines and transformers is 28 years old and the average age of generation assets is 30 years old. The cost of replacing these assets is $4.8 Trillion. To put that into perspective, using non-inflation adjusted numbers, if electric utilities continued pace with 2016 spending, it would take just under 231 years to complete.
3. Mounting Costs & Liabilities from Climate-Related Disasters
PG&E filing for chapter 11 is being called the first climate change related bankruptcy, with recent announcements coming as a shock to many in the energy and investment communities. The company faces enormous potential liabilities from accusations that safety lapses and inadequate maintenance caused a string of disasters in California. While Cal Fire reported last Thursday that a private electricity system was to blame for the 2017 Tubbs Fire, investigations of at least a dozen other fires in 2017 and the Camp Fire in 2018, are still ongoing.
The risk of property damage and personal injury or death from fires tied to utility equipment has been exacerbated by prolonged droughts fed by climate change. While the company asserts that it has increased efforts in recent years to maintain equipment and perform preventative action, especially tree trimming and brush removal in areas that are at high risk for fires, the company has also repeatedly been cited by state auditors for completing work behind schedule.
PG&E’s situation, while extreme, is not unique. For example, in 2012, Hurricane Sandy cost New Jersey utilities $1.8 billion in repair and response costs. As climate change continues to impact the environment, utilities will be forced to react to a world in which extreme weather is the new normal: a costly proposition.
4. Rapid Growth of Distributed Energy Resources
GTM Research in a 2018 report highlighted the “explosive growth” of distributed energy resources and the specific technologies behind the disruption: distributed solar, energy storage, smart thermostats, electric vehicles, and small-scale combined heat and power (below 50 MW). In 2017, these five classes contributed 46.4 GW to the U.S. summer peak, or about 6%, researchers noted. GTM anticipates this will more than double by 2023, to 104.2 GW of flexible capacity.
As the trade journal Transmission & Distribution World describes: “The century-old, one-way electricity delivery model that has been serving the utility industry traditionally, is proving to be inadequate to support the rising demand and diverse energy options being explored by today’s consumers.”
Time for U.S. Utilities to Transform
Together, these four challenges have compounded to drive energy prices higher. Over the last decade, some states experienced increases as high as 40% in both residential and commercial prices. Additionally, these rates are likely low given this past decade’s commodity prices.
From an investor’s perspective, this is a sector that is facing unprecedented challenges. How does a utility forecast climate-related disasters, especially in states like California with such strict liability laws? Can we simply pass these costs onto the customer rate base? If so, how do we think about the substantial growth of cheaper alternatives coming in the form of distributed resources? If “utilities in general are as safe if not safer than they’ve ever been”, investors need to ensure these challenges are being addressed through diligent resource planning and creative solutions that don’t immediately seek to pass costs on to the consumer.