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Optimising equity investment in a reformed power sector
The GB power sector is currently undergoing a period of major change. The need to make investments in low carbon generation capacity and in other carbon abatement actions to meet legally binding targets, combined with the need to maintain security of supply during this transition, means that there is a requirement for significant sums of new capital to fund this investment. In recognition of this requirement, a programme of reform is currently underway, at the heart of which is Electricity Market Reform (EMR). These reforms are aiming to de-risk investment and bring greater certainty and transparency to different earnings streams for generators. For new investors, with less appetite to manage risk than the traditional utility, this helps to enable the structuring of transactions to deploy capital into low risk structures. This will increase the diversity of the sources of capital being invested in the sector, and increasingly lead to fragmented ownership across the value chain. In turn, the increasing diversity in sources of capital could lead to innovative capital allocation strategies being adopted for power generation investment, and a diverse range of organisations considering entry to the sector with energy supply and energy service propositions. This leads to opportunities for the traditional utilities to focus on core areas of expertise, rather than on the deployment of funds into capital intensive activities at a time when their balance sheets are constrained.
Setting the scene The GB power sector is currently undergoing its most significant period of reform for many years. At the heart of this is the Government’s Electricity Market Reform (EMR) programme, but there are many other areas of reform, across the value chain. When the Government first launched EMR a fundamental part of the opening ‘problem statement’ was that meeting policy targets would require
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“increased investment by existing market participants and, in addition, seeking investment from new sources of capital”. Attracting new sources of capital into the sector and increasing the potential for projects to hold debt, in particular for investments in low carbon generation, was therefore seen to be an objective of EMR. The reforms being introduced increase the transparency over the risk allocation between different earnings
Viewpoint – Optimising equity investment in a reformed power sector
streams for generation assets. This is the case, for example, both with the Contracts for Difference being introduced for low carbon generators, and the Capacity Market. With these reforms now being implemented, this Viewpoint examines what the reforms will actually mean for the deployment of capital. We look at the opportunities, both for new investors and for incumbent utilities.
Figure 1 : Role of equity investors across the project lifecycle
Project development
Construction
Early operation
Mature operation
Utilities Portfolio generators Project developers Infrastructure funds Private equity Pension funds
Funding constraint
Requirements of new investors The regulations to deliver policy objectives have become increasingly clear as the reform programme approaches full implementation. As outstanding questions are resolved, new areas of uncertainty emerge (not least the referral of the large Vertically Integrated Utilities (VIUs) to the Competition and Markets Authority (CMA)), but despite this challenging regulatory environment there has been an uptick in interest levels from an increasingly diverse range of investors. This has included financial investors (for example, private equity, infrastructure funds, and pension funds) and non-European utilities and conglomerates.
Issued 2014
Where these investors are new to the sector they have a number of requirements: they need to build up their understanding of the GB market and, in many cases, of the principles underpinning liberalised energy markets in general. Some investors might be looking to then apply this knowledge elsewhere in Europe or in their home markets as they undergo reform programmes of their own they need clarity on the allocation of risk and reward between different parties. This means that clarity and detail on policy changes is critical once the risks are identified and understood, many new investors are looking to limit the level of risk to equity returns. This is leading to innovation in the structuring of deals, with project contracts reallocating risks that the investor is uncomfortable with, for example to a utility also investing in the project.
Figure 1 illustrates the role of different types of equity investor across the project lifecycle, from early project development on the left through to mature, proven operation on the right. Typically, over the past decade VIUs have played a dominant role in providing capital for generation projects right across this lifecycle. While there have been exceptions, often the same investors have been involved in developing an asset and then subsequently holding that asset through its operational life. Market reforms have focused on helping to mitigate risks for operational assets, rather than risks for assets under development or construction. Therefore, the new investors interested in entering the sector are generally focused on providing equity to operational assets, on the right of this figure, where debt gearing levels can also generally be increased through refinancing. Some new investors, such as non-European utilities,
Viewpoint – Optimising equity investment in a reformed power sector
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C hallenges faced by incumbent utilities At the same time as a range of new investors are looking to increase their role across the sector, there are a number of factors constraining the deployment of capital by the VIUs:
might increase their exposure to development and construction risk as they gain experience in the market, while other investors, such as pension funds, are likely to remain focused on operational assets. The perceived risk that new investors identify in construction finance results in a constraint in the provision of equity to projects under development or under construction. To generalise, the risks involved in these investments require skills to manage, whereas the risks involved in operational assets can often be managed effectively through contracts. For renewables projects in particular, pure project developers are playing an increasing role in developing projects, then selling these projects to recycle capital into the next project. This leads to a stream of acquisition opportunities for market participants, which VIUs are unable to capitalise on in light of their constrained balance sheets. The premium that some investor classes are prepared to pay for well-structured deals drives further divestment helping to perpetuate this cycle.
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although the VIUs may also benefit from subsidies across their own renewables portfolios, the increasing volume of renewables generation is putting downward pressure on spark spreads. This is leading to poor economics for gas-fired power generation and reducing the earnings of the large European utilities. The poor performance of these plants has led to large write-downs at many of these businesses (€5bn at RWE; €15bn at GDF Suez) adverse policy decisions are also affecting many of the VIUs in their home markets. RWE and EON are affected by the German phaseout of nuclear, and Iberdrola is affected both by uncertainty over remuneration for renewables in Spain and over the Spanish tariff deficit during the previous decade many of the utilities went on acquisition sprees that were largely financed with debt. For example, RWE expanded rapidly into Eastern Europe, while EDF bought a significant stake in Constellation in the US. If we take the latter example, EDF has suffered writedowns of €2bn on Constellation in recent years.
Viewpoint – Optimising equity investment in a reformed power sector
The VIUs’ reduced capacity to service the debt built up during the last decade means that many are looking to divest non-core assets. However, it is not always obvious what is ‘core’. Raising debt to make significant investments in new power generation capacity, for example, is therefore not an option. Raising new equity is also challenging, given the poor recent performance of utility stocks. It appears, therefore, that VIUs may contribute less equity to generation projects going forward. Recently, non-utility players have been more important in providing the capital required to invest in generation assets. The following are examples of recent investor activity that is indicative of the greater variety in the approaches being used by non-utility investors in the sector: the increasing role of infrastructure funds and pension funds has been demonstrated through extensive activity in the sector; for example through MEAG’s purchase of ESBI’s stake in Marchwood Power, and by EDF’s sale of a majority stake in the Fallago Rig onshore wind farm to Hermes GPE the development of listed funds for operating generation assets, for example, The Renewables Infrastructure Group (TRIG), set up by InfraRed Capital the IPO of Infinis, a renewables generation company, in November 2013.
The implications for deal structures What impact will this shake-up have on the deployment of capital in the sector? Example A in Figure 2 is indicative of the status quo, with VIUs dominating the provision of equity into generation projects. There are many other participants in this market, but they have generally been dependent on long-term contracting with the trading business of one of the VIUs. As new investors have started to take equity stakes in generation projects, we have seen an increasingly innovative approach to structuring deals, as shown in Example B. The structures
put in place have generally provided contractual protection to new financial investors where they are uncomfortable with specific risks. Market risks have been transferred through Power Purchase Agreements (PPAs), technology risks through Operations & Maintenance (O&M) agreements, and even yield risk has been transferred through shareholder agreements. Earnings streams are disaggregated such that each risk is allocated to the partner best placed to manage that risk. These more complex deal structures require careful consideration of the accounting and taxation implications of reallocating risk and control for each party.
As these new investors increase in confidence and in their understanding of the market, we expect some of the highly tailored contractual structures currently being used to fall away. These investors may take on some additional exposure to risks as they increase their understanding of the market. However, they will continue to need first call on equity in the case of a more extreme downside. This might lead to them investing through a preferred tranche of equity, as shown in Example C. Over the next decade, this could evolve into a structure radically different from today’s market, as shown in Example D, where there is yet more disaggregation of earnings streams.
Figure 2: Example deal structures
Example A
Example B
G T
Other market participants
Project finance into generator or FI’s stake
Example C
S
Key
G T
Commodities trader
Example D
U
Utility
FI
Financial investor Ownership
S
Issued 2014
Energy flows Supplier
FI
U G
Contracts or transfer pricing
Gov
PPA
FI
U
Preferred equity or mezzanine debt
VIU
Generator
Supplementary agreements to allocate risk between parties
FI
Some protection against selected market risks
G
Government-like counterparty or revenues underwritten by consumers Portfolio generator
G
G
S
T O&M
May be the ‘rump’ of a VIU or an independent supplier, commodities trader, and O&M provider
Viewpoint – Optimising equity investment in a reformed power sector
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Figure 3: VIU activities
Asset ownership
Many of the reforms being put forward by Government, in particular through EMR, lead to generator cash flows being pseudo-regulated and at least a portion of revenues being underwritten by consumers. The residual risk for investors in generation to manage will be much reduced. This might, over time, mean that more financial investors build generation portfolios of their own, following the examples that are already established in the market. This then leads to a new set of opportunities for today’s VIUs. Over the past 10 years, the VIUs have taken on a wide range of activities, encompassing the provision of capital and subsequent operation of generation assets, but also running a retail business and defining customer propositions to take to market. In the schematic shown in Figure 3 we now expect the activities within the blue circle, where residual risks can mostly be managed contractually, to increasingly be owned
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Customers
by market participants other than the large VIUs. VIUs will then need to select the activities where their skills can be best applied: where should they focus and excel? Answers might include: customer propositions in retail, O&M of generation assets, or project development, for example. Such strategies are already being deployed and can be seen in EON’s “less capital, more value” strategy. For example, in a recent divestment of an offshore wind asset, EON realised approximately €470m from the sale
Viewpoint – Optimising equity investment in a reformed power sector
Operations and maintenance
Capital
of the wind farm but retained the O&M contract and the offtake for the next ten years. In this structure, the investor can deploy capital relatively easily, without having to develop significant operational capabilities; EON crystallises the value of the asset, but retains an enduring P&L value through the O&M contract.
Conclusions In responding to the significant regulatory changes taking place in the market, all market participants need to be clear on their risk appetite and return expectations. New entrant investors need to first ensure they have a good understanding of the residual risk that remains in a new generation investment. Combining this with a clear definition of their risk appetite, they can derive a set of deal selection criteria to be able to select the most suitable opportunities in the market. The VIUs need to revisit their business case for being vertically integrated: does this business case still stack up for shareholders in light of the plethora of reforms? Understanding this is imperative in light of their referral to the CMA. If they determine that the business case does still hold, they need a strategy for raising finance to maintain their generation market share - not a straightforward ‘ask’ in light of the financing challenges highlighted earlier. Conversely, if the business case does not still hold, the VIUs then need to determine what their ‘core’ business will be going forward and ask: what should we be excelling at? VIUs will need to manage their shareholders’ expectations through this period of change. Shareholder cash flows would be affected by any need to raise equity (which may dilute existing shareholders) or any return of funds, which might result from any divestment of generation assets. The equity beta of a VIU stock might also change as the composition of a VIU business evolves. This will require careful, but clear, communications with the market, to ensure that stocks do not underperform simply as a result of mis-matched expectations. In summary, there is the potential for significant changes in the financing structures used for power generation assets as a result of the reforms currently being implemented by Government and the Regulator. These changes will affect all market participants and investors in the sector. This change will drive a need for all market participants to be absolutely clear on their strategic ambitions so that they are then able to deploy capital in line with those ambitions.
Issued 2014
Viewpoint – Optimising equity investment in a reformed power sector
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For more information please contact: energy_advisory@baringa.com +44 (0)203 327 4220
About Baringa Baringa Partners LLP is an award-winning management consultancy that specialises in the energy, financial services and utilities markets in the UK and continental Europe. It partners with organisations when they are developing and delivering key elements of their business strategy, as well as working extensively with government and regulators to provide policy and advisory services. Baringa works with its clients either to implement new or optimise existing business capabilities that relate to their people, processes and technology. Baringa is recognised both in the UK and internationally for its unique culture, which has been acknowledged by a number of awards and accolades and continues to reaffirm Baringa’s status as a leading people-centred organisation.
Baringa Partners LLP, Dominican Court, 17 Hatfields, London SE1 8DJ T +44 (0)203 327 4220 F +44 (0)203 327 4221 W www.baringa.com E info@baringa.com Š Copyright Baringa Partners LLP 2014. All rights reserved. This document is subject to contract and contains confidential and proprietary information.