The fundamentals associated with the energy value chain are rapidly changing and driving a very different dynamic in the investment world. Value is migrating from the wholesale market to capacity and flexibility markets, the importance of the methodologies and stability of network charging methodologies are growing, and long term support frameworks are uncertain.
We are now in a world where around 25% of the UK's generation capacity is renewable (excluding nuclear).
This renewable capacity has created a 'physics' challenge for the system operator- who's role in balancing supply and demand has suddenly got a lot harder, requiring a rapid growth in their demand for flexibility (whether turn up or turn down).
Technology costs are falling far faster than anyone anticipated with batteries, wind and solar all approaching theoretical subsidy free levels.
Small scale rapid deployment of renewables has become the norm, with almost no large scale new generation being built (albeit the lives of many existing plants being extended thanks to the capacity market).
The energy market is an unpredictable but exciting place to be.
With a move away from traditional utility models, a more traditional investor profile prevails ie one which needs to have reasonable visibility of long term earnings in order to make an upfront investment. The willingness to take merchant risk is understandably low, and with uncertainty around both wholesale prices and cost allocation methodologies, it is hard to create bankable investments- despite there being a strong appetite to invest and apparently plenty of capital available.
Naturally, when the fundamentals are the same, the response is the same- follow the money.
Therefore we are seeing, two main areas where projects are successfully getting away today.
Firstly, behind the meter generation is booming- whereby 'net' demand or supply is exposed to the market- rather than a one sided bet. This is a sensible approach to insulate investors from regulated cost uncertainty, and by linking supply and demand, creased an increased natural hedge against wholesale price movements.
The second boom area, is in storage, which, with the drop in technology costs, can deliver economic investment models with support from both the capacity market and contracts direct from National Grid, such as Enhanced Frequency Response.
Both boom areas are legitimate and rational responses to current market conditions.
House of Cards?
As we've seen with solar PV, embedded benefits and wind, when a good thing is perceived as getting too good, the response from policy makers and the regulator can bring a rapidly moving juggernaut to a rapid halt. Whatever the means for knocking away the legs of support, the effects on investors and associated business models have an overnight impact.
The danger is that the current darlings will meet a similar fate, albeit perhaps in a different way. Behind the meter generation, taken to its logical extension, results in a fewer number of consumers and generators having to absorb the total costs of the network with resulting price rises. An unsustainable situation, that will ultimately have to be resolved.
Likewise the need for contracted flexibility from the system operator is finite. With the volume of projects and capacity now in the pipeline, it is easy to foresee an oversupplied market in the not too distant future- particularly if the growth of onshore wind and solar continues to be cauterised by the lack of any support mechanism.
Where next for investors?
There is an argument for just carrying on in the continual 'lurching' market, whereby those who get in whilst times are good do well and those who miss the boat have to reinvent themselves. Reinvention and agility in investment strategies is now almost a pre-requisite to be successful in this rapidly moving, roller coaster, energy market, and following the money is a good strategy for those who can change direction quickly.
The other place to look is in the creation of a more sustainable strategy- which as ever was, harks back to vertical integration. In this model, albeit more complex, a self balance of supply and demand enables a natural hedge against price and cost movements. The difference in today's market, is that in a world of decentralised energy, the ability to balance local supply and demand at whatever scale makes a lot of sense as the model of the future. Small scale vertical integration can supply local businesses and residents with cost efficient renewable power and perhaps electric transport, support the success of the Distribution System Operator model through the provision of flexibility all whilst supporting the growth of value and employment in the local economy. The model is possible today and the runes point to where investor value will sit in the future.
Probably a ‘both’ rather than an ‘either/or’ future- but one characterised by continual change and opportunity.