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Investors have traditionally allocated capital to the power sector for its stability in returns. Reliable and affordable electricity is fundamental to an economy’s well-being, indicating dependable demand drivers for power generation, transmission and distribution investments. As such, relatively foreseeable risk-adjusted returns define the sector, and are an attractive characteristic for long-term oriented investors such as pension funds. While the pre-requisite of reliable electricity for an economy’s health will not change, developed countries around the world are seeing a drastic decoupling of electricity consumption from economic growth – which severely impacts the risk profile of investments in the power sector.
Economic growth no longer requires an increase in energy or electricity consumption in many regions around the world. In fact, economies can grow while electricity consumption remains flat or even falls. To investors in the power sector – whether those investing in regulated utilities, independent power producers, or directly in infrastructure – this decoupling results in rapidly shifting risk profiles of investments, especially over long time horizons. Investors must, therefore, increasingly consider the drivers behind this decoupling – many of which are sustainability issues.
Specifically, investors must assess the impacts of energy efficiency, the largest driver of the declining correlation between electricity consumption and economic growth. Failure to account for the impacts of energy efficiency on investments in the power sector may result in misallocations of capital, excess risks, and poor visibility into returns. The historical investment frameworks used in the power sector must change to account for the impacts of energy efficiency on electricity demand.
Global Decoupling of Economic Growth and Energy Consumption
Between 1990 and 2015, the GDP of the United States grew by 83% while energy consumption increased by only 17%, according to Bloomberg New Energy Finance. In considering electricity demand, we see that annualised electricity demand growth was as high as 5.9% from 1950 to 1990 before falling to 1.9% from 1990 to 2007, and then eventually to zero since 2007. Meanwhile the U.S. economy grew more than 10% since 2007 – and while electricity consumption has been flat, energy consumption has decreased 2.4%.
A portion of the changing nature of this “energy productivity ratio” can be attributed to structural changes in the U.S. economy, including sectoral shifts to less energy intensive services-related industries. However, gains in energy efficiency drive the majority of the impact. The American Council for an Energy-Efficiency Economy estimates that 60% of the gains in energy intensity between 1980 and 2014 were a result of energy efficiency improvements.
This changing relationship is even more dramatic in other developed countries. In fact, the World Resources Institute identified 21 countries that reduced GHG emissions since 2000 while significantly growing GDP. The United Kingdom, for example, cut GHG emissions by 20% during this period while the economy grew by 27%. While GHG emissions are distinct from energy consumption, the power sector serves as the largest emitter of GHG emissions. Thus, reductions in GHG intensity are primarily driven by increasing energy intensity (i.e., energy efficiency gains) and renewable energy’s displacement of fossil fuels (or at least the substitution of relatively cleaner energy such as natural gas).
Sources and Impacts of Energy Efficiency
Technology and public policy largely drive energy efficiency gains. Technological advancements afford opportunities to increase energy efficiency in economically attractive investments. For example, LED lights, called “one of the fastest technology shifts in human history” by Goldman Sachs, are expected to grow to 95% market share by 2025, up from virtually nothing in 2010. With LEDs consuming 85% less electricity than incandescent lighting, and lighting overall consuming 15-20% of global power demand, the impacts for electricity demand are profound.Secondly, policy makers around the world have driven energy efficiency increases via energy efficiency standards and utility-level policies.
While energy efficiency standards drive efficiency directly, many policy makers have looked to utilities themselves to create more pressure around achieving efficiency gains.
As a result, policy makes are increasingly tasking utilities around the world with the added responsibility of energy efficiency. Policy tools available to regulators are abundant and wide-ranging. Examples include decoupling utility revenues from electricity sales, requiring the implementation of cost-effective efficiency measures prior to power plant additions, requiring or incentivizing reductions in end-user consumption, and even policies enabling the utility-financing of efficiency-related capital investments at the consumer level.
These policies and countless others already impact investors in this space, with effects expected to increase over time. Investors must assess how future changes in electricity demand – whether driven by technology, public policy, or utility-level policies – will impact the value of investments in regulated utilities, independent power producers, and direct infrastructure investments.
Regulated utilities, for example, span a wide spectrum in terms of how their business model is positioned to succeed in this environment of flat-to-declining electricity consumption. Many remain attached to volumetric sales rate mechanisms. Others are pushing forward with electric utility transformation based on an electricity services-oriented business model, as opposed to serving as an electricity vendor. Such a services-oriented model may offer growth opportunities through efficiency investments that are added to the rate base. While a volumetric sales model may offer upside in a rising energy consumption environment, it exposes equity and debt investors to significant risk exposure when such drastic gains take place in an energy efficiency environment, not to mention the current and expected future impacts of distributed energy resources (e.g., rooftop solar) and energy storage.
Investors must analyze management strategy related to efficiency, including the rate structures and incentives that can enable a company to add value in this environment. Such variations in business model that pertain to how well sustainability drivers have been incorporated will increasingly determine financial risks and returns of investments.
Corporate Disclosures Confirm Value Impacts
An analysis of corporate disclosures confirms the importance of end-user efficiency in the industry: a review of the prevalence of the term “energy efficiency” in disclosures yields striking results. In 1995, this term appeared in the 10-K or annual report of only two publicly traded utilities. By 2005, this increased to 32 utilities, and by 2015, it more than doubled again to 70 utilities (only a small portion of this increase can be attributed to the growth in the number of publicly traded utilities). Disclosures often address energy efficiency in the context of key risk factors, discussion of operating performance, and results in management discussion and analysis, as well as revisions to rate structures, which ultimately determine financial performance.
According to an analysis by SASB, 100% of leading U.S.-listed electric utilities provide 10-K disclosures on the overall topic of energy efficiency. A heartening 70% of such disclosures include metrics. However, investors need more standardized and decision-useful information to analyze how utilities are weathering this industry transformation. In fact, the leading utilities use well over 20 different types and forms of metrics in order to communicate performance on this issue to investors. The message is clear: the market needs standardized disclosures on the vitally important topic of energy efficiency. Without effective information, investors run the risk of failing to account for the impact of energy efficiency on the power sector.
Bryan Esterly is the Infrastructure sector analyst for the Sustainability Accounting Standards Board (SASB).