New trends shaping the 2016 market
Two investment bankers, a consultant and a market analyst had a wide-ranging discussion at the Infocast power & money conference in New Orleans in January about new trends that are shaping the US power market and what type of year they expect in terms of deal flow.
The panelists are Ted Brandt, CEO of Marathon Capital, Peter Kelly-Detwiler, a principal with consultancy Northbridge Energy Partners, Andy Redinger, managing director and group head of utilities and alternative energy at KeyBanc Capital Markets, and William Nelson, director of analysis, North America, for Bloomberg New Energy Finance. The moderator is Keith Martin with Chadbourne in Washington.
MR. MARTIN: Ted Brandt, what are the new trends this year in the market?
MR. BRANDT: The Christmas or Hanukkah present that we all got when Congress extended the renewable energy tax credits on December 18 is probably the most significant event for many of us. My phone started ringing after that. Renewable energy developers believe their companies are more valuable now. They have moved away from wanting a liquidity event and are starting to focus on raising new capital. The new question among developers is how to scale up to take advantage of this new period of certainty.
MR. MARTIN: Peter Kelly-Detwiler, Ted says the new trend is renewable energy developers are refocused on growth. Are there other new trends?
MR. KELLY-DETWILER: I think the trend this year is the same as last year, which is the continuing spread of distributed energy. Solar obviously remains big. Storage is starting to creep out of the den. We will see the infusion of IT into everything. Use of distributed energy equipment will be much more interactive with the grid. We are just starting to see innovation because of high-performance computing. The ability of computers to perform tasks will increase a thousand times and open up new vistas.
MR. MARTIN: So it will be distributed energy on steroids with the help of high-performance computing. Andy Redinger?
MR. REDINGER: Community solar will continue to grow in appeal. More states will pass legislation to permit it; there are probably a dozen today. I agree with Ted Brandt: another trend this year will be raising capital. Interestingly, at the same time developers will be out searching for equity to grow, debt to finance their projects is becoming more expensive. And the market will figure out how to finance commercial and industrial solar projects at greater scale.
MR. MARTIN: So community solar and C&I solar will get traction and everybody will be raising capital. Will Nelson, other new trends?
MR. NELSON: Low gas prices seem here to stay. We entered last year, after two abnormally cold winters that masked the oversupply in the natural gas market, with the question whether gas would be above or below $4. As we start 2016, the question is whether gas will be above or below $2. This makes for a very different power market.
The next trend is greater certainty for the renewable energy market. The tax credits have been extended for multiple years. State targets have been set under the Clean Power Plan for carbon emissions reductions. It remains to be seen how the plan will be implemented, but the trend is toward greater certainty.
It seems like we have greater certainty than normal on the wholesale side with volatility on the retail side. Virtually at the same time that Congress extended the renewable energy tax credits, there were significant rulings in California and Nevada about net metering, with California deciding largely to preserve its existing net metering program and Nevada coming down on the other side. The battles are just starting around retail rate structures.
MR. MARTIN: Starting again with Ted Brandt, what do you think will be the deal flow this year? What types of deals do you think will dominate?
MR. BRANDT: The renewable energy sector will be not be as frantic to close deals this year as it would have been had the solar tax credits expired at year end. We were in a 2016-or-bust market, so the behavior of most developers, with maybe one or two exceptions, was not to spend a lot of development capital on things that were going to happen past the cliff.
As a consequence, development pipelines are pretty shallow today, so we should see a lot of new development and lots of people looking for new power purchase agreements. I expect most of that stuff to start hitting the market in 2017.
MR. MARTIN: Andy Redinger?
MR. REDINGER: Our pipeline is as strong as it has ever been, but we are looking ahead only as long as six months. We think the first half of 2016 will be better than the first half of 2015, but we are struggling to see how 2016 as a whole can be stronger than 2015 as a whole. We are worried about the second half of 2016 in terms of deal flow.
MR. MARTIN: Andy Redinger, sticking with you, last year was a busy year for financing LNG export terminals. Those were multibillion dollar financings. Merchant gas projects were another big part of the market and then renewables. Is it just renewables this year? Is that all that is left?
MR. REDINGER: No. There are still some gas-fired power plants to finance, but the market is definitely getting tired. It will largely be renewables this year and be focused mainly on rooftop solar and other forms of distributed energy.
MR. MARTIN: One challenge with financing merchant plants is the need for a hedge to put a floor under the electricity price, and hedges seem in short supply.
MR. REDINGER: There are hedges, but if you are trying to get one in ERCOT where everyone else is trying to do merchant deals, good luck. I think if you go to PJM or you go to one of the other liquid markets, there is capacity.
MR. MARTIN: Where else can one finance merchant power plants besides ISO New England, PJM and ERCOT?
MR. REDINGER: That is probably it.
MR. MARTIN: Let me challenge some of you on what you said are the new trends this year. Peter Kelly-Detwiler, you think distributed energy will continue to gain traction fueled by use of information technology and big data. What happens to your prediction if states start rolling back their net metering programs?
MR. KELLY-DETWILER: Some states will preserve net metering, and other states will be a mess. Look at Hawaii, which rolled back net metering in late 2015. We are already hearing reports of rogue installers who are installing solar systems with batteries that let homeowners drop off the grid altogether.
Once the cost of storage creeps below $500 a kilowatt, which is what Schneider Electric says it can now do with the EcoBlade, the market will grow. In states where net metering disappears, I think you will see homeowners using rooftop solar with batteries to take greater advantage of arbitrage opportunities. This is already a huge market in Australia.
MR. MARTIN: Andy Redinger, you are predicting that community solar will start to take off in 2016. What is preventing community solar developers from getting financing today for their projects? They have struggled.
MR. REDINGER: The offtakers don’t have investment-grade ratings. The financial community is still struggling to figure out how to finance long-term revenue streams from unrated entities. It makes no sense to look at entities’ debt ratings once at closing and then lend to them for the next 18 years with no obligation to maintain a stable debt rating after closing. One way to handle this may be to limit the percentage of unrated offtakers to a number, say 20%.
MR. MARTIN: There are different community solar models. In some states, like Minnesota, the utility stands ready to take the electricity at avoided cost to the extent that subscribers default. Isn’t that the answer?
MR. REDINGER: That helps and may determine how big a bucket of unrated assets we can have, but the fact that the utility will take the electricity at avoided cost does not eliminate the uncertainty around the revenue stream. I don’t know what the avoided cost is eight years from now.
MR. MARTIN: You are also bullish this year about the C&I solar market. The challenge there has been lawyers. Every customer agreement is different because the customers want to negotiate the solar power contract or lease, and this makes financing a portfolio of C&I solar installations expensive. The transaction costs become prohibitive when forced to do diligence on a portfolio of deals with multiple forms of contracts. What will change to make this take off?
MR. REDINGER: It’s just a learning curve, I think. As we all do these deals and get smarter, I think everyone will get more efficient.
MR. MARTIN: Ted Brandt, do you see C&I solar taking off this year?
MR. BRANDT: I do. There is strong demand for the product, and we are seeing capital for it. We did two capital raises last year, just the way Andy described, that allowed up to 20% of non-investment-grade credits in the deal. There is no question that standardizing documents and trying to build a diversified pool will also help. The transaction costs are still too high and a lot of people have broken their picks on the market, but I think it is coming.
MR. NELSON: Let me go back to community solar. Distributed solar is an exciting new player in the independent power market. When we try to model how rapidly this market will grow, we have tended to use a consumer adoption model similar to how we might model the rise of cell phones. You are thinking about individuals adopting solar on their roofs. A key variable in these models is the maximum number of rooftops that can handle solar. We rule out rooftops that are too shady, or not strong enough to handle solar, etc.
What is interesting about community solar is that everyone can have access to it, so it boosts the potential pool to 100%. It feels like it can be a model breaker, which is why we are all so excited about it. The pull of community solar to investors is its potential to reach 100% of the population. But the issue, back to Andy Redinger’s point, is every forecast for community solar has been too bullish and it eventually comes back to the point of every offtaker being different.
MR. MARTIN: Will Nelson, as we start this week, natural gas prices are hovering above $2 an mcf. You think $2, or even sub-$2 gas, is here to stay and “this makes for a very different power market.” How so? Play it out for us.
MR. NELSON: Low natural gas prices are making it more difficult for utility-scale renewable energy projects to compete, but they are not putting a dent in the distributed solar business. The wholesale gas price is about a third of your average retail electricity bill. The distributed solar companies are insulated by the wires business, which still occupies two thirds or so of the total cost, and that share is probably growing. The high wires cost is boosting retail rates and creating opportunity for distributed solar.
MR. REDINGER: The interesting question is with gas prices so low and wires costs so high, why isn’t someone developing a gas generator for your house?
MR. MARTIN: It is called a fuel cell.
MR. REDINGER: Yes, but those are a little expensive. I am talking about a generic turbine in your basement. With gas prices expected to remain low and the power companies increasing your rates, eventually someone is going to say: “You know what, I am going to go off grid and hook myself up to the gas line. I don’t need both a gas line and a power line into my house.”
MR. MARTIN: Maybe people don’t believe that low gas prices are here to stay or else they would do that.
MR. REDINGER: Maybe it has not caught up with them yet, but that thinking will become more prevalent.
MR. MARTIN: Do you have a gas generator in your house? Do you have a solar panel on your roof? Which bet have you made?
MR. REDINGER: I live in Ohio. We have 66 sunny days per year, so the answer is no solar panels.
MR. KELLY-DETWILER: I think you will see more on-site micro-generation. I visited a company in California, run by a bunch of PhDs out of Stanford, that has developed a really high-efficiency gas-fired generator that the company expects to bring to the commercial market in the next few years. I see this whole thing fracturing big time based on different market issues . . . .
MR. MARTIN: This “whole thing” means the centralized utility?
MR. KELLY-DETWILER: Yes. Pay attention to the Reforming the Energy Vision, or REV, proceeding in New York. One thing that may come out of that is heavier use of super IT infrastructure like a geographic information system that does a better job of collecting and acting on data. A utility will no longer have one avoided cost, but it will have thousands of them depending on the location of the customer. That means it might not make sense economically to put gas-fired generation in one neighborhood, but distributed generators could make sense in the neighborhood one street over. We are going to see a very different world start to emerge in the next five years.
Yield Co Taint
MR. MARTIN: Next topic. Yield co share prices collapsed starting around July 20 last year. SunEdison’s share price dropped as well, and the rest of solar stocks were also battered. Why should what happened to SunEdison infect the entire sector?
MR. BRANDT: We released a white paper that some people may have seen. Investors did the math; they calculated the discount rates at which yield cos would have to buy new assets in order for acquisitions to be accretive to shareholders while selling more shares in the secondary market to raise capital to make the acquisitions. The math didn’t work. The whole think blew up after about the second deal. It was inevitable that things would come back to earth and that dividends would move closer to where they are today.
The problem was not isolated to SunEdison. Everybody looked around and said that these acquisitions cannot possibly drive growth to a point where the growth justifies a 2% dividend. The market probably over-corrected.
We are still long-term bullish that the public yield co dividend-paying model is the right way to own these assets and that it provides the cheapest form of capital, but clearly we have had a painful last seven months adjusting to get the math right.
MR. MARTIN: Andy Redinger, you have been the most articulate advocate for yield cos. You helped create the first one. What is the attraction to sponsors if yield cos become sleepy vehicles for predictable cash flow? Will that be the cheapest source of capital as Ted Brandt said?
MR. REDINGER: Yield cos are publicly-traded infrastructure funds. There are billions of dollars available to invest in this sector. Yield cos compete with others for this capital. You do not have to look very far north of the border to see several Canadian income trusts trading very well on the same type of assets that are owned here in the US. It is not clear why our assets should trade differently than the assets that they hold. Some rationality will eventually return in the US market.
MR. MARTIN: Does it make sense for a solar company looking today for a way to monetize its operating assets to form a publicly-traded yield co to buy them?
MR. REDINGER: Yield cos were formed originally as a tool. They were not formed to be the exclusive off ramp for solar developers to monetize their assets. The developer should sell its assets to the highest bidder. The highest bidder could be an affiliated yield co or it could be an infrastructure fund.
MR. MARTIN: Ted Brandt, what discount rates are people using today to buy renewable energy projects?
MR. BRANDT: I would normally give you a forthright answer based on having looked at a lot of deals. Last year was a Charles Dickens tale of two periods. There were lots of sales in the beginning of the year. There were few at the end of the year.
My sense is that a contracted wind project would trade today at an 8 1/2% to 9 1/2% discount rate, unleveraged, after-tax based on a 30-year pro forma. Solar is 100 to 125 basis points below that.
For wind, that range is not terribly different than where we have seen discount rates for a number of years, but the rate for solar is about 50 basis points higher than where we saw solar discount rates bottom out.
MR. MARTIN: I was going to say it a little differently. That is where rates were before yield cos took off.
MR. BRANDT: It makes sense. Obviously, if the yield cos come back, there may be some compression, but we are watching solar assets that were getting done at 6 3/4% trade today at 7 1/4%.
MR. MARTIN: Let’s go back to the original question, because I don’t think I got an answer. Why did the troubles that SunEdison ran into when the TerraForm Power share price collapsed, and that NRG ran into when the NRG Yield share price collapsed, infect the entire solar rooftop sector?
MR. BRANDT: It is like asking why does oil affect the entire market in today’s equity markets. There is no good answer to that other than that is how the markets work.
It is a catalytic effect. I had more hedge funds call me and ask, “What the hell is going on?” “I don’t know what the hell is going on. But let me tell you about this company, this company, this company . . . .” The whole sector went in the other direction. I don’t know whether it is tied to oil, but there is a perception on Wall Street that if oil prices are at $25 a barrel, then renewables must suck.
One narrative is to look at Vivint. The deal TerraForm cut to acquire Vivint exposed some very aggressive assumptions that I think SolarCity and Sunrun were also applying, and so the spotlight on Vivint reached SolarCity and Sunrun even though they are very different companies. The questions included where are you going to build all of the new solar that you claim to be building? They all have aggressive growth targets. California is carrying the entire industry. What are the new states that will support the growth these rooftop installers expect?
MR. MARTIN: What should investors in the rooftop sector make of the net metering debate that is spreading across the country?
MR. REDINGER: You could see it coming. Utilities were not going to sit by and watch their customers walk out the door. It should not surprise anybody that this conversation is happening. That said, I am comforted by the strong support there is at the federal level and in a lot of states for solar. You just need to pick your spots. I would not overreact. The solar rooftop business is not in danger of disappearing. The net metering debate is something to be concerned about, but ultimately, the public will win this debate. If the end result is that the public finds a cheaper way of procuring power, then in the long term, the solar rooftop companies will be fine.
MR. KELLY-DETWILER: The lack of grandfather relief in Nevada was painful and sent chills through the industry. I own five solar panels in a virtual net metering community solar project. The Nevada decision makes me think that perhaps I made a bad investment. If I am thinking that, then others are probably also thinking it. [Editor’s note: Nevada originally decided to reduce net metering benefits for all solar customers, but as the NewsWire went to press, it was considering grandfathering customers who bought or leased rooftop solar systems before the new rules were imposed on January 1.]
The other thing to keep in mind is that we are not done yet with declining costs around balancing systems and even for the panels themselves. I just visited a manufacturer, 1366 Technologies, that believes it can cut the cost of silicon PV wafers that account for half the cost of a solar module by 50%. Even though the economics on the retail side may deteriorate, the costs of solar equipment will continue to decline. There is a horse race among competing technologies.
MR. MARTIN: So the declining equipment cost can compensate for the loss of net metering benefits.
MR. KELLY-DETWILER: At least to some degree.
MR. MARTIN: While the net metering debate is important, if the grandfather rules work properly, then solar companies should be able to continue working in a state at least until the law changes.
MR. KELLY-DETWILER: Exactly.
MR. MARTIN: Next topic, energy storage. A lot of people think storage is a transformational technology. There seem to be two market segments for storage. One is adding batteries to rooftop solar systems and utility-scale wind and solar projects, and the other is standalone 20- and 30-megawatt batteries that are interconnected with the grid in order to help balance the grid. I have heard some CEOs say that the standalone storage market is tiny. The frequency regulation market in PJM is not far from being saturated after being in play for only a short time. Which is storage: a transformational technology with enormous potential or a small niche market?
MR. KELLY-DETWILER: If you talk to somebody like Schneider Electric, they think that it is a $20 billion-a-year market just for backing up IT and cloud-based data centers. If you talk to somebody like AES Storage, they think every time there is a bid for a new gas peaker, they can win with storage, and the cost of storage keeps falling. I agree with you that the frequency regulation market is saturated because it is a small market, but that is not where the major value proposition is for utility-scale storage on a go-forward basis. It is grid stabilization. As you see more wind and solar coming on to the system, there will be an
increasing need for storage.
MR. MARTIN: So the biggest market for standalone storage — not as an adjunct to a wind or solar project — is replacing peakers?
MR. KELLY-DETWILER: That is what I am hearing.
MR. MARTIN: What about adding batteries to solar rooftop systems? Peter Rive from SolarCity said last June that it will be five to 10 years before it will be economic to add batteries routinely. A $5,000 battery today produces only about $500 in time-of-use savings over the lifetime of the system.
MR. KELLY-DETWILER: The solar companies say that at $1,000 for a battery, there is no market, but when you push the cost down to $400 or $500, then there starts to be a real market.
These are Lego building blocks: solar, storage, even wind. You need software that ties everything together. The software that makes it all smart is only beginning to emerge. Combining solar with storage is one plus one equals at least two and a half because of the demand charges and the ability to optimize, particularly when you get rid of net metering. How these markets develop will vary by location. Like any other emerging technology, it will hit the beaches and eventually infiltrate and spread in ways that are not entirely foreseeable.
MR. MARTIN: How does it help, if your customer is losing revenue because of a scaling back of net metering, to add to the capital cost to the system?
MR. KELLY-DETWILER: It depends on who is financing the system. I do strategic consulting for companies in the solar sector, and they are all looking for opportunities to provide adjacent services. Each has a core competency. For example, Johnson Controls is one of the largest battery manufacturers in the world. It knows buildings. It knows control systems. It is looking at opportunities to plunk batteries in its customers’ buildings. Sharp is saying the same thing. Sharp says it has $100 million worth of financing lined up for storage. Stem has $85 million worth of financing. A bunch of those companies have money, and they are ready to start deploying batteries today: up to $5 million apiece for commercial and industrial flow batteries onsite.
MR. NELSON: The question is why increase the capital cost of a rooftop system by adding a battery at the same time that a rolling back of net metering is reducing the potential revenue from use of the system.
The answer is the grid is a free socialized battery under net metering. There is no reason to add a storage system if the grid is providing you free storage. If you take away free storage, then many customers will decide storage is a benefit for which they are willing to pay.
The move toward imposing a fixed charge or capacity-based charge to disincentivize solar is starting to incentivize adding storage. There is an interesting synergistic relationship between solar and storage. It shows up in many places. This is just one of them.
The Big Picture
MR. MARTIN: Let’s step back and look at the big picture. There is very slow growth in demand for electricity in the United States: .7% to .9% a year. We have three types of entities competing for market share. There are distributed generators, the regulated utilities and the independent power companies. The independent power companies have made inroads this past year by bypassing the utilities and going directly to the customers by signing commercial PPAs. In 2015, 3,160 megawatts of such PPAs were signed, which is more than double the amount the year before.
How do you see the battle for market share among the three groups playing out? Who is in the ascendancy? For the longest time, it was a battle between regulated utilities and independent power companies, and their market shares remained remarkably stable.
MR. BRANDT: One of the things that we are hearing over and over again from calling on strategic planners at utilities is that the Clean Power Plan has given utilities an incentive to build rate-based renewables in a very big way. So we are watching utilities, like MidAmerican, planning to add renewables, but within the rate base.
At the same time, we are also seeing other, slow-growing utilities develop NextEra envy. NextEra is getting the same multiple on its IPP business as it is on the utility business. Its earning are now divided about 50-50 between the two businesses. A number of regulated utilities are moving in a serious way into the IPP business and adding contracted assets, even to the point of buying developers or trying to make investments in developers’ assets. So my bet is the IPP business will continue to grow. I think the distributed generation business will continue to eat away a bit at the utility business, but I think all three models will coexist for the next number of years.
MR. MARTIN: The IPP business will grow because the regulated utilities will put more effort into unregulated affiliates that compete outside their service territories?
MR. BRANDT: I think so. They have incredible advantages.
MR. REDINGER: We cover 52 regulated utilities, and we are seeing the same thing Ted just mentioned. They are asking us to help them by bringing opportunities outside their service territories.
MR. MARTIN: How big an inflection point will it be in 2016 if the US states that are in court trying to block implementation of the Clean Power Plan win? Would it make a difference?
MR. BRANDT: We have a coal company as a client. It is selling a slice of a supercritical coal plant to an electric coop. They have been saying is that there is just no good news in coal. Forget the Clean Power Plan. They are having their lunch eaten by cheap natural gas. At $2 gas, especially with the new class of gas turbines, the low cost producer by $10 to $15 a megawatt hour in every market is gas. Regardless of whether the Clean Power Plan is implemented, coal is in a downturn anyway. You are going to lose it on a pure economic calculation. Forget about the environmental issues.
MR. MARTIN: So the loss on the Clean Power Plan would not make much difference? The trend lines are already set?
MR. BRANDT: I am sure it would make a difference, maybe in terms of the rate of change in some areas, but I am not buying coal stocks today.
MR. MARTIN: When a Trump, Cruz or Rubio administration on its first day in office reverses everything that Obama has done, it will not make much difference? Coal is on its way out anyway?
MR. BRANDT: I think at worst it would just postpone the inevitable.
MR. MARTIN: Next topic. A lot of developers seem to be rushing south of the border into Mexico. Good idea?
MR. BRANDT: We closed a deal in Mexico last year that took us 31 months to close. We had to go through two different federal law changes and deal with indigenous people that may have traversed the site to a sacred burial ground 600 years ago. We were very happy that the deal closed. I can only say it’s a long, long way away from being anything close to a mature market. To say that everything takes longer is an understatement.
Mexico needs the power as poor people become middle class and as middle class become upper class. Mexico’s economy is growing at 1% to 2% a year, and demand for electricity is growing by 8 1/2% a year. In that respect, it is a completely different market than the United States. It desperately needs power. You are largely displacing very inefficient oil-based generation at the margins. Mexico wants the renewable power. However, it is more challenging to displace oil when oil is at $25 a barrel than when it was at $100.
MR. MARTIN: Next question. Do you think there will be more interest among foreign pension funds in investing in US infrastructure projects after Congress voted in December to waive capital gains taxes on such pension funds when they exit US investments?
MR. REDINGER: We have seen growing interest over the last couple years from foreign pension funds. Will this help? Yes, but the foreign pension funds were already headed in this direction.
MR. MARTIN: So not much change. What really moved the meter?
MR. BRANDT: The equity markets stink. Having 9% long-term infrastructure returns is the attraction.
MR. MARTIN: Next question. Wholesale power prices fell sharply in 2015. New power contracts signed were at very low prices: $40 a megawatt hour for solar and in the low $20s for wind. How much will that offset the boost that would otherwise be expected from extending tax credits for renewable energy?
MR. REDINGER: It comes down to the math. No doubt it will reduce the number of opportunities to build new projects because of declining revenue. On the other hand, equipment costs continue to fall. We have seen developers sign power contracts with low net present value day one, but by the time they are ready to build and are done adding value through the financing, equipment procurement, the EPC contract, etc., they have figured out how to pull a decent net present value for project.
MR. MARTIN: Oil prices. Iran is now able to sell its oil on world markets. It is planning to increase production. What effect, if any, will this have on the US power market?
MR. NELSON: We do a long term gas forecast in the US on a play-by-play basis. The question is what gas-break-even price is needed to bring marginal wells online, just like a merit order for power.
We thought falling oil prices would cause loss of the associated dry gas and wet plays that no one will be able to tap into any more, but what was actually a much stronger impact, and was pretty surprising to us, is the drop in rig counts to drill wet plays for oil means that rigs are freed up for pure gas drilling. The cost of drilling for gas has fallen by about 30%, meaning we can drill gas 30% cheaper today because we have so many rigs sitting around idle, and that fundamentally is what drove the decline in gas prices last year throughout the US.
Any further slack in the rig count in the US should drive lower prices for rigs, drilling and completion and ultimately gas. How that translates to power is obvious.
MR. MARTIN: What is the correlation, if any, between oil prices and natural gas prices?
MR. NELSON: The fall in oil prices cut gas drilling and completion costs by 30%. The correla