In response to the financial crisis, some called for banks to follow the business models of utilities, pointing at the benefits of low risks and lower but steady returns of this capital-intensive and highly regulated industry and aim to gear it towards the needs of society overall. But how sustainable is the industry really?
Utilities are at the forefront of the fight against climate change. They are responsible for 25% of all carbon emissions globally and thus face the challenge to adapt to tighter carbon regulations. Moreover, although energy demand is still rising in emerging markets, and globally overall, in OECD countries it has been flat or even falling, adding to the pressure on utilities to change their business models. Innovation in investments and business models will determine the success of their transition towards a low-carbon economy.
However, as utilities have traditionally been protected from the effect of economic cycles by monopolies and high entry barriers, they have had little incentive to innovate. Investors with a focus on dividends or credit saw a natural alignment with the consistent need for cash by states, which have tended to be the dominant shareholder in the industry.
Of all sectors, utilities are the most affected by climate-driven political choices. On top of political costs resulting from attempts to secure energy supplies, provide low costs for customers and create employment, institutional investors are concerned about falling prices, technological innovations and other disruptive changes to the power sector. Coal has suffered particularly, due to cheap gas in the US and climate policy in Europe. Even more remarkable is that executives of utilities are also becoming more sceptical about the sustainability of the business models. According to PwC, 70% of surveyed executives say that the current market models of power companies will not be sustainable and that they have to change rapidly.
The economics of change
The complexity and high stakes of utilities are now clear to all, but investors have long challenged the economics of the sector, which has seen the market value of a number of its constituents shrink significantly since 2008. For instance, in Europe major utilities such as EDF, Enel, E.ON, RWE have seen their combined market value more than halved over the past seven years.
Data source: Bloomberg, own representation
Political interests still heavily weigh on decision-making, as recently evidenced by the plans of French state-controlled EDF to build a new £18 billion nuclear power station in the UK. EDF’s board, which was split on the decision, gave the go ahead only for the decision to be reviewed again by the UK’s new prime minister. Meanwhile in Germany, the four large utilities are challenging the government’s demands to pay £23.3 billion into a fund for the financing of nuclear decommissioning.
Utility companies have responded differently and at different pace to the pressures from regulators and investors. For instance, the two largest German utilities companies, E.ON and RWE are undergoing major restructuring.
RWE will keep its conventional power generation and create a subsidiary focused on its grid, while spinning off its infrastructure, retail and renewables businesses, which will be listed on the stock exchange later this year in a bid to raise fresh capital. E.ON, on the other hand, has decided to keep its German nuclear exposure and renewables business within the company, while spinning off its upstream, global commodities and power generation businesses into a new company, Uniper.
Enel meanwhile has taken a different direction. By re-integrating its green power subsidiary and placing it at the heart of its strategy, the company has demonstrated its commitment to energy transition and sustainability. It has laid out a strategic shift towards profitable sustainable energy, backed by clear capital allocation and M&A activity. Going beyond the vision of renewables as a clear opportunity for growth, Enel has embedded corporate social responsibility into its process. Its new business model embraces innovation to help address the new energy paradigm.
Focus of our engagement
In our longstanding engagements with most major utility companies, we have encouraged them to ensure that their business models are fit for a low-carbon future. At times, we have insisted on enhanced reporting and climate risk analysis, appropriate expertise on the board and awareness training on climate change for directors. Therefore, we also engage with utilities to ensure they are customer-facing and consider innovating to develop consumer energy efficiency technologies.
In addition, to achieve more systematic change, we have focused on wider advocacy by contributing to the Investor Expectations of Electric Utility Companies developed by the Institutional Investors Group on Climate Change. The 2015 Paris agreement has lent unprecedented weight to our engagements and, indeed, to be successful in engaging with companies, public policy engagement remains crucial. The significant infrastructure investments needed by the industry require clear commitments from nation states to provide a consistent framework and reduce uncertainty and, to paraphrase the International Energy Agency, “repower the markets”.