04-24-2004
The Tipping Point for Distributed Energy
by Jamie Wimberly
In his seminal book, The Tipping Point, Malcolm Gladwell describes how little things can make a big difference. As he describes it, “The Tipping Point is the moment of critical mass, the threshold, the boiling point.”

The Distributed Energy Financial Group (DEFG) was created because we strongly believe that the distributed energy sector will reach an inflection point, or tipping point, in its growth trajectory within the next three to five years, with very rapid growth thereafter.

DEFG recently released its first annual “Distributed Energy Sector Review” (DESR). The DESR marks a milestone in the industry as it is the first comprehensive attempt to review, measure and make recommendations on the financial drivers, performance, and investments in the promising but volatile distributed energy sector.

What do we mean by “distributed energy (DE)?” DEFG takes a very broad, unique view of the sector, with distributed energy encompassing everything from small generators, renewable technologies, enabling/ communications devices, to grid support. The value of the Distributed Energy Sector Review is that it embodies a holistic, customer-oriented vision that challenges current conceptions of the sector. How we define distributed energy is a core part of our vision for the sector’s future.
The DESR confirms that the distributed energy sector is on track to realize the tipping point. The signs, as described by Malcolm Gladwell, are all there:

“The law of the few,” with more and more connectors and mavens in the energy and finance industries starting to pay attention to these technologies;

“The stickiness factor,” with all the ups and downs in the DE sector, people just can’t get the idea out of their heads that we are slowing moving from a centralized, heavily regulated energy/ electric industry to a more decentralized, modular, network-oriented and customer-focused one; and finally,

“The power of context,” with the DESR listing a number of external trends, big and small, having a positive impact on the distributed energy sector.

The Distributed Energy Sector Review is a 150+ PowerPoint presentation broken into four main sections and two appendices. The focus is primarily a financial one – in itself an important difference to how the DE sector has been approached, and a mark of maturity. Key findings in the DESR include:
The economics of the sector is being shaped by a number of strong drivers: Changing customer preferences, a volatile natural gas market, electricity market restructuring, aging and overloaded utility infrastructure, utility market strategies, public policies, rapid technological change and integration, and macro and micro-economic trends.
The drivers have a complex interplay with the DE sector, and the DESR identifies negative, mixed and positive impacts. The drivers on the whole, though, are positive.
A gap currently exists between the capital markets and energy technology companies. This gap is largely one of translation, meaning that investors and DE providers are usually not talking in the same terms. A new analytical framework is needed to understand the opportunities and challenges.
To analyze the sector, traditional market metrics are not enough. An investor must have a complete understanding of the market/ financial, regulatory and technical metrics to fully understand the risks and potential returns in the sector.

The financial performance of the sector has largely been very positive, especially after the August 2003 blackout that more clearly defined the value proposition of many of the DE providers. The DESR used various portfolios of publicly traded firms as a proxy to measure the performance of the sector. Since August, for example, DEFG’s recommended portfolio increased in value by 49 percent.

Individual stocks and company performance are very volatile, speculative and subject to sharp swings. The consensus of the Distributed Energy Investment Consortium, a DEFG project involving 20 firms, was that many of the pure play companies will either be bought or disappear over the next couple of years. As a broad proposition, the capital markets treat all investments -- even publicly traded companies -- as venture capital.

The private placement market for the distributed energy sector is picking up and more investors are entering into deals. DEFG expects that trend to intensify. On the other hand, DEFG does not foresee many initial public offerings (IPOs) over the next couple of years. Project financing of DE projects is problematic.

The distributed energy sector is hindered by a clear framework to segment the sector in a way that investors can understand. The Sector Review reviews four approaches to segment the sector: standard financial analysis, value chain approach, customer value approach, and pure technology segmentation.

DEFG recommends a combination of these approaches to fully understand the sector.Until the DE sector reaches the tipping point, the next three to five years should be a wild ride. As Tom Lord, Managing Partner and COO of DEFG, stated, “While we are optimistic about the future, the distributed energy sector will remain extremely volatile and speculative over the next couple of years. We expect a shake out in the short- to mid-term with at least some of the pure play companies either being bought or going bankrupt. There will be winners and losers.”
Yet the tipping point for DE is getting ever closer. As Malcolm Gladwell concludes, “But the world of the Tipping Point is a place where the unexpected becomes expected, where radical change is more than a possibility. It is – contrary to all our expectations – a certainty.”