2005-01-01
Distributed Energy: A New Vision Emerges
by Lori A. Burkhart for Public Utilities Reports, Inc

(This article first appeared in the May 2004 issues of Fortnightly's SPARK and is avalable as a PDF file for download

“We are getting close to what we refer to as the tipping point for the distributed energy sector,” says Jamie Wimberly, managing partner and CEO of Distributed Energy Financial Group. That notion supports the founding of a new firm, the Distributed Energy Financial Group (DEFG), begun with its founders’ beliefs that in three to five years the distributed energy sector (DE) is going to take off. On April 20, DEFG really made its presence known, releasing an encyclopedic, first annual “Distributed Energy Sector Review (DESR).”The report is intended to start to track the progress and performance toward that tipping point. It marks a milestone in the industry for being the first comprehensive attempt to review, measure and make recommendations on the financial drivers, performance and investments in the now volatile DE sector.

DEFG expects that once the DE industry gets past that speculative, volatile period and reaches the tipping or inflection point, it will experience very rapid growth.But in that volatile period, according to Tom Lord, DEFG managing partner and COO, there will be winners and losers. “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.”

Wimberly makes clear that DEFG is not a trade association, but instead is a specialized financial services firm. “About eight months ago we got together and really started thinking, “what can we do to add value and move the ball forward,” and there are a lot of good trade associations out there already—all very good at promoting members’ interests,” he explained. In fact, DEFG believes those trade associations focus very well on regulation and legislation and increasingly are focusing on some marketing-type help. “But clearly what was missing was a focus on finance, and moreover as pointed out in the DESR, is a need for a bridge to the capital markets,” Wimberly says. “For whatever reason the capital markets and distributed energy sector—the vendors—don’t seem to be working off the same page.”

Wimberly and his partners, also including Nathaniel Treadway, DEFG managing partner and senior v.p., realize that despite more opportunities in distributed, emerging, and alternative energy technologies, and despite the proliferation of promising new companies, that many capital requirements are going unsatisfied, and many investors are turning away from this sector. So DEFG serves as matchmaker for DE companies seeking capital to grow, and for investors seeking placement of capital. DE offers sector analysis, due diligence analysis, portfolio origination and management and advisory services designed to link DE companies to the capital markets.

DEFG wants to take on the challenge facing the DE sector of defining and segmenting the market in a way the investor will understand.“DEFG takes a very broad, unique view of the sector, with DE encompassing everything from small generators, renewable technologies, enabling/communications devices, to grid support,” says Treadway. He finds value in the DESR in that it embraces a holistic, customer oriented vision that challenges present conceptions of the sector.

Sector Drivers

The DESR finds a number of factors supporting the conclusion that once DE reaches the tipping point, that slow, steady growth will be replaced by a major increase in the growth curve caused by rapid adoption of new technologies. The market drivers include changing customer preferences, a volatile natural gas market, electric market restructuring, aging and overloaded utility infrastructure, utility market strategies, public policies, rapid technological change and integration, plus macro- and micro-economic trends.

But those drivers have a complex interplay with the DE sector, and the DESR identifies negative, mixed and positive impacts. For example, while natural gas markets are interacting in new ways with electric markets, that sector is becoming increasingly volatile and gas prices are rising to unprecedented levels. In sum, the report finds that the natural gas market drivers are gas price increases and volatility, pushing customers toward DE as a real option hedge (i.e., distributed generation, combined heat and power and demand responsiveness), but notes that gas price increases can render some DG projects uneconomic. That combination of factors produces a mixed outlook for DE.

Wimberly explains, “what we are trying to do is begin to actually put together an index of those forces that are external or seemingly tangential to the distributed energy sector that impact the distributed energy sector in some way.” He called it a “first stab” at rating what that impact might be. “But what we have said is that what is going on in the natural gas markets, which is obviously a great deal of volatility and upward trend in terms of natural gas prices and the like, is going to impact the sector in a mixed way in the sense that some technologies are reliant on natural gas, whether that be for example, fuel cells to actually make the hydrogen or micro-turbines that use natural gas.” He adds that those technologies will be impacted in a different way than for example, solar. “I think solar might actually do well competing against natural gas-fired technologies or technologies relying in some capacity on natural gas,” he opines.

On the electric side, DESR points out that retail access does not lower rates for small customers as presumed by policy makers, price volatility has increased, DE is part of the customer’s risk-management solution set, and many DE technologies and services do not require retail access. That combination of factors produces a positive outlook for DE.

Looking at drivers for DE in the utility infrastructure sector, the report finds that investments in transmission and distribution infrastructure have lagged behind market-driven need, jurisdictional disputes and regulatory uncertainty continue despite progress in some jurisdictions, customer access to wholesale market economics is an important issue and distribution utilities remain a potential DE market. Combined, these factors produce a positive outlook for DE. In all, the report examines eight drivers for the DE industry, and in addition to the above three, finds the following results:

In all, the report examines eight drivers for the DE industry, and in addition to the above three, finds the following results:

Customer preferences—positive
Utility strategies—mixed/negative;
Public policies—mixed;
Technological change—positive;
Macro- and micro-economic trends—mixed.

Wind-talking

Wimberly explains that a gap exists between the capital markets and energy technology companies. He says t is created because especially the smaller startups have focused on research and development for so long, that now when they are moving into commercialization that they just have a technical or engineering focus that is not necessarily well suited when it is time to go out and raise money. Wimberly calls that a “translation” problem,and says, “others have called us wind talkers, which I kind of like.”

He notes the need for a translation process that encompasses “taking a more technologically focused idea about what their market space is and translating that into things the financial markets care about, which are assessments of risk, looking at an exit strategy, looking at growth and plans, what is your marketing and what is your market.” He believes even some of the bigger firms have had a hard time getting investors to speak the same language and that a new analytical framework is needed for them to better understand opportunities and challenges .

The report finds that to analyze the DE sector, traditional market metrics are not enough. Instead, an investor must have a complete understanding of the market, plus financial, regulatory and technical metrics to fully grasp the risks and potential returns in the sector.DESR says the analytical framework should provide an effective frame of reference for both the investor and the DE provider, and must consider both technologies and traditional market segmentation. The investment methodology constitutes an opportunity identification tool, and DESR notes that a good methodology addresses opposite sides of the same coin, in that while investors want more effective investment of capital, DE providers want more effective attraction of capital.

Also, the investment methodology for distributed energy should include financial, technical and regulatory metrics, with “risk” identified as the key variable. The report points out that while most industries have three major components to the market structure— producer, consumer and investor—that DE has an added component. DE has four major components to the market structure—producer, consumer, investor and utility—and because regulators can influence the utility, it changes the value chain. That complexity increases risk.

Project Financing

“Project finance in distributed energy has been stymied for some time,” laments Wimberly. He says that part of the problem is developers play kind of an intermediary role with overblown expectations about what their personal return is going to be. “They essentially pitch these projects as one-off projects and they try to finance them by making them into almost their own companies,” he explains. He finds part of the problem to be that while all projects will have some mix of debt and equity, that DG projects should be financed more by debt than equity. That is because debt has a whole different profile regarding return and order of payment when bills come due. “So what we’re seeing is the financial markets are less interested in project finance and they are more interested in investing in ongoing concerns—growing companies,” he observes.

But Wimberly believes that could change somewhat if the projects can be bundled together into a size that the financial markets care about—meaning that their transaction costs are lowered through economies of scale. “If projects can be bundled together going from a couple million up to ten or twenty million there is going to be more interest,” he says. “Second, if these projects can have standardized contracts to again lower transaction costs, it will be a boost to project financing.”

That is where DEFG comes in. It was formed to provide a bridge between the capital markets and energy technology firms. In fact, the first annual DESR was released as an effort to begin tracking the financial and market developments and sector performance over a period of years. It provides an in-depth analysis of how the financial sector is segmented.

And while each type of financing has a role to play,DEFG says that some DE companies hope to pay very little to those who assume significant risk, and that such lack of realism must be overcome, especially because technology stocks are viewed quite cautiously by the financial sector.

For example, project financing at the initial equity capital stage usually comes from what is known as “angel money,” which perhaps ranges from $10,000 to $15,000 and the investor makes the investment decision based on trust of the firm’s management. As the company matures, venture capital is often the first external capital source, made by investors with a high-risk tolerance, and with a higher threshold size, usually between half a million and$1 million. Then comes mezzanine financing, which is the non-equity bridge between private equity capital and public equity capital, where risk tolerance goes down as the threshold investment size moves higher, say $2 million to $3 million. The late round equity is the last stage prior to going public, where threshold dollar size is less critical, assurance of no need for further equity rounds is critical and again, there is lower risk tolerance. Public equity is the stage where management sees its own exit strategies mature and finally the project financing is the stage where the transaction, not the company, is the investment vehicle.

But the report finds that some types of DE technologies can be even more problematic for attracting investment. For example, difficulties in transitioning from R&D to commercialization has plagued several segments, such as fuels cells and photovoltaics.

The problem, according to DEFG, is that the financial community has to concern itself with traditional issues such as business plans, management teams, cash flow, growth strategy, future equity, risk management and exit strategy. But there exists a challenge as to how best to communicate hose concerns to DE companies. A translation problem may exist because he financial and DE communities often use the same term to mean different things, says DEFG, making the DE sector a prospect for equity investment higher risk) and less prone to project financing.

Blackouts and Stocks

The report finds the August 2003 blackout that hit the U.S. in the Northeast nd Midwest to be a positive turning point for DE sector stocks. “It is interesting because we put together a tracking portfolio right after the blackout, in essence a portfolio used as a measurement tool rather than an actual financial vehicle,” Wimberly explains. That DE racking portfolio of 12 stocks increased by 49% in a mere seven months, but with significant volatility (see Chart No. 3). Generally, large cap companies nd manufacturers of mature DE technologies have been leaders, the report finds, and emerging technology companies have been laggards.

Next, in a six-month gaming exercise, about 20 members of DEFG’s Distributed Energy Investment Consortium formed three teams to pick stock portfolios starting January 30, 2004 through July 31, 2004. The consensus of the consortium is that many of the pure-play companies will not exist after one to three years, and it expects to see consolidation, with companies and assets bought at a nice premium.

According to Wimberly, these stocks already are starting to pick up. “It is weird because for example in the fuel cell sector recently there has been huge increases in stock prices for companies like Evergreen Solar, Fuel Cell Corporation and others,” he notes. “Basically it is because a variety of interests are trying to buy their way into that sector.” In mid-April, Wimberly notes that Evergreen Solar doubled in stock price the week prior.

DE Development

DEFG does not recommend a purely financial approach or purely technological approach to the segmentation and analysis of the DE sector. Instead, it recommends close attention to customer preferences and its impact to drive the market. It says the eight market segments to watch are: distribution utility technologies, prime movers, power quality/storage, enabling technologies, demand management including communications and control, productivity, including health, convenience and efficiency drivers, transportation sector linkages and federal government linkages (see Chart Nos. 4 and 5). It cautions the investor to understand how the traditional electric utility value chain of delivery differs from the market-driven value chain. DEFG warns that the DE market is immature and not yet “shaken out,” so it contains disruptive technologies not apparent today.

But there are so many factors to assess when it comes to DE investment. “I think what you will find in the regulatory sense is that any attempt to restructure the markets usually incorporates public policy changes that are for the most part favorable to these technologies—like resource portfolio standard and things like that,” maintains Wimberly.

Moreover it challenges the utility to rethink their business, the grid, and their investments. “In fact we are working with a number of utilities that are re-thinking about how these technologies might actually be helpful and not just in a physical sense, meaning that they have a load pocket that they need to take care of or that they need some voltage support—that kind thing, but also in a financial sense, because these technologies may be able to even out their cash flow, which Wall Street always liked,” he says. He adds that it may help utility companies manage their portfolio of assets better from a financial perspective, and might help obtain favorable regulatory treatment. Wimberly concludes that, “it is going beyond a one-trick pony vision of what these technologies can do for you from a utility perspective—which we think on the whole might have a positive impact.”

To that end, DEFG held a workshop on May 18 in Washington, D.C. on DE investment.