- Electric power is being produced by a rapidly changing mix of technologies.
- Wind and solar are rapidly gaining market share and are now cheaper sources than power stations burning hydrocarbons.
- Big utility companies are suffering losses and their fixed assets are losing value
Many countries are experiencing a “Negroponte shift” in their electric power-generating sectors (sidebar). Regulatory mandates have given solar and wind generators preferential access to the market, dramatically impacting the operations and finances of traditional power generators. Power plants fueled by nuclear, coal, or gas that were designed to operate continuously are being shut down and restarted much more frequently. Rather than serving their intended roles as providers of base power, they are becoming “peakers”—sources of power during periods of peak demand. The subsidized price that solar- and wind-generating plants receive is above their cost, enabling them to remain profitable while imposing losses on the legacy gigawatt-scale power stations.
The impact on investors has been severe. Shareholders of E.ON and RWE, two giant German electric utilities, have suffered through 10 years of miserable returns, as the dollar share prices of the two utilities have each fallen about 90 percent. Looking more and more like dinosaurs plodding toward the tar pit, their prospects for rebounding look bleak.
Rise of Renewable Power
Electricity from renewable sources, in particular from wind turbines and solar panels, is rapidly becoming the dominant component of total electricity supply in a growing list of countries. The conventional view of wind and solar has begun to shift, but the full economic implications of the technological transition have not been fully addressed. The economic ripples have barely begun to creep into the public awareness, but already are sprinkling costs and windfall gains across the macro economy.
The growth of wind and solar has been driven both by decreasing costs of power from those sources, and by subsidies for using those technologies, as well as by government mandates requiring a minimum fraction of power from renewable sources. Recently, decreasing costs, driven in part by technology advances, have become a primary driver of new installations, allowing wind and solar to compete on an even playing field with traditional technologies.
Wind turbines are getting bigger. Rotors used to sweep a diameter of 80 meters, but now are as large as 140. The amount of power the turbine generates increases by the square of the length of the blades. So the bigger rotor generates three times as much electric power, despite being slightly less than twice as long. Already requiring circuitous routes and utility pole removal, installation of turbines has become so challenging that Siemens is building a state-of-the-art manufacturing facility in a location where the blades can be moved by barge!
Figure 1: LCOE from wind has been reduced as turbines have grown (US DOE, 2015).
Figure 2: Trends in battery cost and capacity (Crabtree, Kóchs, & Trahey, 2015)
Trends in battery development also show promise for renewable energy technologies. In lithium-based batteries, the trend has been for reduced cost coupled with increased energy density. These trends have led to utility-scale battery storage for renewables. The advent of utility-scale battery storage promises to spur further growth of solar and wind installations, by making intermittency a less severe drawback.
The current framework of pricing kilowatt-hours and apportioning costs already is facing wide discrepancies between prices and fully allocated costs. The discrepancies are on track to become more acute.
Figure 3: Comparing LCOE of wind and solar to U.S. wholesale electricity costs. (Naam, 2014)
In the past two years, the installed base of wind and solar has become large enough that the policies meant to support growth in the industry are being reviewed. Most of those policies, however, are being kept in place, to accelerate the transition to renewables. The (probably unintended) negative side-effects are being felt by the utilities that operate gigawatt power stations.
The owners of large power stations are about to lose more money. As grid-scale battery storage capacity grows, the economic argument in favor of wind and solar improves. The rationale for battery storage used to be expressed in terms of avoided costs, better air quality, and similar external economies that are not captured by the owner of the batteries. Now, lithium ion batteries are cheap enough so that the owner makes a profit simply by charging them when electricity is cheap and selling the kilowatt-hours when electricity is more expensive. Concurrently, solar and wind costs per kilowatt-hour have reached grid parity—meaning that the levelized cost of electricity (LCOE) from wind and solar is at or below the cost of buying the same amount of electricity from the utility grid.
The challenges to traditional utilities reveal that the preferences and penalties implicit in the existing pricing schemes are no longer aligned with the needs of users and producers. Revised policies might bring a better balance of supply and demand, help maintain the capacity to meet power demand, and deliver reliable, low-cost electricity to users, while also delivering adequate returns to investors.
Broadening the Concept of Stranded Capital
In the comfortable days when electric utilities were regulated monopolies, the possibility that a utility’s lenders or shareholders could lose money on their investments was remote. A new generating plant, once it was approved and included in the “rate base” was going to earn a profit for the lenders and the investors. The electric rates included an amount to repay the cost of each large asset that the company purchased. That approach made sense in the era when the priority was to expand the electric grid and deliver service to a very high percentage of the population.
Now, however, those comfortable days are gone, and a utility’s investors can suffer if a plant is not in service long enough to return its entire cost. How should a country pay for the large base-load plants that are still in the rate base, but no longer need to operate continuously? These “base load” plants are now becoming marginalized, like the small, costly “peakers” that operate only during periods of peak demand. “Peakers” have a role because electricity demand is highly variable, and because peak demand periods do not coincide with peak periods of supply coming from intermittent sources. Battery storage obviously affects the need for “peakers”—not only old, high-cost generating facilities, but also new combined-cycle gas turbine facilities.
Another victim of this Negroponte shift is an entire sector that normally is not included in the electric power sector. That is the railroads. Of course, they move many kinds of cargo, but a large share of their volume used to come from moving coal—entire unit trains and their locomotives and associated hardware. Union Pacific was reported to have 292 locomotives sitting idle on a siding.
Since the U.S. election, the railroads hoped for a revival of coal mining, and for the Alberta Tar Sands to ramp up production. Their shares were sagging, but then rebounded. But, now, the approval of the Keystone pipeline, which will transport Alberta crude to Houston more cheaply than unit trains can, puts another cloud of uncertainty over their future prospects.
We need a way to frame the question of what the costs of the Negroponte shift will be. A convenient way of framing the question is to ask which generating facility will be allowed to supply the customers, and which generating facility will be relegated to the shock absorber role, and be effectively forced to dial down its production. The policy has been to give solar and wind the pre-emptive right to sell all they can produce, displacing the supply that previously was coming from the traditional power plants. And, the policy also has been to allow the solar and wind power providers to bill the utility for the high price they are allowed to charge.
As matters stand now, the traditional utilities are suffering two losses. One is the lost market share. They are economically obliged to shut down plants that were intended to operate for more years, and which were budgeted to be base-load capacity. The other loss is that they are obliged to buy expensive electricity from providers that society has chosen to favor, and then sell most of the kilowatt-hours at a loss.
There is a need for public debate to assess the de facto cross-subsidization. The public also will need to decide how much of the cost of retiring stranded capital to pay. At this time, the losses are cushioned because they are deductible on tax returns, but that is an unsatisfactory answer. A better answer would be more encompassing—for example, it would explicitly dictate how much money still needs to be transferred to the alternate energy sector, and how to accomplish that transfer. An answer also is needed for how to apportion subsidies and costs by region and by technology. After deciding that, the debate needs to address how to gather the funds to make the transfer. The current way of paying for the transition to wind and solar appears to have happened as a result of well-intentioned, effective policies that have lingered well after their shelf life.
Eating Their Own Lunch
As wind- and solar-generating facilities have increased their output, an ironic saying has crept into the conventional wisdom: they are their own worst enemy. The reason is that new wind- and solar-generating plants produce electricity in abundance at times of day when the wholesale price is low, so the new installations do not earn as much for their output as they would if they were “base load” technologies. As the wholesale price of solar panels declines, and as wind turbines become taller and produce more electricity at lower costs, the economic case in favor of these rapidly improving technologies is weakened by their success. The pricing schemes and the financial arrangements could accommodate a slow increase in production from renewable sources, but the costs of alternate sources were not supposed to fall so fast. The finances of the sector are weakening, and market signals do not tell executives what to build next.
The disarray is becoming more pressing as battery storage becomes cheaper. For utility-scale battery storage, the tipping point often is said to be $100 per kwh. Recent announcements of utility-scale battery storage installations indicate that battery costs are now flirting with the crucial $100 per kwh threshold. If enough storage is constructed, the distinction between base-load and “peaker” generating plants would become blurred, and would soon become irrelevant.
Germany is the country that faces the best-known pricing dilemma. As Germany implements its social choice to shut its nuclear plants, and de-emphasize its coal-burning plants, it now finds itself with anomalies that are becoming more worrisome. Germany’s retail consumers pay high prices for electricity, while the wholesale price dips down toward zero and from time to time goes negative.
The large German utility RWE is a conspicuous loser. It owns and operates large power stations, and was, in bygone days, a stable investment for those seeking dividend income. From September 2014 to August 2016, the shares of RWE fell by more than 58 percent, and the dividend was cut to one-quarter of its 2012 level and one-seventh of its 2011 level. The company’s CFO said that at the current wholesale price of electricity, the company would not buy more fuel for its nuclear reactor. The reactor would burn its last load, and then shut down.
Obviously not all “stranded capital” is going to receive full remuneration. That conventional way of accounting for, and recovering, the cost of large generating plants was appropriate for a capital-intensive industry producing an essential service, with no threat of obsolescence looming in the near future. It was logical to organize the electric utility industry as a regionalized set of regulated monopolies. Power plants were designed, built, and operated in accord with long-range forecasts of demand. Technology of generating electricity did not change rapidly, and geographical patterns of use changed slowly. Most plants could operate continuously for their entire useful lives.
Winners, Losers, and Investment Implications
This transition is happening fast. With each passing week, there are new announcements about big investments in alternate energy production. To conclude this discussion, we consider winners, losers, and some broader macroeconomic implications. Those lead to investment implications.
The winners might seem likely to be the companies that produce solar panels, wind turbines, and utility-scale battery installations. But, those cutting-edge innovators have not all done well financially because they are in such ferocious competition with each other. They have had to muddle through despite losing the tax incentives that helped them for years, and also have had to contend with competition from cheap petroleum products and cheap natural gas. So, it is not surprising that some of them have struggled. For example, the shares of Trina Solar, a leading producer of solar panels, have fallen approximately 20 percent since September 2014, when crude oil fell by about 50 percent. In contrast, the shares of Vestas, the leading maker of utility-scale wind turbines, have approximately doubled since September 2014. The price trajectories of both were choppy during that time frame, however, so investors could not sit back comfortably and watch as Vestas outperformed, because there were too many counter-trend rallies and downdrafts. And, Vestas already is facing challenges from Siemens and General Electric.
The most obvious winners are the large consumers of electricity. They would pay lower and lower prices for it, and so they might be able to keep some of the savings and bring them to the bottom line. Not surprisingly, aluminum producers and companies that produce nonferrous metals have done well. For example, Alcoa shares have risen 26 percent in the past six months, and Rio Tinto shares have risen 36 percent. Although it is too soon for the lower prices of electricity to reach retail consumers, investors already are buying shares of companies in the consumer discretionary leisure sector.
The longer-term gains from the declining cost of electricity might be quite large, but widespread, and the beneficiaries might see them as costless windfalls. It is useful to consider what the average retail customer would do with the extra money if the monthly electric bill declined by $10, or $50. They would not save much of that money. Instead they would spend most of it. They might take more vacations, or go to eat at restaurants more often, or buy nicer clothes.
There is another possible benefit that these first-round effects do not take into account. As the price of electricity falls, the amount demanded will increase. This might mean that an industry suddenly becomes more competitive, and can hire people to fill new jobs. Energy-intensive industries include steel and heavy construction machinery manufacturers.
The losers are easier to see. The coal industry in the U.S. has suffered bankruptcies. Arch Coal and Peabody Energy have both gone bankrupt. U.S. coal production has declined for eight straight years.
A less publicized but equally hard-hit industry has been the offshore oil drillers. It was a technological achievement to design ships that can drill for oil in deep water. But, the long-term outlook is that there is enough crude oil in more accessible places. The Alberta Tar Sands contain more than 200 billion barrels of crude oil, and with the Keystone pipeline being approved, can now supply the world market more competitively. Two companies whose stock prices have suffered big declines are Transocean and Seadrill. The first has fallen about 67 percent in the past three years, and the second has fallen 95 percent in that same time frame.
Drilling for oil in deep water was so enticing that Brazil spent tens of billions of dollars on developing its “pre-salt” oil reserves. These “elephant” fields of sweet (i.e., low sulfur) crude, though far away from land and in deep water, were going to make Brazil into a dominant producer, at least as large as Saudi Arabia. And, Eike Batista, the flamboyant poster boy for the Brazilian oil boom, was going to be the world’s first trillionaire. Then, the whole fantastic vision crumbled as the price of crude oil fell by one-half. Brazilians have taken their revenge with a public process of reassessments and recriminations. The toxic combination of high costs and a litany of corruption scandals has kept the Brazilian public fiercely determined to demand punishment and prevent further instances of corruption. Eike Batista is now under house arrest awaiting trial, along with many other formerly high-flying Brazilians.
In view of these abrupt and turbulent developments, what should investors do? Caution seems the most prudent posture. Coal might be dying a quick death, but crude oil and natural gas might not slide into obsolescence so quickly. A market test is coming soon: Saudi Arabia is trying to do an IPO for 5 percent of ARAMCO, hoping to bring in $100 billion. If that price is achieved, it would value ARAMCO at $2 trillion. Investors should be watching, and drawing their own conclusions. As that drama is playing out, the technologies that are gaining market share are still improving. But, it is difficult to pick which companies in the wind and solar industries will gain the most market share in the future. And, market share often is gained by cutting prices aggressively, so predicting which companies will be most profitable will be even harder.
In the longer run, truly unexpected developments might occur. If a country or a region has excess kilowatt-hours, it can use them to desalinate sea water. At today’s costs of electricity, that is a use of last resort, an unimaginative way of getting some value for electricity that otherwise would be dumped. But, what if Saudi Arabia installed solar panels and wind turbines in the Empty Quarter, along the coast of the Red Sea, and used the electricity to desalinate water. The water could then be used to turn some of the land into farmland, and Saudi Arabia could then grow crops there. The effects on trade, employment, and geopolitics could be major, and are certainly outside the scope of conventional debate.
In conclusion, it is important to recognize that the trend to excess capacity and declining prices in the electric power sector is well underway, and everyone who is in a decision-making role should monitor the trend and be prepared for its effects.
Crabtree, G., Kócs, E. and Trahey, L. (2015) ‘The energy-storage frontier: Lithium-ion batteries and beyond’, MRS Bulletin, 40(12), pp. 1067–1078. doi: 10.1557/mrs.2015.259.
Naam, R. (2014). Solar and Wind Plunging Below Fossil Fuel Prices. Retrieved from Solar and Wind Plunging Below Fossil Fuel Prices on February 13, 2017.
United States Department of Energy (2015). Wind Vision: A New Era for Wind Power in the United States. Retrieved from Wind Vision: A New Era for Wind Power in the United State (pdf) on February 13, 2017.
Harrabin, R. (2015). UK announces cut in solar subsidies. Retrieved June 9, 2016 from UK announces cut in solar subsidies.
Leblanc, S. (2016). Massachusetts House approves bill to boost hydro, wind power. Retrieved June 9, 2016 fromMassachusetts House approves bill to boost hydro, wind power.
A full list of references is available from the authors upon request.