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Return of Enron to the Energy Sector?

Summary:
The lure of forever-cheap money. But now rates are going up. By Leonard S. Hyman and William I. Tilles: Ignacio Galán warns of Enron-like failures in the energy industry. Ignacio who? Ignacio Galán is the CEO of Iberdrola, the far flung Spanish-based utility holding company with operations in Spain, the UK, Brazil, Mexico, and the US (where it owns Northeast electric and gas distributor Avangrid). In an interview with the Financial Times, Mr. Galan was publicly expressing his concerns regarding the state of the renewables business. In particular, he addressed recent low bids to supply power offered by highly leveraged newcomers to the industry. He likened these new entrants in the renewables business to legendary corporate fraudster Enron in terms of excessive leverage coupled with

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The lure of forever-cheap money. But now rates are going up.

By Leonard S. Hyman and William I. Tilles:

Ignacio Galán warns of Enron-like failures in the energy industry. Ignacio who?

Ignacio Galán is the CEO of Iberdrola, the far flung Spanish-based utility holding company with operations in Spain, the UK, Brazil, Mexico, and the US (where it owns Northeast electric and gas distributor Avangrid). In an interview with the Financial Times, Mr. Galan was publicly expressing his concerns regarding the state of the renewables business. In particular, he addressed recent low bids to supply power offered by highly leveraged newcomers to the industry. He likened these new entrants in the renewables business to legendary corporate fraudster Enron in terms of excessive leverage coupled with limited operational skills.

“Because money is so cheap, many people who have no talent in the sector have been coming with an extremely high level of leverage,” he said. “With the change of the rates, there will be a clean-up of the sector.”

The Financial Times ads:

Mr Galán was not accusing any new entrants in the renewable sector — some of whom are private equity or infrastructure funds — of the kind of false accounting that led to US energy trader Enron’s collapse in 2001. He was instead highlighting how cheap money was pushing some into a business they did not understand.

Is this merely sour grapes from a high cost, losing bidder? Last year in Spain, for example, Iberdrola’s renewables unit did not win any of the 3,000 additional MWs open for bid. Perhaps. But the point of Mr. Galan’s criticism is that a protracted period of extremely low interest rates has affected the bidding process for electricity driving down costs and profitability for all participants. Conversely, he anticipates that rising interest rates will inevitably put pressure on highly leveraged bidders in power markets.

Producing electricity, regardless of technology employed, is a capital intensive business. Cost of capital makes up 70-80% of the levelized cost of a wind or solar project. Most prospective providers of renewable energy purchase equipment from the same list of reputable suppliers like Siemens or GE. As a result, the cost of physical assets ought not to differ significantly from supplier to supplier.

So how can wholesale renewable electricity suppliers differentiate themselves in such a vigorously competitive market? There are three areas:

  • Understanding their own cost structures (with an eye towards rigorous cost controls).
  • Assumptions about energy output.
  • Their underlying cost of capital.

Roughly speaking, a one percentage point increase in cost of capital requires a 15% price hike to cover increased interest and equity expense.

Is a one percentage point rise in interest rates and capital costs so unlikely these days? And what happens to profitability when new builders of renewable generating assets submit bids on the basis of current capital costs yet complete their project with a different, higher cost of capital?

According to international sources, new bids to supply onshore wind and solar electricity are in the 4-5¢ per kwh range. In the US, the Energy Information Administration, which produces the most elaborate technology estimates, projects onshore wind and utility solar levelized costs of 4.4¢ and 5.8.¢ respectively for plants going into service in 2022, after tax credits.

Just to clarify, that means that the actual expected electricity costs from the new renewable assets is about are 5.6¢ and 7.4¢ respectively, before Uncle Sam returns money to plant builders in the form of tax credits. So, are we back to the bad joke – I lose money on every box I sell, but I make it up on volume?

Mr. Galán’s point, we believe, is that a lot of the new financially-motivated highly-leverage low bidders in US and European wholesale renewables power markets will end up in financial distress. His implied point is that they have miscalculated their true costs and when push comes to shove, their bankers can’t or won’t bail them out.

“Bankers always give an umbrella when it is not raining, but when it rains they ask for it back,” he said.

The bottom line? Renewables now face significant near term financial headwinds, so to speak. Production costs, while continuing to fall, are no longer falling as fast as before. And the cost of capital will rise with interest rates, and as we previously showed, that matters.

Many of the amateurish over-leveraged new entrants will exit the business. And so will their bankers. The boom – caused by cheap money and declining costs of wind turbines and solar panels – will eventually meet the bust when that cheap money disappears.

But even after backing out the benefits of tax credits and measures to protect the electric grid from the intermittent nature of renewables, this business remains highly competitive with conventional power generating resources. And over time is likely to become even more so. By Leonard S. Hyman and William I. Tilles.

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