As a follow up to the two previous articles – Split decision: Can utilities keep fossil fuel assets while chasing renewables? and Capital idea: Should utilities invest in the old or the new? – I have taken the lessons learned about the diverging distributed and centralised energy markets to form part of a loose strategic guide for an attempted brown to green transition.
The strategic guide below is just one potential framework for managing shareholder value as part of this transition. But as the title “brown to green” suggests, there are also external carbon liabilities to factor in along with a host of other regulatory considerations specific to particular locations.
The lessons from Europe will tell us that attempting this transition with a single corporate strategy, and efficiently allocating capital to achieve an investment return above the cost of capital between these two competing markets with competing asset bases, is not actually possible.
Despite the best intentions of some of the brightest minds in business, it is highly likely that there will be a number of very well-paid CEOs who will get this wrong and lose billions of dollars for their shareholders over the next 10-15 years.
To have a chance at succeeding, it will be fundamental to have a well thought out and highly flexible strategy that has complete buy-in from all parts of the business and investors, as the forces pulling utility business models apart are only likely to magnify over time.
It will also be important to acknowledge, both externally and internally, that like with any industry disruption – at least until the transition is complete – it is going to be more about minimising shareholder losses rather than creating value.
While this will be very difficult, there are some internal strategies that utilities could use to de-risk the transition for shareholders.
Strategy 1. Where possible embrace the future
The lesson from EON’s loss in shareholder value is that at a strategy level there was no clear direction about where they were going. They just kept hoping the German government might change their mind on carbon and nuclear regulations, so were not able to fully embrace the distributed opportunities until after they had written off billions of Euros in value.
It is true that they would have lost value anyway, but it would almost certainly have been better for shareholders had they said in 2008 “we are going to embrace the future.”
The recent demerger undertaken by EON has created certainty for management by making it crystal clear what market they are chasing. At a strategy level, they have turned all of the carbon risk and technology disruption risk into a tailwind of relative competitive advantage that their rivals will have to deal with, but that they are now better able to manage.
Strategy 2. Be a good parent
The notion of “parenting advantage” was elaborated on in a previous article but this is going to be something regularly monitored at a portfolio level if they are hoping to keep the company together through any brown to green transition.
So as a way of maximising shareholder value, utilities will need to be aware of the strategic rationale for asset divestment, which would relate to the following three conditions:
- Owner logic – is the parent organisation still the best owner for the asset?
- Does the renewables distributed-based business have enough scale to divest?
- Is the parenting benefit/synergies considered by the market as a discount to value?
As utilities go down this path it is going to be important that they can demonstrate to the market, using owner logic, that they are still the highest value adding owner of the asset.
If they can do this, shareholders will still tolerate keeping the assets but if it is at a discount under the current ownership investors will start to want them spun off and the money returned.
Strategy 3. Manage centralised and distributed assets separately
This is the last, but in my view by far the most important strategy of all if you aim to look after your shareholders throughout a transition.
This can be done by keeping the business units separated from a strategy, accounting and governance perspective. By structuring the utility in this way it will give the CEO two very important tools in defending themselves against a shareholder revolt.
- It allows for a transparent comparison of revenue and performance against pure play competitors in both their respective centralised and distributed markets;
- Gives the maximum flexibility in spinning off the assets should there be a strategic need to do so;
- Minimises internal governance problems and trade-offs.
Before expanding on the benefits of this approach it is important to acknowledge the potential deficiencies relating to a possible lack of suitable pure-play listed comparables and the difficulties in transparently separating revenue from parts of the business, like energy trading, that utilise both asset bases.
What this does is enable the CEO to communicate transparently with both shareholders and the market is the relative performance of their respective centralised and distributed assets.
If his or her assets fall in value by 5 per cent while all the other pure-play centralised thermal generators lost 15 per cent, then they have outperformed the market.
Even better would be if they could also demonstrate that by leveraging their incumbency or retail footprint they have been able to grow their distributed business by 25 per cent, relative to other pure-play comparables who might have only been able to achieve 15 per cent.
A lot of the analysis here focused on Europe, but similar problems were also experienced by NRG in the US, whose share price fell from $35 down to $12. Had David Crane (who I greatly admire for what he took on) been able to break the performance of his business into its components, demonstrate their performance relative to peers and then communicate it to the market he may have been able to defend himself better.
If listed utilities want to have any hope of managing this brown to green transition they will need to commit to a plan, present it in a way that is believable, deliver on it, and effectively communicate it to the market.
If the strategy for transition is too complicated for investors they will just tailor their own exposure to these pure-play centralised or distributed companies depending on their risk profile and personal preference.
One of the great risks magnifying this demerging trend is driven not just by technology but by investors who will have a bias towards wanting to tear these utilities apart once the distributed businesses get enough revenue and scale.
It is much easier for them at an investor portfolio level to set their exposure to these respective asset bases than try to understand some complicated value destroying transition that is much more difficult to price.
As a bonus, in most cases of unlocking a parenting discount, they also fix up all the strategy and capital allocation problems at the same time.
Over time, investors will also be much more inclined to get involved in capital raises for these new high growth renewables companies if they have a clear, targeted corporate strategy for a particular market.
If you compare that to what they are doing at the moment, they are giving up their dividends (retained earnings) so that management can fumble around with a single corporate strategy trying to efficiently allocate capital between a growth and declining market.
So I am not saying that a brown to green transition can’t be done (although statistically it remains unlikely), but at least by seeking relative outperformance in both the distributed and centralised markets you are giving your shareholders the greatest optionality as they undertake it.
Matthew Grantham is a guest contributor for RenewEconomy.
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