On December 1st, the German energy utility company E.ON announced it would spin off its conventional energy generation, upstream and trading businesses, and focus on renewable energy, networks and customer solutions. E.ON’s current shareholders will receive shares in this new company, in addition to their holdings in the parent company. E.ON will keep a minority stake in the new company and will divest from it in the medium term. Although this announcement came as a surprise, many investors expected radical change in response to six years of dwindling market capitalization and poor financial results.

The initial market reactions to this announcement were mixed. While some analysts welcomed the “bold new beginning” of the former European utility markets leader, others were not convinced that breaking up the vertically integrated company would actually create shareholder value. However, the market reality E.ON has been facing recently made a big change necessary.

A tale of two worlds: from volume to value

As E.ON’s senior management underscored in their official announcement, utilities have seen the rise of two very different energy worlds: a low-carbon bound market, where customers want more efficient, flexible and environmentally friendly energy solutions, and an “old” underlying energy system where conventional thermal power plants still provide much of the base load power needed to heat and light homes, offices and factories throughout developed countries. These two worlds illustrate the currently observed transition from a linear energy value chain, where centralized power generation provides energy through the grid to end users, to a customer-centered, flexible model, combining distributed generation and smart grids, with companies shifting their business models from volume to value[1]. But while integrated smart grids and low-carbon energy solutions are being tested and deployed, the market still needs the old centralized energy system, which is for now the sole provider of security of supply.

According to the International Energy Agency, gas and coal will still account for 39% of the world’s total primary energy demand in 2040 in a low-carbon scenario[2]. Therefore, these two worlds might co-exist for a long time to come. But with stagnating energy demand in developed countries, the growth prospects for the traditional energy utility model, based on the sale of kWh of energy, have become quite grim. At the same time, investments in capacity maintenance, development and resilience are still due. Someone has to continue paying for energy security, and for the transition from the old world to the new. A regulatory battle between policy makers and utilities on sharing this burden has been raging for the past years in most developed markets. How harmoniously those two energy worlds will coexist is not yet certain.

The smart-grid vs. energy security dilemma has been challenging the business models of utilities for quite some time now, and many have resisted the calls from the market to spin off, split or restructure their businesses in response to the evolving context. It is not the first time that utilities have been under pressure to drastically alter the way they do business. In the 1990s, the rise of the internet bubble made utilities appear very old-fashioned and gave way to companies like Enron which were striving to transition value creation from physical to immaterial assets (which didn’t work out well). In the 2000s, the European Commission pressured EU energy companies to spin off their gas and power networks in order to spur competition. The author advocated then that efficient market liberalization could be achieved without stripping utilities of their pipelines[3]. Many energy companies resisted that call to split and remained integrated. Later that decade, financial markets again pressured some utilities to focus on energy generation and sell their networks; with the decoupling of energy demand and GDP, conventional power generation eventually lost its appeal. What E.ON does today is certainly adapting to a changing environment. But it also proves that the grid is now more than ever at the heart of the energy utility business.

A model for future energy utilities?

By breaking its business model along the fault line between the old world and the new, what E.ON basically has done is give its shareholders clarity and choice. E.ON itself has clearly chosen its side, keeping the name, logo and the majority of its employees in the company devoted to the new energy world. Many analysts see this move as a “divestment” of fossil fuels, which on behalf of the operator of one of the dirtiest coal-fired power plants in the world appears extremely audacious.

E.ON has practically called on other utilities to do the same, and some of them immediately reacted negatively, defending their integrated models[4]. Experience tells us that energy utilities may be right about their industrial choices; and the transition to a low-carbon, more flexible and resilient energy model might also be achieved with vertically and horizontally integrated companies.

Governmental and regulatory organizations praised E.ON’s decision, and it appears indeed as a move comforting the process of liberalization of energy markets. But we should point out that it is a very different type of unbundling than the one European energy regulators fought for in the past decade. Instead of spinning off the networks, E.ON is placing them at the heart of the new model. This in a way vindicates the resistance by energy utilities to let go of their pipelines and power lines; and confirms the intuition that infrastructure is not only a profitable asset, it is also a core element of the energy market and a central piece in designing more flexible, efficient and resilient energy systems.

It’s about sustainable business

From an ESG performance point of view, the new E.ON practically covers all the best performing bits in terms of environmental and social criteria (energy efficiency, renewable energy, smart grids, and customer-oriented solutions). By contrast, the spin-off concentrates the “worst” ESG parts (nuclear, coal, gas, E&P, and also big hydro). A quick look into ESG databases shows that among European energy utilities, eight of the top 10 ESG performers are either pure network players, or are integrated utilities with infrastructure business[5]. E.ON’s choice is significant as it separates the most risky assets of its utility business, especially regarding the issue of climate change.

Similar strategies have been successful before, including the spin-offs by Enel and EDF of their renewable energy businesses, respectively Enel Green Power in 2008 and EDF Energies Nouvelles in 2006. In addition to developing clean energy, those companies have been relatively successful in financial markets. E.ON seems to be replicating this strategy, but on a completely different scale: the parent company is now the clean energy utility. If the market embraces the new E.ON the way it has done for EDF Energies Nouvelles, then this might reveal a promising future.

The new element here again is the role of networks. A substantial part of the EBITDA of the new E.ON, it unveils how distributed energy and smart grids completely rehabilitate old-style gas and power grids. The time when banks and governments were pressing energy companies to sell their networks to pension funds might well be over.

What ultimately matters is not what assets a company possesses, but how they are organized, managed, and how solid, integrated and efficient the company culture is. Separating the two parts of E.ON, and giving them independent means to grow and develop, can potentially produce very positive results for both new companies. But the devil is in the details. The boundaries between the two companies are still not clear, and how financial, social and especially some industrial questions are settled (namely what is related to security of supply and nuclear decommissioning) can significantly change the outcome of the strategy.

The new E.ON has gathered the most promising sides of the utility business: energy services (therefore unleashing the potential of the energy efficiency business); renewable energy (with its tremendous growth prospects); and gas and power networks (and all the comfort that such regulated assets can provide, in addition to their untapped potential in the building of smart grids). As for the high-carbon, thermal power generating and trading company, the market may still offer some upsides, while we wait for a clear and binding international carbon strategy, and a global slowdown of energy demand.

[1] See our article on smart grids: http://cornerstonecapinc.com/2014/04/smart-grid-infrastructure-status-infrastructure-and-risks/ The volume to value trend is similar to what happens with natural resource utilization: http://cornerstonecapinc.com/2014/11/opportunities-in-waste-or-wasted-opportunities/
[2] Source: http://www.worldenergyoutlook.org/
[5] Source: Sustainalytics. The pure network players have also outperformed their energy generation counterparts in terms of total return over the past 5 years (source: Bloomberg).

Margarita Pirovska is currently a shareholder in GDF SUEZ.

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