The large utility infrastructure networks that were built throughout the 20th century underpinned the expansionist model of the linear economy. Centrally monitored electricity, gas and water networks ensured that supply matched demand, and the wires and pipelines were tailored and expanded to meet all customers’ needs. These infrastructure assets were often organized under a monopoly regime, even in deregulated industries, so that the system operator could make all the necessary investments needed to develop the market. But as we strive towards a system change, replacing linear business models with circular, impact-integrating strategies, network infrastructures are at the core of a major shift. From low-risk, low-return physical assets, they are being transformed into smart grids.
Coined in the 1990s to describe the intertwining of electricity and telecommunication infrastructure, “smart grids” refer to the aggregation of technologies, including smart metering, distribution automation and advanced grid applications. Investment in smart grid technologies has risen exponentially for the last decade, reaching $13.9 billion in 2012, and is projected to increase to $25 billion in 2018, of which $4 billion is in North America. The benefits of making the pipes and wires smarter are multiple. Economically, their cost-saving potential has a multiplier effect through the value chains in which they are embedded. Environmentally, they are central to climate change mitigation strategies, in realizing energy efficiency and allow proponents or municipalities to fine-tune demand and supply balancing. They are also a key driver in the expansion of renewable energy and energy storage technologies. Socially, they allow customers to reduce their energy bills while making networks more resilient and flexible.
Before addressing the investment ramifications of smart grid technology, it’s critical to underscore the potential differences in the old utility model versus the new “smart grid” model. An example best illustrates this point: with the development of distributed generation, the roles of suppliers and customers are merged, and even reversed. A homeowner with rooftop solar panels becomes the supplier of the utility company, which buys the electricity produced by its residential client. The network itself transforms from a passive transmission infrastructure to an active element of the balancing system. This reorganization of the energy markets opens up new opportunities for investors.
The increased interdependence of the energy market with the rest of the economy and the added global value of smart grid technologies explain the variety of new players entering the energy infrastructure market. From IT hardware and software to telecommunications companies, these new players want a share of the energy market previously reserved by utilities, as well as direct access to their customers. From an investor standpoint, however, we believe investment implications will be realized over varying time horizons. Rather than a full-scale transformation of the grid, we see a gradual shift taking place, as there are complex (though not insurmountable) barriers to implementation in addition to a multifaceted ecosystem of stakeholders. There won’t be a turnkey, single-point solution; in contrast, smart grid technology will be deployed on a piecemeal basis depending on various considerations including geography, market structure and regulatory regime.
To break down the “smart grid” market, supply-side investments include smart metering, distributed automation and advanced grids, while demand-side applications include demand-response and energy efficiency technologies. When accounting for time horizon and technology risk, some of the immediately addressable low-hanging fruit can be found in demand-side solutions. A particularly intriguing end market is building efficiency, as buildings account for 40% of the world’s energy use. Johnson Controls, a US-based global conglomerate, addresses this market with its Building Efficiency business. Their Metasys product provides central instrumentation and control and collects data from sensors in applications such as HVAC and lighting. It also administers air temperature and lighting needs based on occupancy and schedules equipment to optimize energy use. The company’s complimentary cloud-based product, Panoptix, connects customers to an online community of peers and delivers standardized data from multiple systems to provide insight into building performance. The Building Efficiency segment accounted for approximately 34% of Johnson Controls’ revenues in FY13. While these products do not constitute the entire segment, they clearly are an important strategic business driver for the company.
On the supply side, we believe upstream investment (upstream of the meter) will account for a significant portion of smart grid expenditure. In particular, distributed automation could be a primary focus due to the fact that it enables utilities to realize greater value from their existing networks without engaging customers. Distributed automation is the software and hardware that allows utilities and grid operators to extend influence over grid functions to the distribution level and beyond. With this in mind, it appears Swiss-based ABB is well positioned to capitalize on distributed automation equipment. The company’s Power Systems segment offers turnkey solutions for traditional and renewable energy-based power generation plants, transmission grids and distribution networks. Furthermore, ABB has developed a high-voltage DC (HVDC) circuit breaker that disconnects parts of the grid in the event a problem, allowing the rest to keep working. This has the potential to be disruptive as HVDC has only been used for point-to-point transmission – not to form integrated grid networks. It’s also worth noting that ABB’s Power Products unit supplies the Power Systems segment with equipment. Together, these two segments accounted for 46% of ABB’s revenues in 2013.
Investment opportunities for some represent congruent risks for others. It’s no surprise, then, that some are questioning the sustainability of the traditional utility business model. It’s easy to characterize utilities as being intransigent, but the situation cannot be so easily summarized. Utilities face an inherent dichotomy – they are required to operate in a conservative and steady manner (i.e. keep the lights on), but are simultaneously expected to be on the leading edge of new technology. Some industry experts suggest that utilities bifurcate their model, but the practicality of such a suggestion at scale is not yet clear.
In the meantime, increased customer focus on energy efficiency and demand response, falling costs of renewables generation and anemic or negative power demand growth (the latter applying more to developed markets) are converging to create an unfamiliar set of risks for traditionally risk-averse utility investors. We believe utilities operating in regulated markets that own and integrate renewables and distributed generation into downstream infrastructure (T&D) are less exposed to long-term business risk relative to utilities that operate in non-regulated markets that are heavily dependent on centrally located, commodity-based generation without exposure to downstream assets.
In surveying the utilities sector landscape, the Portuguese electric utility EDP also stands out as being well positioned. Despite some exposure to countries with a weak macroeconomic backdrop (i.e. Portugal), EDP derives more than 90% of EBITDA from long-term contracts and regulated activities. It has significant distribution assets and, since 2009, more than half the electricity produced by EDP comes from renewable sources (64% in 2011). On the other hand, we are concerned with the business risks facing Dynegy, a US-based electric utility that owns and operates natural gas-fired and coal-fired power plants. Dynegy is facing several headwinds in that more than half of its fleet is coal-fired and significant capital expenditure may be required to meet environmental regulations, second it competes in competitive power markets, and there are downstream (transmission) constraints that limit Dynegy’s ability to capture additional value.
Margarita Pirovska, PhD, is the Policy & Sustainability Analyst at Cornerstone Capital Inc. and former Project Manager at GDF Suez in the Sustainable Development Division.
Michael Shavel, CFA is a Research & Business Analyst at Cornerstone Capital Inc. and a former Research Analyst on AllianceBernstein’s Global Growth & Thematic team.
 Tracking clean energy progress (IEA, 2013)
 Accelerating Smart Grid Investments (WEF, 2009)