What Is An Acceptable Yield For A Portfolio Of Toxic Assets?

Includes: NYLD, TERP
by: EnerTuition


The low cost of operating nanogrids essentially ensure that utilities will start losing large-scale customers at an increasing pace.

Utilities will have to start moving to lower cost structures and start building their business models around distribution assets.

Power generating assets, the assets the Yieldcos hold, will be increasingly toxic over time.

This is our fifth article in a series of articles about Yieldcos - specifically TerraForm Power (NASDAQ:TERP) and NRG Yield (NYSE:NYLD). For an introduction to Yieldcos and our view of the energy industry, please refer to the previous articles here, here, here and here.

To summarize earlier articles, utilities are facing a confluence of threats from solar, battery and nanogrid technologies. The responses from utilities so far have been in terms of tariff changes, connection rates and other similar mechanisms. We discussed how these responses are inadequate and how there is a need for utilities to change their business models to counter the emerging threats.

In this article, we look at how utilities can address the threat of nanogrids and the overall impact of utility business model changes on Yieldcos.

Addressing the threat of nanogrids

The one trend that is likely to sting utilities hard in the near term is the deployment of nanogrids. Nanogrids, especially the larger-scale commercial versions, have the potential to siphon away large revenue streams from utilities. In a typical nanogrid, the power is derived from a combination of a low-cost renewable source and an adjunct natural gas power plant. The low cost of the energy produced makes these systems highly attractive to larger industrial and commercial customers.

For example, energy costs from a 1MW+ nanogrid can range from as little as $0.05 to $0.08, depending on the size of a system, solar resource and other regional factors. At these cost levels, customers may save anywhere from 40% to 80% on energy costs compared to the local utility provider. The resulting savings can be dramatic for a high energy-use customer.

These solutions can also be highly desirable tax shields for businesses looking to take advantage of the tax benefits of ITC and MACRS. Depending on the tariffs of the local utility and the amount of solar resource in the region, these solutions may have a payback period as little as three to seven years.

These systems not only have a short payback period, but provide energy at incredibly low rates in the later years. Since the solar power generation profile closely matches that of a typical industrial application, the ongoing cost of the adjunct natural gas generation is likely to be very low. Depending on the usage model, some customers may see a blended cost of $0.01 to $0.02 per KWH - a level which no utility is likely to touch. (On a side note, these low energy costs will likely lead to a resurgence of energy-intensive manufacturing in the US over the next decade.)

Because of this cost structure, nanogrids are a likely to become a major threat to the utility hegemony, and we expect nanogrids to grow rapidly for the foreseeable future. Utilities that respond slowly to the nanogrid threat stand to lose a considerable amount of shareholder wealth in a very short period of time.

So, how can the utilities compete with these nanogrids? The simple answer is that utilities, with their current cost structures, cannot compete with nanogrids. A good near-term solution for utilities is to take a preventive approach and reduce the chance of a customer defecting. It is necessary for utilities to sell customers the mutual benefits of staying connected to the grid.

The advantage that utilities have compared to solution providers selling nanogrids is that utilities understand the consumption patterns of their customers more than any third-party. To protect the revenue streams, what the utilities need to do is identify high-value customers who are likely to defect, and proactively work with them to reduce energy bills.

For the utility business model to survive, the reduction in energy prices to its large customers must be offset by corresponding reductions in cost structures. While such a move could be painful to utilities and their employees, a transition to a leaner utility model is a necessary first step for many utilities as they enter the new competitive world.

Utilities also have the option of getting into the business of installing and managing nanogrids. However, this is likely to be a low-margin business unsuited for the current high overhead utility business model.

To be successful in the nanogrid business, utilities need to reduce their cost structures to be competitive with specialized installers. This would be extremely difficult to achieve, even for some of the best-managed utilities. As an alternative, utilities can invest in or partner with leaner third-party companies that are better suited to be in the nanogrid business. Readers should note that any cash flows that a utility can get from installation and maintenance of a nanogrid will be far smaller the revenue streams that the utilities lose to the nanogrids.

Utility Business Model Prognosis

Market shares are won and lost during technology transitions. Utilities are about to witness a major technology shift in energy production, which will disrupt the utility business model. During this disruption, a once safe cash flow business can become high-risk in a relatively short period of time.

In the short term, utilities can use delay tactics, changing tariffs, and regulations to reduce the attractiveness of solar and battery technologies. This strategy may work moderately well in impeding solar penetration in the short term. However, we believe the current utility strategy of fighting against battery technologies is misguided. Utilities, instead of being afraid of storage and resisting them, should instead push to make storage a mandated part of any intermittent generating power system. Mandating batteries will allow for a more orderly and sustainable growth of solar, which would be of mutual benefits to utilities and their customers. If properly managed, battery technologies can solve a lot of grid challenges and make utilities more effective operators.

In the long term, the utility business models need to change radically. We foresee the need for current utility models to disappear in a decade and be replaced by new business models. To be successful, utilities need to reduce their cost structures, offer market-based solutions, and partner with third-parties, as necessary. The utilities that resist change are likely to be unsuccessful and destroy a considerable amount of shareholder wealth.

Declining solar energy costs, power generating assets, and long-term energy contracts will be significant risk factors for utilities. To mitigate the risk, a typical utility will likely break into two distinct parts. The ownership and management of the grid will become the more valuable and sustainable part of the business, whereas the power generation aspect is likely to be demoted to a smaller role or be divested in its entirety.

The premise here is that a utility's biggest value is in being a grid manager, an energy transporter, and an energy distributor. To serve the customers better and to stay financially strong, utilities need to get rid of expensive energy generation facilities off their balance sheets, and let those toxic assets be financed by more risk-tolerant investors.

In spite of the challenges that we see, we do not believe in utility doomsday scenarios. We believe that many utilities will successfully adapt to these new models. The utilities that are most exposed to losses in this dynamic are the utilities with power generating assets and those with unsustainably high energy procurement costs. The utilities that take precautions to get to a low cost structure and divest the toxic assets are likely to survive and thrive in the new DG era.

Impacts on Yieldcos

The underlying assumption behind the Yieldco model is that utility companies have the market power to pass on the energy procurement cost to the ratepayers or that the utilities or commercial customers will continue to honor the higher-priced PPA, in spite of increasing cost delta with prevailing costs. We find that this assumption is naïve and far-fetched.

The Yieldcos may argue that PPAs with geographically spread out high-credit counterparties are safe bets. We disagree - the trends that we discuss here are universal and not specific to the US. The credit of many of these counterparties over the duration of PPA is likely to change dramatically.

In any conceivable scenario, the Yieldco customers will value power at continually lower rates, and the Yieldcos will be increasingly faced with a tough choice of lower renegotiated rates or a customer default.

Yieldcos, whose entire business model depends on solidity of the asset base and stable returns, will likely suffer increasing losses as the utility business models change and utilities and other commercial customers demand lower-cost power. We predict that the first batch of underperforming or non-performing Yieldco assets will surface as early as 2020. By 2025, there will be a deluge of PPAs that will have to be renegotiated at a substantial discount from the initial rates.

Floating PPAs (i.e., PPAs where the rate is pegged as an ongoing discount to the local utility or another rate) would take much of the default risk away from the Yieldcos, but would create lower and unpredictable cash flows. Readers should note that variable cash flows are an anathema to the Yieldco model, and none of the Yieldcos today use such instruments.

In an era where anyone can generate power and in an era where power costs are going to be on a continuous decline, power generating assets are foolhardy investments. Since power generating assets are the primary assets of a Yieldco, one has to reach an inevitable conclusion that the Yieldcos are high-risk investments.

The question then becomes: What is an acceptable yield for a portfolio of toxic assets?

This concludes our review of the macro trends in the utility industry. In the upcoming articles, we will look at impacts of this emerging landscape on specific companies.

In our next article, we look at the TerraForm Power S-1 and share our view on what an acceptable yield for TERP holders should be.

Our Sentiment on NYLD: Avoid

Our Sentiment on TERP: Avoid

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.