TerraForm Power And NRG Yield: Energy Yieldco Customer Dynamics

| About: NRG Yield, (NYLD)
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Utility business models are under siege from solar, battery and more importantly, nanogrid technologies.

To compete in this new energy market, utility models need to change dramatically.

Investors considering the utility PPA payments to the Yieldcos being safe are in for a surprise.

This is our third article in a series of articles about Yieldcos. For an introduction to Yieldcos and our view of the energy industry please refer to the previous articles here and here.

The allure of TerraForm Power and NRG Yield (NYSE:NYLD) is that they operate in "safe" utility industry. In our last article, we discussed the declining price trends of solar technologies and how that affects the PPAs that the Yieldcos have with the utilities. The trends show unequivocally that the utility industry is facing a disruption in terms of the sources of energy and these changes make utility power generation assets inherently unsafe.

In this article, we take a look at some of the utility industry's other challenges and how utility customers are evolving. We explain how these dynamics impact the business models of utility and Yieldcos. At the end of the article, readers can decide if the utility market is as "safe" as the Yieldco yields suggest.

As things stand today, solar energy, in most parts of the world, is a subsidized source of energy. While the unsubsidized cost of solar has dropped below retail grid parity in several parts of the world, solar energy is generally not economical at the wholesale level without a subsidy regime. Most utilities would not deploy solar today if it were not for the subsidies and state mandates. This dynamic has created complacency in the utility industry regarding solar adoption rates and the long-term impact of solar. However, for several utilities today, this is no longer the case. The increasing penetration of solar due to dropping prices is making utilities start to plan their future in the solar DG world.

In spite of the increased penetration, the reality today is that true grid parity with solar is many years or even decades away if there is no net metering. In fact, it is fair to say that the solar revolution would not have happened without grid connection or net metering. Achieving grid parity without net metering would require a substantial long-term seasonal storage. Enabling such a storage system requires significant technological breakthroughs or a long walk along secular price trends. In either case, we do not see a feasible path to true grid parity without net metering until 2025 or 2030. Even when it is achieved, it will be a very inefficient solution and suboptimal at an individual customer level.

Utilities play a major role in making the overall system optimal for customers. There is substantial value in utility aggregation, and there is substantial value in a customer being connected to the grid. Utilities realize this mutual benefit, and have been developing strategies to stay relevant and viable in a world that is increasingly embracing solar DG.

Just as utilities are starting to grapple with the threat of solar, battery technology is also starting to disrupt the utility industry. There is much talk of how solar combined with battery can take customers off-grid and collapse the utility business model. In a recent missive, Barclays downgraded utility bonds for the fear of what the combination of solar and residential storage might do to the utility business model. While we do not agree with Barclays' assessment for various reasons, there is little doubt that the utility business model is facing a substantial threat from emerging battery technologies.

In our view, the short-term threat from battery technologies is not from customers going off the grid, but from customers using these technologies for energy arbitrage. In recent years, several dozen battery technology companies have been funded with a mission of tapping into the utility revenue streams. Companies such as Stem Inc. are already selling systems that use cost-effective batteries to store energy at times of low tariff and discharge it during times of high tariff. As these battery-based solutions pervade, the resulting energy arbitrage will cut deeply into what is currently a high-margin utility cash flow stream. If left unchecked, energy arbitrage, when combined with distributed solar generation can wreak havoc on utility bottom lines.

The threat to the utilities does not stop with solar and battery technologies - we are now beginning to see a third disruptive force entering the utility picture to capture another slice of the utility revenue stream. This force, which we will call nanogrids, for a lack of a better word, has the potential to be even more devastating to the utility business models than solar and battery technologies.

So, what is a nanogrid?

While there are many possible definitions of a nanogrid, the general definition is a small localized grid designed to solve the energy needs of small private properties, such as homes, apartment complexes, commercial/industrial buildings and complexes. Nanogrids, unlike microgrids, are easy to deploy, because they do not have any public right of way issues and they do not directly compete with utilities.

The advantages of a nanogrid to customers are as follows:

  • It provides for an aggregation of energy needs that cuts down the demand variability and increases the efficiency of the system (except in corner cases where the nanogrid serves a single off-grid home or a single smallish load).
  • It can have the facility to add battery or other storage to even out energy from an intermittent resource like solar or wind.
  • It can have a facility to add backup natural gas or other filler power source, if desired.
  • It provides some amount of scale that decreases the cost of shared resources.
  • It can provide a means to stay completely off the grid, if needed (i.e. grid is optional).

Nanogrids have been around for a long time, but have stayed a narrow niche because of the high cost of small-size carbon-based power sources. However, the availability of low-cost solar energy and low-cost NG power generation systems has dramatically altered the nanogrid landscape.

In the coming decade, we expect to see a tsunami of nanogrids being deployed in the US and rest of the world. The losers of the nanogrid trend: utilities and energy generation Yieldcos. The winners of the nanogrid trend: DG solar players, including SunEdison (SUNE) (see thesis), SolarCity (SCTY) (see thesis), SunPower (NASDAQ:SPWR) (see thesis), FirstSolar (NASDAQ:FSLR) (see thesis), RGS Energy (NASDAQ:RGSE) (see thesis), Chinese project players, and various local and regional contractors.

Readers should note that the initial and primary targets for the nanogrids are high energy-consuming commercial and industrial customers. These customers have economies of scale, need, resources and flexibility to augment cheap solar with battery or Natural Gas backup, and are able to reach grid parity sooner. It is these customers that utilities have to worry about the most. These are their prized customers, and defection in ranks from these customers can significantly hurt a typical utility's economic prospects.

Contrary to what Barclays says, it is not solar+battery that can move people off-grid, but it is the solar+nanogrids. Nanogrid can effectively make large residential, commercial or industrial customers disappear off the grid overnight. Losing these high-volume clients represents a large threat to the utility business model in the short term.

Once a customer is lost to a nanogrid, it is unlikely that customer will ever return. Similarly, once a customer installs solar, that customer's energy needs from the utility go down permanently. It is easier for a utility to sell the customer on an efficient solution for the benefit of the customer and the utility, and keep the customer tied to the grid, rather than letting the customer defect and create a suboptimal situation for anyone.

Utilities have been operating for several decades in a mode where they could take customers for granted. However, with a triple threat of solar, battery and nanogrids, that customer model no longer works. When utilities realize that their customers are no longer as dependent on the utilities and can truly defect, the value of the customer becomes clear and the utility business model's choices become stark.

To succeed in this new paradigm, utilities have no choice but to radically transform their business models, cost structures and tariff structures so that they can effectively compete to retain customers. This will not be easy, but it is possible. In our next article, we discuss how utilities are likely to respond to address these threats, and the resulting implications to the Yieldco model.

As we pointed out at the beginning of the article, the NRG Yield and TerraForm Power Yieldco business models are based on assumption of "safe" revenue streams from the utility customers. With multiple new competitors looking to siphon off utility revenue streams, we assert that the utility business model is far from being safe. We hope readers can see how uncertain and fragile the utility business model is likely to be in the coming years. For those who are interested in DG-based Yieldco models, we recommend our previous article on a related topic here.

With the current industry backdrop, we are skeptical of Yieldcos or other yield vehicles that depend on PPAs from utility and DG industries. Some of the Yieldcos that rely on long-term utility PPAs include: Pattern Energy Group (NASDAQ:PEGI), NextEra Partners (NYSEMKT:NEP), Abengoa Yield (ABY), Hannon Armstrong (NYSE:HASI) and Brookfield Renewable Energy Partners (NYSE:BEP). We urge the readers intending to invest in these and other similar Yieldcos to use caution.

Our Sentiment on NYLD: Avoid

Our Sentiment on TERP: Avoid

Disclosure: The author is long FSLR. 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.