The Hunt for Reforming Energy Markets
The world’s energy markets are driven by differing priorities. Those in developed markets are concerned with generation fuel mix, particularly around renewables subsidies and targets, and the growing relevance of distributed energy. In emerging markets, the focus is on increasing electrification rates to take advantage of the strong link between installed generation capacity and GDP. Underpinning these different priorities is a realization that the current level of electricity pool prices in northern Europe and North America points to a mismatch between where electricity companies have historically placed their bets, and where the winning hands will be dealt in emerging markets.
In both developed and emerging markets, the challenges faced by governments and utilities to balance demand and cost while improving services are often the catalyst for reform. The momentum of reform has gathered pace over the last year, with new profitable opportunities created by the unbundling of incumbent utilities, new retail competition and privatization of utility assets. These developments allow both established businesses and new players to gain new market share amid otherwise challenging growth environments.
But navigating reforming markets is not easy. Early knowledge of where reform is likely to hit next helps potential investors plan a successful entry strategy and manage the inherent risks of entering these volatile markets.
Energy reform opportunities usually take one of two forms:
Opportunity 1: unbundling vertically integrated energy markets
The first type of reform takes place when existing bundled (vertically integrated) markets are unbundled. These reforms offer opportunities for new entrant generation and for new entrant retailers.
The opportunities created by these reforms arise through the unbundling of previous bilateral contracts which tend to be grouped by company rather than by set or station. As the market is designed, the costs of sent-out generation combines with overhead corporate cost allocation and a suite of accurate congestion and constraint equations in the network to provide the first ever view of the relative costs of the merit order.
This scenario means that those generators that do not have long-term contracts with the incumbent may face competition from lower-priced new entrants when the market opens.
Mexico’s growing energy demand attracts foreign investors
This is happening in Mexico, where the Government is progressing what is expected to be a six-month-long process to separate state-owned utility Comision Federal de Electricidad (CFE) into eight independent companies to undertake power generation, transmission, distribution and commercialization activities.
When the Mexican Government commenced reforms of the wholesale generation market in January 2016 and allowed competition from independent companies, there was huge interest from European and US investors and strategic investors. The low utilization rate of existing plants, increasing energy demand of 3%–4% per year and possible coal plant retirements make conditions ripe for foreign investors to explore Mexican inbound opportunities. Mexico’s first electricity auction awarded contracts to prominent utilities from Europe and North America to develop 1,720mw of capacity.
As reforms progress, expect more, diverse players to consider entering the Mexican market, both in targeted retailing opportunities and through generation. Pending resolution of some of the labor market negotiations which will define the market, and the publication of necessary market information to enable forward curves to be fully assessed, there will likely be interest from integrated players and IPPs from the US, western European utilities (already active in Latin America), Chinese and Japanese conglomerates and trading houses looking for stable assets. Financial investors keen to build their infrastructure asset portfolios are also expected to explore opportunities. As always, the devil lies in the detail of market arrangements.
Opportunity 2: opening retail energy markets to competition
The second type of reform opportunities occurs when energy retail markets open to competition. These opportunities are important for new entrant retailers looking to enter new markets either alone or in partnerships, large customers who are keen to supply themselves and potentially others, or companies currently supplying the market with other services such as insurance, gas or telecommunications.
While Mexico provides opportunities as mentioned above, Japan is another prominent example of this type of reform. Already, more than 250 new companies have registered to participate in Japan’s energy retail market, which opened to competition in April 2016. These companies include gas and telecommunication companies, cable television providers and conglomerates that believe this US$67b electricity market offers potential for long-term profits.
Companies with existing last-mile connectivity to customers (gas distribution, telecommunications, cable television, etc.) are planning to capture market share by offering lower tariffs achieved through leveraging cost synergies from existing infrastructure and by offering bundled services at competitive rates.
These new entrants are already creating considerable customer churn for the incumbents. Recent switching support system usage data released suggests more than half a million applications have been made since 1 April to change electricity supplier — an increase of 154,000 or 41% each week. In April 2017, city gas suppliers will also lose their monopoly on the retail city gas market, leading to a decline in market share of monopoly companies, and sure to attract the interest of cross-border investors. The complexity of the relationship between telecommunications companies and customers may provide an advantage to the telco space in this race for churn.
Taking advantage of these types of opportunities is complex. Successful energy retailing requires achieving a level of scale as well as an intimate understanding of overarching policy and network or retail business-to-business procedures. Without this, the prospects for new entrants can be daunting but not impossible. International retailers will do best by partnering with local new entrants where they can find a willing vehicle for their competition-hardened procedures.
Energy reform is always complex, particularly for foreign players
Of course, if investment into new markets was easy, everyone would do it. Navigating the nuances of market changes is difficult for all stakeholders — governments, regulators, incumbents and new entrants. Reforms generate significant risks both in execution and from the unintended consequences of market design. In many reforming markets, regulations and policies are frequently revised as governments adapt to changing conditions, and those closest to the policymakers have the advantage of both relationships and operational market familiarity.
Foreign investors are particularly vulnerable to misjudging regulatory jurisdictions, the local market environment and ground-level policies. Over the past 12 months, many of these investors have learned lessons about the risks of being too quick to enter reforming markets.
Due diligence and domestic partnerships enhance success
Stringent due diligence is critical when considering opportunities in reforming markets. This due diligence must consider regulatory and future forward curve scenarios, many of which are emerging or changing as reform unfolds, as well as market and political conditions. Partnerships are key in this environment.
Only a big picture view of the global energy market and knowledge of the specific features of each local landscape will allow both new entrants and domestic players to realize the potential of reform.
Matt Rennie is EY’s Global Power & Utilities Transactions Leader. He is based in Brisbane. For more information, visit ey.com/powerandutilities.
‘The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organization or its member firms’.
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