Overcoming many obstacles, energy technology continues to have potential.
In January 2000, Microsoft's Money Central Web site named Plug Power, a fuel cell company with virtually no revenues, as one of 10 stocks projected to rise 10,000 percent in the new millennium. This prediction quickly spread across the Internet and financial markets, sending energy technology stocks skyrocketing. Plug shares ultimately rose from their October 1999 IPO price of $15 to $156.50 (resulting in a market value of $6.6 billion). In June 2000, after a very large and over-subscribed round of private financing, Capstone Turbine, a microturbine company with no meaningful revenues, went public at $16 per share and traded as high as $98.50 per share (for a market capitalization of $7.2 billion).
Today, Plug trades at $8.53 per share, Capstone trades at $4.80, Proton Energy has traded as low as $4.29 (Proton has $5.25 per share of cash!), and Red Herring just gave itself a "C-" grade for its prior prediction. Initial exuberance over energy technology has been replaced with tough questions about over-hype and unfulfilled promises.
While the disappointment of public and private market investors is justified by the inability, thus far, of energy technology companies to achieve stated milestones, the promise of energy technology is real and these companies should not be ignored: the innovative products and services being developed and commercialized will dramatically change the future of U.S. energy markets.
The Nature of the Opportunities
Notwithstanding the slow pace of deregulation, lower energy prices, the current U.S. economic environment, and unfulfilled promises of energy technology companies, the opportunities that formed the foundation of sophisticated investor interest in energy technology still exist; in fact, many of these opportunities have only been magnified. Energy technology companies offer product and service solutions to a number of real, severe, and very large problems facing U.S. and global energy markets.
There are six drivers creating significant opportunities for energy technology: 1) dramatically increased demands for highly reliable, high quality power; 2) increasing dissatisfaction with the electric grid, coupled with the attractiveness of distributed power solutions; 3) the inevitability of deregulation; 4) demand for electrification in the developing world; 5) environmental regulation/government spending; and 6) increasing national security concerns. That these drivers are real and significant is powerfully illustrated by the numerous, large energy technology investments being made by incumbent oil companies, automobile manufacturers, and utilities.
While many electricity consumers can live with the flicker of a light bulb, or perhaps even a momentary power outage, many commercial and industrial companies cannot. As the economy has come to rely more and more on sophisticated digital equipment for all aspects of business, a tremendous need has developed for power quality (electricity that does not surge or sag) and power reliability (electricity that does not suffer outages). Digital equipment, be it server farms or telecommunications hardware, requires clean, constant electricity, i.e., power quality and power reliability. The more computers, telecommunication products, and the Internet become part of daily life, so too, do demands for power quality or power reliability.
Energy Tech 1999-2000:
A Tale of Irrational Exuberance?
The Money Central article () was a catalyst for far more than an increase in Plug's stock price. It set off a chain reaction that would lead to numerous initial public offerings involving the most prestigious of the nation's investment banks. In June 2000, Capstone Turbine went public, led by Goldman Sachs, Merrill Lynch, and Morgan Stanley. In August 2000, Active Power, a flywheel technology company, went public (raising $139 million), led by Goldman Sachs as did H Power (a fuel cell developer taken public by Lehman Brothers) and Millennium Cell. And on Sept. 29, 2000, Proton Energy went public, led by Morgan Stanley. In October 2000, Hydrogenics, another fuel cell company, went public, followed by Beacon Power, a flywheel company, and Evergreen Solar, a solar power company, in November.
Goldman Sachs, Banc of America, CSFB, CIBC World Markets, Thomas Wiesel Partners, Morgan Stanley, Lehman Brothers, First Albany, and Merrill Lynch all deployed investment bankers and research analysts to cover the energy technology sector. So too, the popular press, public stock managers, and hedge funds began focusing on energy technology. Articles and conferences began multiplying as energy technology was viewed like the Internet and Biotech spaces before it-an area in which there was relatively easy money to be made.
By the summer and fall of 2000, all this had changed. The once-darling energy technology sector was viewed by some as little more than another example of the irrational exuberance associated with "dot com" stocks. Energy technology stocks are down 60 percent year-to-date, and down over 50 to 75 percent from their 52-week high stock prices, with many companies trading at or near the value of the cash on that balance sheet. Evergreen Solar is down 46.5 percent since Sept. 11, and Beacon Power is down 85.4 percent year-to-date. There have been numerous pulled public offerings and downgrades. Venture capital rounds are not occurring or are getting done at lower valuations with much more onerous terms. And in November, there were lay-offs of energy technology bankers and research analysts at virtually all the top investment banks. Tremendous promise has been replaced with caution, major concern, and severe price declines. -P.J.D.
Bank of America estimates that power associated with Internet use will increase 17 percent from 2000 to 2010 to constitute 40 percent of electric load growth. The equipment used by the Internet and digital economy is delicate, requiring constant, pure electricity. Second, and perhaps more importantly, the cost of an electricity outage, or disruption, is extremely high. For example, E*Trade not only requires high quality, highly reliable electricity for its servers, but also because given its business, the cost of losing power and associated services, even for a few minutes, is enormous.
Thomas Wiesel Partners notes that in June 2000, the 200 members of the Silicon Valley Manufacturing Group lost $100 million in a single day due to rolling blackouts. As a result, Credit Suisse First Boston estimates that customers will pay significant premiums, as much as $6000 per kilowatt, for reliable power. For such energy users, the economics of electricity is no longer based on the lowest cost electricity available from the grid, but the most effective means for avoiding a loss of power.
U.S. Electric Grid: The Dirty Little Secret
The dirty little secret of the U.S. electric market is that the real problem is not adding generation capacity, but rather needed transmission and distribution assets. As Energy Secretary Abraham has noted, it was transmission problems, not a shortage of generation, that led to blackouts in California and high prices in New York.
The impact of the transmission problem shows up in retail prices. In 1998, the average retail price in California was 9 cents, compared to 4.9 cents in neighboring Oregon. The inability (due to political constraints) to add transmission and distribution has been aggravated by deregulation. Deregulation has led to a feeling of financial uncertainty that has caused utilities dramatically to decrease spending on the grid. This situation has given rise to opportunities in the areas of both transmission technologies and distributed generation.
The U.S. electric grid is a tremendous engineering accomplishment. The grid, however, is aging, and investment in it has declined an estimated $115 million a year for over 20 years. The Electric Power Research Institute (EPRI) estimates that, nationwide, 2200 miles of transmission line are candidates for replacement. Adding new transmission and distributions lines is neither easy nor inexpensive. In addition to political problems over siting, transmission line costs can run an average of $1.5 million to $80 million per mile, with approximately 70 percent of this cost caused by excavation, construction, permitting, and other infrastructure costs, according to Salomon Smith Barney.
Grid Problems: Why Not Try the DG Solution?
There is, however, another approach to addressing the problems associated with the grid: distributed generation (DG). Distributed generation refers to generating electricity on-site, as opposed to centralized generation in which electricity is generated by power plants. Distributed solutions might include an industrial user installing its own gas turbine to produce electricity at a key plant. Distributed generation technologies include reciprocating engines (Caterpillar and Cummings are the market leaders), microturbines (Capstone, Ingersoll Rand, Elliott), fuel cells (Fuel Cell Energy, Proton Energy, H Power, Plug Power), wind (Vestas), and solar power (Astro Power, Evergreen Solar). The attractiveness of DG is four-fold: 1) it avoids the significant investment required in adding transmission and distribution capability; 2) it provides immediate solutions to electricity supply constraints; 3) distributed power typically is more reliable than the grid; and 4) distributed power can produce electricity less expensively than the grid.
As its definition makes clear, DG avoids transmission issues, because electricity is not transmitted, it is produced and used on-site. As the CEO of NiSource has said, "We've got to build in Chicago, New York, Philadelphia, Boston, Atlanta, and guess what? Nobody will allow you to build a 250 MW combined-cycle, gas-fired power plant in downtown Chicago or New York or any other place. So what can we turn to? Distributed generation is the answer. This means we put generation on rooftops and in basements." And thus, neither power plants or transmission lines need be built in populated areas.
Distributed generation also offers an immediate solution to generation problems in places such as California and New York City. Look at virtually every building or hotel in any major city, most (if not all) have back-up diesel generators in case of a power outage. These units are currently installed and ready to run. While these back-up units are primarily used only in case of emergency, if they were turned on at the proper times, there would be an immediate and enormous supply of electricity. Caterpillar estimates that if half the installed power generators were connected to the grid, there would be no blackouts. In the June 15, 2001 issue of the Fortnightly, Mark B. Lively estimated that there are 30 gigawatts of distributed generation available in California in the form of stationary diesel engines. Salomon Smith Barney has estimated the size of such stand-by capacity at 70 to 80 gigawatts. A number of energy technology companies are focusing on how to best utilize and control this large distributed power base.
Distributed generation opportunities also are driven by raw economics. More and more energy technology companies assert they can provide electricity at prices that are competitive with the grid. While a customer must make upfront capital costs to install a DG device, depending on the regulatory scheme in place, natural gas prices (most distributed technology is gas fueled), transmission, and distribution charges can be avoided (which are a material part of one's electric bill) and price saving can result. Arthur D. Little estimates that a typical customer could use a 50kW microturbine to reduce annual electricity costs by $28,600, and wind turbine technologies can generate electricity at 5 to 7 cents per kWh (a price which is competitive with the grid).
The Inevitability of Deregulation
That deregulation has stalled is undisputed, but so too is its seeming inevitability. Notwithstanding California's problems, PJM Interconnection, which runs the grid for Pennsylvania, New Jersey, Maryland, Delaware, the District of Columbia, and part of Virginia, is confidently going forward with its deregulation plans. And on Oct. 29, 2001, Trans-Elect and General Electric Capital announced they plan to purchase Consumer Power's transmission system, representing the first sale of a U.S.-based transmission system to an independent company. That deregulation should proceed is logical. The production of electricity is not a natural monopoly nor is retail distribution. Like cable television, there is no reason why there should not be multiple content (read energy) providers supplying product through a shared pipe (read wire). So, too, the existence of one set of local copper phone lines has not prevented competition between digital subscriber line (DSL) and competitive local exchange carriers (CLEC) competitors, nor will it prevent competition between different retail energy aggregators. All this will take time-after all, deregulation in the UK took over 10 years.
Energizing The World: Bringing Power To The Power-less
In understanding the opportunities offered by energy technologies, one should not focus only on the power needs of the United States. The traditional knock against new energy technologies has been their high cost versus available grid power (typically measured on a per kilowatt basis). One way to avoid this calculus is, as discussed earlier, to consider the value of electricity given its reliability. A second way is to consider the value of electricity in areas that do not have an electric grid.
It is estimated that more than 2 billion people worldwide (755 million homes) do not have access to electricity. The Central Intelligence Agency projects that over the next 15 years, sustained economic growth, along with population increases, will drive a nearly 50 percent increase in demand for energy worldwide. And even in those countries, or areas, with electricity, other problems exist. For example, the World Bank estimates that urban areas of China lose 20 percent of potential economic output due to dirty energy's health effects.
Rather, it will be much more efficient and economical to rely on distributed technologies. Running power lines to a remote village does not make sense. BP Solar, through a project led by the Philippine Department of Agrarian Reform, used solar power to promote electricity to 400,000 residents living in 150 isolated villages in the Philippines. And in India, it is estimated that 1.2 gigawatts of wind turbine capacity were installed in 2000. Just as mobile phone adoption rates are higher in countries without an existing telephonic infrastructure, DG and other energy technologies will have higher adoption rates in countries without electric grids.
Government Spending: A Lifeline for Energy Tech?
Increased environmental regulation, as well as federal and state government spending, are also driving opportunities in energy technology.
While government regulation is never sufficient (given its unpredictability) to create solid investment opportunity, environmental regulations are helpful to energy technology companies. Although the U.S. is not a signatory to the Kyoto Protocol, there is no dispute that the environmental concerns are a critical problem, both domestically and globally. Federal clean water, clean air, and particulate matter emission regulations all contain restrictions spurring clean fuel technologies, and certain states have also adopted pro-technology regulations. California requires that 2 percent of the vehicles sold in the state in 2003 have zero emissions, and 8 percent have less pollution. New York is considering a proposal that by 2006 would require a percentage of cars sold in the state to have zero emissions.
Why Energy Tech Hasn't Taken Off
Concerns about energy technology companies have been caused by four factors:
1.The California Deregulation Debacle
One of the catalysts for investor interest in energy technology has been the promise of deregulation. As doubts about deregulation have grown as a result of the California crisis, so too have concerns about energy technology companies.
2. Lower Energy Prices
A second catalyst for investor interest in energy technology companies was anticipation of high electricity prices. The crisis in California focused many on the opportunities of new technologies to provide cheaper power. As electric prices have fallen, this opportunity is seen as less compelling.
In March 2001, electricity spot prices in the Western United States were $600 to $700 a megawatt. By summer, prices had dropped to $150 to $180 a megawatt. Forward prices on electricity have fallen in California from $73 a megawatt to $41. Moreover, concerns over falling energy prices have been aggravated by the expectation of an excess of new generation capacity. While energy growth is expected to grow by 2.5 percent in 2001 and 2.2 percent in 2002, a widely-noted article in Barron's last summer cited the power industry plans to add from 290,000 MW of electricity capacity over the next six years, representing an increase of 30 to 40 percent of current capacity.
3. The Economy
In addition to energy-specific problems affecting the sector, the slowdown in the U.S. economy has also hurt. Energy technology companies are at their core technology companies, and, as such, are often the first to suffer in an economic slowdown. In tough times, customers are less willing to pay for advanced technologies. So too, many energy technology companies are targeting telecommunication companies as their initial customers. Obviously many of these would-be telecomm customers are now worried about their own future and are less inclined to spend monies on new products and services. Last fall, for example, Capstone lowered its third quarter projections-warning that customers are less likely to make capital investment in an economic slowdown. On Oct. 17, 2001, Plug Power cut its work force by 80 to 90 people due to the weak economy and unattractive capital markets.
4. Unfulfilled Promises
Deregulation problems, lower energy prices, and the economy, combined with technological and operational problems, have caused a number of energy technology companies to violate the cardinal rule of the stock market: failing to deliver on promised milestones. Capstone Turbine and Active Power, two blue chip energy technology companies, both provided downward guidance on revenues and earnings. (In the third quarter, Capstone shipped 80 units rather than the 300 Wall Street was anticipating.) As well, H Power and Evergreen Solar have both announced that they would not meet prior milestones. Even Caterpillar, an established manufacturer of power generation products, is not immune to disappointing Wall Street. Last month, the company announced that its power business would not grow at the 20 percent rate it anticipated.
In a prescient research report issued in November of last year-at a time when the value of publicly-traded fuel cell stocks was $15 billion-Goldman Sachs warned that newly public companies had to deliver on their promises or face the crushing fate of the dot-coms. "These high multiples are reminiscent of Internet stock performance, which provides a valuable lesson about what can happen when investors begin to focus on commercial success and profitability," the company stated. Goldman's warnings have proven true across the space: as young energy technology companies have failed to deliver on their milestones, like the Internet stocks before them, their stock prices have been crushed.1
- Price declines not only hurt these companies' investors, they significantly impact a business' ability to raise capital. Access to capital is particularly critical as virtually all energy technology companies project huge earnings losses over the near term.
In addition to regulation, government spending is also encouraging energy technology. At both the federal and state level, spending is occurring. The Department of Energy has programs, such as its $57 million Superconductivity Partnership, and California has adopted a program to promote the installation of solar, microturbine, and fuel cell equipment. The State's latest proposal calls for purchasing 50 MW of microturbines, 20 MW of fuel cells, and 20 MW of solar power in 2002. Interestingly, in 1999, then-governor George W. Bush enacted legislation requiring Texas utilities to have 400 MW of renewable energy capacity by 2003. Investment bank Robertson Stephens estimates there are currently 15 states with renewable energy programs and over $1 billion in funds to speed the adoption of renewable energy sources.
Environmental regulation and government spending are most likely to be of continued help to energy technology given public attitudes: a recent Newsweek poll found that 84 percent of those surveyed favored increasing funding for research and development on an alternative energy sources.
While coal, oil, and nuclear power are unlikely to be displaced by new energy technology sources as primary electricity sources in the next decade, increased concerns about terrorism properly highlighted opportunities in new energy technology. First, there are increased concerns over the vulnerability of the U.S. grid and centralized power plants, focusing users on the need for independent backup power. Second, there are concerns about the supply of oil, given that the U.S. imports 1.7 million barrels of oil a day from Saudi Arabia, and 13 percent of U.S. daily imports are from the Persian Gulf. The combination of these security concerns is quite powerful. As one conservative Fox News commentator admitted on air, "Oil-rich terrorists have turned me as green as the jolly green giant."
The Incumbents: Investing in Disruptive Technologies?
A final reason to be optimistic about the promise of energy technology is to examine the reaction of incumbents. Those companies that have the strongest reason to accept the status quo and resist technological change-utilities, energy companies, oil companies, and automobile manufacturers-have, in fact, spent hundreds of millions of dollars investing in the opportunities offered by new energy technologies.
Faced with the uncertainties surrounding deregulation and the challenge of distributed generation, those companies with the most to lose, and with the most electricity experience, have not stood idly by. Utilities have championed the promise of energy technology. Dozens of utilities have created venture capital arms and formed strategic partnerships with young energy technology companies. DQE Enterprises, a subsidiary of DQE (formerly Duquesne Electric), has invested in Enermetrix, H Power, SatCon Technology, TeamFuel, Beacon Power, and US Power Solutions. DTE Energy (the old Detroit Edison), has investments or partnership agreements with Plug Power, STM Power, iPower Technologies, Turbo-Genset, and Kohler Co., among others. CapiTech, Hydro-Quebec's venture capital arm, has made investments in Capstone, Metallic Power, H Power, and NxtPhase and Minnesota Power's venture capital arm has investments in Proton Energy and Metallic Power.
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