Impact of COVID-19 on M&A in the energy & utilities sector
August 2020 | TALKINGPOINT | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
August 2020 Issue
FW discusses the impact of COVID-19 on M&A in the energy & utilities sector with Lars Holm and Jan Zenneck at Boston Consulting Group.
FW: Could you provide an overview of key trends shaping the energy and utilities sector, especially in the renewables space? What has been the impact of recent developments such as the coronavirus (COVID-19) crisis and the oil price crash, and how does that differ between conventionals and renewables?
Zenneck: The fundamental trend of decarbonisation of the energy sector is strong and ongoing, despite any potential repercussions from coronavirus (COVID-19) and oil prices. Most conventional energy generators have been hit especially hard by COVID-19, as they are the first to be shut down when demand drops due to their high fuel cost. At the same time, renewables continue to produce at close to zero marginal cost. The only exception are probably some countries in the Middle East where oil is used as a major source of electricity generation and, given the oil price collapse, their position was actually strengthened. Zooming in on renewables, we see some short- to mid-term impact due to delays in construction or reaching financial close due to direct COVID-19 impact and the uncertainties derived from both crises. These uncertainties are probably the biggest risk currently, as countries still struggle to navigate their people and economies through the crisis.
Holm: During the pandemic, renewables have proven to be highly reliable and resilient. This has led to an upgrade of renewables in the minds of many grid operators and balancing providers, at the same time it also increased scrutiny on the level of reporting and day-ahead forecasting that is now required by operators. Renewables have not only been technically resilient, but also economically. Players with a large renewable portfolio have suffered least or even increased their market capitalisation during the pandemic.
FW: How would you characterise the current appetite for M&A in the renewables sector? How are utilities and other players approaching transactions at this time, and what are the specific opportunities and risks?
Zenneck: The appetite for M&A is clearly still there with renewables. There is plenty of cash in the market and many are looking for opportunities to invest. Also, there are not many asset classes with such a low risk profile and strong resilience during the current crisis as renewables projects, which makes them highly attractive. On the other hand, there are also some companies that need cash right now, as well as the normal refinancing cycles with growing volumes, leading to a fairly liquid market for these assets. If you go beyond renewable assets as an asset class and look for corporate M&A, then companies with a higher risk profile, such as project developers, may be looked upon with more scrutiny than before due to increased uncertainty.
Holm: On the risk side, we would probably be looking at the power market design. Today’s power markets are not well-suited for renewables; they were designed for thermal fully dispatchable central generation. Deregulation – the separation of generation, transmission and retail – is founded in the understanding that we have three independent businesses. This does not match to a world transitioning to renewables, as renewables are variable energy resources (VER), where there is a greater need for balancing, which is not necessarily best done at the generation site. We will see changes in the market design, but it is unclear which tool will be applied, who is allowed to use the tool and what the transition timelines are. Tools could be, among others, CO2 levies, perhaps capacity elements, compensation for grid services, congestion fees, mitigation tools for capture rates and demand management. This uncertainty on the future design of the power market is a risk, especially for those that have a long investment horizon. This uncertainty has increased through COVID-19, as the pressure to tackle market questions is increasing, lower power consumption – triggered by COVID-19 – has increased the share of VER in the grid and, as we can see in the UK, an unprecedented high number of events with negative power prices. Companies looking at M&A targets will need to be comfortable with this kind of uncertainty and long-term risk.
“The renewables sector has always been very fragmented and dynamic from an M&A point of view, and COVID-19 has a weaker impact than in many other sectors.”
FW: In what ways are the COVID-19 crisis and oil prices both creating and hindering M&A opportunities in this space?
Zenneck: Concrete opportunities can arise from players under distress due to either exposure to oil price risk or a strong hit from COVID-19 and its repercussions on power markets. With renewables, this is mostly happening with suppliers and downstream-oriented players, though less so with renewable projects due to their resilience. This resilience also leads to increased investor interest. On the other hand, we also see that risk assessments are getting much stricter from the buy side, creating some new barriers, especially in less stable markets.
Holm: The first intuition, that a low oil price equals a low power price which then translates into a problem for renewables, does not reflect reality. During the last oil price crises in 2013, we saw renewables grow 16 percent per annum. Today, renewables are in the money. Only 1 percent of power is being produced from oil, so there should be little to no stress on renewables from the offtake side. Low energy costs can actually contribute to lower capital expenditures. We would therefore not expect to see more renewable asset owners on the market because they are in distress, but we would expect more transactions because the appetite for renewable players has increased. The oil and gas sector has traditionally attracted a lot of investors. These investors are now looking for alternatives and renewables are well-positioned.
FW: What differences do you see between large-scale renewables and distributed energy resources (DER)? Which technologies and which parts of the value chain will be most impacted by COVID-19?
Zenneck: In terms of distributed energy, there is now much greater awareness of customer default risk due to this crisis. At the same time, many corporate customers are trying to reduce spend and are shying away from large investments that a clean energy solution, such as solar, typically entails. Then again, some distributed energy resource (DER) companies have business models that include leasing or contracting models that are becoming more attractive now for commercial and industrial customers. Therefore, depending on how DER players are positioned, the impact can be very different. Some players have already started to adjust their offering and have put together solutions which give their customers more independence and flexibility, for example via the integration of battery storage.
Holm: If we make a distinction between buyer groups then we get a clearer picture. A large part of photovoltaic (PV) and battery storage goes into the consumer sector. Due to the more short-term nature of this sector, residential PV installations have seen a significant drop with the outbreak of COVID-19 but are also expected to recover relatively quickly. Industrial customers that invest in large on-site PV installations to offset their self-consumption or players that invest in windfarms or PV-farms before the meter have much longer investment cycles. Large-scale renewables are much less impacted, but, depending on the market, may see a longer slow phase.
FW: Do the trends that you are seeing seem very different from market to market? If so, could you outline the key differentiators between markets?
Zenneck: There are indeed differences between markets. In countries with a comparably low market and regulatory risk like the EU or the US, expected returns from assets are dropping further. Investors are looking for these safe harbours and thus drive deal prices up. On the other hand, many investors try to avoid high-risk markets where they fear regulatory changes, thus driving down prices and increasing expected returns. So, it seems we are going a bit more toward extremes currently.
Holm: Before COVID-19, we had a broad range of inhibitors and accelerators that were different in terms of country and technology. In Germany and France, we have generous feed-ins for onshore wind, but a regulatory process that does not deliver enough fully permitted projects, which has led to undersubscribed auctions. Other countries have other bottlenecks, like grid capacity, space constraints, too-high local content requirements or local building codes. In most markets, costs for renewable power is not the bottleneck. Therefore, growth after COVID-19 will depend to a large extent on updates to the regulatory framework, and only to a small extent on monetary stimulus. We are likely to see three types of government: those that believe past structures need to be restored, those that greenwash their stimulus package but fall short on real action, and those that make it happen without any great upheaval.
“Consolidation has been ongoing on both the supplier and developer side. This is likely to accelerate in the years to come.”
FW: To what extent are we likely to see increased consolidation in the renewables sector, as stronger companies look to pick up the distressed assets of their weaker rivals, for example?
Zenneck: A consolidation trend is surely something that I expect to see, although the impact may not be that drastic. We should keep in mind that the renewables sector has always been very fragmented and dynamic from an M&A point of view, and that COVID-19 has a weaker impact than in many other sectors. Nonetheless, in the short term it will be easier for many players to grow inorganically than organically, as new installations are taking a small hit.
Holm: Consolidation has been ongoing on both the supplier and developer side. This is likely to accelerate in the years to come. What works against this trend is the fact that many players see the renewables portfolio that they have built, even if it is subscale, as a stepping stone into the future, and are therefore reluctant to divest. Finding thermal generation that is for sale is much easier.
FW: Do you expect to see an impact on projects that are currently under construction? If so where, and who will need to bear the burden?
Zenneck: There is an impact on projects under construction. Firstly, some sites had to close down or reduce personnel on the ground during lockdown measures, leading to delays in construction. Secondly, equipment suppliers and logistics have been impacted in a similar manner, also leading to delays in projects waiting to get the equipment delivered. But while some people were expecting big issues, such as the delivery of PV modules from China where the COVID-19 crisis began, typically, all these delays have amounted to weeks to a few months. In many cases, they were within the boundaries of the buffers of the project time plan, leading to a rather moderate impact on ongoing installations. Actual manufacturing output was not that heavily impacted, and while logistics issues were driving delays, they are only a temporary issue for the industry.
Holm: Projects have seen delays. The two major reasons for that were interruptions to the supply chain and limitations in the movement of people. Most suppliers sent a force majeure notification to their customers, but, in reality, the impact turned out to be much less than initially assumed. Offshore wind delays and acceleration due to good weather typically balanced out. In onshore wind and PV, the delay remained in the range of some weeks to a few months. As supply contracts are typically fixed price contracts, the burden for higher costs is mainly with the supplier. But there are also some markets where we see tariffs ending, which means that the assets need to be connected to the grid before deadlines expire. India, and much later the US, have postponed these deadlines. China has mostly adhered to previous deadlines. Consequently, not all megawatt capacity may be connected in time. The financial impact of delays in delivering power, or even worse, the impact of falling into a lower tariff, need to be borne by the asset owner or project developer.
FW: For those in the middle of a transaction process, what factors should determine whether the deal should be cancelled or driven toward completion?
Zenneck: Generally speaking, COVID-19 will rarely be the single red flag in a due diligence assessment. The major hurdle will likely be the chief financial officer of the acquiring company who may put a stop to M&A activities altogether if there is a risk of coming under financial pressure. But if you are in the middle of the process, you will surely adjust your typical risk assessment with a specific COVID-19 angle, such as including the risk incurred by potential future waves of infection. And you will revisit and double check your assumptions regarding market outlooks and the regulatory environment, where your worst-case scenario assumptions may have been adjusted downwards by reality. We have seen transactions being put on hold or delayed, as people are waiting until the dust has settled before proceeding with a transaction.
Holm: The deals we have been involved in were not cancelled due to COVID-19; some took a bit longer or are still ongoing. Clearly, force majeure clauses are being looked at in more detail. Structuring of corporate and institutional power and purchase agreements is becoming more complex, as the spot price for power fell and buyers want to see more load following elements in contracts.
FW: In such uncertain times, what advice can you offer to energy & utilities companies on structuring successful deals in renewables in today’s market? Which aspects of due diligence and transactional risk management are most critical?
Zenneck: My advice would be to make a thorough commercial due diligence assessment, even if you believed this should be limited in maturing renewables markets. The best example is the market assessment, where we have seen players relying on power market models that predict prices for decades to come, only to find out that fundamental market designs change much faster due to increasing competitiveness and penetration of renewables, which limits the visibility of these approaches. Instead, I would advise a strategic, scenario-based approach to market assessments, especially when it comes to regulatory trends and risks. In addition, technology trends like the integration of battery storage will change the way opportunities and risks have to be evaluated, in addition to their direct impact on business cases. These bring additional resilience and reduce dependence on subsidies, leading to a more robust business going forward.
Holm: It would appear that interest in investing in the renewables space has increased – from those that develop and operate assets, as well as the broader range of companies involved. These can be component suppliers, construction service providers or aftermarket players. And it ranges from digital solutions all the way to providing an on-site workforce. In many of these M&A processes, there is a significant difference in size between the buyer and target. The advice I would give is to closely consider the level of integration and where to create value. Do not look for the ‘common payroll, bundling of lease cars and copy paper’ effects. Rather, look at the opportunity for the businesses to complement one another. Do not become the exclusive buyer of the products that your acquisition target is producing, but keep them in a meaningful way in the market.
FW: Looking ahead, what are your predictions for renewables M&A for the remainder of 2020? What about 2021 and beyond? What is the outlook for the sector in general, especially considering the stimulus packages that will likely be deployed?
Zenneck: Overall, I expect some slowdown of M&A activity for the remainder of 2020, mostly in corporate M&A as project transactions remain more stable. But by 2021, this will pick up again. M&A experts have determined that total shareholder returns from deals in a weak economic environment outperform those made in a strong economic environment, where buyers tend to overpay. So, given the strong gross domestic product hit we are currently experiencing, the time is right to think about M&A. However, this also depends on individual target companies, as the ups and downs of stock markets show that valuations have not yet taken a clear path. Of course, stimulus packages can have a strong impact on the fundamental growth trajectory and stability of business and thus influence M&A. Especially in the EU, we are expecting additional tailwinds for renewables given the strong focus on decarbonisation. Other regions may react differently, with India, for example, protecting conventional generators from being overrun by cheap renewables while power demand is lagging behind supply.
Holm: We will see many confusing messages, especially by those that lobby for the future and for change. Not because they are badly organised, but because lobbying for change is always more difficult than lobbying to retain what we already have. 2020 will be a bump in the road for new installations and will trigger even more growth in the years to come. We will see more hybrid solutions, more battery application and, hopefully, a better coordination of power market design. Many innovative solutions are still sub-scale. M&A will provide a significant opportunity for these companies and their buyers.
Lars Holm leads Boston Consulting Group’s global business line large scale renewables. He brings over 10 years of BCG experience and 18 years of industry experience to the table, having worked for players along the full value chain. He can be contacted on +49 (170) 334 6124 or by email: holm.lars@bcg.com.
Jan Zenneck is a global expert on renewable and distributed energy at the Boston Consulting Group. He also leads the solar energy sector within the firm and is working along the full value chain of green energy with technology and manufacturing companies, as well as with utilities, developers, energy service companies (ESCOs) and investors, helping them on strategy and M&A-related questions. He can be contacted on +49 (170) 334 3507 or by email: zenneck.jan@bcg.com.
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