Claude Crampes and Thomas-Olivier Léautier
On 30 November 2014, German energy giant E.ON surprised most industry observers by announcing that it was spinning off its conventional power generation operations in Europe to focus on networks, renewable energy and consumer services. The announcement marks the disappearance of a European energy superpower, whose history is tightly linked with that of the liberalisation of the electricity industry in Europe. This post draws a few observations from this announcement.
Birth of a giant
In the late 1990s, European governments jointly adopted measures to liberalise the electricity and gas industries. In addition to short-term political considerations, two factors seem to have motivated this decision. First, the aim was to include energy, an important sector of the economy, into the common market. It was difficult to reconcile national or regional monopolies, products of the post-war period, with the common market. Second, liberalisation would re-allocate risk and incentives between shareholders of energy companies and customers. Long-standing monopolies appeared to have transferred most of the risk arising from their investments and day-to-day operations to consumers. Moreover, rightly or wrongly, the industry did not have much of a reputation for being innovative. The introduction of competition would contribute to the emergence of operators and markets at European level, and would stimulate innovation.
The E.ON group was created in 2000 by the merger between two German electric utility companies, VEBA and VIAG, themselves composed of several entities, to capitalise on liberalisation. Its name, a transparent reference to internet start-ups, heralds a new era in the power and gas industry. The group positions itself from the outset as a leading energy company, and sets out to conquer the energy world, acquiring Powergen, established in the UK and the US, in 2002, then Ruhrgas, the German gas giant, in 2003. Admired by observers and feared by its competitors, E.ON seems unstoppable. In 2013, it achieves sales of 122 billion euros, outstripping EDF (76 billion euros) and GDF-Suez (89 billion euros).
Why is the company splitting in half less than 15 years after it was formed? Because E.ON (like many other energy companies) underestimated three types of risk: the cyclicality of energy prices, the economic irrationality of energy policy, and the complex nature of international ventures.
Cycles in the power industry
Most industries, and certainly all those connected to commodities, are subject to cycles. When demand increases and/or supply is low, prices go up, triggering massive investment prompted by the prospect of high returns. Due to lack of coordination among investors and to investment maturity periods, there comes a time when capacity exceeds demand (all the more quickly if a crisis drastically reduces it), and prices slump. The most recent example is the collapse of oil prices in the second half of 2014.
By its nature, a regulated electricity industry does not experience cycles since the price is determined by the regulator (or the state) so as to cover average long-term costs. However, a “liberalised” electricity industry is a commodity industry, and is therefore cyclical. The first cycle observed in the US in the 1990s led to the spectacular collapse of Enron and to serious difficulties for other “merchant” generators such as Dynegy, Mirant, Reliant, and Edison Mission. In Europe, the cycle took place 10 years later, when in the late 2000s energy companies invested heavily in gas plants in particular, anticipating strong demand growth. Since the economic crisis has reduced demand, these production facilities are left with no economic value. Energy companies are therefore forced to close plants in perfect working order, and to recognise significant financial losses.
Paradoxically, this outcome is a (partial) success for liberalisation, for if the electricity industry was still regulated, the cost of this misjudgement would be borne by consumers. Liberalisation means that the cost of the error is covered by those responsible for the investment choices, namely company shareholders.
So the first observation to be drawn is that power companies, like other manufacturers, must factor the dynamics of cycles into their strategies.
Economically irrational energy policy
European leaders have been pursuing an ambitious policy to combat global warming since the early 2000s. This policy is structured around two main instruments: a CO2 emissions market and renewable energy subsidies. Since the economic crisis has reduced economic activity, and by extension CO2emissions, the price of CO2 on the market is too low to have a significant impact on agents’ decisions. By contrast, renewable energy subsidies have worked very well, leading to a massive influx of new sources of production, which has automatically reduced the value of existing sources.
Like most of the “incumbent” energy companies (and most governments), E.ON underestimated the impact of renewables on the electricity industry. As a result, it did not invest in them, and left it to new entrants to capture the opportunity. Furthermore, like most of its peers, E.ON failed to anticipate the drop in wholesale prices resulting from the production of renewable energy, which has increased the cost of carrying overcapacity.
This leads to the second observation that power companies, like other manufacturers, must keep a close watch on technological innovations and developments.
This second observation may seem unfair. The sudden emergence of renewables stems from a political decision whose full impact was probably not anticipated by governments. How can power companies protect themselves from governments’ miscalculations?
The answer is that one of the roles of a manufacturer is to inform public decision-making. So the question is why power companies failed to convince policy-makers that renewable energy subsidies would have such a devastating effect. Had they not gauged the full significance of renewables? Or did they fail to make their voices heard in the public debate?
These questions also apply to another public policy which deeply affected E.ON: the phase-out of nuclear power in Germany. Following the Fukushima disaster, the German government decided not to extend the life of German nuclear reactors, without taking into account the impact of the decision on operators’ profitability. As with renewables, one wonders why E.ON (and the other German nuclear operators) did not manage to better negotiate with policy-makers.
The third observation is that even if the industry has been opened up to competition, power companies should not overlook the importance of political decisions, and should ensure that their positions are shared with the public and heard by policy-makers.
This conclusion also applies to energy companies in the UK where the energy regulator, Ofgem, asked the Competition and Markets Authority (CMA) to conduct an investigation into whether the 6 largest operators were responsible (at least partially) for the increase in customers’ bills. The point here is not to ascertain whether 6 competitors are enough for the industry to be deemed competitive, but to find out why said competitors find themselves under suspicion. It appears that poor quality of service, coupled with a misguided communication policy, meant they lost people’s goodwill, leaving them exposed to attacks from consumer associations and politicians.
To make up for its setbacks in European markets, E.ON, quite rationally, set out to conquer new growth markets, particularly Brazil. In accordance with best practice in the field, the company joined forces with a local partner, one of the country’s wealthiest men. Unfortunately, he turned out to be a crook, and has since filed for bankruptcy. The mishap has had limited impact on E.ON’s value, but it illustrates the difficulty of international expansion.
The fourth observation to be drawn is that power companies, like other manufacturers, must be extremely cautious when it comes to international growth.
Following these misfortunes, E.ON therefore decided to spin off all of its historical assets, grouping them in an entity to be sold to shareholders, and to focus on renewables, networks and energy services. Such a decision seems to run counter to the first principle taught in strategy classes, namely that a business should concentrate on operations in which it has distinctive skills. Indeed investors are not very impressed: although E.ON’s share price rose straight after the announcement, it quickly dropped again.
The third observation provides possible justification for the decision: it enables E.ON to protect the value of its profitable operations. If governments implement policies that lead to the closure of conventional production facilities, thereby causing significant job losses, they will no longer be able to turn to the shareholders of a company generating over 120 billion euros in sales. They will be faced with a bankrupt business, and will have to bear the economic and political cost of their decisions. This prospect should encourage policy-makers to consider the impact of their decisions on power producers…
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E.ON’s decision is part of a far-reaching transformation of the electricity industry. The 20th century was characterised by substantial economies of scale, which led to the creation of ever larger centralised production facilities, and the appearance of major companies operating these plants and the networks connecting them to users. The 21st century will see the gradual emergence of a new industry structure, where information technology will support better local optimisation (at building, neighbourhood, and city levels) and will give decentralised production a greater role.
This new structure announced by several observers requires a profound shift in the relationship between consumers and electricity. Under the historical model, we were used to thinking of electricity as a good that is constantly available and at constant prices, whereas a local optimisation system means that prices vary depending on circumstances. This transition, more complex than it might seem, will be examined in subsequent posts.
Postscript: the French government published in the Official Journal dated 22 January 2015 the order subsidising demand response operators discussed in a previous entry. Demand response operators will now receive a €16 incentive for each megawatt hour shifted during peak periods and €2 for each megawatt hour shifted during off-peak periods. The result of the scheme: influence peddling and subsidies for losing strategies 1, democratic processes and protection of consumers’ purchasing power 0.