World Economic Forum Robust Framework for Electricity Infrastructure 2014

Industry Agenda

A Case for Robust Investment Frameworks for an Evolving Electricity System

January 2014

Prepared by Partners of the World Economic Forum Utilities and Technologies CommunityDavos-Klosters, Switzerland 22-25 January

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The views expressed are those of certain participants in the discussion and do not necessarily reflect the views of all participants or of the World Economic Forum.

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3A Case for Robust Investment Frameworks for an Evolving Electricity System

Contents Message from the Chair

5 Executive Summary

6 Rationale for a secure, affordable and sustainable electricity supply 1. Access to electricity is key for prospering societies 2. Electricity is the oxygen of the economy 3. Capital-intensive yet with long payback periods, electricity infrastructure investments need stable policy frameworks

8 The investment challenge faced by electricity infrastructure projects 1. Analysts offer a negative outlook on the sector 2. Electricity markets are governed by unstable or inefficient regulatory frameworks 3. Regulation has not evolved together with the business 4. Risk/return profiles of electricity investments are no longer clear 5. The supply chain for electricity infrastructure has become unstable 6. The traditional business model is changing drastically

13 Drivers of investment in the electricity infrastructure 1. Different tasks for different players 2. Different goals make for different investment needs 3. A three-step approach to foster investments

16 Conclusions and main outcomes

17 Acknowledgements

Peter Terium, Chief Executive Officer of RWE AG and 2013 Chairman of the Utilities and Technologies Community of the World Economic Forum

It’s not only all over my town, but all over the world: The global energy landscape is undergoing one of its most massive transformations. The German word “Energiewende”, the transition of the energy system, has been adopted into English and there is quite a phenomenon behind it. The global goal of the Energiewende is to provide a secure and affordable energy supply for everyone in a more sustainable way.

But there is absolutely no doubt that we need to take care of all three aspects of the “triangle” of the energy business: security of supply, affordability; and sustainability. The balancing act is complex and the resulting challenges are manifold: electrify many regions of the world still unable to profit from modern electrification; build up power markets able to function within the global competition and provide reasonable prices; and do all this in a sustainable way to protect natural resources and the planet.

Due to disruptions in different markets, once established business models in the utilities business are challenged and capital needed for the industry has become scarce. At the World Economic Forum Annual Meeting in Davos in January 2013, the chief executives (CEOs) of the Utilities and Technologies Community all agreed that the Energiewende needs to be supported. However, to make it happen, there is one thing that is badly needed: investments in electricity infrastructure to prepare the energy system for the challenges ahead. The community of CEOs then decided to catalyse a task force to come up with suggestions on how to attract the capital needed for a successful transition of the energy landscape. The report at hand is the result of this collaboration. I am especially proud that the task force did not make do with navel-gazing from an energy viewpoint and created a first draft of the way forward, especially by consulting not only energy experts but also the investors.

Much effort of energy experts has gone into this report and I would like to express my thanks to the World Economic Forum for providing a platform to connect, exchange and collaborate on the opportunities presented by the Energiewende.

My sincerest thanks to the member companies of the Utilities and Technologies Community and my fellow CEOs as well as to their specialists for supporting this initiative and providing expertise and manpower to create the report.

We invited the Investors and Infrastructure Communities of the World Economic Forum and I thank them for accepting this invitation and contributing to this report as well.

I wish you an interesting and stimulating read!

Yours sincerely,

Peter Terium

4 World Economic Forum Utilities and Technologies Community

Context

Significant energy transitions are under way globally and now more than ever society is actively involved in shaping their outcomes. The partner companies of the World Economic Forum Utilities and Technologies Community have been contributing to the ongoing work to shape these transitions.

In particular, during 2013, our community has worked collectively to generate new insights and new approaches for driving investment in global electricity infrastructure, which we believe to be one of the core challenges for industry, policy-makers and society alike. Concern for the future of investment in electricity infrastructure first emerged in January 2013 during the Utilities and Technologies Governors meeting, a CEO-level session held within the context of the Forum’s Annual Meeting in Davos-Klosters, Switzerland. Since then, under the chairmanship of Peter Terium, Chief Executive Officer of RWE AG, this topic has become a unifying theme forming the basis of the community’s work for 2013-2014.

With the subsequent support of the CEOs from the World Economic Forum Utilities and Technologies Community, a working group was formed with company delegates to unearth obstacles for investment in energy infrastructure and formulate key recommendations for bolstering investment to meet growing energy demand. The resulting outcomes described in the paper below may allow for a more robust understanding among energy companies, the investor community and policy-makers.

This document also served as a short pre-read for the preparatory call for the Annual Meeting 2014 which took place on 21 November. The follow-up actions from the call will be taken forward through specific meetings, media/press related awareness-building and put to action through the “Future of Electricity” project, being developed by the World Economic Forum for the next year.


Executive Summary

World Economic Forum Utilities and Technologies Community:A Case for Robust Investment Frameworks for an Evolving Electricity System

Authored by the Utilities and Technologies and Investors communities of the World Economic Forum, with a specific focus on the European region. The views expressed in this document do not necessarily reflect those of individual contributors and their companies, nor those of the World Economic Forum.

One of the biggest global challenges is providing secure, affordable and sustainable electricity access for a rapidly growing world. Global electricity consumption will increase by 93% between 2010 and 2040, according to the US Energy Information Administration. While emerging markets are in dire need of electrification and modernization of the electricity supply, markets in mature economies struggle to transform their energy landscape into a more sustainable and efficient system. To meet the growing electricity demand, roughly US$ 17 trillion of investments are needed in electricity supply infrastructure in the next 20 years.1

Stable industries, those with reasonably predictable demand and low volatility, offer investors certainty and reduced business and financial risk. Consequently, investors require lower expected returns. The utilities sector has traditionally been one of these stable industries, and has benefited in the past from a relatively low cost of capital. The stability of the utilities sector was stemmed in the investors’ belief in a regulatory model that granted investors the opportunity to earn a fair return on their investment.

However, the recent emergence of a number of disruptive challenges is radically testing this model. The rapid pace of development and adoption of new technologies, along with regulatory, societal and economic factors, are having a deep impact on the traditional business model of utilities. As the pace of change accelerates, both the investment profile of utilities and the types of investors who invest in electricity infrastructure will evolve. The regulatory model will also have to adapt to the emerging electricity landscape. A deterioration of the credit rating quality of utilities will result in higher costs of capital, limiting their capacity to attract investments.

As the electricity market evolves, so does its investors and asset classes that are used for these investments. Equity investment in electricity infrastructure used to be the almost exclusive domain of utilities. We observe today, however, a trend of infrastructure funds and large capital providers (such as pension funds and sovereign wealth funds) investing directly in electricity infrastructure. Utility companies, many with significant capital constraints, have been prone to either form partnerships or allow investment funds to finance future capacity.

Yet, the regulation has not caught up with the changing dynamics and needs to be refreshed. Given the long-term investment cycles and the need for long-term planning, regulators need to provide a long-term stable policy framework in a sector that is rapidly evolving, under a situation of uncertainty. The changing dynamics of the electricity sector mean investments in electricity infrastructure remain wary of the future.

The electricity landscape is entering a period of transformation, and, according to BCG, “awaiting a return to past patterns is not an option”. Utilities have historically had a social responsibility to reliably deliver electricity to society. Within this evolving context, all stakeholders have to understand the challenges and opportunities of coping with that societal function. New business models and new entrants will challenge the regulator’s capacity to provide a regulatory framework that attracts the needed investment to fund the electricity infrastructure of the future.

Predictable regulation can help to decrease this policy risk and, therefore, the cost of capital and increase investor money flowing to the sector. On the contrary, unforeseen or poorly justified regulatory changes, can lead to investor scepticism, increase costs and deter new investments.

In this effort, policy-makers, investors and the electricity industry need to work together to find solutions that allow investments to flow, safeguard future supplies while also tackling the decarbonization challenge. The Utilities and Technologies community of the World Economic Forum stands ready to support this effort.

1 IEA World Energy Outlook 2013 New Policies Scenario


Rationale for secure, affordable and sustainable electricity supply

1. Access to electricity is key for prosperous societies

The US Energy Information Administration estimates that global electricity demand will rise by up to almost 93% until 2040 measured against the 2010 level. “As developing countries grow and expand their economies, their need for energy increases. By 2040, about 85% of growth in electricity demand will occur in the non-OECD economies while the OECD countries will see demand rise by about 25%.”2 Yet, 1.3 billion people are without access to electricity worldwide, which severely curtails their prospects for improved social and economic well-being. Sustainable, secure and affordable energy supply underlies the growing world population’s aspiration for prosperity and material well-being. Adequate investment in advanced electricity infrastructure is a key to meeting increasing energy demand while at the same time safeguarding natural resources and the ecosystem.

Case Studies: Energy Access

Of the world’s population of 7 billion people, 19% remain unconnected to the grid. The following two case studies illustrate how actors are trying to bring new models of financing for energy access projects around the world and thereby enabling economic growth.

Luz para Todos: IberdrolaIn 2003, the Brazilian federal government launched the programme “Luz para Todos” (Light for All) with the aim of giving free access to electricity to more than 10 million inhabitants of the country’s rural areas to support their economic and social development. The federal government allocated funds from its energy sector – the Energy Development Account (CDE) and the Global Reversion Reserve (RGR) – with the rest of the investment shared between the state governments and electricity distribution companies. Luz para Todos reached rural areas through network expansion, decentralized generation systems with isolated networks, and individual generation systems.

The programme met the initial goal of serving 10 million people in May 2009 and 14.4 million people by March 2012 throughout the country. Total investments topped R$ 20 billion (US$ 8.6 billion), of which R$ 14.5 billion was provided by the federal government.

The benefits of the arrival of electricity go beyond the direct benefits of electricity supply, and it is estimated that the work of Luz para Todos has generated 439,000 new jobs, used 1 million transformers and over 7.3 million posts. Moreover, the local economy also benefits from the installation work. The impact study conducted in 2009 showed that 79.3% of people served by Luz para Todos owned televisions, 73.3% went on to have a refrigerator and 24.1% bought water pumps.

The Electrification Roadmap: Eskom and Duke Energy

CorporationThe United Nations (UN) has launched the Sustainable Energy for All (SE4All) initiative to provide universal access to modern energy services. One of the vehicles to accelerate delivery of the UN’s universal energy access objective is the Electrification Roadmap Initiative. Led by Eskom and Duke Energy, the Initiative sets out to introduce electrification at scale by gathering funding and resources at a global level. Its goal is ambitious: to establish 100 million new connections to modern energy services by 2025. The initiative will launch in Southern African Development Community (SADC), where the goal is to create 35 million connections by 2025. To date, funding and capability limitations have hindered the progress of many electrification efforts.

The Electrification Roadmap Initiative has a three-pronged approach:1. First, it aims to effect electrification at scale by working

closely with governments to develop a roadmap specifically tailored to their own country.

2. Second, it will accelerate projects that improve the quality of life in both economic and social terms by building local skills and institutions to provide sustainable connections.

3. Third, it will match each country’s funding and skill needs to available sources.

2 2013 ExxonMobil Report, “The Outlook for Energy: A View to 2040”.


Linked and in support of this are: a sound technical approach with the local skills to deliver and sustain the new connections; continual and reliable sources of funding; a sound structure and governance for the Initiative.

Sources of funding will range from governments to NGOs and development partners that will provide concessionary funding, to the private sector, e.g., banks, equipment manufacturers, mining houses. The initiative will use these funds in three ways:

– day-to-day operations of two new organizations (the Execution organization and the Technical partners)

– development of electrification roadmaps and projects (including execution support)

– financial support for non-commercially viable projects.

A fourth funding need, for commercially viable projects, will be met by the private sector and the Sustainable Electricity Access Fund (SEAF), an infrastructure development fund established by Duke Energy that will co-invest in commercially viable electricity access projects. Eskom and Duke Energy have each committed US$ 1 million and human resources. Each additional US$ 1 million will enable the development of another country roadmap and two to three new projects.

2. Electricity is the oxygen of the economy

The electricity industry is one of the most capital-consuming and capital-intensive industries. Corresponding investment costs to expand and enhance global electricity supply structures will amount to about US$ 17 trillion (in constant 2012 dollars) over the next 20 years, according to the IEA. These large capital expenditures flow through the economy, creating additional jobs, tax revenues and GDP by generating demand for intermediate goods and services. Challenges posed by growing concerns related to the climate and environment can – if addressed appropriately - ignite a broad range of energy innovation at all stages of the value chain. Energy innovations are cross-sector innovations that will not only help to solve the challenges of the future electricity systems but also potentially improve entire economies’ technological capabilities, efficiency and resilience to supply risks.

The electricity industry’s large investment requirements make it sensitive to the cost of capital. Competition from governments and businesses (including the energy industry) creates scarcity and drives up the cost of capital. However, capital costs are currently extremely low because of the depressed global financial system. This should play in favour of large-scale capital investments in coming years, provided the regulatory environment is conducive and harnesses the market forces.

In addition to the energy sector’s economic contributions in general, relatively lower and stable energy prices help to stimulate the economy. First, lower energy prices reduce expenses for consumers and businesses, increasing disposable income that can be spent in other ways. Second, lower energy prices reduce input costs for nearly all goods and services in the economy, thus making them more affordable. The converse is also true: relatively higher energy prices place a drag on economic growth everywhere except in economies that are dominated by energy production. Rising energy prices take purchasing power away from consumers, particularly from lower-income groups.

3. Capital-intensive yet with long payback periods, electricity infrastructure investments need stable policy frameworks

It is important to understand the two key features of the energy industry that define conditions for capital funding and determine requirements for an appropriate investment climate:

– The electricity sector is capital-intensive, with high upfront capital costs.

– Electricity infrastructure development involves long lead times and decades-long operating horizons, making the payback period long.

In a capital-intensive business with long payback periods, it is critically important to know in advance how risks are being allocated and the framework rules governing the opportunity to earn an adequate return. For example, policies that avoid intervening on prices resulting from markets or adjusting tax and royalty regimes in response to short-run fiscal needs or market short-run conditions are conducive to attracting investment, while the opposite is not true. Stability and clarity of the policy framework are important for investment decisions.

Due to the electricity industry’s capital intensity and complexity, it is critical that energy policy-making keeps up with realistic cost and technology assessments. If the pace of policy change is too slow, technology does not advance, and when the pace is too fast, additional costs accumulate with few additional benefits.


The investment challenge for electricity infrastructure projects

1. Analysts offer a negative outlook on the sector

The energy sector is often cited by analysts as being one of the least attractive markets for investments. According to The Economist, since September 2008 utilities have been the worst-performing sector in the Morgan Stanley index of global share prices. In 2008, the top 10 European utilities all had credit ratings of A or better. Now only five do. At their peak in 2008, the top 20 energy utilities in Europe were worth roughly €1 trillion (US$1.3 trillion). Now they are worth less than half that.3 Investors are held back by decreasing margins due to rapidly falling power prices. This is due to falling demand in the recession being exacerbated by inflexible subsidization of new capacity, leading to oversupply. HSBC states: “We think that EU power generation is currently an unattractive business. We believe that investors are fully aware of this dismal backdrop as well as the weakness of the sector balance sheets.” Investec and others claim “regulatory uncertainties” as a main obstacle for investments, mainly in conventional generation in Europe. More investments are indeed flowing in either non-conventional or renewable generation in Europe or even in conventional generation in other geographies.

Case study on Ukraine: Why investors prefer liberalized markets

The energy system of Ukraine is the sixth-largest in Europe after Germany, France, Italy, Spain and the United Kingdom. The installed capacity of power plants in Ukraine in 2012 was 53.8 GW; and electricity production amounted to nearly 200 TWh. The country has a branch-structured energy system based on various types of generation. Ukraine’s consumers enjoy full access to energy services.

However, the country’s highly regulated electricity market chases away international investors. During the recent privatization of nine power-generation and distribution companies in 2011-2012 only Ukrainian and Russian investors showed up. Private capital accounts for 30% of generation investments and 50% of coal investments, but it mainly comes from Ukrainian and Russian sources.

What are the main challenges, and what should be done to attract investors? The key internal challenges of the market

are: ageing electricity-generation equipment and absence of guarantees for return on investments.

To begin with, the Ukrainian power sector urgently needs modernization. Over the past 20 years, almost no new capacities have been commissioned in Ukraine. Most of the existing infrastructure was built between 1960 and 1980. Units older than 40 years account for 38% of total capacity in Ukraine (compared to 22% in Europe). According to Ukraine’s new Energy Strategy to 2030, huge investments are needed to modernize Ukrainian electricity sector – US$ 120 billion. Without retrofits and overhauls being made, the breakdown rate will go up and lead to an electricity deficit, making it impossible to maintain the reliability of the energy supply.

On the other hand, electricity tariffs in Ukraine are among the lowest in Europe. The average household energy price for the EU-27 is $0.21 per kWh, compared to only US$ 0.03 in Ukraine. The tariff-setting system in Ukraine’s generation market is heavily influenced by the government; 63% of electricity in the market is sold at the tariffs set by the regulator. The regulator also sets tariffs for all categories of consumers, maintaining low tariffs for households.

The existing system of cross-subsidies significantly hampers competition, economic development and GDP increase. Currently the system is cross-subsidized for US$ 3.5 billion a year (30% of the market).

There is no legislative mechanism that would ensure return on investments. The regulatory environment with low tariffs, cross-subsidies in generation and no mechanism for return on capital in distribution does not attract European investors.

Ukraine’s electricity market had been waiting for the liberalization for more than 10 years now. The law on electricity market liberalization was finally passed by the parliament in October 2013. It envisages bilateral contracts and a balancing market similar to those operating in many European markets. This law got support from various European stakeholders, as it stimulates competition, investments and new construction. In four years, the market will be completely liberalized and Ukraine will finally welcome a wave of investors (including new power generation). The rules of the new Ukrainian electricity market will be clear for international investors and they will be able to estimate all risks and take adequate investment decisions.

3 2013 ExxonMobil Report, “The Outlook for Energy: A View to 2040”.


Case Study: Nord Pool, a good example of a liberalized power market

Norway was the first of the Nordic countries to deregulate its power markets. The Energy Act of 1990 formed the basis for deregulation in the other Nordic countries. In 1996 a joint Norwegian-Swedish power exchange was established, Nord Pool. Nord Pool Spot was then established as a company in 2002 as the world’s first market for trading power. Today it is also the world’s largest market of its kind, and provides the leading market for buying and selling power in the Nordic and Baltic regions, as well as Germany and Great Britain.

The Nordic countries have integrated in the European power market through interconnectors to Germany, the Netherlands, Estonia, Poland and Russia. The Energy Act, which provides the overall framework for the organization of the power supply in Norway, uses the principle of market-based power sales as a basis. Corresponding legislation also exists in Sweden, Denmark and Finland, as well as in most other EU countries.

The market price of power, which is determined each day at the Nord Pool Spot power exchange, is a result of supply and demand. Variations in precipitation and temperature result in considerable fluctuations in power prices. The prices also depend on transportation conditions, within Nordic countries and between the Nordic countries and the rest of Europe. Since there are periodic capacity limitations in the grid, power prices may vary between the different areas.

4 (2013, October 12). How to lose half a trillion euros. The Economist, pp. 5.

2. Electricity markets governed by unstable or inefficient regulatory frameworks

Discretionary taxation and subsidies, discrimination of particular technologies or operators as well as constantly changing political priorities lead to a general uncertainty for utilities and investors alike. For example, as the regulatory risk can no longer be calculated properly due to national interventions, unclear political goals and differing frameworks, investments in conventional generation in Europe have become unattractive, leading to a growing threat for securing affordable and sustainable power supply. The Economist states that “for pension funds and other investors, [European utilities] represent lost capital and lower future earnings.”4

The most threatening development is that in regions with unstable or inefficient regulatory circumstances, markets malfunction due to distortions caused by over-regulation. Therefore, it is extremely important to give room again for the market forces to do their work and this can happen only with the right amount of regulation, which does not curb market forces.

3. Regulation has not evolved together with the business

The electricity sector operates within a regulated market structure with the extent of regulatory oversight differing along the various stages of the electricity value chain. While other sectors can operate almost exclusively under market-based criteria, the electricity sector, due to its characteristic of an essential service, generally relies on a mix of regulatory oversight and competitive tension to correct market failures and achieve an efficient supply that maximizes social welfare. In the case of electricity, the traditional triple policy objectives which the regulation and market design are aimed to achieve are security of supply, efficiency or cost reduction, and sustainability.

Regulation should fulfil a set of principles to ensure that compliance with the stated policy objectives is satisfactorily achieved. Proportionality, effectiveness and efficiency, responsibility and independency, consistency and credibility, transparency and clarity, and predictability are all among these principles.

Given the importance and the length of the recovery periods of electricity investments, it is essential that regulatory schemes are relatively stable or at least predictable so that investors can access capital markets on reasonable terms. A predictable regulation can help to decrease risk and, therefore, the cost of capital. On the contrary, unforeseen or poorly justified regulatory changes, or regulatory frameworks not based on the above principles could lead to investor scepticism, increase costs or even deter new investments.

Regulation, if set according to the above principles, can, therefore, give confidence to the agents operating in the sector. A majority view that emerges among the taskforce members, is that regulated end-user prices and price caps are unlikely to represent good value for energy consumers as they generally fail to deliver the efficiency and innovation benefits resulting from competitive market tension and can lead to under-investment if set below the true cost of providing the service.

The power exchanges and the transmission system operators in Europe are currently working on a project to introduce market coupling of the power markets in north-western Europe, starting in 2013. The project will be implemented in stages where north-western Europe will be a pilot for the rest of Europe. The market coupling will help ensure that the power flows in line with the prices, thus better utilising existing grids and generation.


4. Risk/return profiles of electricity investments are no longer clear

Utilities increasingly cease to be the only or even the dominating investors in the power system. Due to the widespread liberalization and deregulation in the past two decades, new actors have emerged. These have been additionally encouraged by new regulation with respect to renewable energy players (referred to renewable from this point on). Consequently, on the side of assets, renewables (and, in some instances, the grid extension they require) have created a new asset class that in most countries shows an investment profile markedly different from those of traditional investments in generation capacity. Guaranteed feed-in tariffs and privileged grid access for renewables dramatically limit the risks associated with the assets and, therefore, make them interesting for more conservative investors and for smaller players. This has led to a massive expansion of renewables in those countries with a particularly attractive environment, such as Germany or Spain, often driven by small investors in PV and/or onshore wind.

In the overall picture, we now observe a relatively skewed investment landscape. Investments in conventional generation have become riskier because the expansion of renewables – while often not market-led – drives down wholesale market prices. This, in turn, reduces the profitability of conventional power plants because they not only run fewer hours in the year but also earn less when they run. The large amount of conventional capacity that is currently retired from the European markets is a striking evidence of that effect. Yet, everybody agrees that conventional power plants are needed as a back-up for intermittent renewables sources.

Investments in renewables, on the other hand, are largely risk-free because all or most of their revenues are backed up by government support of one form or the other. The positive effect is that more capital has become available for these asset classes, coming from institutional investors, private equity, and other sources. Yet, the risk for these investments is largely borne by consumers or society as a whole.

Considering the enormous investments that will be required to fulfil the future demand for power around the globe, it is paramount to recalibrate this investment landscape. The new class of investors with large amounts of capital at their disposal is vital and should be harnessed for the development of power systems overall. However, the risk-return profiles of different asset classes need to be better aligned, ensuring that investments can flow in all types of infrastructure that are needed.

5. The supply chain for electricity infrastructure has become unstable

The supply chain is an important sector in the stakeholder community, for the supply of products, systems and services. In order to deliver an efficient electricity infrastructure, the infrastructure owner must clearly articulate what is required of the supply chain and commit to contracts so that the supply chain can deliver the time, cost and quality deliverables. In an ever more competitive world, restrictions in the supply chain exist where capacity is limited (high-voltage AC and DC power cables, for example) and the number of competing customers is high (large number of HVDC projects being tendered worldwide). Supply chain failures happen (for example: EDF networks in UK being without HV cables for about seven weeks) and it is important that forward planning takes account of the limitations within the supply chain.

Policy-makers should set clear strategies on infrastructure policy through the regulators, where appropriate, to give the supply chain clear direction to incentivize investment in R&D, manufacturing capacity, and the appropriate knowledge, skills and experience.

In R&D, original equipment manufacturers (OEMs) invest billions of dollars – e.g., ABB US$1.4 billion (2012), Siemens US$ 3.9 billion (2009) a year, partly driven by their own views as to what equipment is needed and partly by what customers tell them. This tends to be technically driven, rather than policy driven.

Lack of clarity on the regulatory framework in a country, however, drives the supply chain to work in countries or regions where the degree of certainty is higher. For example, Shell, EDF and EON have established centres of excellence for renewable energy in the US rather than in Europe. Suppliers who have the flexibility or the capability to supply globally simply turn their attention to markets that are easier to do business in (e.g. ABB has just opened two factories in India, partly for low-cost supply, partly because the market is simpler than in Europe). There are many more local suppliers, who, unable to adapt to the local conditions, do not survive.

Therefore, without clear signals from policy-makers, the supply chain actors may not invest, or may be too late and trying to catch up. Policy clarity is, therefore, the key message for investment in a stable supply chain.


6. The traditional business model is changing drastically

Europe’s electricity industry has entered a period of transformation. The well-known value chain – from upstream generation, through trading and transmission and finally distribution to consumer – is about to change. The downstream part of value creation is expanding at the expense of the traditional way of generating energy.

This reshaping is a result of a significant growth in energy efficiency, decentralized generation and demand-side management (DSM). There are four emerging trends altering the industry. In addition to more efficient use of energy and local energy production, such as solar, micro windmills and micro CHP, we are seeing an introduction to automatic metering of electricity as well as establishment of smart grids. On top of this there is a trend towards expansion of electricity as an energy source in the transport sector. These trends are driven by technology development, but political and climate issues are strongly supporting the changes.

For the industry, these trends could be seen as threats to the established players. However, new business opportunities will arise.

Case Study: From consumer and producer to “prosumer”

For the consumer, the traditional role as electricity subscriber is evolving into a more dynamic role, with more opportunities for engagement in the electricity market. Traditionally, small power system participants have been defined as either small producers or small consumers of electricity. Today, extensive technological development related to distributed renewable energy sources and demand flexibility allow the small consumer as well to produce, and even store, energy. This new emerging entity – the “prosumer” – is an economically motivated entity that:

– Consumes, produces and/or stores electricity and energy in general

– Optimizes economic, and to some extent technological and/or environmental, decisions regarding its energy use

– Becomes an active part of the energy system, rather than a passive “sink”

The prosumer becomes a market-driven stakeholder, and has his home/facility as the arena for energy investments. In conventional electricity systems the wholesale power price constitutes only a part of the residential electricity price (retail price). In Germany, the energy part of the retail price was on average 33% in 2012, and is likely to be even lower in 2013. PV can take advantage of this difference, thanks to its modularity, which leads to relatively small differences in power costs from large and small installations.

Recent cost development of storage solutions and PV generation give further incentives for more distributed energy investments at the end of the value chain. Distributed energy systems coupled with storage solutions and DSM technologies could lead consumers to eventually become independent from the grid. However, weather volatility and security of supply concerns potentially make flexible back-up capacity and a stable grid necessary.

Large deployment of distributed energy systems could have significant impact on the future electricity system and shift the value of generation towards the end-user, reducing the need for conventional central generation and make competition tighter for traditional utilities. As more customers enter the distributed model, fewer remaining customers have to cover the fix costs of the grid. However, distributed generation users still benefit from the back-up capacity provided by the grid. This highlights the need to develop regulatory models that ensure a fair distribution of costs, while promoting the efficiency of the overall system.

As for the example above with changing the grid fees, policy-makers can influence the development of growing differences in PV power vs grid power. On the other hand, the described trends are hardly possible to reverse as the consumer control of energy use and generation/storage has its own dynamics.

The life of the utility-friendly and passive electricity subscriber is changing quickly. Time will show how the different energy utility trends will affect customer behaviour and the birth of new prosumers. The emergence of a distributed-energy landscape in Europe is still immature but is likely to turn to a competitive landscape with new value pools and business opportunities in the years to come. All parties – upstream generators, integrated energy utilities, downstream entities, specialty providers and new entrants – face risks by taking, or by not taking, action early.

In principle, options for residential consumers as described for the prosumer above can be adapted and are being adapted and implemented with increased momentum today for commercial and industrial buildings. Since the beginning of the 1990s, Energy Service Companies (ESCOs)5 have captured and developed a business concept serving mid-size businesses and the larger customers (commercial and industrial). An emerging trend among commercial and industrial customers is that they do not only engage the ESCOs anymore, but partly do the job themselves. This development is excellent documented by Wal-Mart6.

5 http://en.wikipedia.org/wiki/Energy_service_company6 http://az204679.vo.msecnd.net/media/documents/2013-grr-executive-summary_130108648988039481.pdf


Case Study: Wal-Mart documents a new development among large energy customers

Wal-Mart Stores Inc. has 10,900 retail units serving customers under 69 banners in 27 countries. That includes Wal-Mart US, Sam’s Club and Wal-Mart International. Since 2005, Wal-Mart has been committed to three sustainability goals: to be supplied 100% by renewable energy, to create zero waste; and to sell products that sustain people and the environment. Environmental sustainability has become an essential ingredient to doing business responsibly and successfully. As the world’s largest retailer, Wal-Mart is progressing toward a goal of being supplied 100% by renewable energy and at the same time drive a sustainable development as the group expands worldwide.

As of today, Wal-Mart has decided to scale up its renewable energy sources by driving the production or by procuring 7 billion kWh of renewable energy globally by 31 December 2020 – an increase of over 600% vs 2010, and accelerating efficiency by reducing the kWh/sq. ft. energy intensity required to power its buildings around the world by 20% vs 2010.

7 Case study provided by Wal-Mart

Today, Wal-Mart is the largest on-site green power generator in the United States and is a leader in testing and scaling renewable energy projects in stores, including solar, micro-wind in car parks, biodiesel-compatible generators and fuel cells. Individually, some of these resources, such as an on-site fuel cell, provide up to 60% of a store’s energy needs. In 2012 alone, Wal-Mart added more than 100 renewable energy projects, bringing the total number of renewable projects in operation worldwide to over 300. Currently the company has over 230 solar installations in seven countries, along with about 40 US fuel cell installations, and six wind projects. On-site micro-wind, large-scale wind, solar water heating, as well as solar thermal are being tested in various markets, including Canada, Chile, China, Mexico and the US.7


Drivers of investment in the electricity infrastructure

Analysis by Accenture shows that, since January 2008, the combined market capitalisation of the top 26 European utilities has fallen by more than € 230billion. Multiple reasons contribute to this shrinking.8

One key aspect that curtails investment in the electricity sector is that the prices of electricity do not reflect the true cost of power generation and are subsidized due to multiple motivations by the regulators/ politicians. Naturally, this makes it difficult to invest as there is not a lot of trust in the market forces of supply and demand. This is equally true in Europe where consumer prices have increased at the same time as wholesale prices have decreased. This is due to the substantial subsidization of renewable power distorting and even destroying the market. Taxes and changes in taxes are other examples tilting the market forces and making investments harder to justify.

Another factor contributing to delays in investment is driven by the uncertainty of how the climate change problem will be addressed. This general uncertainty in policy development, and consequently of regulation, delays decisions and increases the cost of capital.

This section captures key thoughts and arguments that deepen the ideas of risks and goals related to investments, and offers a framework to foster investments in this sector.

1. Different tasks for different players

There is enough capital available globally for meeting the energy investment challenge. In order to use it efficiently, it is crucial to assign the right tasks for the right players. The financial market is best placed for providing capital and making it available. However, especially with new technologies, there is always a market risk that utilities are well placed to manage. Market signals are crucial to distribute the risks to those players best suited to manage them.

Power plants in full international competition shall always take the market risk, as a functioning market will give their owners the right signals (via market prices) when to produce electricity, when to invest in new capacity or which technology to invest in. Taskforce members are of the view that the private consumers should not be pushed by regulation or legislation to take on market risks as is currently done by governmentally imposed subsidies added to the end-customer power price. They also feel that the grid operators should not be forced into taking entrepreneurial market risks as their business is not accustomed to manage those risks.

In consultation with the Investors community of the World Economic Forum

Case Study: Jädraås Onshore Windfarm

This € 360 million project demonstrated that pension funds can be attracted to invest greenfield investments through smart risk allocation and mitigation. PensionDanmark invested € 120 million in debt financing supported by an AAA-backed credit guarantee from EKF, the Danish export guarantor.

Key risks were shared as follows:

Revenue risk: Revenue from onshore windfarms is a function of the quantity of energy produced and the price received. Vestas, the operator, offered a robust operations and maintenance contract to Jädraås that provided protection against underperformance. The project sponsors were experienced in the market and well placed to manage pricing risk. At current historically low prices, and relatively illiquid markets 10 to 15 years out, Power Purchase Agreements were deemed a poor choice, and the project instead took on a rolling five-year hedge for electricity prices and three-year rolling hedge for renewable electricity credits to avoid locking in low rates at high broker premiums for too long.

Construction risk: Jädraås purchased the windfarm as “ready-to-build” and so avoided delays associated with permitting and public approvals. Construction costs could be allocated to Vestas, the main technology provider, to mitigate risk.

Financing risk: A limited potential pool of interested banks led to only half of the required debt financing being raised from commercial banks. The commitment from EKF to guarantee funding with an AAA wrap underpinned the Jädraås financing structure and was essential to facilitate the investment from PensionDanmark. It is estimated that PensionDanmark secured a return of about 1%-1.5% above that of government bonds for taking the liquidity, currency and interest rate risks, while EKF took the project’s residual commercial, political and non-payment risks.

Export credit agencies are not the only institutions capable of providing the guarantee instrument. Alternative guarantee providers other than export credit agencies, such as private financial institutions, could also address the concerns of long-term investors.

8 “Utilities grapple with renewable surge”, Financial Times, 25 November 2013


2. Different goals make for different investment needs

We have identified four overarching global goals creating different investment needs: (i) Access to energy, (ii) economic growth, (iii) decarbonisation; and (iv) new technology developments. Regionally depending, different combinations of these goals are driving transformation and investment in the energy landscape. Efforts to balance these goals through regulatory frameworks should prioritize robustness over time. Approaches that are not well balanced or sustainable undermine investment.

Clearly formulated goals foster investment as they provide a clear and stable framework for utilities and investors alike to operate in.

During and after the financial markets crisis of 2008, infrastructure investment was seen as one of the levers to encourage and spur economic growth. Yet many companies that owned networks (some have now been sold) also owned generation assets and their balance sheets collapsed after 2008. So some companies that might have supported this growth were (and even now are) unable to do so as they struggle to gain control of their balance sheets. Most emerging markets and mature markets were burdened by austerity measures due to fiscal deficits and high borrowing requirements. Global markets also faced the prospect of an evolving regulatory environment. This has placed a constraint on emerging markets that have been struggling for decades to obtain funding and to finance the enormous infrastructure projects.

The investment frameworks in mature markets have continued in their diversity and search for yield given the low interest rate environment. The liquidity and investments in mature markets were driven by high frequency data and the investment stance of “risk on” and “risk off”. The increase in infrastructure projects across sectors and geographies has resulted in renewed focus on emerging markets. This has stimulated a range of investment products and funding for infrastructure projects that range from the expansion

of existing capacity to renewable energy sources. This has allowed for further diversification and new sources of liquidity. It has also improved the sophistication of capital markets and interest from global investors.

Emerging market economies continue to be supported by Development Finance Institutions (DFIs) and Export Credit Agencies (ECA) of the mature markets. The emerging markets have also experienced an increase in the flow of international capital to emerging markets. The mature capital markets have continued to open up for emerging market borrowers and also for investment opportunities in emerging markets.

Developing markets are making noticeable progress in building capital markets infrastructure and the regulatory frameworks that support a well-functioning, broad-based financial system. These developments have increased new global investment options for a broad new pool of funds. This will allow developing markets to secure funding for the much needed infrastructure projects. This, in turn, will increase investors’ confidence and drive up demand to stabilize these markets, which will also largely solve the funding dilemma of infrastructure projects.

3. A three-step approach to foster investments

Governments and policy-makers need a holistic policy framework. The Investors Industries of the World Economic Forum have developed the following Blueprint Policy recommendations to address this process: First, policy-makers are advised to define and communicate a strategic infrastructure vision that aggregates and prioritizes a project pipeline and defines the role of private investors. Second, infrastructure plans must be underpinned by policy and regulatory enablers. Third, each potential project and investment must demonstrate a clear investor value proposition. The framework is summarized in Figure 1. Sections A, B and C discuss these three categories of recommendations, respectively.

Figure 1: Policy Recommendations Framework

Increased investor interest with a credible

pipeline of future projects, and clear role for investors

Bankable projects that attract investor

interest and generate while maximising value for money for governments

Stable regulatory environment;

Standardised and efficie nt transaction process;

Lower expens es and cost of capital for investors and

more money paid to governments.

Strategic vision

Policy and regulatory enablers

Investor value proposition

• Create an integrated infrastructure pipeline

• Define a viable role for investors

• Develop a Multi-level communication strategy

• Limit re-negotiation risk

• Create an efficient, predictable and standardized procurement process

• Facilitate predictable project permitting processes• Review and assess tax policy

• Analyse the project returns from the investors’ perspective; focus on financial returns

• Create a robust risk allocation methodology

• Conduct market sounding with investors

Key recommendations Key outcomes


These recommendations address the key impediments and concerns expressed by leading investors across countries and types of projects. No recommendation will apply equally to every country given a wide variation in political structures, economic development, current state of infrastructure and government capabilities. Individual governments thus will need to define their own specific roadmaps to incorporate the most critical and relevant recommendations.

In the short term, practicality in addressing major impediments and recommendations should take precedence over developing the perfect framework and process. For example, a number of countries face an urgent electricity shortage that calls for near-term construction of new generation facilities. These governments should not halt project planning to complete a robust strategic vision driven by a lengthy consultation with stakeholders.

In the long term, we would expect that countries which follow the recommendations described herein will increase their attractiveness to infrastructure investors, and realize the competitive and economic advantages provided by sustained infrastructure development.


Conclusion and main outcomes

Significant investments are needed to meet the electricity sector’s multiple goals of providing access to energy and supporting economic growth, while decarbonizing and adapting to new technology developments. The Energy Utility and Technologies Community of the World Economic Forum considers ensuring adequate investment in electricity infrastructure a core challenge for the industry, policy-makers and society alike.

The utilities sector – traditionally a stable and low-risk industry attracting sufficient finance from investors – is undergoing significant changes across the world, driven by new technologies, and societal and regulatory changes. The impact on the traditional utility business models is significant and utilities are evolving in response to new opportunities and threats.

Utilities have historically had a social responsibility to reliably deliver electricity to society. With the introduction at scale of distributed generation from renewable energies in Europe, traditional base load generation – still vital for secure electricity supplies – has lost economic attractiveness for their owners. In combination with falling electricity wholesale prices in Europe, this has put many utilities under economic strain and made investment in base-load capacity as well as electricity grid upgrades a real challenge. The large amount of conventional capacity that is currently retired from the European markets is a striking evidence of that effect. This also raises concerns about the longer-term electricity supply security since base-load capacity is needed alongside intermittent renewable sources.

In the capital-intensive electricity sector with long payback periods for investments, it is critically important for investors to know the policy framework rules governing the opportunity to earn adequate returns. Stability and clarity of the policy framework are paramount for investment decisions. Regulation must naturally evolve with the changing electricity landscape. However, today, policy frameworks and political goals are in many instances unclear and unstable, making risk/return profiles of electricity investments unclear and, as a result, reducing investments. A survey from the World Economic Forum Investors Community suggests that regulatory uncertainty is currently giving most concern when considering investments in electricity infrastructure.

A predictable regulation can help to decrease this policy risk and. therefore, the cost of capital and increase investor money flowing to the sector. On the contrary, unforeseen or poorly justified regulatory changes can lead to investor scepticism, increase costs and deter new investments.

The challenge for regulators is to provide a long-term stable policy framework in a sector and an environment that is rapidly evolving, under a situation of uncertainty. In this effort, policy-makers, investors and the electricity industry need to work together to find solutions that allow investments to flow, safeguard future supplies while also tackling the decarbonization. The utility community of the World Economic Forum is ready to engage in this.


Acknowledgements

The Energy Industries of the World Economic Forum wish to thank:

Peter Terium, Chief Executive Officer, RWE AG, Energy Utilities and Technology Community Leader 2013, and RWE AG for their leadership

The Partner companies of the World Economic Forum Utilities and Technologies Community: – ABB Ltd – Abu Dhabi National Energy Company (TAQA) – Centrica Plc – DONG Energy – DTEK LLC/SCM – Duke Energy Corporation – EN+/Basic Element – Eskom Holdings SOC Limited – Fluor Corporation – GDF SUEZ – General Electric – Iberdrola – JSC RusHydro – Mitsubishi Corporation – NRG Energy – Renova Group – RWE AG – Siemens AG – Statkraft AS – Vattenfall AB

Bloomberg New Energy Finance

Wal-Mart

World Economic Forum Investors community

Global Agenda Countil on New Energy Architecture

The Energy Industries of the World Economic Forum also express a special thank you to these task force members for their written contribution to this paper:

Ian Funnel, Group Vice President, ABB France, ABB

Yulia Burmistenko, Manager, International Public Affairs, DTEK LLC

Kirill Ermichine, Head of International Public Affairs Department, DTEK LLC

Ryer Barcott, Special Adviser, Office of the Chairman, Duke Energy Corporation

Rochelle Chetty, International Agreements and Memberships Manager, Eskom Holdings SOC Limited

César Ortiz Sotelo, Vice-President and Deputy Director, International Department, GDF Suez

Fernando Lasheras, Director, Brussels Office, Iberdrola

Rolf Schatzmann, Advisor to the Chairman of the Executive Board, Renova Management AG

Julia Modenbach, Energy Policy, Public Affairs and National Policy, RWE AG

Sören Buttkereit, Vice-President, Regulatory Strategies, Energy Sector, Siemens AG

Ragnvald Naero, Senior Vice-President and Director, Business Development, Statkraft AS

Erik Filipsson, Strategic Policy Advisor, Business and Stakeholder Relations, Vattenfall AB

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World Economic Forum Robust Framework for Electricity Infrastructure 2014

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