tl;dr: Life is about to get a lot better for demand response and energy efficiency companies.
One of the challenges of venture capital is that you invest in companies now based on what you know now, but the world may look very different by the time the company exits (i.e., when it’s bought or goes public).
When people talk about this, they usually cite the investment bets that look dumb in retrospect – where investors deployed capital at a time of heady expectations and woke up to cold reality later on. (Amidst dot-com hysteria, otherwise-smart people could envision their morning coffee delivered by Kozmo and paid for with Flooz; afterward, not so much.)
However, one can also make the opposite blunder: Deciding not to place bets in a downer environment, and then missing the opportunity to reap returns when things look up.
This is the milieu that demand response and energy efficiency start-ups face today.
Whether they are reducing electricity demand at peak times (Enernoc, Gridium), deploying energy-efficient retrofits (NextStep Living, Ameresco), or doing high-tech real-time stuff to balance the grid (Enbala, CUE), these companies all have one thing in common. They traffic in what I call marginal megawatts – the MW at the very top of the load curve that determine whether the peaker plant gets turned on or whether a new transmission line must be built. The demand response players do this by clipping peaks while the energy efficiency ones do it by dropping the baseline, but they deliver a similar net result. (You could add grid-scale energy storage to this grouping if you wanted to.)
Such companies are poorly valued today. Public stocks tell the tale – for example, as I write this, Enernoc, Ameresco, and PowerSecure are all trading at less than 1x sales and 12x EBITDA. (For those of you who don’t often think about valuations: That’s bad for a growth company.)
This situation is about to change.
What’s the value of a marginal megawatt? In my mind, it should be proportional to two things – 1) the cost to deliver that same MW from conventional generation resources, and 2) the amount of free capacity that’s available to do the generating. Both are hitting inflection points right now.
First, let’s take the marginal cost per MW. For this analysis, let’s consider the market for “frequency regulation,” a horrible misnomer of utility-speak that means “injecting or removing power on the grid over fine time scales to balance supply and demand.” (The name comes from the fact that imbalances cause the grid to deviate from its 60 Hz AC frequency.) Frequency regulation is traded in open marketplaces on a $/MW/hr basis, and its price is probably the purest measure of a marginal megawatt.
As it turns out, the price of frequency regulation correlates very closely with the price of natural gas, because gas plants are usually the market price-setters. See the chart below, which plots the clearing price for frequency regulation (in the United States’ biggest electricity market, the 13-state PJM region) against the price of natural gas (as measured at the Henry Hub distribution center). The r2 on this is 0.80, meaning that natural gas accounts for 80% of the variance in frequency regulation price:
Natural gas prices started plummeting in 2008 due to the hydrofracking revolution and reached a 12-year low of $1.82/MMBtu this past April. As that price was below most producers’ breakeven levels, many folks speculated that drilling only continued because the exploration companies would lose their land leases if they didn’t keep making holes. Since then, new drilling in gas plays has cratered and the price has started climbing back up – it’s at $3.15 as of this writing, and the futures market has it north of $4 by the end of next year.
As the price of natural gas rises, so will the value of marginal megawatts. And there’s reason to believe that the price will increase sharply beyond 2013 if U.S. natural gas starts getting used in new ways – like being exported. Export applications currently filed at the DOE would ship out 16 billion cubic feet per day, which is two-thirds of current U.S. shale gas production!
So higher gas price = more valuable marginal megawatts. Now let’s look at generating capacity.
As goes GDP, so goes electricity demand. When U.S. GDP peaked in 2007, so did our electricity consumption. And when the economy tanked, electricity consumption fell. 2012 should be the first year that these indicators exceed their 2007 levels.
When there’s idle generating capacity around, the companies that own it get hammered. Consider independent power producers, the companies that operate conventional power plants. Their share prices closely track total electricity generation, which in turn tracks GDP – all of which dropped sharply after 2007:
So do I need to write this next paragraph? Only now is electricity demand getting back to its 2007 peak. Doubtless there were new plants getting built five years ago which were completed but unused, so excess capacity will likely persist for a couple more years. But, inexorably, that capacity will get mopped up as GDP rises and electricity demand grows with it, and sooner or later we’ll find ourselves bumping into a new ceiling. Just as predictably, the value of companies that resolve this supply/demand imbalance – those that deliver marginal megawatts – will jump. Note that when Enernoc went public right before the 2007 electricity demand peak, it did so at 20x the previous year’s revenues. It’s now trading at 0.6x. I’ll bet that looks really different in, say, 2016.
The kicker: Demand response and energy efficiency companies will slaughter conventional generators on cost. A new fossil generator costs $1 million per MW in capex, plus or minus, and requires fuel and transmission on top of that. Setting a big user of electricity up to curtail its demand by 1 MW costs maybe $50k – and that’s it. As we climb to a new electricity peak, generators will lose the battle for the marginal megawatt.
So whether your start-up is trimming peaks, lowering baselines, or synchronizing supply and demand, take heart. It’s been a long, hard five years. But a brighter day is just around the corner.