KUHN CAPITAL Monday, March 19, 2018
Dispatches from the front

Energy IT: Life Under the Heavy Hand

The energy industry is one of the few whose operations and economics are nearly completely dictated by regulation. Since this has been true from the industry’s distant Edison and Westinghouse days, when state and Federal government first wrung hands over the “natural monopoly” of local distribution, it is therefore rather predictable that as progress toward deregulation has occurred, “mistakes were made”, as the politicians say. What does this mean for energy IT vendors?

Ward of the State
In the US, the greatest single mistake was when California bureaucrats -- for political purposes -- re-regulated power trading, arbitrarily outlawing long-term energy contracts and thereby forcing buyers into ruinous spot markets. Having created the problem, now the state is busy prosecuting energy traders who are, of course, paid to capitalize on market dislocations. In other states, Enron’s energy trading melt-down and California’s fiasco provided politicians with convenient cover to suspend open market initiatives that threatened their lucrative control of local energy franchises, thereby protecting the inefficiencies of these players against out-of-state competition. The losers in all this meddling are of course industry investors, energy consumers and taxpayers.

But the advantages of sane deregulation – vastly improved efficiency and cheaper end-user energy prices -- are so obvious that in our opinion, it is inevitable. Other parts of the world, places not afflicted by the US’ spectacular market failures, are clearly benefiting from their move toward freer markets, and act as visions of the future US industry environment. Some prominent examples are the UK, the Nordic countries (who have achieved nearly complete deregulation) and Germany.

Meanwhile, back in the USA, the fate of those who serve the energy industry with IT-based products and services like software and trading system vendors is still firmly in the capricious hands of the regulators. So below we’ll make an ambitious effort to read these tea leaves as we explore how regulation, re-regulation and deregulation may affect certain IT sectors. In sum, Europe will attract much of the action over the next several years, with the giant US market then awakening as its tardy deregulation proceeds. Meanwhile, investors in US energy IT properties can expect cheap acquisition pricing in exchange for taking on regulatory risk.

Energy IT Sector Prospects
Energy Trading Exchanges Will Survive, Then Eventually Thrive
We believe the US energy trading industry will slowly recover from its 2001 collapse. We have now at least gained proof of concept through examples of successful clearing mechanisms like the Nord Pool, NYMEX and NGX (Natural Gas Exchange), which demonstrated their capabilities by efficiently laying off Enron’s monster risk. Further, entrepreneurs are continuously offering improved trading environments (NYMEX’s ClearPort) and financial products (ICE’s guaranteed-to-clear OTC contracts). Trading exchanges are relatively free of direct regulatory interference, though as California proves, individual states can regress to a command and control mentality overnight.

Vendors of Energy Asset Management Solutions Will Also Begin to Prosper
The emergence of successful wholesale markets especially in Europe, and performance-based rate making in the US, is heightening industry interest in efficient physical asset management. Two sorts of software applications vendors are pitching solutions to this need -- trading/risk management players and enterprise-oriented asset/demand players. We believe the asset/demand management players are better positioned to exploit this emerging opportunity, since they more clearly address how to improve demand data aggregation and accuracy both within the enterprise and across its trading partners. The growth in energy asset management software is directly related to loosening regulation, so we are seeing it now most clearly in Europe, with the US eventually to follow.

So Will Energy Merchants or Marketers, But Again Mostly in Europe for Now
Energy merchants will grow more rapidly in Europe because of the industry’s more cautious asset leverage than was characteristic in the US, and because Europe’s greater deregulation permits more efficient clearing mechanisms. These conditions will lure global financial institutions like investment and commercial banks into the game (at least some of them American), making them new financial services industry buyers of energy trading and risk management systems.

We’ve got about another two years before the US energy wholesale market recovers from its 2001 confidence crises then followed by its 2002 credit crisis, a double whammy that drove many utility trading operations out of the market. While FERC ruminates over its vaunted Standard Market Design (SMD) (that is, the rules of the road for how investors are permitted to make money), US merchant activity will continue to meander or even dwindle. FERC’s lengthy delays are one of the clearest examples of how regulation kills commerce, but the good news is that when and if FERC creates an attractive investor environment, it will drive massive US IT expenditures. Look for this development in the next several years.

The Dollar Value of European M&A Will Eclipse That of the US, But the US Will Lead in the Number of IT Industry M&A Transactions
European energy industry mergers will outpace US activity as Europe’s freer markets encourage power, gas, and transmission consolidation. That said, US IT M&A activity has been surprisingly strong in the last 18 months, lead by an acquisitive Itron spree financed with bank debt. Some other US buyers included SunGard, Nexant, Global Energy Decisions, Seimens and Indus, these companies picking up relatively cheap properties in pursuit of roll-up strategies. We will see more US energy IT consolidation and new product development in the next several years.

Energy IT Vendor Capital-Raising Prospects
For most energy IT vendors, particularly wholesale energy trading and risk management vendors, VC, private equity and public market investor capital has virtually disappeared. And the few vendors that raised capital several years back are under pressure to generate positive cash flow, forcing them to curtail expansion plans. This fact presents opportunities for strategic market share investment by operating companies at the same time that it accelerates the sale of these properties.

So Who Will Dominate the Global Energy IT Market?
In conclusion, we believe that the energy IT vendors likeliest to prosper quickly will eventually offer enterprise-level asset management, decision support, and portfolio management functions for both retail and wholesale energy suppliers.

In the US, as FERC unveils its SMD, IT vendors who can assist wholesale market participants with this transition will also gain ground, as will those who provide mechanisms whereby the widening net of trading partners can exchange data. Deregulation is all about connectivity. Current examples of vendors with at least some of the above attributes are Global Energy Decisions, Nexant, The Structure Group and Triple Point. Ironically, the most advanced energy IT vendors tend to be found in the US despite this market’s cloying regulation. To some degree, they’re leftovers from the former days of deregulatory momentum.

So the successful US energy IT vendor may be well served by earning its spurs in the open European market -- fine-tuning its solutions and generating sales especially among wholesalers there -- then return home to capitalize on deregulation here as it finally unfolds.

Ryan Kuhn

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