Energy breaks into the boardroom

Dealing with rising and volatile energy costs and carbon cutting challenges have become boardroom priorities. Phil Dominy and Harry Manisty of Ernst & Young outline how corporate energy consumers are seizing the initiative and looking to influence the source of their energy.

Ever since the Industrial Revolution brought abundant sources of coal, oil and gas to the business world, energy has been a critical operational component for all types of enterprise. In a literal sense, energy is the driving force behind many corporates. But it is also becoming increasingly important from a financial perspective.

Ernst & Young’s (EY) recent Global Cleantech Insights and Trends report revealed that half of large corporates spend at least 5 per cent of their operational budget on energy, and 13 per cent spend more than 40 per cent.

In many countries energy prices have risen steadily over recent years, and the EY survey revealed an expectation that this trend will continue. In the next five years, 38 per cent of corporates expect to see their energy bills increase by at least 15 per cent. This trend, combined with a focus on cost reduction following the global financial crisis, has pushed energy up the list of board priorities.

Another emerging feature of modern business is the growing importance of sustainability and climate change challenges. In an energy context, sustainability means decoupling energy supplies from fossil fuels and greenhouse gases.

In a world of rising prices and heightened consumer awareness of climate change issues, businesses recognise that they can experience both a reputational and financial boost by pursuing sustainable energy sources. This has elevated energy buying strategies from a tactical and technical challenge to a strategic and financial necessity.

Once a board has recognised the commercial imperative to act, the next step is to ensure that targets are set and an effective plan of action is in place.

For many large corporates the initial response to energy is to focus on energy efficiency. For example, by rolling out programmes across their estate to minimise wasted energy or by encouraging employees to change their behaviour, then installing smart meters and building management systems, coupled with more efficient lighting, insulation, heating, ventilation, air conditioning and refrigeration equipment.

McDonald's cuts its energy intensity by 20 per cent in the UK through a £9000 investment programme
McDonald’s cuts its energy intensity by 20 per cent in the UK through a £9000 investment programme

Recent examples here include McDonald’s and 3M:

  • McDonald’s cut its energy intensity by 20 per cent in the UK through an investment programme of £9000 ($13,980) per restaurant, which has yielded an average payback of just over two years and annual savings in energy spend in excess of £5 million ($7.7 million).
  • 3M’s energy use has fallen 20 per cent between 2000 and 2010. Its Pollution Prevention Pays programme saved $1.4 billion through 8100 projects that have typically had paybacks of two years or less.

According to EY’s report, for some companies a 20 per cent cut in energy costs represents the same bottom line benefit as a 5 per cent increase in sales – hence the importance of energy efficiency programmes. However, every business will eventually reach a stage where diminishing returns are experienced from efficiency efforts. The next stage is to consider the underlying nature of the energy that has to be consumed and how this energy is procured. The starting point for this analysis is often the environmental credentials of the energy acquired. Large corporates are typically measured on their environmental performance for energy by the greenhouse gases emitted from consumption.

Different fossil fuels have different carbon content. For example, the recent US shale gas boom and improving economics of fuel cells are offering lower (but not zero) carbon grid-based electricity in countries with a heavy coal-based grid mix. However, to get a material cut in carbon, many large corporates recognise the need to be more proactive and shift their supply to a zero carbon, typically renewable, source. Historically, this has taken the form of buying green tariffs, Renewable Energy Certificates (RECs) or carbon offsets. However, recently these instruments have become controversial in justifying carbon reduction and they do not offer any financial benefits. They would typically need an extra operating cost on top of that of energy from traditional sources.

One potential development is an ‘additionality’ requirement: a business must be able to demonstrate it has played a material role in bringing extra capacity on line if it would like to claim that the energy consumed is zero carbon. Even if the rules do not ultimately include this requirement, corporates recognise they have a better story to tell to their stakeholders on renewable energy if this condition is satisfied.

google

So what can a business do if it wants to move beyond a ‘passive’ certificate, green tariff or offset-based strategy? Due to significantly reduced capital costs, a trend has emerged in the past few years for large corporates to invest equity directly with renewable energy generators – both onsite and offsite. On site for increased energy security and off site for increased scale.

ikea

Two high-profile examples of investment are Google, which has already invested more than $1 billion in renewable energy, mostly in wind and solar projects across the US, such as $200m in a 161 MW wind farm in January 2013; and Ikea, which has doubled its planned spending on renewables to $2 billion by 2015 and $4 billion by 2020. The retailer already has 43 MW of solar PV and 180 MW of wind. Other global corporates that have started on the renewable journey include Nike, HSBC, Volkswagen and Apple.

apple

Competitively price powert

Another trend is for corporates to club together on large projects to secure competitively priced zero carbon power. For example, the 164 MW Bii Stinu wind farm in Mexico, where Walmart, ArcelorMittal Steel and three Mexican corporates have signed a 15-year power purchasing agreement.

Investment in non-core assets does bring challenges. Often, corporates’ financial hurdle rates, such as pay-back period, and contractual constraints like contract length have to be flexed to cater for the ‘back-ended’ return profiles for capital-intensive projects. Providing equity for a project can also have reputational benefits and bring a natural power price hedge through the dividend stream. Direct procurement also provides greater flexibility around the corporates’ power offtake agreement. This new source of capital for renewable projects has been welcomed by the capital constrained renewable industry, which has sought to exploit this trend by reaching out to large corporates with an appetite for investment, proposing attractive partnerships and innovative funding structures.

Another trend led by large corporates is for consumers to contract for energy directly with renewable energy generators. Some corporates prefer to adopt a PPA contract procurement-led strategy to secure renewable power rather than tying up capital in non-core assets. ‘Sleeved’ PPA structures are now being adopted in several countries, allowing large consumers to buy renewable power directly from large offsite generators.

PPAs can take many forms, depending on the consumer’s requirements: the PPA may be structured as fixed price contract, typically with indexation built in. Alternative pricing structures include taking some market risk through ‘cap and collar’ limits, or contracts with stepped price increases agreed.

Large corporates are not the only new players to the PPA market, with recent announcements by the US military and the UK government procurement service wishing to sign up to long-term renewable PPAs directly with assets. Such new entrants into the PPA markets are both welcome from an independent power producer perspective, and also raise interesting challenges to the traditional role of the power utility in interfacing between generation and supply.

EY expects increased competition to stimulate a surge in utility engagement across the wholesale-to-retail landscape and potentially a raft of new, more competitive service and product offerings. Large corporates and government organisations with healthy credit ratings are potentially attractive to project finance lenders requiring credit-worthy counterparties for long-term contracts. It is envisaged that these new offtakers will bring increased liquidity to PPA markets.

The attitude that energy supplies and rising bills are to be endured with little influence available to the corporate consumer is no longer tenable. Efficiency drives are typically the initial response, but a business looking to uncover further financial benefits and sustainable sources of energy will need to explore a range of more proactive alternative strategies for procuring energy.

Phil Dominy and Harry Manisty are assistant airectors at Ernst & Young’s Environmental Finance team.

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