Not Your Father’s Infrastructure (Part 3)
Implications for infrastructure companies
We’ve discussed how the world of infrastructure is changing more rapidly than ever before, in Infrastructure Ideas’ two previous posts in this series (Not Your Father’s Infrastructure-overview, and Implications for Policy-Makers). Change is coming from technology, from which infrastructure (excluding telecoms infrastructure) had previously been insulated. This post will continue to explore some of major implications of this change, this time for the companies involved in infrastructure.
For infrastructure companies, as for policy-makers, the rapid and fundamental changes in how infrastructure works are both good news, and bad news. Let’s start with the good news. And there’s plenty of it. The best news is a surge in new investment opportunities. We’ve already seen it, and it is only going to get bigger.
A surge in new opportunities? Now, one might say, isn’t there an infrastructure crisis? An infrastructure crisis in the US? An infrastructure crisis in almost every high or low-income emerging market? Of course there is. But that long-running headline has obscured, for many people, the wave of new investment opportunities that have arisen in the past decade. To date, these have almost entirely arisen in the energy side of infrastructure, but still have been nothing short of phenomenal. Let’s look at a few numbers:
• Investment in wind and solar-based power generation now exceeds $330 billion p.a. worldwide, and since 2010 has accounted for about $2.5 trillion. For a technology that seemed to be interesting curiosity only a decade ago, with smallish investment levels all dependent on some form of government subsidy, this is an amazing development. Solar and wind generation now make up one of the largest business segments across any industries, let alone infrastructure. Putting this in perspective, with an estimated $1 trillion of annual global spending on infrastructure, wind and solar may now account for as much as 1/3 of annual global infrastructure spending.
• Natural gas has been an important part of energy in several countries for many decades. Now supply has expanded with new technology applications, and alongside this transport of gas has been revolutionized by smaller scale transport and import facilities. This has created a huge new area of investment. Over the last five years, investments in new LNG facilities have totaled an estimated $250 billion. The growth rate in LNG terminals alone has been in the neighborhood of 100% p.a. for the past five years – not bad for a highly capital intensive infrastructure segment.
Let’s take a minute to step back and understand what happened here. Technologies have appeared, and been refined, that have had a form of “Moore’s Law,” with costs plunging by double digits annually. As costs drop exponentially, delivery of a service or product now becomes possible at a fraction of what it traditionally cost to deliver that product or service through established technologies. Energy, now and in the future, becomes available at costs well below what it traditionally has. This spurs demand from consumers and governments, and that demand growth creates widespread, and very large, investment opportunities.
These two areas, non-hydro renewable generation, and natural gas midstream, have accounted for an enormous amount of the new infrastructure investment opportunities across the world in the last five years. Probably over half. Maybe three-quarters? So… lack of deal flow the problem for your company? Technology change has delivered deal flow. And this is a movie with more sequels than The Avengers or Star Wars. Energy storage and smart-grid technologies are on similar cost curves, and their markets are just beginning to develop, as part of the infrastructure of delivering energy services. Technology is beginning to have similar cost-dropping and substitution effects in transportation. And consumers and policy-makers will react similarly to these price signals.
Large new markets are the bright side of the new world of infrastructure. Let’s look at the not-so-bright side.
That would be… making money.
There are many more opportunities to place private capital in infrastructure, but these are generally higher risks, and carry no commensurate increase in returns. Why? Because consumers are capturing the benefits of changing technologies, and the lower and lower costs they offer for certain infrastructure services. Making money – even staying afloat – as a provider of capital or an operator of infrastructure services, is getting more complicated. We can see this dynamic increasingly at play in the solar and wind generation business. After almost every solar auction in the past two years, as new low price records get set, the near-ritual question is being asked – how is anyone going to make money at these prices? Well, someone will make some money – we’ll return to the “who” in later posts, but a great many players cannot make money at these prices, and those who do make far thinner margins than was the case even recently. The big winners are consumers (and governments who take credit for delivering lower prices).
Again, why? Much has been written about this, and there are multiple causes – some degree of overcapacity driven by public sector investment programs in upstream products like solar panels, some degree of irrational exuberance or loss-leader strategies. But the big answer is simpler. We tend towards underlying fundamentals as the main explanations for many things, and we’ll do so again here – the big drivers of compressed margins in power generation today being competition and efficiency.
First competition. The world of generating electricity today is dramatically different than a few years ago in terms of lower prices to users. It’s also dramatically different in terms of the number of players. Generally lower capital costs for wind and solar generation than for thermal generation, or than for hydropower, have meant that many more can play. Lower capital costs mean lower barriers to entry. The number of companies involved in renewable energy generation is dramatically higher than for thermal power generation. We can observe this in many ways, including in terms of the number of bidders for tenders for provision of renewable power compared to thermal generation. Even as tenders grow to larger scale – as in the world record size tender for solar generation in Egypt in 2017 – the dynamics have been maintained (in the case of Egypt, with the government splitting “the project” into multiple smaller units).
Second efficiency. As the effects of technology on costs have become more visible, governments have also become more efficient in capturing the benefits of those lower costs. They’ve done this, not surprisingly, by maximizing competition. The early solar and wind days of negotiated transactions have largely given way to procurement through competitive auctions. Bloomberg New Energy Finance and others have pointed out the importance of this shift, showing auctions by themselves accounting for as much if not more than technology cost changes to the drop experienced in power prices. And it is no surprise that those countries experiencing the highest prices for new solar and wind generation – or put it another way, those countries benefiting the least — are those that are still preferring non-competitive procurement: feed-in-tariffs, or old-fashioned bilateral negotiated transactions.
Competition and efficiency have meant compressed margins, and lower profits, for a large share of these new infrastructure investment opportunities created by changing technology. Will we see a similar dynamic for energy storage, for distributed generation, for smart grids, for electric vehicles, for autonomous vehicles, for new municipal infrastructure surrounding EV and AV deployment? Time will tell. In midstream natural gas, the other big opportunity growth area we’ve flagged above, the dynamics have been different – technology has not yet driven a dramatically higher level of competition, and margins remain very healthy. My bet would be these new technologies will have dynamics more comparable to renewables than midstream gas.
There is also a third way in which making money is becoming more complicated in the new world of infrastructure. Substitution. In the first of this series, we talked about how infrastructure has long been seen as synonymous with stability, and how this link is unraveling. In a business characterized by rapidly and continuously falling costs, investments become obsolete far faster: obsolescence ceases to be a question of functional degradation (does the plant still work?), and becomes instead one of loss of price-competitiveness. The issue will become how buyers (mainly but not only governments) react to obsolescence. Infrastructure companies depending for their revenues on long-term purchase contracts will increasingly find buyers questioning whether it makes sense to continue honoring those contracts, with lower cost alternatives increasingly available. As has been the case for subsidy programs in Spain and other countries. Long-term revenue risks will be fundamentally higher than they have been. And this is not to talk about companies who have assets locked up in segments that are becoming obsolescent: good luck finding backers for large-scale biomass investments, for example. Hydropower companies are likely to see dwindling opportunities. The coal business is already seeing widespread bankruptcies, for partially though not fully-related reasons. It’s a new world out there, not a kind one.