Structural changes
Over the last ten years, the energy industry has undergone significant changes, some of which will have a structural impact on the future of the sector. For the purpose of this paper, five “mega-trends” are discussed. The first mega-trend relates to the dynamics of deregulation. Scarce energy resources will be more frequently allocated based on market mechanics. This implies volatile prices on the wholesale level and customer choice on the retail level. The core competencies of utilities need to include therefore sophisticated risk management skills and service-oriented leadership. This may be taken for granted when it comes to some UK energy utilities. However, in regions where the deregulation process has started only recently, investors will find significant variations among the players of the industry.
As a precondition of deregulation, third-party access to power grids and gas pipelines must be granted. The unbundling of the related infrastructure (natural monopolies) is a second mega-trend, which provides investors with the opportunity to allocate capital to an asset class with a unique risk-reward profile. The third mega-trend relates to privatization. As in the case of deregulation, I would not argue that this trend is linear. On a regular basis, important forces will question the benefits of privatization. However, the fundamental trend is irreversible and being bolstered with the explosion of public debt as a result of the current financial crisis.
Driven by environmental and geopolitical motives, the trend towards renewable energy is the fourth global mega-trend, which is irreversible in the foreseeable future. Power from solar, wind, water, biomass and geothermal energies will change the landscape deeply. In most developed nations, ambitious support plans for power from renewable energies have been established, most recently in the European Union. On December 17 2008, the European Parliament signed off on a binding target quota of 20% power from renewable energies by the year 2020. Since most renewable energies have somewhat stochastic production characteristics, power plants with firm and flexible dispatch schemes will – as a result of this megatrend – become more valuable in the years to come.
The integration of commodity markets is an important fifth megatrend on the energy landscape in the future. Investors need to understand how gas, oil, coal, power and CO2 prices are interlinked with each other in the different markets. The identification of critical transmission bottlenecks and marginal power producers belong to the key aspects of this analytical work.
The structural changes described above imply that the investment universe becomes not only broader but also more diverse and more challenging to analyze, as “winners” and “losers” emerge from the related dynamics.

Three Value Drivers
In order to precisely capture the dynamics of the changing energy world, investors may apply a simple analytical framework, which is based on three fundamental pillars. The first pillar relates to technological progress. As renewable energy becomes a serious part of the energy equation, technological dynamics ought to be analyzed deeply before allocating capital towards the industry. In some areas, research and development efforts may transform investments into stranded assets within the next five years. To quote some examples: A breakthrough in the area of so-called second-generation biofuels would seriously deteriorate the value of bio diesel and bio ethanol assets. On the other hand, a breakthrough in energy storage technologies would have a significant positive impact on the value of existing solar plants and wind farms. The same applies with respect to CO2 storage technologies and the implication on the value of coal-fired power plants.
The second pillar of the analytical framework relates to the regulatory environment. For many reasons, the energy sector is and will remain a highly-regulated sector (despite the emergence of wholesale markets and customer choice as mentioned above). Hence, political dynamics ought to be understood in detail before investing in the sector. Some trends appear quite clear: in more and more regions, feed-in tariffs with declining scales for renewable energies are being introduced. On the one hand this will attract new entrants to supply the related equipment; on the other hand, this will put some margin pressure on the firms in question. Low-cost producers of high-quality equipment will emerge as the winners. As another example, in more and more regions with fragmented power markets and low reserve margins, capacity payments are being introduced to incentivize the construction of new power plants.
The third pillar relates to the relative prices of energy commodities, which are one of the key determinants for the profitability of power and gas utilities. Notably, it is not the absolute commodity price level, which is relevant in this context but rather the relative price of gas, oil, coal, power and CO2. The key spreads to observe are the spark spread (power vs. gas), the dark spread (power vs. coal), the clean spread (spark/dark spread minus cost of carbon allowances) and the climate spread (clean dark spread minus clean spark spread). The valuation of firms and assets within the industry depends heavily on the investors’ price forecasts for energy commodities.

The Energy Balance is Key
Once the investor has established an educated view on the dynamics of the three sector drivers, individual firms may be analyzed in detail. Of course ordinary aspects such as financial indicators, management quality, strategic intentions and track record need to be reviewed in this context. This being said, sometimes investors forget about the key value driver of energy companies, which is hidden in their individual energy balance. The energy balance informs investors about the tenors of supply and sourcing obligations. If the balance is neutral, the analyzed company is not exposed to changing price relations. In practice, the reconstruction of an energy balance is a masterpiece of a puzzle and requires long-standing industry experience.

Going “short” by going “long”
Besides providing indications on tactical and strategic short/long positions, the correct interpretation of an energy balance allows investors to take short positions on certain energy commodities by investing in suitable shares. As an example, if a utility has supply obligations at fixed prices, but has a wholesale exposure to either primary or secondary energy commodities, such utility will benefit from declining commodity prices. By the way, many Japanese utilities do have such a profile.

Attractive Investment
Characteristics Over the course of 2008, we analyzed and compared in two (unpublished) studies the performance characteristics of both - energy equities and energy commodities - with broader investment universes. It turned out that all energyrelated investment classes had a superior sharpe ratio than broader investment schemes. Equally important, correlation coefficients indicated that portfolio diversification benefits could be achieved by investing in energy themes.
With respect to equities, relatively low volatilities of utility shares were the main driver for the positive sharpe ratio of that asset class. In the case of renewable and solar shares, superior returns compensated for high volatilities of the respective asset classes. From a diversification perspective, utility and solar shares appear to have the most benefits.
With respect to commodities, growing demand (with little impact from business cycles) on the one side and supply limitations on the other side resulted in an attractive Sharpe ratio of energy commodities. Another reason for the outperformance of energy commodities is that ordinary indices do not consider important secondary energy commodities, such as power and CO2. The relatively low correlation coefficient of energy commodities indicates that institutional investors running commodityrelated satellites may improve portfolio characteristics by allocating to exclusively energy commodities.

Dr. Dominique Candrian, CFA, Managing Director, EIC Partners, Zurich

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