By Sheldon Kimber, CEO, Intersect Power
As a friend recently pointed out, the clean energy industry could learn a lot from Metallica and the first track of their third studio album entitled “Battery.” The opening lines of which are:
Lashing out the action, returning the reaction.
Weak are ripped and torn away.
Hypnotizing power, crushing all that cower.
Battery is here to stay.
There is widespread speculation that they may have had a different form of battery in mind [1]. But, it’s amusing to think of Metallica as early prophets of the battery-powered transformation of clean energy markets with this 1986 prediction that “Battery is here to stay.”
Look, Up In The Sky… It’s A Generator! It’s A Load! It’s BESS!
Battery Energy Storage Systems (BESS) are unique pieces of technology that can appear to the grid as both a load and a generator, depending on whether they are charging or discharging. The ability to choose whether you are a consumer or producer at any point creates enormous optionality, making a battery more and more valuable as the price of the underlying commodity, electricity, becomes more volatile. We are entering an era where the grid is broken, and these types of high optionality loads are increasingly sited at or near the cleanest, most abundant generation. Batteries stand out as the most flexible resource in an emerging clean energy business model (see my new blog in the coming weeks) that focuses on creating vertically integrated constellations of generation and load.
I’ve written about all of this in my prior blogs, linked above. These insights are at the heart of our strategy here at Intersect Power, where we develop, own, and operate some of the country’s largest and most flexibly dispatched BESS assets. What follows is an exploration of some of the market, technology, and supply chain aspects of this rapidly maturing part of the clean energy landscape.
Merchant Curves, Keyser Soze, and Renewable Sharecropping
Regarding markets, I’ve discussed in prior podcasts how the revenue-maximizing strategy for renewable power assets often takes slightly more market risk and eschews long-term Power Purchase Agreements (PPAs). I’ve also articulated how capital markets have, in many cases, perhaps irrationally [2], constrained such offtake strategies and, thus, the clean energy business model itself.
The most common use of the term “merchant curve” has been used to refer to a price forecast that generators add to their financial models for the period after their long-term contracts have expired. This merchant curve is usually a hockey stick shape of stupidly optimistic prices. It has talked many an equity owner into the fact that a generation asset can have a reasonable return to equity even though the offtaker is giving away most of the asset’s value on day one through a below-market contract for the first 15-20 years of the asset’s life. I was recently given the analogy by a colleague that we have constructed a system of renewable “sharecropping” where large offtakers, that have credit quality and are willing to sign long-term offtakes, enabled by debt and tax equity providers’ requirements for revenue certainty have left equity owners with “subsistence” level returns with the promise of a brighter future when the contract is over. The fact that so much equity investment has moved into our sector based on such forecasts while shorter-tenor, higher-priced offtake structures are still seen as suboptimal risk-return profiles is a subject for a lengthy behavioral economics blog by someone more qualified than me.
Nevertheless, the term “merchant,” which began as a fairly innocuous term to describe a non-regulated business model, has become a sort of boogeyman that bankers tell their kids about at bedtime. The Keyser Soze [3] of power markets. A derogatory term that, with one word, reinforces the fervent belief that no amount of revenue should be allowed to remain exposed to the vagaries of market prices.
It’s the equivalent of the old adage “Nobody gets fired for buying IBM,” which was used to imply the security and, by extension, a low level of personal career risk of choosing the dominant industry player. In this case, though, many people deserve to be fired for mindlessly plugging in hockey stick forecasts of prices 15 years into the future while refusing to take a position on what power might be worth next year. In so doing, these folks have doomed billions of dollars of investment to a business model that has mortgaged most of the actual equity returns to investors if they guess wrong on this fictional hockey stick of merchant prices from years 16-35. If this sounds like subprime mortgages and similar financial lunacy, that’s because it is, only this time with a green tinge to make everyone feel good about themselves.
None of this is to say that owners of renewable generation or storage should not have any contracted revenue. Plenty of businesses use long-term contracts to secure a portion of their revenue and enable financing. For instance, if you’re a farmer, you may plant multiple crops and choose to sell the corn forward for a few years under futures contracts of some kind while keeping more valuable cash crops with less liquid futures markets uncontracted to provide margin and upside. Similarly, a power plant often has multiple products, including energy, renewable energy credits (RECs), and capacity. The energy, in particular, also varies by the time of day, month, or year in which it is produced. There are liquid markets to carve up all of these revenue streams and hedge them out over time. The sophistication to do this can enable not only downside protection and financeable assets, but also the upside opportunity for far superior risk-adjusted returns to equity.
BESS Value… Give It Away, Give It Away, Give It Away Now!
In the case of BESS assets this irrational constraint on revenue models is even more perplexing. Whereas a renewable power generator’s revenue is tied to the market price of power in a one-to-one relationship, BESS revenue is a complex function of power prices, but it is not a one-to-one relationship. BESS revenues are driven by the shape of those power prices throughout the hours of the day, the volatility of such prices, and the value of various market instruments, often referred to as ancillary services, created to ensure that the electricity system functions appropriately.
BESS assets make money by charging at a certain time of day and discharging at a later time. In this way, their net revenue is a function of the difference in power prices at certain times of day compared to others; something often referred to as the price shape. BESS assets also make money by capturing extreme and unexpected spikes in power prices. While this is technically a form of price shape, I’ve broken it out as it is distinct from relatively predictable energy arbitrage opportunities that happen day in and day out and is more tied to unexpected extreme events on either the supply or demand side of the market. Finally, BESS assets can generate revenue by selling market instruments such as ancillary services or capacity that are often used to regulate the technical operations of the grid or, in some cases, dampen the volatility of extreme price spikes like a sort of insurance product.
When contracting for this revenue, BESS owners sign tolling arrangements that, like long-term PPAs, transfer the value of all of the project’s outputs to a long-term offtake for a fixed price. Alternatively, they can elect to dispatch the battery themselves, sell these ancillary services, buy energy at charge, and sell energy at discharge. Unfortunately, our good friend, the “merchant” boogeyman, has already found his way to the BESS markets. In an even more confusing evolution of an ill-defined term, many already equate uncontracted revenue from one of these three BESS products with the same risk profiles they saw in the hockey stick “merchant curves.”
A BESS asset doesn’t even sell energy! It is naturally short energy in some hours and naturally long energy in others. It is selling an entirely different product. At the risk of oversimplifying things, it is “selling” volatility. Yet we continue using the same old term that conjures the same old relationships, fears, and investment committee questions. We continue to use this lazy shorthand to describe a fundamentally different investment profile in the hopes that our existing investors may squint at it and treat it like the renewable assets we develop and own today.
The Only Things Certain In Life Are Death and Taxes… And Volatility
When I joined the industry in 2007, electricity from renewable generation was more expensive than market prices. Long-term contracts created value by guaranteeing a premium price was paid to higher-cost early renewable generators for the life of their assets. This was clearly the right contracting strategy in a world where renewable energy capex was declining rapidly, and demand was relatively tepid. Early assets could not take the risk that an oversupply of later, cheaper assets would crater the market prices for clean electricity, and they were right. There is no way the industry could have gotten to where it is today without this business model, but this is very unlikely to be the path forward for renewable generation, let alone BESS assets. If it is, we should all start hoarding reef safe sunscreen for the coming apocalypse as the growth prospects of such a business model are nowhere near rapid enough to meet our climate goals.
BESS assets today are different from renewables in 2007. They exist in a market where the price for many of their services are far more likely to go up than down. The only good macro bets in the energy transition are increasing volatility of electricity prices, increasingly dynamic shapes for such prices throughout the day, and a huge need for capacity products on an aging and increasingly unstable power grid. Furthermore, while BESS’s price will likely decrease over time, changes in trade policy, incentives, and commodity pricing make the short to medium-term direction of BESS capex far less clear. Because of this, it is far more likely that the demand for BESS outputs will be the determining factor in the pricing of its outputs rather than the supply side of the equation.
As I’ve written in the past, Intersect’s short-tenor contract strategy is not a totally unhedged bet on escalating power prices. Similarly, I am not arguing that BESS offtake should be a naked directional bet on market volatility, capacity, or ancillary services. All reputable operators will likely enter into hedges for more limited volumes and durations. That’s just good risk management and planning. It’s important to note, however, that BESS assets exhibit some of the same fixed volume risks in extreme events as generation does. If you don’t show up for your fixed commitments in a volatile market you often take far more risk in one day than remaining uncontracted for years at a time. Good risk management should also consider this when deciding how much to invest in and how to structure these more limited offtake contracts.
Most will choose to deploy the traditional renewable generation business model in developing and owning BESS assets, but at Intersect Power, we are eager to be long volatility, the changing shape of energy prices, capacity, and certain ancillary services. We see it as a natural hedge to our clean generation assets and an amplification of the overall option value that our combined fleet of generation and load provides.
Beige Boxes and Political Realities
With the above understanding of the commercial realities of BESS assets and how they behave in power markets, we can turn our attention to the technical and equipment aspects. While it is still early in the evolution of this technology for grid-scale applications, the value of more tightly integrated solutions engineered specifically for grid applications is already clear.
We saw the same pattern in solar, and believe it or not, personal computers (PCs) before that. When an industry uses the word integrator it usually refers to someone combining off-the-shelf manufactured components into a larger system. Think of the “beige box” PCs made by your local computer store in the 80s and 90s. Now, think of how quickly that store went out of business once integrators were replaced by manufacturers like Dell, who built much higher-performing systems using more bespoke engineering, custom components, and much higher volumes.
In most industries that I’ve seen, integrators are a stepping stone to more mature, higher-performance products. That is no different in BESS assets today. There are only a few companies who are capable of the much tighter integration, more advanced engineering, and value-added customization at scale that these systems will ultimately require.
Beyond this element of integration versus manufacturing, we must also contend with the geopolitical realities of the components themselves. Today, most of the battery cells that are integrated into BESS assets originate in China. Regardless of where you stand on whether this should continue to be the case, the political reality is that it will change in the coming years. There is very little our politicians agree on in this country except for the fact that no components of critical infrastructure should be allowed to originate in China for reasons of industrial policy, national security, and human rights. We should fight hard as an industry to ensure that the transition to this sourcing strategy does not upset the energy transition more generally. Still, the requirement for sources of lithium and battery cell production in the U.S. or allied nations is inevitable. Without solving this problem, the critical BESS assets we need to integrate into the coming wave of clean energy generation will not be possible.
Long Run Equilibrium, Short Run Profitability
We’ve discussed the markets and technology underlying the revolution in utility-scale BESS assets, but so far, we’ve avoided the usual prognostications associated with new technologies. The most frequent subject of such speculation is whether an overbuild of BESS capacity will cannibalize or reduce the value of future BESS assets. In my view, the answer to this question will depend on the speed of the renewable generation buildout. As more intermittent generation is added to the grid, more BESS assets are needed to provide the volatility-reducing, shaping, capacity, and stability services that such a grid will require.
In this sense, it is a footrace between renewables and BESS buildout and one that neither is likely to decisively win for many years. There will be step function build-outs in each that will
temporarily alter short-run economics for their respective technologies. Still, markets will reinstitute long-run balance as the buildout of both continues. As a developer and owner of these assets, I am not worried about being stuck with the last marginal battery asset in this long-run equilibrium for a long time to come. There are much bigger, more likely risks to worry about in this business.
AI! AI! AI!… Hydrogen! Hydrogen! Hydrogen!
No wild speculation today would be complete without a breathless discussion of AI data centers, and clean hydrogen. All of these applications require massive amounts of high capacity factor clean energy, which is likely to be provided by large Behind The Meter (BTM) renewable generators on the same site as these loads. That first part about high capacity factor is where BESS assets and this new model of scalable industrial electrification intersect. Beyond the grid-tied applications of BESS assets, there is another massive opportunity. These assets can take the high capacity factor renewables in a place like the Texas panhandle from a 60-70% capacity factor up to capacity factors that are approaching 100% firm at price levels that are increasingly affordable to end users. Combining BESS, large loads, and generation all behind the meter enables an enormous opportunity for optimization and ultimately provides the grid with tremendously flexible and cost-effective resources to meet growing electricity demand and balance existing customer needs.
Innovation From Experience, Experience From Operations
Finally, it’s worth noting that the BESS revolution and its impact on the power grid is far less advanced than most people think. Because our industry has been talking about large-scale BESS for years, we somehow assume it is a mature asset class with respect to operations, controls, and its dispatch in the market. This is simply not the case. As operators of some of the largest BESS assets in the country and perhaps the largest ones that operate without long-term tolling agreements, we are privy to more information on the operations and dispatch of these assets than most folks in the industry. I am here to tell you that these are incredibly valuable assets, but there is a long way to go until we sort out all the details that many assume we already have.
For instance, basic control systems that coordinate operations of BESS attached to solar systems are an area where the market has proven particularly lacking in experience. Policies such as grid charging constraints are put in place to protect the grid, but in some cases, they conflict with tax policy and financial covenants, with owners caught in the middle. None of these are insurmountable, but what passes for innovation (endless business plans by software engineers who are using an AI model to capture day ahead to real-time spreads) is woefully inadequate and doesn’t seem to be focused on the actual pain points of the industry.
Real innovation will require merging the learnings and data that big operators have access to with new products and tools specifically focused on solving these challenges. In this way, innovation in the BESS ecosystem will likely come from or at least rely on bigger companies with access to lots of operational data to be successful.
Battery Is Here To Stay!
Overall, we’re left with a picture of a vital and valuable technology, but also a technology with lots of runway to improve and evolve. It is a technology that is likely most deployable by existing big players in renewables but radically undervalued if deployed in their current business models. In this way, the most uncertain thing is not whether batteries are “here to stay” but who will deploy the market, technology, and supply chain strategies to capture their value.
[1] It turns out it was likely a reference to a 1980s metal club at 444 Battery Street in San Francisco.
[2] There are many reasons why today’s offtake contracts are not as safe as they appear and in fact open assets up to totally unbounded market price risk at exactly the wrong points in time – end of life and during market dislocations, especially extreme weather.
[3] The Usual Suspects.