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As a result of comments on my recent article concerning Exxon Mobil’s (XOM) prospects, I’ve been struck by the world that some traditional fossil fuel investors think we live in. These investors see a world of base load power where fossil fuels provide certainty and safety, and deviation from this mode of energy supply through renewables is a disaster (sun doesn’t always shine, wind doesn’t always blow etc). NRG Energy’s (NYSE:NRG) Q1 2022 Earnings transcript described a very different world. Here I summarize how a major US integrated power company is going about its business today. Fossil fuel investors might pay attention because many things they don’t acknowledge are becoming central to how NRG does business. While NRG is just beginning to transform its business from fossil fuels to renewable energy, the way the business is being transformed is illustrative. It has evolved a capital-light strategy and strong customer focus in its energy supply. Its new business orientation has implications for investors wanting to participate in the new energy economy.
NRG Energy
NRG Energy uses the tagline “North America’s Leading Energy & Home Services Company”. It is an integrated US electric utility company headquartered in Houston, Texas. It has 6 million residential, commercial, industrial and wholesale customers. NRG produces, sells and delivers electricity and services. Currently electricity is generated primarily from fossil fuels (natural gas 46%, coal 44%, oil), nuclear 6% and solar 1%; it also has battery storage capabilities. Its power generation capacity is 18 GW spread over 25 plants and it manages 23 GW of power generation assets. The company has a turbulent past with an early foray into renewable energy that ended in an asset selloff to recapitalize the company. This led to reversion to a fossil fuel-centric business, but once again the company is reassessing its business. The company now has a goal of 50% reduced emissions by 2025 and net zero by 2050. This is a big goal and there is a long way to go. However, its new business developments are taking it into a new world of customer-focused energy provision.
Electricity grids are complex
It is good to simplify things to get a good understanding, but when that simplification loses touch with reality this is not helpful to investors. The old view of electricity supply was of a small number of large coal, natural gas or nuclear facilities being a core of a grid that provided base load power to consumers (industry and households). And whatever demands consumers threw at them, the power suppliers just turned up the baseload power. Of course, it was never so simple, but this view is etched in the minds of many fossil fuel investors still.
The need for backup supply
Electricity is dynamic. It involves moving electrons (power) and the electrons are “antsy”; they refuse to stand still. Hence a grid works by balancing power supply with demand. In the old days this was all done by the power supplier. Large centralized power plants can be a challenge because if a major supplier breaks down, suddenly there is a huge loss of supply. And so in the old world, big backup capacity needed to be available. Renewables involve distributed power, so the power sources are smaller and breakdown of any windmill or solar PV system is not of great consequence. Renewables are intermittent, but predictably so. Grid operators have always had to balance supply and demand but renewables make the process different, with more emphasis on elements (such as demand management) that were less focused on in the “baseload” era which was heavily biased towards supply.
Of course, the above is a simplified view, but it is more useful than a view that “fossil fuels work and renewables don’t” because such a view does not describe modern grids.
Traditionalists argue that renewables are so unreliable that for every MW of renewable power installed, a matching MW of fossil fuel power capacity must be added. This is not true because a powerful feature of renewable energy is that it is predictable (through weather forecasting) so grid operators know how much power is coming, with increasing accuracy as the time to deliver approaches.
The fact is that grids that have high levels of renewable energy contribution have decreased need for fossil fuel capacity. The grid of South Australia, which receives more than 60% of its power from renewables has consistently decreased the amount of backup gas capacity. Already in 2021 South Australia met 100% of its operational power demand from renewables on 180 days (49% of the time). By 2025/6 forecasts indicate 85% of South Australia’s power could be sourced from renewables. The plan is for 100% renewable energy by 2030; that means essentially the end of natural gas, with coal already long gone.
US readers might consider Texas, which is on a similar trajectory to South Australia. In April of this year in Texas, wind and solar PV contributed 14,172 GWh of power, while natural gas and coal contributed 20,551 GWh. Based on new solar PV and wind additions, renewables could reach parity with natural gas and coal contribution within 2.7 years, and fossil fuel use could be fully replaced in 8.7 years (less if accelerated closures happen, which seems likely; data supplied by Jay14150).
Demand management
A grid has two contrasting levers for managing power. You can either manipulate supply or you can manipulate demand. Of course, the best approach is to manage both. The base-load fossil fuel (and nuclear) view is of supply always being available to meet demand, even though doing this means building a system to have huge excess of power capacity available for a few hours each year. Clearly by having a capacity to manage demand, the requirement for supply is less. In the end this means cheaper prices for consumers.
Adding lots of renewables isn’t breaking the system
Texas is interesting because there is a big growth in renewables, which stand at ~40% of electricity production, notwithstanding the challenges of Storm Uri. The latest from ERCOT (26 million customers) is that power use is at an all-time record and it could go higher as Summer peaks. Peak demand in early July was 77.46 GW; it is expected that the system can handle a Summer peak demand of 91.39 GW, so there is still some capacity to spare. Of course, if power companies get permission to manage customer power consumption (e.g. turning down air conditioning) there would be an additional cushion, but I’m not certain how that works in Texas.
Takeaway messages from NRG’s Q1 2022 transcript
CEO Mauricio Gutierrez made several interesting points about NRG’s business in the Q1 2022 commentary. He highlighted 3 key messages: i) strong performance of the business and 2022 guidance is maintained; ii) the company is well balanced to maintain stability in volatile market conditions and iii) strategic growth priorities are being advanced, bringing the business closer to customers. 2.5 GW of renewable capacity PPAs have been signed with ERCOT, the Electric Reliability Council of Texas, which manages Texas electricity provision to 26 million customers. Renewable PPAs are expected to grow, although in the short term, due to supply constraints and regulatory uncertainty, this may slow down. NRG is well positioned to manage short and long term structural changes in the energy system and they have a team specifically focused on these issues. NRG is very customer focused with clear strategies to retain customers while managing margins in a volatile market. NRG has a 5-year strategy for serving customers in the areas of energy and home services.
A significant focus is energy resilience, which NRG has identified as a key area of customer interest in a time of increased challenges with climate change (extreme weather events) and an aging power grid, which together can mean power outages. NRG has Gold Zero, its scalable home energy resilience and storage company. Gold Zero is growing at 50% CAGR with a 40% gross margin. While currently the contribution to overall revenue and gross margin is small, the CAGR is expected to grow at 50% through 2025 which will make Gold Zero a significant contributor to the business going forward. Mauricio Gutierrez thinks that external factors might help grow the Gold Zero business even faster. He gave as an example the announcement last December that California would ban gas generator sales by 2028 as the kind of development that could drive Gold Zero business faster. Key factors in the new customer experience focus on storage technology and a better customer digital experience. This is a fast moving area that fundamentally changes how customers experience (and engage with) their power use. NRG foreshadows new products in this area which will integrate with and enhance NRG’s core energy offerings.
While NRG has a vision for the future, it needs to address issues that confront it, such as coal supply and cost structures, even as the company plans to exit (and is exiting) these assets.
What is clear is that NRG has addressed key issues that renewables deniers focus on. Specifically, NRG pays a lot of attention to having tools to manage volatility for certain hours (short term) and months (longer term). The interesting point concerning Texas is that the reserve margin on the supply side is the highest margin since the market went competitive (high 20% and moving to low 30%). This provides safety even when renewable contribution is low. Of course, more dispatchable power is a focus. And Mauricio Gutierrez makes clear that NRG has both supply side and demand side solutions. NRG understands how the power grid works and how to manage supply side risks, but they make a big point that they are engaging with customers to manage demand. This means savings for customers who engage with managing the timing and level of their demand. Bill savings are a big issue for customers.
Investor interest in NRG
Given the intense interest in the power sector and fear of power outages, it is surprising that NRG Energy attracts little interest from investors. In the past 30 days just 3 authors have written about NRG, with 1 strong buy, 1 buy and 1 hold ranking. Eleven Wall Street analysts in the past 90 days are fairly evenly divided with 2 strong buy, 2 buy, 5 hold and 2 sell recommendations. In 2018 and 2019 the stock price surged but since then it has been stuck (except for a big drop at the start of the COVID pandemic), leaving overall 5-year performance up 59.7%. The stock price is down 8.6% year-on-year. Given its commitment to dramatic emissions reduction, but with a very large fossil fuel footprint, it is perhaps not surprising that investors are waiting to see how this pans out.
Conclusion
In the above commentary I’ve sketched out some broad parameters surrounding how modern power companies are approaching their role as integrated power suppliers. The marginal cost of renewable power is close to zero, because once the capital cost of building and installing solar PV capture or windmills, the ongoing costs are very small in comparison with a fossil fuel asset which is expensive to mine, transport, refine and deliver. Adding to that, being more sophisticated in managing energy supply and demand leads to cost savings. Companies like NRG Energy “get” this and reading the Q1 2022 earnings report makes clear that this approach is being progressively applied to the business. Companies like NRG are a critical part of the exit from fossil fuels. How they manage the exit from their own fossil fuel assets is a tricky part of the decision by investors as to the value of investment now in these companies of the future. The upside is that investment in the new generation renewables businesses are likely to provide a smoother ride than a fossil fuel investment produces. Perhaps investors might stay on the sidelines currently because NRG has a lot of work to do to decarbonize, but with switched on management NRG is surely the kind of company that any energy investor needs to be paying attention to in a time of great change.
I am not a financial advisor but I follow closely the dramatic changes that power companies are experiencing as the world begins to decarbonize and renewable energy becomes the core source of power. I hope that my commentary helps give you perspective as you consider your fossil fuel investments and how you will approach managing the energy transition from an investment perspective.
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