Demand-side Energy IT: Green is Good

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Paul Sagawa / Artur Pylak

203.901.1633 / 203.901.1634

sagawa@ / pylak@sector-sovereign.com

April 13, 2011

Demand-side Energy IT: Green is Good

  • Recent world events have raised the importance of IT in energy policy. Even as rebellion in the middle east is reaffirming the precariousness of dependence on oil beyond ecological concerns, the Fukushima reactor crisis has reinvigorated opposition to nuclear power. At the same time, ballooning global food prices raise questions over the efficacy of bio-fuel programs, while despite years of investment in solar and wind power, these green technologies remain very expensive and ill-suited to the demands of a primary role in electricity generation. In our view, these conditions may drive a change in global energy policy away from subsidizing generation and toward conservation. In this, technology is likely to play a leading role, with particular opportunity in “smart grid” implementations and in LED lighting
  • The US faces massive capital outlays to address growing electricity demand. Demand for electricity in the US on a track for a 1.3% CAGR through 2020 while supply is projected to grow at only 0.1%/yr., suggesting that reserve margins against summer peak demand will be inadequate by 2018. On this trajectory, more than 100 B kWh of new generation is necessary to maintain current margins. However, construction of new capacity is expensive – coal-fired plants cost $2-3K/kW and nuclear costs more than $4K/kW, with ecological concerns and regulatory challenges adding years, if they can be overcome at all
  • Wind and Solar can only help so much. Clean-tech energy solutions such as wind and solar cost as much as $5K/kW to construct. Moreover, these technologies are naturally unpredictable – not much power if it is calm or cloudy – so their ability to replace traditional generation as more than a supplemental source is limited to off loading the relatively clean gas-fired peak-load capacity. This is important, as the most controversial generating technologies, coal and nuclear, are positioned as “base load”, and must be able to provide steady, cheap and predictable power 24/7
  • Demand side solutions will gain momentum. Without easy answers on the supply side, we expect policy to refocus attention on conservations. Here, we see two major opportunities for investors: Smart Grid and LED lighting. “Smart Grid” technology is a data overlay on the electricity distribution system that helps utilities and their customers to avoid wasting power and to balance power usage to avoid costly peaks. LED lighting uses semiconductor-based diodes to replace traditional incandescent bulbs, with potential energy savings of as much as 90%, along with other operational advantages. In theory, these initiatives could yield more than 30% savings in peak electricity usage, obviating need for trillions of dollars of investment in generation
  • What is a “smart grid”? Like water in pipes, electricity flows to the path of least resistance, and if demand exceeds expectations, large portions of the system may find themselves no longer able to draw power. To avoid system blackouts, utilities must manage generation actively. Smart grid technologies enhance the active monitoring and control of electricity distribution to consumers in real time, reducing system wide inefficiencies and helping users manage their consumption. In doing so, less total power would be needed and the demand could be smoothed to avoid wasteful peaks. These technologies may be implemented by utilities – e.g. monitoring/control devices, fault locator systems, advanced sensors, smart meters, and software/systems to manage the distribution grid – or by consumers – e.g. smart appliances, power storage devices, and advanced switches
  • Smart Grid market is big, fragmented and growing. Market estimates size the smart grid market at $3-6B, growing 10-15%/yr through 2015. These estimates include utility-specific technologies, but not the necessary data communications overlay or smart consumer appliances, which could place the potential considerably higher. Smart grid projects were targeted in 2009 with $3.4B in US Federal stimulus grants out of $16.6B in total to clean-energy. Of this, $2B is earmarked for the installation of 18M new smart meters by 2015, which would bring the total base to 28% or 40M of the 143M US electric consumers
  • LED lighting can significantly cut electricity demand. Lighting is currently 30% of total US electricity demand, and 14% of household demand. LED lighting is 15 times more efficient than incandescent and 4 times more than fluorescent. Moreover, unlike incandescent bulbs, which covert more than 90% of electricity used to heat, LEDs do not burden AC systems (more than 15% of total US power usage) and present no fire hazard ($250M/yr losses from lighting caused fires). LED “bulbs” still cost as much as 50 times incandescent, but can last 20 years, amongst other operating advantages. However, LED costs are coming down quickly, with key innovations in manufacturing expected to offer step function improvements. Gartner projects LED lighting to be a $12B global market by 2015 – we expect that to more than double by 2020, with significant growth thereafter
  • Smart grid and LEDs are significant opportunities for tech players. Both smart grid and LED lighting are likely to gain further momentum in light of the geopolitical debates on carbon emissions, mid-east oil dependence and nuclear safety. As policy and economics drive utilities to push smart grid deployment, Cisco, Google, IBM, Oracle, Qualcomm and Texas Instrument have all made significant investment to stake claims to the emerging market. Smart meters, a key component of smart grid solutions, are led by Itron, Landis+Gyr, Aclara, Sensus and Silver Spring. As for LEDs, we can neither confirm or refute Cree’s claims of proprietary advantage in their design for lighting applications, but note that China has announced grand plans for capacity expansion. Given this we are more comfortable with LED capital equipment suppliers, like Veeco and Aixtron

It’s a Mad, Mad, Mad, Mad, World

Of late, the big debates about electric power have inevitably been debates around the supply of energy. Coal-fired power plants – generating 44.6% of US electricity – spew carbon at twice the rate of natural gas-fired plants, which is still far higher than most ecologists find comfortable. Nuclear plants – 23.3% of our nations electric supply – generate radioactive waste with a half-life measured in hundreds of years in the best of times, and present a grave present danger to life during the worst of them. Hydro-electric power is clean, but necessitates damming up waterways and destroying ecosystems. Wind and solar power are clean, but after years of government subsidies remain very expensive and their output is dependent on the whims of nature, a severe drawback given the precise management needed to keep power supply balanced to demand. Biomass – generating electricity from burning plant-based materials – is renewable, but also polluting and is under scrutiny as food costs rise to record highs. Geothermal is abundant and sustainable, but only viable with current technology near tectonic plates and areas such as geysers where earth’s natural heat is accessible (Exhibit 1 and 2).

The events of 2011 – i.e. revolution in the Middle East and the Fukushima nuclear crisis – have added further spice to a debate already passionate with fears of carbon emissions driven climate change and volatile commodity energy prices. This passion brings the blunt instrument of Government squarely into the debate. Regulations around emissions have become much more stringent, long-standing policies favoring nuclear power are being reassessed in many nations, even while generous subsidies for alternative green power – wind, solar, bio-fuels – are under the pressures of austerity budgets.

Talkin’ ‘Bout My Generation

Meanwhile, demand for electricity continues to grow in the US, and even more so, abroad. The North American Electric Reliability Corporation (NERC) estimates that the current trajectory of supply and demand puts the US on track to fall below the recommended thresholds for capacity vs. peak summer power demand by 2018, risking wide spread brown-outs and black-outs without at least 100 B kW of additional generation (Exhibit 3). This will be very expensive, if the power plants can even pass regulatory and public challenges. Natural gas fired plants are the least expensive to build at $1,200/kW, but are 3-4x more expensive to operate. Coal plants cost $2,000-3,000/kW. Nuclear plants cost as much as $4,000/kW, not including legal expenses. Wind and solar both run up to $5,000/kW for construction, assuming the availability of an appropriate location with ample wind or sun (Exhibit 4). All together, the investment to fill the generation gap would be trillions of dollars. This reality inevitably turns the debate back to energy demand. While savings from reducing peak demand would depend on the elasticity of demand, it is estimated that a 1MW reduction in peak demand saves about $350,000, which translates to about $3.7B for every 1% reduction in peak demand.

A Delicate Balance

Electricity generation, transmission, and delivery is an operationally complex task currently orchestrated on an aging and manual infrastructure. Like all forces in physics, such as gravity governing the flow of water down a hill, electricity follows a path of least resistance as it travels from the power station through high voltage power lines to a local substation and into the premise of a customer, all of which collectively is known as the “grid.” Electricity usually flows from plant to premise in under one second after it is generated. Supply must meet demand at any given instant as any overload/underload can damage the system, which has been prone to failure with frequent localized outages occurring in summer months when demand for power is greatest. Since the early 1980s, growth in peak demand for electricity, which has been driven by population growth as well as demand for more appliances and electronic devices – has exceeded transmission growth by almost 25% every year. Environmental concerns, the rapid evolution of technology, calls for energy efficiency, regulatory pressures, rising costs, etc have further increased pressure to fix the system (Exhibit 5).

The infamous August 2003 Northeast US and Canada blackout illustrates the challenges currently facing the nation’s electricity infrastructure. The blackout was initially caused by human error in resetting a failed, but manually controlled, power flow monitoring tool that set off a sequence of events that resulted in some $6B in damages. The automation of certain systems would have prevented the cascading effect of the blackout that affected about 55M utility customers over the course of two days in several states and provinces. The blackout heightened concerns over the grid and resulted in over $2B in upgrades from the blackout through 2009 and political outcries for modernization. Enter “smart grid.”

The Second Coming of the Internet

Smart grid is fundamentally the deployment and overlay of communications and control technologies to enhance the responsiveness of the grid. It involves a myriad of devices and solutions deployed across various stages of the energy value chain from generation to end use. It is envisioned to help utilities better balance loads, trouble shoot problem areas proactively, incorporate alternative energy solutions, and smooth peak usage. For consumers, the smart grid promises greater efficiency, more information, and the possibility of added conveniences with smarter devices. Overall, smart grid can be thought of much like the internet: a decentralized yet constantly evolving network governed by a set of technological standards.

Estimates of the power savings that can be accomplished range from 7-22% of peak electric load, potentially offsetting trillions of dollars of investment in generating capacity. Other estimates suggest that total U.S. electricity consumption could be reduced by 56 to 203 billion Kilowatt Hours by 2030, saving up to $36B annually. According to EPRI, “the grid of the future will require $165 B over the next 20 years” and can generate benefits to society of $630 to $800B. The smart grid technology market is currently estimated to between $3-6B with a CAGR of between 10 and 15% through 2015 (Exhibit 6). Given the potential benefits, the global political climate, consumer awareness of energy and ecology issues, and the progress on smart grid innovation, we believe that these estimates are extremely conservative.

It’s the law…

The Energy Independence and Security Act of 2007 effectively defined deployment of smart grid as an energy policy goal. A stated aim of the policy is to incorporate renewable and distributed systems with the goal of a 20% reduction in peak load demand by 2015. The resulting government support and funding for smart grid has been strong with $3.4B in stimulus grants committed in October 2009 under the American Reinvestment and Recovery Act out of a total of $16.6B dedicated to energy efficiency and alternative sources (Exhibit 7).

Smart grid policy making currently falls under the Department of Energy, which is leading The Federal Smart Grid Task Force. The importance of smart grid is well illustrated by the impressive number of agencies and commissions involved in the task force: the Federal Energy Regulatory Commission, Department of Commerce, Environmental Protection Agency, Department of Homeland Security,  Department of Agriculture, Department of Defense, Federal Communications Commission, and Department of State. These agencies collectively represent one-third of the President’s appointed cabinet officers. The sheer complexity of smart grid and precedents set with the Internet have made interoperability an obvious concern. The government is also leading this effort with the Smart Grid Interoperability Panel (SGIP) under the National Institute of Standards and Technology (NIST). Data exchange standards for smart grid were set in February 2011, creating certainty and paving the way for investment in the grid.

Smart grid is also a policy issue in Europe as the European Commission (EC) issued a directive in 2009 requiring that 80% of homes be fitted with smart meters where deemed cost effective by 2020. Currently, about 10% of homes in Europe are fitted with the devices. The EC earmarked €2B in funds with the goal of enabling 50% of Europe’s grids to become smart grids. It estimates that deploying smart grids in Europe can save €52B annually.

Green is in

Public awareness and support for energy efficiency is strong with numerous trade groups and grass roots organizations actively promoting a “greener” way of life for consumers. The Department of Energy’s Energy Star program, which debuted in the 1990s in an attempt to reduce electricity consumption, has set guidelines for energy consumption for all consumer devices. Devices such as appliances, televisions, computers, etc. are awarded an energy star label, effectively an official product endorsement, if they meet certain energy standards and guidelines. Energy star criteria are updated every few years for specific product classes. For example, the next iteration of standards for televisions is a more stringent set of criteria known as version 5.1 and will take effect in 2012. The program is estimated to have saved over $16B annually in energy costs. Other countries have also adopted the program and recognize the energy star label, most notably the European Union, Australia, Canada, and Japan.

Beyond current energy star standards is the promise of “smart appliances,” every day appliances and devices that can be connected to a network and managed remotely or in concert with demands of the grid. A number of manufacturers including GE, LG, and Whirlpool have released their first generation of network connected devices. The possibilities and current realities include: coordinating wash cycles for off-peak times, food spoilage alerts, remote appliance diagnostics, pre-heating an oven from a smartphone app, etc.

Everything is becoming smarter

The most visible aspect of smart grid has so far been the deployment of the “smart meter” by utilities. These devices enable two way communications between a customer premise and the utility enabling real time metering.  Along with a change in pricing mechanism to “time of day” prices, the promise of these devices is to curb peak usage. Utilities have been largely supportive of this pricing scheme since peak usage adds expense as utilities must add incremental and more expensive generation capacity to the grid in order to meet demand. The federal government has allocated $2B in stimulus funding to support the deployment of 18M smart meters by 2015. Most US utilities have committed to deploying the devices with about 8M deployed so far in the US before the subsidies (Exhibit 8). Forecast estimates predict 40M+ smart meters will be deployed by 2015. We believe these estimates may be understated as this would only cover approximately 28% of the 143M premises electricity is delivered to in the US. We believe smart meter adoption will accelerate near the pace of internet adoption which reached 50% in a similar timeframe of 5 years.

Smart meters are served by an ecosystem of companies that manufacture physical meters, communications components, and system software all of this collectively known as “Advanced Metering Infrastructure.” A number of companies offer smart meter hardware to both utilities and consumers (Exhibit 9). Publicly traded smart meter makers include Itron, Echelon, and ESCO technologies as well as conglomerate GE. Other meter makers include: Landis+Gyr, Sensus, Elster, and Trilliant. Cleantech Group estimates that about $800M of venture capital was invested in meters between 2007 and 2010. Communications equipment that supports smart meters has been developed by Alcatel, Cisco, Digi International, Motorola, Nokia, Siemens, Sierra Wireless, and Texas Instruments. In the US, a technology known as RF Mesh is largely favored by utilities and is supported by smart meter makers. Cellular communications are more popular with European utilities. High-speed power line communications (PLC) are being explored, but not likely to be deployed in the current generation of smart meters. This leaves telecommunications incumbents: AT&T, Verizon, T-mobile, and Sprint as near term beneficiaries providing communication services to utilities using mostly existing infrastructure.

In terms of system software, major enterprise players like Oracle, Microsoft, HP, and IBM are positioned to offer utilities solutions for running the smart grid. Apple, Cisco, Google, and Intel all have home energy management software solutions either available or in development. Apple patented software in 2010, while Google already makes its PowerMeter available to select smart meter enabled customers in Europe and the US. Cisco offers a home energy management touchscreen unit while Intel developed a similar product as a proof of concept.

Turn Out The Lights, the Party’s Over

Together, lighting and cooling make up the majority of energy usage across both residential and commercial sectors. Traditional lighting technologies are grossly inefficient with incandescent bulbs releasing 90% of energy input as heat rather than light. This in turn puts a burden on air conditioners to cool more thereby consuming a greater amount of electricity. Traditional incandescent lighting is also prone to fire and has required additional construction costs to accommodate heat emissions safely. Over 7K fires are caused annually by lighting causing over $250M in damages. Governments are aware of the drawbacks of incandescent lighting and have begun to mandate a phase out of incandescent bulbs – under the current law, America’s last chance to buy 100W incandescent bulbs will be in 2012. California is set to ban all incandescent lighting by 2018 (Exhibit 10).

The current primary alternative to incandescent lighting is compact fluorescent (CFL), which other than being more efficient in terms of lumens per watt, has a number of drawbacks. Most notable is the quality of lighting that results in mostly cooler color, warm-up time required, and low responsiveness. CFLs do not dim and lives of bulbs are shortened the more they are switched on and off. CFLs also contain some toxins in the form of mercury vapor. Though the content of mercury has been brought down from 5mg to 1mg in some eco-friendly bulbs, even small amounts are a concern as they contribute to pollution if disposed of improperly. Some utilities are currently subsidizing CFL bulbs at retailers like WalMart and Costco, where a 4-pack of basic CFL bulbs can be purchased for $0.99 with the promise of $39 in annual energy savings that are likely to appeal to the average consumer. Despite attractive pricing, the CFL market has somewhat stalled with CFL shipments declining from ~400M to ~300M between 2007 and 2009. Clearly, customer response and adoption to CFLs has not been as expected.

Light Emitting Diode (LED) technology has the potential to address the energy efficiency and safety problems of incandescent while delivering much higher quality than CFL. Given about 30% of all energy across residential and industrial markets is consumed by lighting, LEDs can drastically improve efficiency, as they require only 7% of the energy consumed by incandescent and 25% of that consumed by CFL. LEDs are also much safer – they emit far less heat, thereby preventing fires and do not contain dangerous toxins. Beyond this, the quality of LED is superior to exisiting lighting technologies. LED offers dimmable, instant on and off light, extreme durability vs. fragile incandescent or fluorescent bulbs, useful lives that can exceed 10 years, a significantly more compact form factor, and illumination that is directed rather than emitted in all directions. With expected improvements, LEDs should also be able to deliver light with the same color mix as natural light sources, electronically adjustable to the specific needs of a situation.

The only drawback currently observed is price. Currently, a socket ready LED bulb equivalent in lumens to a 100W incandescent bulb costs nearly $50. In comparison, an unsubsidized CFL with the same light rating costs roughly $15 and an incandescent bulb, just $1. Nonetheless, the durability, lifetime, and energy savings have made LEDs already cost effective for most outdoor and industrial applications. Moreover, LED’s are on a steep cost decline curve owing to the ramp in volumes and to ongoing improvements to material sciences. The amount of light generated by a single diode has been doubling every 30 months, an obvious driver of overall cost (Exhibit 11). Research to enable the use of inexpensive silicon substrates, vs. the expensive sapphire now required, is also promising, as is work to produce cost effective 3-diode RGB solutions. On average, the cost of LED lighting has improved 20% per year over the last two decades, a pace that should bring LED “bulbs” below the cost of CFL before the end of the decade.

Given this, we anticipate growing attention to LED lighting by consumers, utilities and governments, leading to a global movement to subsidize the retrofit of installed fixtures with LED lighting, likely to take root by 2020. Given the current $90B global market for incandescent lighting, such a shift could be an extraordinary opportunity.

Winners and Losers

Smart grid and LED lighting do not cannibalize existing businesses for most electronics companies, and as such, are largely an opportunity that can be exploited or missed (Exhibit 13). In this, Cisco, Google, IBM, Oracle, Qualcomm and Texas Instrument have all made significant investment to stake claims to the emerging market in smart grid technologies, and are likely positioned to exploit the expected growth in spending. The biggest winners in smart grid are likely the smart meter companies, of which, Itron, Echelon, and ESCO technologies are public.

LED lighting may well prove to be a highly competitive field, as the Chinese Government has been aggressive in subsidizing and promoting LED production by Chinese companies. Despite evidence of Chinese investment, Cree has remained confident in its technological advantage, based on a proprietary patent position. We are not able to judge the strength of Cree’s patent claims. The story is less nettlesome in the capital equipment necessary to make LEDs. Here public companies Veeco and Aixtron appear to have a market lead, with traditional semiconductor equipment houses like KLAC and AMAT playing catch up in what promises to be a strong and long-lived expansion in industry capacity.

The potential for smart grid and LED to reduce global electricity demand has the largest implications for the companies with a stake in generation, most of which – e.g GE, Siemens, Honeywell, etc. – fall outside of the purview of TMT. We note that the success of demand oriented policy could reduce the momentum behind government subsidies for alternative generating technologies like wind or solar. If so, companies like Vestas, First Solar, Suntech and others could a damping in the long term demand for their products.

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