Energy: Fundamentals Still Strong, But Caution Rules Day –

Investors in the energy technology sector are entering 2003 with a realistic view of the near-term opportunities and a positive outlook for the fundamentals in the sector. Most importantly, private equity flows into this niche have right-sized, returning back to just above 1999 levels (about $500 million invested in 2002). This creates an environment where the best deals can still find investors, but at valuations that reflect the realities of today’s markets and can provide attractive returns to investors. The fundamental drivers that originally created new business opportunities in the energy sector are still present and will begin to reward those industry participants that adopt advanced technologies and new services.

Next Generation

The most fundamental driver is the need for new technologies and services to make the energy sector more efficient, more reliable, improve the overall quality of customer service and do so without degrading the environment. Although the restructuring process that has been a key driver for new energy technologies has slowed in the United States, it will continue to move forward and as a global phenomenon is not likely to stop.

The Federal Energy Regulatory Commission (FERC) has presented a plan to move U.S. restructuring along and is extremely vocal in its support for truly competitive markets. By learning from the California mistakes, a market structure is likely to be put in place over the next several years that will reward the cost-efficient providers and provide end customers with tools to manage energy more effectively.

As a result, advanced energy technologies will continue to see a receptive audience within the dedicated venture community. The pace of activity in 2003 will likely be similar to 2002 (best guess being another $500 million invested), and the majority of the capital will come from dedicated energy venture funds. Other funds are beginning to evaluate opportunities in the energy sector and participate in syndicates, but they will still represent a minority of the dollars deployed in 2003. What follows is our outlook for some key areas in the energy sector.

* Distributed Generation (DG). The near-term markets and technologies are still developmental but the long-term demand for competitive DG products is still very promising. In North America, low wholesale prices for power make DG a tougher sell for the next few years unless power reliability is a significant component of the value proposition. Markets outside of North America are becoming more attractive for Combined Heat & Power (CHP) applications, so technologies delivering CHP are likely winners.

When wholesale prices in North America become more attractive, with a better balance in supply/demand, we are likely to see a more rapid deployment of DG from major energy service providers to deal with transmission constraints, better customer service and as a competitive hedge for key accounts.

* Power Reliability. This is the fastest-growing area of the energy sector. Separate and distinct from distributed generation, the demand for power reliability products arises from the very high costs that can come from interruption of digital commerce and industrial processes. The criticality of the need for reliable and decentralized energy infrastructure was one of the many lessons learned from 9/11, and the growth in the power reliability segment has accelerated as a result. Specific products include specialized fuel cells, batteries, power electronics and software to control and monitor them.

Independence Declaration

* Renewables. Global demand for renewable sources of energy is very high today, and continued geopolitical uncertainty creates more demand for energy independence through a greater emphasis on renewable technologies. Existing markets for wind and photovoltaic (solar power) products are large and growing in excess of 20% per year. Technologies that can improve the cost competitiveness of renewables or open new applications are the likely winners.

* Utility IT. Utilities are still saddled with legacy systems that are woefully inadequate for a competitive marketplace. Deregulation is the main driver to upgrade the information technology backbone for most utilities, but ultimately inflexible systems and high maintenance costs will drive the change. Advanced billing/customer care, smart metering and asset management are the areas of greatest need.

Expense Management

* Customer Energy Management. Whether it is large commercial/industrial customers or a residential customer, there is increasing awareness that energy costs need to be managed, and tools have been developed to actively manage this expense. Advanced data collection and software tools as well as price responsive systems (thermostats, lighting systems, HVAC) are beginning to penetrate the markets. Demand response to price signals in a competitive market is one of the key platforms of proposed FERC rules.

* Business Services. Like all other industries that experience restructuring and enhanced competition, outsourcing of non-key elements of the value chain are common. For some incumbents it will be power generation, for others it will be call center activities, but the vertically integrated solution will continue to split into pieces and create opportunities for focused enterprises to lower the overall cost of service.

In terms of exits, the energy sector is not likely to see significant opportunities in 2003, so venture investments in the sector must be made accordingly. Even when demand increases for IPOs overall, the energy sector is likely to lag behind the general tech sector by one or two quarters. For active energy technology investors, this is a sector that will provide returns in two to five, and given the size of the industry, the potential rewards are very large.

Maurice Gunderson is co-founder and a managing director of Nth Power Technologies, a 10-year-old energy-focused firm that manages $200 million. Previously Gunderson launched five companies. He sits on the boards of Pentadyne, NeoPhotonics, Metallic Power, STM Power, H2Gen Innovations, Clean Air Partners and CellTech Power.

Tim Woodward joined Nth Power in 1998, following eight years with Liberty Environmental Partners, where he co-managed the firm’s VC practice. He was lead partner on seven deals.