Segue’s Views on Energy Storage and its Place in the Energy Landscape – by Dan Vickery
At Segue, we’re often asked whether we invest in merchant storage assets. It’s the second most common question I get behind “what’s your cost of capital?”. If you must live in a black and white world, then sure, let’s go with “yes.” There… done… Segue’s official stance, they do merchant… no need to read on.
Caring about what others care about
Here’s how we look at it. Segue is an early-stage, risk tolerant, investment fund. Our mandate is to lean into development-stage energy projects and to take a view on their prospects for success. We assess down and upside scenarios and take positions on probabilistic outcomes. We are crafting a diversified portfolio of assets that have different risks, and this approach allows us to invest in projects (even those with significant risks of failure) when a project’s fundamental value to the system is strong. But to be perfectly clear: Segue does not own power plants – we finance development assets. And that matters here because, in theory, it means that things like the realization of eventual merchant revenues is an external risk to us. But this risk reaches us by extension and therefore requires prudent underwriting on our part.
So, our real answer is that we will fund the development of assets which are likely to have significant/total merchant exposure if we see a reasonable pathway to a long-term owner buying the project at a profitable valuation, or in the least, successful plan-B offramps. Or, put another way, we underwrite our investments based on defensible operating revenues that we believe the buyer market will underwrite and value.
With that lens, the things we care about are slightly different than a typical financier. We poke holes in the dev asset and in our own views, forecasts, and assumptions too. We care about our own revenue forecasts (or, perhaps when a rapid erosion of, say, ancillary services might occur)… but we care more about the eventual owner’s forecasts for the same. We care about where on the grid operators will want to own assets, how owners will dispatch them, and about the ability for debt providers to lean into and finance those assets. And if we’re deliberating those pieces internally and we have a knot in our collective stomach, we make sure to consider the viability of other offramps – like if the market for tolls will become more liquid. If this sounds familiar, it should: because we invest from the mindset of a developer.
All of this is to say that we do not focus on where a market is today (good or bad), but where the market will be in a few years. We work in mature markets and in markets where buyers don’t yet exist, so long as fundamental value drivers exist. To do what we do well, you have to invest into what you think is around the corner, and there’s no subsector where that’s truer than storage.
So, knowing that, how does Segue view storage fundamentals?
I would expect I’m not alone in my ‘vintage’ of storage peers in labeling myself a “jaded but eternal optimist.” We’re jaded because we know that software does head-scratching stuff, hardware goes offline on that day you’re about to get 30% of your annual revenue, regulatory changes leave you at the altar with a fully paid custom-designed box full of batteries, and revenue forecasts… well those can just disappear. But we’re optimistic because many of these issues are in the rearview and storage is rightfully on a trajectory to fundamentally change the energy landscape… and soon. New challenges will always emerge, but the pains endured have brought us to a place where storage is financeable, reliable, scalable, and a necessary piece to our country’s energy infrastructure. There’s no turning back – and so long as we’re eyes wide open, we can create meaningful value by developing storage assets… merchant or otherwise.
To speak specifically to revenue forecasts, I’ve long subscribed to the Energy GPS school of thought here. Energy GPS takes the simple view that increasing storage penetrations first erode ancillary revenues, then real-time energy revenues, and finally day-ahead energy revenues. They don’t go as far as forecasting a specific curve or when revenues might drop off a cliff (trust me, I tried…), but the thought process is rational and is playing out in California today. Maybe your view that ancillary service pricing in ERCOT will go up 6x next year turns out to be right. We might be skeptics today but are open to evolving our views – we like working with developers that have a well-informed and pragmatic view of fundamental value drivers, can defend those positions (even if contrarian), and approach development with the eye on multiple potential prizes.
And as for financing markets? Debt and sponsor equity to finance merchant storage assets appears to be very favorably swinging in the direction of asset owners (and by extension project developers). Only ~5 years ago folks were questioning if California CCA’s were sufficiently creditworthy to finance PPAs, and early movers there clearly won out. We’re in a similar place now with merchant storage (touché Broad Reach). Lenders and investors are leaning in, but that’s not to say we should proceed blindly assuming the spigot readily flows. For one reason or another, the financing pendulum will swing back at some point, even if only slightly. Shocks happen (heard of Winter Storm Uri?) and may create painful blips, but they drive the market toward a more economically sustainable solution. In the process, some folks will get it wrong and lose some money, development assets may get stranded, etc. What exactly happens and when? It’s anybody’s guess. But we believe that methodically planning for success through multiple avenues is the best way to protect a development asset’s value.
So, you think revenues will erode and financing markets will suck… but you still want to invest in merchant storage?
Well, just to clarify, I didn’t say any of those things, and certainly didn’t mean them as sweeping statements.
At Segue, we are big believers in fundamental value, and we believe storage has enormous fundamental value to our electricity system. It’s an if-you-build-it-they-will-come situation, we think. We like storage in Texas, the Northeast, and the West all for different reasons – but fundamentally, if we’re going to reach the levels of renewable penetration we need to reach (and for which there is buyer demand), we’re going to need a lot of storage. How and exactly where the massive buildout happens isn’t perfectly clear to me today. Maybe we work on a Texas project and sell to an IPP at NTP who puts sponsor-friendly debt on the facility and captures $30/kW-month for 15 straight years for retire-in-two-years level equity returns. Maybe it’s somewhere between that and an owner contracting a $6 retail energy swap for solar PPA-like returns. Or maybe reliability needs manifest themselves quickly, like in California, and markets for capacity swing quickly to favor long-term owners.
Regardless, where there is fundamental value in an energy storage system being an intrinsic part of a region’s energy infrastructure, Segue will be leaning into that – and probably heavily. We are designed specifically to partner through transient uncertainty, so long as we both do so prudently and cautiously. So, call us if you need capital, we do merchant.
* If others are.
