Germany's energy sector caught between transformation and hope

By Martin Hoyer and Adrian Pielken

Few sectors of the economy are under as much pressure to transform as the German energy industry. The goal of becoming climate neutral by 2045 as formulated by Germany's previous government also necessitates the transformation of the country's energy supplies to provide climate-neutral power. This decision is already visibly leading to a large-scale restructuring of numerous energy suppliers, which some are implementing by spinning off business units to give them greater strategic flexibility and enable more value creation.

However, since the start of the war in Ukraine, the industry finds itself facing a paradox: The expansion of renewable energies needs to continue, even in this difficult situation, if we are to overcome our dependency on fossil fuels and coal and gas imports. Yet the situation changed abruptly overnight with the full-scale energy crisis brought on by the war, and conventional power generation suddenly became more important again. The high energy prices make electricity generated from coal and the like temporarily very profitable and means that we are seeing some energy utilities raking in record profits. The bottom line is, things remain tricky and highly challenging – whichever way you look at it, companies are struggling with the incredible volatility in electricity prices and some unprecedented liquidity risks. Stemming from the growing amount of companies' capital locked up in working capital and the fact that liquidity is tied up in forward transactions on the energy trading market, the unparalleled liquidity risks may in fact turn into an existential threat for power utilities, depending on the market price, the amount of volume they are trading and the type of transactions they are engaging in.

Liquidity is squeezed despite record profits

This is not going to change in the foreseeable future if the global crises persist, and it will continue to put a great deal of pressure on energy companies' liquidity situations. Despite high profit levels, the rampant rise of electricity prices has already resulted in a liquidity squeeze for some energy suppliers, which they have only been able to overcome with government support. Municipal utilities in particular are feeling the pressure, as they are especially dependent on stable earnings to help finance things like the transformation of municipal infrastructure toward more green offerings.

Is the crisis hurting renewables?

Renewable energy producers are in a much better situation, as they produce their electricity without fuel costs and are therefore not dependent on input price fluctuations. And the imminent interest rate rises will not change that. But the faster expansion of alternative means of power generation that the government has called for could stall if the acute material shortages and global supply chain problems that we are currently experiencing continue. That said, one thing is clear: Renewable energy is the future. There is no longer a question mark over the transformation to renewables – only how soon it can be achieved.

Power grid operations: Inflation puts the brakes on rising returns

Electricity and gas grid operators could now be reaching a turning point because the higher interest rates – raised for the first time in a decade – also mean that the returns guaranteed by the regulator are higher, as these are tied to the interest rate. But the relief for operators will not kick in until the expiration of the regulatory periods for gas (2023) and electricity (2024). Until then, pressure on margins will persist owing to rising inflation and higher wages, which may well slow the momentum of the energy transition. After all, the success of the transformation depends to a great extent on the modernization and continued development of the energy grids – one of the essential next steps being the integration of the millions of electric cars in the country.

To summarize the outlook for the sector as a whole, the pressure to transform business models is rising and companies' ability to forecast their future operating performance is falling. This could make (re)financing increasingly challenging – or even impossible without a plausible path to decarbonization. That is not the least of the reasons why energy suppliers need to be even more stringent in managing their business risks and not just focus on profitability targets but pay more attention to the liquidity and financing side. With banks and investors now demanding higher ESG (environmental, social and governance) standards, extensive risk management is in any case unavoidable.

The energy mix becomes more relevant

Many energy suppliers have already started to pass through the increased energy costs to their customers. This strategic move is no easy decision to make, as it can lead to widespread churn of longstanding customers. Suppliers with an unfavorable energy mix – a high proportion of fossil fuels coupled with a low proportion of renewable power generation – are the ones likely to come under the most pressure. However, rising electricity and gas prices not only affect customers' willingness to switch supplier but also impact the utilities' business models, given that it means that households and companies that generate their own electricity are lost as customers and thus also as revenue generators.

The crux of the matter: Energy security and climate goals

The biggest uncertainty remains the disruption caused by the war in Ukraine and a potential worsening of the already fragile geopolitical situation. As long-term gas supply contracts come to an end, some suppliers may go under. Policymakers must put a suitable framework in place to support companies and maintain energy security across the board. At the same time, Germany cannot lose sight of its climate goals and must continue to make it possible for the ambitious targets to be met.

Conclusion

The energy sector faces some major challenges. At present, it is unclear whether the Ukraine war will totally take the wind out of the sails of Germany's climate policy or even speed up the green transition on balance. But one thing is certain: Now more than ever, private and public sector stakeholders must prepare for further possible crises, anticipate risks as early as possible, and work shoulder to shoulder to drive the complex transformation of the energy sector. That is the only way to successfully master the challenges and give Germany a chance of having a sustainable energy industry.

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