April 2021

A couple of months ago, we published my conversation with Tony Seba, the Stanford lecturer and energy expert in which we discussed “the Internet of Energy.” The piece elicited positive feedback, along with some lively discussions I’ve had with a few investors. Here, I wanted to go a bit deeper on some of the core concepts and research laid out within our conversation. I also wanted to describe some a few of the key players involved in this disruption—and how our team is thinking about the investment opportunities in front of us.

Specifically, I want to talk about virtual power plants, and how we think a software revolution across the energy industry is catalyzing a transformation to a more decentralized grid. Given the enormous total addressable market for localized energy, there has been a rush of interest in this category. But, from my perspective at least, investors should be a bit wary of many of these new entrants, many with unproven models, that have quickly attracted significant capital—not to mention lofty valuations and media attention in the category. Still, the opportunity to find the select winners of this disruption, in our view at least, is huge—and that’s an understatement. The International Energy Agency estimates that $7.2 trillion will be invested in the global electricity sector in the decade to 2025—and the impact in terms of decarbonizing the grid could be transformative.

First, to draw a line in the sand.

Right now, many investors are focused on business models built around the hardware or the “hard assets” of the renewables disruption — i.e. photovoltaic solar panels, wind turbines, electric vehicles, lithium-ion and flow battery technologies, and so on. This piece is not about those technologies. Rather, this article is an exploration of what comes after the hard assets of the renewables disruption are deployed at scale: The connective tissue between them.

To us, this connective tissue—the software layer that unites a distributed system—is the underexplored, and yet potentially more critical (and lucrative) business model that will lead to a more resilient, efficient, decentralized, deflationary—and thus ultimately cheaper global power system.

Much like Amazon Web Services (AWS) united the open architecture of the Internet through cloud computing, making it easier (and cheaper) for businesses to power their IT infrastructure, virtual power plants—VPPs—have the ability to provide a new network to enable individual operators to transact with the global power system.

As Tony said in my conversation with him, “Most of us are passive consumers of energy. We consume it, at the end of the month we pay for it. That is going to dramatically change to a world where most of us, or many of us, are going to generate, store, use, and basically sell or give away energy. And that changes everything. If I can sell energy to my neighbor, or if Walmart can sell or give away energy, that literally changes everything. On top of that, you have the idea that energy is going to be cheap and distributed and on the network… that has a lot of implications for new products, just like the Internet created new business model innovations.”

To use a simple example, let’s consider the second-order effects of the eventual transition to a world in which battery electric vehicles are the norm—widespread and individually-owned at scale. When the vehicle is not in use and fully charged, it essentially becomes a large battery that could be generating power for a third-party—whether for your home to lower your utility bill, selling excess power to a neighbor, or even selling excess battery capacity back into the grid. The implications of such a new paradigm are profound.

The electric grid, as it works today, is in constant imbalance, and this imbalance is what creates a marketplace. Just like the stock market, energy prices are in flux given demand and supply. In the current iteration of the grid—let’s call it Energy 1.0—prices are passed along to the consumer from utilities.

This is typically a one-way transaction. In summer months, more often than not, electric bills skyrocket as demand exceeds supply. (And in unregulated regions like Texas, extreme weather events can create cataclysmic imbalances. See: “His Lights Stayed on During Texas’ Storm. Now He Owes $16,752.”) Extreme weather events also have the unfortunate effect of paralyzing the grid, especially when these system rely on fossil-fuel-based legacy systems. In Texas, 82% of the state’s electricity comes from natural gas and coal.

Over the last decade, however, the costs of solar and wind technologies have dropped precipitously, and the efficiencies of energy storage through batteries have increased dramatically. These efficiencies will also help alleviate many of the recurring problems in places like California where, despite a shift to wind and solar, storage technologies have not deployed at large enough scale to prevent occasional rolling blackouts. More utility-scale and localized batteries (through EVs, home battery backup systems, and so on)—combined with software to optimize the flow—could help alleviate many of these problems.

This is where VPPs enter the system.

What are VPPs?

At its simplest level, think of a virtual power plant as a network of energy resources—from rooftop solar panels to wind farms to home batteries to even the electric cars parked in driveways.

On their own, rooftop solar and home batteries can lower individual energy costs. However, these resources can also be connected and aggregated via software in the cloud to supply and optimize the energy infrastructure of a given system—be it a house, a manufacturing plant, or even an entire city. That’s a virtual power plant—and the opportunities here are significant. According to a recent Wood Mackenzie report, the cumulative distributed energy resource capacity in the United States will reach 387 gigawatts by 2025, significantly more than the existing amount of coal/nuclear capacity in the today in the United States.

Like AWS, a virtual power plant is an inherently deflationary system. The software that powers VPPs, like AWS as well, can be enormously lucrative. And that’s where it gets interesting.

Not surprisingly, there is a battle for control of this new paradigm—from both public and private companies, including Enbala (acquired by Generac | NYSE: GNRC), Fluence/AMS, SunRun (NASDAQ: RUN), Hanwha Geli, STEM Energy (NYSE: STPK, soon to be STEM), Kraftweke (acquired by Shell | NYSE: RDS.A) and of course Autobidder by Tesla (NASDAQ: TSLA).

The excitement across the industry is growing. The competition is not, however, limited to a handful of companies.

As Matthew Bandyk of Utility Dive recently put it, the utilities themselves are eager to get a piece of this action. He writes:

The existence of that much power leads to an inevitable question: who controls it?

Utilities see distributed energy as both a threat to their business models and an opportunity to harness this relatively new and massive source of energy to make money.

The rise of distributed energy has led to a conflict between a utility-centered business model and a service model based around third parties. “The fundamental question is who can manage and schedule distributed energy resources (DERs) and how?” said Omar Saadeh, business strategy manager at Accenture. “It’s a question being asked in a number of states.

Here, we’re at a critical juncture—an explosion of new companies and existing incumbents who are looking to own the software layer to not only optimize the grid—but act as the marketplace on which buyers and sellers can transact in excess energy.

If history serves as any guide, the winner of this disruption stands to reap enormous benefits.

From oil barons to VPP magnates

Thinking about today’s inflection point around renewables, some historical context (and some basic economic theory) is helpful to see why this disruption is happening—and where we thinking it might be going.

Going back to the mid-1800s, the industrial revolution was largely driven by the introduction of coal and steam engines; the 1900s saw the explosion of oil into industries and capital markets. Each energy resource brought massive efficiencies to multiple sectors of the economy, not to mention wealth to those who led these new innovations.

This is the era of the global energy market is what I like to call Energy 1.0: The “extraction era.”

Despite innovative improvements to extract and refine oil and coal, the downstream requirements to process—and distribute it—was always limited its margin potential.

In other words, despite innovations to make fossil fuels more efficient, their efficiency is always limited by the fact that it is both a finite and physical material that requires combustion. On top of these cost variables, there are always additional resources required to extract oil/coal, refine it, distribute it, and ultimately integrate it into a form suitable use.

At a high level, the principal reason oil barons became so famously (infamously?) wealthy was not necessarily a function of lack of regulation (though that was part of it) but rather a function of the needs to vertically integrate and consolidate interests across the supply chain to make these enterprises economically viable. Big Oil existed for many years not only because of pricing monopolies and regulatory deficiencies: it existed because of the necessity of scale to make these highly capital-intensive industries profitable.

Again, what’s important to understand here is that in this “extraction era” of energy, the need for a centralization of energy assets is required in order to make the unit economics work. This explains why, over the last 200 years, very few individual homeowners or small businesses dug coal mines in their backyards, nor did they purchase oil rigs to drill for oil behind their storefronts (though perhaps some may have tried at the height of some boom cycles!)

The reasons for this are obvious—there are high barriers to entry. Not only are there cost issues for the individual operator, but there are geographic issues, labor issues, maintenance issues, and so on. In other words, the centralization of assets in the extraction era of oil was a feature—not a bug—of the system. If you tried to decentralize the system, the system itself would break down.

That is what is changing.

The technologies to harvest renewable sources, from wind, to solar, to hydro, have seen dramatic efficiency improvements and cost declines, such that the levelized costs of energy favor a tipping point towards renewables by almost any measure. Now that we have massive battery deployments, from long-duration batteries to EVs, we are entering the next phase of the energy ecosystem—Energy 2.0. We don’t know what this future necessarily looks like, but we have a strong belief that it’s more decentralized, more efficient, and enables more business model innovations for new entrants into the market. Those companies that can effectively deploy virtual power plants—at scale—will be the clear winners of this transition.

“The allure of virtual power plants is clear,” a team of energy scientists advised recently in the publication Utility Dive. “As intermittent wind and solar power surges onto the grid and displaces conventional generators, grid operators will increasingly struggle to balance supply and demand in real-time. Hybrid renewable plants equipped with storage will help, as could new transmission links.”

Many investors in recent years have been focused on the renewable revolution in terms of lowering costs of hardware, such as solar panels or electric vehicles or big batteries. These hard assets of the renewables disruption are incredibly important, but what comes next is even more fascinating and potentially even more lucrative: the software systems to unite the power grid.


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