Why distributed generation is becoming the next transition play

The distributed energy space has, historically, not been one particularly populated by infrastructure funds and institutional investors. The reasons for this are multi-faceted, but principal among them are the perceptions of the subsector as too small to move the financial or climate needle, with investors choosing to deploy capital in larger, utility-scale projects and platforms.

In the US, that’s been changing over the past 12-18 months, where funds have been agreeing a string of deals in the space, the most recent occurring in May when Basalt Infrastructure Partners acquired AEP’s distributed generation portfolio company AEP OnSite Partners for more than $315 million.

A mid-market play, then? Not as such, with investments also explored by Stonepeak, Global Infrastructure Partners and EQT. Consultant Wood Mackenzie last year released research predicting the distributed energy market in the US to nearly double in capacity from 2022 to 2027, with capital expenditure reaching $68 billion per year. Significantly, the prediction envisaged 262GW of distributed generation to be installed from 2023 to 2027, with 272GW of utility-scale installations also expected in the same period.

Part of this growth has been due to the widening definition of the market, now commonly described as distributed energy, rather than distributed generation. Once thought of as small rooftop solar installations, the market has widened because of the inclusion of storage, microgrids and electric vehicles into the equation. When it comes to solar, investors are generally viewing installations up to 20MW as part of the sector.

“Going from 25GW to north of 100GW provides ample opportunity for someone like EQT’s infrastructure funds to deploy significant capital into this space almost as much as we would like”

Alex Darden
EQT

“Historically, people have thought about this as 500kW or 1MW rooftop solar,” says Alex Darden, New York-based partner at EQT, which made its entry into the sector with the agreement in December 2022 to acquire commercial and industrial solar platform Madison Energy from Stonepeak.

“That’s not what we think the industry should be or what we should be doing as investors. We think we should be developing these companies to have stable cashflow profiles, but also to be solution providers to their customers.”

Skipping the queue

One of the central reasons for managers looking sideways to the distributed generation space is a somewhat weariness with the US’s notorious interconnection queue for power projects, a situation that is getting increasingly worse.

According to research from the Lawrence Berkeley National Lab, grid interconnection queues in the US have increased from three years in 2015 to nearly five years in 2023. Congestion costs – typically passed on to consumers – rose by 53 percent to $20.8 billion in 2022, according to consultant Grid Strategies.

“The capability to develop large-scale projects is becoming harder, longer and more expensive,” says Darden. “So, if you take the increasing demand, supply side challenges, increasing cost on the utility side and you roll them up together, it creates a very strong environment for a distributed energy solution, just from an economics standpoint. From a stability of energy supply and from a cost standpoint, it creates a very interesting product for a commercial and industrial customer.”

The energy supply point could become critical if the interconnection woes continue, with 900GW of power added to the queue in 2023 alone. There’s no guarantee of success, though, with the Lawrence Berkeley research showing more than 70 percent of interconnection requests between 2000 and 2018 eventually withdrawn.

“For someone like Madison, you can go from identifying a project with a customer to executing a project in a span of 12 to 18 months,” explains Darden. “With someone like a utility-scale provider, there’s much more creativity, arc duration and skill over a five-year period that’s required.”

Igneo Infrastructure Partners is also one that’s tapped into this phenomenon, acquiring a majority interest in New Jersey-based Soltage in September, which develops and owns distributed utility-scale solar and storage assets for utility, commercial, industrial and municipal customers across the US.

John DiMarco, managing director at Igneo, also identified the interconnection queue as a motivation to look sideways, as well as difficulties in executing projects once that challenge is solved.

“The actual development of long-haul transmission to bolster the grid and support the renewable resources that are sitting on the interconnection queue has been a very big challenge for the industry. I think to effect the energy transition we really need to build out the utility-scale side, but we really need to maximise the resources at the lower voltage side as well.”

Not all distributed energy projects are created equal, though, and energy-focused manager Arclight Capital Partners has found joy in both skipping the interconnection queue for behind-the-meter projects, while also deploying in front of the meter too, since it paid Duke Energy $364 million for its commercial distributed energy platform comprising REC Solar and Bloom Energy last year.

“With the right platform, we think that there is an advantage and frankly, repeatable pathway to developing and delivering these projects in comparison to the utility-scale market where we’ve experienced delays from permitting standpoints and from grid interconnectivity standpoints,” says Jake Erhard, partner at Arclight.

“I think, in general, that’s a big reason why the distributed market exists and why capital is forming around this market. The distributed market is not just a behind-the-meter proposition. We look at certain front-of-the-meter types of deployments like community solar and some small utility-scale as fitting within what we see, broadly speaking, as within the mandate of REC Solar.”

Pricing power

Investing in utility-scale renewables over the past 18 months or so has, at times, come with a little more uncertainty than some infrastructure investors typically enjoy, with power purchase agreements being renegotiated to reflect both interest rate rises and volatility in power prices.

“When you’re operating in the timescale of a distributed generation project, there is an element of greater wherewithal to deliver a more cost-certain proposition, which further serves to take some volatility out of the returns proposition that might otherwise exist more broadly in the renewable space,” says Erhard.

As Erhard demonstrates, those investing in distributed generation can view their projects on a more favourable footing than in the utility-scale sector, driven by the dynamic of projects more often than not tied to retail power prices, rather than the more unpredictable wholesale power price.

“Retail power prices are partly driven by the cost of fuel but mostly driven by the utilities’ capex – what they’re spending on the grid – and even what they’re paying on opex,” says Ben Baker, managing director at Greenbacker Capital, which has invested in distributed generation platform Sunrock.

“Rates grow stably over time and over the last few years, utility rates have grown significantly because of inflation and rising interest rates. That is one of the reasons we really like to find asset classes that attach to retail rates because over time, retail rates tend not to go down, but now utility prices are increasing.”

This depends on the type of asset being invested in, as DiMarco explains some of the intricacies. “Retail power is typically, depending on the area, maybe two times the cost of wholesale power. Community solar and commercial and industrial solar will price at a discount to that, but they’ll still be above the price of power at the wholesale trading level.”

This dynamic leads to a particularly bullish Erhard at Arclight, who believes that distributed generation investments can, on an unlevered basis, earn a return “several hundred basis points” above that of utility-scale power.

“With the right platform, it’s an interesting relative return proposition in comparison to investing in the utility-scale renewables market,” he says.

“That’s a function of the fact that at the project level, at the asset level, the unit economics tend to be pretty attractive. The returns on projects are higher in the distributed generation space.”

Scaling beyond rooftops

The challenge for some investors in this subsector is scaling projects into platforms. With maximum capacity typically not exceeding 20MW, firms such as EQT, which is in the process of raising a €20 billion fund, will have requirements to build substantially sized platforms relative to other assets held by the fund.

“I think to effect the energy transition we really need to build out the utility-scale side, but we really need to maximise the resources at the lower voltage side as well”

John DiMarco
Igneo Infrastructure Partners

Darden says: “We generally look at the places we can invest, where we can make a real difference with our capital and build companies and really be more than capital to the businesses. Distributed energy is in the early stages of development as an industry and in its infancy in terms of how it’s going to develop models to deploy that on a broad scale. We like being on the front end of that trend and investing with that trend. Going from 25GW to north of 100GW provides ample opportunity for someone like EQT’s infrastructure funds to deploy significant capital into this space almost as much as we would like.”

However, despite Arclight also raising a multi-billion-dollar fund, Erhard is less concerned about scaling to a particular size and more about being well-placed to capitalise on the market dynamics that will drive the scale.

“We don’t see scale as something that we necessarily have to achieve at all costs,” Erhard says. “For us, return on invested capital is what matters the most. This is a growing market, and what is attractive about these kinds of platforms is that they are positioned to capture that growth.”

Regardless, in a more nascent space and one with some different dynamics to the more traditional utility-scale side, Igneo’s DiMarco suggests making small projects more unified structures to achieve some form of scale. “What you want to do is make it as easy as possible for a lender to look at 10 5MW projects as it would be for them to look at one 50MW project. Having a common EPC arrangement across the region of projects is helpful both in achieving scale and achieving cost efficiencies.”

For more lower mid-market players such as Greenbacker, the strategy is around creating a larger platform, potentially made up of several smaller developers, to be able to attract larger infrastructure funds or strategics.

“A lot of it is having the right local relationships to actually be successful in winning sites and commercialising projects,” Baker says. “Then there’s scaling through acquisition, in addition to being organic. We do have certain portfolio companies that are roll-up platforms that can go and buy even smaller regional businesses or smaller assets across the US.”

Driving factors going forward will include policy measures at the state and federal level, whereby from the former there are now 19 states with dedicated programmes to help propel the growth, while certain projects will be available for credits from the Inflation Reduction Act and potential aid from the Bipartisan Infrastructure Law. Further tailwinds can come from the growing need for energy from data centres.

“It’s a micro-grid solution that data centres typically want,” argues Erhard. “There’s enormous power demand and reliability requirements that these data centres have. There’s a distributed solution to support that. It’s a big growth market.”

The rise of electric vehicles will also grow distributed generation to a new level, says Baker, where a plugged-in vehicle will both receive and provide power. “To think about how distributed generation is actually going from not just small solar farms – which is what it was five or 10 years ago – to this, is a huge leap forward that requires significant technology innovation and significant software innovation to be able to connect all these tiny distributed resources to act as one.”

The roof used to be the limit. Now the sky might be.