Embracing Uncertainty: Why Focusing Solely On The Numbers Never Adds Up

A Pangea SI Expert

Paradoxes

Under dynamic energy markets, the following paradoxes can be observed:

1. The more managers aim to achieve predictable cash returns, the higher the chances of investments under-performing or incurring losses;
2. The more generous the state subsidises, the less likely it is that investments are going to be sustained; and
3. The more hyperactive governments are in championing specific energy technologies, the more those technologies are likely to fail.

It is vital to examine how each of these paradoxes emerged.

The Pursuit of Predictable Returns

When the market favours them with better prices or costs, managers are quick to claim foresight.

Equally, when investments under-perform or result in financial losses, managers look for culprits to blame: “The data was wrong”; “The market moved against us unexpectedly”; “The prices and costs were too volatile”; “The government changed its policies”…

Few, however, would admit to the flaws in their methods.

One example of a failed method is the propensity for over reliance on a solitary data point. A single number – net present value (NPV) – often defines whether an investment is funded or rejected. The faith managers place on this judgment may be misplaced, as outcomes seldom conform to plan. In attempting to simplify a situation into one consolidated number, many are limiting their chances of succeeding before they even start.

To achieve predictable cash flows, managers commit to rigid long-term prices and volumes, based on dubious foresight. When contracted prices or volumes deviate from market, sellers suffer or gain, depending on whether prices are higher or lower than contracted. The opposite is true for buyers. This asymmetric outcome would push the one side to vigorously impose the contract, while the other would creatively find ways to avoid a bad deal.

The result? Continual renegotiations to repetitively realign the contracting parties’ economics.

Subsidies

Subsidies started with a lofty ideal of compensating renewables’ higher private costs (e.g.- more expensive capex) for the social benefits they deliver (e.g.- lower pollution).

However, subsidies tend to over- or under-compensate. If they are overly generous, consumer numbers coax regulators to cut back, leading numbers to drop dramatically before the method has truly taken hold in the market. If they fall short, investors shy away in the first place, and solutions with long-term benefits never get into the mainstream.

The paradox? A subsidy, which is designed to secure revenues through fixed incentive payments, becomes the very source of uncertainties.

Government Policy

The first two paradoxes often cause renewables deployment to seriously lag behind targets. Policies are then introduced with the good intention of pushing to try and catch up. Politicians and managers are simultaneously admonished for not doing enough and encouraged to do more, faster, and bigger. Unfortunately, they tend to attempt to remedy slow adoption of specific renewable technologies by repeating approaches that failed to work previously. Furthermore, this has the opposite effect to the intention behind it. Having been bitten before, when policy’s vagaries caused bankruptcies among investors, policy’s good intentions are either ignored or resisted by industry.

Solutions To The Problem

The real remedies lie in recognising the dynamic energy market for what it is. It is volatile, it mutates, and it is influenced by policy and managerial actions. Hence, managers cannot make markets more predictable by financial modelling. Trying to control complex situations that, fundamentally, cannot be fully controlled is futile. Being adaptable and maximising potential within scenarios that emerge is the truly important skill.

As the world begins its transition towards low carbon systems, managers flourish when they adapt, or are able to influence markets by reconfiguring their resources and capabilities. Clearly, the question should no longer be as simple as “what is the NPV that would get our project funded?”. Instead, strategic thinking should evolve towards methods of effectively solving important problems with the right solutions.

– Speak to the senior investment leader who wrote this 

Expert Bio:
The Expert has held senior leadership roles at Royal Dutch Shell, in the Netherlands and London. Prior to that, as an investment banker, he was consistently a top-rated equity analyst and adviser for European utilities whilst at SBC Warburg and ABN AMRO/Rothschild.

The Expert is able to extract strategic insights by blending the aforementioned experiences at multinational companies with academic rigour, having obtained his PhD in Management from King’s College London. He is the author of a ground-breaking book on energy investments under dynamic markets, and his research focuses on energy and investment decisions in uncertain conditions.

The Expert delivers courses and briefings at leading business schools in Asia and Europe.

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Contact Mike Callis on 020 7551 0782 or by email mike.callis@pangea-si.com to connect with this Expert.