Financing the energy transition – The role of smart meters

In the first part of our new series, we explore the importance of smart meters in the drive to net-zero

Introduction to our Financing the Energy Transition series

Energy resilience is in the spotlight as the war in Ukraine has forced the UK to focus on security of supply while experiencing record-breaking gas prices and low storage capacity, all the while balancing these demands against our promised path to net-zero.

Transitioning the UK's energy usage away from globally sourced fossil fuels and towards domestically located renewables such as wind and solar will play a major role in improving the nation's energy stability and reducing its carbon emissions. However, obtaining energy from intermittent sources which are unavailable when the wind isn't blowing or the sun isn't shining comes with its own challenges. Primarily, how do you encourage consumers to reduce their energy consumption at times when limited renewable energy can be generated and how do you store intermittent energy so it is consistently available.

Herbert Smith Freehills (HSF) regularly advises clients from across the energy transition space who are grappling with and finding solutions to these issues. In particular, HSF's energy and infrastructure finance team has been working alongside both sponsors and lenders to develop financing strategies and advise on first-of-a-kind financings in this area.

This article is the first in a series that HSF will be publishing covering many aspects of energy transition from a finance perspective.

Smart Meters – What is their role in energy transition and why are they such a strong asset class?

HSF has advised both sponsors and lenders on many financings of smart meter businesses, including those owned by Arcus, GLIL, Energy Assets Group and Northern Powergrid. The financings have been for a combination of acquisitions, additional capital for growth and raising holdco debt.

Smart meter businesses have proven to be a strong asset class with a fast growth projection and have received a lot of interest from investors and lenders alike over the last few years. This is based on the stability of revenues, supportive legislation – such as the supplier of last resort regime under the Energy Act (SoLR) – and the government's initiative to roll-out smart meters nationally over a relatively short period of time.

What are smart meters and why are they a big deal?

Smart meters are the next generation of the traditional electricity and gas meter and enable real time consumption information to be delivered directly to consumers, suppliers and energy network operators. Before the introduction of smart meters, while we had knowledge of energy production, transmission and distribution, there was limited information on the final consumption of that energy.

Smart meters measure the amount of gas and electricity that a property (domestic or small business) is using. This information is delivered directly to the consumer via a secure in-home display and to suppliers, network operators and authorised third parties via the Data Communications Company (DCC), a company which is part of Capital plc and is regulated by Ofgem. Suppliers use this information for settlement, switching and meter configuration, while network operators aggregate the data to improve network management and energy distribution.

The introduction of the newer SMETS2 smart meter allows for instantaneous transfer of data and settlement across much of the energy industry.

Market-wide half hourly settlement

Ofgem's aim is to move the electricity industry to market-wide half-hourly settlement (MHHS). MHHS will align the wholesale and business energy markets, where electricity is traded in half-hourly periods, with the non-half-hourly basis of consumer settlement (currently taken over weeks and months). By reconciling the two, Ofgem envisions suppliers offering variable tariffs to customers that respond to the cost of energy in the wholesale market; and we are already beginning to see movements in this direction from certain energy suppliers such as Octopus Energy. Half hourly energy prices will be communicated via smart meters and will incentivise consumers to shift their energy consumption to times when energy is cheaper due to, in the case of intermittent renewables, it being more readily available and discourage consumption at peak times or periods when the market price of energy is high.

MHHS is not aimed at shifting peak demand from one time to another but instead flattening the peaks and raising the troughs of energy demand, resulting in more responsive and flexible energy usage.

Smart devices

Consumers will be able to take advantage of dynamic tariffs which vary according to the MHHS by saving energy intensive tasks for times of low demand or high supply when the energy price is lower. However, these times are often unpredictable or occur at times when consumers are not able to undertake energy intensive tasks. The proposed solution is the concurrent roll-out of appliances with smart functionality. These devices will allow users to select a time or tariff that will switch on or off intensive energy appliances such as washing machines, electric heating or EV charging ports, with the tariffs being relayed to the smart appliances through the SMETS2 smart meter's MHHS.

The benefits of this have led the UK Department for Business, Energy and Industrial Strategy to propose the Energy Bill 2022-23. The Bill seeks to provide the government with powers to introduce regulations for smart appliances while also mandating that certain appliances must have smart functionality and prohibiting the sale of non-smart devices.

Benefits

For consumers, the move to a smart meter enabled MHHS should manifest itself in cost savings and more accurate billing in addition to the faster and easier switching of energy supplier.

For network operators, the benefits are equally positive. Matching demand to energy generation (rather than vice versa) allows operators to take full advantage of the intermittent nature of renewable energy, further integrating wind and solar generation into the UK energy mix, while also aiding the path towards net-zero.

Having a more even and consistent demand for energy also means that less infrastructure will be needed to meet the same overall volume of demand, leading to network operators being able to reduce expensive network reinforcements and protections.

Why are Smart Meter Companies such attractive investments?

With the far-reaching application of smart meters, it is no surprise that smart meter companies (SMCs) have become an attractive asset class for investors and lenders, however, the allure of SMCs has been further bolstered by the low-risk business model, the SoLR and the government's keenness for the nationwide roll-out of smart meters.

'All reasonable steps'

Most notably, energy suppliers are subject to a requirement to take "all reasonable steps" to have a smart meter installed in every home by the end of 2025, a cost Ofgem has allowed energy suppliers to pass on to the end consumer. This has created a solid growth path for successful SMCs.

Deemed rates and energy crisis

The ongoing energy crisis, which has led to the insolvency of many energy suppliers, has tested and proven the resilience of SMCs. Smart meter rental rates are generally agreed under a meter rental agreement between the SMC and the consumer's energy supplier. However, where a smart meter churns to a new energy supplier (due to the consumer changing supplier, either voluntarily or under the SoLR regime) higher deemed rates apply until the new energy supplier enters into a meter rental agreement with the SMC. This has enabled SMCs to continue to grow despite the demise of many of their energy supplier counterparties.

National Security and Investment Act 2021

As SMCs do not hold the data collected from the smart meters (instead it is channelled via the DCC) they fall outside the ambit of the National Security and Investment Act 2021 (NSIA). This enables investors to acquire SMCs without needing to follow the notification procedure under the NSIA. This also avoids any complications from a lender's perspective in relation to the enforcement of security.

Financing smart meter companies

As smart meters are such a strong asset class, we have seen sponsors lean towards pure-play smart meter financings in order to achieve better pricing from lenders. As with any business, lenders will be looking for the key contracts to include certain provisions and minimum protection levels. For a smart meter business, lenders will be keen to ensure that any asset purchase agreements are with reputable smart meter suppliers, include certain warranties and have a minimum term. Lenders will look for smart meter rental agreements to include termination payments in the event that an energy supplier removes a functional smart meter from a property.

Looking forwards

Due to the strength of smart meters as an asset class, investors may, when debt pricing conditions are appropriate, look to raise additional holdco debt – such holdco debt being structurally subordinated to the senior debt but supported by the reliability of revenues from smart meters. Investors may also look to build up complementary businesses to sit alongside their smart meter activities such as businesses relating to networking, air source heat pumps or EV charging.