Cool Vector Video-Podcast TRANSCRIPT: "'Strange' Power Market Driven by Data Center 'Inelastic Demand'"

Cool Vector Video-Podcast: Charting the rise of data centers and the digital infrastructure asset class.

Episode Title: 'Strange' Power Market Driven by Data Center 'Inelastic Demand'

Episode Duration: 26:06

Originally Posted: February 2, 2025

Listen to the Full Episode here.

Speakers: Jim Hughes, ⁠EnCap Investment⁠; MODERATOR: David Snow, Cool Vector

Episode Overview: In his 35 years in the power business, ⁠EnCap Investment⁠'s James Hughes has never seen a market as "strange" as the current one, driven by data center inelastic demand as well as industrial projects across the US.

Hughes is a Managing Partner and head of the EnCap's energy transition business, which last May raised a $1.5 billion fund to invest in power, low-carbon fuels and carbon management. In a wide-ranging interview with Cool Vector, Hughes says hyperscaler demand for data centers has created an attractive supply-demand dynamic for his strategy. "I've never seen a large class of customer, a large set of demand, that is price inelastic," he says.

Hughes predicts a five- to seven-year window during which he is confident "we will be able to take capital and earn a return that is a premium return on that capital."

Hughes shares his analysis of the the "Republican trifecta" in Washington and its likely impact on his strategy. While the removal of incentives for low-carbon fuels and carbon management companies may challenge those business models, Hughes says any changes to the Biden-administration Inflation Reduction Act will have little impact EnCap's opportunities in power generation.

"If I can execute a power project, there is somebody that's going to buy that power under a long term fixed price agreement," says Hughes. "The challenge is not identifying a customer for the power. The challenge is, okay, can I find a site and get control of that site? Can I gain access to the grid?"

Formed in 1988, EnCap is one of the largest energy-focused private equity firms in the world. Hughes says his team has the experience to recognize opportunities in a rapidly changing market. "What we bring to the table is gray hair, and having done this for a very long time and having lived through several cycles," he says.

Hughes shares is views on the prospects for renewable energy in digital infrastructure, noting the huge interest in using "clean, green" power, offset by an urgency to get projects built using whatever energy sources are available, led by oil and gas.

He gives his take on an oft-repeated question in today's digital infrastructure and energy market: Are we in a bubble? Hughes predicts efficiencies in the next generation of GPUs, but says he doesn't see any trend that will reverse excess power demand in the coming years.

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TRANSCRIPT

David Snow: Hello and welcome to Cool Vector. I'm David Snow, and today we're joined by Jim Hughes, a managing partner at EnCap Investments. Jim, thanks so much for being part of a Cool Vector program. Great to have you here.

Jim Hughes: Great to be here. Thank you for the invitation.

David Snow: Jim, you are in charge of a strategy at EnCap called Energy Transition. We're going to learn more about how you define that. But first, why don't we start with some relatively recent news about your platform. In May, EnCap closed a fund led by you. It's a $1.5 billion investment vehicle that is dedicated to the energy transition. While you were raising that fund and talking to institutional investors and others, what kinds of questions did they have for you? What did they want to know before they agreed to commit?

Jim Hughes: Well, you know, one, they want to know what we're going to do with the funds. Energy transition is a very broad and somewhat, these days, generic term. And so they wanted a little more in-depth detail as to where we really saw the opportunities and where we anticipated deploying the funds. They want to know what sort of returns we think we can target within that strategy. And then I think the other thing that was on everybody's mind, as well as our mind, is what were the likely results of the upcoming election, which had not occurred when we were raising the fund. And how do we think that would affect our targeted investments and the environment in which we were investing? Obviously, with some concern that—what would the impact on the energy transition be if you had what has in fact occurred, which is a Republican trifecta winning the House, the Senate, and the Presidency.

David Snow: When you say energy transition, what do you mean?

Jim Hughes: Energy transition was sort of the buzzword that everybody was using when we created this organization in 2019. It has been broadened to the point that I don't really think it tells you very much. So we really sort of go out of our way with investors to define what we believe is the energy transition. And that's really—we think there are three primary areas of focus. One is power. The largest addressable market within the energy transition, the largest contributor to CO2 emissions in the United States, is in fact the power sector. So that's obviously one large focus of the energy transition.

Second would be low-carbon fuels. There's basically two pathways to a low-carbon fuel. One is bio-derived—ethanol's been around a long time, renewable diesel—and then the new one that everybody wants to talk about is e-fuels, or basically hydrogen-derived fuels, where you electrolyze water and create hydrogen.

And then the third area is really what we broadly call carbon management. That could include carbon capture, carbon utilization, carbon sequestration, carbon offsets. Rather than avoiding the creation of carbon, it's the management of carbon either as it's naturally occurring or at the time of emission.

We don't include in our definition of energy transition recycling, circular economy, water usage—even though there may be legitimate investments that have an impact on climate, have an impact on CO2. For our purposes, we define the energy transition as really consisting of those three vertical arenas of investment.

David Snow: Without getting too deep into the realm of politics, to what extent will a Republican trifecta affect your firm's ability to make successful investments in the energy transition?

Jim Hughes: The opportunity in power today is driven by fundamentals. The biggest fundamental being that we are facing a multi-year, relatively medium-to-long-term period of time where we believe power demand will exceed power supply. There will be upward pressure on prices, there will be a scarcity factor with respect to power.

So what that tells you is, if the IRA benefits were to be taken away under a Republican administration, that's going to impact the end cost of power to the user. A significant portion of the demand that's occurring is price-inelastic demand. It's a very strange market circumstance. In my 35 years in the power business at this point, I've never seen a large class of customer, a large set of demand, that is price inelastic.

But the digital infrastructure demand that we have today—power is a tiny percent of the total cost. They have to have the power to pursue the growth in their industry, and they view that growth as existential. We need to know the outcome from a regulatory and incentive standpoint of the IRA. But we don't really particularly care whether it exists or it doesn't exist. We simply need to know what the outcome is, and there will be a significant opportunity irrespective of that outcome.

The same is not true of the other categories I identified. We already face significant challenges in terms of demand for low-carbon fuels simply because they're high-priced, even with incentives. Without incentives, I think it's a very challenging environment. And then on carbon management, I think the economics of that are entirely dependent upon the provisions of the IRA. I don't think you can underwrite investments in that arena until we know what the outcome of certainly this first session of Congress is.

David Snow: Jim, you mentioned inelastic demand. Are you referring to the hyperscaler customers? Is that the inelastic demand that you refer to?

Jim Hughes: It's broader than the hyperscalers. It's really all data center demand is not particularly sensitive to the power price. If I'm offering a PPA today in the mid-forties, and circumstances changed and the project simply wasn't economic unless I had a 60 PPA, I don't think any of the data center demand goes away—whether it's hyperscaler or otherwise. I don't think that delta, or even more than that, is going to change the level of demand that's out there.

Some of the other increased demand we have in the economy could be impacted by price—some of the reindustrialization, some of the electrification perhaps—but in particular, that digital infrastructure data center demand, I don't think prices dramatically change the level of demand.

David Snow: What percentage of your overall activity do you estimate will be focused on digital infrastructure and providing power to customers like data centers?

Jim Hughes: The last decade, we've had flat power demand. Any incremental power demand that was generated from growth in the economy was offset by increased efficiency. We've had the switch to LED lighting, the switch to LED display screens, other efficiencies in the market. And so we've been left with flat power demand for basically a decade.

All of a sudden, like a switch, we're into an environment where we have projections of demand growth ranging from two and a half to four percent over the next decade. It doesn't sound dramatic, but given the scale of the power infrastructure and the dollars that are associated with it, it's a dramatic paradigm shift in the environment for power.

Of that growth in demand, I think the estimates are anywhere from 25 percent to 40–45 percent of that increased demand is attributable to digital infrastructure/data centers. The other major components are growth in energy production and all of the downstream processing and export of energy. And then, in addition, the reindustrialization that is occurring across semiconductors, solar panels, battery production, and other industrial activities that are being reshored back into the U.S. domestic economy.

David Snow: With that demand profile in mind, can you characterize the deal flow that your team has seen since you kicked off investments with the $1.5 billion fund back in May?

Jim Hughes: If I were to go back 10 years, magically transport us back 10 years, the renewable power business—identifying a buildable, viable project, gaining an interconnect to the grid, gaining control of land, buying equipment, finding a contractor that can build it—none of those things were a constraint on your ability to execute a project. Your primary constraint was, who am I going to sell this power to?

So you spent all of your time focused on how am I going to earn a PPA. You focused on bidding into the California utilities, bidding into other state utilities, talking to the industrials that wanted to buy power.

Fast forward to today. If I can execute a power project, there is somebody that's going to buy that power under a long-term fixed-price agreement. The challenge is not identifying a customer for the power. The challenge is, can I find a site, get control of that site? Can I gain access to the grid via whatever the interconnection process in that particular transmission system is? Can I buy the equipment I need on a timely basis, particularly transformers and switchgear? Can I find a contractor that has capacity and available labor to build that facility?

So it's changed from "can I find someone to buy it" to "can I put together all of the elements necessary to execute a project?" It’s an execution story as opposed to a sort of offtake and customer viability story. It could not be more dramatically different today versus where we all sat 10 years ago.

David Snow: You mentioned transformers. Can you dig into that a little bit more? Why is that a constraint, and is there something particular to the supply chain of that critical piece of equipment that you can tell us about?

Jim Hughes: So transformers is a very unsexy, non-technology-driven business. The transformers we buy today are basically the same devices that we've been buying for the last 50 years. There's a fairly set global production capacity of those devices, and this sudden uptick in demand and sudden increase in the development of incremental power—both traditional and renewable—has just overstressed the supply chain. Just more demand than there is capacity.

We're seeing some relaxation. Twelve to eighteen months ago, I would have said it's a five- to six-year wait for transformers. Today, it's probably more three to four, maybe in a severe case five. But still, that's a very long lead time for a very nontechnical, non-sexy, unusual piece of the infrastructure.

Switchgear is a similar circumstance, and I think the supply chain was caught by surprise in terms of this sudden burst of demand, and it takes a little while for it to react. I also think some of the manufacturers are probably scratching their heads going, do I really want to increase production capacity?

David Snow: How long is this going to last? Am I going to be able to amortize my increased investment in production capacity? Over what period of time is this going to last? Or am I better off earning better margins on my existing production capacity? What advantages does your team have in securing all the resources necessary, securing the contracts? How has your experience and the experience of your team given EnCap an advantage in that regard?

Jim Hughes: I think it's simply the fact that we have the experience. So what we bring to the table is gray hair and having done this for a very long time and having lived through several cycles in the past. We laugh sometimes that if you want to buy a gas turbine today, it's a get-in-line circumstance, and we can look back to prior cycles and remember points in time where you could make money simply by placing orders for gas turbines and then waiting and selling those orders down the road.

This is an industry that is prone to these capacity cycles. So we've seen it, we've lived through it. We're spending a lot of time trying to look around the corner and think about what's coming. We've spent a lot of time thinking about the results of the election and gaming out this result. How should we think about the opportunity set? What steps do we need to be taking today?

We've made equipment orders very early in the life of our projects so that we know we have access to that scarce and critical equipment. But at the end of the day, we have very experienced teams that operate at our portfolio companies, and it's that experience and that savvy that allows us to really operate effectively in this sort of environment of scarcity.

David Snow: I'd love to learn a bit more about your background and maybe use that as an example to help us understand what's going on in the current market.

You were CEO of publicly traded First Solar from 2012 to 2016. Since 2016, the share price of First Solar has essentially quadrupled. Give us your analysis for why that is and what that tells us about the state of the renewable energy market.

Jim Hughes: So First Solar is a different technology from the more common polysilicon technology that the Chinese panels and other panels have. They're the largest and the dominant thin-film solar panel producer. There were two events that really happened during my tenure that set the company up for a long period of continued success.

One, we acquired some technology from GE. GE was the other major company pursuing cad-tel thin-film solar panels. The combination of our existing technology and what we acquired from GE really was kind of a two-plus-two-equals-five type of circumstance.

At that time, in 2012, 13, 14, we were making a smaller panel, a two-foot by four-foot panel, whereas the Chinese had gone to a much larger form factor. And we determined that that form factor difference had a huge cost impact. Basically, the balance of system that you had to invest in with the smaller panel size was very significant.

So the decision was made that we were going to invest in modifying our manufacturing process to make a much larger panel similar in size to the standard polysilicon panels, and there was a huge cost benefit of that decision. It really brought the product into competitiveness with the polysilicon panels, and that set the stage, combined with the reshoring industrial policy of the U.S., for First Solar to do a dramatic expansion of their production capability in North America, which has led to growth in sales, growth in profitability, and the share price performance that you've seen.

Mark Widmar, the CEO, has done a fantastic job with the company since he took over after my departure in 2016, and I think they're positioned for continued success.

David Snow: These days, when a data center project is being launched, to what extent is the power provided to that project able to be fully renewable? Are these things starting life with zero carbon impact? Or is it more phased in typically?

Jim Hughes: If you were to ask someone about data center development 10 years ago and said, what's a great site, how do you prioritize the siting of a data center, the answer you would have gotten had nothing to do with power. That would have been ambient temperature, availability of water for cooling, and most importantly, the existence of fiber capacity for the transmission of data into and out of, and throughout the network of data centers.

Today, the first question that is a threshold question that has to be answered before anyone even thinks about any of the rest of those questions is, where's the power going to come from? There are parts of the country where there is huge existing data center capacity where you can't add any more. The Northeast, Washington-Virginia corridor is probably the best example. There is simply no power capacity that would allow adding additional data centers in that area.

The first question the data center developer is going to ask today is where is my power going to come from? The second question is, what kind of power is it? Is it clean, green power, or is it older power? I think we've seen a shift. It is very important to the data center owners, developers, and customers that ultimately the power be low carbon, but I think there is a willingness to live through a transition period that allows them to get the center operational, even if it has to be thermal power as opposed to renewable power on some transitional or interim basis.

I certainly think we see a willingness today where there may not have been a willingness, let's call it five years ago.

David Snow: Can you assign a percentage to what most of these hyperscaler customers expect or want at the launch of a project? Is it 50 percent renewable?

Jim Hughes: I think it depends upon the circumstances. If it's a critical location where they don't have any other alternative, I think they'll use all thermal power if necessary to bring the asset into operation. You have to recognize the hyperscalers view the AI race as existential for their business model. They will make subservient every other goal they have if it's going to stand in the way of implementing what they believe are their needs and what they believe are critical mission plans in terms of adopting AI and bringing it into their business model.

Getting the data centers into operation, allowing them to put into operation the processors that they've acquired from NVIDIA and others, is job number one.

David Snow: And if they need to endure an interim period of time with even 100 percent thermal power, I think they're willing to do that. You've touched on this, but given the centrality of inelastic demand in today's market, how is your team forecasting demand? How far into the future are you able to look and feel comfortable about it?

Jim Hughes: We spend a lot of time talking about and thinking about, are we living in the early stages of a bubble? And is that bubble going to burst? We talk and think about things like the next generation of GPUs are going to be dramatically more energy efficient than the existing generation. Does that change the dynamic and reduce the growth in demand? Possibly. Do you reach a point where there are winners and losers in this technology race with respect to AI, and half of the customers are fading away or no longer creditworthy, and half of the customers have captured the market?

I have no idea. There's certainly a five-year window and probably more like a seven-to-ten-year window where we're going to have excess demand. Again, remember, in our view, the demand is driven by more than just the digital data. There are other components of our economy that are generating incremental demand. So I think we feel comfortable that if we're underwriting over an ownership horizon that's between, let's call it five and ten years, we're comfortable that we're going to be in an attractive demand environment over that time period. Is the world going to be the same in 15 years? I don't know. I don't think we try to underwrite that far ahead.

David Snow: In talking about your former company, First Solar, and how it has gained a lot of advantages by innovating its approach to solar energy—if you look across the energy transition landscape, where do you see pockets of great innovation that are making a difference in the way that energy is being provided?

Jim Hughes: I think the two areas that are not having a huge impact yet, but we believe will have a big impact, are probably the combination of geothermal and nuclear. I think they both are a few years down the road. Geothermal needs to be proven. There is the application of modern drilling technology to the concept of geothermal power. There are companies out there that are starting to do that. It needs to get proven up and then it needs to get scaled. But that has the potential to bring a whole new source of reliable, dispatchable, renewable power to the grid that could make a dramatic difference in the way we think about the grid and the power market.

And then nuclear—we need to figure out in this country how to cost-effectively permit and construct nuclear facilities. There is a lot of focus in Congress and, I think, focus in this administration on reforming the Nuclear Regulatory Commission such that we can build power plants at the cost that other parts of the world can build power plants, and in the time frames that other parts of the world can build power plants. But if we can bring those two technologies to bear, combined with the existing advances we've seen in utility-scale wind and utility-scale solar, along with the grid support and grid flexibility that utility-scale battery systems provide, I think we would have visibility to a fully decarbonized power grid. Absent those technology advances, I don't think it's realistic to view a fully decarbonized power grid. Absent a lot of nuclear and geothermal, I think you still have to have a lot of natural gas.

Now, we can have a lot of natural gas on the grid and still have a dramatically less carbon-intense power system than we've had historically. But if you really and truly want to move to a fully decarbonized grid, we have to be placing bets on those technologies, in my opinion.

David Snow: Are there any black swan type events or outlier risks that you would see and think, wow, that really changes the energy outlook—either to the upside or downside?

Jim Hughes: If you had a set of economic and political circumstances such that, as a society, we reached a point where we just decided we're not going to pursue a decarbonized economy—that we're going to focus on adaptation and mitigation or geoengineering as opposed to mitigation—that's kind of a black swan. It's a very low probability potential, but it's greater than zero.

As I have always explained to people, one dynamic of renewable or green energy that has always been there is the support for it is 10,000 miles wide, but it's a millimeter deep. The best example—in competitive power markets for retail residential users—they'll do surveys and ask, “Are you interested in green power?” And 90%+ of people will say, “Yes, I'm interested in green power.” Then the question is, at how much of a premium? And the answer is a tiny premium—maybe 2%, 3%, 4%, 5% higher cost. But if you say, “Well, it’s going to be 50% higher cost,” then the answer is, “Oh, well no, I’m not interested.”

There is no more politically volatile topic in the world than energy prices and energy access and energy availability. People riot over energy prices the world over. I don't think the developed markets of the U.S. and Europe are immune to that. Those of us in the renewable energy business need to bear in mind that making the energy transition cost-effective and making it work for the economy is of critical importance. And so, to me, the black swan is that we get that wrong.

David Snow: What makes you feel bullish about having a $1.5 billion fund to invest in the energy transition at this point in the market?

Jim Hughes: Simple—supply and demand. There’s no better environment to invest in than fundamentals that are in your direction. And so having an environment where the thing we know how to do—which is we know how to develop and build energy infrastructure—having an environment where there is more demand for that infrastructure than there is supply makes me bullish that we will be able to take capital and earn a return that is a premium return on that capital.

David Snow: Excellent. Well, Jim Hughes from EnCap Investments, thanks so much for being part of a Cool Vector interview. And I hope we can have you back in the future to share your expertise.

Jim Hughes: Thanks for having me. I'll come back anytime.

END