A Year of Uncertainty

Capital expenditures in the electric industry for 2007

By Nancy Spring, managing editor, with Dan Gabaldon, Booz Allen Hamilton

Anytime the U.S. electric system is the topic of discussion, there’s a call to action. Experts warn that the transmission grid must be strengthened, that we need to build new power plants and that we should do everything A.S.A.P. We must, they say, invest in the future and embrace new technologies.

It’s been years since the Northeast Blackout of 2003 and passage of the Energy Policy Act of 2005, but there’s still a sense of urgency and frustration. We started off 2007 with a stern reminder from Edison Electric Institute President Tom Kuhn that it was time–high time, really–to invest in America’s electric future. “More power plants and transmission wires must be built to meet this demand,” Kuhn said. “The distribution system needs to be modernized and expanded. And investments need to be made in technologies that can further reduce air emissions and increase energy efficiency.”

While acknowledging that investment in the electric industry has increased, the jury’s still out on whether the dollars are being spent fast enough and in the right places. Now that the numbers are in for 2007, we wanted to know how the year stacked up. What was unique about 2007? What should we be watching for next?

We turned to Dan Gabaldon, a principal in Booz Allen Hamilton’s energy practice, to find out. Gabaldon focuses on advising participants, suppliers and investors in the conventional and renewable electricity sectors. For this report, he zeroed in on generation because “that’s the area that was most interesting in 2007.”

First and foremost, Gabaldon sees 2007 as characterized by uncertainty. “It’s as if the background music in a Hitchcock movie is getting louder and louder from 2004 to the present,” he said. While the year brought higher costs throughout the economy, sector specific to the power industry what was remarkable about 2007 was the rise of renewables, the level of plant cancellations and “just sheer cost increases.”

Looking back first

We begin our assessment of 2007 by placing the year in its historical context to examine the level of expenditures, the mix and what some of the drivers are that, over a longer time horizon, explain the way money is spent.

It’s no news that there have been some big mistakes in electricity sector predictions made in the past, but whether we use our understanding of those miscalculations to avoid the same kinds of mistakes in the future is the still-unwritten story.

“People have made mistakes in terms of electricity demand predictions and price predictions, largely by underestimating the medium-term impact of markets,” said Gabaldon. “The biggest mistakes, which led in the generation sector to big overbuilds, were made when people extrapolated from what happened in the late ’60s and early ’70s–and even, frankly, since World War II–in terms of demand growth.”

What happened instead was a very strong reaction to the first oil crisis, which delinked electricity and energy demand from gross domestic product.

“Historically, there had been a linear relationship between GDP and energy demand, but when you look at the data after 1973 or 1974, they get delinked, very dramatically. Momentum was maintained in terms of optimism–fast forward to mortgage markets today–and people thought that the good times would continue. As a result there was a significant overbuild.”

Source: Energy Information Administration, Census USA data; Booz Allen Hamilton Analysis
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Similarly, Gabaldon said there was an underestimation during the ’80s when gas prices fell and there was a real demand elasticity effect. “People underestimated demand growth because of the price impact.”

One of the themes he saw in 2007 that he believes we’ll see more of in the future is the rippling effect of underlying prices. “People get caught up in the challenges of engineering and of the regulatory process in terms of getting things built and forget about the economic fundamentals after they’ve made their decision to go forward. That can come back to get you.”

Technological wild cards will throw off predictions, too. That happened in the ’60s, when demand growth caused by air conditioning was underestimated. “There was real uptick in demand growth that wasn’t foreseen,” said Gabaldon. “So the question is, will something happen in terms of technology going forward that could change our existing relationships between supply and demand and adversely impact the supply side?”

Volatility and predictability

With the delinking between GDP growth and energy growth, per capita growth now drives demand, which in turn requires supply growth. “That’s been true for the last few years, including 2007, in terms of the overall capital expenditures,” said Gabaldon. “But if you look at those levels they’re actually fairly steady in aggregate for the most part. Distribution’s been quite steady year on year with volatility at about 8 percent over the last 10 years, but generation and transmission are very volatile.”

Standard deviation year to year in that same time frame in terms of “the spend” for transmission is 26 percent and for generation, 35 percent.

“That’s not too surprising,” said Gabaldon, “because the lumpiness of those kinds of investments is much greater than you see in distribution. They also tend to be funded differently.” He pointed out that the public power sector spends more of its money on distribution than do the investor-owned utilities and that public power funding tends to be steadier.

For transmission, volatility and predictability are driven by different factors.

“There’s been a great deal of focus on RTOs and states mandating or allowing transmission projects to go through,” said Gabaldon. “Of the three different sectors, we have seen transmission grow much faster than distribution or generation across most regions of the country over the last several years and that trend continued in 2007.”

This, he explained, is a result of EPAct 2005 and more broadly, FERC policy, plus the fact that RTOs are running more smoothly now, particularly in PJM.

“There’s a broad coalition of folks in the policy set and regulatory set who recognize the value of transmission.”

Gabaldon also described the interesting confluence with a longer-term trend that drives transmission–the 10-year bond. “There’s a relatively tight correlation between bond yields and transmission that explains about 20 percent or 30 percent of the variance. That’s been accentuated by companies like Macquarie Co. that have made infrastructure investments more fashionable.”

A lot of private equity and institutional money is looking for investments that are rateable and long-lived and uncorrelated with other capital market trends. Transmission projects are perfect “and with the extra incentive rate of return from FERC and the relative simplicity in terms of regulatory authorities compared to other electricity related infrastructure investments, it’s kind of an easy place for them to put their money.”

Generation’s different

Gabaldon said that historically, there’s actually a very steady relationship in terms of the mix between generation, transmission and distribution over time and that there have only been a couple of disturbances to that. One big disturbance occurred in the ’70s and ’80s when there was a real run-up in generation. Gabaldon thinks that was related to changes in prices and oil going out of the generation mix, with substitutes coming in, plus the interest in nuclear.

Gabaldon pointed out another building bubble, when “the merchant sector and all the gas came in” at the end of the ’90s, continuing into the early ’00s. Several factors caused that bubble, among them advances in combined cycle technology, an expectation of low gas prices and high environmental prices to comply with CO2, NOx and SOx regulations, and the fashion for low capital intensity in terms of the capital stock.

Source: Booz Allen Hamilton Analysis
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What it all boiled down to was a significant overbuild and more volatility.

“People think that generation is where all the action is in terms of capital,” said Gabaldon, “but you can see that that’s not true when you look at the actual dollars.” Investment in generation actually is relatively steady in terms of the mix and in terms of its overall impact.

“Although there was a lot of “˜sound and fury’ in terms of the overall mix of capital expenditures, generation still wasn’t that big a deal even during that up-tick. Lots of megawatts went in, but they were cheap megawatts–one of the reasons they went in at all,” said Gabaldon. “I don’t think we can foresee any near-term watersheds like that, but there are two potential candidates–renewables and nuclear.”

The brink of a fourth epoch?

The history of electrification in the U.S. can be broken into three epochs: the hydro epoch, which ran from the beginning to the ’50s, the coal epoch that ended with take-off of new gas capacity in the late 1980s, and the third epoch, natural gas, which started with gas deregulation and has now trailed off. Gabaldon thinks we could be on the brink of the fourth epoch, a return to renewables or perhaps the arrival of nuclear. For him, that was one of the interesting trends of 2007: renewables coming on big.

“To a large degree, it was a wind story, which has replaced what’s traditionally been our biggest renewable source, biomass,” said Gabaldon. “I think it was driven by several factors: the maturation of renewables markets and renewables administrative procedures in various states; the maturation of project finance in the renewables development community, which is getting a bit consolidated so they’re able to move more quickly than they used to. Before, they were more of a cottage industry.

Source: Booz Allen Hamilton Analysis
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“It was driven in part by the expectation of falling renewables prices relative to conventional prices, as gas stayed high and as CO2 loomed on the horizon. But, as we all know, the reality was that renewables components experienced very, very significant price inflation, most notably in wind, both for some component parts and building sites.”

For solar, the issue has been the scarcity of polysilicon capacity, leading to significant price escalation and severe shortages. To find supplies, there’s been quite a flurry of acquisition and alliance activities, some players trying to lock in their current, very advantageous positions and others just trying to find some solar panels.

“We’ve also seen thin film taking on polysilicon much faster than most people thought was possible,” said Gabaldon.

What about nuclear?

While there was a lot of talk about nuclear, shifting alliances and recertification and relicensing activity, there was only limited deployment of money. Even in its heyday, nuclear wasn’t predominant enough to claim its own epoch. “But maybe that’s just around the corner,” said Gabaldon.

The cost of uncertainty

What’s for sure is that 2007 was characterized by uncertainty and higher costs and that “one of the manifestions of that was renewables,” said Gabaldon. “They were affected by higher costs and you could argue that choosing renewables was a relatively safe response to all the uncertainty.”

The uncertainty is fundamentally about CO2 prices and gas prices, and importantly,what the real price of nuclear and clean coal will be. Renewables benefitted because from a PR standpoint or a funding standpoint, it was a “no-brainer” to turn to them.

“However, from a social standpoint,” said Gabaldon, “Some folks say we could look back and think this is a return of PURPA, we’re sending crazy price signals for a laudable public policy objective, but we’re meeting that objective in the most expensive way conceivable.”

Coal was also affected by all the uncertainty and higher costs in 2007, but instead of growing like the renewables sector, its story is one of contraction. While coal plants weren’t the only generation type to be cancelled in 2007, they certainly took the biggest hit.

Note: 2007 is only inclusive through the third quarter. Source: Edison Electric Insitute; Booz Allen Hamilton Analysis
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“The public was more vociferous in the case of coal than nuclear,” said Gabaldon, “which is sort of interesting and reflects where many of the more economically minded environmentalists have been for several years.”

Some natural gas projects also fell victim to uncertainty and higher costs and were cancelled or deferred. There, the uncertainty was partially around market mechanisms and high capacity market functions, but more about the relative prices of coal, CO2 and gas going forward.

When generation really had to come in, “there was old reliable gas and renewables,” said Gabaldon. “What we’re seeing is the cost of uncertainty. If you’re trying to find the highest average cost sources of electricity, you couldn’t do much better than looking at peakers and renewable projects given current economics.”

Price increases

Given the way these markets work, Gabaldon explained that generally when there are price increases in terms of the underlying costs, the profitability goes up–and that’s how it worked in 2007.

Last year, there were real commodity price increases, especially in steel, and lots of supply constraints around highly specialized manufactured products, especially for renewables. There were also major constraints in availability of specialized engineering procurement and construction firm skills, for clean and classic coal and renewable projects.

Source: Booz Allen Hamilton Analysis
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“But I think there was also profit taking,” said Gabaldon. “The reality is that all of these markets tend to be relatively supply inelastic in the very short term.”

Idiosyncrasies of the year

In 2007, a gold rush mentality swept through the renewables sector. Wind farm sites were scooped up and building supplies for wind and solar became scarce.

Some real innovation in technologies like clean coal also characterized the year, but once again, it was all about rising prices. The price tag for quite a few integrated gasification combined cycle (IGCC) projects, for instance, caused sticker shock.

“What’s interesting is how you can get things wrong when you under-estimate the medium- and long-term impact of prices,” said Gabaldon.

In electricity markets, the equilibrium gross margin is set by the price at which new entry occurs. As these technology and commodity factors and constraints have their impacts–significant price increases–we see the “knock-on-effect.” The price at which electricity has to rise in order to bring in new entry will go up, so an equilibrium reserve margin should tighten and the value of existing assets should go up as well. Gabaldon said we’ve begun to see that across the board. At the same time, the cost of new equipment has gone up and that could mean medium-term ramifications for electricity markets.

What reserve margin do we need before new entrants are attracted to the market? “That could make some predictions wrong about how the supply response is going to change; it could be lagged,” said Gabaldon. “That means existing assets could enjoy some rents that aren’t fully baked in right now.”

Pain points are shifting

In 2007, the once hotly debated market design issue was no longer at the forefront of concern; rather, the questions centered around the prospect of re-regulation.

“The drama around capacity markets and whether we trust capacity markets to build new capacity kind of went away,” said Gabaldon. “In the Northeast, the debates were concluded with a belief that peaking capacity was close to what it needed to be. Capacity markets were not designed to attract base load, so people gave up on trying to build large baseload projects based on merchant markets, Texas being the exception.”

The pain points are shifting. The possibility of re-regulation is lurking in the backs of many minds.

Things to watch in 2008

“People are behaving rationally in the face of uncertainty and they’re waiting to see how it’s resolved,” said Gabaldon. While we wait, here’s a list of five things Gabaldon suggests we watch for in the near term:

  1. Will we see a lot of asset turnover? Some of the financial players have been sitting on the assets they bought during the crisis for several years now and they may want to monetize. Will we see a big turnover as the strategics buy in?
  2. What more are we going to learn about the real costs and feasibility of nuclear and clean coal (including gasification)? Will we continue to be negatively surprised or will we turn the corner?
  3. Will some of the supply bottlenecks for renewables break? Will there be a return to price decreases or a glut, especially in photovoltaics? “It’s not a CalTech problem, it’s a VoTech problem,” said Gabaldon. “You don’t need gee-whiz basic research breakthroughs, you need to get the manufacturing right. Blocking and tackling breakthroughs could lead to a real discontinuity in terms of the costs and that would surprise people.”
  4. Will we see enough tightening of reserve margins that we begin to have real reliability problems? And will that cause further momentum toward re-regulation?
  5. What will a very low dollar mean in terms of foreign incursions? Will the foreigners finally come?


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