Challenges continue, but big opportunities are ahead

by Teresa Hansen, editor in chief

As in past years, electric utility executives made tough decisions in 2012, often based on incomplete information. During the first 10 months of the year, electric utilities and nearly everyone else in the U.S. were focused on a presidential race that was too close to call until the election was over. The candidates’ differing views on energy, taxes and the economy made short- and long-term planning difficult for utilities. Compliance with stringent Environmental Protection Agency (EPA) emissions regulations also led to some tough decisions. And what seemed like an unprecedented number of severe weather events, which culminated with Hurricane Sandy in late October, put utilities’ infrastructure vulnerabilities in the spotlight and created more difficult decisions.

Despite continued uncertainty, low capital cost provided utilities with a historic opportunity, said Tom Flaherty, a senior partner with Booz & Company.

“A low cost of capital has made it much more palatable for utilities to undertake the sustained funding necessary to upgrade and improve performance,” he said. “The (U.S.) utility industry is moving toward $100 billion in capital expenditures annually.”

According to Booz & Company, whose energy experts have provided content for Electric Light & Power’s annual utility spending report for several years, utilities have a once-in-a-generation opportunity to build new infrastructure that will drive better performance and returns for decades.

Flaherty said utilities in coming years will invest even more extensively in their distribution systems.

“Modernization and protection are on everyone’s list,” he said.

Utilities want to smarten the grid in a way that allows them to preserve, protect and enhance what they already have in place. In addition, politicians, regulators and customers are acutely interested in electricity grids and their ability–or inability–to withstand disruptive events. This increased scrutiny will require more investment in the grid to satisfy the stated and unstated mandates for high system reliability and performance.

One trend in 2013 and beyond will be the evolution to more customer-focused technologies and processes, Flaherty said. Customers are becoming more aware of and involved in their energy consumption. Their changing behavior and expectations will impact utilities greatly in coming years. Utilities must change their mindsets and processes to accommodate changing customers.

“Customer engagement will be the next forefront of change in utilities’ business models,” Flaherty said. “Customer behavior shifts will be a game changer when it comes to how utilities do business. This evolution is now in an embryotic state, but it will intensify. Customer awareness and interest increase because technologies are changing and becoming more accessible, which makes more information available. We don’t know the full shape of this enhanced customer relationship, but it will look very different than it does now and be more demanding.”

The explosion of available usage data also will drive this change, he said. Flaherty said utilities will increase spending slowly on microgrid and distributed generation technologies to reflect a changing business model, but customer engagement technologies and processes will mature before they do.

As for consolidation, Flaherty said, 2013 will look more like 2010 and 2011 and less like 2012. More consolidation will occur. The industry has shrunk by half since 1995. The big utilities get bigger and the small utilities get smaller or taken over by the big utilities.

“More than 50 percent of U.S. utilities are under $5 billion in market cap,” Flaherty said. “In 2000, no U.S. utilities were among the top 15 largest utilities globally. Today, five utilities are among the largest 15 in the world (see Figure).”

“I believe overall smart grid investment has and will continue to wane.” –Tom Flaherty, Booz & Company

Election Brings Some Clarity, But Picture’s Not Always Pretty

The re-election of President Barack Obama brings utility executives some certainty in 2013 that they didn’t have in 2012. Four more years of the same administration will result in continued spending on coal plant retrofits, as well as new generating facilities to replace the capacity lost as utilities retire coal plants that are too expensive to retrofit, Flaherty said.

“We’ve seen a brief respite since carbon legislation didn’t pass, but I expect the Obama administration to invigorate its attempts to implement policy through regulatory fiat rather than legislation, consistent with what’s occurred with the EPA over the last two to three years,” he said. “I expect this administration to be hyperaggressive when it comes to environmental issues with water quality joining that of air in garnering federal-level attention.”

During the past couple of years, utilities began complying with the new emissions regulations. Older, smaller, less-efficient coal plants have been retired or have been identified for future retirement. In addition, utilities have invested in compliance technologies at some coal plants, especially the larger, newer and more economical plants.

“EPA compliance is driving capacity off the system,” Flaherty said, “and many plants are still on the bubble.”

These “bubble” plants will be more expensive to retrofit for continued operation than those already retrofitted. This will lead to construction of smaller replacement units to replace retired bubble plants’ capacity.

When asked if EPA Administrator Lisa Jackson’s resignation could mean looser regulations in the future, Flaherty said he doesn’t think so.

“Lisa Jackson’s resignation won’t make much difference,” he said. “Her resignation doesn’t change the band; it just puts another band leader out front.”

Obama did not push for a federal energy policy during his first term, and Flaherty doubts such a policy will be on his second-term agenda.

“The patchwork of individual policies we have will continue,” Flaherty said. “Individual energy issues might be addressed, but not an overall energy policy that is true to its title.”

Flaherty said Sen. Ron Wyden’s move to chairman of the Senate Energy and Natural Resources Committee in December after Sen. Jeff Bingaman retired could be good for the industry.

“He (Wyden) has said publically that there should be a national energy policy, but I don’t think that will happen soon,” Flaherty said. “Creating a comprehensive national energy policy will be complex and difficult.”

American Taxpayer Relief Act Impact

Obama’s re-election means investment in renewable energy likely will continue at least through 2013. The American Taxpayer Relief Act of 2012 passed in early January to avert the so-called fiscal cliff includes a one-year extension of the wind production tax credit.

Flaherty said the administration will keep renewable subsidies as long as possible.

“This is partially because of the tie to perceived job creation,” Flaherty said. “I say “Ëœperceived’ because wind (and solar) projects do not seem to have created the level of long-term jobs that were expected. Almost no staff are needed to operate or maintain a wind or solar facility once it’s online. Jobs are created during the production stage, but we’ve seen that cyclicality results in closed or ramped-down manufacturing facility output and lost jobs. While jobs are temporarily created during the construction phase, most of them go away once the project is operational and are not renewed.”

In addition, Flaherty said, many of the companies that manufacture wind towers, turbines and other components are owned by foreign companies, so many of the back-office jobs are not in the U.S.

“Adding temporary renewable energy jobs may actually result in a decline in overall energy jobs because anytime wind replaces coal generation, more permanent jobs are lost.

“The questions we should ask about wind are: “ËœHave we already bent the curve on the level of benefits’ being reaped from tax credits?’ and “ËœHas the industry received enough of a shot in the arm to stand on its own?'”

Even with the absence of a carbon tax, cap and trade or some other carbon-cost recognition mechanism, the U.S. already has been meeting its short-term goal of cutting carbon emissions, which have returned to early 1990 levels, invalidating part of the initial argument for renewable subsidies, Flaherty said.

“Unless our real intent is to support emissions reduction on a global scale, which is fruitless given the stance of China and India, it seems counterproductive to consider lower emissions as a primary driver of renewable subsidies,” he said. “The U.S. can’t afford to support a global emissions reduction goal, at least not relative to other spending needs.”

In addition to extending the production tax credit for renewable energy sources, the American Taxpayer Relief Act of 2012 kept equal tax rates on dividends and capital gains–good news for electric utilities, Flaherty said. The Act increased rates for the wealthiest Americans (individuals earning more than $400,000 and married couples earning more than $450,000), but left them unchanged for most.

“Keeping dividend and capital gains tax rates equal is critical for utilities,” Flaherty said.

Other observers believe a change in the dividend and capital gains tax rates could have caused a 5 to 7 percent reduction in utilities’ market value, making it more difficult for them to attract investors just when capital expenditures in 2012 arced to an all-time high.

“As it is, utilities are seen as safe, stable stocks in a portfolio,” he said. “Utilities are attractive because their lower risk, stable returns–from price appreciation and dividend yield–and prudent capital structure policies–from reasonable debt-to-equity ratios–allow them to borrow money relatively cheaply.”

Currently utilities’ yield (dividend) is about 4 percent, and earnings growth is between 4 and 6 percent, he said. If the industry were to lose 5 to 7 percent of its market capitalization, that likely would impact capital spending and in the long term jobs, he said.

“Low-cost capital is the most effective support to growth and long-term jobs that can be provided,” Flaherty said.

Smart Grid Spending Slows

“I believe overall smart grid investment has and will continue to wane,” Flaherty said. “Investment in system intelligence collection, real-time communications, data management and customer engagement technologies, however, will increase.”

Most of the money for smart grid projects awarded to utilities as part of the American Recovery and Reinvestment Act has been spent, but utilities will continue to invest in digital sensing and communications technologies. They will continue to add equipment such as intelligent sensing devices to detect imminent failures to their distribution lines so they have a better idea of what’s happening with their assets and how these assets can be expected to perform as they are stressed, he said. Utilities want to be able to identify where problems will occur as much as where they have occurred.

Money also will be spent on communication and interaction with customers. These technologies are important to utilities’ day-to-day operations, but as severe weather events such as Hurricane Sandy have shown, they also are important to outage restoration. Utilities will need to show policymakers, regulators and customers that they learned from Sandy and similar catastrophic events and will adjust their procedures and invest in technologies that will keep information and power flowing, even when Mother Nature doesn’t cooperate.

“Utilities still need better planning and infrastructure in place to support restoration efforts,” Flaherty said. “The industry has come a long way but is still maturing in its readiness to execute.”

Short-term Information, Long-term Impacts

Utility executives’ and board members’ decisions for capital planning are based on short-term information and data, such as today’s gas prices. Those decisions, however, will impact utilities as long as 50 to 70 years, especially when it comes to new baseload generation because the next plant built reflects the current view of the future and will carry those assumptions for its entire life .

No one knows what technology, policy or the economy will look like years from now, so it’s shortsighted to base a 50-plus-year decision only on what is known today, Flaherty said.

Utility leaders should not make decisions with the assumption that today’s economic climate and fuel prices will be the same in 50 years, Flaherty is certain.

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