Capital Constraints Challenge Utilities

2008 Electric Utility Capital Expenditures

by Teresa Hansen, editor in chief

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The energy sector continued to be a hot topic in 2008. As in 2007, experts warned that the transmission grid must be strengthened and new power plants must be built. Lawmakers’ and the public’s global-warming concerns escalated, making it harder than ever for electricity providers to establish a doable plan to meet future capacity needs. Fuel and commodity prices rose just as they had in 2007, and supply bottlenecks—especially in the renewable sector—continued in 2008. Trends in 2007 continued into 2008, at least during the first half of the year. By mid- to late-summer, however, things changed dramatically: The housing bubble burst; some of the nation’s biggest banks teetered on the verge of failure; the government implemented an unprecedented bailout plan to keep the economy afloat; and suddenly, cash availability became the biggest issue for all industries, including electric utilities.

In November 2008, the United States elected a president whose administration’s outlook on U.S. energy policy is much different than those of previous administrations. The Obama administration add uncertainty to an already uncertain future for electric utilities. The uncertainty that characterized the industry in 2007 and escalated in 2008 will continue into 2009. Utilities and electricity generators face unprecedented challenges (see Figures 1 and 2).

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Electric Light & Power magazine editors worked with Dan Gabaldon, a principal with Booz and Co.’s energy practice, to develop the capital expenditures article in the January/February 2008 issue. There he discussed 2007 industry occurrences and offered predictions for 2008. Gabaldon, whose professional duties include advising participants, suppliers and investors in the conventional and renewable energy sectors, provides invaluable insight when it comes to evaluating past years and forecasting the future. It seemed fitting to enlist his input again this year and assess his 2008 predictions against what actually occurred. In the following pages, Gabaldon also shares his 2009 expectations.

The 2008 Watch List

In last year’s article, Gabaldon listed five items the industry should watch in 2008. The first was asset turnover. Some of the financial players have been sitting on assets they bought several years ago, and Gabaldon questioned if 2008 would be the year these companies would begin monetizing those assets. He wondered if 2008 would see a big turnover as the strategics buy in.

-We saw some consolidation in renewables and new construction in 2008, Gabaldon said, -but we didn’t see much consolidation with conventional generation.

In 2007, generation assets looked undervalued. It became more extreme in 2008 with the economic crises. Gabaldon, however, said that no one is taking advantage of the situation because no one has the cash and financing to buy the assets—even at their undervalued prices (see Figure 3).

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-Cash availability is the biggest issue for all players in the industry—basically in any industry, Gabaldon said. -I’ve never seen anything like it before.

The second watch list item questioned if the industry could determine the real costs and feasibility of nuclear power and clean coal (including gasification).

-Will we continue to be negatively surprised, or will we turn the corner? Gabaldon asked.

Neither area demonstrated much progress in 2008. Higher-than-anticipated cost and regulatory complexity continued, but financing concerns predominated.

-These are the most capital-intensive options for power generation, and so they’re going to be particularly vulnerable to problems in the financial markets, Gabaldon said. -And with slow to negative load growth and lower natural gas prices, the arguments about energy security and the urgency of adding baseload don’t sound quite as compelling as they did a few years back.

Conversely, the series of cost increases that have plagued these projects likely will become a thing of the past. As a result of the recession, the cost of capital equipment (major components, etc.) and commodities (steel, concrete, etc.), labor shortages and supply constraints began to show signs of easing in 2008, Gabaldon said.

-The prices, backlogs and shortages have eased, he said. -This should allow renewables and nuclear to take a breather and get their acts together, slow down and take advantage of the lower costs of capital equipment and commodities.

The third item on the watch list questioned if supply bottlenecks for renewable energy installations would break in 2008. Gabaldon asked if there would be a return to price decreases or a glut, especially in photovoltaics (PV).

-Yes, he said, -the short answer is, we’ve seen bottlenecks lessen.

A lot of new start-up solar manufacturing began in 2007 and increased in 2008. Investment in nontraditional PV—thin film—and next-generation solar—dish arrays, the next step after concentrating solar thermal parabolic trough—continued.

-In wind, suppliers continue to be challenged to get quality products out on time, he said.

Manufacturers still have some quality issues, especially with large components such as gears, as they try to meet demand. Bottlenecks in the wind-energy sector are loosening, Gabaldon said.

-In both wind and solar, the credit crunch has halted projects if the financing wasn’t already completed, he said.

Now that prices have dropped, some developers worry because they bought components and equipment at high prices during the supply constraint.

-They are trying to determine what to do now, he said.

The fourth item on Gabaldon’s watch list was reserve margins and reliability problems. Many expected reserve margins to tighten enough that reliability problems would surface and possibly cause further momentum toward reregulation.

Again, the combination of the credit crunch with dramatically decelerating demand has lessened the urgency of capacity additions, and with it, associated regulatory changes. Little if any movement toward reregulation and liberalization that might have been necessary to address current and future reliability issues occurred, Gabaldon said.

-The pressure to add new capacity is lessening rapidly, even in New England and New York, he said. -Demand response and demand side management technologies have helped lessen demand in these areas, where there was the most concern about reliability.

Mild weather helped, too.

The fifth item on the 2008 watch list was whether the low dollar would spur foreign investment in U.S. utilities. As it turns out, foreign investment did increase, but not because of the low dollar.

-The low dollar didn’t spark investment, but the credit crises did, Gabaldon said. -Utilities are being challenged by their need for new capital, especially for new nuclear and energy trading.

Currently, bargains in the U.S. nuclear industry exist for European nuclear companies such as EDF. The EDF-Constellation investment agreement is the first big one, and there was a good reason for it, Gabaldon said.

-Constellation needed the money due to strains on its balance sheet caused by its large commodity-trading business and its exposure to the financial sector, combined with its nuclear plans, he said. -EDF has the capital, deep nuclear expertise and good insight into Constellation’s business. Strategically, this deal also provides an attractive entry option for EDF into the U.S. market.

Nuclear requires much capital and technical depth and expertise, which helped drive previous consolidations in the United States and provided economic reason for big mergers in the past, such as Unicom Corp. and Peco Energy Co.

Gabaldon said 2009’s question is: Will big balance sheets and doing business in a carbon-constrained world give Europeans an edge in buying U.S. companies?

-We are going to see strategic partnerships between large, investor-owned utilities (IOUs) or foreign investors taking over capital-hungry businesses, such as renewables, smart grid and trading, he said.

After Enron and the other major electricity-trading companies folded, banks, big oil and hedge funds took over most of the electricity-trading business. Now banks and hedge funds are having trouble finding the capital to continue. So who will take their place—if anyone?

-Maybe big oil will step in and take over more of it, Gabaldon said, -Maybe IOUs will consolidate and step into the trading arena; maybe foreign companies will; or, maybe no one will. In the short to medium term until liquidity returns, these most capital-hungry portions of the power value chain—baseload building and trading—may simply remain underserved.

Because IOUs in this business environment may have greater access to capital than other industries, if they consolidate, they might be able to get more involved in trading. This could allow them to take market share from the financial players that have come to predominate trading.

Other 2008 Observations

Little change in the split of capital invested in new generation occurred from 2007, according to data Gabaldon compiled. Renewables still accounted for some 35 percent of capital spending. Dollars spent on gas-fired generation accounted for 50 percent of capital expenditures, and the rest was spent on odds and ends with a good part of the remainder going to coal uprates. The number of proposed projects fell in 2008. Capacity need also declined with the slowing economy.

As for the smart grid, more studies were conducted and some progress was made on standards for it, but no obvious breakthroughs occurred.

-The business case—on purely pecuniary grounds—for the smart grid remains controversial, Gabaldon said. -There should be major progress in this area with the Obama administration, which is well-aware of its role in enabling renewable generation growth and enhancing energy efficiency, both of which have near-term employment benefits as well.

While 2007 was a good year for demand response, it experienced a little setback in 2008 after regional transmission operators developed verification and measurement requirements that were more difficult to comply with than expected.

Plug-in hybrid electric vehicles (PHEVs) gained significant ground in 2008.

-Many utility and transportation executives now speak much more confidently about the imminent electrification of the transportation sector. And much of the discussion is now turning to what this will mean for the utilities’ distribution and generation businesses, and what role they should be playing here, Gabaldon said. The obvious question is how the current enthusiasm will fare as gasoline prices moderate once again.

The New Administration

Gabaldon expects the Obama administration’s biggest impact to be on solar energy, energy efficiency and the smart grid. The president has said he will focus on labor-intensive green initiatives.

-Not only are these initiatives aimed at creating jobs, but they will also garner a lot of goodwill, Gabaldon said.

Questions surrounding Obama’s plans, according to Gabaldon, include:

  • How fast will some sort of action occur?
  • Will our federal and state governments be effective?
  • Can they overcome public opposition, such as -not in my backyard (NIMBY)?
  • Can they establish regulations that allow progress in these areas?

-With a big push from government, there is the danger of a backlash as voters later come to suspect the program was wasteful due to its haste or ideological biases, Gabaldon said. -There is a great resistance in this country to the states’ “Ëœpicking technologies,’ as well as resentment against federal government intrusion into the states’ realm of electricity regulation.

Gabaldon thinks a federal renewable portfolio standard (RPS) likely will be enacted under the Obama administration. He said there will be benefits from standardization over current state-by-state, piecemeal standards. Some utilities will be unhappy with a federal RPS; it will depend on their resource base and where they have already invested, he said.

Other 2009 Predictions

Thanks to global recession, 2009 coal prices should remain moderate, resulting in lower demand, input prices and other energy-commodity prices. Gabaldon said that in past years when steel and other commodities were in high demand and bringing high prices, industries and manufacturers were willing to pay the high coal prices to produce their wares. As the recession reduced product demand and consequently prices, industries no longer are willing to pay high coal prices. The result is coal prices that should continue declining throughout 2009 (see Figure 4, page 22).

Gabaldon expects capital equipment prices to fall in 2009, as well—possibly faster than most people expect.

-Gas turbines might be the exception, he said. -I can see the price of gas turbines increase, even if demand for commodities decreases.

Unless electricity demand decreases enough that no new capacity is needed, gas turbines will likely remain in demand.

-Gas turbines will be the option of choice for new generation, so gas-turbine prices could hold steady, and their manufacturers could benefit, Gabaldon said.

Clean tech will be another theme of 2009. Clean technologies include renewables, energy storage and smart grid.

-Renewables may have a chance to catch up and mature in 2009 due to the decline in equipment demand and supply bottleneck resolution, Gabaldon said.

The technologies may also begin to look more like traditional generating technologies and industries. It’s happening already with wind technology, and it likely will continue in 2009. Solar technologies will continue posting impressive efficiency and cost improvements, although they likely will remain immature in terms of business processes. Consolidation will address this as smaller players become vulnerable during rapid supply growth and capital constraints.

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How will clean tech play out in 2009? Credit constraints will slow its growth, but increasing regulatory demands will drive its growth, Gabaldon said.

-Many new entrants could be much larger and more business-savvy than the current suppliers, but they will also be less-experienced and somewhat naive about the industry, he said. New entrants may be large, high-tech companies and engineering conglomerates such as Unicom and Peco and more nontraditional players, he said.

Carbon Restraints, Capital Constraints

As he did in 2008, Gabaldon wonders if 2009 will see a lot of asset turnover and consolidation.

-Carbon restraints and capital constraints are two good reasons for IOUs to consolidate, he said. -There is more reason for IOU consolidation now than in the past.

Reducing carbon emissions and complying with carbon caps or taxes, one of which is likely to be enacted, will be expensive. Investing in nuclear and clean coal will require scale—in capital and expertise—available only to much larger entities.

-Will underlying economics overcome regulatory and political resistance to consolidation? In the short run, politics normally wins, Gabaldon said.

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