Effects of the Downturn for Distribution

Rob Robinson, Vice President, Booz and Company

Dan Gabaldon, Principal, Booz and Company

Many would argue that electric utilities have gotten off easily compared with most other sectors of the U.S. economy. Indeed the sector has lost only a mere 33 percent of its value (excluding Constellation, whose exposure to investment banks and its large financing capital requirements put it squarely in the path of the credit market avalanche) since the beginning of the year as opposed to 40 percent for the broader market. But, the sector is beginning to feel the credit drought effects and what appears to be a deep and protracted recession.

Our scan of recent investor presentations by some of the largest IOUs reveals capital expenditure reductions of about 14 percent among those already making such announcements. About half of the total deferred investment was for emissions-related expenditures. The next largest chunk, about a quarter, was referred to as “growth capital,” and includes both generation and wires related projects. About 20 percent was not defined, and the remaining 5 percent or so was related to renewable generation projects. But don’t let this small renewable project percentage mislead you. We are seeing delays–or worse–in numerous permitted but not fully-funded projects. The shrinking tax equity market and broader liquidity concerns are hitting the renewable sector hard.

Compared with other sectors, and even other electricity business segments, the T&D sector appears to be somewhat sheltered from the storm. Industry efforts to minimize regulatory lag are paying off. Cash flow coverage has improved in recent years. And recent upticks in regulatory capital for back-to-basics recovery and then environmental remediation peaked in 2007. Unfortunately, the downside of this run-up in capital expenditure will be affordability, as the first round of rate increases start making their way into customers’ bills, with the pain aggravated by the recession.

Don’t be fooled. Funding for other business segments will benefit from the growing trend of providing improved regulatory certainty and transparency, ostensibly a good thing. Riders, adjustment clauses, and file-and-use rates are typically linked to major spend categories like environmental and transmission. North American Electric Reliability Corp. requirements, legislative and public utility commission orders, and so forth are typically directed to supporting new peaking capacity, renewable generation or demand side management initiatives.

Core distribution, on the other hand, remains the segment that carries the greatest regulatory lag and most granular spend that existing mechanisims cannot easily cover. Reduced load growth does translate into lower new-capacity requirements. But deferred backbone expansion projects typically contain a lot of asset upgrade and replacement spending. Time marches on, even in a downturn, and upgrade projects for some assets most at risk get pushed out yet again. At the same time, diminished revenues (especially if not decoupled) during the recession and bad debt go straight to the bottom line. Typically, costs incurred for uncollectibles do not get charged back to other business units.

Organizational realities within many utilities don’t help the distribution segment either. Distribution system planning itself is often under-resourced, so many utilities don;t have the analytical rigor and feedback loops required to justify core spending, only mandatory spending. Unlike generation projects, which can offer well-understood scenarios pointing to the risks of inadequate capacity, distribution projects often can’t offer similarly harrowing what-ifs. So, from the standpoint of the utility’s leadership, a de facto distribution maintenance strategy of run to failure often appears to be the more manageable risk. And, all the excitement and uncertainty surrounding the potential impacts on the grid of emerging technologies like smart grid and load-to-system resources such as PHEVs and DER give planners yet more reason to pause.

But there’s hope. Tax incentives for distribution investment may create an infrastructure-oriented fiscal stimulus package. As distribution waits for the fiscal cavalry to arrive, its leaders should have a few priorities. Creating awareness of distribution system needs and avoiding institutional knowledge loss will be critical. But without integrated planning and out-year placeholders for needed distribution expenditures, the under-investment cycle will continue.

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