by Randall L. Speck, David L. Cousineau and Chimera Bowen, Kaye Scholer LLP
Impending retirements of significant baseload generation sites during the next three years and evolving Environment Protect Agency (EPA) regulations for next-generation power plants provide an opportunity for utilities to plan an orderly transition to cleaner, more efficient resource portfolios.
Natural gas plants, renewable facilities and energy efficiency and demand response programs will be integral to these updated portfolios but will not provide the entire baseload capacity to power the economy. Generation owners might need to rely, at least in part, on innovative or not recently constructed, capital-intensive technologies such as nuclear and coal with carbon capture, which entail significant financial risks.
These risks probably will deter merchant generators from undertaking such projects, and regulated utilities with their statutory right to recover prudently incurred costs are more likely to be the early adopters of necessary innovations. But this statutory expectation does not prevent the economic risk for regulated utilities, as demonstrated by the billions of dollars of cost disallowances during the last nuclear generation build out in the 1970s and ’80s. Careful planning is essential to increase the likelihood of full cost recovery.
Recovering Capital Costs Requires Long-term Planning
Under current statutory regimes, utilities generally seek preapproval of costs to study and then build major new generation projects, but they must return to regulators for regular updates and to seek approval for additional costs if cost estimates increase.
This process–from when the utility initially seeks costs to study the project until construction is complete and the plant is operational–can take more than 10 years and can create obstacles if not calculated carefully.
Utilities should apply to their strategies for recovering prudently incurred costs the same long-term planning concepts they use in developing their generation portfolios and constructing major projects. Just as a project manager must develop a plan that considers known and unknown challenges, a manager who anticipates a prudence defense should develop a plan that considers challenges that will guide this subproject from the early proceedings through completion.
First, the utility must develop a foundation that will support the project against imprudence claims. This entails more than convincing a regulator that the project is a reasonable economic option to meet expected demand (e.g., through an integrated resource planning (IRP) analysis). The utility must convince the commission to buy into the project (i.e., to agree the project provides the best value to ratepayers). Only then will the utility have a legitimate possibility of recovering all its costs, if costs overrun estimates. Although an IRP analysis often sufficiently demonstrates the prudence of the decision to construct a plant–especially because regulators generally defer to the utility in deciding what type of plant to construct–that initial IRP analysis might no longer appear as favorable to the new technology when costs increase, casting doubt on whether the plant ever presented the best value to ratepayers.
A comprehensive presentation that focuses on the project’s financial and environmental benefits, benefits to the local economy, the extent to which the project will address anticipated or unexpected environmental regulations, how the project will incorporate future technological advancements, and how the project fits into the utility’s current and future portfolio will provide a more compelling picture of the project’s benefits.
Such a presentation also must be realistic about the construction and operating challenges the new technology poses, the greatest perceived challenges to completing the project on time and on budget, and the challenges that remain unknown until work begins. Having described these challenges, the utility must explain clearly why the new technology provides the greatest overall benefit to ratepayers.
The utility also must identify, appreciate and ease commission concerns. This includes regulators’ concerns at the beginning of the project and reservations that likely will arise if costs escalate or the plant does not operate as expected.
For instance, if costs increase, a commission legitimately will question whether the cost estimate should have anticipated those overruns. To pre-empt those reactions, the initial cost estimate presentation should explain its assumptions, the confidence level associated with the estimate and what that confidence level means for the costs ratepayers might be expected to bear, and the level of design and engineering work that supports the estimate.
Regulators generally do not have engineering backgrounds and do not understand basic engineering and project management concepts. To foster unambiguous communications, utilities should explain concepts in ways commissioners will appreciate.
The utility also must build confidence with regulators. One way is to introduce key project managers to regulators to assure them the right managers are on the job. A thorough, candid evaluation of management’s qualifications at the project’s inception will provide sufficient time to assess gaps in skill sets and permit supplementation with expert consultants and contractors as necessary. Introducing managers to regulators will help establish the managers’ qualifications and develop trust before any escalating costs cause contention.
Because environmental regulations may dictate innovative technologies, managers might have limited direct experience on these types of projects. Opponents might seize on this to argue the utility’s managers are unqualified. Although such an argument is misleading, it might be effective unless those managers have demonstrated to the commission they are competent to manage the project.
In addition to laying a secure foundation of trust, the utility should anticipate that every statement it makes, even in the initial stages of regulatory proceedings, has the potential to create unexpected consequences. Context and candor should be the utility’s hallmarks. For example, even a seemingly benign statement that the utility has “confidence” in its estimate could be viewed as deceptive if the commission learns years later that knowledgeable insiders at the company or contractors had undisclosed reservations about the estimate.
Those apprehensions might have been resolved routinely or might have been unfounded, but that they were not highlighted for the commission when the cost estimate was submitted might allow objectors to argue the utility concealed internal dissent. The utility need not detail every disagreement or alternative analysis, but it must be able to demonstrate it sought to identify and disclose information it believed the commission could find relevant.
Make Prudence an Everyday Consideration
The legacy of the most recent big generator build out in the ’70s and ’80s was billions of dollars in cost disallowances. Commissions often, and most likely wrongly, disallowed cost recovery because of mistakes a contractor made–even if the utility acted prudently–on the theory that the utility, not ratepayers, could manage the contractor and seek recovery from the contractor.
The fallacy of this reasoning is for another discussion. Nevertheless, economic regulators will not consider approving significant cost increases after a project is approved unless the utility can demonstrate it sought to protect ratepayers from cost increases.
One way to make this demonstration is to make prudence an everyday consideration. Prudence requires no more than the utility’s managing the project reasonably and documenting decisions to provide concrete evidence that the utility considered relevant information and reached a reasoned decision based on that analysis.
Utilities should, for instance, assess and document whether contractual provisions with their contractors protect the utilities (and thus ratepayers) to the fullest extent possible given the market conditions, challenge–without interfering with–their contractors to ensure they act reasonably, and, when necessary, enforce contractual rights. It is insufficient to threaten a contractor or preserve a litigation position; utilities should take proactive steps to resolve disputes efficiently and with ratepayers’ interests foremost. Prudence is neither materially different from reasonable management nor is it burdensome to implement, but it requires a slightly different mindset that reflects constant consideration of ratepayers’ interests and regulators’ perspective.
The industry is embarking on the build out of cleaner, more efficient generating fleets. Given the contentious environment that seems to plague all innovation, there can be no guarantee of full cost recovery, but careful planning can reduce the likelihood of a significant disallowance.
Randall L. Speck, David L. Cousineau and Chimera Bowen are attorneys in Kaye Scholer LLP’s energy regulatory and litigation practice. They have represented utilities and state commissions in prudence proceedings at state and federal levels. Reach them at 202-682-3500 or email Speck at rspeck@kaye scholer.com, Cousineau at dcousineau@kaye scholer.com, and Bowen at email@example.com.