Uncertainty, Declining Revenue and Cash Conservation Concern Utilities

2009 Electric Utility Capital Expenditures

by Teresa Hansen, editor in chief

Just two years ago, energy experts warned that the electricity industry needed new generating and transmission capacity to keep up with the growing demand for electric power. In addition, fuel prices were higher than ever and manufacturing bottlenecks were prevalent, especially in the renewables sector. The industry had accepted that climate legislation was inevitable and it was anxiously awaiting clear direction from lawmakers.

In 2009, a deep recession changed the immediate need for new generation capacity as demand for electricity declined. A new president added more uncertainty to future climate change legislation. Cash availability became the No. 1 issue for most utility executives, prompting them to cancel and postpone investments to conserve it.

Last year’s electric utility capital expenditure article reported that the uncertainty utilities faced in 2007 and 2008 would continue in 2009. That prediction was and remains true for 2010.

As in years past, Electric Light & Power turned to an expert with Booz and Co.’s energy practice as its source for this article. Tom Flaherty, a partner with the company, revealed the biggest utility challenges in 2009 and what he expects in 2010.

No. 1 Issue Going Into 2009: Cash Availability

“Financeability was a big concern in late 2008 going into 2009,” Flaherty said. “The thinking in late 2008 was to cut back on spending and hoard cash because it would likely be hard to get. Going into 2009, cash was the only thing that was important to strengthen the balance sheet.”

In the first half of 2009, utilities focused on avoiding future investment, which they could do by following the recession. With the recession came a decrease in electricity demand, so utilities were able to postpone a lot of their planned capital spending for new capacity.

Things changed in the second half of 2009, Flaherty said. Cash was more available to adequate credit borrowers than was anticipated earlier in the year. The markets opened up for qualified borrowers, including most utilities.

No. 1 Issue Going Into 2010: Climate Change Policy or Not

In the second half of 2009, utilities’ focus shifted from obtaining capital to determining how future policy would impact capital flow.

“A lack of policy direction is quite possibly the biggest issue utilities will face in the coming months,” Flaherty said. “Utilities are in a worse place in 2010 than they were in 2008 or 2009. Utilities were expecting regulation to be enacted by now, however, there is less predictability going into 2010 than there was in 2008 and 2009. Utilities are still waiting on guidance and requirements, but they aren’t getting it.”

This lack of certainty makes it hard for utilities to predict spending and investment requirements. Utilities cannot, however, stand still and wait for legislation. The industry must make some “no-regret” decisions, Flaherty said.

“Companies must select a path, without sufficient guidance, quickly enough to make future investment decisions and strategic choices,” he said. “They are in the worst of all places. They can’t see the end-of-game rules that will dictate what decisions need to be made in the short term and they also can’t wait on the specificity they desire.”

A greater concern than the absence of legislation is the possibility that the U.S. Environmental Protection Agency (EPA) may step in and mandate greenhouse gasses and carbon restraints.

In December 2009, in response to the 2007 U.S. Supreme Court decision that greenhouse gases fit within the Clean Air Act definition of air pollutants, the EPA declared that greenhouse gases threaten the public health and welfare of the American people. While these findings do not impose any emission reduction requirements by themselves, most experts have said the announcement indicates the EPA is ready to regulate greenhouse gases if Congress fails to act.

“This could be disastrous for utilities because the EPA doesn’t really look much at cost incurred vs. benefits received when making rules,” Flaherty said. “It tends to focus primarily on meeting its objectives and nothing else.”

President Barack Obama and EPA Administrator Lisa Jackson publicly support climate change legislation. The Obama administration, however, has done little on that front.

“The issue is not what the Obama administration has done during its first year in office, but instead what it hasn’t done or may not do,” Flaherty said. “This lack of action is really impacting utilities by making it difficult for them to know what to do.”

Taxes and Interest Rates

Other areas where utilities seek the administration’s guidance are tax policy and capital cost, or interest rates.

“How dividends will be taxed will affect investment in utilities,” Flaherty said. “And at some point interest rates are going to go up. The U.S. is printing money like there are no limits.”

Flaherty said the cost of capital must go up because money is being provided much too cheaply when compared with risk. For a capital-intensive industry such as electric utilities, an interest rate increase will ripple through to customers.

Fuel Prices and Baseload Generation

Last year’s article predicted continued coal price declines in 2009 as demand for steel and other commodities declined. This prediction was also correct. All fuel prices declined in 2009 as a result of supply and lower demand, however, a floor for all fuel prices was established during 2009, Flaherty said.

“Prices will begin to rise above that floor,” he said. “This is already occurring with natural gas, which bottomed out and is now beginning to creep back up. Other fuel prices, including coal, will creep back up over the near term.”

Coal prices are the most uncertain, however, because of the lack of legislation. Extreme greenhouse gas regulation could cause coal demand to decline, creating substantial coal oversupply for the foreseeable future.

Capital investment, or retirement, decisions on coal-fired generation are already being deferred because of the unknowns associated with greenhouse gas regulation coupled with decline in electricity demand. Demand decline also postpones the need for new, large baseload coal capacity. In addition, some utilities are retiring older coal units rather than investing in scrubbers and other cleanup technologies. Coal will remain low-cost as long as these types of decisions are made.

While fuel costs are a lesser concern for nuclear generators, capital investment decisions for new nuclear units are being postponed. Nuclear units are expensive and built to provide large baseload capacity. Demand decline has allowed many companies to delay or postpone their decisions regarding new nuclear power plants.

“Some new units will be built for 2016-2017 start-up, but most previously announced plans are going to slip out to 2020,” Flaherty said. “These decisions are driven by absence in demand, not adverse policy. Extreme EPA rules on greenhouse gas emissions could, however, accelerate nuclear plant decisions.”

Clean Technologies

Last year’s article predicted that clean technologies including renewable energy, energy storage and smart grid would be a 2009 theme.

“Clean tech was more than a theme in 2009,” Flaherty said. “It went from a theme to a campaign, incented by the ARRA (American Recovery and Reinvestment Act) and political rhetoric.”

Energy storage was the exception. It is still in its infancy, Flaherty said.

ARRA money encouraged multiple people to accelerate plans, make plans or both, he said. ARRA didn’t cause companies to turn to smart grid or renewable energy, but it caused them to adjust their plans so they could participate, meet the program’s requirements and take advantage of the money.

As for renewables, Flaherty said late players in the utility sector are rethinking their approaches and the merits of participating. Many large utilities wonder how to take advantage of renewables when the amount of capacity renewables can contribute to their overall generation needs is so small. For many, it amounts to dabbling in renewables, which is a distraction, especially this late.

Large utilities that are not mandated by state renewable portfolio standards (RPS) to install renewables and have not begun large-scale renewable projects—most in the southeastern and southwestern U.S.—probably are not going to move into renewables in a fashion as significant as the early movers. Much of the state RPS legislation passed to date has not defined well what is considered renewable and clean-tech, for example new nuclear, which sub-optimizes the original objectives.

Although ARRA did not cause many utilities without planned clean-tech projects to enter the clean-tech sector, it provided incentive for companies other than utilities to enter the space.

“They are too numerous to count,” Flaherty said. “Large companies have formed renewable divisions, and many small start-up companies have entered the space with private capital. The absence of policy did not discourage clean tech. In fact, it provided opportunities for it.”

It is becoming harder to get venture capital for clean-tech start-up, Flaherty said. He expects this should soften, however, in 2010.

“The concern about available capital in the first part of 2009 was a dampener, but not a stopper, for clean tech,” he said.

Mergers and Acquisitions

Last year’s article asked whether 2009 would see a lot of asset turnover and investor-owned utility (IOU) consolidation. It did not.

“There have been plenty of nods and winks at the company level, but they haven’t led to anything beyond that,” Flaherty said.

Asset turnover and mergers and acquisitions (M&A) activity can be addressed in two parts, he said.

One part involves selling properties, such as generation assets. This type of activity slowed in 2009 with the decline in demand for new capacity and the need for new load. The other part of M&A activity involves IOU consolidation, which has been dampened by uncertainty.

“The uncertainty about carbon legislation has made it very difficult to evaluate the worth of assets,” Flaherty said.

He said M&A are important to the energy industry for three reasons. These were important in 2008 and 2009 but are acute today. They are:

  1. Strong balance sheet. Consolidation will allow utilities to strengthen their balance sheets. Utilities need strong balance sheets that allow them to borrow money for sustained levels of capital investments and other business decisions. They also need flexibility to respond to upturns and downturns and manage through periods of uncertainty. This requires a healthy balance sheet, which can be advantaged through bulking up.
  2. Strong portfolio. Utilities need to mitigate business and operation risks based on strong portfolios. Many utilities own a variety of legacy assets that may not make sense to hold in the future. Rationalizing the current portfolio of assets and properties offers utilities the opportunity to monetize value that may be locked up, while improving the positioning of the remaining business. More important, a stronger business may come from a combination with either advantaged or complementary assets that will reshape the company’s risk profile. To win in the future, utilities must think about how to build a balanced portfolio that accentuates high-performing assets and mitigates risks from those that underperform.
  3. Adequate bench strength. The future also will require utilities to shift their focus toward long-term business stewardship and strategic positioning. Many utilities’ upper-management organizations do not have sufficient talent depth to support the nature and range of future strategic vs. operational roles. In other words, the management model needs to mature beyond the short-term operations- or regulator-focused models prevalent today. Boards of directors often must look outside their companies and the industry for qualified upper-management candidates. The shape of utilities has changed, and the type of people needed to lead them is changing. Management must understand the burgeoning intelligence that will be available within tomorrow’s electric system. It needs insight about more dynamic, two-way networks that will come with the maturing smart grid, which will be different than managing traditional one-way systems.

Stimulus Money

For much of 2009, many utilities worked to complete their ARRA applications for stimulus money. They then awaited the Department of Energy’s (DOE’s) announcement identifying the recipients.

Flaherty said, however, that stimulus money has made little difference for utilities. Loan guarantees and funding awarded to utilities has had little impact for a couple of reasons. First, few loan guarantees have been issued and companies are still waiting for the funding.

“Although the DOE has identified the stimulus money recipients, the actual cash will follow the investments still to be made by companies,” he said.

In addition, Flaherty said the amount of money being awarded to the recipients—$200 million maximum to the largest utilities—is helpful, but not an end in itself.

“It is not enough to impact a utility’s need for or commitment to its programs,” Flaherty said. “The stimulus awards provided a backstop to many utilities that already had project plans.”

Loan guarantees, however, did impact smaller companies, he said. Stimulus money for loan guarantees made a difference on whether companies moved ahead, especially those in new space.

“These loan guarantees will allow weaker-financed companies to go ahead and enter and remain in the clean-tech sector,” he said.

Utility Stocks in 2010

After leading the Standard & Poor’s 500 Index for four years, utility stocks lagged it in 2009. According to a Jan. 6 Wall Street Journal article, “A Classic Dividend Play,” in 2009 utility funds were the weakest performers among 21 U.S. stock categories tracked by Morningstar Inc. They returned just 18 percent during the year when the S&P 500 Index returned more than 26 percent.

Flaherty said that one question must be answered when considering utility stock values.

“What do you measure against: the high point or the trough?”

Although utility stock values and earnings are still considerably lower than their pre-recession highs, Flaherty said they still perform well when compared with the Dow Jones and the recovery as a whole.

Predicting how utility stocks will perform is difficult. Some experts say the likelihood of higher interest rates and uncertainty around greenhouse gas regulation will hurt the industry during the next few years.

Flaherty agrees and said that utility values also will be tied to how regulators respond to requested price increases.

“I anticipate that utilities will have less success in getting rate increases in 2010 and 2011 than they’ve had in previous years,” he said. “Success in this single area, or lack of it, will ultimately impact stock value.”

Reduced Revenues and Capital Spending in 2010

According to the latest data (January 2010) from the U.S. Energy Information Administration, October 2009 marked the 15th consecutive month that net generation in the United States fell from the same period a year earlier.

This decline impacted utilities’ investments and capital spending plans.

Revenue from U.S. electricity sales has decreased 4 percent overall and 13 percent from industrial accounts, Flaherty said, but this decline bottomed out in late 2009.

“The recession and this reduction in revenue have resulted in approximately an average 15 percent reduction in utility investments, beginning in late 2008 and continuing into early 2009,” Flaherty said. “Nearly all utilities reduced investment.”

Besides the recession, weather impacted revenue.

“The summers of 2008 and 2009 were mild,” Flaherty said. “This impacted utilities’ cash flows and revenue also. The mild summers, coupled with the recession, had a large impact on utility earnings.”

While reduction in utilities’ investments is the result of less cash flow, it is also a result of the level of required investments for new capacity being extended because of reduced demand.

“Investment in new baseload capacity is being pushed out,” he said. “In 2010, investment patterns by utilities will be more stable. While the average investment by all utilities will still be mostly flat, some utilities are actually spending at higher levels than 2009.”

Many experts expect a long time before electricity demand reaches pre-recession levels. Flaherty agrees.

“I don’t think we’ll see the level of pre-recession capacity utilized in the industrial sector until 2012 or 2013, maybe even 2014, however, it won’t take much of a turn up in the industrial sector to see a turn up in demand that the industry could be unprepared for,” he said.

Flaherty predicts the real economic recovery will begin in the second half of 2010 and will really get underway in 2011, which will be the better year for utilities.

What’s Next?

“The road to recovery begins in third quarter 2010,” Flaherty said, “but the economy still has some less than attractive days in front of it.”

He predicts that interest rates will increase, natural gas prices will increase from $4 to $6 in the next year, on up to $7 in a couple of years, and utilities will consolidate to strengthen balance sheets, become more flexible and gain the bench strength needed to make plans for the future.

Flaherty said the biggest issue for utilities will be future planning with no clear rules on greenhouse gas emissions.

The industry will retire more coal plants in lieu of adding capital investments needed to clean them. But that doesn’t mean coal-fired generation will go away.

“Utilities must continue to use coal to keep balanced portfolios,” Flaherty said. “The industry and our country cannot walk away from a 200-year-plus coal supply.

“We absolutely need it for baseload generation. The industry must invest in developing new clean coal technologies, but it will do so only if the government contributes to that technology development.

“The industry will need government incentives for clean coal for some time. The industry can’t afford the price volatility of natural gas, and new nuclear baseload is too far off.

“A backlash from lack of defined regulations and unrealistic expectations will occur.”


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