2013 Utilities Industry Perspective
published December 13, 2012 | by Christopher Dann, Todd Jirovec, and Tom Flaherty
Superstorm Sandy made the challenge for public utilities clear: They must take advantage of a historic economic moment by investing in infrastructure and next-generation capabilities.
Although the presidential campaign held the attention of utility executives during the last half of 2012, it appears that the destructive power of Superstorm Sandy is likely to have just as much impact on the industry in the years ahead. The aftereffects of the storm that knocked out power to 10 million people in the Northeast will include new regulatory and media scrutiny of the utilities’ ability to withstand and respond to weather catastrophes.
Meanwhile, the reelection of President Obama means utilities can expect more of the policies he has pursued, along with a continued divergence among priorities at the state and federal levels. Under the Obama administration, the Environmental Protection Agency (EPA) is likely to keep pressing utilities about emissions, while state regulators focus on basic reliability and costs.
Fortunately, these challenges come at a time of historic opportunity for the industry. During the past few years, an unprecedented convergence of low costs of capital and pent-up infrastructure demand easing rate pressures have created ideal conditions for building the electric and gas utilities of the future. But these conditions won’t last forever; several variables, including an economic upswing, could upend the dynamics quickly.
Nevertheless, we expect low interest rates and electricity prices to persist through 2013. Now is the time to invest in the capabilities and assets that will provide the foundation for strong performance over the next 50 years. The challenge for executives is picking investments that make sense in light of Superstorm Sandy, the election, and other long-term factors that will influence returns over the next several decades. Here we present the considerations affecting utilities’ investment choices, and the capabilities they will need to emphasize to prosper in the years to come.
Even before Sandy, a string of severe storms in recent years raised the stakes when it comes to disaster preparedness and response. Utilities must show policymakers, regulators, and the general public that they’ve learned the lessons of Sandy, by investing in new approaches that will keep the lights on when winds blow and waves rise.
To be sure, there’s only so much a utility can do to “harden” its infrastructure against the 14-foot surge of a storm like Sandy. But utilities can and should enhance the resiliency and “self-healing” capabilities of the grid by investing in digitization and broader automation. The storm also demonstrated how the industry has improved its capacity for coordinated action when storms hit, marshaling resources from many companies and deploying them where they’re needed most—and how it can and should improve that capacity still further.
As the industry bolsters its readiness for natural disasters, it must also prepare for another four years of an Obama administration. President Obama has encouraged the development of renewable energy sources and smart-grid systems, though the subsidies he provided for these technologies in the stimulus program are largely exhausted. Still formidable, however, is the EPA, which has over the last four years pushed for tighter emissions controls at electric power plants. As noted earlier, this federal emphasis on renewables and carbon emissions runs counter to an increasing focus on reliability and costs by state utility regulators.
President Obama’s reelection also has potential financial implications for utilities and investors. If tax rates on dividends rise, utility stocks could become less attractive to investors, raising the cost of capital for new infrastructure investments—just when it is most needed. Although comprehensive tax reform could lower corporate rates, this benefit will be offset by the impact of changes in individual rates and capital gains. It is important to recognize that taxpayers are also electricity customers, and lower distributable income affects both power and gas demand.
This year, utilities have a once-in-a-generation opportunity to build new infrastructure that will drive better performance and returns for decades. They should take advantage of this opportunity now, before conditions change.
Capital expenditure requirements across the U.S. utility industry are expected to exceed US$100 billion annually through 2020. This represents an increase of 100 percent over the annual costs of the early 2000s, according to Edison Electric Institute. For years the industry spent relatively little to upgrade basic infrastructure, much of which dates back to the 1970s or 1980s. Aging assets now must be repaired, improved, or replaced. The good news is that these expenditures can drive earnings growth for regulated utilities, if they choose their investments wisely.
Although the “bonus depreciation” and smart-grid subsidies of the economic stimulus act are over, costs of capital have never been lower. Rock-bottom interest rates have reduced the cost of raising this capital—hundreds of billions of dollars—needed to build the digitized infrastructure that will reshape the industry in the next few decades.
For example, Duke Energy recently floated five-year bonds at a rate of 1.625 percent. At the same time, utilities are feeling less rate pressure from regulators and politicians as low natural gas prices bring down consumers’ electric bills. The lower price of natural gas, along with low inflation, has created headroom to add big infrastructure investments to the rate base if benefits to customers are clearly demonstrated.
Deciding how to allocate capital among a wide array of new investment opportunities will be the central challenge facing utility executives in 2013 and the next several years. A range of political, economic, and technological variables complicates these investment decisions.
For example, investments must strengthen the core capabilities of the company, while taking full advantage of the technical advances that are transforming every aspect of the utility industry. At the same time, they must dovetail with, or at least avoid conflicting with, the priorities of regulators and elected officials who establish the return on these investments in their role as the steward of customer rates. Finally, capital invested today must position the company for future industry cycles, when electricity demand and natural gas prices are likely to be much higher than they are today.
Policy cross-currents. As always, utilities must make sure their investments are deemed prudent by state regulators. Regulatory preferences, of course, track the policy priorities of the elected officials who appoint utility commissioners. Therefore, political power shifts in states across the country will continue to influence the investments likely to win regulators’ approval.
As prevailing political sentiments are in flux, U.S. utilities face a high degree of long-term regulatory uncertainty. The country still lacks a comprehensive energy policy, and appears unlikely to adopt one in the foreseeable future. Utilities, despite the national or regional scope many have achieved in recent decades, will operate under the prevailing patchwork of state-by-state regulations reflecting a smorgasbord of local priorities.