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.
Even if policies change in Washington, states are likely to pursue their own agendas. The same election that gave President Obama four more years also brought the number of Republican governors to 30, promising a sharp divergence in policy perspectives at the federal and state levels.
For example, recent years saw a surge of support among federal and some state policymakers for investments in smart-grid upgrades to utility transmission and distribution systems and renewable fuel technologies. But that support has been dwindling in many states and localities. Regulators (and consumers) have been skeptical of the benefits of “behind the meter” smart-grid technologies, such as enabling customers to control power usage. Similarly, the high cost of renewable energy has some policymakers balking at requiring consumers to purchase pricier electricity from renewable sources at a time of economic hardship.
Meanwhile, as ancillary investments lose favor, regulators are refocusing on the utility’s core mission of providing electricity safely, reliably, and affordably. Recent events such as the nuclear power-plant failure in Japan and the powerful storms causing widespread outages in the U.S. reinforce these concerns.
This trend suggests that utilities will reap better returns from investments that strengthen their essential capabilities. At the same time, Superstorm Sandy could be the catalyst for wider deployment of upgrades to the grid—by demonstrating the need for technology that could help restore power more quickly by providing better information to field crews during mass outages.
The risks of recovery. The favorable investment climate for utilities stems largely from the sluggish economic growth that has plagued the U.S. since 2008. Interest rates are at historic lows because the Federal Reserve needs to stimulate growth. Natural gas prices continue to remain low, because anemic economic growth has slackened demand.
There’s no doubt that these conditions are good for regulated utilities, whose earnings are not dependent on market power prices and which feel less regulatory pressure when prices are low. The opposite is true for merchant power generators, whose profits rise and fall with gas prices.
Executives at utilities should avoid getting too accustomed to the current economic environment. Although dramatic change isn’t likely in 2013, history shows that prices can rise quickly when conditions shift. For example, natural gas prices shot up 500 percent between the late 1990s and their peak in 2005.
In the short term, an economic recovery could lead to higher interest rates, gas prices, and electricity rates. The current favorable investment climate would give way to conditions that make it more difficult for utilities to finance new infrastructure. Higher costs of capital make projects more expensive, while rising electricity bills make regulators reluctant to approve new investments.
Over the longer term, these variables will fluctuate with the economic cycles. Executives should keep this in mind as they contemplate 50- to 60-year investments in new infrastructure. Investments should enhance the core performance capabilities that generate strong returns in any economic or pricing environment.
New digital technologies give utilities the tools to build systems that are more resilient, intelligent, and responsive. These technical advances will improve efficiency, reliability, and productivity. They also set the stage for a new utility business model. Utilities in the future will become larger, leaner, and more performance-driven. An explosion of data (and insight) from new technologies will drive long-term strategy and day-to-day decision making.
As executives weigh investment choices today, they should consider the capabilities their company will need to capitalize on these technologies, and build a best-in-class operating model for the future. The capabilities each company needs will vary based on the strategy it chooses. For example, some will opt for a low-cost, core utility model, whereas others will adopt a customer-centric, retail-oriented approach.
Whatever your strategic focus, your company will need suitable capabilities in four key areas:
Transmission and Distribution Delivery
Utilities have a rare opportunity to invest in 21st-century electrical systems. Choosing the right investments is critical, as executives must take into account shifting regulatory policies, new technological options, and potential economic changes. Amid such uncertainty, investments that advance the utilities’ core mission of providing safe, reliable, and affordable power are most likely to pay off over the long term. In making these investments, utilities should aim to enhance the capabilities that serve their broader corporate strategies.
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