Natural gas prices are predicted to remain low over the next two decades, albeit not as low as today's price just under $2MMBtu, while the only way is up for electricity retail prices.
You'd think that gas-fired power plants would be a no-brainer for investors looking to put long-term dollars to work in the power generation sector - even if the US introduces a price on carbon by the 12th of never, natural gas is far cleaner and less of a risk than coal.
But betting on natural gas as a non-volatile commodity is a high-risk strategy, according to a new report published this week by Ceres, which did a lot of work last year to lobby for even more stringent CAFE standards for vehicle fuel economy.
Practicing risk-aware electricity generation: what every state regulator needs to know sets out the challenges facing the energy industry in the US. Unlike other sectors, it is regulated to balance the needs of investors who want returns, utilities who want to make money for their shareholders and consumers who need to be protected from price shocks in electricity prices.
These interests compete with each other in a context where the US has huge imbalances in the power sector: the country already has a legacy of overcapacity in gas-fired power generation in some regions thanks to a build-out campaign in the last decade (see figure above); coal-fired power plants in the rustbelt east are already likely to be phased out in favour of more gas generation thanks to EPA regulations; nuclear power plants around the country are approaching the end of their licence periods; and renewables are becoming disproportionately expensive compared with cheap natural gas-generated electricity.
"These challenges call for new utility business models and new regulatory paradigms. Both regulators and utilities need to evolve beyond historical practice," says the report. "About 70 percent of US electric generating capacity is at least 30 years old," says the report. "Much of this older capacity is coal-based generation subject to significant pressure from the Clean Air Act (CAA) because of its emissions of traditional pollutants such as nitrous oxides, sulfur dioxides, mercury and particulates."
Investment in transmission has also failed to keep pace with demand and technology, with some U.S. transmission facilities approaching 100 years old, it says.
Utility investment in transmission facilities slowed significantly from 1975 to 1998. In recent years, especially after the creation of deregulated generation markets in about half of the U.S., it has become clear that the transmission deficit will have to be filled.
One of the questions posed by Ceres in this report is: does the US want to bet the farm on yet more gas-fired generation? Clearly the answer is no.
Ron Binz, report co-author, president of Public Policy Consulting and former Chairman of the Colorado Public Utilities Commission, said: "Utilities, regulators and customers are entering what's going to be the most uncertain, complex and risky period in the history of the electric power industry.
"We have relatively flat load growth and that's predicted to continue for quite a while that makes capital to the utility system a lot more important to rates there's going to be a lot of upward pressure on rates and all of the intended effects that that creates in the economy and the politics around regulation."
The report estimates that the net asset value of the plant in service for all U.S. electric utilities in 2010 was about $1.1 trillion, broken down as $765 billion for IOUs, about $200 billion for municipal (publicly-owned) utilities (or “munis”), and $112 billion for rural electric cooperatives (or “co-ops”).
It cites the Brattle Group report in 2009 which predicted that total industry-wide capital expenditures from 2010 to 2030 would amount to between $1.5 trillion and $2.0 trillion.
"If the U.S. utility industry adds $100 billion each year between 2010 and 2030, the net value of utility plant in service will grow from today’s $1.1 trillion to more than $2.0 trillion— a doubling of net invested capital," the report says.
But utilities will struggle to raise large volumes of capital required as their balance sheets droop because of flat demand and the erosion of their creditworthiness since the 1970s and 1980s - there are now no triple A rated utilities in the USA.
"The financial metrics of the utilities going into this build cycle are much weaker than they were when the last build cycle occurred," said Binz. "We had some triple A rated utilities and a lot of double A and single A utilities back in the 70s and 80s the average rating was in the range of a this time around it's around the B triple B range, two or three clicks lower than it was before. That puts the utilities much closer to the boundary of non-investment grade ratings."
Denise Furey, report co-author, and principal of Regent Square Advisors, said that a diversified fuel mix is a credit positive for a utility.
"A sizeable negative event will have an impact on the utilities credit ratings and the market appetite for its bonds which will result in turn in an increase in the cost of capital.
"The problem with natural gas and anything that is commodity based like this is that the price of it is a short-term price and we can't hedge very far out.
"A portfolio with diversified fuel mix reduces risk the sector is looking to build new generation assets currently the price of natural gas makes gas-fired generation look optimal. However, gas power plants have long lives and conversely the price of natural gas used constantly relying on current natural gas prices as predicted in long-term trends is pure folly. A mix of asset types including renewables is really optimal.
But beyond the regulators attempts to rein in rates for consumers, the social contract in the energy industry extends much further. Some 65% of utility equities and fixed income securities are owned by institutional investors such as insurance companies, mutual funds and pension plans while most retail investors own utility stock and bonds indirectly through mutual funds and 401k plans.
More than any other industrial sector, if utilities do well, everyone is a winner from the investment fund managers to the pensioners who have the potential to win twice on regulated rates and a comfortable retirement.
The utility industry is not yet being dismantled one residential rooftop solar panel at a time, but managers, utilities and regulators know that business models cannot stay the same over the next 20 years.
Regulators will play an essential role in playing referee in the long game to come in the energy sector.
Sue Tierney, managing principal at the Analysis Group and former Massachusetts Public Utilities Commissioner, said:
"What signals do regulators and policy makers send to private decision makers about what matters? Regulators often inject other measures of what matters in utility investment decisions.
"As we look across the US there are parts of the country that are in competitive markets where investors in new power generation technology are merging or competitive players and they are not making decisions based on guidance from regulators about what they may or may not invest in. In those markets we're highly likely to see gas generation dominate.
But west of the Rocky Mountains the regulated energy markets could look very different, she said: "Those are the parts of the country that are being addressed in this report where regulators can put a different non-market orientation onto the decisions at utilities managers where to invest."
"There is likely to be a different role for diversification, hedging for fuel risk … so those decisions are being made by shareholders and managers of merchant companies."