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."
