2013 Outlook on Power & Utilities
My take: By John McCue
Emerging trends in the U.S. electric power sector are challenging conventional wisdom about where the industry may be headed, prompting companies to reassess strategies and consider new business models. Two trends worth spending some time considering are:
- Continued requirements for heavy capital expenditures to replace aging infrastructure and modernize the grid, reconfigure the power generation portfolio and meet evolving environmental regulations
- Moderating or even declining U.S. electric demand as slow population growth, energy efficiency, conservation and more “resourceful” commercial, industrial and residential consumers have noticeable impacts on historical consumption patterns
Together, these trends lead some industry executives to suggest “the math doesn’t work” — that these heavy expenditures, when spread over low or no-growth consumption, will lead to either large cost increases and/or severe industry financial difficulties.
However, other factors such as abundant domestic shale gas, evolving regulatory mechanisms, merger and acquisition (M&A) transactions, technological advancements and innovative business models hold promise for ensuring the industry can maintain its financial health over the long term.
Key trends to watch in 2013 (and beyond)
Increasing capital expenditures and costs: The electric utility industry is facing significant financial pressure as capital spending rises with requirements to upgrade aging infrastructure, deploy smart grid technology and comply with new environmental regulations, renewable portfolio standards and nuclear plant safety mandates, among other initiatives. The power industry faces a number of federal regulations or proposals that boost costs and inject uncertainty into the planning process.
Environmental Protection Agency (EPA) regulations, if upheld by the courts, will require power companies to retrofit or retire coal plants, alter cooling water intake structures, dispose of coal ash differently and limit carbon emissions. Evolving North American Electric Reliability Corporation (NERC) standards require increased investment in reliability, and new and proposed Nuclear Regulatory Commission (NRC) regulations mandate additional nuclear power plant safety standards. As a result, capital expenditures in the U.S. over the next 20 years are expected to cumulatively total well over $3 trillion, spent primarily on environmental compliance, investment in transmission and distribution infrastructure, new generation capacity and the introduction of advanced technologies to the overall power system.
Moderating demand: The demand for electricity appears to be moderating and potentially even declining in the U.S. (and most of the developed world), not just due to a slow economy, but also due to real changes in consumer attitudes, stricter building and appliance efficiency standards, conservation program implementation, a focus on sustainability and corporate social responsibility, and an emphasis on demand management. The Deloitte reSources 2012 Study found that 83 percent of consumers took steps to reduce their electric bills over the past year, up from 68 percent in the reSources 2011 Study. U.S. businesses, on average, are targeting reductions in energy consumption of 23-24 percent over a three-to four-year period across electricity, natural gas and transportation fleets. Deloitte’s survey indicated that companies are increasingly recognizing the value of an energy management strategy as key to competitiveness — a trend that is likely to grow.
Making the math work
“In the coming year, we expect companies to continue seeking ways to test and even break through existing constraints — such as company and industry structure, geography or mindset — as they strive to make the math work in today’s challenging business climate.”
Natural gas fuel cost relief: Burgeoning supplies of shale gas sent U.S. natural gas prices plunging to 10-year lows in 2012, which, combined with stricter environmental regulations, continued shifting power generation from coal to natural gas. While the U.S. Energy Information Administration (EIA) sees this trend slowing due to a projected uptick in natural gas prices, some see the trend continuing longer term. Because fuel traditionally comprises 40–50 percent of a customer’s total electric bill, a decrease in generation fuel costs can dramatically impact the overall cost of delivered electricity, as well as provide more flexibility to shift spending toward the previously mentioned capital expenditures without having to substantially increase rates.
Natural gas prices have been one of the few costs to decline for power and utility (P&U) companies, and many have passed these fuel cost decreases through to customers. As long as prices stay low, natural gas will often win the competition with renewables and nuclear power in utilities’ decisions to add generation capacity. Many utilities will still choose to diversify energy sources by investing in renewables, although expiring government incentives and lack of financing instruments continue to cast a shadow on the sector. The nuclear power industry continues to struggle with high initial construction costs, potentially exacerbated by looming safety mandates.
Innovative regulatory policy: Regulated electric utilities look to state or federal regulators to approve rate increases so they can recover operating and capital investment costs. In response to lower sales volumes, higher costs and requirements for increased energy efficiency programs, utilities are filing a greater number of rate increase requests. With the inevitable regulatory lag and consumer response, public utilities and their regulators are adopting regulatory practices to supplement the traditional cost of service (COS) approach. These include mechanisms such as multiyear rate and revenue caps, expanded use of cost trackers and inclusion of construction work in progress in rate base, among others.
State regulators have introduced policies to promote more renewable energy supplies, provide higher reliability levels and introduce greater energy efficiency. This has resulted in some regulatory approvals for smart grid technologies, distribution system upgrades, demand-side management programs, feed-in tariffs for renewable energy and dynamic pricing and net metering.
Utilities will likely continue to work with their regulators toward mutually acceptable solutions if costs continue to rise while demand and consumption moderate.
M&A: Although in a deep freeze during the financial crisis, M&A activity for public utilities recovered during 2011-2012 with a series of mega-mergers as utilities strived to gain financial strength by harvesting the mergers’ economies of scale and scope. Companies generally looked to combine into larger, financially stronger regional public utilities with reduced risk profiles, reduced costs, stronger balance sheets, more diversified state regulatory risk and an enhanced ability to execute large capital investment programs. They sought to grow rate base and provide more stable, predictable earnings.
M&A activity will likely continue, but some power companies will be put off by the long and sometimes arduous regulatory process, which has been the toughest hurdle for recent mega-mergers. State regulators have tried to extract maximum benefits for their rate payers and maintain in-state jobs. Companies with less appetite for this process may turn to asset purchases instead, as in the case of utilities looking to acquire renewables capacity to meet their renewable portfolio standards (RPS
Technology and innovation: Lower fuel costs, an evolving regulatory framework and advantageous M&A deals can help power and utility companies make the math “work,” but in some cases, something more game-changing may be required. Increasingly, the industry will look toward technological advancements and innovative business models to provide solutions. Energy companies now rank among the most important, and sophisticated, technology companies in the world.
In the P&U sector, companies have made notable breakthroughs in energy management technology, renewable and alternative energy, and energy storage. Analyses of new data provided by smart grid technologies such as smart meters, advanced meter infrastructure and distribution automation are helping utilities better understand their customers, improve customer service and explore ideas for new services. Utilities are testing new business models, such as ownership of solar panels on customer rooftops or electric vehicle (EV) charging stations in public garages, or encouraging the “electrification” of some industry segments that may have historically relied on other sources of energy. Some are offering these services beyond their own service territories or specializing in areas such as Demand Response and offering software or programs to other utilities. Utilities have not historically had an entrepreneurial mindset and are not capitalized to invest in technology for returns that may not materialize in the short or even longer term. In response, some are partnering with investment firms to help start-ups with commercialization challenges by facilitating pilot programs, demonstrations and test beds.
Power and utility companies are currently caught between moderating electric demand and the requirements for increased capital expenditures – a situation that challenges historical business models. In the coming year, we expect companies to continue seeking ways to test and even break through existing constraints – such as company and industry structure, geography or mindset – as they strive to make the math work in today’s challenging business climate.
As used in this document, “Deloitte” means Deloitte LLP [and its subsidiaries]. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting.