The Paris Climate Accord: What’s Next for Utilities
Now that the Paris Climate Accord has been signed by the who-is-who of the world polluting powers, the globe can sigh in relief. But stop, not so fast! What really has changed? Countries agreed to a below 2 degree Celsius compared to pre-industrial levels. The New York Times assessed the main implications as “more ambitious” than ever before. Protection of forests will be incentivized (higher taxes) , transparency will be established to evaluate countries’ adherence to targets, signatory states are encouraged to reach peak emission as soon as possible (exploit the current regime before the good times end) and a system of transfer payments to the most impacted island nations at sea level is in the making.
National Geographic indicated that this will bring upon a surge in low-carbon systems (nuclear, renewables).
So what does this mean for a European or North American utility visiting Paris? How will it adapt their business model and growth plans to support the ever expanding need for power? After all, populations grow, urbanization drives 60% of the globe’s population into cities and countries like India, China, Brazil, etc. create massive middle-classes as they industrialize.
Let’s look into the past to see what’s next. Back then, utility executives vowed to halt or at least limit plant expansion or new construction despite increased load requirements to protect investors’ return from the plant investment. After all, the cost plus pricing model is rather sensitive to short term changes in regulations, e.g. to adhere to various carbon regulation in light of long cycles to build and amortize massive plant investment.
Regulators wanted to counter this lack of capital investment with incentives (tax, loan, regulation). In the Eighties, investors only looked at the returns exceeding the cost of plant expansion. Nowadays, utility investors need to subscribe to the formula that the financial return exceeds the cost of capital employed in the construction and operation of a plant, not the actual plant investment. (Kihm, 2014)
Back then, the cost of debt and equity (typically 3-4% above debt due to a higher degree of risk) was very high and tending upwards hovering between 8 and 10% for the better half of this period. Utility bond yields were therefore trending in that same band. Plant construction cost increased to more than four-fold as government incentives persuaded utilities to expand. The cost for the required debt level had to be passed on to consumers, which reflects the sharply increasing producer price index (PPI), which increased two-and-a-half fold over the same period. Investors became increasingly worried if they would see a positive return.
As incentivized capacity expanded and consumer prices moved in lock-step to support high levels of debt; utility book value, earnings and dividends grew. (Moody’s Public Utility Manual) Back then, investors were willing to pay somewhere between 80%-200% of book value. Today we are at about 140%. However, despite a fairly health valuation, the stock prices fell in the Eighties by about half during the same period, despite disallowances (i.e. expiration of deductions).
So what does this have to do with the utility industry today and data, you ask? Well, follow me on this yellow-brick road, Dorothy.
The Paris Accord, to bring it full circle, will undoubtedly entice regulators to start incentivizing utilities to invest in the construction of carbon-neutral energy systems using tax and loan schemes; a repeat of Eighties’ policies. It will also levy taxes and penalties on market participants not adhering to set goals, which will be passed to the consumer, reflected via an increase PPI….like in the Eighties.
Investors with a longer memory and horizon, required to operate successfully in this sector, will remember the above story and ask themselves: Should I invest in a utility building new plants or one, which buys-in capacity? After all, construction and operational cost (including shut-down provisions for nuclear facilities) are amortized over decades but regulators are quick to introduce carbon taxes and similar instruments driven by the new climate regime. The immediate allocation of higher risks on the financing side does not mirror regulatory rate case regime because of its delay and often highly political, not financial nature.
This mismatch of time horizons between short and long-term cost and always-lagging roll-out approvals of price increases creates uncertainty for investors. Their inability to financially plan a return, especially in such a “considered stable” sector like utility, is an investment disincentive. Greenhouse gas regulation, Quantitative Easing speculation, inflation, falling electricity demand over the last decade due to distributed (micro grid) generation, fuel price volatility and energy efficiency programs hinder effective rate making.
In order to a cushion this mismatch in the market; utilities can do a few things:
- Ensure that the degree of structural similarity between well-performing plants is increased. This requires a clean view of the plant equipment, suppliers and staff during maintenance operations and when running performance analytics.
- Ensure that large customers (metal fabricators, oil & gas firms, distribution centers), are provisioned with accurate consumption statistics so that the utility can become a trusted service provider on how to optimize its customers’ operations.
- Ensure that FEED data across suppliers is harmonized and integrated when handed to the plant operator to avoid contractual penalties and win contracts with superior service performance, de-risking the operator’s investment.
- Ensure visibility of distributed generation systems (home batteries, EVs) in terms of performance, components, capacity and pricing to allow for long and short term buying opportunities, create micro-grid investment incentives and service schemes. This will allow utility investors to fund more, lower-risk smaller operators and smooth supply in light of demand spikes not accommodated by major plant capacity given aforementioned market imbalance. It will require a clean grid view including valve, pump, transformer and breaker UTC data, which can be shared with operators and service partners.
So for all you micro-grid operators: Who has put some solar panels or wind turbines in their backyard yet? Who is actively feeding power into the grid? What did you project as a project break-even period? Is your utility assisting with financing and servicing? Are you anticipating a rate increase for your operation or do you believe the network operator will pocket most of it?