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Leonard Hyman & William Tilles

Leonard Hyman & William Tilles

Leonard S. Hyman is an economist and financial analyst specializing in the energy sector. He headed utility equity research at a major brokerage house and…

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The Inevitable Capex Boom In US Energy

Electric utility capital expenditures (CAPEX) in the US have been rising steadily. But they are not remotely large enough to meet future industry requirements to decarbonize, harden infrastructure, modernize, digitize and meet the demand for new electric vehicle charging infrastructure.

The last time our electric industry faced a rapid increase in capital expenditure was in the 1970s and early 1980s. A mideast oil embargo essentially (technically two of them in that decade) forced utilities into rapid construction of nuclear power generation. At the same time fossil fueled plants, particularly coal, were also facing higher CAPEX/ retrofit needs to address increasing environmental restrictions on emissions. And this rapid shift in the industry’s power generation was being financed at corporate interest rates often well over 10%—a very different macroeconomic environment than the one we now face. But rapid technological changes always increase business risk at least for some asset owners.

These annual spending levels from half a century ago appear small relative to current industry CAPEX numbers but these amounts were large relative to existing plant in service. And that meant the need for hefty rate increases from often beleaguered state utility commissions. The reluctance of regulators to fully compensate utilities for nuclear cost overruns did result in one utility bankruptcy and several near misses.

But finally the long industry nightmare was over. First, even though coming in at roughly two to five times over budget, the new nuclear plants were ultimately completed, fought over at the regulatory level and placed in rates. Second, the looming industry uncertainty revolving around deregulation left traditionally conservative executives uncertain about what to build. This hiatus also permitted industry balance sheets to recover.

As CAPEX resumed its uptrend in this century, favored asset classes are transmission lines and renewable generation. But the industry is facing environmental “overhang, ” this time from potential restrictions on carbon emissions. And the response is once again a new build cycle. But this time the industry is far from moving in lockstep. Some want to replace shuttered coal with natural gas while other managements have embraced a wholly renewable future. Both strategies face business risks. Related: Yergin: No End In Sight For The Oil Price Crisis

Figure 1 shows the five year spending of investor owned utilities (IOUs) on electric plant in current dollars. Note how the numbers peak in the early eighties. More meaningfully, Figure 2 shows the five year spending program as a percent of beginning of period electric plant in service. This figure shows the same pattern in a different way. But that is history.

Figure 1. IOU electric capital spending ($ billions)

Figure 2. IOU electric CAPEX as % of beginning of period electric gross plant in service

Now, here is our current dilemma. The present electric system in the US is old (much of its plant is 35 years old which is near retirement age). It is not hardened for the increasing ravages of a harsher climate nor prepared for an increasingly electrified, zero carbon future. Retiring old plant, dealing with rebuilding and often relocating principal generating resources while also decarbonizing could cost $8 trillion for all electric operations in the US (at least $6 trillion for the IOU segment of the industry). And this hefty figure doesn’t include the required service infrastructure for a new electric fleet of cars, trucks and buses. Related: Saudi Arabia Strikes Back At Russia In Key Oil Market

Changes of this magnitude obviously take time and we imagine this effort spread out over 20 years This implies a capital program for the IOUs of $300 billion per year—more than twice the current level of annual expenditures. If the industry were to spend that much, the bar on Figure 1 would go off the chart (at $1500 billion for the next five years) and the so would the bar on Figure 2 (to 111% of gross plant in service at beginning of period). Current spending plans aren’t even close. We’re actually surprised these figures aren’t higher. Maybe the industry and its regulators figure that our current POTUS will remain in office forever, or a Canute-like figure will stand at the shores and prevent the water from rising, or maybe that global warming really is a hoax. We don’t know.

What we’re fairly certain of is that there is an inevitability to electric utility capital spending orders of magnitude larger than that recently seen. Either current utilities will replace and build out this infrastructure or someone else will. And once again capital programs along the lines contemplated entails significant risk.

But the risk this time is whether microgrids and similar distributed applications jeopardize the financial integrity of the last remaining sphere of utility monopoly, the distribution grid. With utility equity valuations still at robust levels we doubt this is a concern for investors especially given recent market gyrations. To shamelessly steal a much over used phrase, this to us is the next black swan.

By Leonard Hyman and William Tilles for Oilprice.com

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