Electric utility managers run in herds so to speak. Decades ago they decided to build nuclear-generating stations and almost every utility company that could did it. Financial meltdown followed— caused by runaway cost escalations made even worse by rampant inflation. (Most of the plants eventually operated but the builders’ finances tanked and both equity and fixed income investors suffered.) Then the “herd” decided to diversify into varied industries: real estate, mining, paper, lending, and one company even processed spent hens into chicken soup. Most of these ventures ended badly too. The lesson learned? Only go into businesses you understand. So the “herd” plunged into power generation but with some foreign utility and generation investments. The result? Huge write-downs. So it’s back to basics for the U.S. electric utility industry which has worked out fairly well so far. So what comes next? The biggest spending spree in the industry’s history, thanks to the Inflation Reduction Act, is because the only way to receive the varied financial incentives is by investing money for the designated purposes.
Perhaps ironically the “herd” is now investing in the same carbon-free and carbon-reducing concepts they fought in the courts for years while smilingly endorsing far-off climate goals. What changed? The government offered carrots instead of sticks and made offers that would be financially hard to refuse.
But that brings us to financing. A few years ago, we estimated that the electric industry would have to invest an average of $350-400 billion a year over 20 years to decarbonize existing utility plant and replace related assets due for retirement. That estimate did not include any allowance to finance growth in sales, because, at the time, sales growth had stalled. Since that estimate, we’ve seen a pandemic, inflation, war-induced shortages, and now a huge batch of government incentives that could restart sales growth in the industry.
After making some heroic assumptions about improved productivity of renewables and storage (20% above current estimates) and adding in a roughly 30% increase in construction costs since the original estimates as well expenditures needed to meet newly expected growth, we believe that required expenditures for decarbonization, modernization, and growth requirement will have to exceed $400 billion per year, in real terms.
We estimate that the electric utility industry will spend something like $170-$180 billion on capital projects in 2022. That number equals roughly 10% of non-farm business capital spending in the U.S.
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The industry also accounts for 8% of outstanding corporate debt and roughly 3% of new corporate debt issuance. So doubling industry spending or financing is a big deal for the industry, capital markets, and for the U.S. economy as a whole. Spending money at the pace required would put the industry into a position similar to when it was building nuclear power plants. Financially uncomfortable but do-able, especially with so much federal aid available. But with this caveat.
The U.S. electric industry plunged into its previous nuclear spending program when it had impeccable financials, top-grade bond ratings, and rock-solid dividends. Now the average utility bond rating is close to the bottom of investment grade, and the industry has taken few discernible steps to get in shape for what is coming—which is plenty of rate requests, higher fuel and power prices, and a higher cost of capital along with inflation. The industry’s finances could deteriorate again. Is the “herd” again sort of sleepwalking the industry into a several decade-long period of financial underperformance?
We all know to be skeptical of long-term estimates, especially those with more than one significant figure and decimal points, however, a big societal change like decarbonization will likely come about largely through electrification. The federal government is supporting the project and cleverly produced incentives and tax savings to encourage action. Even if the GOP returns to power, Republicans are typically reluctant to take tax benefits away from the business community. All of this adds up to a huge capital spending program by US electric companies and others in addition to electrification’s impact on the purchase of new electrical consumer goods, ranging from electric automobiles to heat pumps.
Whatever the actual capital spending number, electrification spells opportunity for some, and US electric companies appear to be the biggest potential beneficiaries. Rate base (the underpinning of earnings) will grow at a faster rate than in decades— at least 8% per year. But let’s face it, decades of monopoly behavior have not sharpened the industry’s commercial acumen. The industry tends to overlook opportunities and can only make so much money before the regulators step in. We think the major beneficiaries of the industry’s big capital program will be investment bankers who finance the expansion, companies that supply key metals, consultants who furnish expertise, construction firms and those that sell new products and services in the consumer electricity market. This is a major business opportunity. Don’t debate the virtues of the Inflation Reduction Act or the honesty of the name. Go for the business.
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By Leonard S. Hyman and William I. Tilles
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