For more than a decade, the electricity market has stood still on a growth basis. Electricity generated (measured in kwh) rose 3.8% from 2010 to 2022, or 0.3% per year while the US economy grew 2.0% per year. That is a picture of stagnation, is it not? But electric companies managed to grow more than sales, financially. Pretax operating income rose 8.0% in the same period, or 0.6% per year. Okay, not that great either. But now for the growth: total assets rose 76.9%, or 4.8% per year. (See Figure 1.)
Figure 1. Electricity generated ( trillion kwh), pretax operating income ($ ten billion) and total assets ($ trillion) —semilog scale
The scale in Figure 1 was designed to show the difference in growth rates. The steeper the slope, the faster the growth. One might expect total assets to rise as sales grow. And since they did not grow, why do electric companies need to increase assets at an accelerated rate to serve the same volume of demand? Obviously, inflation has something to do with the matter. After all, new facilities are much more expensive than facilities built 30 years ago that they replace. But cynics might see a different explanation that one might say is inherent in the regulatory model. Regulated utilities must increase their rate base (assets) in order to grow earnings. As a result their managers favor strategies that add to the plant account, especially if the regulators let them earn a return on investment in excess of cost of capital. The interesting question for us is, “How did the electric companies get away with increasing assets so much?” We think the likely answer is that increased costs attributable to those assets were masked by a decline in two key expenses, interest and fuel. US Treasury rates, a reference point for all corporate fixed income securities, fell to historically low levels. As a result the cost of maintaining a growing capital did not rise proportionately with the rising investment. You can see that in the trend of pretax operating income, a good proxy for capital costs. Second, fuel costs trended downwards as well, helping also to offset the higher costs of new capital. Not a bad rut to be in.
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Now let’s look ahead. The electric industry now has to really increase its capital spending, maybe double it. This is to fortify its plant against climate change and to decarbonize, and to improve reliability. The industry needs new facilities ahead of growing electricity demand from electric vehicles and electrification of heating and other industrial processes. We have calculated that the electricity industry (or its customers and competitors ) will have to double capital spending in the sector, without the benefit of the two big offsetting factors (lower interest rates and fuel expense) that mitigated pricing pressure. Borrowing money will cost more, now that the bond bull market has ended. And fuel prices will be higher, too. (Inflation Reduction Act tax credits will help, maybe knocking off 10% from the capital raising requirements over the coming decade.) The electric utilities missed a golden opportunity to prepare for the future when costs were lower.
Electrification, of course, will lead to greater sales of electricity, to perhaps as much as 50-100% over current levels. But when? Facing inadequate service, reliability risks and sparse recharging facilities, consumers might decide to wait before electrifying. However with respect to home heating virtually all systems apart from wood burning stoves are electric to some degree already and power outages render them useless. Spending on electric plant now might just hasten electrification. But how to convince companies to spend before the customer is guaranteed to “plug in”? And how to convince regulators to charge today's utility customers while building services mainly to be useful mainly for future customers? That may be the real dilemma.
Many decades ago, Brazilian regulators would not allow the telephone company to charge a new telephone installation fee that covered the cost of installation, supposedly to protect consumers. As a result the telephone company had to severely limit installations in order to stay solvent. Consumers who wanted telephones had to go to black market suppliers who charged for more than the real cost of installation. Limiting the installation price did not protect utility consumers. People who wanted or needed service paid for it. They just paid more, to somebody else, rather than to the telephone company.
And that brings us to what may be the biggest threat to the established investor owned electricity industry, reluctant regulators. Because of the higher rates implied, they may push back against the enormous spending ahead, especially given the industry’s long neglect of climate and reliability issues. We have shown, elsewhere, that the electric industry can bear the costs of an expanded capital program over the long term and that the impact on consumers would be modest. But the first years of an elevated utility capital program might involve big spending with little apparent return. Regulators might tell the electric companies to ease off because price increases do not help incumbent regulators or politicians win elections or stay employed. And utility executives, for whom the status quo is good enough, may see little reason to push the issue. Our point (and how it relates to Brazil)? That people who want a given level of service (from an environmental or reliability standpoint) will spend whatever it takes (within reason) to get what they want. Society as a whole may not save anything. If they reduce service or reliability, the legacy electric company won’t get more money, but some other energy service provider will.
In short, the electricity industry is at an inflection point. From a capital spending perspective the challenge is to get in the fast lane while staying out of the ditch. Let’s see how they handle it.
By Leonard Hyman and William Tilles for Oilprice.com
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