This is the third in a series of six blogs that summarize discussions by top executives, investment bankers, and ex-Federal Energy Regulatory Commission (FERC) Commissioners about developments in the U.S. utility and power sectors. The discussions took place at the virtual 34th Annual Power and Gas M&A Symposium on February 24, 2021.
Curt Ophaug-Johansen, Energy Research Director at S&P Global Market Intelligence moderated the session that focused on Market Dynamics of the Energy Transition. Presenters were: (1) Lillian Federico and (2) Steve Pipe, both Directors of Energy Research at S&P Global Market Intelligence.
The Roundtable focused on:
- Regulatory perspectives on the energy transition and general trends in the industry.
- A more granular discussion of market dynamics of the energy transition.
A few highlights:
- 2021 is shaping to be another challenging year for the utility industry and its regulators as they continue to grapple with a mix of core traditional utility issues and the challenges presented by the energy transition under the overhang of the COVID-19 pandemic.
- Rate case activity will likely continue at or near the levels seen in recent years.
- Authorized ROEs and, by extension, industry profitability, will be pressured by historically low interest rates and the need to moderate rate changes in the current environment.
- Merger activity could pick up with the strategy behind the deals driven by the energy transition.
- Forecasts by S&P Global market Intelligence show greater penetration of generation markets with solar and storage hybrids. This takes its toll in terms of market share on coal and natural gas, and tilts things in favor of solar and against wind generation.
- While there is a significant reduction in capital outlay for offshore wind projects coming on by 2025, it will not make them competitive on a stand-alone basis.
- The big story in Texas is the emerging solar segment.
Regulatory perspectives and general trends
The need to address issues related to the pandemic will demand a good deal of attention going forward, and may limit the industry's ability to grapple with other issues, including the energy transition. All 53 of the state-level jurisdictions followed by Market Intelligence implemented some type of moratorium on utility service disconnections during the pandemic. As of January 31, the moratoriums had expired in 29 of these jurisdictions and were expected to expire in a handful of others. However, consumer groups in several states are calling for the governor or regulators to reinstate or extend the moratoriums. Some states have adopted a generic policy regarding recovery of the related costs, while others have taken a company-specific approach. Regulatory Research Associates (RRA) views it unlikely that a federal suspension moratorium will be forthcoming, giving the variability in the impacts of COVID-19 from state to state.
President Biden has issued a series of executive orders and named two climate czars to develop and implement energy policy. While the administration pledged to curtail gas exploration and production activity, it wants to preserve a role for natural gas within the economy. A new administration may also reverse the Trump-era corporate tax reductions, likely leading to a wave of federal and state regulatory activity to address the utility revenue requirement impacts. There will also be changes at FERC, and coordination between FERC and the states will be increasingly important for the transition.
The cornerstone of the transition is the proliferation of renewable resources. Currently, eight jurisdictions have mandates that call for a 100% renewable or carbon-free generation portfolio by 2050 or earlier, and six have standards with targets of 50% or more. A renewed federal policy push may force others to develop standards.
There is reemergence of stranded cost issues that first arose as part of the introduction of retail competition in the mid-1990s. Policymakers generally agreed then that a utility should be compensated for stranded costs that were beyond their control, and this appears to be the approach that regulators are taking now. Stranded costs in the electric distribution business are being addressed to some extent as part of the rate case process through accelerated depreciation and changes in rate design. It is the residential customer class that bears a greater portion of approved rate increases, so progress will be difficult as the pandemic and unemployment levels persist. By contrast, the specter of stranded costs is a relatively new consideration for gas pipelines and the gas LDCs.
The energy transition is creating the need for regulatory action at a time when asking for rate increases is simply not acceptable. Even so, electric and gas rate cases completed in 2020 were on par with 2018 and 2019 numbers. There are currently about 80 electric and gas rate cases underway, and several companies are proposing mitigation measures, a trend that is likely to continue during the pandemic.
Robust capital spending will continue to drive much of the expected rate case activity, as investment continues to outpace ratemaking. RRA anticipates that this upward trend will continue as company plans for future projects solidify and new opportunities arise. This level of capital spending spurs an increased focus on authorized ROEs. In 2020, the averages authorized for electric and gas utilities nationwide fell to their lowest levels on record, and our expectation is that they will decline further.
Consolidation and sector convergence have historically been avenues utilities have pursued to lower costs and achieve growth. Even before COVID-19, prospects for M&A activity in the energy utility sector were lackluster, although activity picked up later in the year. The latest uptick in activity could well present the beginning of another resurgence in transactions in the form of deals aimed at better positioning the participants to respond to the energy transition. Even so, regulatory scrutiny of transactions is likely to continue to intensify and prove challenging for bringing planned deals to fruition.
A more granular discussion of market dynamics of the energy transition
The energy transition is resuming after a flurry of activity in 2019 around renewable portfolio standards, carve-outs for new asset classes, and procurement targets for storage and offshore wind. 2020 also saw delays in project construction and contracting. Outside the disastrous second quarter of 2020, the impacts on electricity demand, for example, were not as bad as feared, and a lot of activity resumed in full force at year end. This was concentrated in renewable energy and storage, both in hybrid and stand-alone configurations. The market has assessed that the pandemic's end is close enough to get on with the fleet transformation and decarbonization of the electric sector that are hallmarks of the energy transition. The priorities of the Biden administration appear poised to lend momentum to this transformation.
Solar-plus-storage: This novel technology was being tried in certain markets, but the stand-alone economics didn't look great until last year. Now we see the combination of a firmer natural gas strip relative to the first half of 2020 and declining build costs for hybrid solar-plus-storage, aided by an investment tax credit. These twin events have made solar-plus-storage competitive in markets where conventional peaking generation previously prevailed. The attractiveness of using solar-plus-storage to address both renewable portfolio standards and resource adequacy at the same time lends further momentum. Visibility into projects gives us 8.5 gigawatts by the end of 2021, plus 2 gigawatts per year through 2025 and over the course of our 20-year forecast. This is enough to start disrupting continued growth and penetration that was anticipated for fossil generation, whether peaking or combined cycle generation.
Over the longer term, the attractive economics of hybrid solar-plus-storage drives a lot of additional solar into the market. This takes its toll on the market share of coal and natural gas, and tilts things in favor of solar and against wind generation. The disruption of these markets creates competition between green asset classes. Overall, we forecast that renewable generation will increase more rapidly than demand growth over this period.
We have renewable portfolio standards driving additional generation into the market. At the same time, there is increased penetration of storage, creating a new demand center for injection of those excess megawatt hours. We see that generation from these resources will grow more rapidly than demand growth, a necessary precondition for rapid decarbonization. This is done via storage facilitating the additional volumes of renewables coming into the system. As a secondary impact, it drives surplus green energy into the renewable portfolio standard (RPS) markets, those markets that use renewable and energy credits for compliance. That will keep observed direct prices low, especially where storage is forecast to penetrate the most.
The fossil market in Texas and the Southwest is forecast to shrink significantly as hybrid solar and storage moves these regions from supply deficits to sufficiency, or even surplus reserve margins. The storage capacity starts to taper off in our forecast in the late 2020s. As the economic arbitrage of storage gets narrower, we will start to see some resumption in demand for gas peaking capability.While fossil is no longer in growth mode for generation in our view, neither do we predict it to decline very quickly under a static policy case. Following the current policy suite, we forecast only a marginal improvement in the market share of carbon emissions-free generation, even with cheaper storage, optimizing renewables and bringing still more solar to the market. Part of this relates to the expected turndown of nuclear generation. Even some hydro capacity is going to be retired over this time in the absence of some repowering. That ends up offsetting any contribution from nuclear.
Decarbonization won't happen organically, nor with the current policy suite. It is going to require additional policy commitments, such as the passage of the Biden clean electricity standard or a doubling down of mandates at the state level.
Offshore wind: Buried in the stimulus package that outgoing President Trump signed over Christmas week was a substantial extension of the 30% investment tax credit for offshore winds. While there is a significant reduction in capital outlay for projects coming on by 2025, it will not make them competitive on a stand-alone basis in our assessment. The ITC should broaden the pool of equity investors in offshore wind projects and become a catalyst for projects further down the Atlantic coast.
The big story in Texas is the emerging solar segment. The combination of declining construction costs for solar, superior resource profiles, and firm wholesale pricing due to low reserve margins have worked to make solar an attractive option., and these projects are starting to emerge. Solar PV doesn't provide operating reserves, but it does free up more dispatchable generation.
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