As of this writing, we are well over three years beyond the initial shock of the COVID-19 pandemic. The utilities industry has been dealing with post-COVID whipsaw effects of higher prices, higher interest rates, and evolving objectives.
Utility strategy these net-zero initiatives
During and before the pandemic—from 2019 through 2021 and beyond—many states and utilities adopted 100% clean energy or net-zero policies. Utility strategy initiatives, which pursue these net-zero initiatives, are facing large investment needs.
- For example, gas utilities are seeking ways to reduce methane emission profiles, through both lower emissions fuels (hydrogen and renewable natural gas) and replacement of leak-prone pipes.
- Power utilities are preparing for increased vehicle and building electrification, which some believe could increase electricity demand by 50% or more over the long term.
- Power generators are under pressure with lower spark spreads, while facing increasing sustenance capital and ongoing O&M needs as they continue to be called upon by system operators to balance more variable-output renewables. Those generators are investing in renewables as well.
With anticipated high capital spending ahead, the utility sector faces both tailwinds and headwinds in planning and deploying capital.
TAILWINDS
Possibly the most significant tailwind in the past year or two in the utilities industry is the establishment of policy support and funding for infrastructure projects via the Infrastructure Investment and Jobs Act (IIJA), enacted in November 2021, and the Inflation Reduction Act (IRA), enacted in August 2022. The IIJA allocated more than $80 billion toward electric vehicle charging, power infrastructure, and transmission. The IRA has allocated approximately $370 billion toward energy-related investments. Many of these incentives take the form of loans and tax credits throughout the clean energy supply chain.
Citing the fact that many tax credits do not have spending caps, Goldman Sachs points to significant IRA spending — “creating the most supportive regulatory environment in clean tech history” — that will invigorate asset development and investment returns and provide rich CapEx opportunities for investors.
Continued interest by both public and private investors, aided by government support, has put focus on technology development across the utilities industry. These technology development activities provide industry participants with an opportunity to test and deploy new technologies for lower-emission options, improved and hardened infrastructure, and fuel diversity, driving key trends in utility infrastructure.
Another benefit of federal funding of energy infrastructure via the IIJA and IRA is that it reduces financial (rate) impacts on retail customers of utility investment.
Finally, another tailwind for the utilities industry is the generally strong public and regulatory support in many jurisdictions for utility investments in system modernization and net-zero initiatives.
HEADWINDS
Of course, the utilities industry faces headwinds as it deploys billions in capital. The Edison Electric Institute projects that its member investor-owned electric utilities will spend more than $155 billion in 2023 and 2024.
First, the relationship between utilities and interest rates has become increasingly important as interest rates have been ratcheting higher over the past 12 months, and it is unclear whether the Federal Reserve’s continuing battle against inflation will further affect them. To date, higher interest rates have been driving up interest costs, in some cases, narrowing utilities’ cash flow cushion. Until recently, Standard & Poor’s had a negative outlook for credit ratings for utility sector companies, but has recently upgraded to stable, reflecting lower inflationary pressures, lower natural gas prices, and improving economic indicators.
However, despite this positive news, managing high capital spending and growing debt (leverage) and debt service requirements, together with lower free cash flow metrics, remain risks to the sector. Credit ratings in the utility sector continue to be closely monitored by investors and analysts.
On a more practical level, the utilities industry faces challenges and delays in getting infrastructure built, particularly with permitting barriers and local opposition remaining in place. Recent discussions in Congress about potential permitting reform are still a work in progress. Updates to the National Environmental Policy Act to set time limits on project review were included in the June 3 debt ceiling law. Still, most observers and key Congress members believe that broader reform is needed. And it will take time for any reforms to be implemented, even if enacted.
Finally, the utility industry continues to have cost management challenges as it contends with supply chain issues and labor availability and cost, which now seem more structural than COVID-related. These represent ongoing challenges in the energy and utilities industry.
CONCERNS
Aside from both headwinds and tailwinds, there are some longer-term concerns for the utilities industry and other stakeholders, despite anticipated investment in the sector.
First is how the utilities industry and regulators will guide the gas and power grids through a net-zero energy transition. Particularly, how the industry should manage the pace of generator retirements and capacity performance of the existing and future generation fleet. This may affect the pace of transition.
Second, as utility investments increase and the potential for rising fuel costs endures, the utilities industry and regulators continue to monitor energy affordability for customers. There are indications that the combination of higher investment levels, inflation, and fuel costs led to an uptick in utility rates in 2021 and particularly in 2022. It is unclear whether this is an aberration due to an unusual geopolitical and economic environment in 2022 or signs of a secular trend.
GROWING ROLE OF ENERGY EQUITY AND ENVIRONMENTAL JUSTICE
Not discussed by many industry observers is the increasing role of energy equity and environmental justice (EE/EJ) in the development and implementation of utility investment and capital strategies. These considerations will impact the nature and location of utility infrastructure, as well as the process by which those determinations are made.
Both the IIJA and IRA have provisions that expressly require consideration of EE/EJ factors as well as incentives for facilities that advance EE/EJ goals. States, as well, are advancing these efforts through grid modernization programs (mandated by enabling legislation) and resource planning initiatives. For example, Illinois’ Climate and Equitable Jobs Act requires utilities to prepare multi-year grid plans that support bringing 40% of the benefits of grid modernization and clean energy, including distributed energy resources, to “equity investment eligible communities.”
Organizational changes have been made as well to increase focus on EE/EJ issues. The IIJA established an Office of Public Participation within FERC, and the Department of Energy (DOE) has an Office of Economic Impact and Diversity, both of which have energy justice as a core goal. For states, the National Association of Regulatory Utility Commissioners supports state efforts to advance energy justice efforts through initiatives in partnership with DOE, the National Association of State Energy Officials, the National Governors Association, and others.
Some EE/EJ efforts envision a wider stakeholder process that is not necessarily focused on physical needs (e.g., locations to relieve constraints or charging infrastructure near highly trafficked areas) but also needs and interests of selected constituents, particularly in disadvantaged communities.
It is too early to tell how this will affect energy infrastructure development, but utilities will be spending more time on EE/EJ issues than has historically been the case.
Key Strategies for Energy & Utilities Industry Monitoring
Other developments that utilities and their stakeholders will be closely monitoring include:
- The effects of emerging EPA policy initiatives regarding vehicle emissions and power plant emissions
- Continued commission support for requested rate increases
- Strategic actions by utilities and others — a strategic “sorting out” process for some utilities seeking either to reduce exposure to some utility sectors or acquire complementary business or increase scale
- Balance in real-world operations among three energy sector goals: reliability, affordability, and “clean”
Developing effective strategies for energy & utilities companies requires monitoring multiple factors. Utilities would also be well served to continue monitoring their financial metrics, measuring their pace of investment, and engaging with regulators as investments in energy transition, grid modernization, resilience, electrification, and decarbonization ramp up. Understanding why to invest in the utilities sector opportunities remains strong despite challenges will be crucial for stakeholders.
