2012 Strategic Directions in the U.S. Electric Utility Industry

August 1, 2012

Executive Summary:
Everything Changes While Staying Relatively the Same

In
the 12 months since the last Black & Veatch electric utility industry
report, the industry has seen its primary fuel choice challenged and natural
gas prices drop to levels not seen since 2001. A historically warm winter
across much of the country drove down consumption (and hence revenue), creating
a cash crunch for many utilities. Further, the industry’s hopes for some
progress on the regulation of carbon continue to wax and wane in a U.S.
Congress unable to make a decision.

Yet for all of the changes across political, economic, and
cultural lines, results from this year’s report are strikingly consistent with
those of the past three years in terms of concerns, worries, and the potential
impacts of regulation and other requirements. Perhaps it is the historic focus
of the industry on reliability and safety; perhaps it is a return to
back-to-basics management approaches; or perhaps it is the generally
conservative nature of the industry, which results in this remarkable
consistency from year-to-year.

Black & Veatch conducted its sixth
annual electric utility industry survey from February 22?March 23, 2012.
Analyzed survey responses are from qualified electric utility industry
participants. Statistical significance testing was conducted, and the
represented results have a 95% confidence level.

Utility respondents represented a broad cross section of the
industry and country. The eight mainland regional reliability councils, under
the North American Electric Reliability Corporation, were represented in this
survey. Responses were also grouped by four geographic regions to give
additional insights into geographic differences.

Key Survey Findings

The
industry, according to the survey, continues to hold fast to some fundamental
beliefs: that there will be some certainty on carbon; that prices for
electricity will continue to rise; that, while coal has a future, renewables
have a growing but limited one; and that water is a critical environmental
concern. There is also significant agreement in several areas, and this is
interesting because, typically, a survey of the general public, regulators, and
legislators on the same topics would yield different results. When it comes to
“viable clean energy” technologies, for example, the “big three” that electric
utilities project for 2020 are natural gas, hydroelectric, and nuclear. It is
doubtful that the general public would rate any of those choices as
particularly “green” technologies.

More than 90% of utility respondents believe, however, that
renewables will increase prices for consumers anywhere from 5 to 30%, with the
largest percentage (38%) assuming a 10% increase for their customers. This may
tie to the 65% of utility respondents who reported rate increases during the
past year, and the 92% who reported that the cost of regulations will cause
prices to rise for consumers. More than 60% of utility respondents believe they
will hit their renewable energy targets?but a surprising 25% of utility
respondents stated they do not know if it is achievable. One has to wonder
whether the pending increase in rates, due to renewables, and the potential
demise of the production tax credit are behind this uncertainty.

Reliability, aging infrastructure (not workforce), and the
environment continue their reign as the top industry concerns, followed closely
by the need for long-term investment. Interestingly, security and technology?inextricably
linked in terms of deployment?are tied in the fifth position. While water did
not make the Top Ten Issues list, it did come in second only to carbon
emissions legislation, in terms of environmental concerns. In fact, when water
supply (second) and water effluent (sixth) are combined, they rise to the top
of environmental concerns.

The hope for certainty in carbon emissions legislation is
common across all regions and, as it has been since 2008, leads the ranking in
environmental concerns, followed closely by water supply. Interestingly, when
broken down into the four geographic regions, Northeast respondents rank
disposal and storage of nuclear fuel as their top concerns?an issue that does
not even make the top three in the Midwest, South, or West. The concern over
nuclear disposal, overall, jumped significantly since 2009 when it was near the
bottom of industry issues?likely due to the lingering influence of the
unfortunate incidents at Fukushima, as well as the abandonment of plans for a
national geologic storage facility at Yucca Mountain.

The potential impact of environmental regulation continues to
be a primary focus for utility survey respondents. It is interesting to note
that the survey’s timeframe in March pre-dated, and yet predicted, the U.S.
Environmental Protection Agency’s (EPA) and Department of Interior’s new
hydraulic fracturing rules issued in May. More than 80% of respondents saw this
coming in their crystal balls. Of course, 93% of survey respondents believe
these new rules, and any subsequent rule additions, will have a significant or
slight upward pressure on the price of natural gas. Respondents’ prediction on
the price of natural gas in 2020 showed a virtual tie between $4-$6 per one
million British Thermal units (MMBtu) and $6-$8 per MMBtu. More than one-fifth
of survey respondents (22%), perhaps those who have been around to watch
historical gas price fluctuations, reported not knowing what the price will be
in the same period.

Regulations are also causing concern
regarding the operational effectiveness of utilities as well as concern for
increasing rates. A full 86% of respondents believe there will be impacts on
operational effectiveness, with 16% believing it will be “significant.”
Regulatory impacts are also key drivers in investment, the development of
sustainability plans, and the perception of utilities on Wall Street?either for
stock prices or bond ratings. Concern over whether or not utilities will be
able to recover adequate returns on investment?or any costs for that matter?for
smart grid investments weigh on the minds of utility respondents. This is
especially true now that American Recovery and Reinvestment Act dollars are
almost gone.

Smart grid, which burst onto the survey
scene several years ago, continues to struggle from “a lack of customer
interest and knowledge,” which utility respondents view as the single greatest
impediment to investment programs. Yet, when pressed further, more and more
companies are investing in systems to improve customer communications, which
are driven by smart systems. More than three-fourths (76.9%) will be building
customer self-service websites, expanding their web presence, social media, and
potentially implementing variable rates?all areas in which the smart grid is a
key component or at least a primary enabler. It may be that the grudging
acceptance of intelligent infrastructure is part of the historically
conservative nature of the business, where even “fast followers” are viewed as
radically different and risk-takers.

Regulation at the federal and state/local level is also
influencing the market for merger and acquisition (M&A) activity. The
2011/2012 timeframe has seen three significant mergers and acquisitions and,
for the first time, the Black & Veatch survey looked at the impacts of
these activities. With Exelon/Constellation, Duke/Progress, and Northeast Utilities/Nstar
each at some stage in the M&A process, all utilities are considering their own futures and what these mergers
really mean. The vast majority see financial scale, rather than operating
synergies, as a driving force of profitability in this area moving forward. The
benefits of scale are particularly apparent when considering that regulators
require most utilities to either hand over, or at least share, cost-cutting and
operational savings with customers?especially in light of continued slow load
growth or declining kilowatt hour sales.

Looking at the numbers, the industry has changed remarkably
in some capacities, while remaining steady in its core function. For example,
58% of utility respondents believe, “When fiscal realities are fully considered
in the United States,” there is still a future for coal. This is a significant
drop from the 81.5% who indicated this to be the case in last year’s survey. As
noted within, the industry is taking more environmental concerns into account
than ever before, even though nearly a third (29.2%) believe that global
warming is still “speculative.” It is not unexpected that an industry that
prides itself on reliability, safety, and long-term investment focuses so
intently on certainty, potentially at the risk of missing dynamic changes. It
could be as Voltaire once noted, “Doubt is not a pleasant condition, but
certainty is absurd,” as many more surprises are to come in this rapidly
changing, energy market.

 

Sidebar: Implications of Domestic Natural Gas

By Greg Hopper

North American natural gas reserves, once thought to be
high-cost and diminishing in nature, have reversed course and now are expected
to serve as a baseload energy source for decades to come. Driving this change
are the technological advances in the exploration and production of
non-conventional reserves, most notably shale gas, which has rejuvenated the
gas industry. The massive scale and accessibility of North American shale gas
has many implications for consumers and businesses, particularly in the
electric industry.

Though the industry is more than 10 years into the
development of shale gas resources, estimates of economically recoverable North
American natural gas have increased year-over-year. Recent estimates by the
Energy Information Administration indicate that technically recoverable gas
resources in the United States exceed 2,200 trillion cubic feet (Tcf). At
current consumption levels, this equates to approximately 90 years of supply to
meet market demands. While the question concerning the adequacy of available
gas resources is now of less interest to industry stakeholders, the location of
specific resources, the cost of extracting them, and the construction of
pipelines to deliver them to market, are now key issues facing gas market
participants.

Finding and development costs for shale resources are heavily
influenced by the properties of the specific shale rocks and the costs of fully
completing a producing well. Technology and improved understanding of shale
formations have cut the cost of production nearly in half in the last 5 years.
Notwithstanding, rising environmental costs are expected to impart upward
pressure on the price of gas over time. The extent to which regional
environmental costs add to price increases may cause shifts in the location of
shale production.

Low gas prices stimulate new markets. In 2008, natural gas
prices at the Henry Hub in southern Louisiana, a primary price reference point
for the global natural gas market, topped $13 per MMBtu. During the price run
up, power generators?driven by emissions concerns, fiscal pressures, and the
need for reliable fuel stocks?pivoted their capital investments for future
generation needs to the development of renewables, nuclear, and clean coal
technologies.

Since that time, rapid shale gas production growth from
multiple supply basins has created a supply “bubble” that dropped the spring
2012 prices below $2 per MMBtu. The drive to produce highly valuable natural
gas liquids in tandem with shale gas has subsidized the cost of producing
natural gas. However, few industry watchers expect prices will remain this low.
Black & Veatch’s most recent energy market forecast projects the price range
will be between $4-6 per MMBtu through 2020. Survey responses align with this
projection, with 37% agreeing that gas prices will be $6 per MMBtu or lower by
2020. In contrast, only 12% expect prices will be $8 per MMBtu or higher.

Lower prices and increasing energy industry confidence that
shale resources are large and sustainable, have positioned the gas industry to
capture the lion’s share of new generating capacity builds for the foreseeable
future. Although renewables and nuclear investments will continue to be part of
the fleet, natural gas is clearly the preferred technology to replace coal as
North America’s primary energy source. In addition to natural gas’ low price,
the decreased price volatility that accompanies its plentiful production
further increases the attractiveness of gas to utility and merchant generators
alike.

Risks center on safety and environmental concerns. Although
the energy industry has gained confidence in the geology and technology
underlying the economics of shale and non-conventional production, concerns
remain about the risks of environmental and political opposition. As noted in
the survey results, more than 80% of utility respondents expect that the EPA
will impose regulations to regulate hydraulic fracturing activity as it relates
to water. In particular, concerns about hydraulic fracturing safety have risen
as numerous federal and state government agencies, as well as public watchdog
groups, have reacted to the rapid growth of shale-gas fields. The opposition
has been greatest in locations such as New York, where there is little or no
prior experience with petroleum resource developments. Common objections have
centered on potential impacts to drinking water supplies, air emissions, and
road traffic.

The most frequent issue cited by opponents of hydraulic
fracturing is the large volume of water required for the process, added
chemicals, and whether the use of these supplies threatens the adequacy of
water needed by other types of users. A report commissioned in 2009 by the U.S.
Department of Energy, the Ground Water Protection Council, and ALL Consulting,
LLC found that a typical shale-gas well requires at least 3 to 4 million
gallons of water for drilling and completion, including hydraulic fracturing.
Water transportation, handling, and the precautions taken to prevent wastewater
spills can be a logistical challenge?especially in Pennsylvania where geology
and regulations do not support injection wells. As such, the transportation of
wastewater to disposal wells in Ohio generates a significant cost.

Research conducted by Black & Veatch showed that shale
gas water costs are higher than those for industrial water in the 50 largest
U.S. cities. As of 2010, shale-gas developers paid at least 1.4 cents per
gallon for source water, and another 11 to 16 cents per gallon to handle the
wastewater. By contrast, the most expensive industrial water associated with
municipalities was 0.7 cent per gallon for source water and 1.7 cents per
gallon for wastewater. This research is consistent with the survey results, in
which 70% of utility respondents expect EPA regulation of hydraulic fracturing
and water use will influence natural gas prices but not substantially. However,
shale gas developers are highly motivated to reduce water costs and have moved
toward recycling and on-site treatment to reduce total volume and
transportation needs.

Evolving Pipeline Infrastructure Needs

The
North American natural gas pipeline grid was primarily built to move natural
gas from the Gulf Coast, southwestern United States, and western Canada, to
consumer markets throughout North America. The emerging shale basins in the
Northeast, predominantly the Marcellus basin located in Pennsylvania, New York,
and West Virginia, have created substantial changes to the movement of gas
supplies across the country. Pipelines constructed to transport gas from Texas
and Louisiana to the Northeast are now experiencing substantial drops in
volume, as Marcellus production grows. In some cases, gas is now being shipped
from the Northeast back to Louisiana to avoid bottlenecks in Pennsylvania and
access the more liquid Gulf Coast gas market.

This shift of supply has in turn created the resurgence of
pipeline rate cases to redesign rates or establish new billing determinants.
Pipelines and their customers are both considering innovative ways to
reapportion cost and fairly allocate risks, as contracting and shipping volumes
change. As increased gas is used for power generation, concern is growing as to
whether adequate pipeline infrastructure will exist to deliver supplies to
power plants on a reliable basis. Numerous studies are underway by various
parties to assess the compatibility of the electric and gas grids and the need
for additional infrastructure investments.

Impacts to the
Electric Industry

Overall, the shift towards natural gas and the growing
resource base in North America are creating price stability and long-term
assurance of natural gas as a generation fuel. Natural gas is now viewed as the
clear leader among clean energy technologies to address greenhouse gas
emissions (natural gas has only 42% of the carbon output of coal) in the United
States. Natural gas is now tied with nuclear when it comes to environmentally
friendly technologies that the industry should emphasize. In addition, nearly
80% of all survey respondents, representing utilities and non-utility
organizations, viewed natural gas as an economically viable technology without
portfolio standards, credits, or subsidies. Comparatively, just over half of
respondents indicated this will be the case for nuclear
.

This shift will require different
approaches in obtaining and managing natural gas as fuel to a growing North
American gas-fired power generation fleet. To take advantage of gas supply
resources, utilities must first reevaluate their existing gas supply
portfolios. It is important to learn where flexibilities exist in order to
reconfigure the fuel portfolio to lower costs and to reach shale resource
supply basins. Within the gas supply portfolio, utilities will need optionality
through transportation, storage, and delivered supply. This will allow
utilities to reposition supply access as opportunities arise. Finally,
utilities should explore participation in the natural gas supply chain as an
investor, by bringing demand and capacity commitments to fund additional and
needed infrastructure.

 

This report was reprinted, in part, with permission
from Black & Veatch. The full report is available at http://bv.com/docs/management-consulting-brochures/2012-electric-utility-report-web.pdf.

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