December 2014 Issue
The energy & utilities sector is currently experiencing a period of sustained disruption to the status quo – regulatory factors, global economic stagnation, and new entrants to the market are all playing their part in destabilising the landscape. Consequently, there is an air of transformation about the sector as it gets to grips with an increasing potential for innovation. Ultimately there will be winners and losers as companies are forced to radically re-think their strategic approach at a time of immense and unprecedented change.
FW: In broad terms, what key developments have caught your eye in the energy & utilities space in recent months? How are companies in this sector faring in general?
Vince: An abundance of domestic oil and natural gas remains the most important development influencing the US energy sector, though significant challenges related to infrastructure, regulations, environmental issues and popular response remain. Market economics dominate developments and are more influential at present than tighter environmental requirements. In terms of power generation and use, cheap and abundant domestic gas has done more to displace coal and reduce emissions than stringent environmental rules. Distributed generation, particularly rooftop solar, is rapidly gaining traction and has the potential to revolutionise the utility landscape. This comes with its own set of challenges, as it requires the utility industry to re-think traditional rate structures. The past year has also witnessed growing focus on critical infrastructure security ‒ physical and cyber – along with developments in information technology that promise to completely transform the industry.
Barron: Global economic stagnation or near term recession has impacted energy demand downward during the recent increase in US energy production to create an imbalance during which renewable energies may suffer while clean burning fossil fuels secure long term market share utilising advanced technologies to remain profitable during current price swings. Companies that manage cost of capital, development costs and operating expense while reducing their exposure to high risk, low and moderate reward projects, may have a better opportunity to prosper over the economic cycle. A continued economic downturn may jeopardise some projects and cause delays and cancellations of others whose principal backers are financially stressed.
Kopp: As plant operators begin to evaluate market changes such as PJM’s Capacity Performance product, several factors limiting the effectiveness of the proposed solutions have presented themselves. Simply procuring firm natural gas fuel delivery is not a catch-all solution, as commodity availability or force majeure issues can still result in availability issues. Additionally, persistently high oil prices have incentivised operators to minimise fuel-oil inventories to free up operating capital. As oil prices have fallen over the past several weeks, there is renewed interest in dual-fuel conversions, however the cost of such retrofits ranges from approximately $50 to $100/kW for the most common technologies, driving offer prices on marginally competitive units higher while energy markets continue to exhibit weakness. The issue is further exacerbated by limitations imposed by existing air permit structures that were written prior to current National Ambient Air Quality Standards. Existing resources may have limited ability to permit a dual fuel retrofit without subjecting their existing permit to current standards and potentially forcing new emissions control, and proposed advanced technology combustion turbines have been largely unproven on fuel-oil operations.
Beneby: The utility industry is experiencing more disruptive change now than it has in the last hundred years combined. Advances in grid technology, with the creation of modern networks that can handle – and frankly, monetise – demand response and intermittent renewable resources, are also changing the industry, as is the entrance of non-utility players, such as Google and Apple, seeking to get between utilities and their customers. New federal regulations demanding deep reductions in carbon emissions from existing power plants also have the potential to change the face of generation in this country. Some utilities are open to innovation, new business models and opportunities. As with telecoms and computing, I see winners and losers as the industry continues to evolve.
Lang: The global natural gas business continues to face significant changes as a result of the shale gas revolution in North America and the prospect of significant exports of natural gas into the global market. While the full effects of this remain to be seen, we expect this supply and increased connectivity in global gas markets to drive significant changes to global natural gas markets, including in terms of pricing, contract structure and trade flows. In addition to developments in North America, events in Ukraine and sanctions against Russia raise questions about future impacts on Russian exports to Europe and, as evidenced by the recently announced deal with China, flows of Russian gas eastward.
Nordlinger: Brent crude oil prices have dropped by 25 percent to below $90 a barrel since this past June, partially as a result of increased US crude oil production and the Saudi decision to maintain market share rather than reduce production in the face of falling oil prices. Faced with increasing project costs, some oil producers might decide to postpone or even cancel upstream projects. In addition, heightened sanctions by the US and EU against Russia might affect upstream oil projects, particularly in the deep offshore and Arctic regions of that country. In the utility sector, reserve margins for the UK’s electricity grid are substantially squeezed, creating a risk to security of supply in the medium or even near term. The UK requires additional investment in electric generating capacity, but outside renewables and the approved new nuclear plant, uncertainty has hindered new investment. Meanwhile, the US is becoming increasingly self-sufficient for oil and gas and may soon become a net exporter. The issue in the US is not the resource; it is transportation infrastructure as increased production is located in non-traditional producing areas.
“Policies and political agendas favouring renewables and security of supply while seeking to reduce costs to the electricity consumer have created some difficult hurdles for the industry.”
FW: Could you provide an insight into current energy prices, and how they are affecting the market? How are energy companies responding?
Barron: Current energy prices are down from their recent high values with oil having shown a recent dramatic drop and gas having slowly but continuously moved downward from last winter’s seasonal high. The gas price both with the US and on a global market has not been totally unexpected while the oil decline has been surprisingly dramatic and more intense than many anticipated. Major projects have not recoiled but next year’s budgets may be affected if the global oil price remains below $90 through the remainder of the year. Energy companies are cautious for the moment and beginning to reassess major capital intensive projects whose high capital requirements and operating costs generate marginal returns should prices retreat into the sustained $80 range. Energy companies are beginning to become more selective in their assessment of both long term projects and target objectives within developing projects.
Nordlinger: In the European utility sector, companies are seeking to reduce the cost of electricity to the consumer in the face of government policies favouring higher-cost renewables and disfavouring in some countries nuclear energy. As a result, electricity generated from low-cost coal imports from the US has taken an increasing market share from electricity generated by higher-cost natural gas. The cost of carbon emissions has not changed the competitive position of gas in the EU. Owners of gas-fired electric generation in the EU, especially in the UK are looking to hang on in anticipation of higher prices, for example, via the UK capacity market commencing later in the decade.
Beneby: We’re seeing a clear downward trend on fuel prices, natural gas and to some extent oil, thanks in large part to the shale revolution. From a power perspective, we are seeing pretty flat demand. The market is relatively soft, meaning prices are good for consumers, but margins are slim for existing generators, and have made it harder for new entrants to get financing to build. With tighter margins, I’ve been focused on tightening our business processes and gaining efficiencies. We remain well positioned with a diverse generation fleet of generation and sufficient reserve capacity.
Lang: Focusing on natural gas prices, Atlantic and Pacific markets remain segmented. North America has seen significant reductions on natural gas prices driven by the shale revolution and, because of the connectivity of the North American and European markets, corresponding price reductions in Europe. Asia remains largely insulated from these factors but we are seeing increased pressure on oil-linked pricing in Asia. We continue to see buyers push to move away from oil-linkage, including by seeking blended pricing that includes other indexes, such as the United States’ Henry Hub. Of course, some Asian buyers have also entered into contracts to purchase LNG from North America, directly tying supply to Henry Hub pricing when those deliveries commence.
Kopp: Absent weather anomalies, like what was experienced in the Northeast and Texas, energy markets have been generally depressed and slow to return to pre-recessionary levels. This is likely due to a number of factors including slow load growth, low natural gas prices and increased market penetration of renewable generation. Energy prices have remained depressed for a sustained period of time, putting pressure on the bottom line due to reduced operating margins. This has caused utilities and plant operators to focus on ways to reduce fixed costs and explore cost effective efficiency improvements that will make their generation assets more competitive in the market. Utilities are looking at options such as seasonal operation, delayed/deferred capital expenditures, heat rate improvements and even plant mothball or retirement.
Vince: The US is experiencing a manufacturing boom due to the availability of cheap natural gas. Several reports indicate that the US shale boom has put the equivalent of $1200 into every household through reduced energy costs, whether directly or derivatively as a component of the products that consumers purchase. Some sectors have yet to recover completely from the recession, but on the whole, lower energy prices have helped the US become competitive once again in world markets. Abundant low-cost energy has also helped both the energy and manufacturing sectors in the US become very attractive for inbound foreign investment.
FW: In what ways are energy policies and political agendas changing the playing field for energy & utilities companies?
Kopp: Energy policies and political agendas are changing the playing field mainly in two areas: firstly, by increasing the cost of coal-fired generation to reduce the usage of those assets, and secondly, by promoting increased installation of renewable generation. A major driver changing the playing field is the number of regulations affecting coal-fired power plants. Recently enacted and proposed regulations are increasing the cost of operating coal-fired power plants by requiring them to install more air, water and waste control equipment. Additionally, the Environmental Protection Agency (EPA) has proposed rules aimed at cutting CO2 emissions from existing power plants, which will further increase the cost of operating the plants or may force coal-fired power plants to retire altogether, thus leading utilities to install new power plants with different fuel sources. Another major driver facing the industry has been the promotion of renewable generation through either tax incentives or mandates through renewable energy standards.
Vince: The President’s ‘All of the Above’ energy platform is good news for most energy and utility companies, as it purports to include development of a wide variety of energy resources. However, the Administration’s Climate Action Plan means that the share of the national energy portfolio that a particular resource holds will likely change. Coal still dominates, but gas is rapidly catching up, and renewables, including hydropower, now account for nearly 10 percent of the nation’s fuel mix. The changes we are witnessing, however, are due more to economics than policy decisions, although on the local level, politics may play a more prominent role, as energy companies have come to realise. Companies that are partnering with local regulators and populations and integrating local needs into their plans are enjoying success in their ventures.
Beneby: The biggest challenge facing power producers right now is the EPA’s new limits on carbon emissions. States have been given some degree of flexibility in how they meet these proposed new rules, and we’re seeing a wide range of responses. Some states appear poised to fight the federal government on this. From my perspective, these rules have been a long time coming, and I believe are largely inevitable. So we have been working to reduce the carbon intensity of our fleet, which has left us in a better position than many. We have also focused on trying to get all the players – generators, regulators and elected officials – together to see if we can’t find areas of compromise with the EPA. It will be of keen interest to us and others, how the mid-term elections play out and if energy policy will be impacted.
Barron: North American projects continue to be hindered by political rhetoric and environmental pressure in the name of preventing global warming – for example, the Keystone Pipeline and the impact on Canadian development and US transmission to refining and eventual markets. Internationally, bans on hydraulic fracking prevent development of unconventional resources that could potentially offset certain countries’ dependence on natural gas imports. Positive political changes in Mexico that will take several years to impact international markets may not be able to overcome negative impacts associated with political instability associated with Venezuela production and exports to the world market. China national oil companies, however, continue to receive favourable regulatory incentive to develop unconventional resources to offset internal demand for coal utilised in power generation.
Lang: Focusing on developments in North American shale and Russian sanctions, energy policies in the United States, Canada and Europe could have a significant role in changing the playing field for energy companies. Policies in the US and Canada regarding the export of natural gas and siting of export facilities and related pipelines may impact the quantity of natural gas exported from these markets, which would affect global pricing and interconnectivity of markets. Continued and increased sanctions against Russia could have a number of effects, including politically-motivated temporary supply disruptions, longer-term supply deterioration through reduced investment and increased focus by Russia on eastward sales to China and other countries in Asia.
Nordlinger: Policies and political agendas favouring renewables and security of supply while seeking to reduce costs to the electricity consumer have created some difficult hurdles for the industry. Renewable energy and distributed generation have been increasing in almost all of the EU countries. The most dramatic example being that of Germany, which is switching from nuclear and fossil fuels to renewables, with the goal of deriving 80 percent of electricity from renewable energy by midcentury. Some EU countries have responded to a consumer backlash against higher electricity prices by cutting back on renewables subsidies and even seeking to undo power purchase agreements for conventional power plants. As the US emissions reduction policies back out coal-fired generation and gas prices in the US continue at low levels, we could see increased US coal imports into the European market. In the UK, the referral of the energy market by OFGEM to the Competition and Markets Authority for review, as well as the pledge by the UK Labour party to place a freeze on gas and electricity prices to 2017 for all the energy companies should it win the next election, are examples of policies and actions that could have a detrimental effect on existing and planned capital and operating budgets for the industry.
“The primary method for ensuring security of supply is through diversity of supply and we continue to see companies and governments target diverse supply sources.”
FW: Has the government implemented any specific legislation or regulations that will affect this sector going forward?
Beneby: In addition to the EPA’s Clean Power Plan, we’re also working to comply with the new Mercury and Air Toxics Rule, as well as updated provisions of the Clean Water Act, which would require additional treatment of power plant wastewater. Taken together, these regulations will continue the sector’s move away from coal and toward cleaner burning fuels such as natural gas, plus a greater reliance on renewables, energy efficiency and demand response, which come with their own set of challenges. The possible expiration of investment and production tax credits for wind and solar power could further alter the landscape.
Nordlinger: The UK Energy Act 2013 introduced two market mechanisms to incentivise investment. First, after a transition period, the current subsidy program for large-scale, low-carbon generation known as a ‘Renewables Obligation’ will be replaced by a scheme of ‘Contracts for Difference’ (CfD) which are long-term contracts expected to provide greater revenue certainty to investors. The Department of Energy and Climate Change (DECC) recently announced that it will add funding for large-scale renewable energy projects to reach a total of £300m in subsidy support during the first allocation round of the CfD scheme. Selected projects will receive CfD support for 15 years. Second, the Energy Act also introduced a ‘capacity mechanism’ for gas-fired power generation, to encourage new thermal investment in the UK.
Vince: For several years, Congressional gridlock has been among the most significant, albeit negative, legal and policy developments impacting the domestic energy sector. No major energy legislation has come from the US Congress since 2007, and the situation has worsened since then as the partisan divide on Capitol Hill has grown. Over the past several months, even the few legislative proposals thought to have bipartisan support, such as energy efficiency, have failed. When Congress fails to act, the other branches of federal government, along with state and local governments, step in. The Executive branch, especially the EPA, and the Departments of Defense (DOD) and Energy (DOE), have made several bold attempts to set policy impacting energy and fuel mix. DOE initiated a ‘Quadrennial Energy Review’ process, beginning with a survey of US infrastructure, to identify capabilities and needs in the US energy sector. Many executive actions are challenged in the federal courts, tasking the judiciary with policy-making. Meanwhile, state and local governments have become highly innovative and visible in their regulatory efforts.
Lang: Russian sanctions will affect the sector. In the United States, we are assisting a number of clients with navigating the evolving process for approving LNG export licences and helping them to assess the impact that the policies of the DOE will have on the timing and viability of their projects. In China, regulations on the import of LNG and domestic pricing of natural gas are also key factors affecting the sector. China has great potential demand for natural gas but liberalisation of import and pricing regulations will be key for fully realising that demand.
Barron: Specific legislation and regulation in North America and Europe continues to impede the oil and gas sector which constrains the use of hydraulic fracking in the development of unconventional resources, especially when increased supplies of natural gas in Europe could help stabilise various areas financially and politically. Favourable regulation and tax treatment of alternative energy supplies are passed along in hidden fees that mask the true cost to the consuming public, putting increased pressure on the utility industry to provide spare capacity without the benefit of the same incentive treatment.
Kopp: No recent legislation at the Federal level has been passed affecting the sector. However, under the Clean Air Act and other prior legislation, the EPA has recently enacted and proposed regulations aimed at requiring further control of emissions and operations of coal-fired power plants. These regulations deal with air emissions, water supplies and discharges, and combustion by-products. Regulations have been enacted and proposed for both existing and new generation associated with coal-fired power plants and other fossil fuelled power plants. The most recently proposed regulation affecting the sector includes the EPA’s Clean Power Plan which aims to significantly reduce the CO2 emission from existing power plants through a combination of efficiency improvements, increased use of existing combined cycle units, new renewable generation and overall lower usage of electricity. If this regulation moves forward as currently proposed it will have a dramatic impact on how the entire electricity sector will function from existing power plant operation to energy demand at the consumer level.
FW: Could you explain some of the key issues in energy security and supply around the world? What steps are being taken to ensure that companies and governments can meet long-term demand?
Lang: The primary method for ensuring security of supply is through diversity of supply and we continue to see companies and governments target diverse supply sources. Companies in China have for a number of years made upstream acquisitions around the globe to secure diverse sources of commodities, including natural gas. Looking to a smaller market, BG secured the role of LNG demand aggregator in Singapore, which now has an LNG import terminal that was underpinned by a government policy to increase the diversity of natural gas supply, which previously only came from Indonesia and Malaysia. We expect diversity of supply source to remain at the forefront of methods used to ensure security of supply.
Barron: A key issue for countries is for oil and gas prices to remain at a level enabling companies to achieve target goals and satisfactory economic returns. If prices average below $75 per barrel on the international market, many companies may begin to reduce their development projects and reduce their commitments to long term exploration activities in the E&P sector, or utility projects that require secure supply that may suddenly seem in jeopardy. Countries such as Argentina that are changing their hydrocarbon law to attract capital for the development of shale plays may find that companies scale back their investments with a lowered return on their investment. Sustained lower world prices may result in an easing of restrictions in various regulations, but only after prices remain low for an extended period of time.
Vince: The US energy boom is helping this nation to move towards ‘energy independence’; but it also is doing much to change the ability of some countries to use energy as a political weapon in their dealings with one another. For example, Europe is looking at LNG imports as a means of reducing reliance on Russian gas. China, Japan, India and Korea are looking to LNG imports from the US and elsewhere to help meet rapidly rising energy demand. China is experiencing energy builds on a scale never before seen – and will add generation equivalent to the entire US fleet by the end of this decade. Much will be coal-based, which is problematic for climate issues. However, China is also investing more in renewable energy worldwide than any other country. The African continent has vast pools of resources that can be tapped to meet rapidly growing demand, but also has significant infrastructure challenges and political barriers that will need to be overcome.
Kopp: The evolution from vertically integrated utilities to larger balancing authorities with increased competition for long-term power sales agreements and integration of substantial renewable resources has largely resulted in slower growth rates of wholesale and retail electric rates and increased system efficiencies. However, combining slow demand growth with short-term capacity forward markets has the potential to increase market volatility. Rather than providing timely demand signals which allow for development of new resources, supply markets may experience volatility, and potential supply deficiencies followed by periods of oversupply. The result may actually drive project costs higher as commodity, equipment, and labour demands ebb and flow.
Nordlinger: A key issue is whether European countries currently dependent on Russian gas supply will be able to diversify into alternate sources of gas supply in reaction to the Ukrainian situation and the resulting sanctions by the EU and the US. Another threat to electricity supply security in the UK is the very tight electricity reserve margins, which has figured in recent media headlines. OFGEM has predicted that electricity reserve margins could tighten in 2015-16 to between 2-5 percent. Substantial new investment in generating capacity is required to increase those reserve margins.
Beneby: Europe’s dependence on Russian natural gas, combined with its aversion to hydraulic fracturing, and in some cases, nuclear power, is clearly impacting energy security there. In the US, fracking has flipped our longstanding role as an energy importer, as we’re now becoming a net exporter. Germany’s heavy play into renewable power has brought with it a unique set of challenges we may be able to learn from as renewable penetration continues to increase here.
“Clean alternative energy continues to slowly and systematically make inroads into the supply sector pushed along by environmental pressures and regulatory enabling economic benefits that fail to let market dynamics make the choice of record.”
FW: How would you describe the evolving market dynamics between traditional, fossil fuels and clean, alternative energy?
Nordlinger: Given the concern over global warming, I do not foresee a substantial reduction in support for renewables, although some countries have cut back subsidies, even retroactively, in the face of concern over increasing consumer electricity prices and government budget deficits. The EU recently adopted a binding target to cut greenhouse gas emissions by at least 40 percent from 1990 levels by 2030. Advances in technology, particularly for solar electricity generation, may make some renewable energy sources competitive over time without subsidies. Imported low-cost coal has backed out gas-fired electric generation in some parts of the EU. However this reduction in gas-fired market share may not be entirely market driven, but could be, to a substantial extent, the result of government policies. In light of the environmental benefits of natural gas, as compared to coal and fuel oil, I would expect to see an increase in gas-fired electric generation capacity worldwide, even in the EU. Natural gas prices are still higher in Europe than in the US and higher still in Asia. However, it is possible that the abundance of new LNG coming online will result in a somewhat greater convergence of global pricing for natural gas.
Beneby: As renewable power continues to gain market share, it affects how traditional fossil fuel plants operate. Designed to run steadily and provide baseload power. Today, however, they’re being asked to cycle up and down in response to the intermittency of renewables. As we have added renewable generation as part of our strategy to diversify and reduce the carbon intensity of our fleet, we’ve added combined cycle natural gas, as well as additional peaking capacity with combustion turbines to address these cycling issues.
Kopp: A combination of changing economics and regulatory policy has resulted in a significant shift from the traditional energy market dynamics of coal-fired baseload, combined cycle intermediate load and simple cycle peak load operations. The economics of renewable energy have gotten better, combined with the production tax credit and investment tax credit along with renewable portfolio standards. This had led to a relatively sharp increase in these intermittent resources. The impact has actually been a reduction in coal fired generation, as the valleys in alternative energy output have been filled with more flexible gas fired generation resources. Couple that with low gas prices, and the result has been reduced coal-fired generation. As a result, we’ve seen quite a bit more interest in cycling coal units or even laying them up in the off-peak months or retiring them altogether.
Vince: The energy mix in the US is driven as much by fuel availability as by policy and regulatory decisions. Strict environmental regulations and abundant, cheap natural gas are prompting a decline of coal new builds and retrofits in favour of less emissive gas-fired generation, although there is growing recognition that gas, while cleaner than coal, has its own set of issues. New EPA standards for power plants are expected to further discourage new coal builds. Some argue that the effect of these rules is being felt even though they are not all finalised and certainly will be challenged in court.
Lang: While various non-traditional energy sources will likely see increases in the share of the energy market over the coming years, fossil fuels will remain the core of the energy industry for the foreseeable future. Natural gas is likely to play an increased role within that core, particularly in emerging economies seeking a transition to more environmentally-friendly power generation. China in particular has indicated a policy of increasing the role of natural gas in its fuel mix as pollution levels in its cities become intolerable to its people and a number of companies are working to help fill the demand for natural gas in China. The role of nuclear power will also be important in determining the fuel mix of the future. Germany and Japan have moved away from nuclear power, driving demand for other fuel sources – notably LNG in Japan. It remains to be seen how other markets that have in the past planned to rely on nuclear power as part of the power generation mix will develop.
Barron: Clean alternative energy continues to slowly and systematically make inroads into the supply sector pushed along by environmental pressures and regulatory enabling economic benefits that fail to let market dynamics make the choice of record. Fossil fuels continue to be the fuel of choice from availability, transportation and economic considerations in the consumption market, but generally with environmental problems that are only slowly addressed by the supply side providers. For clean energy to be a true alternative, it must survive as a choice on its economic merits a well as its environmental considerations in order to displace the traditional and fossil fuels in the marketplace.
FW: To what extent are energy and utilities companies taking proactive steps to address environmental concerns arising from their operations?
Vince: Last year, the White House announced its ‘Climate Action Plan’ calling on all sectors to step up efforts to meet challenges posed by climate change. To some extent, the energy industry was already out in front of the issue, although the driver of industry action is not necessarily climate change per se. In the US, the market has been the single largest driver of emissions reductions in recent years, at least with respect to CO2 and particulate matters. Cheap gas is pushing out coal on a greater scale than tighter environmental regulations. Other concerns, such as infrastructure resilience, are also prompting the energy industry to take actions that respond to climate and sustainability imperatives as well as security concerns. We also see responses to environmental challenges growing out of measures designed to address practical problems. For example, companies are building infrastructure and improving technologies to capture gas produced along with oil, rather than flare it, which will help reduce methane emissions.
Kopp: Energy and utility companies are continually evaluating how the proposed environmental regulations will impact their generation fleet. Typically, companies determine whether the regulations will force the installation of additional equipment or change the operation of the plant, and then they determine cost associated with the installation and operation of the new equipment. The companies perform a cost and benefit evaluation to determine whether to continue to operate the affected power plant with the new equipment or retire the power plant and replace it with a new unit. Due to the number of regulations recently proposed, increased renewable requirements and low natural gas prices, utility companies are continually performing these evaluations and the frequency with which this is required has only increased in recent years. For regulated utilities, they are continually evaluating impacts even outside their typical planning requirements which are required every two to three years by public service commissions.
Barron: The majority of companies, especially the major national, international and national corporations embarking on major projects, must include planning and design contingencies dealing with natural and man-made circumstances that could result in environmental consequences. Containment design, alternative systems, contingency planning and levels of authority to deal with situations must be considered, anticipated as an eventuality rather than as a probability, and the cost of design, construction and probable implementation included as a part of the initial capital considerations of a project’s economic viability.
Beneby: Over the past decade, traditional fossil fuel power plants have become cleaner, as evolving technology has allowed for the removal of more pollutants from plant emissions. That said, generators and utilities are not responding equally to environmental concerns. Those heavily invested in older coal and natural gas technologies have been slower to invest in new technologies. We have reduced the carbon intensity of our fleet even as we’ve increased generation. Our Spruce coal units are recognised as among the cleanest in the nation, and we were one of the first utilities to commit to shuttering our oldest units, 15 years ahead of schedule.
“In the US, the market has been the single largest driver of emissions reductions in recent years, at least with respect to CO2 and particulate matters. Cheap gas is pushing out coal on a greater scale than tighter environmental regulations.”
FW: What other risks and challenges are keeping energy executives awake at night?
Barron: Energy executives must deal with fluctuations in product prices and government regulations that change after a company has undertaken significant commitments in the planning and development of a project. Projects undertaken in times of stable price environments, under compliance with existing governmental regulations and meeting current environmental requirements, are oftentimes met with sudden changes that dramatically alter the potential outcome of the overall investment, including possible financial ruin. Political instability may allow areas to be overrun by conflicting groups that target international companies as an example of the current government’s policies toward outside development of local assets. The larger of the energy and utility companies often embark on new projects in remote areas with little support or infrastructure, thereby putting the entire project at risk since new and perhaps unproven technology may be the defining factor upon which the success depends.
Nordlinger: There are many risks and challenges. Among them are falling energy prices, especially a collapse in oil prices. We see continued war and political instability in the Middle East and parts of Africa, as well as heightened political or military tensions in the South China Sea. Unresolved tension in the Ukraine, leading to continued or increased sanctions against Russia, is another problem. A potential economic slowdown in China and Europe, reducing the demand for energy, would have negative consequences. Unexpected changes in government policies are another risk, including moratoria on price increases or new and increased taxes or taxes that discriminate in favour of one type of fuel over other types of fuel. There is the risk of increased government enforcement action, including settlements resulting in ever increasing liabilities. Uncertainty surrounds UK membership in the EU. There is always potential for large-scale accidents and environmental incidents. Finally, increased shareholder activism puts pressure on companies to divest assets or take other steps to return cash to shareholders, rather than increase or maintain capital expenditures.
Kopp: Utility executives face a number of challenges. Utilities must consider significant investment decisions driven by regulatory pressure on a number of fronts, including environmental and security concerns. Identifying both the internal and external risks to major capital projects in a world of tight operating margins and pressure from customers to keep rates low is a significant challenge. The importance of these capital deployment decisions are magnified by increasing customer choice options that threaten to shrink a utility’s customer base should rates rise too much. Technology and decentralisation are driving faster evolution in the industry and unnecessary investment will only put further pressure on the competitive position of a utility.
Beneby: Many utilities faces an aging workforce, at a time when rapid changes in the industry demand new skill sets. Our challenge is to make sure we’re properly developing enough next generation employees to fill our ranks. Security remains a key concern, and we are currently beefing up and integrating cyber and physical security capabilities, as we employ more computer-based control systems, intelligent grid capabilities and multiple electronic ways customers communicate with us and control their energy use. Uncertainty over new federal regulations – when they’ll be implemented, and how they might impact rates – remains a concern.
Vince: Energy executives are at a crossroads of tremendous change in the US energy industry. Traditional utility companies must carve out new roles to remain relevant and profitable in an unpredictable and ever-evolving energy landscape. Energy company leaders are confronted with the daunting task of addressing declining demand, shrinking customer bases, rigorous national and state environmental and efficiency mandates, and an urgent need for investment of trillions of dollars to bring energy infrastructure up to 21st century requirements in terms of security and reliability. Additionally, they must consider the incorporation of new power sources, rapidly changing technology and heightened customer exigencies and expectations, all in the context of an uncertain regulatory environment.
FW: What impact is advancing technology having on the energy & utilities market? Are there any disruptive, game-changing innovations on the horizon?
Kopp: Advanced combustion turbine technologies are demonstrating increased efficiency and economies of scale, but there is always some hesitation to be the first to build a plant using a new combustion turbine design. On the renewable front, wind turbines and solar panel designs continue to improve, resulting in higher capacity factors and better economics. Implementation of smart grid technologies continues to gain interest and certainly has the potential to change the way power is consumed and paid for by customers. Smart meters and synchrophasers on the transmission system lead to enhanced distribution system health awareness and advanced rate options. Increased data and monitoring on distribution assets can allow for more condition-based maintenance. These all represent significant operational improvement. Advances in battery technology and other grid scale storage options appear to be potential game changers, offering utilities more flexibility to integrate greater penetration of renewables on systems. Customer-scale storage options will offer customers the ability to maximise distributed renewable generation value or control their net load and manage energy costs. Microgrids offer the ability to drive control and generation closer to load.
Lang: Focusing on natural gas, we see two significant technologies driving change. First, evolution of shale gas production technologies has had and could continue to have a disruptive effect on the global gas market. Obviously, exploitation of North American shale gas has already had a significant impact. Thus far, exporting North America’s success has proved difficult. China, for example, has had to reduce the role of domestic shale gas in its forecasts due to disappointing development results. If technology unlocks China’s shale gas resources, those advances would have a significant impact on the Pacific Basin gas market. Second, new floating and modular LNG technologies have the potential to unlock significant quantities of stranded gas. Large-scale facilities to be used in distant offshore waters – such as Shell’s Prelude project and PETRONAS’ two floating LNG projects – could commercialise large fields of stranded gas. A number of companies are looking to use smaller-scale and modular facilities, which offer the potential of unlocking smaller resource basins that previously have not justified large-scale LNG facilities.
Vince: A number of huge game changers are currently making their effects felt on the sector. In the oil and gas sector, technological improvements have enabled resource recovery at rates far greater than imagined even a couple of years ago. The EPA believes its proposed rules for power plants will spur carbon capture technology, although some are sceptical. The cost of wind and solar is coming down, bringing these technologies closer on par with more traditional energy sources and allowing for broader deployment. National and international climate initiatives, the impact of China and emerging markets on the global energy picture, the development of energy storage, and infrastructure security and reliability needs will all have a transformative impact on the industry. One of the biggest developing stories is the advent of big data, which will not only transform how the sector itself operates in terms of communications, efficiency and so forth; but also this will have a tremendous effect on demand as the globe moves toward a digital economy.
Beneby: Almost everything facing our industry today is disruptive and game-changing. We are looking at a future with networked grids and big data analytics that will allow for better integration of renewable resources, distributed generation, microgrids, electric vehicles, demand response and distribution automation, storage capabilities, smart inverters and solid state transformers. It will be a difficult and expensive transition, but again, I believe there are great opportunities for utilities willing to take chances and adapt.
Barron: Increased utilisation of coal gasification for the production of liquid fuels, chemicals and with combined-cycle power plants offer alternative uses for an abundant energy source with environmental hurdles in historical markets. Applications of advanced technologies in seismic processing, drilling and completion techniques and particularly stimulation methods have dramatically enhanced the E&P sector in the oil industry. Exploitation of unconventional reservoirs remains dependent upon relatively high product prices, increased demand and easing of regulatory restrictions to allow for technological advances in the E&P sector. New advances in massive amounts of data management will allow companies with even moderate budgets access to information to plan and generate projects and manage data with fewer personnel in less time.
Nordlinger: Distributed generation and off-grid energy supply solutions have the potential to disrupt conventional electricity supply sources. Global revenue from distributed generation is expected to grow from $97bn in 2014 to more than $182bn by 2023. The issue for utilities and regulators will be in accommodating this enormous growth in sources of supply that are not controlled from a central source and which require utilities to maintain back-up generating capacity. To date, distributed generation has been more disruptive in Western Europe than in any other region, although exciting initiatives have been undertaken in the US. Increasing penetration of electric and hybrid automobiles, together with efficiencies from new technologies such as from driverless cars, may at some time approach a tipping point resulting in substantial reductions in demand for liquid fuels.
“Identifying both the internal and external risks to major capital projects in a world of tight operating margins and pressure from customers to keep rates low is a significant challenge.”
FW: What levels of M&A activity have you seen in the last 12-18 months? What factors are driving deals?
Beneby: My general sense is that utilities continue to merge to gain size and cost advantages in light of weak demand for electricity brought on by distributed energy resources, weak earnings and unfavourable regulation. They are also looking to diversify away from competitive and deregulated markets – look at PPL and AES’s recent transactions – in order to lower the risk on their profiles. I think we’ll continue to see merger activity as larger players buy up smaller, regulated entities. Future M&A activity may also focus on utilities right-sizing their generation fleets relative to DERs and new 111d Clean Air Act rulings. Our focus is on the asset level. In 2012, we acquired an 800 MW combined cycle natural gas plant that will replace the retirement of our shuttered coal units in 2018.
Nordlinger: Global M&A activity in the energy and power sector is still gathering pace, with deal volumes reaching $405.13bn – 15 percent of total global M&A activity. The principal drivers for this increased global activity include the disposal of refinery and marketing business by the energy majors as they move into the more lucrative upstream business. Privatisations and consolidations are occuring in emerging and other markets, such as Turkey, Nigeria and Russia. Further, developing markets in Asia and Africa continue to receive large-scale investment in response to government electrification programs. There is also a growing trend for private equity investors and infrastructure funds to acquire interests in the sector. In the UK energy and utilities sector, the depletion of reserves in the North Sea has resulted in major oil companies gradually withdrawing from this market, which has presented an opportunity for independents to fill the void.
Barron: The total value of M&A activity in the upstream sector of the energy industry was reported to be down approximately 30 percent worldwide in the third quarter of the year from the second quarter of 2014, while activity in North America continued to be on an upward trend over the last year. The lack of large deals outside of North America has been offset by continued activity in the unconventional oil resource plays, with increasing activity in natural gas driven by interest in future gas export potential from the US. Many corporations remain cash flush from high product prices and indications are they will increase their acquisition activity through the end of the year and into early 2015, especially in what they consider to be core areas for development and operations.
Vince: Energy sector deals are taking place as the economy improves, and foreign investors are taking an increased interest in the US energy sector. Much of the interest reflects improving returns, particularly after a number of sluggish years. It also may be attributed, in part, to instability in other regions of the globe where countries have traditionally sought supply. For regulated companies, the hurdles to successful M&A remain high. Regulators seek maximum benefits for customers, which cuts into profitability of a combination. We continue to see the trend of transactions involving companies – especially utilities – selling off less-productive assets and retreating to core businesses, but we also see activity reflecting attempts by certain companies to reinvent themselves to prevent their business models from becoming obsolete in the face of changing demand.
Lang: We have seen a lot of M&A activity in the past 12-18 months. North America has been the most vibrant region for this activity, but we have seen a lot of activity elsewhere as well. Many international players have sold assets around the world as they focus on core development regions, such as North America. Large Chinese state-owned enterprises have not been as active recently as in prior years but we anticipate that their cross-border transaction activities will pick back up in the coming years, particularly in the downstream. During this slower period for the largest SOEs, we have seen an increase in activity from smaller SOEs, privately-held energy companies and private equity funds in China. More broadly, global private equity has continued to play an important role in M&A activity and we note a concerted entry into Southeast Asia by a number of large private equity funds.
Kopp: M&A activity around wind farms seems to have remained rather steady over the last several years, as the production tax credit and investment tax credit have been renewed. The market for combined cycle and simple cycle assets seems to have slowed down quite a bit over the last year or two, but we have seen a resurgence in this market, particularly for combined cycle assets, over the past several months. We see combined cycle plants as a potential area for continued M&A activity moving forward, particularly as more coal plants are retired and combined cycle unit capacity factors increase.
“My general sense is that utilities continue to merge to gain size and cost advantages in light of weak demand for electricity brought on by distributed energy resources, weak earnings and unfavourable regulation.”
FW: Looking ahead, what are your expectations for the energy & utilities sector heading into 2015, and beyond? What issues will dominate the thinking of energy executives as they craft their business strategy?
Lang: We expect continued strength in the global energy industry and significant investment and acquisition activity in 2015. In the natural gas sector, 2015 will be an important year for North America, particularly Canada, as a number of projects consider final investment decisions. Likewise, progress on East African LNG projects will be a significant factor in the development of the global gas market. Pricing is going to be a key issue for these projects and thus will be a dominant consideration for energy executives as they craft their business strategies. Likewise, the regulatory regimes in place in various jurisdictions will play a role in executives’ decisions as to where to deploy capital. 2015 promises to be another dynamic year for the global gas business.
Kopp: Looking ahead to 2015, I think security – both cyber and physical – will be prominent in energy executive discussions and strategy. Beyond security, development of a long-term strategy to address greenhouse gases, and more specifically carbon, will also be important. There will be a lot of discussion on the regulatory front from the EPA on carbon in 2015. There is unlikely to be certainty in the near term about what a final rule or legislation on carbon looks like, but every utility will have to take a look at their generation fleet and see how they are positioned to meet the potential future regulation and how they might comply with it. I think the other component that will play an important role in future business strategy is transmission investment and the uncertainty around future returns on those investments.
Vince: Key issues in national policy discussions in the near term will include reliability, access to capital, the effect of federal agency and state government policies on fuel price and availability, when and where the next major storm or cyber attack will strike, the impact of rooftop solar, new and disruptive technologies, the increasing role of big data and cloud-scale computing, globalisation, energy storage concepts, and the smart grid.
Beneby: In the last several years we’ve seen a great deal of innovation on the generation side of the equation, but I think now that’s shifting to delivery. With the increased sophistication of the smart grid, home area networks, distributed generation and storage technologies, we’ll be seeing a much more networked system, much like telecoms. For utilities to thrive in this brave new world, we will need to continue to innovate, adapt our business models and become more customer-centric. I look forward to those challenges.
Nordlinger: Executives in the oil and gas industry will undoubtedly review capital budgets in light of uncertainty as to future oil prices and increasing project costs. It is unclear whether or not the recent drop in oil prices is a short-term blip or a new normal, or even presages further price declines. On the natural gas side, producers will seek to take advantage of arbitrage opportunities, diverting supplies from lower to higher value markets, such as Asia, Latin America and Europe. The oil and gas industries, however, are long term industries, and temporary volatility in prices likely will not result in material changes to long-term strategy.
Barron: Business strategies will depend upon trends that can be forecast with certainty and assurance that variations can be dealt with in a timely and cost effective manner. Topics such as price stability, reliable governmental regulations that provide a level transparent environment and opportunities to apply technological advances in a manner that enhances commercial success, should be on the minds of energy executives as they look for the areas to take their companies in the coming years. Taking advantage of their particular expertise in the marketplace should enable them to compete competitively if given the opportunity. However, again the energy industry needs a pricing environment that is stable and sufficient to deliver a reasonable return on investment, and currently, that appears to be $75 to $80 for the next year as a minimum.
Jeff Kopp is a manager in the Business Consulting Department at Burns & McDonnell, specialising in consulting services for power generation and transmission and distribution projects. This includes energy project development, due diligence reviews, resource planning, renewable project development, rate studies and analysis, power plant decommissioning studies, and transmission planning. Mr Kopp has project management and engineering experiences that include power plant development assistance, site retirement and decommissioning studies, site evaluations, and strategic site selection. He can be contacted on +1 (816) 822 4239 or by email: jkopp@burnsmcd.com.
Doyle Beneby is the chief executive officer of CPS Energy, the largest electric and gas utility in the nation. Mr Beneby is a 25 year veteran of the energy industry and has expertise in strategic planning, generation and delivery operations and asset acquisition. Since joining CPS Energy, Mr Beneby has led the transition to a lower carbon intense generation fleet, utilising clean coal, natural gas and nuclear combined with targeted renewables such as wind and solar. He can be contacted on +1 (210) 353 4158 or by email: ceo@cpsenergy.com.
Clint Vince is co-chair of Dentons’ Global Energy Sector, with professionals in more than 79 locations worldwide, and is based in Washington, DC. He is widely recognised for his cutting-edge counsel and innovative solutions within the energy industry and pertaining to international commercial law. His experience includes high-profile litigation and appellate cases, including US Supreme Court advocacy, major project development, and legislative and regulatory advocacy on behalf of public and private clients. He can be contacted on +1 (202) 408 8004 or by email: clinton.vince@dentons.com.
Allen Barron has over 40 years of experience as a reservoir engineer in evaluating domestic and international oil and gas properties, providing certification of reserves for public filings and regulatory reporting. The evaluation of properties includes analysis for the sale and acquisition of fields and projects, preparation of development programs and as an expert witness in legal proceedings. He is a University of Houston graduate in Chemical and Petroleum Engineering and a licensed Professional Engineer in the State of Texas. He can be contacted on +1 (713) 622 8955 ext 313 or by email: acbarron@ralphedavis.com.
Douglas Nordlinger is a partner at Skadden, Arps, Slate, Meagher & Flom LLP, and global head of the firm’s Energy and Infrastructure Projects Group. He represents clients in a broad array of corporate, commercial and finance-related transactions, with a particular emphasis on the energy industry and other infrastructure projects. In the course of his almost 30 years of practice, he has advised clients worldwide in connection with mergers and acquisitions, joint ventures, structured and project financings, and commercial agreements. He can be contacted on +44 (0)20 7519 7030 or by email: douglas.nordlinger@skadden.com.
David Lang is the managing partner of Vinson & Elkins LLP’s Hong Kong office. His practice focuses on international energy transactions, with a particular focus on LNG project development. In addition to LNG projects, he works on various projects, mergers and acquisitions in the upstream, natural gas transmission and storage, power, mining, renewable energy and petrochemicals sectors. Prior to entering law school, Mr Lang worked as a reservoir engineer for a major international energy company. He can be contacted on +852 3658 6426 or by email: dlang@velaw.com.
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