Utilities and pipelines – diversification into non-traditional businesses

January 2025  |  SPECIAL REPORT: ENERGY & UTILITIES

Financier Worldwide Magazine

January 2025 Issue

A number of factors are driving electric utilities and pipeline companies to diversify their business models to participate in unique, novel or non-traditional businesses, which can have significant regulatory, transactional and litigation implications for these companies.

While each company is likely to assign a unique value to the benefits and risks of diversifying its core business model, there are a number of common drivers and challenges to be gleaned from companies that have already undergone, or are currently undergoing, such diversification.

Diversification of business

Numerous electric utility and pipeline companies have undergone, or are undergoing, some form of diversification to their core business model. Some of the more common examples of this diversification include regulated electric utilities forming unregulated affiliates to develop renewable energy assets, gas or oil pipeline companies investing in, or owning and operating, renewable energy projects, or innovative technologies or projects with a greater risk profile than would typically be acceptable to a business segment that is, historically, relatively risk averse.

In addition to some of these macro-examples of diversification, there are also other examples of efforts to expand or diversify electric utility and pipeline company businesses. These include: (i) novel or unique contracts entered into through unique tariffs or similar structures (such as with large load customers like data centres); (ii) the development of, or investment in, new products or services (such as renewable natural gas, hydrogen or distributed generation resources); and (iii) investing in non-traditional or developing technologies (such as small-modular nuclear reactors, coal gasification, renewable assets used to power compressors on the pipeline distribution system, or advanced transmission technologies to support utilisation and management of the electricity grid).

Moreover, numerous factors are driving this diversification and investment. While each company decides to diversify based on its own set of circumstances, some of the more significant, industry-wide factors driving diversification include demands from large load customers (such as data centres) for non-emitting sources of energy. Other key factors include environmental, social and governance (ESG) frameworks, corporate sustainability commitments, state clean energy mandates or carbon reduction programmes, institutional investor demands and investing criteria, economic considerations, opportunities to deploy significant capital, growth of new and developing technologies, permitting and legal barriers to development of certain assets, and ageing infrastructure necessitating replacement.

Among the more significant of these factors is the push by electric utilities and pipeline companies to attract new customers, particularly those with large energy needs such as data centres. At the same time, these large customers are becoming increasingly sophisticated with respect to their energy needs and engagement with energy suppliers.

A confluence of any number of these factors may support a decision to diversify an electric utility’s or gas pipeline company’s core business into new areas, technologies or techniques for performing its core business functions. However, diversification is not without risks. Energy companies seeking to diversify their business model may face significant regulatory, transactional and litigation challenges.

Regulatory issues

Companies may face increased regulatory scrutiny, both for what they do and what they choose not to do, in relation to new and novel business approaches. This scrutiny may lead to negative outcomes or regulatory uncertainty. Therefore, companies must be mindful of their regulators and have an appropriate plan to engage with regulators to try to mitigate any negative impact from a venture into a new or novel business approach.

One issue that is constantly of concern for regulated parties and their regulators is the parameters around who bears the risk for approaches or ideas that do not succeed. Purely unregulated ventures, such as a company setting up a trading arm, are typically the responsibility of the company itself.

However, other ventures – such as the company’s pursuit and development of a new technology – may be appropriately shouldered both by the company and its customers, even in the event the new technology or approach is not successful. In either scenario, the company must ensure, to the extent possible, that it and the regulator know how risk is being allocated and who will ultimately be responsible for the costs of an unsuccessful venture.

Regulators will also be very focused on the impact of anything new on existing, regulated customers. Certain customer groups or classes may have to share a disproportionate portion of the costs of a new or novel programme, and to the extent they do not receive commensurate benefits from such a programme, the regulator likely will not approve it.

There have been, and likely will continue to be, significant regulatory fights about whether certain types of customers and types of technologies are appropriately shouldering costs they are causing, and this dispute will be of particular importance for any new or novel approaches.

Transactional considerations

Various efforts to diversify utility and pipeline companies’ business models also present transactional issues that should be considered. Structurally, expanding into non-traditional areas may require significant hiring or expansion of internal capabilities for utility or pipeline companies, particularly where these companies are seeking to develop new infrastructure assets or deploy significant capital to do so.

Renewable energy or novel technology transactions can be expensive, time consuming, taxing of internal resources, and require a level of market knowledge and understanding that may not already exist within a utility or pipeline company. This lack of knowledge and experience may lead to added time and expense to get deals done, and can also result in ‘bad’ deals without support from a sophisticated market adviser, particularly during the early stages of a utility’s or pipeline company’s transition into the new business or technology.

Another significant transactional consideration is the applicable regulatory framework and how it impacts, promotes or inhibits the contemplated investments. Some states have lengthy approval processes for standing up an unregulated affiliate, which some companies choose to do in order to pursue novel or riskier technologies, or to participate in a regulated-affiliate’s request for proposal (RFP). As novel transactions or issues arise, understanding applicable market rules may be the difference between a successful deal that receives regulatory approval and those that do not.

Similarly, the regulated nature of utility and pipeline companies’ businesses may require unique contract provisions or approval timelines to be considered when negotiating and drafting transaction documents. Other timing considerations to keep in mind when contracting with a regulated business include how to account for cost and price uncertainties when bidding a project into an RFP that may not close for a year (or more) or the time and expense associated with documenting a transaction where the counterparty may not have a sophisticated deal team.

When negotiating deals with, or on behalf of, utility and gas pipeline companies, it is also important to consider each party’s unique risk profile. For example, most utilities and gas companies are risk averse, meaning they will desire significant contractual protections in the form of covenants, representations and warranties, and indemnities in the relevant transaction documents.

In contrast, many companies whose core business is development of assets or technologies have a greater appetite for risk, in addition to a need for speed in contracting, thereby resulting in the expenditure of capital. Evolving markets and business models emphasise the need for a sophisticated understanding of the relevant rules, deal types and risk allocation mechanisms.

Without these skills, diversifying utility or gas companies may expose the company, its shareholders or ratepayers to unnecessary transactional risks.

Litigation issues

As utilities and pipelines diversify into new businesses, litigation risks increase. While some disputes are project-specific, there are several risk areas where litigation is more likely to arise.

Utilities and pipelines are highly experienced in building infrastructure and capital projects, but their experience developed in traditional business areas does not always translate perfectly to managing and executing a new type of project. Project delays, cost overruns and disputes about whether a project functions consistent with operational performance requirements set by contract can lead to disputes.

Where these disputes arise, the utility or pipeline is often characterised as inexpert in developing projects outside its traditional business areas, in the habit of ‘gold-plating’ projects, and incapable of managing a project with financial consequences that are not covered by ratepayers. While these criticisms may be unfounded, they are a vulnerability in litigation.

In addition, the complex interaction between new business ventures and regulatory regimes generates litigation risk. Utilities and pipelines are branching into new businesses in areas where regulatory regimes are evolving and may lag the kinds of projects that are already being developed. Changing regulatory requirements can alter underlying deal economics, in some cases prompting parties to look to litigation as a potential way out of a transaction that no longer makes economic sense.

Similarly, utilities or pipelines seeking the regulatory approvals necessary to operate a new line of business face litigation risks before state and federal regulators, as well as the courts – particularly where stakeholders perceive the utility or pipeline as infringing on their businesses, unfairly favouring their own projects or affiliates or failing to provide sufficient transparency underlying the purpose for forming a new business line.

Further down the road, allocating wind up or project end of life costs can also be a source of disputes, particularly where regulatory obligations like environmental compliance obligations have evolved over time and have not been adequately addressed in contracts or during operations.

Lastly, tariffs, regulations and other rules that apply to regulated entities can impact litigation more broadly, both as a shield and a sword, even when it involves unregulated entities. As a result, it is especially important to engage litigation counsel who understand the entire commercial and regulatory landscape when disputes arise.

Shaun Boedicker, Jennifer Quinn-Barabanov and Chris Zentz are partners at Steptoe. Mr Boedicker can be contacted on +1 (202) 429 8066 or by email: sboedicker@steptoe.com. Ms Quinn-Barabanov can be contacted on +1 (202) 429 8027 or by email: jquinnbarabanov@steptoe.com. Mr Zentz can be contacted on +1 (202) 429 6703 or by email: czentz@steptoe.com.

© Financier Worldwide

BY

Shaun Boedicker, Jennifer Quinn-Barabanov and Chris Zentz

Steptoe

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