Growth Opportunities for the Electric Utilities in a era of Climate Adaptation

Its a cold and wet Saturday in Raleigh. Cooped up in my apt, I continue my favorite way to pass time  of  thinking about our energy system. Here's some of my uncoordinated thoughts- 

US Climate Report (released in the auspiciously during thanksgiving day) tells us that US can lose up to 10% of its GDP by climate change- if we do nothing. Snippet from the executive summary of the report- 

"Our Nation’s aging and deteriorating infrastructure is further stressed by increases in heavy precipitation events, coastal flooding, heat, wildfires, and other extreme events, as well as changes to average precipitation and temperature. Without adaptation, climate change will continue to degrade infrastructure performance over the rest of the century, with the potential for cascading impacts that threaten our economy, national security, essential services, and health and well-being."


As scary this is, this provides us electric utilities with the "wild west" of growth opportunities. The antiquated electric grid system needs to be revitalized to make it adaptable to climate change. Here's some of my thoughts on how it can be achieved.

Understanding electric utility firm behavior

In terms of investment theory, electric utilities in the US are often considered a mature industry. A typical electric utility operates with a tried and true business model with a regulatory compact allowing some form of monopoly with a guaranteed rate of return. As long as the utility continues to provide electricity often through large generating assets that are depreciated over decades, the return the utilities get on their equity does not change much. This "un-exciting" but reliable firm behavior allows a stream of guaranteed dividends that are attractive to many risk averse investors.

Firm behavior because of low growth potential (boring but my rational revolves around this)

A comparison of the "return on assets" on these electric utilities with the other firms (for instance software firms) shows the stark contrast in firm behavior. The software firms, often are considered to have high growth potential and these firms enjoy return on assets on median of 15%. Electric utilities who are not really considered to have any growth potential enjoy about 6% return on assets. I am including return on assets, rather than return on equity because the return on equity is affected by leverage. Electric utilities often have high leveraged (high debt and equity ratio) compared to software firms.

This return on assets difference then affects the plowback ratio- which is how much firms decided to invest their profits back on the firm rather than giving out dividends. Electric Utilities have low plowback ratio, giving out much of its earnings back to the investors. Software companies often do not pay out their profits as dividends, instead, they reinvest all of their profits back into the firm, since they can continue to grow.


kWh sales

Almost a cliche- "electric utility gets its electricity by amount of kWh sales". This is true, and however many states have tried to revert away from this model (revenue decoupling, increased competition), they cannot completely get away from it, as fundamentally, this will continue to remain true. However lets look at that closely - "to make money the utility has to sell kWh" - if the power lines are down, the utility wont make money. If the transmission lines goes out, the utility wont make money. If the entire town burns down (like the town of Paradise, of the city goes underwater- like NYC during Sandy), the utility will not make money.

So the utility and the utility regulators need to open its eyes and break from the traditional norm allowing investments in resiliency.

What the utility do to-

Utilities are seeing this across the states, are they are going back to the same old play-book. They come back to the regulators with a billions of dollars of resiliency plan, with startling amount of money. Any regulator in the right sense of mind will not approve of such high cost resiliency plans that requires astronomical increase in electricity prices.

The utility need to take it from to software firms play-book, and increase its plow-back ratio so that it can invest itself in making the grid resilient. A billion dollar resiliency plan cannot be funded solely by plow back ratio, but it shows the regulators that the utility understands the severity of the situation and is committed to making long term change.

Instead of going to the regulator will a multi billion dollar resiliency investment plant - and asking for 9% to 12% return on investment. The utility needs to prove that it really understands the needs for resiliency, and is committed to make improvements in the grid not just to get greater return, but to make sure that the grid will continue to operate in the future of climate uncertainty. 

Start with pilot projects - The utility needs to be proactive. It can start by using the its profits back into investments in resiliency as pilot projects, or making certain critical improvements. These pilot projects will not need lengthy regulatory approval since the utility is using its own profits. And it should not expect return on these investments. However, these projects will help the regulator understand the need for such investments and make them more favorable to such investments in the future. 

What will happen to the stock price?

But you might say- Achyut that makes no sense, if the dividends are decreased, then the utility stock will fall. Well that is not necessary true. Stock prices are calculated based on the future value of the earnings. Any long term investor  will welcome this opportunity since the investment in resiliency will further cement the utility's financial position in the future. Investors are not looking to investment in utilities for capital gain! They should not be. If the stock of electric utility is going up as software firms then something is not right! Investments in electric utility are low risk, and commensurate stable return.  

The immediate stock price may go down, but that is fine, utilities are in for the long haul. Utility firm cannot have be on the same mind-set thinking about the quarterly earnings.

What can utility regulator do?

Utility regulators are in tremendous position to make change. This change can effectively happen if the regulators decided to include the cost Carbon and resiliency costs are included in the LCOE and benefit cost calculations.
Many regulators are binded by the legislation (often on "lowest cost" states), but even then, revision of the what is meant by the 'lowest cost" is required. Should the customers pay the lowest kWh for 5 years, and then after the grid goes down, pay all the astronomical cost to put it back together?
 Someone has to pay for the utility upgrades, and the portion of the money will be recovered from the kWh sales. Balancing this act is the duty of the regulator. But the regulator cannot be blinded to every grid modernization proposals that the utility puts forward. The utility should make a good faith effort in making sure it understands the critical need for new infrastructure- for its customers, not just to appease shareholders. The regulators should bind the return on investments on conditions of increased reliability that goes beyond typical reliability indices (SAFI, SADI- discussed on next blog post). 

All challenges are opportunities- but only if we make them to be. 

The best of writings require several edits, this article has not been edited. While all the errors are my own, it is not representative of the best of my writing ability. 

Yes, the electric industry is excited about the solar eclipse as well!

One might assume that electric industry would be concerned about the effect of solar eclipse on the electric grid, after all, if the sunlight is blocked for a period of time, then the solar PV systems would not be able to generate any electricity, and thus adversely impact our grid. The logic is correct; however, consider a question- the sun does not shine at night, and the electric grid seems to be doing fine every night!

Balancing supply and demand

The fundamental principle underlying today’s electricity system is that the electricity that is consumed must be matched with the electricity that is generated at that very instant. When a lamp switch is turned on, the power station in that grid must generate the exact amount of energy required to power the lamp, and decrease generation by the same amount when the light is turned off. Essentially, at current economics, there is very minimum storage of electricity to draw from. All electricity demand must be met by generating electricity at that very instant. The electric utilities, balancing authorities, and system operator performs this job of balancing the demand and supply of electricity. The balance of the system measured in the frequency of the power supply is monitored very closely with a high degree of precision and accuracy.

Although the act of balancing each unit of energy consumed with each unit of energy supplied seems like an impossible challenge, grid operators are proficient at doing so. While energy from the solar output is will drastically decrease during the eclipse, the grid operators have a number of tools in both supply and demand side to help them prepare for the event. 

Managing supply side

Certainty: Unlike traditional power plants whose output can be precisely controlled by the grid operators, renewable energy sources like solar and wind are intermittent and the power output is dependent on the availability of resources. Most grid operators use sophisticated grid models to forecast what the renewable energy looks like which helps grid operations to plan ahead. In this case of an eclipse, the grid operators know with a high degree of certainty at what time and how much of the output will be disrupted due to the eclipse. Because of this high degree of certainty, the grid operators can plan well ahead in time to make sure that other power plants are turned on to meet the demand while the power from the solar systems are curtailed.

Redundancy: Electric power systems are designed with adequate redundancy so if any critical component fails, there is a backup available immediately. In terms of power capacity, the power plants are built and available to generate 10%-20% more than the peak demand of the system. Even if the power from the solar PV is reduced, there are power plants that can turn on and deliver the required power. Electric power markets have defined market rules to price and deliver energy and capacity during normal and critical moments.

Negligible portion: Our electricity comes from diverse sources. In 2016 electricity from the solar PV constituted less than 1% of the total electricity consumed in the U.S. The energy mix varies by utility, state, and balancing authority, but even in North Carolina- ranked second among states with the total solar PV capacity installed- solar PV accounts for about 1% of the total electricity delivered. Since solar PV total only contributes such a minimal amount of the energy delivered into the system, any impact due to eclipse is not going to have a tremendous impact on the grid.

Demand management: In addition to managing the supply of electricity during the eclipse, the grid operators also have the option to control the electric demand during the period of the eclipse, which should help with balancing. Commercial and industrial sector uses the bulk of the electricity generated at any given moment. Unlike the residential sector where the electricity rate is static, the electric rates for large industrial and commercial customers are more dynamic and most are enrolled in demand response programs that provides financial incentives to curtail energy use during periods of stress in the electric grid. The grid operators can call upon the large industrial and commercial users to reduce their load during the period of eclipse to help balance the energy shortfall from solar PV.

Figure 1: Solar PV array output the eclipse. Green shade provides the total energy generated by the solar array. The blue line provides the sun's irradiance, and yellow line follows the ambient temperature. Image courtesy FREEDM Center at NC State University. 

Still a not a easy task: Back to the earlier question- although the electric grid does run smoothly run at night when there is no sun, the eclipse does pose certain challenges. The grid operators may not have idea when a particular individual is going to turn on their light, but they have a really good sense of habits and seasonality of electric demand on aggregate. The grid operators are fairly adept at managing the predictable load profile. The solar eclipse will provide different circumstance when all of the solar PV output from the system will turn off in a short period during the eclipse, and all of them will come back up on after the eclipse. This sharp changes are challenging to balance. The grid operators will have to ramp up their generators during the eclipse, and rapidly ramp down after the eclipses. With certain exceptions, most electric power generators, usually not designed to ramp up and down at such short intervals.

The balancing of the grid during the eclipse will depend on how the grid operators are able to use their supply and demand tools to hand the sharp drop in solar PV production during eclipse, and rapidly increased production after the eclipse.

Reasons for excitement for electric industry

Although the energy from solar is currently at low significant levels, the electric industry and the solar industry are both excited about this event. There are two certainties – i) in the long term solar energy will constitute a much larger portion of the energy mix, and ii) there will be another eclipse, or other abnormal events that require a similar balancing of the grid. This Great American Eclipse will provide a rare opportunity to grid operators to prepare and test their grid balancing measures. There might valuable lessons to learn from this experience which can help prepare for similar conditions in the future. 

Connecticut 2015 energy legislative changes

CT legislature passed three major renewable energy bills this legislative session. As of today SB 1070, HB 6838, and SB 928 have been passed by both houses and is before the Governor Malloy for approval. He is very likely to sign all three bills into law as much of it has been put forward by his administration, especially HB 6838, which has been his signature initiative. Broadly, all these bills makes significant changes to the renewable energy policy in the State.

SB 929 authorizes the Department of Energy and Environmental Protection (DEEP) to create a pilot “shared clean energy” program. Shared renewable energy program or popularly known as community energy program allows residents to purchase a share of energy produced by a solar farm, and claim the energy and environmental benefits associated with this. This program expands the solar  (or other renewables) energy for people who do not own their own houses to put solar in the roofs, or live in situations where solar PV is not practice. A developer in the community would be able to install a large solar array, and could “sell” portion of the electricity to any residents. Purchased electricity share of the electricity from the community energy farm would be deducted from the residents electricity bill. Total amount of such community solar projects are capped at 4MW in Eversource territory and 2 MW in UIL territory.

This program however will be offered as a pilot program, and DEEP is required to analyze and offer recommendations as to the viability of making such community energy projects into a permanent program. This bill follows a very recent example of successful legislation in Maryland (HB 1087) to establish pilot community energy projects as well.

Enabling community solar projects or shared renewables is significant step towards creating energy justice as it allows people to receive benefits from solar energy previously would not have been able to because of various reasons. More solar projects will help decentralize CT’s energy sources and will enable to receive clean and affordable energy from local sources. It is perhaps a good idea that the program is capped, since the program would have otherwise have created exponential demand similar to Minnisota. Pilot program will help to figure out nut and bolts of offering such program, and given how intrinsically beneficial solar energy is, this program would surely be continued in the future.

One key attribute about such community solar projects is who is allowed own them. If it is the utility who owns and provides such service then this is would not mean change from the current status quo in the monopoly energy market (which has been popular in Virginia). However, in CT, the law allows any party to build such solar projects, which is definitely the right way to go.

SB 1078 shuffles up the responsibilities of the Board of Public Utilities (BPU) (their version of public service commission) and the Department of Energy and Environmental Protection (DEEP). This bill shifts the responsibility of procuring large scale renewable energy, demand response, and natural gas as provided in the state’s Integrated Resource Planning from the BPU to DEEP. DEEP can issue multiple solicitations to contract up to 10% of the total load served by the state’s electric companies. Renewable energy procured under this would be used for state’s RPS compliance.

I am not sure why exactly why the legislature decided to shift this responsibly from BPU to DEEP, but this would be a huge change how the energy would be procured. This model is very similar to New York where, the state agency- NYSERDA procures all the energy for RPS compliance. Maybe this is CT slowly transitioning into the NY central procurement model.

Although, the bill specifies that the utilities can use the renewable energy credits for its RPS compliance for can sell the RECs out side of state. More of REC sales analyzed in section below.

HB 6838 has been Governor’s Malloy’s signature initiative, and has been very popular in the media. The bill expands the State’s Residential Solar Investment Program’s goal to 300 MW of new residential PV by 2022, from its previous goal of 30MW by 2022. This ten fold increase in the goal would be facilitated by creating Solar Home Renewable Energy Credits (SHRECs)..( this in a state that already has LRECs, and ZRECs; a new addition to its REC alphabet soup).

CT has an unique RPS in that it does not have a solar carve out like other states. It has tried to create distinction between solar and other resources by creating Zero emission RECs (ZRECs) and Low emission RECS (LRECs) and has imposed utilities to purchase a percentage of each. This bill requires the utilities to purchase SHRECs at predetermined price, which creates a market for these SHRECs. This is very creative and impressive in that this bill effectively creates a pseudo solar carve out, in the state RPS that does not have a solar carve out.

Any residential homeowever who installs solar through participating in the Solar Investment Program offered by DEEP would forgo their rights to the environmental credits to DEEP. DEEP would then sell these SHRECs to utilities in a long term contract to generate more revenue to provide incentives to for more home solar. 

This self-funding cyclic process is great, and if you give it a thought, it appears that the all the homeowners would be paying for the solar (which they should) by a increase in their general electric bill, but if you read the bill closer, it specifies that the utilities can sell these SRECs out of state to generate revenue which then must be used to relieve the ratepayers in CT.

This bring the issue of double counting of these RECs, especially since there SHREC by law are going to be priced significantly lower than other markets. Other unique attribute about CT is its fixed Alternative Compliance Payment (ACP), which is the amount that the utilities would have to pay if they do not meet the state’s RPS goal. The law has fixed this payment to $55 MWh, which effectively provides the ceiling price for these RECs, since a utility would rather pay the ACP then purchase RECs for higher price.

So since these SHRECs can be sold out of state where they may be priced higher, this would be a significant revenue stream for CT. In a way they are funding their solar growth, it other’s back- the same way one could argue Vermont has been doing it. Vermont does not have an RPS, so most of the SRECs in VT is sold in CT, so one solar panel is being counted toward meeting Vermont’s own goal, and to meet CT RPS- effectively counting the output from the same solar panel twice.

CT although has been careful saying that the if the SHREC is used to comply with the State’s RPS then the must be retired, which is great, and limits these RECs from being double counted. But for the RECs that the utilities sell out of state, it is a little complicated.

The trouble is that CT has two goals - RPS Class I requirement, and 300 MW goal under this program. I assume most of the SHRECs will be retired for the compliance towards RPS, but there will be a lot that the utilities will just sell out of state. While this may not be used to comply with the RPS, it will be counted towards meeting this 300 MW goal- which I would argue is a kind of double counting.

But CT has been careful against possible legal challenges. It its last changes to the bill House changed the language in the bill from being a "goal" to a "cap" which I think that takes care of the double counting in a legal way. Since one could argue that there is no goal under the Residential Solar program. 

I dont mean to be critical, this bill is going to be great for home solar deployment, but it is as not tight that I would hope for; but again with one of the highest electric rates in US, the legislatures probably wanted to put in a check that the cost dont escalate further.

Anyways, this sums up little of complexity in electric markets. Electric markets natural tendency is to act like a monopoly, and for various reasonable arguments we have tried to make turn it into competitive market. This process was described as a person trying to push a large bag of spaghetti up hill- if you push on one side of the bag, the other side bulges down. This is similar to what we observe in electric market, there are just number of ways, one can shuffle around, and one has to be careful while modeling such market.

Thanking the Solar Early Adopters.

Which is a smarter economic decision- the person who buys the first ipod in the market as soon as it becomes available, or the person who waits for a year until better next generation of the product is available at a much lower price? While the person who bought the first ipod must have had compelling reasons to buy it then, one could argue that by waiting a little longer, the second person was able to get a much better product a lower price- all the person needed was a little time.

The same thing can be true in solar markets. The first generation users are the European countries including Germany, Italy, Spain, England, who starting around 2009 have aggressively pursued renewable energy. These early adopters have experimented with various financial models have achieved success and failures in a broad spectrum, all helpful in providing very insightful reasons what to do and what not to do while pursing solar. 

•   Solar Manufacturing: Their heavily subsidized market helped to activate the solar manufacturing industry, making the industries sustain while the manufacturing cost where high, while lessons were learned towards making various technological improvements and economics of scale. It basically helped to sustain solar through its initial tough times.
•     Identifying soft costs: While the manufactures were working on manufacturing challenges, people quickly realized that marketing, permitting, installation or “soft cost” consisted of a significant part of installation solar panels. This helped develop various innovative financial and  permitting techniques to minimize these soft costs help making solar panels more economical. 
•    Understanding effects of electric market: The effect of increasing solar PV on the traditional electric markets was not well understood. The traditional market include a single monopoly utility who is in charge of providing electricity usually from large generations, and are guaranteed recovery. Solar PV are small generators put in the distribution sector, and are owned by the multitude of owners. It was soon realized that the much feared “utility death spiral” where traditional utilities would slowly start to go out of business was true- unless they start to re-define their purpose in the market was soon realized. 
•     Technological challenges: This perhaps was the most important aspect of solar insurrection. While it is easy to wish and make goals for large renewable energy integration, it was unclear how much the grid would be able to handle renewable energy which are intermittent and are completely in different in nature from traditional power plants. Many were skeptic of the ability to the grid to handle solar in large capacity; many in US still do. However, we have seen industrialized countries such as Germany been able to get more than 17% of its total electricity through solar, and other countries such as Denmark where in certain instances have been able to feed all of its electric demand through renewable energy sources. This helped proved that solar and other renewable energy in fact can be integrated in the traditional grid.

How long should one wait?

Thanks to the first users, the solar industries we have been able to understand come up with ways to figure out much of the major challenges. One could argue that there is much to gain if you wait even longer time. Is the costs of solar doing to come down more in the future? Looking at historical record, and future projections, the answer is a definite yes. But how long should one wait?

The answer empirically is quite easy, one can simply analyze cost benefit of the investment and do it if there is more to gain. Cost of solar for most are the same- the material cost, and other soft cost; however benefits of solar range widely based on ideals of the individual. For many, the effect of increasing carbon is the greatest moral challenge human civilization has ever faced. For them, including the many early adopters including many European countries little extra cents in their electric bill is trivial. For the rest cost, the cost of solar panels are already at “grid parity” meaning that the cost of solar electricity is a same price as the grid. And the rest who are still skeptical, they could wait a little longer where the cost of solar PV get so low that it would be stupid not to switch to solar.

Just depending on the time frame, solar electricity will keep increasing. Technically, the world has always been powered by the Sun, yet soon enough I look forward to a time when it is fully powered by solar PV.  

Starting a energy company?

Are you thinking about starting a new energy company? or perhaps wondering about the process? Here's a brief on how can possibly go about it, including important terms and concepts in debt financing.

 

The early process of project finance beings with an entrepreneur or parent company realizing an economic opportunity. Through a back of the envelop calculation, rough estimates are made to evaluate if the project is profitable and financeable. The entrepreneur or the company determines the institutional and financial structure for the project. If they determine to proceed through project finance then an LLC is established to protect from the liabilities. The case is then presented to the utility buyer to obtain a financeable PPA through the help of a competent lawyer. The PPA is brought to the investment banker to assist secure the capital required to finance the project. The investment banker helps to obtain debt financing by matching investors to the project. The investment banker will also assist in creating a Pro Forma and other wide range of financial services required for the project finance. Through the debt financing process, because of the non-recourse nature of the project finance, the parties are interested in reducing uncertainty by appropriate risk allocation and mitigation. Some of the important stages in the project finance are provide below:

Offering memorandum: Offering memorandum is the first step in securing an investment. It contains a detailed overview of the project and participants. It includes the capital required, EPC contract, and other entities involved in the project along with their creditworthiness. Offering memo helps to solicit bids from the lenders to obtain the capital.

Commitment Letter: After you have a lead bank, you then arrange to put together the letter of intent or the commitment letter. Commitment letter is a negotiating document that includes the

terms and conditions that need to be met to get a loan. This is subject to the due diligence to the parties.

Credit Agreement: Credit Agreement is the second most important document in project finance after the PPA. It includes the terms and conditions of the loan, including how the loan is dispersed, interest rate and other important factors of the loan. Credit Agreement takes place after the borrower fulfills the obligations in the commitment letter.

Construction Contract: Construction contract is the biggest part of the project finance. The construction contract can either be turnkey, or EPC model. The three most important factors during construction are Price, Performance and Schedule. It is crucial for the plant to be build at specified cost, with specified performance levels before the COD. It is important to select a creditworthy construction contract, who have the credit to support obligations of the contract or have parent guarantee. The contract price should offer sufficient risk premium for the contractor to build the project as specified on the contract. The construction ends on substantial completion where the company takes the ownership of the project.

Security Documents: It is the project collateral that secures the loan and provides guarantees to pay back the funds. The lender is concerned with ensuring that they have sufficient authority to oversee or in need step in and take over the project in event of default. The contract could also include performance bonds and collateral warranties to protect from the losses in termination of the project.

Representation: It is the statement made by the contracting party stating that the fact provided is correct on the date made. Every time there is a reissuance of the contract, it is important to re-represent to know that nothing has changed. This process helps the parties to provides incentive not to deviate from the previously agreed contract.

Legal Opinions: Legal opinions are formal statements from the lawyers based on their legal knowledge and review of the facts that the information provided is true. This provides a backing of the representation. There legal opinions can be classified into 3 types - “would, could and should” types. Legal opinions is one of most valued documents in project finance since it provides reassurance to the lenders.

Covenants: Covenants are agreements or promises the company agrees to perform specified tasks in the future. The covenants would be either affirmative (agree to perform) or negative (withhold from certain action). Violating a covenant can lead to default under which the lender has the rights to undertake corrective measures.

Event of a Default: Any breach of rep, or covenants, bankruptcy, breach of credit support can lead to default. The contract includes remedies for default which provides steps to fix the breach through liquidated damages, termination of the contract, payment of direct or other measures. The final step is the foreclosure where the assets of the company is put up for sale to recoup the loan.

Although project finance offers significant challenge in terms of coordination, allocating risks and reducing uncertainty, the success can be rewarding. As the project building is completed and starts to generate predicted cash flows, the company can assign a developmental fee that the lender would be willing to finance as cost of the project.